Finance Quiz: Hedging With Derivatives
20 questions · exam conditions
0:00
Hedging With DerivativesQuestion 1 of 20

A copper fabricator holds a short hedge using copper futures to manage the price risk of its inventory. The fabricator is concerned about basis risk. If the basis strengthens unexpectedly just before the hedge is lifted, what is the most likely impact on the fabricator's position?

The effective selling price of the copper will be higher than anticipated.
The effective selling price of the copper will be lower than anticipated.
The gain on the futures position will be larger than the loss on the spot position.
The hedge will result in a net loss regardless of the direction of copper prices.
← Back to quizzes

Finance Quiz

Finance Quiz: Hedging With Derivatives

Practice Hedging With Derivatives in Finance with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Hedging With Derivatives, giving you a quick way to practice the rules, question types, and explanations that matter most for Finance.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

All questions

Question 1

A copper fabricator holds a short hedge using copper futures to manage the price risk of its inventory. The fabricator is concerned about basis risk. If the basis strengthens unexpectedly just before the hedge is lifted, what is the most likely impact on the fabricator's position?

  1. The effective selling price of the copper will be higher than anticipated. (correct answer)
  2. The effective selling price of the copper will be lower than anticipated.
  3. The gain on the futures position will be larger than the loss on the spot position.
  4. The hedge will result in a net loss regardless of the direction of copper prices.
Explanation: Basis is defined as Spot Price - Futures Price. For a short hedger (who is long the spot asset and short futures), the effective price is P_F1 + ($S_2$ - $F_2$), where P_F1 is the initial futures price and ($S_2$ - $F_2$) is the basis at the time the hedge is lifted. A strengthening basis means the basis becomes more positive or less negative (i.e., S2S_2 - F2F_2 increases). Therefore, a stronger-than-expected basis will result in a higher-than-anticipated effective selling price.

Question 2

A corn syrup producer needs to buy corn in the future and implements a long hedge with corn futures. At the time the hedge is lifted, the producer finds that the basis has weakened more than expected (i.e., the spot price is lower relative to the futures price than anticipated). What is the consequence for the producer?

  1. The hedge will perform perfectly, locking in the initial futures price.
  2. The effective purchase price will be higher than expected.
  3. The loss on the spot position will be greater than the gain on the futures position.
  4. The effective purchase price will be lower than expected. (correct answer)
Explanation: When you encounter hedging questions, focus on how basis risk affects the hedge outcome. Basis is the difference between spot and futures prices, and changes in basis determine whether a hedge performs better or worse than expected. In this long hedge scenario, the corn syrup producer bought corn futures to protect against rising corn prices. When basis weakens more than expected, it means the spot price fell relative to the futures price compared to what was anticipated. This creates a favorable situation for someone who needs to buy the underlying commodity. Here's why: When the producer closes the hedge, they'll sell their futures contracts (likely at a loss since spot prices are lower) but buy corn in the spot market at these unexpectedly low prices. The additional basis weakness means the spot corn is even cheaper relative to futures than planned, so the savings on the actual corn purchase exceed the losses on the futures position. This results in a lower effective purchase price than originally expected, making answer D correct. Answer A is wrong because basis risk prevents perfect hedging - only when basis remains exactly as expected does a hedge lock in the initial price. Answer B incorrectly suggests the outcome is unfavorable when basis weakness actually benefits a long hedger who needs to buy the commodity. Answer C mischaracterizes the situation - there's no "loss on the spot position" since the producer is buying corn at favorable low prices. Remember: basis weakness helps long hedgers who are natural buyers of the commodity, while basis strengthening helps short hedgers who are natural sellers.

Question 3

A U.S. company has an accounts receivable of JPY 100 million due in 60 days. To hedge this exposure, the company's analyst suggests selling JPY futures. However, the CFO decides to buy a JPY put option instead. What is the most significant strategic advantage of the CFO's choice over the analyst's suggestion?

