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NEW QUESTION 56
Which of the following statements is true:
I. On-the-run bonds are priced higher than off-the-run bonds from the same issuer even if they have the same duration.
II. The difference in pricing of on-the-run and off-the-run bonds reflects the differences in their liquidity III. Strips carry a coupon generally equal to that of similar on-the-run bonds IV. A low bid-ask spread indicates lower liquidity
- A. II and IV
- B. I and II
- C. I, II and III
- D. III and IV
Answer: B
Explanation:
Explanation
On-the-run bonds yield less, and therefore are priced higher than similar off-the-run bonds. The difference in their pricing reflects the fact that on-the-run bonds are more liquid than off-the-run bonds. Therefore statements I and II are correct. Bonds are on-the-run when they are issued, and change hands frequently, and over time as they become 'seasoned', newer bonds take their place as on-the-run bonds making them off-the-run.
Strips are zero coupon instruments, and do not carry any coupon. Therefore statement III is not correct.
A lower bid-ask or bid-offer spread indicates lower transaction costs and is a result of greater liquidity. A higher bid-ask spread results for less liquid securities. Therefore statement IV is not correct.
NEW QUESTION 57
For a deep out-of-the-money option:
- A. Both gamma and delta approach
- B. Both gamma and delta approach 1
- C. Both gamma and delta approach 0
- D. None of the above
Answer: C
Explanation:
Explanation
A deep out of the money option will not react much to the change in the price of the underlying. In fact, the more out of the money it is, the more unresponsive it will be to changes in the prices of the underlying.
Therefore, its delta will approach zero. Since delta is zero, gamma, which measures the rate of change in the delta, will also be zero as delta is unchanging. Therefore Choice 'a' is the correct answer.
NEW QUESTION 58
A bullet bond refers to a bond:
- A. that provides for floating rate interest payments during its lifetime
- B. that carries no coupon payments during its lifetime
- C. that is issued by a sovereign
- D. that provides for fixed coupons and repayment of principal at maturity
Answer: D
Explanation:
Explanation
Choice 'b' represents a correct description of a bullet bond. All other choices are incorrect.
NEW QUESTION 59
A futures clearing house:
- A. guarantees the cash settlement of a futures contract
- B. provides a dispute settlement forum for the buyers and sellers
- C. guarantees the obligations associated with physical delivery
- D. all of the above
Answer: A
Explanation:
Explanation
It is important to note the distinction between the clearing house and the exchange itself. The clearing house does not get involved with physical delivery, nor does it provide any dispute settlement services. It only makes sure that cash is settled as and when due between the members. Therefore Choice 'c' is the correct answer
NEW QUESTION 60
For a forward contract on a commodity, an increase in carrying costs (all other factors remaining constant) has the effect of:
- A. increasing the spot price
- B. increasing the forward price
- C. decreasing the spot price
- D. decreasing the forward price
Answer: B
Explanation:
Explanation
The forward price for a commodity is nothing but the spot price plus carrying costs till the maturity date of the forward contract. Any increase in carrying costs therefore has the effect of increasing the forward price. Note that carrying costs include interest cost in respect of funding the position, costs of storage, less any convenience yield.
Increase in the carrying costs will not affect the spot prices.
NEW QUESTION 61
What would be the total all in price payable on an 5% annual coupon bond quoted at a clean price of $98, where the settlement date is 60 days after the latest coupon payment. Use Act/360 day basis.
- A. $100.00
- B. $97.17
- C. $98.00
- D. $98.83
Answer: D
Explanation:
Explanation
The all in price would be equal to the clean price plus accrued interest. The accrued interest for the 60 days that have passed since the last coupon payment is $5 x 60/360 = $0.83. Therefore the dirty price, or the all in price, will be $98.83. (Note that the $5 is the annual 5% coupon on the $100 face.)
NEW QUESTION 62
Repos are used for:
I. Short term borrowings
II. Managing credit risk exposures
III. Money market operations by central banks
IV. Facilitating short positions
- A. II and IV
- B. I, II and III
- C. I, III and IV
- D. II, III and IV
Answer: C
Explanation:
Explanation
Repos are collateralized borrowing arrangements. They are used for providing short term funding. They are not used for managing credit risk exposures. They are also used by central banks as part of their money market operations. They are also useful for facilitating short positions, for example, in corporate bonds where the party desirous of shorting the bond may 'borrow' the bond on repo in order to be able to sell it short.
NEW QUESTION 63
A corn farmer has committed to sell 20,000 bushels of corn in November. The spot price has a standard deviation of 20 cents per bushel, and its correlation with the December futures prices is 0.9. The futures contract is for 5000 bushels and has a standard deviation of 24 cents per bushel. What should the corn producer do if he/she wishes to hedge the risk of price movements between now and November?
