Strategies Using Exchange Traded Interest Rate Futures and Options

Learn these topics

• What an Option Premium Is Made OfLesson
• DeltaLesson
• Options breakeven calculatorCalculator
• F&O lot sizesReference
• Market, Limit and Stop OrdersLesson

More units in NISM Series IV

• Introduction to Interest Rate, Interest Rate Instruments and Fixed Income Market30
• Interest Rate Derivatives10
• Exchange Traded Interest Rate Futures20
• Exchange Traded Interest Rate Options22
• Trading Mechanism in Exchange Traded Interest Rate Derivatives10
• Clearing, Settlement and Risk Management of Interest Rate Derivatives16
• Regulatory Framework for Interest Rate Derivatives8
• Accounting and Taxation of Interest Rate Derivatives4
• Code of Conduct and Investor Protection Measures in Interest Rate Derivatives6

Practise all of NISM Series IV

Exam format

All 24 questions on Strategies Using Exchange Traded Interest Rate Futures and Options, with answers

1. Q1A manager already owns fixed-rate government bonds and wants to reduce losses from a rise in yields. Assuming closely matching bond-price futures, which directional hedge is appropriate?

   • A

     Option A. Buy more bond-price futures

     Why it is wrong: This adds positive bond-price exposure to the existing long portfolio.

   • B

     Option B. Sell bond-price puts without another offset

     Why it is wrong: A short put adds downside exposure when bond prices fall.

   • C

     Option C. Sell bond-price futures — Correct answer

   • D

     Option D. Buy additional long-duration bonds using borrowed funds

     Why it is wrong: This generally increases the same interest-rate exposure rather than reducing it.

   Answer: C. The manager is economically long bond prices. To reduce that sensitivity, the hedge should have the opposite price exposure: short comparable futures. When yields rise and bond prices fall, futures gains can offset part of the cash loss. The size must still be set using relevant risk measures rather than direction alone. Remember: Determine the existing exposure before choosing hedge direction.

   Hint, shown before you answer in practice mode: Common mistake: Buying futures merely because the underlying portfolio consists of purchased bonds.

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2. Q2A pension fund will receive cash in two months and then buy fixed-rate government bonds. It fears yields may fall before the purchase. Which hedge best addresses the resulting higher purchase price?

   • A

     Option A. Buy a bond-price put only because the word “fall” appears in the forecast

     Why it is wrong: The feared fall is in yields. A put on bond price protects the opposite price direction.

   • B

     Option B. Increase unhedged exposure to future purchases

     Why it is wrong: A larger planned purchase increases the price risk rather than offsetting it.

   • C

     Option C. Buy matching bond-price futures now — Correct answer

   • D

     Option D. Sell matching bond-price futures now

     Why it is wrong: A short position loses when bond prices rise, worsening the stated risk.

   Answer: C. The fund does not yet own the bonds. Its exposure is to the cost of a planned purchase. Falling yields raise that cost. A long bond-price future can earn a compensating gain while cash remains unavailable for the bond purchase. This is a different exposure from an existing long bond holding. Remember: An anticipated purchase often requires the opposite hedge from an existing asset holding.

   Hint, shown before you answer in practice mode: Common mistake: Confusing a forecast of falling yields with a forecast of falling bond prices.

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3. Q3A company expects floating-rate borrowing costs to rise. Its proposed futures hedge is quoted so that its price falls when the relevant rate rises. Ignoring basis risk, which position provides the desired offset?

   • A

     Option A. Short the price-quoted futures — Correct answer

   • B

     Option B. Buy both an equal long and short position in the same contract

     Why it is wrong: The two futures positions cancel rather than hedge the borrowing exposure.

   • C

     Option C. Choose direction without checking the quotation formula

     Why it is wrong: The relation between rate and quote is essential for correct direction.

   • D

     Option D. Long the same futures

     Why it is wrong: The long would lose in the stated adverse rate scenario.

