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CA Final AFM practice questions

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Question 1Financial Policy and Corporate Strategy

Under the traditional (static) trade-off theory of capital structure, a firm maximises its value by choosing the debt-equity mix at which which of the following is achieved?

  1. The weighted average cost of capital is minimised by using the maximum debt the lenders will permit
  2. The cost of equity equals the cost of debt so that no arbitrage remains between the two sources
  3. The firm's earnings per share is maximised at the point where interest coverage is exactly one
  4. The present value of the tax shield on debt equals the present value of expected financial distress costs Correct answer.

Explanation

The static trade-off theory balances the tax benefit of debt against the present value of financial distress (and agency) costs, and the optimum is where the marginal benefit of the tax shield equals the marginal distress cost. At that point firm value is maximised and WACC is minimised. Maximising debt capacity or EPS are not the criterion the theory uses.

Question 2Financial Policy and Corporate Strategy

A company follows a residual dividend policy. It has net income of Rs 800 crore, a target capital structure of 60% equity and 40% debt, and an approved capital budget of Rs 1,200 crore. What dividend will it pay?

  1. Rs 720 crore
  2. Rs 200 crore
  3. Rs 480 crore
  4. Rs 80 crore Correct answer.

Explanation

Under the residual policy, equity needed to fund the capital budget is 60% of Rs 1,200 crore, i.e. Rs 720 crore. Dividends are the residue of net income after this equity requirement: Rs 800 crore less Rs 720 crore equals Rs 80 crore.

Question 3Financial Policy and Corporate Strategy

Which statement best describes the role of corporate strategy in the financial policy framework tested at the strategic level of AFM?

  1. Financial policy is independent of strategy and is driven solely by prevailing market interest rates
  2. Corporate strategy defines the long-term direction and competitive scope, and financial policy translates it into funding, investment and distribution decisions Correct answer.
  3. Financial policy sets the operating budget while corporate strategy merely reports the variances to the board
  4. Corporate strategy is confined to product-market choices and has no bearing on capital structure or dividend decisions

Explanation

Corporate strategy sets the long-run direction, markets and competitive positioning of the firm, while financial policy is the mechanism that converts that direction into capital budgeting, financing mix and distribution choices. The two are linked because strategy determines the risk profile and funding needs that financial policy must serve.

Question 4Financial Policy and Corporate Strategy

A firm's debt is rated BBB and its marginal tax rate is 30%. The pre-tax cost of debt is 9% and the risk-free rate is 6%. Using the after-tax cost of debt for WACC purposes, what rate should be used?

  1. 6.30% Correct answer.
  2. 6.00%
  3. 2.70%
  4. 9.00%

Explanation

Interest is tax-deductible, so the relevant cost for WACC is the after-tax cost of debt: 9% x (1 - 0.30) = 6.30%. The risk-free rate is irrelevant to this computation.

Question 5Financial Policy and Corporate Strategy

A company's board is considering a rights issue priced at a discount to the market price. Which statement about the theoretical ex-rights price (TERP) is correct?

  1. TERP is always equal to the cum-rights price because existing shareholders receive the value of the rights
  2. TERP is higher than the cum-rights price when the subscription price is set below the market price
  3. TERP equals the rights subscription price whenever the issue is fully underwritten
  4. TERP is a weighted average of the cum-rights market price and the subscription price, weighted by the number of existing and new shares Correct answer.

Explanation

TERP is computed as the total value of the old shares at the cum-rights price plus the cash raised from the new shares, divided by the total shares after the issue. It therefore lies between the subscription price and the cum-rights price, weighted by share counts.

Question 6Financial Policy and Corporate Strategy

In the Modigliani-Miller framework with corporate taxes but no distress costs, the value of a levered firm equals the value of an unlevered firm plus which term?

  1. The tax rate multiplied by the market value of equity
  2. The interest expense multiplied by the debt-equity ratio
  3. The tax rate multiplied by the market value of debt Correct answer.
  4. The present value of expected bankruptcy costs

Explanation

With taxes and perpetual debt, MM Proposition I states VL = VU + Tc x D, where Tc is the corporate tax rate and D the market value of debt. The added term is the present value of the interest tax shield.

