Derivatives Interview Questions

Question 1

Calendar spread

Answer 1

• Sell near-term put/call (same strike price)
• Buy longer-term put/call (same strike price)
• Preferable but not required that implied volatility is low

Question 2

Long call butterfly spread

Answer 2

• Butterfly spreads pay off the most if the underlying asset doesn’t move before the option expires.
• These spreads use four options and three different strike prices (OTM, ATM, ITM).
• The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.

Example:
Buy 1 call at 95
Sell 2 calls at 100
Buy 1 call at 105

_/_ = long butterfly spread with calls at expiration

Question 3

Selling Volatility

Answer 3

Selling volatility allows the fund manager to make money on both a decrease in volatility and time decay.

A short straddle trade is considered one of the purest approaches to this opportunity although a short strangle (sale of an out of the money call and an out of the money put) may also work.

Question 4

Straddle

Answer 4

• A straddle is an options strategy involving the purchase of both a put and call option for the same expiration date and strike price on the same underlying security (i.e. \/ shifted down by the paid premium)
• The strategy is profitable only when the stock either rises or falls from the strike price by more than the total premium paid.
• A straddle implies what the expected volatility and trading range of a security may be by the expiration date.

Question 5

Strangle

Answer 5

• A strangle is an options strategy in which the investor holds a position in both a call and a put option with different strike prices, but with the same expiration date and underlying asset (i.e. _/ shifted down by the paid premium)
• A strangle is similar to a straddle but uses options at different strike prices, while a straddle uses a call and put at the same strike price.
• A strangle covers investors who think an asset will move dramatically but are unsure of the direction.
• A strangle is profitable only if the underlying asset does swing sharply in price.

Question 6

(Barrier) reverse convertible (BRC)

Answer 6

• Reverse convertibles are among the most popular risk-optimisation products and are suited above all for investors who are anticipating a sideways or slightly upward trending market.
• Bond (zero coupon) + short put option (strike at 80%)

Question 7

VIX

Answer 7

(i) The Cboe Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility over the coming 30 days.

(ii) Investors use the VIX to measure the level of risk, fear, or stress in the market when making investment decisions.

(iii) Traders can also trade the VIX using a variety of options and exchange-traded products, or they can use VIX values to price derivatives.

(iv) The VIX generally rises when stocks fall, and declines when stocks rise

(v) The long-run average of the VIX has been around 21. High levels of the VIX (normally when it is above 30) can point to increased volatility and fear in the market, often associated with a bear market.

Question 8

VXEEM

Answer 8

The Cboe Emerging Markets Volatility Index (VXEEM) is a VIX-style estimate of the expected 30-day volatility of returns on the MSCI EEM Index

What Is the MSCI Emerging Markets Index? The MSCI Emerging Markets Index is a selection of stocks that is designed to track the financial performance of key companies in fast-growing nations

Question 9

GVZ

Answer 9

CBOE Gold Volatility Index

The Cboe Gold ETF Volatility IndexSM (GVZ) is an estimate of the expected 30-day volatility of returns on the SPDR Gold Shares ETF (GLD). Like the Cboe VIX Index®, GVZ is calculated by interpolating between two time-weighted sums of option mid-quote values - in this case, options on GLD

Question 10

What are derivatives?

Answer 10

They’re considered a financial contract, and they drive their value from the underlying spot price. For example, a coffee shop owner may enter a contract with their supplier regarding the price of coffee beans to avoid the risk of prices changing before the owner needs the beans. This contract exists through a forward or futures market, which is part of the derivatives market

Question 11

When is a forward contract useful?

Answer 11

A forward contract involves two parties agreeing to do a future date for a specific quantity and price. While the parties agree on the terms, they don’t exchange any goods or funds until the agreed-upon date. This type of contract may be useful when speculation potential prices.

For example, if you have information that indicates prices for a certain good may increase in the future, you may benefit from using a forward contract to secure the current, more affordable price for your future exchange.

Question 12

What are some common problems that affect forward markets?

Answer 12

A few problems that may affect forward markets include illiquidity and the lack of centralization of trading. However, I feel like one of the biggest problems related to forward markets is how long some forward contracts are open. When forward contracts are open longer, this leaves more room for prices to change, potentially increasing and leading to bad deals.

To avoid this, I ensure I do thorough research into pricing trends and strive to make reasonably short forward contracts.

Question 13

What Is Volatility Skew in Trading?

Answer 13

• Volatility skew describes the observation that not all options on the same underlying and expiration have the same implied volatility assigned to them in the market.
• For stock options, skew indicates that downside strikes have greater implied volatility that upside strikes.
• For some underlying assets, there is a convex volatility “smile/smirk” that shows that demand for options is greater when they are in-the-money or out-of-the-money, versus at-the-money.

Question 14

What is Beta in Finance?

Answer 14

The beta of an investment security (i.e., a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM)

beta = 1 exactly as volatile as the market
beta = 0 uncorrelated to the market
beta < 0 negatively correlated to the market

Question 15

The price of an option is most sensitive to which of the following Greeks?

Answer 15

Delta

Question 16

The price of a future contract is not dependent on the
a) current stock price
b) time to expiry
c) interest rates
d) stock volatility

Answer 16

Stock volatility

Question 17

You sold a put option with an exercise price of $100 for $5. At expiry what is your profit/loss if the underlying trades at $83?

Answer 17

+5 - 17 = -12

Question 18

Which of the following options will increase in price the most if interest rates increase? Assume the stock trades at $100.

a) call option with strike 50, 1 month expiry
b) call option with strike 150, 1 year expiry
c) call option with strike 50, 1 year expiry
d) call option with strike 150, 1 month expiry

Answer 18

c) call option with strike 50, 1 year expiry

Question 19

The Vega of a call option and a put option __ and __ respectively as time to expiry decreases

Answer 19

decrease, decrease

Question 20

The price of a call option is __ correlated with the dividend amount and __ correlated with the risk-free interest rate

Answer 20

negatively, positively

Question 21

What do we need to do to delta hedge a long position in a put option?

