Analyst Prep FMP 2024
Analyst Prep FMP 2024
By AnalystPrep
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©2024 AnalystPrep “This document is protected by International copyright laws. Reproduction and/or distribution of this document is
27 - Banks 3
28 - Insurance Companies and Pension Plans 25
29 - Fund Management 48
30 - Introduction to Derivatives 79
31 - Exchanges and OTC Markets 107
32 - Central Clearing 137
33 - Futures Markets 175
34 - Using Futures for Hedging 189
35 - Foreign Exchange Markets 206
36 - Pricing Financial Forwards and Futures 238
37 - Commodity Forwards and Futures 257
38 - Options Markets 276
39 - Properties of Options 292
40 - Trading Strategies 314
41 - Exotic Options 341
42 - Properties of Interest Rates 358
43 - Corporate Bonds 400
44 - Mortgages and Mortgage-Backed Securities 414
45 - Interest Rate Futures 446
46 - Swaps 484
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Reading 27: Banks
Scenario I: This describes credit risk - the risk that counterparties in loan transactions will
default, in this case due to natural disasters. Credit risk arises when a borrower is not able to
repay a debt.
Scenario II: This scenario refers to market risk - the possibility that the bank's assets and
financial instruments will decline in value due to movement in key market variables like interest
Scenario III: This is operational risk - the risk of loss resulting from inadequate or failed internal
processes, people and systems, or from external events. Here it refers to losses from
Things to Remember
Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan
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transactions will default.
Market risk, also called "systematic risk," cannot be eliminated through diversification.
events that affect the entire market. The most common types of market risk are equity
Operational Risk refers to the risks associated with day-to-day operations and includes
risks arising from human errors, system failures, fraud, and external events.
Operational risks are harder to quantify and manage than credit or market risks.
Risk management involves identifying potential risks in advance, analyzing them and
Banks use various measures like Value at Risk (VaR), Conditional Value at Risk (CVaR),
B. Regulatory capital is the amount of capital a bank needs as prescribed by its own (risk)
models, whereas economic capital is the amount of capital a bank is required to hold to
sufficiently mitigate the risk of failure.
C. Regulatory capital is the amount of capital a bank needs to hold in accordance with
stipulated rules and regulations while economic capital is the amount of capital every
bank needs to deposit at the Federal Reserve Bank.
D. Regulatory capital is the amount of capital a bank needs to hold in cash at any given
time. In contrast, economic is the total amount of capital held, including cash deposits
and tangible/intangible financial assets.
Regulatory capital and economic capital are two different concepts in banking. Regulatory
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capital refers to the minimum amount of capital that a bank is required to hold by regulatory
authorities. This is to ensure that the bank has enough capital to absorb a reasonable amount of
loss and mitigates the risk of failure. The amount is determined based on the bank's financial
condition and compliance with regulatory standards. On the other hand, economic capital is the
amount of money that a bank chooses to hold based on its own risk models. This is determined
by the bank's internal assessment of potential risks and the capital required to cover those risks.
Therefore, the statement 'Regulatory capital is the amount of capital a bank is required to hold in
accordance with regulatory guidance to sufficiently mitigate the risk of failure, whereas
economic capital is the amount of capital a bank needs as prescribed by its own (risk) models'
Things to Remember
Both economic and regulatory capital are crucial for maintaining financial stability in
The Basel Accords provide international standards for calculating regulatory capital for
banks. These accords aim at ensuring that a bank holds enough reserve in order to
Economic Capital is often calculated using Value-at-Risk (VaR) models which estimate
the potential losses a firm might suffer due to market risk or credit risk within a certain
Q.1096 Following several high-profile bank failures, the Central Bank of a certain Asian country
is advocating the creation of a deposit insurance corporation to protect depositors in the event
that banks fail in the future. How might the establishment of the corporation create a moral
hazard?
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other sectors of the economy.
C. Banks may increasingly venture into risky businesses that would not otherwise be
feasible.
The establishment of a deposit insurance corporation can indeed create a moral hazard by
encouraging banks to engage in riskier business ventures. The term 'moral hazard' refers to the
risk that a party insulated from risk may behave differently than it would if it were fully exposed
to the risk. In this case, banks, knowing that their depositors are protected by the insurance
corporation, may feel emboldened to venture into riskier businesses that they would otherwise
avoid due to the potential for high losses. This is because the insurance corporation essentially
provides a safety net for the banks, reducing the consequences of their potential failure. As a
result, banks may take on excessive risk, leading to instability in the banking sector. This
phenomenon is a classic example of moral hazard, where the provision of insurance leads to
Choice A is incorrect. While banks might refuse to make premium payments, this does not
constitute a moral hazard. Moral hazard refers to the risk that a party insulated from risk may
behave differently than it would if it were fully exposed to the risk. In this case, refusing to pay
premiums would expose banks to more risks rather than insulate them.
Choice B is incorrect. Depositors channeling more of their savings into banks due to the
establishment of a deposit insurance corporation does not represent a moral hazard for the
banks themselves. This scenario could potentially lead to an imbalance in the economy, but it
doesn't change the behavior of banks in terms of taking on more risks because they are insured.
behavior rather than moral hazard. The moral hazard would occur if banks take on higher risks
knowing they have insurance coverage, not through manipulation of their financial health status.
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Things to Remember
Moral hazard refers to the risk that one party has an incentive to engage in risky
behavior.
In the context of banking, moral hazard can occur when banks take on excessive risk
knowing they are insured by a deposit insurance corporation. This is because they
banks. The level of these premiums may be linked to the risk profile of each bank.
could also lead to distortions in capital allocation across different sectors of the
economy.
While deposit insurance can protect individual depositors from bank failures, it does
not eliminate systemic risk in the banking sector. Systemic risk refers to the possibility
that a triggering event such as a major bank failure could cause a chain reaction
Q.1097 As the chief officer in charge of bank risk monitoring at the Federal Reserve Bank, Peter
Musk is asked to advise the regulator on the best strategy to curb moral hazards among banks
after the establishment of a deposit insurance agency. Mr. Musk could most likely advise the
regulator to:
C. Advise the insurance agency to adjust the premiums required, reflecting the individual
risk profile of each bank.
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despite the increased risks.
