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CISI – Derivatives Level 3 (Capital Markets Programme) Quiz 08 is completed –
understand the importance of hedging ratios in cheapest to deliver bonds (CTDs): • price factors • highest implied repo rate • number of contracts to hedge an exposure to the CTD bond • duration based hedge ratios for nonCTD bonds
understand hedge ratio calculation for other shortterm interest rate futures: • basis point value • number of contracts to hedge an interest rate exposure
understand hedge ratio calculation for equity futures: • stock and portfolio beta • number of contracts to hedge an equity exposure
understand basis, basis trading and basis risk: • problems caused by changes in basis • how changes in basis can be used to advantage by an investor
understand the application and effects of delta hedging and be able to establish an investor’s net long / short position
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Question 1 of 30
1. Question
Suppose an investor wants to hedge against the risk of falling stock prices. Which derivatives strategy would be most suitable for this purpose?
Correct
Explanation:
To hedge against the risk of falling stock prices, an investor should consider buying put options. Put options give the holder the right to sell the underlying asset at a predetermined price (the strike price) within a specified period. By buying put options, the investor can protect their portfolio from potential losses resulting from declining stock prices.Incorrect
Explanation:
To hedge against the risk of falling stock prices, an investor should consider buying put options. Put options give the holder the right to sell the underlying asset at a predetermined price (the strike price) within a specified period. By buying put options, the investor can protect their portfolio from potential losses resulting from declining stock prices. 
Question 2 of 30
2. Question
Which characteristic distinguishes a long position from a short position in derivatives trading?
Correct
Explanation:
In derivatives trading, a long position profits from price increases in the underlying asset, while a short position profits from price decreases. Long positions involve buying contracts with the expectation that their value will increase, whereas short positions involve selling contracts with the expectation that their value will decrease.Incorrect
Explanation:
In derivatives trading, a long position profits from price increases in the underlying asset, while a short position profits from price decreases. Long positions involve buying contracts with the expectation that their value will increase, whereas short positions involve selling contracts with the expectation that their value will decrease. 
Question 3 of 30
3. Question
Suppose an investor wants to hedge against interest rate risk using shortterm interest rate futures. Which factor determines the number of contracts needed to hedge the exposure?
Correct
Explanation:
The number of contracts needed to hedge an interest rate exposure using shortterm interest rate futures is determined by the basis point value. The basis point value represents the change in the value of the futures contract for a onebasispoint change in interest rates. By calculating the basis point value, investors can determine the appropriate number of contracts required to hedge their exposure effectively.Incorrect
Explanation:
The number of contracts needed to hedge an interest rate exposure using shortterm interest rate futures is determined by the basis point value. The basis point value represents the change in the value of the futures contract for a onebasispoint change in interest rates. By calculating the basis point value, investors can determine the appropriate number of contracts required to hedge their exposure effectively. 
Question 4 of 30
4. Question
In the context of shortterm interest rate futures, what does the term “hedge ratio” refer to?
Correct
Explanation:
In shortterm interest rate futures, the hedge ratio refers to the ratio of the number of contracts to the basis point value. It represents the relationship between the interest rate exposure being hedged and the value of the futures contracts. By calculating the hedge ratio, investors can determine the appropriate number of contracts needed to offset their interest rate risk.Incorrect
Explanation:
In shortterm interest rate futures, the hedge ratio refers to the ratio of the number of contracts to the basis point value. It represents the relationship between the interest rate exposure being hedged and the value of the futures contracts. By calculating the hedge ratio, investors can determine the appropriate number of contracts needed to offset their interest rate risk. 
Question 5 of 30
5. Question
Ms. Rodriguez holds a portfolio of fixedincome securities and wants to hedge against potential interest rate fluctuations. Which factor should Ms. Rodriguez consider when calculating the hedge ratio for shortterm interest rate futures?
Correct
Explanation:
When calculating the hedge ratio for shortterm interest rate futures, Ms. Rodriguez should consider the duration of the securities in her portfolio. Duration measures the sensitivity of the securities’ prices to changes in interest rates. By matching the duration of the securities with the duration of the futures contracts, Ms. Rodriguez can effectively hedge against interest rate risk.Incorrect
Explanation:
When calculating the hedge ratio for shortterm interest rate futures, Ms. Rodriguez should consider the duration of the securities in her portfolio. Duration measures the sensitivity of the securities’ prices to changes in interest rates. By matching the duration of the securities with the duration of the futures contracts, Ms. Rodriguez can effectively hedge against interest rate risk. 
Question 6 of 30
6. Question
Which of the following formulas represents the calculation of the basis point value (BPV) for shortterm interest rate futures?
