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risk management financial

Questions and Answers of Risk Management Financial

5. Demonstrate how interest rate futures can be used to hedge.
4. Explain the basis risk associated with hedging.
3. Explain what hedging and cross hedging are.
2. Explain the basic principles of controlling risk with interest rate futures.
1. Describe the preliminary steps in any risk control strategy.
22. The binomial method can be used to value a cap or a floor by valuing the cap or floor for each period and then summing these values.
21. If an option is viewed as one in which the underlying is an interest rate, then buying a cap is equivalent to buying a package of calls on interest rates and buying a floor is equivalent to
20. Buying a cap is equivalent to buying a package of puts on a fixedincome security and buying a floor is equivalent to buying a package of calls on a fixed-income security.
19. In an interest rate cap and floor, the buyer pays an upfront fee, which represents the maximum amount that the buyer can lose and the maximum amount that the seller of the agreement can gain.
18. An interest rate collar can be created by buying an interest rate cap and selling an interest rate floor.
17. The terms of a cap and floor set forth the reference rate, the strike rate, the length of the agreement, the frequency of reset, and the notional principal amount.
16. An interest rate floor is an agreement whereby the seller agrees to pay the buyer if the reference rate is below the strike rate.
15. An interest rate cap is an agreement whereby the seller agrees to pay the buyer if the reference rate exceeds the strike rate.
14. The back fee for a compound option is the fee paid by the buyer if the option is exercised.
13. The front fee for a compound option is the initial payment that the buyer makes.
12. A compound option (also called a split-fee option) is an option to purchase an option.
11. The put-call parity relationship is satisfied by the binomial model.
10. The put-call parity relationship is the pricing relationship between the price of a call option and the price of a put option on the same underlying instrument, with the same strike price and the
9. The arbitrage-free binomial model allows for the consistent pricing of Treasury bonds, Treasury bond futures, and options on Treasury bonds.
8. The arbitrage-free binomial model is the proper model to value options on fixed-income securities since it takes into account the yield curve.
7. Two common spread options are options on the yield curve and options on the spread between mortgages and Treasuries.
6. Spread options can be structured with a payoff that is either cash settled or requires an exchange of ownership of the two securities underlying the option.
5. There are OTC options on the spread between two yields.
4. There are OTC options on specific securities.
3. An OTC option can be created whereby the buyer pays the premium at the expiration date.
2. An OTC option can be created in which the buyer may exercise prior to the expiration date but only on designated dates (so called modified American or Atlantic or Bermuda options).
1. OTC interest rate options are customized by dealers for their clients in terms of the expiration date, the underlying, and the type of exercise.
6. Demonstrate how caps and floors can be valued using the binomial model.
5. Describe what a cap and a floor are and how they can be used to create a collar.
4. Describe what a compound option is.
3. Explain how the binomial model can be extended to value futures options.
2. Demonstrate how to value an option on a fixed-income security using the binomial model.
1. Describe the different types of OTC options and how they can be structured.
23. The duration of an interest rate option is a measure of its price sensitivity to small changes in interest rates and depends on the option’s delta, the option’s leverage, and the duration of
22. The vega of an option measures the dollar price change in the price of the option for a 1% change in expected yield volatility.
21. The theta of an option measures the change in the option price as the time to expiration decreases.
20. The gamma of an option measures the rate of change of delta as the price of the underlying bond changes.
19. The delta of an option measures how sensitive the option price is to changes in the price of the underlying bond and varies from zero (for call options deep out of the money) to one (for call
18. Managers need to know how sensitive an option’s value is to changes in the factors that affect the value of an option.
17. Failure to take into account the yield curve can result in an inconsistent valuation of bonds, bond futures, and futures options.
16. The Black model and the Adesi-Barone and Whaley model were originally developed for equities and as a result did not take into account the Treasury yield curve.
15. The Black model was extended by Adesi-Barone and Whaley to futures options that are of the American type.
14. The Black model is used for valuing futures options but is limited because it deals with European-type options.
13. Several assumptions of the Black-Scholes model limit its use in pricing options on interest rate instruments and futures options.
12. With the exception of the short-term risk-free interest rate, how an option changes when one of the factors changes is the same for futures options and options on fixed-income instruments.
11. With the exception of the coupon interest payment, the value of a futures option is affected by the same factors that affect an option on a fixed-income instrument.