Answer 21

Buy stock

Question 22

How would you hedge your portfolio of airline stock If you expect prices to fall?

Answer 22

Buy a put option

Question 23

The price of a call option and put option are respectively __ correlated and __ correlated with the underlying volatility

Answer 23

positively, positively

Question 24

What Is Open Interest?

Answer 24

(i) Open interest is the total number of open derivative contracts, such as options or futures that have not been settled.

(ii) Open interest equals the total number of bought or sold contracts, not the total of both added together.

(iii) Open interest is commonly associated with the futures and options markets.

(iv) Increasing open interest represents new or additional money coming into the market while decreasing open interest indicates money flowing out of the market.

Question 25

Compare the difference between futures and forward contracts

Answer 25

The most significant difference between futures and forward contracts is how you can trade them. You trade forwards contracts over the counter (counter-party risk), but you trade futures contracts on exchanges. As a result, you can only trade specific futures contracts on exchange. Forward contracts, however, provide more flexibility because they’re negotiated privately, may represent assets and may change settlement dates if both parties involved agree.

Question 26

Why is it important to consider interest rates when determining the price of options?

Answer 26

When determining the price of options, it’s essential to consider interest rates. This is because higher interest rates typically lower the value of call options if all else is equal. This is a result of the net present value concept

Question 27

LIBOR

Answer 27

The London Inter-Bank Offered Rate (LIBOR) is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks

Is being replaced by SOFR (Secured Overnight Financing Rate)

Question 28

SOFR

Answer 28

• The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London Interbank Offered Rate (LIBOR).
• SOFR is based on transactions in the Treasury repurchase market and is seen as preferable to LIBOR since it is based on data from observable transactions rather than on estimated borrowing rates.

Alternatives:
- SONIA (Sterling Overnight Index Average)
- EONIA (Euro Overnight Index Average)
- TONAR (Tokyo overnight average rate)
- SARON (Swiss Average Rate Overnight)

Question 29

SARON

Answer 29

SARON stands for Swiss Average Rate Overnight and represents the overnight interest rate of the secured funding market for the Swiss Franc. is an overnight interest rates average referencing the Swiss Franc CHF. It is based on transactions and quotes posted in the Swiss repo market

Question 30

Explain Black-Scholes intuitively

Answer 30

(i) The Black-Scholes formula values options based on the underlying security’s price, its dividend yield, the option’s time to expiration, the strike price, the risk-free rate, the implied volatility, and a cumulative density function.

(ii) For a call option, it estimates the probability of the underlying stock reaching various prices, including the strike price, according to a lognormal distribution.

(iii) It sums up the expected value (value * probability) at each possible price “under the curve” to determine the option’s value.

(iv) If the strike price and stock price are closer, the probability of reaching the strike price is higher, so the option is worth more; higher volatility boosts the option’s value for the same reason.

(v) As the time to expiration decreases, the option is worth less because the probability of exceeding the strike price goes down as more time passes.

(vi) And as the dividend yield increases, the option also becomes worth less because you’re missing out on more of the underlying stock’s dividend.

Question 31

What is delta, and how does it change with the underlying’s price, volatility, and the passage of time?

Answer 31

(i) Delta is the first derivative of the option’s value with respect to the underlying security’s price, i.e., it tells you how quickly the option’s value changes as the stock price changes.

(ii) It also represents the amount of the underlying stock you must own to be delta hedged, i.e., to offset gains and losses on the option with gains and losses on the stock.

(iii) Delta moves from 0 to 1 as the option goes from out-of-the-money to in-the-money, and it’s 0.5 when the option is at-the-money.

(iv) Higher volatility increases delta for out-of-the-money options and decreases it for in-the-money options (i.e. flatter), and increasing the time to maturity has the same effect.

Question 32

What about gamma?

Answer 32

(i) Gamma is the second derivative of the option’s value with respect to the underlying security’s price, so it gives you delta’s rate of change.

(ii) Gamma is highest when the option is ATM because delta is the most sensitive to changes in the underlying price there; it decreases as an option moves further OTM or ITM.

(iii) Increased volatility increases gamma (decreases kurtosis -> negative) for ITM and OTM options but reduces gamma for ATM options, and increasing the time to maturity has the same effect.

Question 33

VIX formula

Answer 33

VIX = 100 * sqrt(365/30 * (T1 * sigma1^2 * (T2 - 30) / (T2 - T1) + T2 * sigma2^2 * (30 - T1) / (T2 - T1) ))

sigma1^2 = near-term implied volatility
sigma2^2 = long-term implied volatility

Question 34

Why are derivatives more interesting to trade than delta one products (e.g. futures, forwards, or anything else with a linear, symmetric payoff profile)?

Answer 34

In a client flow book you have thousands of positions, so your risk can quite easily flip as parameters move. That is why you need to look at your risk in three dimensions:

time, spot, and volatility.

This is much harder to risk-manage

Question 35

Is short gamma good or bad? Elaborate

Answer 35

If you’re long gamma, you benefit from stock price movement, and the bigger the better. If you’re short gamma that hurts you because you’ve bet against stock price movement and now the stock has just made a big move.

Because of the short gamma, you are long a lot of delta.

Do you sell the shares 5% down, or hold on and hope it rallies back?

As a personal rule, I like to keep my delta’s from my short gamma’s to a certain limit, and I hedge so that it never crosses that limit.

It’s important that you know everything about your short gamma’s, more so than your long’s, because if something gaps down you need to know the impact on your P&L and delta.