Directing the agency to tailor premiums payable according to each bank's risk level is the most
effective strategy to curb moral hazards among banks. This approach would discourage banks
from engaging in excessively risky strategies that could potentially put depositors' funds at risk.
Each bank would be required to pay a premium that is proportional to the level of risk it
presents. This would incentivize banks to manage their risks more effectively, as higher risks
would result in higher premiums. Furthermore, this strategy aligns with the principle of risk-
based pricing, which is a common practice in the insurance industry. Risk-based pricing ensures
that the price of an insurance policy reflects the risk profile of the insured entity. In this case,
banks with higher risk profiles would pay higher premiums, thereby discouraging risky behavior.
This approach also promotes fairness, as banks that pose less risk would not be required to
Choice A is incorrect. While cracking down on banks for paying their senior management
excessive sums may discourage reckless behavior, it does not directly address the issue of moral
hazard associated with deposit insurance. The moral hazard problem arises when banks take on
excessive risk knowing that they are insured, and this is not necessarily linked to the
Choice B is incorrect. Demanding all details of each bank’s transactions on a regular basis
could be an overwhelming task for the agency and may not effectively mitigate moral hazards. It
would be more efficient to focus on key risk indicators rather than every single transaction.
Choice D is incorrect. While competition and self-regulation can indeed play a positive role in a
functioning financial system, this approach might not be effective in curbing moral hazards,
particularly in the context of a deposit insurance agency. Deregulation might actually exacerbate
moral hazards, as there would be fewer regulatory checks and balances to prevent risk-taking
behavior.
Things to Remember
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Moral hazard refers to the risk that one party has an incentive to engage in risky
behavior because the cost of that behavior will be borne, at least in part, by another
party.
depositors, in full or in part, from losses caused by a bank's inability to pay its debts
when due. However, it can also lead to moral hazard if banks take on excessive risk
Regulators often use various strategies such as capital requirements, supervision and
Tailoring premiums payable according to each bank’s risk level is one way of mitigating
moral hazard. This means that banks with higher levels of risk would have higher
Q.1098 In the context of financial risk management, different types of risks are associated with
different aspects of a business's operations. These risks include market risk, liquidity risk, credit
risk, and operational risk. Under which category of risk would losses due to fraudulent activities
carried out by employees be classified?
A. Market risk.
B. Liquidity risk.
C. Credit risk.
D. Operational risk.
Operational risk refers to the risk of loss resulting from inadequate or failed internal processes,
people, and systems, or from external events. This definition includes legal risk, but excludes
strategic and reputational risk. In the context of this question, losses resulting from employee
fraud fall under operational risk. This is because employee fraud is a result of internal flaws or
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failures, such as inadequate internal controls, lack of oversight, or failure to enforce compliance
with company policies. These are all aspects of operational risk. Therefore, any losses that a
company incurs due to fraudulent activities by its employees would be classified as operational
risk. It's important to note that operational risk is inherent in all business activities, regardless of
the industry or sector. Therefore, effective management of operational risk is crucial for the
Choice A is incorrect. Market risk refers to the potential for financial loss due to changes in
the market conditions such as interest rates, exchange rates, commodity prices, and equity
prices. It does not cover losses due to fraudulent activities carried out by employees.
Choice B is incorrect. Liquidity risk pertains to a company's inability to meet its short-term
financial obligations because it cannot convert its assets into cash quickly enough or at a
reasonable cost. This type of risk does not encompass losses resulting from employee fraud.
Choice C is incorrect. Credit risk involves the possibility that a borrower or counterparty will
fail to fulfill their obligations under a contract, leading to financial loss for the lender or other
Things to Remember:
Operational risk is a broad category that covers risks arising from failures or
Operational risk includes legal risk but excludes strategic and reputational risk.
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Operational risk contrasts with market, liquidity, and credit risks, which deal with
external market fluctuations, cash flow issues, and contractual obligations respectively,
Q.1100 Investment banks play a crucial role in the financial sector, performing a variety of
functions. What is the primary role of investment banks in the financial market?
C. Facilitating mergers and acquisitions, and raising capital through issuing debt or
equity for corporations.
D. Providing short-term loans and accepting deposits from corporations and individuals.
The primary role of an investment bank like Fairchild is to facilitate mergers and acquisitions
(M&A) and assist corporations in raising capital by issuing debt or equity. Investment banks
serve as intermediaries between investors and those in need of capital. They provide the
expertise and knowledge required to structure and execute complex financial transactions,
A is incorrect. While some investment banks do have brokerage divisions that cater to large
institutional investors, acting as a broker is not the primary role of an investment bank.
B is incorrect. Providing insurance policies against financial and operational risks is typically
the role of insurance companies, not investment banks. While some investment banks do engage
D is incorrect. Offering short-term loans and accepting deposits are typically functions
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Q.1101 A manufacturing company has an ambitious plan to expand its factory operations and has
approached an investment bank for financial assistance. The bank is considering raising the
necessary funds through a private placement. This means that:
A. The bank will provide the funds itself without enlisting any third-party investor.
B. The bank will sell the desired security to a few large investors such as insurance
companies.
C. The manufacturing company will only accept proposals/bids from privately owned
limited liability companies.
D. The bank must sell the securities to one and only one investor.
In the context of investment banking, a private placement refers to the process where securities
are sold to a select group of large institutional investors. These investors can include insurance
companies, pension funds, or mutual funds. The investment bank that underwrites the
arrangement receives a fee that is negotiated with the issuer, in this case, the manufacturing
company. The bank does not need to find just one investor; the issuer may prefer more than one
financier. This method of raising funds is often preferred when the issuer wants to avoid the
regulatory requirements and costs associated with a public offering. It also allows the issuer to
raise funds more quickly as the securities do not have to be registered with the Securities and
Exchange Commission.
Choice A is incorrect. In a private placement, the investment bank does not provide the funds
itself. Instead, it acts as an intermediary to facilitate the transaction between the company
Choice C is incorrect. The type of companies that can participate in a private placement
Choice D is incorrect. While a private placement involves selling securities to a limited number
of investors, there's no requirement that it must be only one investor. It could be multiple
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Things to Remember
This method is often faster and less costly than an initial public offering (IPO) because
The securities sold in private placements are typically not registered with the
Securities and Exchange Commission (SEC), which means they cannot be resold on the
Investors in private placements are usually large institutions like mutual funds, banks,
insurance companies and pension funds. These investors are considered to have the
knowledge and expertise to understand and manage the risks associated with these
investments.