- A. Sell 3 December corn futures contracts, and close these out in November when he/she sells the corn
- B. Buy 4 December corn futures contracts, and close these out in November when he/she sells the corn
- C. Sell 4 December corn futures contracts, and close these out in November when he/she sells the corn
- D. Buy 3 December corn futures contracts, and close these out in November when he/she sells the corn
Answer: A
Explanation:
Explanation
We calculate the minimum variance hedge ratio as 0.9*20/24 = 0.75; and multiply this by the ratio of the
[units required to be hedged] to the [units per futures contract], ie 0.75*20000/5000 = 3. Therefore the right quantity of contracts to sell is 3 contracts. Since the corn farmer has an obligation to sell in November, he or she can sell the futures now and lock a price in. The price locked in will be equal to the futures price, plus the basis (ie the difference between the spot and the futures price) in November.
Therefore the correct answer is to sell 3 December corn futures contracts and close these out prior to delivery in November when the November spot price will be realized. If prices have fallen, the loss on the spot trade will be made up by the profit on the hedge in the form of the futures, and also the other way round.
NEW QUESTION 64
Which of the following is NOT an assumption underlying the Black Scholes Merton option valuation formula:
- A. There are no transaction costs
- B. There is no credit risk
- C. The option can be exercised at any time up to expiry
- D. Volatility of the underlying and the risk free interest rate is constant
Answer: C
Explanation:
Explanation
All the choices listed are valid assumptions underlying the BSM option valuation formula except that the BSM formula is based upon the option being exercisable only at expiry. The assumption is that early exercise is not permitted. In other words, BSM applies to European options and not American options. Therefore Choice 'd' represents the correct answer as it is not an assumption underlying Black Scholes.
NEW QUESTION 65
What is the coupon on a treasury bill?
- A. The 3-month rate
- B. Libor
- C. The fed funds rate
- D. 0%
Answer: D
Explanation:
Explanation
Treasury bills are short-term government securities with maturities ranging from a few days to 52 weeks. Bills are sold at a discount from their face value, and do not carry a coupon.
NEW QUESTION 66
What is the fair price for a bond paying annual coupons at 5% and maturing in 5 years. Assume par value of
$100 and the yield curve is flat at 6%.
- A. $100.00
- B. $95.79
- C. $104.33
- D. $94.73
Answer: B
Explanation:
Explanation
The coupon payments can be considered an annuity which can be valued using the formula for the PV of annuities= annuity . Therefore the value of the five coupon payments is 5 * ((1-1/(1.06^5))/0.06) = $21.06 Similarly the principal payment at the end of 5 years can be valued as 100/1.065 = $74.73 Therefore the total value of the bond today is $95.79
NEW QUESTION 67
An investor believes that the market is likely to stay where it is. Which of the following option strategies will help him profit should his view be proven correct (assume all strategies described below are long only)?
- A. Collar
- B. Butterfly spread
- C. Straddle
- D. Strangle
Answer: B
Explanation:
Explanation
Only the butterfly spread has a payoff profile that benefits when prices do not move much. The collar benefits during declining markets, the straddle and the strangle benefit from sharp movements in the markets.
Therefore Choice 'c' is the correct answer.
NEW QUESTION 68
Which of the following relationships are true:
I. Delta of Put = Delta of Call - 1
II. Vega of Call = Vega of Put
III. Gamma of Call = Gamma of Put
IV. Theta of Put > Theta of Call
Assume dividends are zero.
- A. II and IV
- B. I, II, III and IV
- C. I, II and III
- D. I and III
Answer: B
Explanation:
Explanation
All the statements are correct, and represent the relationships between the values of the Greek variables for calls and puts for the same option. It is important to know why as the PRM exam often asks tough questions about the Greeks.
Statement I is correct because of the put-call parity. According to the put-call parity, Value of call - Value of put = Spot price - Exercise price discounted to the present Now the delta of the spot is 1, and that of the discounted price is zero. Therefore Delta of Call - Delta of Put = 1 - 0, or by rearranging we get the equation in statement I.
Statements II and III are correct as the gamma and vega of both the spot price and the discounted price are zero. Therefore using the put-call parity, we can say Gamma of Call - Gamma of Put = 0 - 0, and Vega of Call - Vega of Put = 0 - 0 Rearranging, we get statements II and III.
Statement IV is correct because of the following relationship between theta of call and theta of put:
Theta of Put = Theta of Call + rKe^(-rt).
Since rKe^(-rt) can only be a positive number, theta of put can only exceed the theta of a call. However, since theta is generally negative, it often implies that the theta of a call is the larger absolute number.
Additional explanation for the last point: Assume rKe^(-rt) =+1 and theta of a put is -5 (completely hypothetical) Now Theta of Put = Theta of Call + rKe^(-rt) Ie -5 = -6 + 1 Now -5 is the larger number than -6. In other words, theta of put exceeds that of the call in a pure mathematical sense, which is what I mean when I say "theta of put can only exceed the theta of call". But if you ignore the sign, then theta of call is larger at 6 when compared to 5. Therefore the theta of the put is greater than the theta of the call - which is what the answer says.
