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8006 - Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition Practice Tests 2021 | LatestCram
NEW QUESTION 163
[According to the PRMIA study guide for Exam 1, Simple Exotics and Convertible Bonds have been excluded from the syllabus. You may choose to ignore this question. It appears here solely because the Handbook continues to have these chapters.] The price of an 'out-of-the-money' convertible security is affected by:
I. Changes in interest rates
II. Changes in the issuer's credit risk
III. Changes in the issuer's share price
IV. Changes in the implied volatility of the issuer's share price
- A. I, III and IV
- B. I and II
- C. All of the above
- D. III and IV
Answer: B
Explanation:
Explanation
An out of the money convertible security behaves just like a regular debt security as the option is near worthless. Therefore it is affected by changes in interest rates and the credit risk of the issuer, and unaffected by changes in the prices or volatility of the issuer's shares (the underlying).
NEW QUESTION 164
Which of the following expressions represents the Treynor ratio, where is the expected return, is the standard deviation of returns, rm is the return of the market portfolio and rf is the risk free rate:
A)
B)
C)
D)
- A. Option A
- B. Option D
- C. Option B
- D. Option C
Answer: A
Explanation:
Explanation
The Sharpe ratio is the ratio of the excess returns of a portfolio to its volatility. It provides an intuitive measure of a portfolio's excess return over the risk free rate. The Sharpe ratio is calculated as [(Portfolio return - Risk free return)/Portfolio standard deviation].
The Treynor ratio is similar to the Sharpe ratio, but instead of using volatility in the denominator, it uses the portfolio's beta. Therefore the Treynor Ratio is calculated as [(Portfolio return - Risk free return)/Portfolio's beta]. Therefore Choice 'a' is the correct answer.
Jensen's alpha is another risk adjusted performance measure. It considers only the 'alpha', or the return attributable to a portfolio manager's skill. It is the difference between the return of the portfolio, and what the portfolio should theoretically have earned. Any portfolio can be expected to earn the risk free rate (rf), plus the market risk premium (which is given by [Beta x (Market portfolio's return - Risk free rate)]. Jensen's alpha is therefore the actual return earned less the risk free rate and the beta return.
Refer to the tutorial on risk adjusted performance measures for more details
NEW QUESTION 165
A bank holding a basket of credit sensitive securities transfers these to a special purpose vehicle (SPV), which sells notes based on these securities to third party investors. Which of the following terms best describes this arrangement?
- A. A collateralized debt obligation issuance
- B. A credit default swap purchase
- C. n-th to default swap
- D. A synthetic CDO creation
Answer: A
Explanation:
Explanation
A traditional collateralized debt obligation (CDO) involves the complete transfer of securities to an SPV, which then issues notes or securities to investors. Therefore Choice 'd' is the correct answer.
A synthetic CDO achieves the same result as a traditional CDO, but uses credit derivatives to synthetically create the same economic effect as a traditional CDO.
A credit default swap is a derivative instrument that pays in the event of the occurrence of agreed credit events. The arrangement described in the question is not a credit default swap purchase. n-th to default swap arrangements are similar to CDSs, but on a portfolio with the first 'n' losses being covered by the swap.
NEW QUESTION 166
Which of the following are valid reasons that explain an upward sloping yield curve?
I. The market expects interest rates to increase in the future
II. The market expects interest rates to decline in the future
III. Investors prize liquidity over illiquidity
IV. Investors believe the economy is likely to enter recession
- A. II and IV
- B. I, III and IV
- C. II and III
- D. I and III
Answer: D
Explanation:
Explanation
There are two main theories that explain an upward sloping yield curve. The first is the market expectations hypothesis (called 'pure expectations'). According to this explanation, the yield curve represents investor expectations of future yields, and forward rates are predictors of future interest rates. The yield curve slopes upwards when investors expect interest rates to go up in the future. Thus, statement I is correct. By the same logic, statement II is incorrect.
The second explanation for an upward sloping yield curve is the liquidity preference theory - according to which investors value liquidity and are prepared to pay more for instruments that mature earlier. Having their money tied up in longer maturity instruments increases all kinds of risks, and therefore longer term instruments are priced lower than instruments maturing earlier. Since the price of instruments that mature earlier is higher, their yield is lower than that of longer dated securities, thereby leading to an upward sloping yield curve. Therefore statement III is correct.