Correct
Explanation:
The basis point value (BPV) for shortterm interest rate futures is calculated as the ratio of the contract size to the change in futures price. It represents the change in the value of the futures contract for a onebasispoint change in interest rates. By calculating the BPV, investors can determine the sensitivity of the futures contract to changes in interest rates.Incorrect
Explanation:
The basis point value (BPV) for shortterm interest rate futures is calculated as the ratio of the contract size to the change in futures price. It represents the change in the value of the futures contract for a onebasispoint change in interest rates. By calculating the BPV, investors can determine the sensitivity of the futures contract to changes in interest rates. 
Question 7 of 30
7. Question
Suppose an investor wants to hedge against rising interest rates using shortterm interest rate futures. Which hedge ratio would be most appropriate for this purpose?
Correct
Explanation:
When hedging against rising interest rates using shortterm interest rate futures, the hedge ratio should be greater than 1.0. This means that the investor would take a larger short position in the futures contracts relative to the exposure being hedged. A hedge ratio greater than 1.0 provides greater protection against potential losses resulting from the increase in interest rates.Incorrect
Explanation:
When hedging against rising interest rates using shortterm interest rate futures, the hedge ratio should be greater than 1.0. This means that the investor would take a larger short position in the futures contracts relative to the exposure being hedged. A hedge ratio greater than 1.0 provides greater protection against potential losses resulting from the increase in interest rates. 
Question 8 of 30
8. Question
Which factor determines the number of contracts needed to hedge an interest rate exposure using shortterm interest rate futures?
Correct
Explanation:
The number of contracts needed to hedge an interest rate exposure using shortterm interest rate futures is determined by the duration of the bond. Duration measures the sensitivity of the bond’s price to changes in interest rates. By matching the duration of the bond with the duration of the futures contracts, investors can effectively hedge against interest rate risk.Incorrect
Explanation:
The number of contracts needed to hedge an interest rate exposure using shortterm interest rate futures is determined by the duration of the bond. Duration measures the sensitivity of the bond’s price to changes in interest rates. By matching the duration of the bond with the duration of the futures contracts, investors can effectively hedge against interest rate risk. 
Question 9 of 30
9. Question
Suppose an investor wants to hedge against the risk of a decline in the stock market using equity futures. Which factor should the investor consider when calculating the hedge ratio?
Correct
Explanation:
When calculating the hedge ratio for equity futures, investors should consider the stock’s beta coefficient. Beta measures the sensitivity of a stock’s returns to changes in the overall market. By matching the hedge ratio to the stock’s beta, investors can effectively hedge their exposure to market risk using equity futures.Incorrect
Explanation:
When calculating the hedge ratio for equity futures, investors should consider the stock’s beta coefficient. Beta measures the sensitivity of a stock’s returns to changes in the overall market. By matching the hedge ratio to the stock’s beta, investors can effectively hedge their exposure to market risk using equity futures. 
Question 10 of 30
10. Question
Ms. Garcia holds a diversified portfolio of stocks and wants to hedge against market risk using equity futures. Which factor should Ms. Garcia consider when determining the number of contracts needed for hedging?
Correct
Explanation:
When determining the number of contracts needed for hedging with equity futures, Ms. Garcia should consider the beta coefficients of the stocks in her portfolio. Beta measures the stocks’ sensitivity to market movements. By adjusting the hedge ratio based on the beta coefficients, Ms. Garcia can effectively hedge her portfolio against market risk using equity futures.Incorrect
Explanation:
When determining the number of contracts needed for hedging with equity futures, Ms. Garcia should consider the beta coefficients of the stocks in her portfolio. Beta measures the stocks’ sensitivity to market movements. By adjusting the hedge ratio based on the beta coefficients, Ms. Garcia can effectively hedge her portfolio against market risk using equity futures. 
Question 11 of 30
11. Question
Which of the following formulas represents the calculation of the hedge ratio for equity futures?
Correct
Explanation:
The hedge ratio for equity futures is calculated as the ratio of the portfolio value to the stock’s beta coefficient. This formula helps investors determine the number of futures contracts needed to hedge their exposure to market risk based on the beta of the stocks in their portfolio.Incorrect
Explanation:
The hedge ratio for equity futures is calculated as the ratio of the portfolio value to the stock’s beta coefficient. This formula helps investors determine the number of futures contracts needed to hedge their exposure to market risk based on the beta of the stocks in their portfolio. 
Question 12 of 30
12. Question
Suppose an investor has a portfolio with a beta of 1.5 and wants to hedge against market risk using equity futures. If the value of the portfolio is $500,000, how many contracts should the investor buy if each contract covers $50,000 worth of stocks?
