Derivatives, Hedging and Risk Transfer

Introduction and Context

Investment banks transform, price, distribute and warehouse risk. A corporate client may face foreign-exchange risk, an issuer may face interest-rate risk, a lender may face borrower default, and an insurer or securitization vehicle may assume risks that banks do not wish to retain. Derivatives and other risk-transfer instruments allow these exposures to be separated, priced and allocated among parties with different risk capacities.

Risk transfer, however, does not eliminate risk. It changes its form. A hedge may introduce basis risk, counterparty credit risk, liquidity risk, model risk, legal risk, collateral funding risk and operational risk. Effective risk management therefore requires more than selecting an instrument whose notional amount resembles the underlying exposure. The manager must identify the exposure, define the hedging objective, select an appropriate instrument, measure effectiveness and monitor residual risk.

This chapter develops the practical foundations for constructing and evaluating hedges using forwards, futures, swaps, options, credit derivatives, securitization and insurance. It also considers collateralization, central clearing, governance and contemporary developments in risk transfer.

Learning Objectives

By the end of this chapter, the learner should be able to:

1. Distinguish hedging, speculation, arbitrage and risk transfer.
2. Construct basic hedges using forwards, futures, swaps and options.
3. Calculate hedge ratios, futures profit and loss, and option payoffs.
4. Explain basis risk, hedge effectiveness and residual exposure.
5. Evaluate credit derivatives, securitization and insurance as risk-transfer mechanisms.
6. Assess the effects of collateral, margining and central clearing.
7. Recommend a hedge structure while considering liquidity, accounting, legal and governance constraints.

1. The Architecture of Risk Transfer

A risk exposure is an uncertain change in value, cash flow or economic capital caused by a risk factor. Common risk factors include interest rates, exchange rates, equity prices, commodity prices, credit spreads, default events and volatility.

A hedge is a position whose value tends to move in the opposite direction to an existing exposure. If a bank will receive a fixed amount of foreign currency in three months and fears that the currency will depreciate, it can sell that currency forward. If a bank owns a floating-rate asset but funds itself at a floating rate and wishes to lock its net interest margin, it may use an interest-rate swap.

The main distinctions are:

A complete hedge decision includes five questions:

1. What is the underlying exposure and its sign?
2. Which risk factor drives its value?
3. What is the hedging horizon and required liquidity?
4. Which instrument provides the best offset after transaction costs and constraints?
5. Which risks remain after the hedge?

2. Forward and Futures Hedges

2.1 Forward contracts

A forward is a customized agreement to buy or sell an underlying asset at a specified price and future date. It is normally traded over the counter. The contract has no exchange-traded daily settlement, although collateral may be required under the credit support arrangement.

For a long forward position, the maturity payoff is:

For a short forward position:

Here, S_T is the spot price at maturity, K is the contracted delivery price, and Π_T is the payoff per unit of the underlying. These formulas assume physical or cash settlement with no interim cash flows. They describe payoff, not accounting profit after financing, collateral and transaction costs.

A forward hedge is especially useful when the quantity, date or underlying is customized. Its principal disadvantages are counterparty credit exposure, potentially limited liquidity and valuation uncertainty.

2.2 Futures contracts

A futures contract is standardized and traded on an organized exchange. The clearing house becomes the buyer to every seller and seller to every buyer. Positions are marked to market, and gains and losses are settled through variation margin, generally each business day.

A short futures hedge is appropriate for an asset whose value falls when futures prices fall. A long futures hedge is appropriate for a future purchase whose cost rises when futures prices rise.

The minimum-variance hedge ratio is commonly estimated as:

The number of futures contracts is then approximately:

where h* is the optimal hedge ratio, ρ is the correlation between changes in the spot and futures prices, σ_S and σ_F are their standard deviations over the hedging horizon, Q_A is the quantity of the asset exposure, and Q_F is the quantity represented by one futures contract. Quantities must be expressed in consistent units. The formula assumes a linear hedge, stable relationships over the estimation period and a variance-minimization objective.

2.3 Basis risk

The basis is the difference between the spot price and the futures price:

A short futures hedge may be evaluated using:

where ΔV_H is the change in the combined hedged position, ΔS and ΔF are changes in spot and futures prices, and the signs reflect a long underlying asset and short futures position. If ΔS and ΔF are not equal, the hedge is imperfect. Causes include maturity mismatch, asset mismatch, location or grade differences, and changing market liquidity.