   Answer: A. The exposure is a higher borrowing rate, while the contract is inversely quoted to that rate. A short futures position therefore gains in the adverse borrowing scenario. With a futures contract quoted directly on a rate rather than inversely, the required direction could differ. The stated price convention governs. Remember: Trace the adverse exposure through the contract’s quotation before selecting long or short.

   Hint, shown before you answer in practice mode: Common mistake: Using a generic “rising rates means buy” rule for every interest-rate derivative.

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4. Q4CASE H: A long bond portfolio has market value ₹10 crore and modified duration 4. Each available bond futures contract has PVBP ₹80. Assuming matching yield changes, how many futures contracts hedge the portfolio’s first-order rate sensitivity?

   • A

     Option A. Sell 1,250 contracts

     Why it is wrong: This divides market value by an unrelated amount rather than matching PVBP.

   • B

     Option B. Sell 500 contracts — Correct answer

   • C

     Option C. Sell 50 contracts

     Why it is wrong: This understates the portfolio PVBP by ten.

   • D

     Option D. Buy 500 contracts

     Why it is wrong: The number is right but the long futures direction adds portfolio exposure.

   Answer: B. Portfolio PVBP = ₹10 crore × 4 × 0.0001 = ₹40,000 per basis point. The hedge count is ₹40,000/₹80 = 500 contracts. Since the portfolio is long bond prices, use short futures. This first-order calculation assumes matching rate moves and does not eliminate convexity or basis risk. Remember: Size a duration hedge using comparable rupee sensitivities.

   Hint, shown before you answer in practice mode: Common mistake: Matching face amounts while ignoring differing price sensitivities.

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5. Q5CASE H: A ₹10 crore bond portfolio has modified duration 4. The manager wants duration 2, not a fully neutral position. Each bond futures contract has PVBP ₹80. With value fixed and matching yield changes, what adjustment is required?

   • A

     Option A. Sell 250 contracts — Correct answer

   • B

     Option B. Buy 250 contracts

     Why it is wrong: Buying adds duration instead of reducing it.

   • C

     Option C. Sell 500 contracts

     Why it is wrong: This removes the full first-order exposure rather than leaving target duration 2.

   • D

     Option D. Make no change because duration 2 remains positive

     Why it is wrong: A positive target can still require reducing the current positive duration.

   Answer: A. Current PVBP is ₹10 crore × 4 × 0.0001 = ₹40,000. Target PVBP is ₹10 crore × 2 × 0.0001 = ₹20,000. Sell (40,000 − 20,000)/80 = 250 contracts. A target-duration hedge should preserve the intended residual exposure rather than automatically neutralising everything. Remember: Hedge the difference between current and desired sensitivity.

   Hint, shown before you answer in practice mode: Common mistake: Using the full-hedge quantity when the mandate specifies a non-zero risk target.

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6. Q6A portfolio has positive PVBP ₹10,350. Each short futures contract offsets ₹80 of PVBP. Only whole contracts are allowed. Which short position minimises the absolute residual PVBP?

   • A

     Option A. 129 contracts — Correct answer

   • B

     Option B. 130 contracts

     Why it is wrong: Its absolute residual of ₹50 is larger than ₹30 for 129 contracts.

   • C

     Option C. 128 contracts

     Why it is wrong: It leaves +₹110 of residual PVBP.

   • D

     Option D. No hedge because the exact ratio is not an integer

     Why it is wrong: An imperfect whole-contract hedge can still reduce exposure substantially.

   Answer: A. The theoretical count is 10,350/80 = 129.375. Compare nearby integers rather than blindly rounding upward: 129 leaves 10,350 − 129×80 = +₹30. 130 leaves −₹50. Under the stated absolute-residual objective, 129 is better. A policy against any underhedge could lead to a different choice, but that is not the objective here. Remember: Rounding policy should follow the hedge objective.

   Hint, shown before you answer in practice mode: Common mistake: Assuming every fractional hedge ratio must be rounded upward.

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7. Q7A cash portfolio has PVBP ₹50,000 per basis point of its own yield. Its yield is expected to change by 1.2 basis points for each one-basis-point change in the futures reference yield. One futures contract has PVBP ₹80 to its reference. What first-order short hedge count follows?

