CTP Financial Risk Management 2 — Questions and Answers
Question 1: A company's Value at Risk (VaR) is $2 million at the 99% confidence level over a 1-day horizon. What does this mean?
- There is a 1% chance losses will exceed $2M in a single day (Correct answer)
- The company will lose exactly $2M on 1% of trading days
- The maximum possible loss is $2M
- Average daily losses are $2M
Correct answer: There is a 1% chance losses will exceed $2M in a single day
VaR at 99% confidence means there is a 1% probability that losses will exceed the stated amount over the specified horizon.
Question 2: Which hedging instrument provides the most flexibility because it conveys the right but not the obligation to transact?
- Forward contract
- Futures contract
- Option (Correct answer)
- Interest rate swap
Correct answer: Option
Options grant the holder the right but not the obligation to buy or sell, providing flexibility that forward and futures contracts do not.
Question 3: Counterparty credit risk in derivatives is best mitigated by requiring the posting of:
- Letters of credit only
- Collateral under a Credit Support Annex (CSA) (Correct answer)
- A performance bond from a third party
- Additional covenants in the ISDA Master Agreement
Correct answer: Collateral under a Credit Support Annex (CSA)
A Credit Support Annex (CSA) attached to the ISDA Master Agreement requires counterparties to post collateral based on mark-to-market exposure.
Question 4: A company holds a portfolio of floating-rate liabilities and wants to convert them to fixed-rate obligations. Which instrument accomplishes this?
- Buy a put option on interest rates
- Enter a pay-fixed, receive-floating interest rate swap (Correct answer)
- Sell interest rate futures
- Buy an interest rate cap
Correct answer: Enter a pay-fixed, receive-floating interest rate swap
In a pay-fixed, receive-floating swap, the company pays a fixed rate and receives floating, effectively converting its floating liability to a fixed obligation.
Question 5: Which of the following best describes basis risk in a hedging program?
- The risk that a counterparty defaults on its obligation
- The risk that the hedge instrument does not perfectly offset changes in the hedged item's value (Correct answer)
- The risk of adverse regulatory changes affecting hedge accounting
- The risk of liquidity shortfalls when margin calls are made
Correct answer: The risk that the hedge instrument does not perfectly offset changes in the hedged item's value
Basis risk arises when the price movements of the hedging instrument and the hedged item are not perfectly correlated.
Question 6: Under FASB ASC 815, a cash flow hedge of a forecasted transaction requires the effective portion of the hedge's gain or loss to be reported in:
- Net income immediately
- Other Comprehensive Income (OCI) until the hedged transaction affects earnings (Correct answer)
- A deferred tax asset account
- An off-balance-sheet memo account
Correct answer: Other Comprehensive Income (OCI) until the hedged transaction affects earnings
For cash flow hedges, the effective portion of the hedging instrument's gain or loss is deferred in OCI and reclassified into earnings when the hedged item impacts income.
Question 7: A treasury manager is concerned about the company's exposure to a potential sharp decline in the value of a key foreign currency receivable. The most appropriate hedge would be to:
- Buy a call option on the foreign currency
- Sell a forward contract on the foreign currency (Correct answer)
- Enter a pay-floating interest rate swap
- Buy a commodity futures contract
Correct answer: Sell a forward contract on the foreign currency
Selling a forward contract on the foreign currency locks in a future exchange rate, protecting against a decline in the currency's value on a receivable.
CTP Financial Risk Management 2
A company's Value at Risk (VaR) is $2 million at the 99% confidence level over a 1-day horizon.
What does this mean?