Question 7Financial Policy and Corporate Strategy

A firm's dividend policy is described as a 'signalling' device. Which explanation is most consistent with the dividend signalling hypothesis?

  1. Firms pay dividends mainly to reduce the agency cost of free cash flow held by managers
  2. An increase in dividends conveys management's private information that future earnings are expected to be sustainable Correct answer.
  3. Dividends are set only after all positive-NPV projects are funded, so they carry no information
  4. Dividends are irrelevant because investors can create homemade dividends by selling shares

Explanation

The signalling hypothesis holds that managers know more about future prospects than outsiders, so a dividend increase is a costly, credible signal of durable earnings. Because cutting dividends is expensive, only confident managers raise them.

Question 8Financial Policy and Corporate Strategy

A company wants to hedge a highly probable forecast purchase of raw material in a foreign currency. It enters a forward contract. Under the relevant accounting treatment, how is the effective portion of the gain or loss on this cash flow hedge recognised?

  1. Directly in retained earnings without any subsequent recycling
  2. As an adjustment to the carrying amount of the raw material inventory permanently
  3. Immediately in the statement of profit and loss
  4. In other comprehensive income and recycled to profit or loss when the hedged item affects profit Correct answer.

Explanation

For a cash flow hedge, the effective portion of the hedging instrument's gain or loss is recognised in other comprehensive income and reclassified to profit or loss in the period the hedged transaction affects profit. The ineffective portion is recognised immediately in profit or loss.

Question 9Financial Policy and Corporate Strategy

Which of the following is the most accurate description of economic value added (EVA) as a performance measure?

  1. It equals net operating profit after tax less a charge for the capital employed at the weighted average cost of capital Correct answer.
  2. It equals the excess of return on equity over the risk-free rate multiplied by shareholders' funds
  3. It equals the market value of equity less the book value of equity
  4. It equals profit after tax divided by the number of equity shares outstanding

Explanation

EVA = NOPAT - (WACC x capital employed), so it charges the firm for the opportunity cost of all capital, not just debt. A positive EVA means the firm has created value above its cost of capital.

Question 10Financial Policy and Corporate Strategy

A firm's operations generate a return on capital employed of 14% and its weighted average cost of capital is 11%. The board is evaluating a new project that will earn 12% and is of similar risk to existing operations. Which decision is consistent with value-based financial policy?

  1. Accept only if funded entirely by debt to lower the effective cost of capital
  2. Reject, because the project return is below the firm's current ROCE of 14%
  3. Reject, because any project earning less than the highest division's return destroys value
  4. Accept, because the project return exceeds the WACC even though it is below the current ROCE Correct answer.

Explanation

Value is created whenever a project earns more than its risk-adjusted cost of capital. A 12% return exceeds the 11% WACC, so the project adds value even though it dilutes the average ROCE. Comparing against the current ROCE is a common but incorrect hurdle.

Question 11Financial Policy and Corporate Strategy

A company has a target debt-equity ratio of 1:1 (debt 50%, equity 50% on a market value basis). The after-tax cost of debt is 6% and the cost of equity is 14%. What is the WACC?

  1. 10.0% Correct answer.
  2. 7.0%
  3. 8.0%
  4. 12.0%

Explanation

WACC is the market-value weighted average of the after-tax cost of debt and the cost of equity: 0.50 x 6% + 0.50 x 14% = 3% + 7% = 10%. Book weights should not be substituted for market weights.

Question 12Financial Policy and Corporate Strategy

Which of the following best captures the agency cost of debt that arises between shareholders and lenders?

  1. The cost of issuing new equity to fund a takeover
  2. The loss of tax shield when a firm redeems its debentures early
  3. Shareholders favouring high-risk projects after debt has been priced, so lenders price in the anticipated asset substitution Correct answer.
  4. Managers incurring monitoring costs to report segment results to the board

Explanation

Once debt is priced, shareholders have an incentive to shift into riskier projects because they capture upside while lenders bear downside, known as asset substitution or risk-shifting. Anticipating this, lenders demand a higher yield, creating an agency cost of debt.