Private placements can involve equity or debt securities. Equity involves selling shares
of stock while debt involves selling bonds or notes that will be repaid over time with
interest.
Q.1102 The management of XYX Inc. wishes to raise some $50 million via a public offering.
Which of the following methods would be most appropriate, given that the total amount MUST
be raised?
A. Private placement.
B. Best efforts.
C. Firm commitment.
D. Dutch auction.
In a firm commitment public offering, an underwriting investment bank guarantees the sale of
the entire issue of securities. The bank agrees to purchase the entire issue from the issuer, and
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then resells the securities to the public. The issuer is assured of raising the full amount of
capital, as the bank bears the risk of not being able to sell all the securities. This method is most
appropriate for XYZ Corporation as it ensures that the entire $50 million will be raised. The
bank's commitment to buy the entire issue provides the issuer with certainty of funding, which is
Choice A is incorrect. Private placement is not a method of public offering. It involves selling
securities to a small group of investors, typically institutional, and not to the general public.
Choice B is incorrect. In a best efforts offering, the underwriters agree to do their best to sell
all the securities being offered by the issuer but do not guarantee that all will be sold. This does
not ensure that XYZ Corporation will raise its desired capital of $50 million.
Choice D is incorrect. A Dutch auction also does not guarantee that all shares will be sold or
that XYZ Corporation will raise its desired capital of $50 million as it depends on bidding process
Things to Remember:
A firm commitment public offering is a type of underwriting where the investment bank
guarantees the sale of the entire issue of securities, ensuring the issuer raises the full
amount of capital.
In this arrangement, the investment bank buys the entire issue from the issuer and
then resells it to the public. The risk of not being able to sell all the securities is borne
This method provides the issuer with certainty of funding, making it the most suitable
The firm commitment approach contrasts with other methods such as best efforts
offerings or Dutch auctions, where there is no guarantee of raising the full desired
amount.
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Q.1103 In financial markets, a public offering is a critical event that involves the sale of
securities. This process can be executed in several ways, one of which is a 'best efforts' basis.
Which of the following is the most accurate description of a public offering on a best efforts
basis?
B. The underwriter does as well as they can to place securities with investors and gets
paid a fee commensurate with the extent of its success.
C. The underwriter buys the securities and then sells them to investors at a premium.
D. The issuer does not enlist the services of an underwriter but instead offers securities
to investors directly.
A public offering on a 'best efforts' basis is a type of securities sale where the underwriter,
typically an investment bank, strives to place the securities with investors to the best of its
ability. The underwriter's compensation is commensurate with the degree of its success in selling
the securities at the predetermined price. This arrangement is beneficial for both the issuer and
the underwriter. The issuer does not have to worry about unsold securities, as the underwriter
does not guarantee the sale of all securities. On the other hand, the underwriter does not bear
the risk of buying the securities and not being able to sell them. This type of offering is
commonly used for riskier investments, where it is uncertain how well the securities will be
Choice A is incorrect. While it's true that an issuer can work with multiple investment banks as
underwriters, this is not a defining characteristic of a 'best efforts' basis public offering. In such
an offering, the underwriter does their best to sell the securities but doesn't guarantee the sale
of all securities.
Choice C is incorrect. This choice describes a firm commitment offering, not a 'best efforts'
basis public offering. In a firm commitment offering, the underwriter buys all the securities from
Choice D is incorrect. This choice describes direct listing or direct public offerings where no
underwriters are involved in selling securities to investors directly from issuers. It does not
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describe 'best efforts' basis public offerings where an underwriter attempts to sell as many
Things to Remember:
A 'best efforts' public offering refers to a securities sale where the underwriter (usually
an investment bank) works to place the securities with investors to the best of their
ability.
selling the securities. The more securities sold, the higher the underwriter's
compensation.
This type of offering does not involve a guarantee of sale for all securities, which means
the underwriter does not carry the risk of unsold securities. This feature distinguishes
'Best efforts' offerings are often used for riskier investments where the reception of the
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Q.1104 ABC Company Limited, a privately held firm, has been considering expansion. However,
internal funding is insufficient for the intended scale of growth. To raise the required funds, the
company is planning to issue 50 million shares. Notably, the firm wants to retain some level of
control over the ownership distribution and minimize public disclosure about its business due to
competitive reasons. Moreover, the company is unsure about the suitable price per share. In this
scenario, what is the most likely method for the company to issue these shares?
B. Rights issue
C. Firm commitment
D. Private placement
institutional or high-net-worth investors) rather than to the public. This method allows ABC
Company Limited to have more control over who buys its shares and to reduce public disclosure,
thus preserving its competitive advantage. The uncertainty over the share price could also be
A is incorrect. In this scenario, an investment bank would make its best effort to sell the
securities to the public, but there is no guarantee of sale for all the shares. Moreover, the
company's desire to limit disclosure and maintain control over ownership is not compatible with
a public offering.
B is incorrect. A rights issue involves offering new shares to existing shareholders, usually at a
discount. However, as a private company, ABC Company Limited might not have a broad
C is incorrect. In this case, an investment bank would buy all the shares and resell them to the
public. While this would ensure raising the needed funds, it would involve wide public disclosure
and does not allow the company to control its ownership distribution.
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Q.1105 A company intends to employ the Dutch Auction Approach (DAA) to sell 1 million shares.
It receives the following bids:
Which of the following is closest to the price all successful buyers will pay per share?
A. 37
B. 41
C. 40.5
D. 39
Under the DAA, potential investors enter their bids quoting the number of shares they intend to
purchase and the price they are willing to pay per share. Once the bids have been submitted, the
allotment is done starting from the highest bid down, until all the allotted shares have been
assigned. However, the final price paid per share is that which has been quoted by the last
successful bidder – the buyer whose bid coincides with the end of the intended allotment.
Following the methodology outlined above, here’s what would happen in this scenario: First,
400,000 shares would be allocated to C, 200,000 shares to A, 150,000 shares to B, and 100,000
shares to D. At this point, only 150,000 shares remain out of the planned 1 million shares
allotment. This means the next highest bid of 300,000 shares at $39 each can only be half-filled.
As such, $39 is the price that would be paid by all the other successful bidders.