   • A

     Option A. 750 contracts — Correct answer

   • B

     Option B. 60 contracts

     Why it is wrong: This omits or mis-scales the contract PVBP conversion.

   • C

     Option C. 625 contracts

     Why it is wrong: This ignores the 1.2 sensitivity of cash yield to reference yield.

   • D

     Option D. 521 contracts approximately

     Why it is wrong: This divides by 1.2 rather than multiplying to convert exposure into reference-yield units.

   Answer: A. The exposures must first be expressed against the same risk factor. A one-basis-point futures-reference move causes a 1.2-basis-point cash-yield move, so cash value sensitivity is ₹60,000. Offsetting it requires 60,000/80 = 750 short futures. The result is model-dependent because the stated yield relationship may change. Remember: Convert risk sensitivities to a common reference before taking their ratio.

   Hint, shown before you answer in practice mode: Common mistake: Assuming cash and futures yields always move one-for-one.

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8. Q8Over a period, a bond portfolio loses ₹6,00,000. Its short futures hedge gains ₹5,50,000 and total hedge costs are ₹20,000. What is the combined net result?

   • A

     Option A. A loss of ₹11,70,000

     Why it is wrong: This incorrectly adds the futures gain as another loss.

   • B

     Option B. A gain of ₹5,30,000

     Why it is wrong: This evaluates only the derivative leg after costs and omits the bond loss.

   • C

     Option C. A loss of ₹50,000

     Why it is wrong: This ignores the hedge costs.

   • D

     Option D. A loss of ₹70,000 — Correct answer

   Answer: D. The relevant result combines cash asset, derivative and costs: −6,00,000 + 5,50,000 − 20,000 = −₹70,000. The hedge substantially reduced the unhedged loss but did not produce a perfect offset. That can reflect basis effects, sizing, costs or other imperfect matching. Remember: Assess the total economic exposure, not the derivative leg in isolation.

   Hint, shown before you answer in practice mode: Common mistake: Calling a hedge successful merely because its futures trade made money.

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9. Q9A futures hedge was initially PVBP-neutral. Since then bonds were sold from the cash portfolio and the remaining bonds’ duration changed. What should the manager do?

   • A

     Option A. Use only the original face value and ignore current prices

     Why it is wrong: Current rupee risk depends on current holdings and sensitivities.

   • B

     Option B. Keep the old count because an initially neutral hedge remains neutral forever

     Why it is wrong: Holdings, prices, durations and contract sensitivities can change.

   • C

     Option C. Double the hedge automatically after any portfolio sale

     Why it is wrong: There is no such general rebalancing rule.

   • D

     Option D. Recalculate current cash and futures sensitivities and adjust the hedge as needed — Correct answer

   Answer: D. PVBP neutrality is a point-in-time condition. Changes in portfolio composition, prices, yields and time to maturity alter exposure. The futures sensitivity can also change. Rebalancing should be driven by current risk and the mandate, while considering transaction costs and trading constraints. Remember: A hedge ratio is an estimate to monitor, not a permanent label.

   Hint, shown before you answer in practice mode: Common mistake: Treating a hedge established once as maintenance-free.

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10. Q10Define basis as S − F. A trader buys one unit of a bond at S₀=100 and shorts matching futures at F₀=101. On closing both, S₁=98 and F₁=98.50. Ignoring carry, costs and multipliers, what is combined P/L per unit?

    • A

      Option A. A loss of 2.00

      Why it is wrong: This omits the futures gain.

    • B

      Option B. Zero because the number of units matches

      Why it is wrong: Equal units do not guarantee zero P/L when basis changes.

    • C

      Option C. A loss of 0.50

      Why it is wrong: This reverses the basis change for the specified long-cash/short-futures combination.

    • D

      Option D. A gain of 0.50 — Correct answer

    Answer: D. Combined P/L = (98 − 100) + (101 − 98.50) = +0.50. Equivalently, it equals (S₁−F₁) − (S₀−F₀) = −0.50 − (−1.00). Thus matching quantities does not remove basis risk. The basis can move favourably or adversely during the hedge. Remember: For equal units of long cash and short futures, net price P/L follows the change in the defined basis.