  1. The put option eliminates the possibility of a loss on the transaction.
  2. The put option preserves upside potential if the JPY appreciates against the USD. (correct answer)
  3. The put option has a lower total transaction cost than a futures contract.
  4. The put option hedge does not need to be adjusted if the JPY/USD exchange rate becomes volatile.
Explanation: Both selling JPY futures and buying JPY puts would protect the company from a depreciation of the yen. However, selling futures locks in the exchange rate. If the yen were to unexpectedly appreciate, the company would forgo the gain. By buying a put option, the company establishes a floor for the exchange rate. If the yen appreciates, the put can be left to expire worthless, and the company can convert its JPY receivable at the more favorable spot rate, thus preserving the upside potential.

Question 4

A company is considering hedging a future purchase of a commodity. A perfect hedge is not available due to a mismatch between the commodity grade the company uses and the grade specified in the futures contract. When constructing a minimum-variance hedge in this situation, the hedge ratio will be primarily determined by:

  1. the company's risk aversion and the expected return of the commodity.
  2. the convenience yield of the commodity and the risk-free rate of interest.
  3. the bid-ask spread and daily trading volume of the futures contract.
  4. the correlation and relative price volatilities of the spot commodity and the futures contract. (correct answer)
Explanation: When you encounter hedging questions involving basis risk (the mismatch between what you're hedging and the available futures contract), you're dealing with minimum-variance hedge ratio calculations. This is a cornerstone concept in risk management. The minimum-variance hedge ratio aims to minimize the overall risk of your hedged position. This ratio is calculated using the formula: h∗=ρ×σSσFh^* = \rho \times \frac{\sigma_S}{\sigma_F}, where ρ is the correlation between the spot commodity price and futures price, σ_S is the volatility of the spot commodity, and σ_F is the volatility of the futures contract. The hedge ratio depends entirely on how closely the two assets move together (correlation) and their relative price movements (volatilities). Answer D correctly identifies these two critical components. The stronger the correlation and the higher the spot commodity's volatility relative to the futures volatility, the larger the optimal hedge ratio becomes. Answer A confuses hedge ratio determination with portfolio optimization theory. Risk aversion affects whether you choose to hedge at all, but not the mathematically optimal hedge ratio. Answer B mentions factors relevant to futures pricing models like cost-of-carry, but these don't determine the variance-minimizing hedge ratio. Answer C focuses on market microstructure issues that affect transaction costs and execution quality, but liquidity measures don't enter the minimum-variance hedge ratio formula. Remember: minimum-variance hedge ratios always come down to correlation and relative volatilities. When you see basis risk hedging questions, immediately think about how closely correlated the hedge instrument is with your underlying exposure.

Question 5

A market maker writes a European put option on a stock. The option's delta is -0.45. To create a delta-neutral hedge, what action must the market maker take for each 100-share contract written?

  1. Buy 45 shares of the stock.
  2. Sell 45 shares of the stock. (correct answer)
  3. Buy 55 shares of the stock.
  4. Sell 55 shares of the stock.
Explanation: Delta measures the change in an option's price for a $1 change in the underlying stock's price. The market maker is short a put option. The delta of the position is the number of options sold times the option's delta: -100 * (-0.45) = +45. To achieve a delta-neutral position (a total delta of zero), the market maker must take an offsetting position with a delta of -45. Since one share of stock has a delta of +1, the market maker must sell 45 shares of the stock.

Question 6

An investor owns 200 shares of XYZ stock, purchased at $48 per share. To generate income, the investor writes two covered call contracts with a strike price of $50. The premium received is $3 per share. If the stock price is $55 at expiration, what is the investor's total profit from this combined strategy?

  1. $400
  2. $1,000 (correct answer)
  3. $1,600
  4. $2,000
Explanation: With a covered call, if the stock price at expiration is above the strike price, the shares will be called away at the strike price. 1) The capital gain on the stock is ($50 strike price - $48 purchase price) * 200 shares = $400. 2) The income from selling the calls is $3/share * 200 shares = $600. 3) The total profit is the capital gain plus the option premium received: $400 + $600 = $1,000. The investor forgoes any stock appreciation above the $50 strike price.