Question 13Financial Policy and Corporate Strategy

A company's current share price is Rs 100. It makes a 1-for-4 rights issue at Rs 70 per share. What is the theoretical ex-rights price per share?

  1. Rs 85.00
  2. Rs 96.00
  3. Rs 94.00 Correct answer.
  4. Rs 92.00

Explanation

For every 4 existing shares at Rs 100, one new share is issued at Rs 70. TERP = (4 x 100 + 1 x 70) / 5 = 470 / 5 = Rs 94. The value of the right per existing share is Rs 6.

Question 14Financial Policy and Corporate Strategy

A firm has a high proportion of debt in its capital structure and faces a restrictive debt covenant limiting further borrowing and dividend payments. Which strategic consequence is most directly attributable to this covenant?

  1. The firm gains financial flexibility to pursue acquisitions funded by new debt
  2. The firm's cost of equity falls because lenders have accepted tighter terms
  3. The firm's ability to fund growth through debt or to distribute cash is constrained, forcing it to prioritise internally generated funds Correct answer.
  4. The firm can ignore its investment opportunity set because covenants guarantee solvency

Explanation

Restrictive covenants are designed to protect lenders by limiting additional leverage and distributions, which reduces managerial and shareholder flexibility. The firm must therefore rely more on retained earnings and equity for growth and has less freedom over payout.

Question 15Financial Policy and Corporate Strategy

Which of the following best describes a 'pecking order' financing preference?

  1. Firms prefer equity first because it carries no fixed obligation
  2. Firms prefer internal funds, then debt, then external equity, reflecting asymmetric information and issue costs Correct answer.
  3. Firms prefer debt over equity because debt is always cheaper in after-tax terms
  4. Firms maintain a constant target debt-equity ratio and issue securities in proportion to it

Explanation

The pecking order arises from information asymmetry and issuance costs: managers prefer retained earnings, then low-risk debt, and turn to external equity last because equity issues are interpreted as bad news. There is no single optimal target ratio in this view.

Question 16Financial Policy and Corporate Strategy

A company with substantial free cash flow and few positive-NPV projects is considering a higher dividend payout. Which strategic rationale from financial policy best supports this decision?

  1. Retaining the cash to build a large cash reserve for future contingencies
  2. Issuing new equity to fund the higher dividend so that leverage remains unchanged
  3. Increasing payout to reduce the agency cost of free cash flow that managers might otherwise deploy in value-destroying investments Correct answer.
  4. Reducing the payout to signal confidence in future earnings

Explanation

Jensen's free cash flow hypothesis holds that high payouts discipline managers by returning surplus cash to shareholders, reducing the risk of wasteful investment or empire building. The payout substitutes for debt as a bonding mechanism.

Question 17Risk Management (including derivatives, hedging and exposure management)

A treasury desk wants a single figure that states the maximum loss a portfolio could suffer over one trading day at a 99% confidence level. Which risk measure directly answers this?

  1. Beta of the portfolio against the benchmark index
  2. Modified duration of the portfolio's bond holdings
  3. Sharpe ratio computed over the past year
  4. Value at Risk at 99% for a one-day horizon Correct answer.

Explanation

Value at Risk states the loss threshold that is expected to be exceeded only with a stated small probability over a defined horizon, so a 99% one-day VaR is exactly the maximum loss estimate requested. Beta, duration and the Sharpe ratio describe sensitivity or risk-adjusted return, not a rupee loss quantile.

Question 18Risk Management (including derivatives, hedging and exposure management)

An Indian exporter expects to receive USD 2,00,000 in three months and wants certainty on the rupee amount. Which action locks in the exchange rate today?

  1. Buy a USD call option expiring in three months
  2. Buy a three-month forward contract in USD
  3. Purchase a USD put option expiring in three months
  4. Sell a three-month forward contract in USD Correct answer.

Explanation

A receivable in USD is hedged by selling USD forward, which fixes the rate at which the exporter will convert the dollars into rupees. A forward removes both upside and downside, whereas options retain a premium cost and leave the outcome uncertain.

Question 19Risk Management (including derivatives, hedging and exposure management)

In a currency futures contract, the party who agrees to buy the foreign currency at maturity is said to hold which position?