Basis risk is often more important than the notional size of the derivative. A hedge can be economically sensible but still produce losses because the selected futures contract does not track the exposure sufficiently closely.

Worked Example 1: Futures Hedge

An investment bank holds 500,000 barrels of a crude-oil-related exposure. The relevant futures contract represents 1,000 barrels. Historical estimates are ρ = 0.90, σ_S = 2.0% and σ_F = 2.5% for the intended horizon.

The optimal hedge ratio is:

The number of contracts is:

The bank should therefore sell approximately 360 futures contracts. This is a statistical recommendation, not a guarantee. If the correlation changes, the hedge should be re-estimated and monitored.

3. Swaps and Interest-Rate Risk

A swap exchanges cash flows according to agreed reference rates or prices. The most common investment-banking applications involve interest rates, currencies and commodities.

In a plain-vanilla fixed-for-floating interest-rate swap, one party pays a fixed rate and receives a floating reference rate; the counterparty does the reverse. Usually only the net cash difference is exchanged.

Suppose a bank owns a floating-rate loan and wants to lock its receipt. It can receive fixed and pay floating in a swap. The floating receipt on the loan is offset by the floating payment on the swap, leaving an approximately fixed receipt. If the bank funds the loan with floating-rate liabilities, the desired structure may differ; the hedge must be designed for the net exposure rather than the asset in isolation.

For a notional principal N, fixed rate K, floating rate L_t, and accrual fraction δ_t, the net payment to the fixed-rate receiver is:

The formula assumes a standard net-settled interest-rate swap and consistent day-count conventions. A swap's value is the present value of expected future net cash flows, discounted using an appropriate collateral and funding framework. In modern practice, valuation generally incorporates collateral terms, discounting conventions, credit valuation adjustment and funding effects where relevant.

Currency swaps exchange cash flows in different currencies and may include exchanges of principal. They can hedge both currency and interest-rate exposures, but introduce foreign-currency basis risk, settlement risk and potentially substantial collateral requirements.

4. Options and Nonlinear Hedging

An option gives the buyer a right, but not an obligation, to buy or sell an underlying at a strike price. The buyer pays a premium; the seller receives the premium and assumes contingent obligations.

A European call option payoff is:

A European put option payoff is:

The buyer's net profit equals payoff minus premium, adjusted for discounting and contract units. A call protects against a rising purchase price; a put protects the value of an owned asset against a decline. Options are valuable when the exposure is uncertain in amount or direction, because the buyer retains favorable market participation.

Important option risks include:

• Delta risk: sensitivity to the underlying price.
• Gamma risk: change in delta as the underlying price changes.
• Vega risk: sensitivity to implied volatility.
• Theta risk: sensitivity to the passage of time.
• Rho risk: sensitivity to interest rates.
• Smile and skew risk: sensitivity to the shape of the implied-volatility surface.

A delta hedge offsets first-order price sensitivity. For a portfolio with option delta Δ and underlying unit exposure, the approximate change is:

This approximation is local and becomes less reliable for large price movements because of gamma. A delta-neutral portfolio is not risk-neutral: volatility, time decay, jumps, liquidity and model error remain.

Worked Example 2: Protective Put

A bank owns 10,000 shares currently worth 50 currency units each. It buys puts with strike 47, paying a premium of 1.20 per share. If the share price at maturity is 40, the put payoff is:

The net option gain is 7 − 1.20 = 5.80 per share. The share loses 10 per share, so the combined position loses approximately 4.20 per share before financing and transaction costs. The put has established a floor while allowing the bank to benefit if the shares rise.

5. Measuring Hedge Effectiveness

Hedge effectiveness is the extent to which the hedging instrument offsets changes in the hedged exposure. It must be defined in relation to the objective. A treasury manager may minimize cash-flow variance, while a trading desk may minimize mark-to-market value-at-risk.

A simple effectiveness measure for a loss-reducing hedge is:

A result of 1 indicates complete variance elimination and 0 indicates no variance reduction. Negative values indicate that the hedge increased variance. This is a management metric, not a universal accounting rule. Accounting standards may require formal documentation, eligible hedging relationships, prospective and retrospective assessments, and treatment of ineffectiveness according to the applicable framework.

