Deriva'ves: Interview Ques'ons

Set 1

Tricky Questions

1. How does a forward contract differ from a futures contract in terms of

counterparty risk and liquidity?
o Answer: Forward contracts are customized OTC agreements, which expose both
parties to counterparty risk due to the lack of an intermediary. In contrast, futures
contracts are standardized and traded on exchanges, with a clearinghouse that
mitigates counterparty risk and provides higher liquidity.
2. Explain the concept of arbitrage in derivative pricing and provide an example of
how it works in futures markets.
o Answer: Arbitrage in derivative pricing involves exploiting price discrepancies
between related markets to earn a risk-free profit. For example, if the futures price
of a commodity is higher than its spot price plus the cost of carry, an arbitrager
can buy the commodity in the spot market and sell it in the futures market to lock
in a risk-free profit.
3. What are some of the main differences between using swaps for hedging versus
speculation?
o Answer: Swaps used for hedging aim to reduce exposure to financial risks, such as
interest rate or currency fluctuations, aligning with the user’s underlying assets or
liabilities. When used for speculation, swaps aim to profit from anticipated market
movements without any direct exposure to the underlying asset.

Difficult Questions

4. How does the expiration value of a call option differ from its intrinsic value at
expiration, and how does it affect profit calculation?
o Answer: The expiration value is the difference between the asset's spot price and
the strike price at expiration, but it only counts as intrinsic value if it's positive.
Profit is then calculated by subtracting the premium paid from the expiration
value, affecting whether the position is profitable or not.
5. Describe a scenario in which a credit default swap (CDS) could potentially increase
systemic risk in the financial system.
o Answer: If numerous financial institutions hold CDS contracts on the same
underlying asset or entity, a default event could trigger massive payouts
simultaneously. This could lead to cascading failures across institutions that might
be unable to meet their obligations, increasing systemic risk.
6. In what situations would an investor choose an OTC derivative over an exchange-
traded derivative, despite the higher counterparty risk?
o Answer: An investor may opt for OTC derivatives to customize terms such as the
notional amount, maturity, and underlying asset, which may not be available in
standardized exchange-traded derivatives. These customized contracts cater to
specific hedging needs or speculative strategies not achievable in the standardized
market.
Deriva'ves: Interview Ques'ons

7. How does the concept of replication relate to the pricing of derivatives, particularly
options?
o Answer: Replication involves constructing a portfolio of the underlying asset and
risk-free bonds to mimic the payoff of a derivative. For options, the replicating
portfolio may include buying the underlying asset and borrowing, or selling the
asset and lending, to match the option’s payoff at expiration. This technique
underpins the Black-Scholes option pricing model.

Set 2

1. What are the main features of derivative instruments that differentiate them from
other financial instruments?
o Answer: Derivatives derive their value from an underlying asset, index, or rate,
involve leverage, and can be traded on exchanges or OTC markets. They also
often involve a notional amount rather than an actual exchange of assets.

Features of a Derivative Instrument

2. How do you determine the fair value of a derivative?

o Answer: The fair value is typically calculated using pricing models that consider
the derivative's time to maturity, underlying asset price, volatility, interest rates,
and, in some cases, dividend yields for options.

Derivatives Advantages Over Cash Market Transactions

3. Why might an investor prefer to use derivatives over directly investing in the
underlying asset?
o Answer: Derivatives provide leverage, which can amplify returns (and losses),
often involve lower transaction costs, allow for hedging risk without direct
ownership, and enable speculation on price movements without full capital outlay.

Exchange-Traded Derivatives vs. Over-The-Counter (OTC)

4. Compare the counterparty risks and liquidity differences between exchange-traded

derivatives and OTC derivatives.
o Answer: Exchange-traded derivatives have lower counterparty risk due to
clearinghouse involvement and higher liquidity due to standardization. OTC
derivatives carry higher counterparty risk and often have lower liquidity but
provide customization.