Question 7

An oil producer sells one crude oil futures contract (1,000 barrels) at $80 per barrel to hedge a portion of its upcoming production. Over the next month, the spot price of oil rises to $85, and the futures price rises to $86. The producer closes out the futures position. What is the profit or loss on the futures contract, and what type of risk does the difference between the spot and futures price movements represent?

  1. $6,000 gain on futures; represents liquidity risk.
  2. $5,000 gain on futures; represents systemic risk.
  3. $1,000 loss on futures; represents credit risk.
  4. $6,000 loss on futures; represents basis risk. (correct answer)
Explanation: When you encounter futures hedging problems, focus on two key elements: the profit/loss calculation and the relationship between spot and futures price movements. To calculate the futures profit/loss, remember that this oil producer sold a futures contract at $80 and later bought it back at $86 to close the position. Since the producer sold high and bought back higher, this results in a loss: $(80 - 86) \times 1,000 = -\6,000 or a $6,000 loss. The spot price rose 5(5 (80 to $85) while the futures price rose 6(6 (80 to $86). This $1 difference in price movements illustrates basis risk - the risk that the spread between spot and futures prices will change unexpectedly. Perfect hedges assume spot and futures prices move in lockstep, but they rarely do. Looking at the wrong answers: Choice A incorrectly calculates the profit as a gain and misidentifies the risk as liquidity risk (difficulty buying/selling assets). Choice B also treats this as a gain and calls it systemic risk (broad market risk affecting all participants). Choice C gets the direction wrong by calling it a $1,000 loss instead of $6,000, and incorrectly identifies credit risk (default risk). Study tip: In futures problems, always track whether the party is long or short the contract, then calculate profit as (selling price - buying price) × contract size. When spot and futures don't move by identical amounts, that's basis risk - a key concern in any hedging strategy.

Question 8

An investor holds 1,000 shares of a stock currently trading at $150 per share. To protect against a market downturn over the next two months, the investor purchases 10 protective put contracts with a strike price of $145. The premium for each put is $4.00 per share. At the expiration of the options, the stock price has fallen to $130. What is the net profit or loss on the combined position (stock and options)?

  1. A loss of $9,000 (correct answer)
  2. A loss of $11,000
  3. A loss of $20,000
  4. A loss of $24,000
Explanation: This is a multi-step calculation for a protective put. 1) Calculate the loss on the stock: ($130 - 150)∗1,000shares=−150) * 1,000 shares = -20,000. 2) Calculate the cost of the puts: 10 contracts * 100 shares/contract * $4.00/share = 4,000.3)Calculatethegainontheputsatexpiration:(4,000. 3) Calculate the gain on the puts at expiration: (145 strike - $130 stock price) * 1,000 shares = $15,000. 4) Calculate the net profit/loss on the puts: $15,000 gain - $4,000 cost = 11,000profit.5)Calculatethetotalnetprofit/lossonthecombinedposition:−11,000 profit. 5) Calculate the total net profit/loss on the combined position: -20,000 (from stock) + 11,000(fromputs)=−11,000 (from puts) = -9,000.

Question 9

An investor wants to protect a long stock position while retaining unlimited upside potential. The investor also wishes to finance the cost of this protection by forgoing some of that upside potential. Which of the following strategies best accomplishes these objectives?

  1. A long straddle, which profits from large price movements in either direction.
  2. A covered call, where the premium received provides downside protection.
  3. A short hedge using stock index futures, which provides symmetric protection.
  4. A protective put, financed by selling a call option with a higher strike price (a collar). (correct answer)
Explanation: When you encounter questions about protecting stock positions while managing costs, think about option strategies that combine protective elements with income generation to offset expenses. The investor needs three things: downside protection, unlimited upside potential, and cost financing through limited upside sacrifice. A collar strategy perfectly achieves this by combining a protective put (which provides downside protection while preserving unlimited upside) with a short call option at a higher strike price. The premium received from selling the call helps finance the protective put's cost, while only limiting gains above the call's strike price rather than eliminating upside potential entirely. Let's examine why the other strategies fall short. Choice A, a long straddle, requires buying both a put and call, which increases costs rather than financing protection and doesn't specifically protect an existing long position. Choice B, a covered call, generates income but provides no real downside protection—it only slightly reduces the cost basis and actually caps upside potential at the call strike. Choice C, shorting index futures, creates a hedge but eliminates upside potential entirely since gains in the stock are offset by losses in the short futures position. The collar (choice D) uniquely satisfies all requirements: the long put protects against downside, the underlying stock provides unlimited upside until the short call strike, and the call premium finances the put cost. Remember this pattern: when a question asks for protection plus cost management, look for combination strategies that pair protective options with premium-generating positions.