I. In a "best effort offering," the underwriters buy an issue and use their best effort to sell
the issue to investors.
II. In an "underwritten offering," the underwriters buy an issue and then attempt to sell the
issue to investors.
III. A "best effort offering" is the most common type of offering.
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A. I & III only
C. II only
Statement II is correct. In an "underwritten offering," the underwriter buys an issue and then
Statement I is incorrect. In a "best effort offering," the underwriters do not buy the issue, they
Statement III is incorrect. Underwritten offerings are the most common type of offering because
they ensure the success of the proposed issue of shares by providing some insurance against
under-subscription. Any shares not taken up by investors are held by the underwriter, thereby
ensuring that the issuer gets to generate the amount of cash targeted. In addition, the
underwriter offers expert advice and is in charge of marketing the offer. This ensures that the
issuer's human resources are not stretched and paves the way for a smooth transition. Things to
Remember
price for a certain number of securities to the party that is issuing the security (the issuer). Thus,
the issuer is secure that they will raise a certain minimum from the issue, while the underwriter
takes the risk of the issue not being fully subscribed to.
2. In a best efforts offering, the underwriters act as agents who try to sell as much of the
securities as they can for the issuer. However, they do not guarantee the amount raised, but will
3. The choice between an underwritten and best efforts offering depends on the issuer's need for
certainty of raising a certain amount, and the willingness to pay for that certainty. In general,
underwritten offerings are more common because they provide more assurance of success for
the issuer.
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Q.4883 Which of the following best defines a broker's discretionary account?
A. An account where the broker can trade the investor's funds without the investor's
explicit consent.
B. An account where a trader can buy and sell privately traded securities only
C. An account that holds securities traded solely for the benefit of the broker, not
investors.
D. An account that doesn't have to comply with the rules set by the Securities and
Exchange Commission.
A broker's discretionary account is an investment account that allows an approved broker to buy
and sell securities without obtaining the client's permission for each transaction. But to be able
to do so, the client must sign a discretionary disclosure with the broker.
discretionary account.
Option C is incorrect. All the proceeds of a discretionary account flow to the investor, less the
Option D is incorrect. All trading accounts must comply with the rules and regulations set by
Q.4884 What is the difference between a banking book and a trading book as used in banks?
A. The banking book consists of assets on the bank's balance sheet expected to be held
until maturity while the trading book consists of assets that are available for sale.
B. The banking book consists of assets held on the bank’s balance sheet while the trading
book consists of assets held off the balance sheet.
C. The banking book reports assets whose value if fixed (e.g. fixed income bonds) while
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the trading book reports assets whose value fluctuates in response to market variables.
D. The banking book only shows primary financial instruments such as cash while the
trading book shows secondary financial derivative instruments such as interest rate
futures and options.
The banking book and trading book are two different portfolios within a bank. The banking book
consists of assets on the bank's balance sheet that are expected to be held until maturity. These
assets are not marked to market, meaning they are usually held at historical cost. The banking
book typically includes loans, mortgages, and bonds. The purpose of the banking book is to earn
interest over a long period, and the risks associated with the banking book are credit risk and
On the other hand, the trading book consists of assets that are available for sale, meaning that
they are eligible for day-to-day trading. Under Basel II and III, the trading book has to be marked
to market on a daily basis. The trading book typically includes financial instruments like
government and corporate bonds, derivatives, and equities. The purpose of the trading book is to
earn profits from short-term price fluctuations, and the risks associated with the trading book
Choice B is incorrect. Both the banking book and trading book consist of assets that are held
on the bank's balance sheet. The distinction between them lies in their purpose and how they are
Choice C is incorrect. While it's true that the value of assets in the trading book can fluctuate
due to market variables, it's not accurate to say that all assets in the banking book have fixed
values. The banking book can include loans and bonds whose values may change due to interest
Choice D is incorrect. The banking book does not only show primary financial instruments
such as cash; it also includes other long-term investments like loans and bonds which are
expected to be held until maturity. Similarly, while the trading book may include derivative
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Q.4885 Which of the following is an example of a poison pill?
A. Providing attractive stock options to key workers that can be exercised in the case of a
takeover.
B. Issuing preferred shares that immediately convert to common shares in the case of a
takeover.
C. Adding a clause to the company's charter prohibiting a new owner from firing existing
directors for a period of time.
All the options provided are examples of a 'poison pill' strategy. A 'poison pill' is a defensive
tactic used by companies to prevent or discourage hostile takeovers. By making the company
less attractive to potential acquirers, it helps to protect the interests of the existing shareholders
Option A: Providing attractive stock options to key workers that can be exercised in
the event of a takeover. This increases the cost of acquisition as the acquirer would
Option B: Issuing preferred shares that immediately convert to common shares in the
event of a takeover. This dilutes the ownership of the acquirer, making the takeover
less attractive.
Option C: Adding a clause to the company's charter prohibiting a new owner from
firing existing directors for a period of time. This ensures continuity in the company's
management and may deter acquirers who wish to replace the existing management.
Choice A is incorrect. While providing attractive stock options to key workers that can be
exercised in the case of a takeover may seem like a deterrent, it does not necessarily make the
company less attractive to potential acquirers. This strategy could potentially increase the cost
of acquisition due to increased compensation expenses, but it does not trigger any costly events
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Choice B is incorrect. Issuing preferred shares that immediately convert to common shares in
case of a takeover might dilute the ownership stake of an acquirer, making it more difficult for
them to gain control over the company. However, this strategy alone does not necessarily make
the company less attractive or trigger any costly events upon a hostile takeover attempt.
Choice C is incorrect. Adding a clause to the company's charter prohibiting a new owner from
firing existing directors for a period of time could potentially deter some acquirers who wish to
replace current management with their own team. However, this strategy alone doesn't
necessarily make the company less attractive or trigger any costly events upon an attempted
hostile takeover.
Q.4886 Which of the following are offers that can be made by the acquiring company in a
takeover?