Forward Contracts

5. What are the potential drawbacks of using forward contracts compared to other
derivatives?
Deriva'ves: Interview Ques'ons

o Answer: Forward contracts are not standardized, have low liquidity, involve
counterparty risk, and can lead to significant losses as they are not marked to
market, making them less suitable for speculative purposes.

Futures Contracts

6. Explain how margin requirements in futures contracts help in managing risk.

o Answer: Initial and maintenance margins reduce default risk by ensuring both
parties have a stake in the contract. Daily mark-to-market adjustments further
manage risk by ensuring any gains or losses are settled regularly.

Futures vs. Forwards

7. Under what circumstances would an investor choose a forward contract over a

futures contract?
o Answer: Investors may prefer forwards when they need customization (e.g.,
specific terms not available in futures markets), prefer to avoid daily margin calls,
or seek to hedge a specific exposure without standardization.

Swaps and Options

8. What are the primary differences between swaps and options, and when would an
investor use one over the other?
o Answer: Swaps involve an exchange of cash flows and are used to hedge risks like
interest rate fluctuations over time, while options provide the right but not the
obligation to buy/sell at a certain price, used for hedging or speculation.

One-way Nature of Options

9. How does the one-way nature of options impact risk and reward compared to
forwards or futures?
o Answer: With options, the risk is limited to the premium paid, while the reward
can be theoretically unlimited. Forwards/futures have symmetrical risk and
reward, meaning both sides can gain or lose significantly.

Credit Swaps

10. Explain how a credit default swap (CDS) works and the role it plays in managing
credit risk.
o Answer: A CDS transfers the credit risk of a borrower to a third party, where the
buyer pays a premium to the seller in exchange for a payout if the borrower
defaults. It is a form of insurance against credit events.

The Expiration Value and The Profit for Both Long and Short Positions in Call
or Put Options
Deriva'ves: Interview Ques'ons

11. How do you calculate the expiration value and profit for a long call option position?
o Answer: Expiration value for a long call is max(0, S - K). Profit = max(0, S - K) -
Premium, where S is the underlying asset price at expiration and K is the strike
price.

Profit Calculation for Options

12. Describe the steps to calculate the profit for a short put option.
o Answer: Profit = Premium - max(0, K - S). If the option is in-the-money (S < K),
the payoff is negative, limited by the strike price and asset price difference, minus
the premium.

Credit Derivatives and Their Characteristics

13. What are some common types of credit derivatives, and how do they differ?
o Answer: Common types include credit default swaps (CDS), total return swaps,
and credit-linked notes. They differ in structure, payment terms, and the type of
credit risk transferred.

Advantage, Risk, and Use of Derivatives

14. What are the primary risks associated with using derivatives, and how can these
risks be mitigated?
o Answer: Risks include counterparty risk, market risk, liquidity risk, and
operational risk. Mitigation strategies include using clearinghouses,
diversification, setting limits, and employing hedging techniques.

Advantages of Derivative Instruments

15. What are the key benefits of using derivative instruments for investors and
companies?
o Answer: Derivatives enable risk management, lower transaction costs, leverage
for greater potential returns, and provide opportunities for arbitrage and access to
otherwise inaccessible markets.

Risks Associated with Derivative Instruments

16. Why are derivatives considered high-risk instruments, and what factors contribute
to these risks?
o Answer: Leverage, complexity, counterparty risk, and high sensitivity to market
conditions contribute to derivatives' high risk. Small changes in the underlying
asset can lead to disproportionate gains or losses.

Comparing Derivatives Use Among Issuers and Investors

Deriva'ves: Interview Ques'ons

17. How might a corporation's use of derivatives differ from that of an individual
investor?
o Answer: Corporations typically use derivatives for hedging operational risks, such
as currency and interest rate exposure, while individual investors may use them
for speculative purposes or portfolio diversification.

Arbitrage and Replication in Derivative Pricing

18. Explain how replication can be used to determine the price of a derivative,
specifically in options pricing.
o Answer: Replication involves constructing a portfolio that mimics the option's
payoff. For options, this often includes a combination of the underlying asset and
a risk-free bond, as used in the Black-Scholes model.