Question 10

A U.S.-based airline needs to purchase 420,000 gallons of jet fuel in three months. To hedge against a price increase, the airline considers using heating oil futures contracts, as no jet fuel contract is available. Each heating oil contract is for 42,000 gallons. The standard deviation of the change in jet fuel prices is 0.045, the standard deviation of the change in heating oil futures prices is 0.030, and the correlation coefficient between them is 0.80. What is the optimal number of futures contracts to implement a minimum-variance hedge?

  1. 8 contracts
  2. 10 contracts
  3. 12 contracts (correct answer)
  4. 15 contracts
Explanation: This is a multi-step cross-hedging problem. First, calculate the optimal hedge ratio (h*). The formula is h* = ρ * (σ_S / σ_F), where ρ is the correlation, σ_S is the standard deviation of the spot asset (jet fuel), and σ_F is the standard deviation of the futures asset (heating oil). Here, h* = 0.80 * (0.045 / 0.030) = 0.80 * 1.5 = 1.2. Next, calculate the number of contracts needed. The formula is N* = h* * (Q_A / Q_F), where Q_A is the quantity of the asset to be hedged and Q_F is the quantity per contract. N* = 1.2 * (420,000 / 42,000) = 1.2 * 10 = 12 contracts.

Question 11

A U.S. firm hedges a £1 million payable due in three months by entering a long forward contract at a rate of $1.25/£. Three months later, the spot exchange rate is $1.20/£. Which statement best describes the outcome?

  1. The firm experienced an opportunity loss of $50,000 relative to the spot market. (correct answer)
  2. The firm realized a hedging gain of $50,000 on the forward contract.
  3. The hedge was ineffective as the firm paid more than the spot rate for the pounds.
  4. The firm's total cash outflow in dollars was $1,200,000.
Explanation: The firm was obligated to buy pounds at $1.25. The spot rate at settlement was $1.20. This means the firm paid $0.05 more per pound than the prevailing market rate. The total cost was £1,000,000 * $1.25/£ = $1,250,000. Had they not hedged, the cost would have been £1,000,000 * $1.20/£ = $1,200,000. The difference is $50,000. This is an opportunity loss (or an economic loss on the hedge itself), not a gain. The purpose of the hedge was to eliminate uncertainty, which it did, but in this case, the outcome was unfavorable compared to not hedging.

Question 12

A portfolio manager wants to hedge a $120 million equity portfolio that has a beta of 1.25 relative to the S&P 500. The current S&P 500 index level is 5,000, and the futures contract multiplier is $250. To fully hedge the systematic risk of the portfolio, the manager should:

  1. sell 96 futures contracts.
  2. buy 96 futures contracts.
  3. sell 120 futures contracts. (correct answer)
  4. buy 120 futures contracts.
Explanation: First, calculate the beta-adjusted value of the portfolio to be hedged: $120 million * 1.25 = $150 million. Second, calculate the value of one S&P 500 futures contract: 5,000 * $250 = $1,250,000. Third, calculate the number of contracts needed: $150 million / $1,250,000 = 120 contracts. Because the manager holds the equity portfolio (a long position) and wants to hedge against a market decline, they must take a short position in the futures contracts. Therefore, the manager should sell 120 contracts. A common error is to beta-adjust the number of contracts, not the portfolio value, leading to 96 contracts.

Question 13

A U.S. company will receive a payment of €5 million in 90 days. The treasurer is concerned about the euro depreciating against the U.S. dollar. They are considering hedging with either futures or options. Which statement most accurately contrasts these two hedging alternatives in this specific scenario?