A. Cash offer.
B. Share-for-share offer.
All of the above. In a corporate takeover, the acquiring company can make several types of offers
to the target company. These include a cash offer, a share-for-share offer, or a combination of
both. A cash offer involves the acquiring company buying the existing shares of the target
company for cash. This means that the acquiring company bears the risk of the acquisition. A
share-for-share offer involves the acquiring company issuing new shares in exchange for the
existing shares of the target company. This results in the shareholders of the target company
becoming shareholders of the acquiring company, and the risks of the acquisition are shared
between the two companies. A combination of a cash offer and a share-for-share exchange
involves elements of both types of offers. The initial offer made by the acquiring company is not
necessarily the final offer, and the investment bank must rely on its previous experience to
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Choice A is incorrect. While a cash offer is indeed one of the types of offers an acquiring
company can make, it does not represent all the possible options. In a cash offer, the acquiring
company simply offers to buy out the target company's shares for a certain amount of cash per
share.
where the acquiring company proposes to exchange its own shares for those of the target
company at a predetermined ratio. However, this choice also does not encompass all possible
types of offers.
yet another type of acquisition strategy that an acquiring firm may employ. This involves offering
both cash and shares in exchange for those of the target firm. Despite being another valid
option, it still doesn't cover all potential strategies that can be used in corporate acquisitions.
Q.4887 The following table shows information about the bid and bidders in a Dutch Auction to
sell 10,000 shares.
A. 44
B. 42
C. 36
D. 40
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In a Dutch auction, the auctioneer starts with the highest asking price and lowers it until it
reaches a price level where the bids received will cover the entire offer quantity.
First, we sort the bids from the highest to the lowest (according to bid price)
9,500 shares can be sold for 43 or more. 11,500 shares can be sold for 42 or more. This is the
price that coincides with a cumulative total of 10,000 shares as targeted by the auctioneer.
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Q.5041 Which of the following best describes the liquidity coverage ratio?
A. A requirement to ensure that banks have enough funding to survive a 30-day period of
acute stress such as downgrading, losing deposits or drawdowns on its lines of credit.
B. A requirement that limits the size of mismatches between the maturity of assets and
the maturity of the assets.
C. A capital requirement designed to cover losses arising from defaults on loans and
derivatives contracts.
The liquidity coverage ratio (LCR) is a regulatory requirement introduced by the Basel
Committee on Banking Supervision. It is designed to ensure that banks have sufficient high-
quality liquid assets to survive a 30-day period of acute stress. This stress could be caused by a
variety of factors, such as a downgrade in the bank's credit rating, a loss of deposits, or
drawdowns on its lines of credit. The LCR is calculated by dividing a bank's high-quality liquid
assets by its total net cash outflows over a 30-day stress period. The aim is to promote short-term
resilience of a bank's liquidity risk profile by ensuring it has sufficient high-quality liquid assets
Choice B is incorrect. While it is true that managing maturity mismatches between assets and
liabilities is crucial for a bank's liquidity management, this does not specifically describe the
purpose of the Liquidity Coverage Ratio (LCR). The LCR is designed to ensure that banks have
Choice C is incorrect. This choice describes a capital requirement, which aims to cover
potential losses from loan defaults or derivative contracts. However, this does not accurately
represent the function of the LCR. The LCR focuses on liquidity risk rather than credit risk.
associated with failures in systems, processes or personnel within an organization. This concept
differs from the Liquidity Coverage Ratio which primarily addresses liquidity risk during periods
of financial stress.
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Q.5333 Which of the following investment banking financing approaches involves an underwriter
purchasing the entire issue from the issuer and then reselling it to the public?
A. Private placement.
B. Public offering.
C. Best efforts.
D. Dutch auction.
In a public offering, an investment bank (or a group of banks) serves as an underwriter for the
issuance of securities by a company or government entity. The underwriter purchases the entire
issue from the issuer at a negotiated price and then resells the securities to the public, often
making a profit on the spread between the purchase price and the public offering price. The
underwriter assumes the risk of not being able to sell the entire issue to the public. In exchange
for taking on this risk, the underwriter is compensated through the fees and the difference
between the price paid to the issuer and the price at which the securities are sold to the public.
Choice A is incorrect. Private placement is a method of raising capital where securities are
sold directly to a small group of institutional investors, not the general public. The underwriter
does not purchase the entire issue and resell it in this approach.
Choice C is incorrect. In a best efforts approach, the underwriter agrees to sell as many shares
as possible but does not guarantee the sale of all shares issued by the issuer. Therefore, this
choice does not accurately describe a financing approach where the underwriter purchases and
Choice D is incorrect. A Dutch auction involves investors bidding on shares, with each
subsequent bid being lower than the previous one until all shares are sold or no further bids are
made. This method doesn't involve an underwriter purchasing and then reselling securities to
public.
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Q.5334 Which of the following is a potential drawback of the originate-to-distribute banking
model?
A. It allows banks to hold onto assets that are difficult to sell in the market.
between banks and investors. This is because banks, under this model, may prioritize the
quantity of loans originated over their quality. This is due to the fact that banks do not retain the
loans on their balance sheets and, therefore, do not bear the risk of default. As a result, they may
borrowers, leading to increased risk for the investors who purchase these loans. This
misalignment of incentives was one of the factors that contributed to the subprime mortgage
crisis in 2007-2008.
Choice A is incorrect. The originate-to-distribute banking model does not allow banks to hold
onto assets that are difficult to sell in the market. In fact, it's quite the opposite. This model
allows banks to offload loans from their balance sheets by selling them to investors, thereby
Choice B is incorrect. While this model may introduce some level of flexibility into a bank's
financial statements by allowing it to manage its risk exposure and capital requirements more
effectively, this is generally considered an advantage rather than a disadvantage of the originate-
Choice D is incorrect. The originate-to-distribute banking model does not increase the amount
of capital that banks need to hold. Instead, it can actually reduce capital requirements as loans
are sold off and removed from the bank's balance sheet.
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Q.5335 A risk manager at ABC Bank is discussing the moral hazard problem in risk management
with newly hired employees. Which of the following correctly describes the moral hazard
problem associated with deposit insurance?
A. Depositors are incentivized to take on more risk due to the protection of deposit
insurance.
B. Banks are incentivized to take on riskier investments due to the protection of deposit
insurance.