    Hint, shown before you answer in practice mode: Common mistake: Assuming quantity matching guarantees an exact price offset.

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11. Q11A bond portfolio needs a hedge for another three months, but its existing short futures expire soon. Which transaction rolls the short hedge into a later expiry?

    • A

      Option A. Buy both expiries in equal amounts

      Why it is wrong: Buying the later expiry creates a long rather than the required continued short hedge.

    • B

      Option B. Let the old futures expire and assume their exposure continues automatically

      Why it is wrong: An expiring contract does not automatically become a later contract.

    • C

      Option C. Sell additional near-expiry futures and buy later futures

      Why it is wrong: This adds to the old short while establishing the opposite later exposure.

    • D

      Option D. Buy back the near-expiry futures and sell the later-expiry futures — Correct answer

    Answer: D. Rolling replaces an expiring position with another maturity. For a short hedge, buy the old contract and sell the new one. The calendar spread, execution costs and altered contract sensitivity matter, so a roll is not necessarily costless and the new number of contracts may need recalculation. Remember: A roll has a closing leg and a new opening leg.

    Hint, shown before you answer in practice mode: Common mistake: Treating expiry as an automatic extension of the same hedge.

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12. Q12An investor buys a bond at 100 and a put on the same bond with strike 98 for premium 0.70. Evaluate only the terminal bond price plus option payoff. Assume no coupons, financing or costs. What is the maximum loss per unit?

    • A

      Option A. 0.70

      Why it is wrong: This is only the put premium and ignores the fall from bond purchase price to strike.

    • B

      Option B. 100.70

      Why it is wrong: The put provides a floor, so the entire initial outlay is not at risk under the stated assumptions.

    • C

      Option C. 2.00

      Why it is wrong: This ignores the protection premium.

    • D

      Option D. 2.70 — Correct answer

    Answer: D. Terminal bond-plus-put value is S_T + max(98 − S_T, 0) = max(S_T, 98). The minimum is 98, while initial cost is 100 + 0.70 = 100.70. Maximum loss is therefore 2.70. The protection floor must be adjusted for the cost of acquiring it when discussing net results. Remember: A protective put provides a price floor, not a free guarantee of the original purchase price.

    Hint, shown before you answer in practice mode: Common mistake: Ignoring premium when measuring protected portfolio downside.

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13. Q13An investor owns a bond bought at 100 and writes a call with strike 102 for premium 0.50 on the same amount. Ignore coupons and costs. If the bond finishes at 105, what is the combined profit per unit?

    • A

      Option A. 0.50

      Why it is wrong: This ignores the bond’s retained gain up to the strike.

    • B

      Option B. 5.50

      Why it is wrong: This counts the bond gain and premium but omits the call obligation.

    • C

      Option C. 3.50

      Why it is wrong: This does not correctly net the written call’s 3-unit intrinsic liability.

    • D

      Option D. 2.50 — Correct answer

    Answer: D. Combined profit = (105 − 100) − max(105 − 102, 0) + 0.50 = 2.50. Writing the call exchanges some potential upside for premium. It does not remove the bond’s downside. The premium merely provides a small buffer against a price decline. Remember: A covered call limits upside while retaining substantial downside exposure.

    Hint, shown before you answer in practice mode: Common mistake: Calling a covered call a complete downside hedge.

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14. Q14A trader buys a bond-price call at strike 100 for 1.20 and sells an otherwise matching call at strike 103 for 0.40. What is the spread’s maximum expiry profit per unit, excluding costs?

    • A

      Option A. 3.00

      Why it is wrong: This is the maximum gross exercise payoff before the net debit.

    • B

      Option B. 0.80

      Why it is wrong: This is the net premium paid and maximum loss, not maximum profit.

    • C

      Option C. 2.20 — Correct answer

    • D

      Option D. 3.80

      Why it is wrong: This adds the premium paid instead of subtracting it.