Statement IV actually explains why an yield curve may be downward sloping - in fact an inverted yield curve is considered an indicator of an upcoming recession. Therefore statement IV does not explain an upward sloping yield curve, and is therefore not a correct choice for the answer.
Thus statements I and III correctly explain an upward sloping yield curve. Other choices are incorrect.
NEW QUESTION 167
An investor holds a portfolio of mortage backed securities valued at $100m. Using a Monte Carlo based pricing model, he determines that the value of the portfolio would rise to $102m if interest rates were to fall by
45 basis points, and fall to $97m if interest rates were to rise by 45 basis points. What is the estimated modified duration of the investor's portfolio?
- A. 11.12
- B. 0
- C. None of the above
- D. 5.56
Answer: D
Explanation:
Explanation
For fixed income portfolios where standard cash flow discounting models are not available, duration calculations are based upon estimated price moves in response to a change in rates. Recall that we define duration as the percentage change in price expected for a 1% change in yield. In this case, we have three price points known to us:
Line | Price | Yield
a | $102 | r - 45bps
b | $100 | r
c | $ 97 | r + 45bps
(where r is the current yield)
The change in price from line a to line c is $102m - $97m = $5m. We use the middle point, ie $100m, to calculate the percentage change. Therefore the percentage change in price is $5m/$100m = 5%.
The change in yield between lines a and c is 90 basis points [=(r+45bps) - (r-45bps)]. In other words, the change in price is 5% for a 90 bps change in yield. So the duration can be calculated as 5/(90/100) = 5.56. The other answers are incorrect.
NEW QUESTION 168
Which of the following statements is true:
I. The OTC market for foreign exchange is much larger than the exchange traded futures market for foreign currencies II. DVP arrangements help avoid the risk of counterparty defaults on settlements III. Exchanges offer the advantage of lower trading costs than ECNs IV. ISDA master agreements form the basis of a large number of OTC derivative trades
- A. II and IV
- B. I, III and IV
- C. I, II and IV
- D. I, II and III
Answer: C
Explanation:
Explanation
The OTC market for foreign exchange is indeed much larger than the exchange traded futures market for FX.
Therefore statement I is correct.
Delivery-versus-payment (DVP) arrangements make sure that title to a security passes only when payment has been made, and these arrangements, usually implemented through national clearing agencies such as the DTC in the US, help avoid the risk of counterparty defaults.
Electronic Clearing Networks (ECNs) offer cheaper trading costs than exchanges, in fact that is their primary attraction. Exchanges offer other advantages, but lower trading costs is not one of them.
ISDA master agreements provide templates that a large number of OTC market participants use to standardize their OTC trading activities. Therefore statement IV is correct.
NEW QUESTION 169
If x is the standard deviation of the asset to be hedged, and y is the standard deviation of the asset being used to hedge against price movements in x, then the minimum variance hedge ratio is given by which of the following expressions (given that x,y is their correlation) A)
B)
C)
D)
- A. Option A
- B. Option D
- C. Option B
- D. Option C
Answer: B
Explanation:
Explanation
The minimum variance hedge ratio answers the question of how much of the hedge to buy to hedge a given position. It minimizes the combined volatility of the primary and the hedge position. The minimum variance hedge ratio is given by the expression 103.10.b103.10.b. Effectively, this is the same as the beta of the primary
position with respect to the hedge.
All other choices are incorrect.
Intuitive understanding of the hedge ratio: There are two standard deviations in play here: one, the standard deviation of the asset to be hedged (x), and two, the standard deviation of the asset being used as the hedge(y).
Now assume an extreme case where both the asset to be hedged and the asset being used as the hedge have a correlation of 1. (That keeps the calculation simple.). Also assume that the std dev of the asset to be hedged is
10% annually, and that of the asset being used as a hedge is say 20%. At this point, just ignore all formulae, and think intuitively about how much of the hedge should we buy to have the same risk (in the opposite direction) as the primary position but in the opposite direction so the variation in the primary position is cancelled by opposite movements in the hedge position. Obviously, we need to buy half because the asset being used as a hedge is twice as volatile. In other words, we divided the volatility (std dev) of the primary position by the volatility of the asset being used as a hedge.In this question, x is the standard deviation of the asset to be hedged, and y is the standard deviation of the asset being used to hedge. We will need to divide x by y.