  1. Buying euro put options requires an upfront premium but allows the company to benefit if the euro strengthens unexpectedly. (correct answer)
  2. Selling euro futures contracts locks in an exchange rate, providing better protection than options if the euro strengthens.
  3. Buying euro call options is the appropriate options strategy and is less costly than a futures hedge if the euro depreciates.
  4. Selling euro futures contracts has no upfront cost but exposes the company to unlimited loss if the euro depreciates.
Explanation: The company is long euros (will receive them) and fears a price drop (depreciation). The correct hedges are selling euro futures or buying euro puts. Buying euro puts provides a floor for the exchange rate. If the euro strengthens (appreciates), the put expires worthless, and the company exchanges its euros at the more favorable spot rate, thus benefiting from the upside. This insurance-like protection comes at the cost of the option premium. Selling futures locks in the rate, eliminating both downside risk and upside potential.

Question 14

An airline wishes to hedge against rising fuel costs but wants to avoid the margin calls associated with futures contracts. The airline also wants to benefit if fuel prices fall. Which of the following derivative instruments is most suitable for this purpose?

  1. A long position in an over-the-counter (OTC) forward contract on jet fuel.
  2. A short position in crude oil futures contracts traded on an exchange.
  3. Buying at-the-money call options on crude oil. (correct answer)
  4. Selling at-the-money put options on crude oil.
Explanation: Buying call options provides a cap on the purchase price of fuel. If prices rise, the option becomes valuable, offsetting the higher spot price. If prices fall, the option expires worthless (loss is limited to the premium paid), and the airline can buy fuel at the lower market price. Options have no margin calls for the buyer. A forward contract (A) would not allow the airline to benefit from falling prices. A short futures position (B) is the wrong direction for hedging a future purchase. Selling puts (D) would generate premium income but create a loss if prices fall, which is the opposite of the desired outcome.

Question 15

A corporate treasurer needs to lock in a borrowing rate for a future loan. They decide to use interest rate futures. Which of the following strategies is most appropriate, and what is the primary risk associated with it?

  1. Sell interest rate futures; the primary risk is that rates fall instead of rise. (correct answer)
  2. Buy interest rate futures; the primary risk is that rates fall instead of rise.
  3. Sell interest rate futures; the primary risk is that the yield curve shifts in a non-parallel fashion.
  4. Buy interest rate futures; the primary risk is that the company's credit spread widens.
Explanation: To hedge against a rise in interest rates (which would increase borrowing costs), the treasurer must sell interest rate futures. A sale of futures profits if rates rise (and futures prices fall). This profit would offset the higher borrowing cost. The risk of any hedge is that the price moves in the favorable direction. If rates fall, the company would have been better off without the hedge, as the gain from lower borrowing costs would be offset by a loss on the short futures position. While non-parallel shifts (basis risk) and credit spread changes are risks, the fundamental trade-off in hedging is forgoing potential gains to protect against losses.

Question 16

A wheat farmer expects to harvest 50,000 bushels of wheat in September. In June, the September futures price is $7.50 per bushel. The farmer sells 10 futures contracts (5,000 bushels each) to hedge his position. By September, the spot price has fallen to $7.00 per bushel, and the September futures price is $7.05 per bushel. What is the effective price per bushel the farmer receives for his wheat, including the result of the hedge?

  1. $7.00
  2. $7.45 (correct answer)
  3. $7.50
  4. $7.95
Explanation: This requires calculating the outcome of a short hedge. The farmer's gain on the futures position is the initial price minus the final price: $7.50 - $7.05 = $0.45 per bushel. The farmer sells the physical wheat in the spot market for $7.00 per bushel. The effective price received is the spot price plus the gain from the futures contract: $7.00 + $0.45 = $7.45 per bushel. Alternatively, for a short hedge, Effective Price = Initial Futures Price + Final Basis. Initial basis is unknown, but Final Basis = Spot - Futures = $7.00 - 7.05=−7.05 = -0.05. Effective Price = 7.50+(−7.50 + (-0.05) = $7.45.