  1. A covered position
  2. A long position Correct answer.
  3. A straddle position
  4. A short position

Explanation

The buyer of a futures contract profits when the underlying price rises, so agreeing to buy the currency is a long position. The seller who agrees to deliver the currency holds the short position.

Question 20Risk Management (including derivatives, hedging and exposure management)

A company pays a floating rate of MIBOR plus 2% on a loan and wishes to convert this to a fixed-rate liability. In a plain vanilla interest rate swap, the company should:

  1. Pay fixed and pay floating
  2. Receive fixed and receive floating
  3. Pay fixed and receive floating Correct answer.
  4. Pay floating and receive fixed

Explanation

The company already pays floating on its loan, so it enters a swap in which it pays fixed and receives floating; the floating legs offset and the net cost becomes fixed. Paying floating in the swap would double the floating exposure.

Question 21Risk Management (including derivatives, hedging and exposure management)

Which statement about the intrinsic value of an option is correct?

  1. It can never be zero for an in-the-money option
  2. It equals the premium paid for the option
  3. It is always equal to the time value
  4. It is the payoff the option would give if exercised immediately Correct answer.

Explanation

Intrinsic value is the amount by which the option is in the money, measured as the payoff from immediate exercise. Time value is the excess of the premium over intrinsic value, and intrinsic value is zero for out-of-the-money and at-the-money options.

Question 22Risk Management (including derivatives, hedging and exposure management)

A firm's transaction exposure arises primarily from which source?

  1. A change in the firm's competitive position due to exchange rate moves
  2. Unsettled foreign currency receivables and payables Correct answer.
  3. Depreciation of plant located overseas
  4. Translation of foreign subsidiary financial statements

Explanation

Transaction exposure comes from contractual cash flows denominated in foreign currency that are still outstanding, such as receivables and payables. Translation exposure relates to consolidating foreign statements, and economic exposure relates to competitive position.

Question 23Risk Management (including derivatives, hedging and exposure management)

A portfolio has a one-day 95% VaR of Rs 10 lakh. Under the historical simulation approach, this figure means that:

  1. The maximum possible loss is Rs 10 lakh
  2. The portfolio cannot lose more than Rs 10 lakh in a year
  3. The expected loss on any day is Rs 10 lakh
  4. Losses will exceed Rs 10 lakh on about 5% of trading days Correct answer.

Explanation

VaR is a quantile of the loss distribution, so a 95% one-day VaR of Rs 10 lakh implies losses larger than that figure are expected on roughly 5% of days. It says nothing about the maximum possible loss or the average loss.

Question 24Risk Management (including derivatives, hedging and exposure management)

Which risk is best described as the risk that a counterparty fails to make a promised payment on a derivative or loan?

  1. Operational risk
  2. Credit risk Correct answer.
  3. Liquidity risk
  4. Market risk

Explanation

Credit risk is the risk of loss because a counterparty defaults or fails to perform on its obligation. Market risk arises from price movements, liquidity risk from inability to trade or fund, and operational risk from failed processes or people.

Question 25Risk Management (including derivatives, hedging and exposure management)

A trader buys a call option on USD/INR with a strike of 84.00 and pays a premium of Rs 0.50 per dollar. At expiry the spot rate is 85.20. What is the net profit per dollar?

  1. Rs 0.70 Correct answer.
  2. Rs 1.70
  3. Rs 1.20
  4. Rs 0.50

Explanation

The call's intrinsic payoff at expiry is 85.20 minus 84.00, equal to Rs 1.20 per dollar. Subtracting the premium of Rs 0.50 gives a net profit of Rs 0.70 per dollar.

Question 26Risk Management (including derivatives, hedging and exposure management)

An importer will pay USD 1,00,000 in two months. The two-month forward rate is 83.50 and the importer expects the spot rate to fall to 82.00. If the importer leaves the exposure unhedged and the spot rate actually turns out to be 84.50, the extra rupee cost compared with a forward hedge is:

  1. Rs 1,50,000
  2. Rs 1,00,000 Correct answer.
  3. Rs 50,000
  4. Rs 2,50,000

Explanation

Under the forward hedge the cost is 1,00,000 times 83.50, equal to Rs 83,50,000. At the actual spot of 84.50 the cost is Rs 84,50,000, so the unhedged position costs Rs 1,00,000 more, which is the difference of Rs 1.00 per dollar.

