Chapter 8 - Using Futures For Hedging (FRM Part 1 - Book 3)
Chapter 8 - Using Futures For Hedging
Chapter 8 - Using Futures For Hedging
1. What is the main purpose of a short hedge?
A. To profit from falling prices without holding the asset
B. To hedge a long position against a price decrease
C. To speculate on future price increases
D. To lock in profit for a short position
A short hedge is used when holding a long position and expecting prices to fall. Selling futures offsets potential losses in the asset's value.
2. When is a long hedge typically used?
A. When holding a long position and prices are expected to fall
B. When wanting to short sell a security
C. When holding a short position and prices are expected to rise
D. When prices are stable and market is neutral
A long hedge is suitable for protecting a short position when prices are expected to increase.
3. In a short hedge, what is the expected market movement?
A. Prices are expected to decline
B. Prices are expected to remain constant
C. Prices are expected to rise
D. Volatility is expected to increase
A short hedge is used when prices are expected to decline. Selling futures helps offset the potential loss in the held long position.
4. Which of the following best differentiates a long hedge from a short hedge?
A. A long hedge is used when prices are falling, while a short hedge is used when prices are rising
B. A short hedge involves buying futures; a long hedge involves selling futures
C. Both are used only for speculative purposes
D. A long hedge involves buying futures to protect a short position, while a short hedge involves selling futures to protect a long position
The long hedge buys futures to protect short positions from rising prices, while the short hedge sells futures to protect long positions from falling prices.
5. What is the primary goal of hedging with futures contracts?
A. To maximize returns in volatile markets
B. To reduce or eliminate price risk
C. To speculate on future price movements
D. To avoid paying margin requirements
Hedging with futures contracts is primarily used to reduce or eliminate price risk associated with assets or liabilities.
6. A cereal company expecting to purchase corn in the future and locking in the price by buying corn futures is using which type of hedge?
A. Long hedge
B. Short hedge
C. Spread hedge
D. Cross hedge
A long hedge is used when a company anticipates a future need to buy an asset and wants to lock in the purchase price.
7. Which of the following is a valid argument **against** hedging?
A. Hedging always leads to losses
B. Hedging increases volatility in earnings
C. Shareholders can hedge risk by diversifying their investments
D. Hedging is illegal in many financial markets
One argument against hedging is that shareholders can manage risk on their own through diversification.
8. What is the potential downside of hedging when the asset being hedged increases in value?
A. No impact, as hedging neutralizes all risk
B. The firm benefits from both asset appreciation and futures gain
C. The firm must liquidate its position early
D. The gain in asset value is offset by a loss in the futures contract
If the asset being hedged increases in value, a corresponding loss in the futures position may offset this gain, reducing overall profitability.
9. Which situation might discourage a firm from hedging, according to industry behavior?
A. If competitors do not hedge and prices adjust frequently in the industry
B. If shareholders request a risk management strategy
C. If the company exports products globally
D. If basis risk is zero
A firm may be discouraged from hedging if industry prices adjust frequently and competitors do not hedge, making hedging potentially unnecessary and unprofitable.
10. What is cross hedging?
A. Hedging using options instead of futures
B. Hedging a futures position with another futures contract
C. Simultaneously holding long and short futures positions
D. Hedging a cash asset using a futures contract on a related but different asset
Cross hedging occurs when the hedging instrument is not the same as the asset being hedged, but closely related.
11. Why are perfect hedges rare in practice?
A. Because asset characteristics and futures contracts rarely match exactly
B. Because futures contracts are illegal in many countries
C. Because hedging always leads to losses
D. Because hedging eliminates profits
Perfect hedges are rare because either the asset being hedged is different from the futures contract's underlying asset, or the hedge horizon does not match the contract's maturity.
12. What is basis risk?
A. The risk of not having enough margin in a futures position
B. The risk of counterparty default
C. The risk arising from changes in the difference between the spot price and futures price
D. The risk of selecting the wrong futures contract
Basis risk refers to the risk that the difference (basis) between the spot and futures prices changes unfavorably during the hedge period.
13. How is basis generally defined in the context of hedging?
A. Futures price minus spot price
B. Spot price minus futures price
C. Hedge ratio divided by volatility
D. Spot price plus futures price
The typical definition of basis is: spot price of the asset being hedged minus the futures price of the contract used in the hedge.