    Answer: C. The lower-strike long call and higher-strike short call create a bull call spread. Net debit = 1.20 − 0.40 = 0.80. At or above 103, the payoff difference is capped at 103 − 100 = 3, so maximum profit is 3 − 0.80 = 2.20. Below 100 both expire worthless and the debit is lost. Remember: For a debit vertical spread, maximum profit is strike width minus net premium paid.

    Hint, shown before you answer in practice mode: Common mistake: Ignoring the short option when extrapolating gains above its strike.

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15. Q15A trader buys a put with strike 102 for 1.50 and sells a put with strike 99 for 0.50. Both reference the same bond and expiry. If settlement is 100, what is net profit per unit?

    • A

      Option A. 1.00 — Correct answer

    • B

      Option B. 3.00

      Why it is wrong: This confuses the strike width with the payoff at settlement 100.

    • C

      Option C. A loss of 1.00

      Why it is wrong: This ignores the in-the-money long put receipt.

    • D

      Option D. 2.00

      Why it is wrong: This is the gross payoff before the net debit.

    Answer: A. At settlement 100, the 102 put is worth 2 and the 99 put is out of the money. Combined gross payoff is 2 − 0 = 2. The initial net debit is 1.50 − 0.50 = 1, producing profit 1. An expiry price between strikes requires evaluating each leg, not assuming the maximum spread payoff. Remember: Evaluate each option separately before combining a multi-leg payoff.

    Hint, shown before you answer in practice mode: Common mistake: Using maximum-profit formulas at settlement prices inside the strike interval.

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16. Q16A trader buys a call and a put on the same bond, each with strike 100 and the same expiry. Premiums are 1.10 and 0.90. Ignoring costs, what are the expiry break-even prices?

    • A

      Option A. 98 and 102 — Correct answer

    • B

      Option B. 100 only

      Why it is wrong: At the strike both options expire worthless and the full premium is lost.

    • C

      Option C. 99.10 and 101.10

      Why it is wrong: This uses individual leg premiums instead of the total strategy cost.

    • D

      Option D. 99 and 101

      Why it is wrong: This uses only half of the combined premium.

    Answer: A. Total premium is 1.10 + 0.90 = 2. At expiry, straddle payoff is |S_T − 100|. Break-even requires |S_T − 100| = 2, giving 98 and 102. A large enough move in either direction can profit, but merely expecting volatility is insufficient if the movement does not cover the premium. Remember: A long straddle pays for two options and must recover both premiums.

    Hint, shown before you answer in practice mode: Common mistake: Using the call’s or put’s standalone break-even for the combined strategy.

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17. Q17A trader writes a call and a put with the same strike and expiry on a bond. Which risk characteristic best describes this short straddle?

    • A

      Option A. It benefits mechanically from any increase in implied volatility

      Why it is wrong: Short vanilla options generally have negative vega.

    • B

      Option B. Its maximum loss is always the total premium received

      Why it is wrong: That is not the loss profile of written options.

    • C

      Option C. It guarantees the two exercise obligations will offset at every settlement price

      Why it is wrong: At a given expiry one side can be in the money while the other is worthless.

    • D

      Option D. It earns limited premium but can suffer large losses from sufficiently large price moves — Correct answer

    Answer: D. A short straddle collects both premiums and performs best near the common strike at expiry. A large rise generates losses on the short call, while a large fall generates losses on the short put. The combined position is normally short gamma and short vega. Premium income is not a substitute for risk capacity. Remember: Income strategies can hide adverse tail exposure behind frequent small gains.

    Hint, shown before you answer in practice mode: Common mistake: Describing premium collection as risk-free yield.

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18. Q18A bond investor buys a protective put at strike 98 and writes a call at strike 103 on the same holding. Equal premiums make the net option premium zero. What does this arrangement achieve, ignoring coupons and costs?

    • A

      Option A. Full downside protection with unlimited upside at no economic cost

      Why it is wrong: Financing the put with a call surrenders upside beyond the call strike.