Question 27Risk Management (including derivatives, hedging and exposure management)

A firm has borrowed at a floating rate and enters a swap to pay fixed and receive floating. If interest rates rise sharply, the effect on the firm's total position is that:

  1. Its net interest cost falls because it receives floating
  2. Its net interest cost rises because the swap loses value
  3. Its net interest cost becomes zero
  4. Its net interest cost stays broadly fixed because the swap gain offsets the higher loan interest Correct answer.

Explanation

The fixed leg of the swap sets the cost, while the floating receipt rises with the loan interest, so the two floating legs offset and the net cost remains effectively fixed. Rising rates improve the value of the receive-floating leg rather than hurting the hedged position.

Question 28Risk Management (including derivatives, hedging and exposure management)

The six-month interest rate in India is 7% and in the United States it is 5%. The current spot rate is Rs 83.00 per USD. Ignoring transaction costs, the six-month forward rate consistent with interest rate parity is closest to:

  1. Rs 84.62
  2. Rs 82.20
  3. Rs 83.80 Correct answer.
  4. Rs 81.40

Explanation

Interest rate parity gives the forward rate as spot multiplied by the ratio of the domestic to foreign interest factor, that is 83.00 times 1.035 divided by 1.025. This equals about Rs 83.81, so Rs 83.80 is the closest figure and the higher Indian rate produces a forward premium on the dollar.

Question 29Risk Management (including derivatives, hedging and exposure management)

A company has a floating-rate loan and buys an interest rate cap with a strike of 8%. If the reference rate fixes at 9.5% for a period, the payoff on the cap for that period is based on:

  1. 8% of the notional for the period
  2. 9.5% of the notional for the period
  3. 1.5% of the notional for the period Correct answer.
  4. Zero, because the cap only protects against falling rates

Explanation

A cap pays the excess of the reference rate over the strike, so the payoff is 9.5% minus 8.0%, equal to 1.5% of the notional for the period. The cap is a series of call options on the interest rate and protects the borrower against rising rates.

Question 30Risk Management (including derivatives, hedging and exposure management)

Which of the following best describes the payoff profile of a long straddle on a currency?

  1. A guaranteed profit equal to the difference between the two strikes
  2. Profit from large moves in either direction, with loss limited to the premiums paid Correct answer.
  3. Limited profit and limited loss within a narrow range
  4. Profit only if the currency stays within a narrow band

Explanation

A long straddle combines a purchased call and a purchased put at the same strike, so it profits when the underlying moves sharply in either direction. The maximum loss is the total premium paid, which occurs if the rate finishes at the strike.

Question 31Risk Management (including derivatives, hedging and exposure management)

A firm holds a diversified equity portfolio worth Rs 50 crore with a beta of 1.2 against the Nifty. It wants to reduce the portfolio beta to 0.6 using Nifty futures, where the lot size is 50 and the futures price is 24,000. How many contracts should be sold?

  1. 60 contracts
  2. 100 contracts
  3. 50 contracts
  4. 25 contracts Correct answer.

Explanation

The number of contracts equals the value of the portfolio times the change in beta divided by the value of one futures contract. That is 50,00,00,000 times 0.6 divided by 12,00,000, which equals 25 contracts to be sold.

Question 32Risk Management (including derivatives, hedging and exposure management)

A bank computes VaR using the variance-covariance method. Which assumption is central to this approach?

  1. Historical returns never repeat
  2. Returns follow a normal distribution and are linearly related to risk factors Correct answer.
  3. Option payoffs are always linear
  4. Returns are independent of the holding period

Explanation

The variance-covariance method assumes risk factor returns are normally distributed and that the portfolio value responds linearly to those factors. This makes it simple to compute but weak for options, whose payoffs are non-linear.