Correct
Explanation:
To calculate the number of contracts needed, we use the formula:
Number of Contracts=Portfolio ValueContract Size×Stock Beta
Number of Contracts=
Contract Size×Stock Beta
Portfolio Value
Substituting the given values:
Number of Contracts=500,00050,000×1.5=10
Number of Contracts=
50,000×1.5
500,000
=10
So, the investor should buy 10 contracts to hedge against market risk.Incorrect
Explanation:
To calculate the number of contracts needed, we use the formula:
Number of Contracts=Portfolio ValueContract Size×Stock Beta
Number of Contracts=
Contract Size×Stock Beta
Portfolio Value
Substituting the given values:
Number of Contracts=500,00050,000×1.5=10
Number of Contracts=
50,000×1.5
500,000
=10
So, the investor should buy 10 contracts to hedge against market risk. 
Question 13 of 30
13. Question
Mr. Thompson has a portfolio with a beta of 0.8 and wants to hedge against market risk using equity futures. If the stock index futures contract size is $100,000 and the futures price is $2,000 per contract, how many contracts should Mr. Thompson buy?
Correct
Explanation:
Using the hedge ratio formula:
Number of Contracts=Portfolio ValueContract Size×Stock Beta
Number of Contracts=
Contract Size×Stock Beta
Portfolio Value
Substituting the given values:
Number of Contracts=500,000100,000×0.8=6
Number of Contracts=
100,000×0.8
500,000
=6
So, Mr. Thompson should buy 6 contracts to hedge against market risk.Incorrect
Explanation:
Using the hedge ratio formula:
Number of Contracts=Portfolio ValueContract Size×Stock Beta
Number of Contracts=
Contract Size×Stock Beta
Portfolio Value
Substituting the given values:
Number of Contracts=500,000100,000×0.8=6
Number of Contracts=
100,000×0.8
500,000
=6
So, Mr. Thompson should buy 6 contracts to hedge against market risk. 
Question 14 of 30
14. Question
Which of the following statements regarding the hedge ratio for equity futures is true?
Correct
Explanation:
The hedge ratio for equity futures is directly proportional to the stock’s beta coefficient. A higher beta implies a higher sensitivity to market movements, leading to a higher hedge ratio. By adjusting the hedge ratio based on the stock’s beta, investors can effectively hedge their exposure to market risk using equity futures.Incorrect
Explanation:
The hedge ratio for equity futures is directly proportional to the stock’s beta coefficient. A higher beta implies a higher sensitivity to market movements, leading to a higher hedge ratio. By adjusting the hedge ratio based on the stock’s beta, investors can effectively hedge their exposure to market risk using equity futures. 
Question 15 of 30
15. Question
What does the term “basis” refer to in the context of derivatives trading?
Correct
Explanation:
In derivatives trading, the basis represents the difference between the spot price (current market price) of an underlying asset and the futures price (agreedupon price) of the same asset for a specified future date. Understanding basis is crucial for assessing the relationship between the cash market and the futures market and for implementing basis trading strategies.Incorrect
Explanation:
In derivatives trading, the basis represents the difference between the spot price (current market price) of an underlying asset and the futures price (agreedupon price) of the same asset for a specified future date. Understanding basis is crucial for assessing the relationship between the cash market and the futures market and for implementing basis trading strategies. 
Question 16 of 30
16. Question
Which situation illustrates basis risk in derivatives trading?
Correct
Explanation:
Basis risk arises when there are unexpected changes in the price difference between the cash market and the futures market. For example, a farmer may face basis risk if the actual selling price of their grain differs significantly from the futures price they used to hedge their crop. This discrepancy can lead to unexpected gains or losses for the farmer.Incorrect
Explanation:
Basis risk arises when there are unexpected changes in the price difference between the cash market and the futures market. For example, a farmer may face basis risk if the actual selling price of their grain differs significantly from the futures price they used to hedge their crop. This discrepancy can lead to unexpected gains or losses for the farmer. 
Question 17 of 30
17. Question
Mr. Thompson, an investor, notices that the basis for a particular commodity has widened significantly. What advantage could Mr. Thompson potentially gain from this situation?
Correct
Explanation:
When the basis widens significantly, it may present arbitrage opportunities for investors like Mr. Thompson. Arbitrage involves exploiting price differences between markets to make riskfree profits. Mr. Thompson could potentially profit by buying the commodity in the cash market and simultaneously selling it in the futures market (or vice versa) to capture the spread.Incorrect
Explanation:
When the basis widens significantly, it may present arbitrage opportunities for investors like Mr. Thompson. Arbitrage involves exploiting price differences between markets to make riskfree profits. Mr. Thompson could potentially profit by buying the commodity in the cash market and simultaneously selling it in the futures market (or vice versa) to capture the spread. 