    • B

      Option B. No exposure to either price movement or counterparty and execution risks

      Why it is wrong: The structure reshapes price payoff. It does not remove every implementation risk.

    • C

      Option C. A terminal bond-plus-options value bounded between 98 and 103 — Correct answer

    • D

      Option D. A guaranteed terminal value of exactly 100

      Why it is wrong: The combined value can vary between the two strikes.

    Answer: C. Combined terminal value is S_T + max(98−S_T,0) − max(S_T−103,0). It equals 98 below the put strike, S_T between strikes, and 103 above the call strike. Zero net premium means premiums offset. It does not mean zero economic trade-off or zero trading costs. Remember: Zero-cost usually refers to net upfront premium, not the absence of sacrificed opportunities.

    Hint, shown before you answer in practice mode: Common mistake: Calling a financed protective structure a free, unlimited-upside guarantee.

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19. Q19A deliverable bond forward is priced above the cost of buying the same bond and carrying it to delivery. Assume financing, purchase and forward sale can be locked in simultaneously with all costs included. Which trade exploits the discrepancy?

    • A

      Option A. Short the bond and buy the overpriced forward

      Why it is wrong: This is the reverse direction and pays too much to reacquire the bond.

    • B

      Option B. Sell the forward without acquiring or financing the bond

      Why it is wrong: That leaves a naked short exposure rather than the stated covered arbitrage.

    • C

      Option C. Buy both the bond and the forward

      Why it is wrong: This adds directional exposure rather than locking a carry spread.

    • D

      Option D. Buy and finance the bond. Sell the forward — Correct answer

    Answer: D. A replicating cash-and-carry portfolio funds the bond until delivery and receives interim cash flows. If the forward sale price exceeds its fully locked-in net cost, buying cash and selling forward captures the difference. The strong assumptions matter: unmatched settlement references, unavailable funding or execution slippage can undermine a supposed arbitrage. Remember: Arbitrage compares executable complete strategies, not isolated screen prices.

    Hint, shown before you answer in practice mode: Common mistake: Calling a naked directional futures sale cash-and-carry arbitrage.

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20. Q20A zero-coupon bond can be short-sold for 100. The sale proceeds can be invested to become 102 at forward maturity. A matching deliverable forward can be bought at 100.80, and all bond-borrowing and trading costs total 0.40 per unit. What profit can be locked in under these assumptions?

    • A

      Option A. 0.80 per unit — Correct answer

    • B

      Option B. 1.20 per unit

      Why it is wrong: This ignores bond-borrowing and trading costs.

    • C

      Option C. A loss of 0.80 per unit

      Why it is wrong: The investment proceeds exceed the complete repurchase and cost outlay.

    • D

      Option D. 1.60 per unit

      Why it is wrong: This adds rather than subtracts costs.

    Answer: A. Short the bond, invest the proceeds and buy the forward to obtain the bond needed to return the borrowed security. Terminal surplus = 102 − 100.80 − 0.40 = 0.80. The example assumes borrow availability and all cash flows locked in. Those assumptions cannot be omitted when evaluating a real reverse cash-and-carry trade. Remember: Include security-borrowing costs and delivery availability in reverse carry.

    Hint, shown before you answer in practice mode: Common mistake: Ignoring the practical cost of maintaining a short cash position.

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21. Q21A trader buys the near bond future at 100 and sells the far future at 101, one contract each. Later the near is 100.40 and the far is 101.10. Both multipliers are 2,000. What is the combined profit before costs?

    • A

      Option A. A loss of ₹600

      Why it is wrong: This reverses the signed spread change.

    • B

      Option B. ₹600 — Correct answer

    • C

      Option C. ₹1,000

      Why it is wrong: This adds both price increases as gains even though the far leg is short.

    • D

      Option D. ₹800

      Why it is wrong: This includes only the near-leg gain.

    Answer: B. Near-leg P/L = (100.40−100)×2,000 = ₹800. Far-leg P/L = (101−101.10)×2,000 = −₹200. Combined result is ₹600. The position profits because the far-minus-near spread narrows from 1.00 to 0.70, not merely because both outright prices rise. Remember: Spread positions depend on relative movement and the sign of each leg.