Regression analysis can support hedge design:

Here, ΔS_t is the change in the exposure's value or price, ΔF_t is the derivative price change, β estimates the hedge sensitivity, α captures a systematic intercept and ε_t is unexplained residual risk. The regression approach assumes that historical relationships provide useful information about the hedging period. Structural breaks, stressed markets and illiquidity can invalidate that assumption.

Effectiveness should be assessed through scenario analysis as well as historical statistics. Relevant scenarios include parallel and nonparallel rate shifts, currency gaps, volatility shocks, spread widening, default clusters, market closures and collateral calls.

6. Credit Derivatives and Credit Risk Transfer

Credit risk is the possibility that a borrower, issuer or counterparty fails to meet contractual obligations or that its credit quality deteriorates. Credit derivatives separate credit exposure from ownership of the underlying instrument.

6.1 Credit default swaps

In a credit default swap, the protection buyer pays a periodic premium, often called the spread, to the protection seller. If a defined credit event occurs, the seller makes a payment based on the loss under the contract.

A simplified loss-given-default relationship is:

If a reference obligation has notional N and recovery rate R, a stylized default payment is:

The actual amount depends on the contract's auction, deliverable obligations, restructuring terms, accrued premium and settlement method. A CDS hedge may fail to match the bank's loan because of maturity, seniority, documentation, restructuring definition or reference-entity mismatch. This is credit basis risk.

6.2 Total return swaps

A total return swap transfers the economic return of an asset, including price appreciation, depreciation and income, in exchange for a financing-rate payment. It can provide synthetic exposure without transferring legal ownership. It can also create leverage and concentrated counterparty exposure, requiring robust margin and collateral controls.

6.3 Credit-linked notes

A credit-linked note combines a debt instrument with an embedded credit derivative. Investors receive a higher coupon but bear losses if a specified credit event occurs. The issuing bank transfers credit risk to investors, although legal, disclosure, correlation and model risks remain.

7. Securitization as a Risk-Transfer Mechanism

Securitization pools financial assets—such as mortgages, auto loans, credit-card receivables or corporate loans—and finances them through securities issued to investors. Cash flows are allocated through a waterfall, commonly creating senior, mezzanine and subordinated tranches.

The basic logic is:

1. Assets are originated or acquired.
2. A special-purpose vehicle purchases or receives the assets.
3. Securities are issued against the asset cash flows.
4. Credit enhancement allocates losses among tranches.
5. Collections are distributed according to contractual priority.

Credit enhancement may be structural subordination, excess spread, overcollateralization, reserve accounts or guarantees. Securitization can reduce funding costs and diversify investors, but it does not automatically remove risk. Originators may retain first-loss positions, servicing risk, representations-and-warranties risk, liquidity facilities or reputational exposure.

Key risks include prepayment risk, extension risk, correlation risk, model risk, tranche liquidity risk and adverse selection. Complex structures can obscure the distribution of losses, particularly under stress. Effective governance requires transparent asset data, independent valuation, stress testing and clear investor disclosures.

8. Insurance and Alternative Risk Transfer

Insurance transfers specified risks to an insurer in exchange for a premium. It is appropriate where events are measurable, contractually definable and sufficiently diversifiable. Examples relevant to investment banking include directors' and officers' liability, cyber insurance, trade credit insurance, political-risk insurance, representations-and-warranties insurance and insurance against operational losses.

Insurance differs from a derivative in several respects. Coverage commonly requires an insurable interest, proof of loss, exclusions and claims procedures. A derivative generally pays according to a defined market variable or event, whether or not the holder suffers a legally recognized loss.

Alternative risk-transfer instruments include catastrophe bonds and insurance-linked securities. These may use parametric triggers, such as wind speed or earthquake intensity, rather than indemnity-based claims. Parametric structures can settle quickly but create basis risk if the trigger does not closely match the insured loss.

9. Collateralization, Margin and Central Clearing

Collateral reduces current exposure by supporting a party's obligations. Variation margin covers changes in mark-to-market value; initial margin is intended to cover potential future exposure during the close-out period.

For a collateralized derivative, net current exposure can be represented conceptually as:

where MtM_t is the mark-to-market value from the institution's perspective and Collateral_t is eligible collateral after haircuts. This simplified expression excludes legally complex netting, thresholds, minimum transfer amounts, settlement timing and disputes.

Collateral creates its own risks:

• Liquidity risk from sudden margin calls.
• Wrong-way risk when collateral quality deteriorates with the counterparty.
• Haircut risk when collateral values fall.
• Reinvestment and rehypothecation risk.
• Dispute and operational risk.
• Funding and liquidity valuation adjustment risk.