Deposit insurance provides protection to depositors in case their bank fails, which reduces the
risk for depositors. However, it also creates a moral hazard problem for banks, as they are
incentivized to take on riskier investments since the cost of default is borne by the insurance
A is incorrect because depositors are not the ones who are taking on the risk. Banks are the
ones who are taking on the risk by making investments. Depositors are simply the ones who are
entrusting their money to banks. If a bank fails, depositors may lose their money, but it is the
bank that is taking on the risk of failure. Instead, insurance makes depositors less keen on
C is incorrect. Deposit insurance does not incentivize regulators to reduce oversight of banks,
as regulators are responsible for ensuring that banks meet certain standards of safety and
D is incorrect. Deposit insurance does not incentivize bank employees to engage in fraudulent
activities, as fraudulent activities can lead to regulatory sanctions, lawsuits, and other adverse
consequences.
Q.5336 A bank executive is attending a seminar on the major risks faced by banks and the ways
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in which these risks can arise. The seminar is meant to provide an overview of the different types
of risks and their implications for the banking industry. Which of the following is an example of
operational risk?
B. The risk of default on a debt that may arise from a borrower failing to make required
payments.
C. The risk of losses due to inadequate or failed internal processes, people, and systems.
D. The risk of losses due to events outside of the bank's control, such as natural disasters
or political events.
Operational risk is defined as the risk of losses resulting from inadequate or failed internal
processes, people, and systems. This can encompass a wide range of potential issues, including:
Inadequate or failed internal processes: These can range from errors in transaction
processing to system failures, or even insufficient controls that fail to prevent fraud or
misuse of the bank's resources. For example, a bank might have a flawed process for
approving loans, leading to the approval of loans that should have been denied. This
People: Human errors or misconduct can also lead to operational risk. Employees
might make mistakes in data entry, fail to follow established procedures, or engage in
fraudulent activities. For instance, an employee might accidentally transfer funds to the
can lead to operational risk by disrupting normal banking operations and potentially
causing losses. For example, a cyberattack might result in a data breach, leading to
Choice A is incorrect. This refers to market risk, not operational risk. Market risk arises from
Choice B is incorrect. This describes credit risk which occurs when a borrower fails to repay a
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loan and the lender loses the principal of the loan or the interest associated with it.
Choice D is incorrect. While this could be considered a form of operational risk under certain
circumstances, it's more accurately described as systemic or external risk. These risks are
outside of an organization's control and can impact an entire industry rather than just one
institution.
A. The investment banking division pressuring the bank's brokers to buy certain
securities for clients.
C. The investment banking division receiving material nonpublic information from the
commercial banking division about the existing client.
The primary concern for the compliance officer in this scenario would be the possibility of the
investment banking division receiving material nonpublic information from the commercial
banking division about the existing client. This is because such information could potentially be
used against the existing client, leading to a conflict of interest for the bank. Moreover, this
could also result in a violation of securities laws and regulations, which prohibit the use of
material nonpublic information for trading purposes. This is a serious concern as it could lead to
legal repercussions for the bank and damage its reputation. Therefore, the compliance officer
would need to ensure that appropriate measures are in place to prevent such a situation from
occurring.
Choice A is incorrect. While it's possible that the investment banking division could pressure
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the bank's brokers to buy certain securities for clients, this isn't directly related to the conflict of
interest between serving a new client who is a direct competitor of an existing client in the
commercial banking division. The compliance officer's primary concern would be about
information flow and potential misuse, not about influencing investment decisions.
Choice B is incorrect. Pressuring researchers to generate buy recommendations for the new
client might be a concern, but it doesn't represent the primary conflict of interest in this
scenario. The main issue here revolves around access and potential misuse of material nonpublic
Choice D is incorrect. Although offering preferential rates to the new client could potentially
create conflicts within different divisions of the bank, it does not address directly the compliance
officer's main concern which would be about maintaining confidentiality and preventing misuse
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Reading 28: Insurance Companies and Pension Plans
Q.1108 Which one of the following statements regarding traditional whole life insurance is
incorrect?
A. The beneficiary receives the sum assured only on the death of the insured.
The statement that the payout time is known with certainty is incorrect in the context of
traditional whole life insurance. The payout time, or the time when the sum insured will be paid
out, is not predictable in a whole life insurance policy. This is because the payout is triggered by
the death of the insured, which is an event that cannot be predicted with certainty. Therefore,
while it is guaranteed that the sum insured will be paid out at some point (provided the
policyholder continues to make the required premium payments), the exact timing of this payout
is uncertain.
Choice A is incorrect. The beneficiary indeed receives the sum assured only on the death of the
insured in a traditional whole life insurance policy. This is one of the defining characteristics of
Choice C is incorrect. It's true that in a traditional whole life insurance policy, premiums are
paid throughout the lifetime of the insured. This ensures that coverage continues for as long as
they live.
whole life insurance policy, providing predictability and stability for policyholders.
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Q.1109 Under term life insurance, the sum assured is payable only if:
Term life insurance is a type of life insurance that provides coverage for a certain period of time,
or a 'term'. If the insured dies during this term, the death benefit is paid out to the beneficiary.
This is the fundamental principle of term life insurance. The purpose of this type of insurance is
to provide financial protection to the beneficiary in the event of the insured's death during the
term of the policy. The sum assured is not payable if the insured survives beyond the term of the
policy. Therefore, the sum assured is payable only if the insured dies within the specified time
period.
Choice B is incorrect. The sum assured in a term life insurance policy is not dependent on
whether the beneficiary is alive at the end of the specified term. The policy pays out if the
insured dies within the specified time period, regardless of whether or not the beneficiary
Choice C is incorrect. If the insured lives beyond the specified term period, no death benefit
will be paid out under a term life insurance policy. This type of insurance only provides coverage
for a specific 'term' or duration; if this duration expires and no claim has been made (i.e., if the
Choice D is incorrect. The death of a beneficiary within a specified term does not trigger
payment in a term life insurance policy. The payout condition for such policies revolves around
whether or not insured dies within that specific timeframe, irrespective of when beneficiaries
pass away.
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Q.1112 The following data gives the mortality experience among males in Europe in 1931.
Calculate the probability of a new-born male dying between his 30th and 31st birthday.
A. 0.97372
B. 0.99862
C. 0.001418
D. 0.00138
The probability that a new-born male dies between age 30 and 31 equals the probability that the
newborn lives until age 30 (0.97372) and dies in the 30th year (0.001419)
Thus, the probability of a new-born male dying between his 30th and 31st birthday is:
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Q.1113 The following data gives the mortality experience among males in Europe in 1931.
