Economics · Financial Derivatives

Consider the following statements regarding derivatives and hedging: Statement 1: A barrier option is a type of exotic derivative where the payoff is contingent upon the price of the underlying asset reaching or not reaching a predetermined price level known as the barrier during a specific time frame. These options are classified into knock-in options which become active only if the barrier is hit, and knock-out options which expire worthless if the barrier is breached at any point. Because of this conditional nature, they are generally more expensive for the buyer than standard vanilla options due to the increased complexity of the hedging requirements for the seller. Statement 2: Basis risk in a derivative transaction occurs when the value of the hedging instrument does not move in perfect correlation with the value of the underlying asset being hedged. This often happens in interest rate swaps when the floating rate benchmark of the swap is different from the floating rate of the actual loan, or when there is a mismatch in the reset dates or the day count conventions. A classic example is a bank that hedges a loan linked to the Prime Lending Rate using a swap linked to the MIBOR, which leaves the bank exposed to fluctuations in the spread between these two distinct rates. Statement 3: The process of dynamic hedging involves a market maker continuously adjusting their position in the underlying asset to maintain a delta-neutral portfolio. For a seller of a call option, the delta is negative, and as the price of the underlying asset rises, the delta becomes more negative, requiring the seller to buy more of the underlying asset to offset the risk. This strategy aims to eliminate directional price risk, but it exposes the market maker to gamma risk and theta decay, especially during periods of high market volatility. Based on the statements above, which of the following is true?