Central counterparties reduce bilateral counterparty exposures through multilateral netting, default funds, margin and mutualized loss arrangements. They do not eliminate risk. A member remains exposed to the clearing house, default waterfalls, liquidity demands, concentration risk and the possibility that a position cannot be closed efficiently during market stress. Central clearing also concentrates systemic importance in the CCP, making governance, recovery and resolution critical.

10. Integrated Applied Case: Hedging a Cross-Border Acquisition

The following is an illustrative case, with simplified assumptions.

Background

An investment bank advises a domestic technology company acquiring a European target for EUR 120 million. Completion is expected in six months. The acquirer has domestic-currency funding and will need euros at completion. It also expects to issue floating-rate debt to fund part of the transaction. The bank must recommend a risk-transfer program.

Problem

The acquirer faces two principal exposures:

1. The domestic-currency cost of EUR 120 million may rise if the euro appreciates.
2. Interest expense may rise if the floating reference rate increases.

A forward would lock the exchange rate but remove the benefit of a euro depreciation. An option would preserve that benefit but require an upfront premium. The interest-rate exposure may be hedged with a swap, although the final debt amount and drawdown date are uncertain.

Analysis and approach

The bank recommends:

• A staged euro call option strategy for the acquisition currency, possibly supplemented by forwards once the transaction becomes highly certain.
• A receive-fixed/pay-floating or pay-fixed/receive-floating swap only after matching the swap direction to the actual debt cash flows. For floating-rate debt, a pay-fixed/receive-floating swap generally converts the debt's floating interest cost into a fixed cost.
• A hedge ratio below 100% until regulatory approval and completion probability become clearer, reducing over-hedging risk.
• Collateral and liquidity forecasts incorporating adverse currency and interest-rate scenarios.
• Documentation specifying the hedged item, notional, maturity, settlement terms and termination rights.

Assume the company buys a EUR call with a strike of 1.10 domestic currency units per euro and pays a premium of 0.025 per euro. If the spot rate at completion is 1.18, the option payoff is 0.08 per euro. The net option benefit before discounting is 0.055 per euro. On EUR 120 million, the net benefit is:

If the spot rate is 1.03, the option expires unused. The company purchases euros in the market at the favorable rate and loses only the premium:

The option therefore protects the maximum acquisition cost while preserving favorable currency movements.

Outcome

The program reduces the probability that currency or interest-rate movements make the acquisition unaffordable. It does not eliminate risk. Residual exposures include option volatility and premium risk, timing mismatch, debt-size uncertainty, counterparty and collateral risk, and the possibility that the acquisition fails after hedges have been entered.

Learning points

The correct hedge depends on the certainty and flexibility of the underlying exposure. A fully locked hedge may be inappropriate when the transaction can be delayed or abandoned. A more expensive option may be economically superior because it protects flexibility. Governance must therefore evaluate transaction probability, not merely market forecasts.

11. Governance, Regulation and Ethical Considerations

A professional hedge program requires an approved risk appetite, delegated authority, independent valuation and documented controls. Essential governance practices include:

• Defining permitted instruments, counterparties, maturities and concentrations.
• Separating trading, confirmation, valuation, collateral and settlement functions.
• Using independent price verification and model validation.
• Monitoring limit usage, stress losses, liquidity and collateral requirements.
• Performing legal review of master agreements, netting and close-out provisions.
• Recording the economic purpose and expected effectiveness of each hedge.
• Escalating breaches and material model or basis changes promptly.

Regulatory frameworks in major jurisdictions generally emphasize reporting, margin, clearing, capital, liquidity and conduct requirements for derivatives. Exact obligations depend on entity type, jurisdiction, product and counterparty classification. Institutions must not treat regulatory compliance as a substitute for economic risk analysis.

Ethically, risk transfer must not become risk concealment. Selling complex credit or securitized products without explaining loss mechanisms, liquidity assumptions and conflicts of interest can shift risk to parties unable to evaluate it. Fair dealing requires balanced disclosure of benefits, costs, tail risks and scenarios. Compensation structures should not reward short-term premium generation while leaving long-term losses with clients or the institution.