A. 0.001407
B. 0.001443
C. 0.998557
D. 0.001445
The probability of a man who is aged 30 dying between ages 31 and 32 means the man survives
for one year but dies in the second year. This is equal to the probability that the man survives in
the first year (between ages 30 and 31) multiplied by the probability that he dies in the second
year (between ages 31 and 32). This is:
Q.1114 The following data gives the mortality experience among males in Europe in 1931.
Assuming that: I. Interest rate = 4% II. Premiums are paid annually in advance (at the beginning
of the year) III. Compounding is semi-annual. A 30-year-old man takes up a term insurance policy
that expires in two years.Calculate the expected payout given that the policy has a sum assured
of $100,000. (Assume that deaths occur mid-way through the year).
A. 144.62
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B. 275.09
C. 283.42
D. 125
If the man dies during the first year, the expected payout is the probability of a 30-year-old dying
And because we assume that the payout is made approximately half-way through the year, we
Similarly, if the man dies during the second year, the expected payout is the probability of a 30-
year-old surviving for the first year and then dying in the second year multiplied by the sum
assured.
Q.1115 The following data gives the mortality experience among males in Europe in 1931.
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Assuming that:
I. Interest rate = 4%
II. Premiums are paid annually in advance (at the beginning of the year)
III. Compounding is semi-annual
If the policy has a sum assured of $100,000, and a 30-year-old man takes up a term insurance
policy that expires in two years, then which of the following is closest to the break-even premium
payable by the policyholder?
A. 140.37
B. 123.62
C. 150
D. 80
If the man dies during the first year, the expected payout is the probability of a 30-year-old dying
And because we assume that the payout is made approximately half-way through the year, we
Similarly, if the man dies during the second year, the expected payout is the probability of a 30-
year-old surviving for the first year and then dying in the second year multiplied by the sum
assured.
If we let P be the annual premium payable, then the first premium is received at time zero with a
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probability of 1. The second premium is received at the beginning of the second year. This
particular premium is subject to the probability that the man does not die in the first year. It also
(1−0.001419)p
Thus, present value of premiums = p + = 1.9598p
1.02 2
To calculate the value of p, we then equate the present value of the expected payout to the
275.09 = 1.9598p
p = $140.37
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Q.1116 How does an increase in longevity risk affect the profitability of lifelong annuity
contracts?
Longevity risk refers to the risk that policyholders may live longer than initially estimated. In the
context of lifelong annuity contracts, this risk directly impacts the profitability of the insurance
company. Lifelong annuity contracts are structured such that the insurer agrees to make regular
payments to the policyholder from a certain age until their death. If the policyholder lives longer
than initially estimated, the insurer is obligated to continue making these payments for a longer
period. This results in higher costs for the insurer, thereby reducing their profitability. Therefore,
Choice A is incorrect. Longevity risk, or the potential increase in the average lifespan of
policyholders, does not increase profits made by the insurer. In fact, it's quite the opposite. If
policyholders live longer than expected, insurers will have to make more payments than initially
Choice C is incorrect. While longevity risk may impact the return on investment for an
insurance company due to increased payouts over time, it does not directly reduce the return on
determined by factors such as premium rates and terms of contract rather than longevity risk.
company offering lifelong annuity contracts. As mentioned earlier, if policyholders live longer
than expected, this means that insurers will have to make more payments over time which can
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Q.1117 How does increased mortality risk affect the profitability of life insurance contracts?
An increase in mortality risk decreases the profits made by the insurer. This is because mortality
risk is the risk that policyholders will die sooner than expected due to factors such as epidemics,
pandemics, and wars. When mortality risk increases, policyholders live for shorter periods of
time than expected and therefore make fewer premium payments to the insurance company
before the insurance company needs to make payments for the sum assured. The insurance
company will receive less in payments but still be required to pay the policy assured amount to
Choice A is incorrect. An increase in mortality risk does not increase the profits made by the
insurer. In fact, it's quite the opposite. Higher mortality rates mean that insurers have to pay out
Choice C is incorrect. Mortality risk has no direct impact on the return on investment to the
policyholder. The return on investment for a life insurance policyholder is determined by factors
such as premium payments, cash value accumulation and dividends, not mortality rates.
Choice D is incorrect. Mortality risk certainly affects profitability of life insurance contracts as
it directly influences claim payouts from insurers. Therefore, stating that an increase in mortality
Q.1118 Which of the following strategies presents the best way to deal with longevity and
mortality risks in the insurance business?
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B. Avoiding high-risk business.
C. Reinsurance.
Reinsurance is a strategy used by insurance companies to manage longevity and mortality risks.
It involves transferring a portion of the insurer's risk portfolio to another party, known as the
reinsurer. The reinsurer agrees to cover the losses exceeding a certain amount, thereby reducing
the likelihood of the insurer having to make large payouts when the mortality experience turns
out to be worse than expected. This strategy is particularly effective in managing longevity and
mortality risks as it allows the insurer to spread the risks and protect itself from potentially
catastrophic losses. Furthermore, reinsurance can provide the insurer with greater capacity to
underwrite more policies, thereby increasing its profitability. It also enables the insurer to
stabilize its financial results by smoothing out the peaks and valleys of underwriting cycles.
Choice A is incorrect. Adding a substantial risk premium to the final break-even premium
payable may not be an effective strategy for managing longevity and mortality risks. This is
because it could potentially make the insurance product unaffordable for many customers,
Choice B is incorrect. Avoiding high-risk business might reduce exposure to longevity and
mortality risks but it also limits the potential for higher returns that come with higher risk.
Moreover, this strategy does not manage the risk but rather avoids it altogether which is not
Choice D is incorrect. Using a high interest rate can increase investment income but it does
not directly address longevity and mortality risks which are related more to life expectancy
trends than interest rates. Furthermore, using a high interest rate could lead to other financial
Q.1119 Richard Brad, FRM, owns a high-rise mixed-use building located in the heart of London.
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Although he has complied with all quality and safety standards, he fears that a major accident,
such as a fire, might result in injuries to residents and third parties and he might be forced to
pay for such damages. To protect his building and avoid losses resulting from large-scale
compensations, Mr. Brad could most likely:
A. Make life insurance and disability insurance mandatory requirements for every tenant
as well as visitors.
Seeking property-casualty insurance is the most appropriate measure for Mr. Brad to protect his
building and avoid losses resulting from large-scale compensations. Property insurance would
provide protection against damage to the building resulting from fire, theft, water damage, etc.
