Quiz: Introduction to Derivatives and Hedging — 22 questions

1. What best describes a derivative contract?

A. A contract whose value depends on an underlying asset

B. A contract whose payoff is unrelated to market prices

C. A contract that is traded only on organized exchanges

D. A contract that guarantees a fixed profit to both parties

Answer: (A)

Explanation

A derivative derives its value from an underlying asset and transfers risk between parties. It does not create value independently of the underlying.

2. Which feature distinguishes a futures contract from a forward contract?

A. It is exchange-traded and settled daily through a clearinghouse

B. It gives the holder the right, but not the obligation, to trade later

C. It has no obligation for either party to perform

D. It is privately negotiated and settled only at maturity

Answer: (A)

Explanation

Futures are standardized exchange-traded contracts that are marked to market daily through a clearinghouse. Forwards are OTC agreements settled at maturity.

3. When a forward is overpriced relative to fair value, which strategy creates a riskless profit?

A. Short the spot asset and short the forward

B. Borrow to buy the spot asset and sell the forward

C. Sell the spot asset and buy the forward

D. Buy the forward and hold cash until maturity

Answer: (B)

Explanation

This is cash-and-carry arbitrage: borrow, buy spot, and sell the expensive forward. The locked-in profit comes from the gap between the market forward price and fair value.

4. In the gold example with spot 1200, interest rate 3%, and forward price 1300, what is the arbitrage profit per ounce?

A. 36 per ounce

B. 64 per ounce

C. 76 per ounce

D. 30 per ounce

Answer: (B)

Explanation

Fair value is 1200 × 1.03 = 1236, so the overpriced forward creates a profit of 1300 − 1236 = 64 per ounce. The strategy earns that spread after repaying the loan.

5. Ignoring the option premium, what is the payoff pattern of a put option buyer?

A. The payoff is negative whenever the underlying price rises

B. The payoff is never negative because the holder can choose not to exercise

C. The payoff is always zero unless the option is exercised early

D. The payoff is always positive because the holder has a guaranteed gain

Answer: (B)

Explanation

A put buyer has the right, not the obligation, to sell at the strike, so the holder can avoid a loss by not exercising. That makes the payoff nonnegative before premium is considered.

6. What is the break-even stock price for a short put with strike K and premium c?

A. K plus c

B. K minus c

C. K divided by c

D. c minus K

Answer: (B)

Explanation

For a short put, break-even occurs when the premium received exactly offsets the option’s eventual obligation, which is at K − c. This is the stock price where profit is zero at expiration.

7. Which market participant uses derivatives mainly to reduce an existing risk exposure?

A. A hedger

B. A market maker

C. A speculator

D. A short seller

Answer: (A)

Explanation

A hedger uses derivatives to offset losses from an existing exposure and reduce overall risk. A speculator mainly seeks profit from price movements.

8. Why do options usually have nonzero value at initiation?

A. Because the seller must always deliver the underlying immediately

B. Because the payoff is guaranteed to be positive

C. Because the buyer pays a premium at trade time

D. Because the strike price is reset after trade execution

Answer: (C)

Explanation

Options are not free; the buyer pays a premium up front, so the contract has value at initiation. The seller receives that premium in exchange for taking on the obligation.

9. What is the main reason futures contracts have very low counterparty credit risk?

A. They are never exposed to price changes before expiration

B. They can only be traded by banks and insurers

C. A clearinghouse settles gains and losses daily through mark-to-market

D. They are always fully prepaid at the start of the contract

Answer: (C)

Explanation

Daily settlement through a clearinghouse means gains and losses are realized continuously, which greatly limits credit exposure. This is a key difference from most OTC forwards.

10. When does open interest in a futures market increase?

A. When both parties open new positions

B. When both parties close existing positions

C. When the settlement price changes

D. When volume exceeds open interest

Answer: (A)

Explanation

Open interest rises only when a new long and a new short are created together. It falls when both sides close positions, and it is not the same as trading volume.

11. What triggers a margin call on a futures position?

A. When the settlement price equals the strike price

B. When the margin account balance falls below the maintenance margin

C. When the futures contract reaches expiration

D. When the trader has an unrealized gain on the position

Answer: (B)

Explanation

A margin call occurs when the margin account drops below the maintenance margin, requiring the trader to add funds. The account is then typically restored to the initial margin level.