12. Technology, Data and Contemporary Developments

Electronic confirmation, automated collateral management, distributed ledgers and application programming interfaces can reduce processing errors and improve transparency. Machine-learning tools may assist with anomaly detection, margin forecasting, default prediction and hedge-ratio estimation. Nevertheless, AI models can amplify unstable correlations, embed historical bias and fail during regime changes. Human governance, explainability, independent validation and override procedures remain necessary.

Contemporary risk-transfer practice is also shaped by transition risk, climate-related insurance losses, cyber risk, benchmark reform, geopolitical fragmentation and the increasing use of non-bank financial intermediaries. These developments make historical data less reliable and increase the importance of scenario analysis, liquidity planning and contractual resilience.

13. Best-Practice Framework for Hedge Construction

A disciplined process can be organized as follows:

1. Identify the exposure: specify cash flows, valuation basis, timing, currency and risk factor.
2. Define the objective: reduce value variance, protect a budget, stabilize margin or transfer default risk.
3. Select the instrument: compare forwards, futures, swaps, options, credit derivatives, insurance and securitization.
4. Estimate the hedge ratio: use exposure mapping, sensitivity analysis and, where appropriate, statistical estimation.
5. Evaluate costs: include premium, bid–ask spread, funding, margin, capital, collateral and legal costs.
6. Test scenarios: include basis widening, volatility shocks, default, illiquidity, counterparty failure and transaction cancellation.
7. Document and execute: record terms, authority, valuation source, collateral and termination provisions.
8. Monitor and rebalance: track effectiveness, residual exposures, model performance and changing correlations.
9. Review outcomes: distinguish market loss from hedge ineffectiveness, operational error and inappropriate design.

Challenges and Limitations

No instrument creates a perfect hedge in all circumstances. Forward and swap contracts can create locked-in losses when market conditions move favorably. Futures introduce basis and roll risk. Options require premiums and depend on volatility assumptions. Credit derivatives may not match the exact loan exposure. Securitization can create opacity and model dependence. Insurance is subject to exclusions, claims disputes and insurer solvency. Collateral reduces counterparty exposure but can intensify liquidity stress.

The most dangerous misconception is that a hedge eliminates uncertainty. In practice, it converts one set of risks into another. Senior decision-makers should therefore evaluate the entire risk chain: underlying exposure, derivative, counterparty, collateral, funding, accounting, legal enforceability, operations and close-out under stress.

Chapter Summary

Derivatives and other risk-transfer mechanisms allow investment banks and their clients to reshape exposures to market, credit, liquidity and event risk. Forwards and futures provide linear protection but may contain basis, roll and counterparty risks. Swaps transform rates or currencies and must be matched to the institution's net cash flows. Options provide nonlinear protection and preserve favorable outcomes, but require premiums and create volatility and model sensitivities.

Hedge effectiveness should be assessed against a clearly defined objective using sensitivity, variance, regression and stress analysis. Credit default swaps, total return swaps and credit-linked notes transfer credit risk but may contain reference-entity, recovery, documentation and counterparty mismatches. Securitization reallocates asset cash flows through tranching, while insurance transfers specified event risks subject to exclusions and solvency.

Collateral, margin and central clearing reduce some counterparty exposures but create liquidity, concentration and operational risks. A sound hedge program combines quantitative analysis with governance, legal documentation, independent valuation, ethical disclosure and continuous monitoring. Residual risk is not a failure of hedging; it is the risk that must be identified, priced, governed and reported after the hedge is established.

Key Terms

Basis risk: Risk that the hedging instrument and underlying exposure do not move together.

Central counterparty: An institution that interposes itself between buyers and sellers of cleared contracts.

Collateral: Assets pledged to secure performance under a financial contract.

Credit default swap: A contract transferring specified credit-event loss from one party to another.

Delta: Sensitivity of an option or portfolio value to a change in the underlying price.

Futures contract: A standardized, exchange-traded derivative subject to margining and daily settlement.

Forward contract: A customized agreement to transact an underlying asset at a future date and price.

Hedge effectiveness: The degree to which a hedge offsets the intended exposure.

Hedge ratio: The size of a hedging position relative to the underlying exposure.

Initial margin: Collateral intended to cover potential future exposure during close-out.

Insurance-linked security: A security whose payments depend on an insured event or catastrophe trigger.

Interest-rate swap: A contract exchanging fixed and floating interest cash flows.

Option premium: The price paid by an option buyer for the contractual right.

Residual exposure: Risk remaining after a hedge is implemented.