Question 33Risk Management (including derivatives, hedging and exposure management)

A firm's estimated daily earnings at risk is Rs 4 lakh with a 95% confidence level. Using the square root of time rule, the 10-day VaR is closest to:

  1. Rs 12.65 lakh Correct answer.
  2. Rs 4 lakh
  3. Rs 8 lakh
  4. Rs 40 lakh

Explanation

Under the square root of time rule, the 10-day VaR equals the one-day VaR multiplied by the square root of 10, that is 4 lakh times 3.162, giving about Rs 12.65 lakh. Scaling linearly would overstate the risk because volatility grows with the square root of the horizon.

Question 34Risk Management (including derivatives, hedging and exposure management)

An Indian company has a payable in euros in six months and decides to hedge using a money market hedge. The correct sequence is to:

  1. Borrow euros now, convert to rupees, and invest the rupees for six months
  2. Borrow rupees now, convert to euros, and invest the euros for six months Correct answer.
  3. Invest rupees now and borrow euros at maturity
  4. Buy a euro call option and also sell a euro forward

Explanation

For a foreign currency payable, a money market hedge means borrowing in the home currency today, converting it into the foreign currency at spot, and investing that foreign currency so it accumulates to the payable amount at maturity. This creates a synthetic forward using domestic and foreign borrowing and lending rates.

Question 35Risk Management (including derivatives, hedging and exposure management)

A gold jeweller will buy gold in three months and fears a price rise. It buys a call option on gold futures. Which statement about the hedge is correct?

  1. The hedge is ineffective unless the option is exercised
  2. The hedge sets a maximum purchase price while allowing the jeweller to benefit if prices fall Correct answer.
  3. The hedge removes all price risk at no cost
  4. The hedge obliges the jeweller to buy at the strike price

Explanation

A purchased call gives the right, not the obligation, to buy at the strike, so it caps the effective purchase price at the strike plus premium while leaving the jeweller free to buy cheaper in the market if prices fall. The cost of this flexibility is the premium.

Question 36Risk Management (including derivatives, hedging and exposure management)

Which of the following is a source of basis risk in a cross-currency futures hedge?

  1. The hedged exposure and the futures contract are in different currencies Correct answer.
  2. The hedger holds the position until expiry
  3. The contract is traded on a recognised exchange
  4. The futures exchange requires daily settlement

Explanation

Basis risk arises when the instrument used to hedge is not identical to the exposure, for example hedging an exposure in one currency with a futures contract in another currency. The residual difference between the two prices can move against the hedger.

Question 37Risk Management (including derivatives, hedging and exposure management)

A company has a floating-rate loan and enters an interest rate swap to pay fixed and receive floating. Which statement about the credit exposure on the swap is correct?

  1. The company faces credit exposure to the bank throughout the swap regardless of its value
  2. There is no credit exposure because the swap is a derivative
  3. The company faces credit exposure to the bank only when the swap has positive value to the company Correct answer.
  4. The bank faces credit exposure to the company only on the fixed leg

Explanation

Credit exposure on a swap equals the cost of replacing the contract if the counterparty defaults, so it exists only when the contract has positive mark-to-market value for the non-defaulting party. The exposure therefore varies over the life of the swap.

Question 38Risk Management (including derivatives, hedging and exposure management)

A firm uses a short hedge in futures to protect an inventory of a commodity. If the spot price falls by more than the futures price falls, the hedger's outcome compared with an unhedged position is:

  1. Better, because the futures gain exceeds the inventory loss
  2. Better, because the basis has widened in the hedger's favour
  3. Identical to the unhedged position
  4. Worse, because the futures gain is smaller than the inventory loss, though still better than unhedged Correct answer.

Explanation

In a short hedge the futures gain offsets the fall in inventory value, but if the futures price falls less than the spot price the gain is smaller than the loss. The hedger is still better off than if unhedged, but the residual basis change reduces the protection.

Question 39Risk Management (including derivatives, hedging and exposure management)

A bank reports a 99% one-day VaR of Rs 20 crore but a 99% ten-day VaR of Rs 63 crore. A trader argues that the ten-day figure should be Rs 200 crore. The trader's error is that he:

  1. Confused VaR with expected shortfall
  2. Used the wrong confidence level
  3. Scaled the one-day VaR linearly with the number of days instead of by the square root of time Correct answer.
  4. Applied the square root of time scaling instead of linear scaling

Explanation

Under the square root of time rule, the ten-day VaR is the one-day VaR multiplied by the square root of ten, giving about Rs 63 crore. Multiplying by ten assumes risk grows linearly with time, which overstates the figure.

