Derivatives And Currency Management

Question 1

If the MXN/GBP rate was 1.5684 and one month later it is 1.7538, what currency has appreciated and what currency has depreciated?

Answer 1

The MXN has depreciated and the GBP appreciated

Question 2

What is basis/spread risk?

Answer 2

When a portfolio manager uses one instrument to hedge another, this can cause basis risk.

This risk reflects the fact that the price movements in the exposure being hedged and the price movements in the cross hedge instrument are not perfectly correlated

Question 3

What is a bear spread?

Answer 3

A bear spread is a combination of a long put option and a short put option on the same underlying, where the long put has a higher strike price than the short put.

Question 4

What is a bull spread?

Question 5

What is the gamma of an option?

Answer 5

Gamma measures the sensitivity of an option’s delta to a change in the underlying.

Long positions will have a positive gamma, and short positions will have a negative gamma.

The largest gamma occurs when options are trading at the money or near expiration, when the deltas of such options move quickly toward 1.0 or 0.0.

Under these conditions, the gammas tend to be largest and delta hedges are hardest to maintain.

Question 6

If you purchase a call option on GBP/USD, what currency are you buying?

Answer 6

USD

Question 7

If you purchase a put option on GBP/USD, what currency are you selling?

Answer 7

Selling USD

Question 8

What is a protective put?

Answer 8

Holding the underlying and long a put

The investor believes that the short-term share price will fall

Question 9

What is a covered call?

Answer 9

Holding the underlying while shorting a call

This generates option income and extra yield.

This reduces a position size, as the investor will miss out on upside gain

Question 10

What is a long straddle?

Answer 10

This is a volatility play

The investor does not hold the underlying, but buys a call and a put at the same strike price and expiry date

Question 11

What is a short straddle?

Answer 11

This is a volatility play

The investor does not hold the underlying, but shorts a call and a put at the same strike price and expiry date

Question 12

What is a collar?

Answer 12

A collar is a combination of protective put and covered call.

The investor will buy the underlying, buy an ATM put, sell an OTM call

This is a cheaper way of hedging (limits upside, but protects against downside, but earn premium from call)

Question 13

What are the three types of currency hedges?

Answer 13

Direct hedge; when an asset is directly hedged with a contract on the same underlying

Cross hedge; when a position in one asset is used to hedge the risk exposures of a different asset.

Macro hedge; a cross hedge that’s used at a portfolio level, particularly when individual price movements are highly correlated.

Question 14

What is a long strangle?

Answer 14

A long strangle consists of a long position in both an out-of-the-money (OTM) call and put option with the same absolute deltas, maturities, and underlying currency.

Question 15

What is a minimum variance hedge ratio?

Answer 15

A mathematical approach to determining the optimal cross hedging ratio is known as the minimum-variance hedge ratio.

When the correlation is highly positive, the ratio will be greater than one.

When the correlation is highly negative, the ratio will be less than one.

Question 16

What risk does managing interest rate liabilities with swaps create?

Answer 16

Basis/Spread risk

When using an interest rate swap to hedge, it is possible that the changes in the underlying rate of the derivative contract, and thus in the value of the swap, do not perfectly mirror changes in the value of the bond portfolio.