NEW QUESTION 170
What is the standard deviation (in dollars) of a portfolio worth $10,000, of which $4,000 is invested in Stock A, with an expected return of 10% and standard deviation of 20%; and the rest in Stock B, with an expected return of 12% and a standard deviation of 25%. The correlation between the two stocks is 0.6.
- A. $2,081
- B. $4,330,000
- C. $1,204
- D. $1,201
Answer: A
Explanation:
Explanation
Standard deviation of this portfolio can be calculated as SQRT(4000^2*20%^2 + 6000^2*25%^2 +
2*0.6*4000*6000*20%*25%), which is equal to $2,081. Choice 'a' is the correct answer. The other answers are incorrect.
NEW QUESTION 171
A bank advertises its certificates of deposits as yielding a 5.2% annual effective rate. What is the equivalent continuously compounded rate of return?
- A. 4.82%
- B. 5%
- C. 5.07%
- D. 5.20%
Answer: C
Explanation:
Explanation
The equivalent continuously compounded rate in this case can be calculated as ln(1+5.2%) = 5.07%. The other answers are incorrect.
Refer to the tutorial on interest rates for more details on how continuously compounded rates work.
NEW QUESTION 172
If the quoted discount rate of a 3 month treasury bill futures contract is 10%, what is the price of a 3-month treasury bill with a principal at maturity of $100?
- A. $90
- B. $102.50
- C. $97.50
- D. $110.00
Answer: C
Explanation:
Explanation
T-bill futures 'discount' can be converted to a price for the bill using the formula Price = [1 - discount * number of days/360]. In this case, this works out to (1- 10% *90/360) * 100 = $97.50. Choice 'd' is the correct answer.
NEW QUESTION 173
What is the notional value of one equity index futures contract where the value of the index is 1500 and the contract multiplier is $50:
- A. 0
- B. 1
- C. 2
- D. 3
Answer: C
Explanation:
The correct answer is the index value times the contract size, in this case 1500 x 50.
One way to think about index futures is this: Consider equity index trading as trading in the shares of a company whose share price is equal to a number of dollars which is the same as the index. If the 'contract multiplier' for a index futures contract is 50, that means the futures contract is for 50 shares of such a fictitious company. Therefore the notional value of the contract will be 15000 x 50, and Choice 'a' is the correct answer.
NEW QUESTION 174
The cheapest to deliver bond for a treasury bond futures contract is the one with the :
- A. the lowest yield to maturity adjusted by the conversion factor
- B. the lowest coupon
- C. the highest coupon
- D. the lowest basis when comparing cash price to the futures spot price adjusted by the conversion factor
Answer: D
Explanation:
Explanation
Treasury bond futures do not specify which bond can be used to effect delivery, but allow the seller to pick from a number of available bonds. As a result, one of these eligible bonds emerges as being the 'cheapest' to deliver, and this CTD bond is determined by the basis between the cash price of the bond and the futures spot price as adjusted by the conversion factor for this specific bond. (ie, basis = Cash Price of the Bond - Futures Price x Conversion Factor) The bond with the lowest basis is generally the CTD - therefore Choice 'c' is the correct answer.
NEW QUESTION 175
In the context of futures contracts traded on an exchange, the term 'open interest' refers to:
- A. The total number of long contracts net of the number of short contracts
- B. The total number of contracts expiring in the near month
- C. The total number of outstanding contracts
- D. The total number of contracts traded during the day
Answer: C
Explanation:
Explanation
Open interest refers to the number of outstanding contracts, which is the same as the number of long positions or short positions held by market participants. Note that since for every long futures contract position held there is a seller who holds the short side, the open interest that is long is identical to the open interest that is short. (This is unlike the spot market where one could have long positions without anyone else needing to be symmetrically short).
The total number of contracts traded refers to traded volumes, and not open interest. Other choices are irrelevant in the context.