12. What is daily mark-to-market in a futures contract?

A. The final settlement of gains and losses only at expiration

B. The daily payment of the full contract value between the two parties

C. The process of matching a futures contract to a different underlying asset

D. The daily revaluation of the position using the settlement price and updating the margin account

Answer: (D)

Explanation

Daily mark-to-market means the contract is revalued each day at the settlement price, and gains or losses are posted to the margin account. It is not deferred until expiration like a forward.

13. Why does a long futures hedge still face basis risk?

A. Because the underlying asset cannot be sold at maturity

B. Because the hedge ratio must always equal one

C. Because futures prices are not publicly observed

D. Because the final basis at close-out is uncertain

Answer: (D)

Explanation

Basis risk comes from uncertainty in the final basis, which affects the realized hedge outcome. Even with a futures hedge, changes in basis can make the effective price differ from the initial futures price.

14. If the basis strengthens during the life of a hedge, which outcome is correct?

A. It improves the outcome for a short hedge and worsens the outcome for a long hedge

B. It improves the outcome for both long and short hedges

C. It worsens the outcome for a short hedge and improves the outcome for a long hedge

D. It has no effect because basis changes are fully offset by futures prices

Answer: (A)

Explanation

When basis strengthens, the realized hedge result is better for a short hedge and worse for a long hedge. This reflects how changes in basis alter the effective price paid or received.

15. What is cross hedging?

A. Hedging only with contracts that mature on the same date as the exposure

B. Buying the exact same asset in the spot market to offset price risk

C. Using options instead of futures to avoid all basis risk

D. Using a futures contract on a different underlying asset than the one being hedged

Answer: (D)

Explanation

Cross hedging uses a futures contract on a related but different underlying asset, such as hedging jet fuel with crude oil futures. This is done when an exact futures match is unavailable.

16. How is the minimum variance hedge ratio calculated?

A. As the premium divided by the strike price

B. As the difference between spot and futures prices divided by the contract size

C. As correlation times the ratio of spot volatility to futures volatility

D. As the exposure size divided by the initial margin

Answer: (C)

Explanation

The minimum variance hedge ratio is computed as h* = ρ × (σS/σF). It uses correlation and relative volatility to choose hedge strength.

17. For an equity portfolio hedged with index futures, what is the main purpose of setting the target beta to zero?

A. To eliminate all idiosyncratic stock-specific risk

B. To guarantee a profit regardless of market direction

C. To convert the portfolio into a futures-only position

D. To remove systematic market risk from the portfolio

Answer: (D)

Explanation

Setting target beta to zero aims to neutralize exposure to broad market movements, leaving mostly stock-specific return. It does not eliminate idiosyncratic risk.

18. How many index futures contracts should be shorted to hedge a $1,500,000 portfolio with beta 1.3 when each contract is worth $75,000 and the target beta is zero?

A. 20 contracts

B. 18 contracts

C. 26 contracts

D. 52 contracts

Answer: (C)

Explanation

The hedge uses N* = (β − β*) × (P/F) = 1.3 × (1,500,000/75,000) = 26. Shorting these contracts helps neutralize market exposure.

19. What is the intrinsic value of a call option?

A. max(K - S, 0)

B. The amount of time remaining until expiration

C. max(S - K, 0)

D. Option premium minus strike price

Answer: (C)

Explanation

A call’s intrinsic value is the immediate exercise value, which is max(S − K, 0). This value is never negative.

20. What is the key difference between a European option and an American option?

A. An American option can only be exercised at expiration, while a European option can be exercised anytime

B. A European option is always more valuable because it is less flexible

C. A European option can be exercised only at expiration, while an American option can be exercised any time up to expiration

D. A European option has no time value, while an American option always does

Answer: (C)

Explanation

European options are exercisable only at expiration, whereas American options can be exercised at any time through expiration. The extra flexibility of American-style exercise is the defining difference.

21. Which statement best describes a protective put position?

A. Buying a call and a put on the same stock to profit from volatility

B. Selling a put on stock you already own to collect premium income

C. Setting a stop-loss order to automatically exit at a fixed price

D. Buying a put on stock you already own to limit downside risk

Answer: (D)

Explanation

A protective put combines stock ownership with a long put, giving the investor the right to sell at the strike price and limit losses. A stop-loss reduces risk differently because it does not provide an option-like floor.

22. What is the expiration profit formula for a long put with strike K and premium p?

A. max(S_T - K, 0) - p

B. S_T - K + p

C. max(K - S_T, 0) - p

D. K - S_T + p

Answer: (C)

Explanation

A long put pays off when the stock ends below the strike, so its payoff is max(K - S_T, 0), and the premium is then subtracted to get profit. The premium shifts the breakeven to K - p.