14. To minimize basis risk, what should a hedger ideally do?
A. Choose a futures contract highly correlated with the hedged asset and match the maturity closely with the hedging horizon
B. Always hedge using short positions regardless of the situation
C. Only hedge in the spot market
D. Avoid hedging with futures contracts
The hedger should select the most correlated futures contract and match its maturity as closely as possible with the hedge duration to minimize basis risk.
15. What does the optimal hedge ratio (HR) represent?
A. The maximum gain possible from a futures contract
B. The ratio of total risk to systematic risk
C. The proportion of the spot position to be hedged using futures to minimize variance
D. The number of contracts traded in a day
The optimal hedge ratio minimizes the variance of the combined spot and futures position. It represents how much of the spot position should be hedged using futures.
16. Which of the following is the correct formula for calculating the optimal hedge ratio (HR)?
A. HR = σF / σS
B. HR = βS,F × ρ
C. HR = CovS,F / σSσF
D. HR = ρS,F × (σS / σF)
The optimal hedge ratio is HR = ρS,F × (σS / σF), which minimizes the variance of the hedged portfolio.
17. In the regression of changes in spot prices on changes in futures prices, what does the slope coefficient (β) represent?
A. The optimal hedge ratio
B. The inverse of volatility
C. The risk-free rate
D. The Sharpe ratio
The slope coefficient (β) in the regression represents the hedge ratio, showing how changes in futures prices relate to changes in spot prices.
18. What does hedge effectiveness measure?
A. The maximum possible return from hedging
B. The duration of the hedge
C. The percentage of variance in spot returns reduced by using the hedge
D. The gain from arbitrage opportunities
Hedge effectiveness measures how much of the variance in the spot position is reduced by applying the hedge. It is given by R², the square of the correlation coefficient.
19. What is the value of hedge effectiveness when the correlation between spot and futures prices is 0.95?
A. 0.90
B. 0.9025
C. 0.975
D. 0.980
Hedge effectiveness is calculated as R² = ρ² = 0.95² = 0.9025 or 90.25%.
20. What does the beta (β) of a portfolio represent in index futures hedging?
A. Total return of the portfolio
B. Sensitivity of the portfolio to market movements
C. The dividend yield of the portfolio
D. The volatility of individual assets
Beta measures how much a portfolio moves in relation to the market, making it essential in determining the number of futures contracts for hedging.
21. What is the correct formula to calculate the number of futures contracts for hedging an equity portfolio?
A. Portfolio value / futures price
B. Portfolio beta / contract multiplier
C. β × (Portfolio value / (Futures price × Contract multiplier))
D. Futures price / Portfolio value
The number of contracts = β × (Portfolio value / (Futures price × Contract multiplier)). This formula ensures proportional hedging.
22. What is the purpose of "tailing the hedge" when using futures contracts?
A. To adjust for daily settlement and avoid overhedging
B. To reduce the beta of the portfolio
C. To match spot and futures prices exactly
D. To convert cash flows into forward rates
Tailing the hedge helps account for the effect of daily marking to market, which can otherwise lead to overhedging.
23. Which of the following components are required to calculate the value of a futures contract?
A. Spot price and beta
B. Contract multiplier and portfolio beta
C. Portfolio value and risk-free rate
D. Futures price and contract multiplier
The value of a single futures contract is determined by multiplying the futures price by the contract multiplier.
24. In "tailing the hedge," which ratio is used to adjust the hedge ratio?
A. Beta to futures price ratio
B. Spot price to futures price ratio
C. Futures price to spot price ratio
D. Contract size to portfolio size ratio
To tail the hedge, the hedge ratio is adjusted using the spot-to-futures price ratio to correct for daily settlement effects.
25. Why is it not efficient to adjust the hedge daily using tailing the hedge method?
A. Because beta values remain constant
B. Because futures prices do not fluctuate
C. Because daily spot-to-futures ratios change frequently
D. Because futures contracts are not marked to market
Spot-to-futures ratios vary daily, making frequent adjustments inefficient in practice.
26. What does a negative value in the formula (β* − β) × (P / A) indicate when adjusting a portfolio's beta using index futures?
A. Buying call options
B. Increasing the portfolio's market exposure
C. Rolling the futures position forward
D. Selling futures to decrease systematic risk
A negative value indicates that futures should be sold to lower the portfolio's beta and reduce market risk.
27. In the formula (β* − β) × (P / A), what does β* represent?
A. The target beta after hedging
B. The actual beta of the futures contract
C. The correlation between portfolio and index
D. The tracking error of the index
β* is the beta you aim to achieve after using index futures to modify the portfolio's risk profile.