Question 18 of 30
18. Question
What problem can be caused by a narrowing basis in derivatives trading?
Correct
Explanation:
A narrowing basis can reduce profit potential in derivatives trading. When the basis narrows, the difference between the spot price and the futures price decreases, limiting opportunities for profit from basis trading strategies. Traders may need to adjust their positions to adapt to changing market conditions and maintain profitability.Incorrect
Explanation:
A narrowing basis can reduce profit potential in derivatives trading. When the basis narrows, the difference between the spot price and the futures price decreases, limiting opportunities for profit from basis trading strategies. Traders may need to adjust their positions to adapt to changing market conditions and maintain profitability. 
Question 19 of 30
19. Question
Which strategy could an investor employ to mitigate basis risk in derivatives trading?
Correct
Explanation:
Hedging with options contracts can help mitigate basis risk in derivatives trading. Options provide flexibility and allow investors to protect against adverse price movements while still potentially benefiting from favorable market conditions. By using options to hedge against basis risk, investors can limit their downside exposure while retaining the potential for upside gains.Incorrect
Explanation:
Hedging with options contracts can help mitigate basis risk in derivatives trading. Options provide flexibility and allow investors to protect against adverse price movements while still potentially benefiting from favorable market conditions. By using options to hedge against basis risk, investors can limit their downside exposure while retaining the potential for upside gains. 
Question 20 of 30
20. Question
Mr. Davis, a commodities trader, observes that the basis for a particular commodity has widened significantly. What could be a possible cause of this widening basis?
Correct
Explanation:
Changes in supply and demand dynamics can cause the basis for a commodity to widen significantly. For example, unexpected changes in weather conditions affecting crop yields or geopolitical events disrupting supply chains can lead to imbalances between the cash market and the futures market, resulting in a widening basis.Incorrect
Explanation:
Changes in supply and demand dynamics can cause the basis for a commodity to widen significantly. For example, unexpected changes in weather conditions affecting crop yields or geopolitical events disrupting supply chains can lead to imbalances between the cash market and the futures market, resulting in a widening basis. 
Question 21 of 30
21. Question
In derivatives trading, what effect does a widening basis typically have on hedging effectiveness?
Correct
Explanation:
A widening basis often reduces hedging effectiveness in derivatives trading. When the basis widens, the correlation between the cash market and the futures market weakens, making it more challenging to accurately hedge against price movements. Traders may need to adjust their hedge positions or explore alternative hedging strategies to mitigate this effect.Incorrect
Explanation:
A widening basis often reduces hedging effectiveness in derivatives trading. When the basis widens, the correlation between the cash market and the futures market weakens, making it more challenging to accurately hedge against price movements. Traders may need to adjust their hedge positions or explore alternative hedging strategies to mitigate this effect. 
Question 22 of 30
22. Question
Which factor determines the number of contracts needed to hedge an equity exposure using equity futures?
Correct
Explanation:
The number of contracts needed to hedge an equity exposure using equity futures is determined by the stock’s beta. Beta measures the sensitivity of a stock’s returns to changes in the overall market. By matching the beta of the stock with the beta of the futures contracts, investors can effectively hedge their equity exposure.Incorrect
Explanation:
The number of contracts needed to hedge an equity exposure using equity futures is determined by the stock’s beta. Beta measures the sensitivity of a stock’s returns to changes in the overall market. By matching the beta of the stock with the beta of the futures contracts, investors can effectively hedge their equity exposure. 
Question 23 of 30
23. Question
Suppose an investor holds a diversified portfolio of stocks with varying betas. Which situation would most likely prompt the investor to increase the number of equity futures contracts used for hedging?
Correct
Explanation:
A decrease in the correlation among stocks in a portfolio would likely prompt the investor to increase the number of equity futures contracts used for hedging. When stocks in the portfolio become less correlated, the effectiveness of diversification decreases, increasing the need for additional hedging to manage overall portfolio risk.Incorrect
Explanation:
A decrease in the correlation among stocks in a portfolio would likely prompt the investor to increase the number of equity futures contracts used for hedging. When stocks in the portfolio become less correlated, the effectiveness of diversification decreases, increasing the need for additional hedging to manage overall portfolio risk. 
Question 24 of 30
24. Question
Ms. Parker, an investor, notices that the basis for a particular stock has narrowed significantly. What advantage could Ms. Parker potentially gain from this situation?