NEW QUESTION 69
[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.] Which of the following statements is true:
I. Knock-out options start lifeless and convert to a plain vanilla option when the barrier is hit II. Barrier options are cheaper than equivalent vanilla options III. Average price options are more expensive than equivalent vanilla options IV. Digital options have a high gamma close to the strike price
- A. I and III
- B. I, II and IV
- C. II, III and IV
- D. II and IV
Answer: D
Explanation:
Knock-out options start as plain vanilla options and are 'knocked-out', ie cease to exist, when the barrier is hit.
Knock-in options start lifeless and 'kick-in', ie come into play as plain vanilla options when the barrier is hit.
Therefore statement I is not correct.
Barrier options are certainly cheaper than equivalent vanilla options because vanilla options have a larger range of prices over which they pay out. Therefore statement II is correct.
Statement III is not correct. Average price options, also called Asian options, are less attractive to a buyer of options and therefore they are cheaper and not more expensive than vanilla options. This is because average prices are less volatile, and also when compared to a strip of equivalent vanilla options, some of the individual vanilla options in the strip may pay out whereas on the average nothing may pay out.
Digital options have a very high gamma close to the strike price as the option payout becomes uncertain and fluctuates sharply between 0 and 1. Therefore statement IV is correct.
NEW QUESTION 70
An investor has a portfolio with a value of $1,000,000 and a beta of 2.5. He believes the portfolio carries more market risk than he desires and wishes to reduce the beta to 1. How many futures contracts should be buy or sell to reduce the beta if the futures contracts have a beta of 1.2 and the notional value of each contract is
$240,000?
- A. Sell 9 contracts
- B. Buy 4 contracts
- C. Sell 5 contracts
- D. Buy 1 contracts
Answer: C
Explanation:
Explanation
The investor's needs to sell futures contracts, as his current position is long. He needs to sell ($1,000,000 x (2.5-1)) / ($240,000 x 1.2) = 5.2 contracts, or rounded to 5 contracts.
It is important to note here that the investor wishes to retain a beta of 1, and does not want to get rid of all market exposure.
NEW QUESTION 71
[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.] A digital cash-or-nothing option can be hedged reasonably effectively using:
- A. a long call and a short call with a higher strike
- B. a short call and a long put with a higher strike
- C. a long call and a long put with a higher strike
- D. a long call and a short call with a lower strike
Answer: A
Explanation:
Explanation
Consider a long vanilla call at a strike of K1, and a short call with a strike price of K2 so that K2>K1. If you construct the payoff diagrams for these option positions, you will see that the combined payoff resembles very closely the payoff of a digital cash-or-nothing option. By bringing K2 and K1 closer together, we can make it very close to a digital cash-or-nothing option. Therefore Choice 'c' is the correct answer.
NEW QUESTION 72
When considering an appropriate mix of debt and equity, Chief Financial Officers generally consider:
I. Tax advantage of debt
II. Financial distress costs
III. Agency costs of equity
IV. Retaining financial flexibility
- A. I, III and IV
- B. I, II and IV
- C. I, II, III and IV
- D. I and II
Answer: B
Explanation:
Explanation
The tax advantage of debt is an important input into a decision on the financial structure of a firm. Increasing debt increases the fixed expenses of a business that must be paid out of current cash flows, thereby increasing the cost of financial distress. CFOs consider the volatility of their earnings, outlook for the future and the possibility of financial distress at varying levels of debt, so that certainly is an input into the debt-equity tradeoff. Holding higher levels of equity increases financial flexibility for financing new investments or acquisitions, and depending upon their plans for such activities, they may decide to hold a certain level of equity versus debt.
The agency costs of equity refer to the cost to shareholders arising from the management acting in its own interest rather than that of shareholders - and this is irrelevant to a decision on capital structure. Therefore Choice 'd' is the correct answer.
NEW QUESTION 73
Which of the following statements is true in relation to the capital markets line (CML):
I. The CML is a transformation line that is tangential to the efficient frontier II. The CML allows an investor to obtain the highest return for a given level of risk chosen according to the investor's risk attitude III. The CML is the line passing through the point on the efficient frontier with the highest Sharpe ratio, and a y-intercept equal to the risk free rate IV. The Sharpe ratio for the points on the CML increase in a linear fashion
- A. I, II and III
- B. I and III
- C. I and II
- D. II, III and IV
Answer: A
Explanation:
Explanation
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. Therefore statement IV is not true, while the rest are.
NEW QUESTION 74
Profits and losses on futures contracts are:
- A. settled upfront
- B. settled by moving collateral
- C. settled daily
- D. settled upon the expiry of the contract
Answer: C
Explanation:
Explanation
Profits and losses on futures contracts are settled daily. (P&L on forward contracts is often settled upon the expiry of the contract, and may even be collateralized.) Therefore Choice 'd' is the correct answer.
NEW QUESTION 75
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