NEW QUESTION 176
The LIBOR square swap offers the square of the interest rate change between contract inception and settlement date. If LIBOR at inception is y, and upon settlement is x, the contract pays (x - y)2 for x > y; and
-(x - y)2 for x < y.
What of the following cannot be a value of the gamma of this contract?
- A. 0
- B. 1
- C. 2
- D. 3
Answer: C
Explanation:
Explanation
The LIBOR square is a (rare) derivative contract which pays, as mentioned in the question, the square of the interest rate move between two dates. If LIBOR at inception is y, and upon settlement is x, the contract pays (x
- y)^2 for x > y; and -(x - y)^2 for x < y.
For any question that involves calculating delta or gamma, and the payoff is described in terms of variables as is the case here, remember that delta is always the first derivative and gamma is the second derivative. For this question, let us calculate the second derivative and see what the gamma is:
If x > y, then the payoff is (x - y)^2
The first derivative wrt x is 2(x - y)
The second derivative wrt x is 2.
ie, the gamma is 2
If x < y, then the payoff is -(x - y)^2
The first derivative wrt x is -2(x - y)
The second derivative wrt x is -2.
ie, the gamma is -2
If x = y, then the payoff is 0. Both the first and the second derivatives are zero. ie the gamma is 0.
Based on the above, we see that the contract can have a gamma of either 0, +2 or -2. 1 is not a possible value for gamma, and therefore Choice 'b' is the correct answer.
NEW QUESTION 177
The transformation line has a y-intercept equal to
- A. the risk-free rate
- B. the expected rate of return
- C. zero
- D. the expected portfolio standard deviation
Answer: A
Explanation:
Explanation
The transformation line represents the combination of a 'risky bundle' and the risk free asset. Investors can choose different combinations of these assets depending upon their risk appetite. The transformation line meets the y-axis (portfolio returns) at the point equal to the risk free rate. Choice 'b' is the correct answer and the rest are incorrect.The highest possible transformation line, ie the transformation line with the maximum slope, is the transformation line joining the risk free rate on the y-axis and the portfolio with the maximum Sharpe ratio on the efficient frontier. This line is called the 'capital markets line'. Investors can pick any point on this line according to their risk appetite, and doing so would maximize the return they can obtain for their desired level of risk. The capital markets line is tangential to the efficient frontier. The Sharpe ratio stays constant throughout the CML.
NEW QUESTION 178
Theta for a call option:
- A. approaches 1 as the expiration date draws closer
- B. approaches 0 as the expiration date draws closer
- C. approaches -1 as the expiration date draws closer
- D. approaches as the expiration date draws closer
Answer: B
Explanation:
Explanation
Theta measures time decay, ie the change in value of the option with the passage of time. When the option is close to expiry, theta is very low as the value of the option is driven by intrinsic value rather than the time value. Therefore theta approaches zero as the option comes closer to expiry.
NEW QUESTION 179
The price of an interest rate cap is determined by:
I. The period to which the cap relates
II. Volatility of the underlying interest rate
III. The exercise or the strike rate
IV. The risk free rate
- A. I, II and III
- B. I, II and IV
- C. I, II, III and IV
- D. II, III and IV
Answer: A
Explanation:
Explanation
The price of an interest rate cap is affected by all of the listed choices except the risk free rate. The risk free rate does not come into play in the pricing of caps, and therefore Choice 'b' is the correct answer.
NEW QUESTION 180
A portfolio comprising a long call and a short put option has the same payoff as:
- A. a short underlying asset and a long bond position
- B. a short underlying asset and a short bond position
- C. a long underlying asset and a short bond position
- D. a long underlying asset and a long bond position
Answer: C
Explanation:
Explanation
To answer this question, we need to look at the put-call parity, which can be expressed as:
Value of call - Value of put = Spot price - Exercise price discounted to the present or, Value of call - Value of put = Stock - Bond with a future value equal to exercise price Therefore, a long call and a short put is equivalent to a long stock position and a short bond.
Choice 'a' is therefore the correct answer. (Alternatively, we could also have constructed a graph of the payoff profiles to arrive at the same answer).
NEW QUESTION 181
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