CPM Derivatives & Hedging Strategies 1 — Questions and Answers
Question 1: What is the primary purpose of a protective put strategy in portfolio management?
- To generate additional income from the portfolio
- To limit downside losses while retaining upside potential (Correct answer)
- To increase portfolio leverage
- To eliminate all portfolio risk
Correct answer: To limit downside losses while retaining upside potential
A protective put involves buying put options on held securities to cap downside losses while still allowing the portfolio to benefit from price appreciation.
Question 2: Which derivative instrument gives the holder the right, but not the obligation, to buy an underlying asset at a specified price?
- Futures contract
- Forward contract
- Call option (Correct answer)
- Put option
Correct answer: Call option
A call option grants the holder the right—but not the obligation—to purchase the underlying asset at the strike price before or at expiration.
Question 3: To reduce a portfolio's beta from 1.2 to 0.8 using equity index futures, the portfolio manager should:
- Buy equity index futures
- Sell equity index futures (Correct answer)
- Buy call options on the index
- Enter a total return swap as the receiver
Correct answer: Sell equity index futures
Selling equity index futures reduces systematic risk exposure (beta) because the short futures position gains when the market falls, offsetting portfolio losses.
Question 4: The delta of a standard European call option is always bounded between:
- -1 and 0
- 0 and 1 (Correct answer)
- -1 and 1
- 0 and infinity
Correct answer: 0 and 1
Call option delta is always between 0 and 1, representing the fractional change in option price for a $1 change in the underlying asset price.
Question 5: In a collar strategy, the portfolio manager simultaneously:
- Buys a put and buys a call at different strikes
- Sells a put and buys a call at the same strike
- Buys a put and sells a call at a higher strike (Correct answer)
- Sells both a put and a call at the current market price
Correct answer: Buys a put and sells a call at a higher strike
A collar involves holding the underlying asset, buying a protective put (downside floor), and selling a covered call (upside cap), reducing the net cost of the hedge.
Question 6: What is the key difference between a forward contract and a futures contract?
- Futures contracts are settled only at maturity, while forwards are marked to market daily
- Forwards are standardized and exchange-traded, while futures are customized OTC contracts
- Futures are standardized and marked to market daily, while forwards are customized OTC contracts (Correct answer)
- There is no practical difference between the two instruments
Correct answer: Futures are standardized and marked to market daily, while forwards are customized OTC contracts
Futures contracts are standardized, exchange-traded, and subject to daily mark-to-market settlement, while forward contracts are customized OTC agreements settled only at maturity.
Question 7: Which hedging strategy involves selling call options on securities already held in the portfolio?
- Protective put
- Covered call (Correct answer)
- Long straddle
- Collar
Correct answer: Covered call
A covered call strategy involves selling call options on securities already owned, generating premium income while capping upside potential.
CPM Derivatives & Hedging Strategies 1
What is the primary purpose of a protective put strategy in portfolio management?