Question 1

Basis risk:

Accepted Answer

Basis risk is the risk that the difference between the futures or forward price and the spot price will widen or narrow unexpectedly, leading to unexpected gains or losses. Therefore, option B is the correct choice as it says basis risk is the degree to which the futures or forward price is unpredictable. Option A is incorrect as it defines basis as the difference between the discounted futures price and the spot price. Option C is incorrect as it defines basis as the sum of the futures price and the spot price. Option D is incorrect as it does not accurately describe the source of basis risk.

Question 2

A one-year futures contract is riskier than a one-year forward contract because:

Accepted Answer

Futures contracts are marked-to-market daily, meaning that gains or losses are settled daily. This increases the level of risk for futures contracts as compared to forward contracts, which are settled at maturity.

Question 3

Which of the following is true of the tailing of the hedge?

Accepted Answer

Tailing of the hedge involves adjusting the hedge ratio to account for factors like the convenience yield. When hedging with futures, the convenience yield can affect the degree of tailing needed.

Question 4

What is basis risk? What are the sources of basis risk?

Accepted Answer

The answer of What is basis risk? What are the...

Question 5

Which of the following is a fundamental problem associated with futures contracts in hedging?

Accepted Answer

Most futures contracts have relatively short maturities, which can be a fundamental problem for hedging long-term commitments because it may be difficult to find contracts that match the duration of the exposure being hedged.

Question 6

In an off-market contract:

Accepted Answer

In an off-market contract, cash is typically exchanged at the contract's inception. The other options are not necessarily true. There still may be a chance of arbitraging, an exchange may not necessarily act as an intermediary, and there may be obligations on either the buyer or the seller.

Question 7

Compare and contrast simulation method and regression method.

Accepted Answer

The answer of Compare and contrast simulation method and regression...

Question 8

Which of the following is true of value at risk (VAR)?

Accepted Answer

Value at risk (VAR) is the maximum loss that a financial asset or portfolio can suffer with a given probability over a given time horizon, under normal market conditions. It is typically expressed as a specific dollar amount or percentage of the portfolio's value. Therefore, option D, which defines VAR as the worst loss possible under normal market conditions for a given time horizon, is the correct answer. Option A is incorrect because VAR can be applied at any significance level, not just 5%. Option B is incorrect because the normal distribution curve of VAR becomes more concentrated (narrower and higher) as the time horizon shortens. Option C is incorrect because the percentage of the portfolio invested in risk-free assets is not related to VAR.

Question 9

A money market hedge:

Accepted Answer

A money market hedge involves borrowing one currency on a short-term basis and converting it to another currency immediately.

Question 10

_____ is the practice of selling less than one financial contract to hedge one unit of the spot asset.

Accepted Answer

Tailing the hedge is the practice of selling less than one financial contract to hedge one unit of the spot asset. This is done when the size of the financial contract available is larger than the size of the spot asset being hedged.

Question 11

Which of the following is a correct property of variance in hedging with regression?

Accepted Answer

The answer of Which of the following is a correct...

Question 12

Which of the following is true of the comparison between simulation and regression?

Accepted Answer

Simulation often involves more subjective decisions, such as choosing which variables to include and how to model their interactions, compared to regression analysis which relies more on historical data and statistical methods.

Question 13

Which of the following is true of convenience yield?

Accepted Answer

Convenience yield is the benefit or premium from holding an inventory of a commodity net of its direct storage costs. It is not related to financial instruments such as forward contracts and options. Option A is incorrect. Option C is partially correct but is not a complete definition of convenience yield. Option D is also incorrect as the choice of futures or forward contracts used to hedge the commodity may depend on the date of the future obligation.

Question 14

The size of the position per unit of the underlying asset or commodity that achieves minimum risk is known as the _____.

Accepted Answer

The size of the position per unit of the underlying asset or commodity that achieves minimum risk is known as the hedge ratio. A rolling hedge refers to a hedging strategy where an investor takes a position in a futures contract that is about to expire and then closes that position by opening a new one in a contract with a later expiration date. A hedgelet is not a commonly used term in finance. An asset ratio is not a term commonly used in the context of hedging.

Question 15

Explain how forward contracts are used to hedge currency obligations.

Accepted Answer

The answer of Explain how forward contracts are used to...

Question 16

Hedging with regression can be viewed as a:

Accepted Answer

Hedging with regression involves finding the coefficients of a linear regression model to minimize the variance of the hedging position. This is a special case of minimizing variance hedging. As the question states that the hedging instrument is costless, the answer is B. If the hedging instrument were costly but risk-free, the answer would be D.

Question 17

In a covered option strategy:

Accepted Answer

In a covered option strategy, one option is issued or bought per unit of the asset or liability generating the risk exposure, typically to hedge or cover the risk associated with holding the underlying asset.

Question 18

Which of the following is true of hedging with interest rate swaps?

Accepted Answer

The present value of the floating side of an interest rate swap resets with each payment, aligning closely with current interest rates, thus exhibiting minimal sensitivity to interest rate changes.

Question 19

Define convenience yield.

Accepted Answer

The answer of Define convenience yield....

Quiz 22: The Practice of Hedging