Derivatives Exam 2 Conceptual UPDATED
ACTUAL Exam Questions and CORRECT
Answers
Under what circumstances are (a) a short hedge and (b) a long hedge appropriate? - CORRECT
ANSWER - A short hedge is appropriate when a company owns an asset and expects to
sell that asset in the future. It can also be used when the company does not currently own the
asset but expects to do so at some time in the future. A long hedge is appropriate when a
company knows it will have to purchase an asset in the future. It can also be used to offset the
risk from an existing short position.
Explain what is meant by basis risk when futures contracts are used for hedging. - CORRECT
ANSWER - Basis risk arises from the hedger's uncertainty as to the difference between the
spot price and futures price at the expiration of the hedge.
Explain what is meant by a perfect hedge. Does a perfect hedge always lead to a better outcome
than an imperfect hedge? Explain your answer. - CORRECT ANSWER - A perfect hedge
is one that completely eliminates the hedger's risk. A perfect hedge does not always lead to a
better outcome than an imperfect hedge. It just leads to a more certain outcome. Consider a
company that hedges its exposure to the price of an asset. Suppose the asset's price movements
prove to be favorable to the company. A perfect hedge totally neutralizes the company's gain
from these favorable price movements. An imperfect hedge, which only partially neutralizes the
gains, might well give a better outcome.
Under what circumstances does a minimum-variance hedge portfolio lead to no hedging at all? -
CORRECT ANSWER - A minimum variance hedge leads to no hedging when the
coefficient of correlation between the futures price changes and changes in the price of the asset
being hedged is zero.
Give three reasons why the treasurer of a company might not hedge the company's exposure to a
particular risk. - CORRECT ANSWER - (a) If the company's competitors are not hedging,
the treasurer might feel that the company will experience less risk if it does not hedge.
(b) The shareholders might not want the company to hedge because the risks are hedged within
their portfolios.
, (c) If there is a loss on the hedge and a gain from the company's exposure to the underlying asset,
the treasurer might feel that he or she will have difficulty justifying the hedging to other
executives within the organization.
Does a perfect hedge always succeed in locking in the current spot price of an asset for a future
transaction. Explain - CORRECT ANSWER - No. Consider, for example, the use of a
forward contract to hedge a known cash inflow in a foreign currency. The forward contract locks
in the forward exchange rate- which in general different from the spot exchange rate.
Explain why a short hedger's position improves when the basis strengthens unexpectedly and
worsens when the basis weakens unexpectedly. - CORRECT ANSWER - Basis is amount
by which the spot price exceeds the futures price. A short hedger is long the asset and short
futures contracts. The value of his or her position therefore improves as the basis increases.
Similarly, it worsens as the basis decreases.
Imagine you are the treasurer of a Japanese company exporting electronic equipment to the US.
Discuss how you would design a foreign exchange hedging strategy and the arguments you
would use to sell the strategy to your fellow executives. - CORRECT ANSWER - Simple
answer to this question is the treasurer should:
1) Estimate the company's future cash flows in Japanese yen and USD
2) Enter into forward and futures contracts to lock in the exchange rate for the USD cash flows.
This is not whole story however. The company should examine whether the magnitude of the
foreign cash flows depend on the exchange rate. For example, will the company be able to raise
the price of its product in USD if the yen appreciates? If the company can do so, its foreign
exchange exposure may be quite low. The key estimates required are those showing the overall
effect on the company's profitability of changes in the exchange rate at various times in the
future. Once these estimates have been produced the company can choose between using futures
and options to hedge its risk. The results of the analysis should be presented carefully to other
executives. It should be explained that a hedge does not ensure that profits will be higher. It
means that profit will be more certain. When futures/forwards are used both the downside and
upside are eliminated. With options a premium is paid to eliminate only the downside.