Question 40Risk Management (including derivatives, hedging and exposure management)

A firm has a USD receivable and simultaneously buys a USD put and sells a USD call at a higher strike, with the premiums roughly offsetting. This hedge is a:

  1. Butterfly spread
  2. Long straddle
  3. Collar Correct answer.
  4. Covered call

Explanation

A collar combines a purchased put that sets a floor with a written call that sets a ceiling, and the two premiums are often arranged to offset. The hedger gives up gains above the call strike in exchange for protection below the put strike.

Question 41Risk Management (including derivatives, hedging and exposure management)

A portfolio manager wants to hedge an equity portfolio but finds that the index futures contract available has a maturity shorter than the desired hedge horizon. The practical approach is to:

  1. Roll the futures position forward as each contract nears expiry Correct answer.
  2. Short the underlying shares and hold the proceeds in cash
  3. Use a longer-dated option with no delta adjustment
  4. Leave the portfolio unhedged because the horizon cannot be matched

Explanation

When no futures contract matches the hedge horizon, the hedger uses the nearest contract and rolls it into the next contract before expiry. This introduces rollover basis risk, but it maintains the hedge over the required period.

Question 42Risk Management (including derivatives, hedging and exposure management)

An Indian exporter expects to receive USD 5,00,000 in three months and wants to lock in the rupee value today using a forward contract. Which exposure is being managed by this decision?

  1. Economic exposure arising from long-run changes in competitive position
  2. Translation exposure arising from consolidation of a foreign subsidiary
  3. Transaction exposure arising from a firm foreign-currency commitment Correct answer.
  4. Operating exposure arising from changes in input cost structure

Explanation

A forward hedge of a known foreign-currency receivable addresses transaction exposure, which stems from a definite contractual cash flow denominated in a foreign currency. Translation exposure concerns restating foreign subsidiary accounts, while economic/operating exposure concerns the effect of exchange-rate changes on future competitiveness and cash flows.

Question 43Risk Management (including derivatives, hedging and exposure management)

A treasury team computes Value at Risk for a portfolio using the variance-covariance method. Which input is essential to this computation?

  1. The implied volatility smile of each option in the portfolio
  2. The covariance matrix of asset returns together with each asset's volatility Correct answer.
  3. The full set of Monte Carlo simulated price paths for each asset
  4. The complete historical time series of portfolio profit and loss

Explanation

The variance-covariance (parametric) method requires the portfolio's return variance, built from individual asset volatilities and their correlations. Historical simulation needs the historical P&L series, Monte Carlo simulation needs simulated paths, and the volatility smile is relevant to option pricing rather than to the parametric VaR inputs.

Question 44Risk Management (including derivatives, hedging and exposure management)

A company has a floating-rate borrowing linked to a benchmark and buys an interest rate floor with a strike of 7.5% while continuing to pay the floating rate. If the benchmark fixes at 6.0%, what is the net effect for the company?

  1. It pays 6.0% plus the premium, and receives a payoff of 1.5% under the floor Correct answer.
  2. It pays a fixed 7.5% plus the premium, with no payoff
  3. It pays 6.0% and pays an additional 1.5% to the floor seller
  4. It pays a fixed 7.5% and receives a payoff of 1.5%

Explanation

A floor pays the buyer the excess of the strike over the reference rate when the reference rate falls below the strike. With the benchmark at 6.0% and a strike of 7.5%, the payoff is 1.5%, which offsets the lower interest cost, leaving the effective cost at the 7.5% floor level plus the premium paid.

Question 45Risk Management (including derivatives, hedging and exposure management)

An Indian firm has a USD payable due in six months and decides to use a money market hedge. Which sequence of transactions correctly implements the hedge?