Question 17

A jewelry manufacturer needs to purchase 1,000 ounces of gold in six months and decides to implement a long hedge by buying gold futures contracts. At the time of the hedge, the six-month futures price is $1,800/oz. Six months later, the manufacturer closes the futures position at $1,850/oz and buys gold in the spot market at $1,860/oz. What was the effective price per ounce paid for the gold?

  1. $1,800
  2. $1,810 (correct answer)
  3. $1,860
  4. $1,910
Explanation: The manufacturer implemented a long hedge. The gain on the futures position is the final price minus the initial price: $1,850 - $1,800 = $50 per ounce. The manufacturer paid $1,860 per ounce in the spot market. The effective purchase price is the spot price paid minus the gain from the futures contract: $1,860 - $50 = 1,810perounce.Thebasisweakenedfromanexpectedzero(atmaturity)to+1,810 per ounce. The basis weakened from an expected zero (at maturity) to +10 ($1,860 spot - $1,850 futures), which hurt the long hedger.

Question 18

A pension fund manager holds a diversified portfolio of bonds and is concerned that interest rates will rise sharply. The manager decides to hedge this risk using Treasury bond futures. The portfolio's duration is significantly higher than the duration of the cheapest-to-deliver bond underlying the futures contract. This situation will require the manager to:

  1. sell a smaller face value of futures contracts than the portfolio's market value.
  2. sell a larger face value of futures contracts than the portfolio's market value. (correct answer)
  3. buy futures contracts to offset the portfolio's negative convexity.
  4. use options instead of futures, as duration hedging is not feasible.
Explanation: To hedge interest rate risk using derivatives, the goal is to match the price sensitivity (duration) of the asset with the price sensitivity of the hedge. The number of contracts needed is proportional to the ratio of the portfolio's duration to the futures' duration (and also their respective market values). Since the portfolio's duration is much higher, it is more sensitive to interest rate changes than the futures contract on a dollar-for-dollar basis. To create an equivalent offset, the manager must sell a larger total face value of the less-sensitive futures contracts.

Question 19

A copper fabricator holds a short hedge using copper futures to manage the price risk of its inventory. The fabricator is concerned about basis risk. If the basis strengthens unexpectedly just before the hedge is lifted, what is the most likely impact on the fabricator's position?

  1. The effective selling price of the copper will be higher than anticipated. (correct answer)
  2. The effective selling price of the copper will be lower than anticipated.
  3. The gain on the futures position will be larger than the loss on the spot position.
  4. The hedge will result in a net loss regardless of the direction of copper prices.
Explanation: Basis is defined as Spot Price - Futures Price. For a short hedger (who is long the spot asset and short futures), the effective price is P_F1 + ($S_2$ - $F_2$), where P_F1 is the initial futures price and ($S_2$ - $F_2$) is the basis at the time the hedge is lifted. A strengthening basis means the basis becomes more positive or less negative (i.e., S2S_2 - F2F_2 increases). Therefore, a stronger-than-expected basis will result in a higher-than-anticipated effective selling price.

Question 20

A portfolio manager wants to hedge a $120 million equity portfolio that has a beta of 1.25 relative to the S&P 500. The current S&P 500 index level is 5,000, and the futures contract multiplier is $250. To fully hedge the systematic risk of the portfolio, the manager should:

  1. sell 96 futures contracts.
  2. buy 96 futures contracts.
  3. sell 120 futures contracts. (correct answer)
  4. buy 120 futures contracts.
Explanation: First, calculate the beta-adjusted value of the portfolio to be hedged: $120 million * 1.25 = $150 million. Second, calculate the value of one S&P 500 futures contract: 5,000 * $250 = $1,250,000. Third, calculate the number of contracts needed: $150 million / $1,250,000 = 120 contracts. Because the manager holds the equity portfolio (a long position) and wants to hedge against a market decline, they must take a short position in the futures contracts. Therefore, the manager should sell 120 contracts. A common error is to beta-adjust the number of contracts, not the portfolio value, leading to 96 contracts.