28. What is the purpose of using index futures to change a portfolio’s beta?
A. To reduce the alpha of the portfolio
B. To change the portfolio's systematic risk
C. To eliminate unsystematic risk
D. To calculate expected return using CAPM
Futures can increase or decrease the beta, thus adjusting the exposure to systematic market risk.
29. What is the main idea behind the "stack and roll" hedging strategy?
A. Buying deep in-the-money options and holding
B. Using short-duration swaps instead of futures
C. Replacing expiring futures with new ones of later maturity
D. Adjusting hedge ratios daily
In "stack and roll", futures positions are rolled forward by closing expiring contracts and entering new ones with longer maturities.
30. What is a key risk of using the “stack and roll” hedging strategy?
A. Rollover basis risk from changing futures prices
B. Interest rate parity mismatch
C. Illiquidity in the spot market
D. High delta-gamma exposure
Each time the hedge is rolled, the hedger is exposed to a new basis risk — called rollover basis risk — which can reduce hedge effectiveness.
31. How can an investor hedge against a potential decline in the value of an asset?
A. Buying futures contracts on the asset
B. Shorting futures contracts on the asset
C. Buying call options on the asset
D. Selling the asset in the spot market
To protect against falling asset prices, investors short futures to offset potential losses in the spot position.
32. What is a key advantage of hedging with futures contracts?
A. Higher portfolio return potential
B. Guaranteed positive cash flows
C. Enhanced market timing
D. Reduced uncertainty in future profitability
Hedging with futures reduces price uncertainty, helping businesses and investors plan future cash flows more reliably.
33. What is a potential disadvantage of hedging with a short futures position?
A. Reduced gains if the asset price rises
B. Increased beta of the portfolio
C. Exposure to foreign exchange risk
D. Need for physical delivery of the asset
If prices rise after hedging with short futures, potential profits from the spot asset are offset by losses in the futures position.
34. What is basis risk in the context of hedging with futures?
A. The risk of currency mismatch
B. The risk of illiquidity in the spot market
C. The risk that the spot and futures prices do not move identically
D. The risk of margin calls due to volatility
Basis risk arises when there is an imperfect correlation between the spot price of the asset and the futures contract used to hedge it.
35. When is basis risk equal to zero?
A. When the asset is highly volatile
B. When the asset and futures perfectly match in type and maturity
C. When the hedge is rebalanced monthly
D. When futures contracts are settled daily
Basis risk is eliminated only if the hedged asset exactly matches the futures contract’s underlying asset and maturity date.
36. What is the purpose of using a hedge ratio when implementing a futures hedge?
A. To determine the correct size of the futures position relative to the spot position
B. To calculate the margin requirements for futures contracts
C. To forecast the future spot price
D. To measure the risk of the futures contract
The hedge ratio (HR) helps determine how many futures contracts are needed to match the size of the underlying position in the spot market.
37. How is the effectiveness of a hedge measured?
A. By the amount of margin saved
B. By the size of the futures contracts relative to the spot position
C. By the variance reduction achieved by implementing the optimal hedge
D. By the profit or loss from the hedge position
The effectiveness of the hedge is measured by how much variance or risk in the spot asset is reduced by the hedge.
38. What does the formula for the hedge ratio (HR) represent?
A. The number of contracts required to hedge a specific portfolio
B. The relationship between the correlation of spot and futures price changes and their respective volatilities
C. The contract size of the futures required to hedge
D. The maximum risk that can be tolerated in the hedging strategy
The hedge ratio (HR) takes into account the correlation (ρ) and volatility (σ) between the spot asset and the futures contract.
39. When cross-hedging, why might an investor hedge with an asset that is not identical to the underlying asset?
A. To increase the variance of the position
B. To enhance the correlation between spot and futures prices
C. To reduce the margin requirement for futures
D. To take advantage of a closely related but different asset to manage risk
Cross-hedging is used when the hedging asset is closely related to the asset being hedged, offering a reasonable protection while reducing transaction costs.
40. What is the purpose of "tailing the hedge" in futures trading?
A. To correct for potential overhedging by adjusting for daily changes in the spot-to-futures price ratio
B. To reduce margin calls in the futures market
C. To prevent the futures contracts from expiring prematurely
D. To avoid rolling over futures contracts before maturity
Tailing the hedge involves adjusting the hedge ratio based on the spot-to-futures price ratio to avoid overhedging or underhedging when the futures price changes.