Securitization: Pooling assets and issuing claims whose payments derive from the asset cash flows.

Total return swap: A contract transferring the economic return of an asset for a financing payment.

Variation margin: Collateral exchanged to reflect current mark-to-market changes.

Wrong-way risk: Risk that exposure to a counterparty increases when that counterparty's credit quality deteriorates.

Review Questions

Short Answer Questions

1. Distinguish hedging from speculation and arbitrage.
2. What is basis risk, and why does it arise in futures hedging?
3. Explain the difference between initial margin and variation margin.
4. State the maturity payoffs of a long forward and a long put option.
5. Why does central clearing not eliminate systemic risk?

Long Answer Questions

1. Explain how an investment bank would construct and monitor an interest-rate swap hedge for a floating-rate loan portfolio.
2. Compare forwards, futures and options as instruments for hedging a foreign-currency acquisition.
3. Discuss how securitization transfers and retains credit, liquidity and reputational risks.
4. Explain the role of hedge effectiveness testing, regression analysis and stress testing.
5. Evaluate the governance and ethical requirements for selling complex risk-transfer products to clients.

Analytical / Application Questions

1. A bank holds 800,000 units of an asset. The relevant futures contract covers 2,000 units, and estimates are ρ = 0.85, σ_S = 1.8% and σ_F = 2.0%. Calculate the minimum-variance hedge ratio and the approximate number of futures contracts.
2. A company expects to pay EUR 75 million in six months. It buys a EUR call with a strike of 1.12 domestic currency units per euro and a premium of 0.018. Calculate the option's net benefit per euro if the maturity spot rate is 1.20, ignoring discounting.
3. Design a risk-transfer program for a bank financing a leveraged acquisition where the purchase price is uncertain, funding is floating-rate and the target's credit quality may deteriorate before completion. Identify instruments, hedge timing, residual risks and governance controls.

Multiple Choice Questions with Answers

Question 1

Which position generally hedges a future foreign-currency payment when the payer fears the currency will appreciate?

A. Sell the foreign currency forward

B. Buy the foreign currency forward

C. Sell a put on the domestic currency

D. Buy a futures contract on a declining asset

Correct Answer: B. Buy the foreign currency forward

Question 2

Using h* = ρ × (σ_S ÷ σ_F), what is the hedge ratio when ρ = 0.8, σ_S = 2% and σ_F = 2.5%?

A. 0.32

B. 0.64

C. 1.00

D. 1.25

Correct Answer: B. 0.64

Question 3

What is the principal source of basis risk in a futures hedge?

A. The option premium is too high

B. The futures and exposure prices do not move identically

C. The clearing house guarantees settlement

D. The contract is marked to market

Correct Answer: B. The futures and exposure prices do not move identically

Question 4

Which option provides protection against a decline in the value of an owned asset?

A. Long call

B. Short call

C. Long put

D. Short put

Correct Answer: C. Long put

Question 5

In a plain-vanilla swap, which position generally converts floating-rate borrowing into fixed-rate borrowing?

A. Pay fixed and receive floating

B. Pay floating and receive fixed

C. Pay fixed and receive fixed

D. Receive floating and receive floating

Correct Answer: A. Pay fixed and receive floating

Question 6

If a reference obligation has notional 10 million and recovery rate 40%, what is the stylized credit default payment?

A. 4 million

B. 6 million

C. 10 million

D. 14 million

Correct Answer: B. 6 million

Question 7

What is variation margin primarily intended to cover?

A. Future legal fees only

B. Current mark-to-market changes

C. The option buyer's premium

D. The issuer's retained earnings

Correct Answer: B. Current mark-to-market changes

Question 8

Which statement about securitization is most accurate?

A. It automatically eliminates all credit risk for the originator

B. It pools assets and allocates cash flows through a structured waterfall

C. It is identical to an exchange-traded futures contract

D. It removes the need for asset-level data

Correct Answer: B. It pools assets and allocates cash flows through a structured waterfall

Question 9

A protective put has a strike of 50 and the underlying price at maturity is 44. What is the put payoff per unit before premium?

A. 0

B. 4

C. 6

D. 94

Correct Answer: C. 6

Question 10

Which is a residual risk of central clearing?

A. There is no requirement for margin

B. Clearing eliminates liquidity risk

C. Concentration and margin-call risk may increase

D. Bilateral netting becomes impossible in every case

Correct Answer: C. Concentration and margin-call risk may increase