10. The six factors that affect the value of an option on a fixedincome instrument are the current price of the underlying security, the strike price, the time to expiration of the option, the
9. The value of an option is composed of its intrinsic value and its time value.
8. The Chicago Board of Trade has introduced customized futures options called flexible Treasury futures options.
7. Futures options are usually American-type options.
6. The only actively-traded exchange-traded options are futures options.
5. There are exchange-traded options and over-the-counter options.
4. Interest rate options include options on fixed-income securities and options on interest rate futures contracts, called futures options.
3. A call option allows the option buyer to purchase the underlying from the option writer at the strike price; a put option allows the option buyer to sell the underlying to the option writer at the
2. The option buyer pays the option writer (seller) a fee, called the option price.
1. An option is a contract in which the writer of the option grants the buyer the right, but not the obligation, to purchase from or sell to the writer something at a specified price within a
9. Explain how to estimate the duration of an option.
8. Explain how to measure the sensitivity of an option to changes in the factors that affect its value.
7. Discuss the limitations of applying the Black-Scholes pricing model to value futures options and options on fixed-income instruments.
6. Explain the two components of the option price and the factors that affect the value of an option.
5. Explain the risk and return characteristics for basic option positions.
4. Review the various futures options currently traded.
3. Describe what futures options are, their trading mechanics, and the reasons for their popularity.
2. Explain the differences between options and futures.
1. Describe the basic features of options contracts.
17. The key factors that impact a swaption’s value are the yield curve, volatility, strike rate, and time to expiration.
16. The lattice approach is a commonly used method to value swaptions.
15. Swaptions are options to establish a position in an interest rate swap at some future date.
14. The net present value of all cash flows is the fair price for canceling a swap.
13. Nongeneric swaps include constant maturity, accreting/amortizing, zero-coupon, Libor-in-arrears, basis, margin, off-market, differential and forward-start.
12. The swap spread is the spread over the Treasury par curve specified at the initiation of the swap that the fixed-rate payer must pay.
11. The value of an existing swap is equal to the difference in the present value of the two payments.
10. The discount rates used to calculate the present value of the cash flows in a swap are forward rates.
9. In a Libor-based swap, the cash flow of the floating-rate side is determined from the Eurodollar CD futures contract.
8. The swap rate is determined by finding the rate that will make the present value of the cash flow of both sides of the swap equal.
7. The convention that has evolved for quoting swap levels is that a swap dealer sets the floating rate equal to the reference rate and then quotes the fixed rate that will apply.
6. A swap position can be interpreted as either a package of forward contracts or a package of cash flows from buying and selling cash market instruments.
5. The default risk in a swap agreement is called counterparty risk.
4. Interest rate swaps are over-the-counter instruments.
3. The most common reference rate for the floating-rate payments is Libor.
2. In a generic interest rate swap, one party agrees to make fixed-rate payments and receive floating-rate payments while the counterparty agrees to make floating-rate payments and receive fixed-rate
1. An interest rate swap is an agreement between two parties to exchange interest payments at designated times in the future based on a notional principal amount.
9. Explain the important elements of swaption valuation.
8. Explain what a swaption is.
7. Describe several types of non-generic swaps.
6. Explain the primary determinants of swap spreads.
5. Demonstrate how the value of a swap is determined.
4. Demonstrate how the swap rate is determined.
3. Explain swap terminology, conventions, and market quotes.
2. Explain how a swap should be interpreted.
1. Explain what a generic interest rate swap is.
26. In contrast to an interest rate futures contract, the buyer of an FRA benefits if the reference rate increases and the seller benefits if the reference rate decreases.
25. The amount that must be exchanged at the settlement date is the present value of the interest differential.
24. The buyer of an FRA is agreeing to pay the FRA rate and the seller of the FRA is agreeing to receive the FRA rate.
23. The elements of an FRA are the FRA rate, reference rate, notional amount, contract period, and settlement date.
22. A forward rate agreement is an over-the-counter derivative instrument which is essentially a forward-starting loan, but with no exchange of principal, so the cash exchanged between the
21. For a Treasury bond futures contract, the delivery options granted to the short reduce the theoretical futures price below the theoretical futures price suggested by the standard arbitrage model.
20. The standard arbitrage model must be modified to take into consideration the nuances of particular futures contracts.
19. The shape of the yield curve affects the cost of carry.
18. The cost of carry is equal to the cost of financing the position less the cash yield on the underlying security.

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