  1. Borrow rupees now, convert to dollars and invest for six months, then use the maturity proceeds to pay Correct answer.
  2. Invest rupees now for six months and buy dollars in the spot market at maturity
  3. Borrow dollars now, convert to rupees and invest for six months, then repay the dollar loan
  4. Buy dollars forward for six months and simultaneously sell a dollar futures contract

Explanation

For a foreign-currency payable, a money market hedge creates a matching foreign-currency asset today: borrow in the home currency, convert to the foreign currency at spot, and invest it so the maturity value covers the payable. This locks in the domestic-currency cost of the payable without using a forward.

Question 46Risk Management (including derivatives, hedging and exposure management)

A jeweller will purchase gold in three months and hedges by buying a call option on gold futures with a strike of Rs 60,000 per 10 grams, paying a premium of Rs 1,200. At expiry the futures price is Rs 63,500. What is the net effective purchase price per 10 grams?

  1. Rs 63,500
  2. Rs 60,000
  3. Rs 58,800
  4. Rs 61,200 Correct answer.

Explanation

The call option is exercised because the futures price exceeds the strike, giving a payoff of Rs 3,500. The net cost is the strike plus the premium paid, that is, Rs 60,000 plus Rs 1,200, which equals Rs 61,200, and this caps the effective purchase price.

Question 47Risk Management (including derivatives, hedging and exposure management)

A firm has a floating-rate loan and enters an interest rate swap to pay fixed and receive floating. Which statement about the resulting position is accurate?

  1. The firm's net interest cost becomes effectively fixed, but it retains exposure to the floating leg's reset and counterparty risk Correct answer.
  2. The firm's net interest cost becomes fully floating, removing all interest rate risk
  3. The firm eliminates its obligation to pay interest on the underlying loan
  4. The firm's net cost becomes fixed only if the swap is combined with a purchased cap

Explanation

Paying fixed and receiving floating on a swap offsets the floating payments on the loan, so the net cost is effectively fixed at the swap rate plus the loan spread. The firm still faces reset timing differences and the credit risk of the swap counterparty, so risk is transformed rather than eliminated.

Question 48Risk Management (including derivatives, hedging and exposure management)

The spot rate is Rs 83.00 per USD, the six-month Indian interest rate is 7% and the six-month US interest rate is 5%, both quoted on an annualised basis with simple interest. What is the fair six-month forward rate?

  1. Rs 83.00 per USD
  2. Rs 83.81 per USD Correct answer.
  3. Rs 86.81 per USD
  4. Rs 82.22 per USD

Explanation

Covered interest parity sets the forward rate at spot multiplied by the ratio of domestic to foreign interest factors. Using half-year simple factors, Rs 83.00 multiplied by (1 + 0.035) divided by (1 + 0.025) gives approximately Rs 83.81 per USD, reflecting the higher Indian interest rate.

Question 49Risk Management (including derivatives, hedging and exposure management)

A bank reports a one-day 99% VaR of Rs 20 crore. Assuming returns are independent and identically distributed, what is the approximate ten-day 99% VaR under the square root of time rule?

  1. Rs 20 crore
  2. Rs 200 crore
  3. Rs 40 crore
  4. Rs 63.25 crore Correct answer.

Explanation

Under the square root of time rule, VaR scales with the square root of the holding period. Multiplying the one-day VaR of Rs 20 crore by the square root of ten, approximately 3.162, gives about Rs 63.25 crore.

Question 50Risk Management (including derivatives, hedging and exposure management)

A portfolio manager holds a diversified equity portfolio with a beta of 0.8 and wants to reduce the effective beta to zero using Nifty futures when the index is at 22,000 and the lot size is 50. Approximately how many futures contracts must be sold?

  1. A number equal to beta multiplied by the number of stocks in the portfolio
  2. Exactly one contract for every Rs 22,000 of portfolio value held
  3. A number that depends on the portfolio value, computed as beta times portfolio value divided by the contract value Correct answer.
  4. A number equal to the portfolio value divided by the contract value, ignoring beta

Explanation

The hedge ratio is the portfolio beta multiplied by the portfolio value, divided by the value of one futures contract, which is the index level times the lot size. The exact number of contracts therefore depends on the portfolio value, which is not stated.