Correct
Explanation:
When the basis narrows significantly, it may present arbitrage opportunities for investors like Ms. Parker. Arbitrage involves exploiting price differences between markets to make riskfree profits. Ms. Parker could potentially profit by buying the stock in the futures market and simultaneously selling it in the cash market (or vice versa) to capture the spread.Incorrect
Explanation:
When the basis narrows significantly, it may present arbitrage opportunities for investors like Ms. Parker. Arbitrage involves exploiting price differences between markets to make riskfree profits. Ms. Parker could potentially profit by buying the stock in the futures market and simultaneously selling it in the cash market (or vice versa) to capture the spread. 
Question 25 of 30
25. Question
What is the primary risk associated with basis trading in derivatives markets?
Correct
Explanation:
The primary risk associated with basis trading in derivatives markets is basis risk. Basis risk arises from unexpected changes in the difference between the cash price and the futures price of an underlying asset. Traders engaging in basis trading strategies must carefully manage basis risk to avoid potential losses resulting from unfavorable basis movements.Incorrect
Explanation:
The primary risk associated with basis trading in derivatives markets is basis risk. Basis risk arises from unexpected changes in the difference between the cash price and the futures price of an underlying asset. Traders engaging in basis trading strategies must carefully manage basis risk to avoid potential losses resulting from unfavorable basis movements. 
Question 26 of 30
26. Question
When an investor engages in delta hedging, what does it primarily aim to achieve?
Correct
Explanation:
Delta hedging involves adjusting the portfolio to offset changes in the value of the underlying asset. The primary objective of delta hedging is to eliminate market risk by ensuring that the overall position remains neutral to small price movements in the underlying asset. This strategy helps protect the investor from potential losses due to adverse market fluctuations.Incorrect
Explanation:
Delta hedging involves adjusting the portfolio to offset changes in the value of the underlying asset. The primary objective of delta hedging is to eliminate market risk by ensuring that the overall position remains neutral to small price movements in the underlying asset. This strategy helps protect the investor from potential losses due to adverse market fluctuations. 
Question 27 of 30
27. Question
Ms. Smith holds a portfolio of call options on a particular stock. To delta hedge her position, what action should she take?
Correct
Explanation:
To delta hedge a portfolio of call options, Ms. Smith should sell call options on the same stock. This action allows her to offset the positive delta of the call options in her portfolio. By selling call options, she effectively reduces her net long position in the underlying stock, thereby neutralizing her market risk.Incorrect
Explanation:
To delta hedge a portfolio of call options, Ms. Smith should sell call options on the same stock. This action allows her to offset the positive delta of the call options in her portfolio. By selling call options, she effectively reduces her net long position in the underlying stock, thereby neutralizing her market risk. 
Question 28 of 30
28. Question
What is the effect of delta hedging on an investor’s exposure to market movements?
Correct
Explanation:
Delta hedging decreases an investor’s exposure to market movements. By adjusting the portfolio to maintain a neutral delta, delta hedging reduces the sensitivity of the portfolio’s value to changes in the price of the underlying asset. This helps mitigate the impact of market fluctuations on the investor’s overall position.Incorrect
Explanation:
Delta hedging decreases an investor’s exposure to market movements. By adjusting the portfolio to maintain a neutral delta, delta hedging reduces the sensitivity of the portfolio’s value to changes in the price of the underlying asset. This helps mitigate the impact of market fluctuations on the investor’s overall position. 
Question 29 of 30
29. Question
Suppose an investor has a net long position in a particular asset. Which of the following actions is consistent with delta hedging?
Correct
Explanation:
If an investor has a net long position in an asset, delta hedging involves selling call options on the same asset. Selling call options generates income and helps offset the positive delta of the investor’s long position. This action effectively reduces the investor’s exposure to market risk, helping maintain a neutral delta position.Incorrect
Explanation:
If an investor has a net long position in an asset, delta hedging involves selling call options on the same asset. Selling call options generates income and helps offset the positive delta of the investor’s long position. This action effectively reduces the investor’s exposure to market risk, helping maintain a neutral delta position. 
Question 30 of 30
30. Question
In the context of delta hedging, what does the term “delta” represent?
Correct
Explanation:
Delta represents the rate of change of the option price with respect to changes in the underlying asset price. It indicates how much the option price is expected to change for a oneunit change in the price of the underlying asset. Delta plays a crucial role in delta hedging strategies, as it determines the adjustments needed to maintain a neutral position.Incorrect
Explanation:
Delta represents the rate of change of the option price with respect to changes in the underlying asset price. It indicates how much the option price is expected to change for a oneunit change in the price of the underlying asset. Delta plays a crucial role in delta hedging strategies, as it determines the adjustments needed to maintain a neutral position.