    Hint, shown before you answer in practice mode: Common mistake: Adding absolute price changes without considering long and short directions.

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22. Q22A trader holds long two-year bond-price futures with PVBP ₹1,000 and short ten-year bond-price futures with the same PVBP magnitude. The two-year yield rises 5 bp and the ten-year yield rises 15 bp. Under linear sensitivities, what is the combined P/L?

    • A

      Option A. A loss of ₹10,000

      Why it is wrong: This reverses both the spread direction and its resulting P/L.

    • B

      Option B. A gain of ₹10,000 — Correct answer

    • C

      Option C. Zero because the position was PVBP-neutral

      Why it is wrong: Neutrality to a parallel move does not imply neutrality to a change in curve slope.

    • D

      Option D. A loss of ₹20,000

      Why it is wrong: This treats the short ten-year exposure as if it were long.

    Answer: B. The long two-year position loses 1,000×5 = ₹5,000. The short ten-year position gains 1,000×15 = ₹15,000. Net profit is ₹10,000. Equal opposite PVBP would cancel a common parallel move, but the larger long-end rise creates a curve-steepening gain for this configuration. Remember: Parallel-shift neutrality is not yield-curve neutrality.

    Hint, shown before you answer in practice mode: Common mistake: Treating one aggregate PVBP number as a complete description of rate risk.

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23. Q23A trader sees a favourable cash–futures spread and buys the cash bond, but the offsetting futures order does not execute before prices move. What risk has materialised?

    • A

      Option A. Automatic cancellation of the cash bond purchase by the exchange

      Why it is wrong: A failed hedge order does not automatically reverse the executed cash trade.

    • B

      Option B. Leg or execution risk, leaving a temporarily unhedged cash position — Correct answer

    • C

      Option C. A guaranteed arbitrage gain, because one leg has already executed

      Why it is wrong: An incomplete hedge does not lock the combined spread.

    • D

      Option D. Elimination of funding risk, because futures orders are placed electronically

      Why it is wrong: Execution technology does not ensure the second leg or remove funding needs.

    Answer: B. An arbitrage calculation assumes all necessary legs can be executed at the required prices. After only the cash purchase, the trader has directional bond exposure and financing needs. Changes in price or liquidity before the futures leg executes can eliminate the apparent profit or create a loss. Remember: The implementation of a multi-leg strategy is part of its risk analysis.

    Hint, shown before you answer in practice mode: Common mistake: Calling an opportunity riskless before both legs and financing are secured.

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24. Q24A corporate-bond portfolio is hedged against government yield movements using G-Sec futures. Government yields are unchanged, but the issuers’ credit spreads widen sharply. Which outcome remains possible?

    • A

      Option A. The corporate bonds lose value without a matching gain on the government-rate hedge — Correct answer

    • B

      Option B. The hedge must offset all losses because both instruments are debt-related

      Why it is wrong: Credit-spread and government-rate risks are different factors.

    • C

      Option C. Corporate-bond prices cannot change unless government yields change

      Why it is wrong: Required corporate yields also reflect credit and liquidity spreads.

    • D

      Option D. The widening spread automatically changes the fixed contractual coupon

      Why it is wrong: The market-required yield can change while the contractual coupon stays fixed.

    Answer: A. A corporate yield includes a government benchmark plus credit and other spread components. A G-Sec futures hedge primarily tracks government-rate exposure. If credit spreads widen while the benchmark is unchanged, corporate prices can fall with little offset from the government futures. Residual risks should be identified before describing a portfolio as hedged. Remember: Name the risk being hedged and the risks left unhedged.

    Hint, shown before you answer in practice mode: Common mistake: Claiming a rate hedge also insures issuer credit deterioration.

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Trading Mechanism in Exchange Traded Interest Rate Derivatives

10 questions on Trading Mechanism in Exchange Traded Interest Rate Derivatives. Its quiz opens on that unit.