A corn farmer argues "I do not use futures contracts for hedging. My real risk is not the price of
corn. It is that my whole crop gets wiped out by the weather." Discuss this viewpoint. Should the
farmer estimate his or her expected production of corn and hedge to try to lock in a price for
ACTUAL Exam Questions and CORRECT
Answers
Under what circumstances are (a) a short hedge and (b) a long hedge appropriate? - CORRECT
ANSWER - A short hedge is appropriate when a company owns an asset and expects to
sell that asset in the future. It can also be used when the company does not currently own the
asset but expects to do so at some time in the future. A long hedge is appropriate when a
company knows it will have to purchase an asset in the future. It can also be used to offset the
risk from an existing short position.
Explain what is meant by basis risk when futures contracts are used for hedging. - CORRECT
ANSWER - Basis risk arises from the hedger's uncertainty as to the difference between the
spot price and futures price at the expiration of the hedge.
Explain what is meant by a perfect hedge. Does a perfect hedge always lead to a better outcome
than an imperfect hedge? Explain your answer. - CORRECT ANSWER - A perfect hedge
is one that completely eliminates the hedger's risk. A perfect hedge does not always lead to a
better outcome than an imperfect hedge. It just leads to a more certain outcome. Consider a
company that hedges its exposure to the price of an asset. Suppose the asset's price movements
prove to be favorable to the company. A perfect hedge totally neutralizes the company's gain
from these favorable price movements. An imperfect hedge, which only partially neutralizes the
gains, might well give a better outcome.
Under what circumstances does a minimum-variance hedge portfolio lead to no hedging at all? -
CORRECT ANSWER - A minimum variance hedge leads to no hedging when the
coefficient of correlation between the futures price changes and changes in the price of the asset
being hedged is zero.
Give three reasons why the treasurer of a company might not hedge the company's exposure to a
particular risk. - CORRECT ANSWER - (a) If the company's competitors are not hedging,
the treasurer might feel that the company will experience less risk if it does not hedge.
(b) The shareholders might not want the company to hedge because the risks are hedged within
their portfolios.
, (c) If there is a loss on the hedge and a gain from the company's exposure to the underlying asset,
the treasurer might feel that he or she will have difficulty justifying the hedging to other
executives within the organization.
Does a perfect hedge always succeed in locking in the current spot price of an asset for a future
transaction. Explain - CORRECT ANSWER - No. Consider, for example, the use of a
forward contract to hedge a known cash inflow in a foreign currency. The forward contract locks
in the forward exchange rate- which in general different from the spot exchange rate.
Explain why a short hedger's position improves when the basis strengthens unexpectedly and
worsens when the basis weakens unexpectedly. - CORRECT ANSWER - Basis is amount
by which the spot price exceeds the futures price. A short hedger is long the asset and short
futures contracts. The value of his or her position therefore improves as the basis increases.
Similarly, it worsens as the basis decreases.
Imagine you are the treasurer of a Japanese company exporting electronic equipment to the US.
Discuss how you would design a foreign exchange hedging strategy and the arguments you
would use to sell the strategy to your fellow executives. - CORRECT ANSWER - Simple
answer to this question is the treasurer should:
1) Estimate the company's future cash flows in Japanese yen and USD
2) Enter into forward and futures contracts to lock in the exchange rate for the USD cash flows.
This is not whole story however. The company should examine whether the magnitude of the
foreign cash flows depend on the exchange rate. For example, will the company be able to raise
the price of its product in USD if the yen appreciates? If the company can do so, its foreign
exchange exposure may be quite low. The key estimates required are those showing the overall
effect on the company's profitability of changes in the exchange rate at various times in the
future. Once these estimates have been produced the company can choose between using futures
and options to hedge its risk. The results of the analysis should be presented carefully to other
executives. It should be explained that a hedge does not ensure that profits will be higher. It
means that profit will be more certain. When futures/forwards are used both the downside and
upside are eliminated. With options a premium is paid to eliminate only the downside.
A corn farmer argues "I do not use futures contracts for hedging. My real risk is not the price of
corn. It is that my whole crop gets wiped out by the weather." Discuss this viewpoint. Should the
farmer estimate his or her expected production of corn and hedge to try to lock in a price for