Casualty insurance, on the other hand, would provide protection against legal liability exposures,
such as injuries to visitors in case of an inferno or the occurrence of any risk. This combination of
property and casualty insurance would ensure that Mr. Brad is covered for both physical
damages to his property and any liabilities arising from injuries or damages sustained by others.
Therefore, this choice is the most comprehensive and suitable option for Mr. Brad to safeguard
his interests.
Choice A is incorrect. Making life insurance and disability insurance mandatory for every
tenant and visitor would not provide Mr. Brad with protection against potential losses. These
types of insurances are personal coverages that protect the insured individuals, not the property
Choice B is incorrect. Reinsuring the building against large-scale loss could potentially help to
mitigate some financial risk associated with a major accident, but it does not directly protect Mr.
Brad from liability claims arising from injuries to residents and third parties.
Choice C is incorrect. While property insurance would cover damages to the building itself due
to accidents like fire, it does not typically include liability coverage for injuries or damages
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Q.1120 Suppose you are the chief risk officer of a growing insurance company, "SafeGuard
Insurances Ltd." Recently, you noticed an increase in the number of claims. Digging deeper, you
found that the claims primarily originated from policies bought in the last 6 months. You suspect
adverse selection may be causing this increase in claims, and thus, you are conducting a
thorough review to identify potential examples. Which of the following is most likely an example
of adverse selection risk?
A. The company has seen a surge in life insurance policies sold to elderly customers with
pre-existing health conditions.
B. There is an increase in car insurance claims due to severe weather conditions in areas
where the company has a significant market presence.
C. The company's stock value has recently decreased, leading to a decline in market
confidence.
D. The IT system of the company has been hacked, causing significant losses in digital
assets.
Adverse selection occurs when the party with more information takes advantage of the party
with less information. In this scenario, the elderly customers with pre-existing health conditions
are more likely to claim insurance than the average person. This is because they know they have
health issues, which is information not initially disclosed or factored in during the underwriting
process, which leads to a higher-than-expected loss rate for the insurance company. This is a
Options B, C, and D are incorrect. Adverse selection specifically pertains to risks that arise due
to asymmetrical information between the insurer and the insured before the agreement. Severe
weather conditions, stock market performance, and IT breaches are all external factors not
influenced by the policyholder's actions or choices and do not involve information asymmetry.
Q.1121 If an insurance company offers the same premium to both smokers and non-smokers, it is
likely to attract high-risk policyholders and might contend with more payouts than initially
expected. This problem is called:
A. Moral hazard.
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B. Poor selection.
C. Adverse selection.
Adverse selection refers to a situation where an insurer faces the challenge of distinguishing
between good and bad risks when processing policy applications. If the insurer does not gather
sufficient information about the applicant, they risk overlooking certain 'grey areas' that could
make the policy too risky to underwrite. For instance, if the insurer does not inquire about the
applicant's smoking status, they might end up charging the same premium for both smokers and
non-smokers. This could result in higher-than-expected claims and payouts, as a large number of
smokers, including those rejected by other insurers, might seek to purchase policies from this
insurer. There have been instances where insurers have suffered significant losses due to such
practices.
Choice A is incorrect. Moral hazard refers to the risk that a party insulated from risk behaves
differently than it would if it were fully exposed to the risk. In this case, charging the same
premium for both smokers and non-smokers does not change their behavior, hence moral hazard
Choice B is incorrect. Poor selection refers to a situation where an insurer fails to select
suitable policyholders based on their individual risk profiles. While this scenario does involve
poor decision-making by the insurance company, it doesn't accurately describe the problem of
Choice D is incorrect. Adverse risk modeling refers to a situation where an insurer's model for
assessing and pricing risks proves inaccurate or ineffective in practice. Although this could
potentially be part of the problem in this scenario, it doesn't capture the specific issue of
attracting more high-risk policyholders due to equal premiums for smokers and non-smokers.
Q.1122 The main difference between a defined benefit scheme and a defined contribution
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scheme is that:
C. Defined benefit schemes are tax-deductible but defined contribution schemes are not.
D. A defined benefit scheme promises a specific income upon retirement whereas, with a
defined contribution scheme, the income depends on factors such as the size of monthly
contributions and investment performance.
A defined benefit scheme promises a specific income upon retirement whereas, with a defined
contribution scheme, the income depends on factors such as the size of monthly contributions
and investment performance. Defined benefit schemes, as the name suggests, offer a 'defined' or
'fixed' benefit upon retirement. This benefit is usually calculated based on the employee's salary
and years of service. The employer bears the investment risk in this type of scheme, as they are
obligated to provide the promised benefit regardless of the performance of the underlying
investments. On the other hand, in a defined contribution scheme, both the employee and the
employer contribute to the employee's individual account. The final benefit upon retirement
depends on the total contributions made and the performance of the investments. Therefore, the
investment risk in this type of scheme is borne by the employee. The key difference between the
two schemes lies in who bears the investment risk and how the retirement benefit is determined.
Choice A is incorrect. Both defined benefit schemes and defined contribution schemes can be
employer-sponsored. The key difference lies in the structure and benefits, not in who runs the
scheme.
Choice B is incorrect. The duration of both defined contribution and defined benefit schemes
can vary depending on the specific terms set by employers or plan administrators, not
Choice C is incorrect. Both types of pension plans have tax implications, but their tax-
deductibility does not distinguish them from each other. In many jurisdictions, contributions to
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both types of plans are tax-deductible up to certain limits.
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Q.4888 Which of the following factors poses the greatest risk of loss to whole life insurance
business?
B. Mortality risk.
C. Longevity risk.
D. Currency risk.
Mortality risk is the most significant risk faced by life insurance companies. This risk arises when
policyholders die earlier than expected, which could be due to various reasons such as illness,
disease, or fatal accidents. When this happens, the insurance company is forced to make life
insurance payouts earlier than anticipated. This can lead to significant financial losses for the
company, especially if the number of early deaths is higher than what was initially projected
when pricing the insurance policies. Therefore, managing mortality risk is a critical aspect of the
Choice A is incorrect. While low rates of interest can impact the profitability of a life insurance
company, they do not pose the most significant threat to a whole life insurance business. This is
because these companies have strategies in place to manage interest rate risk, such as asset-
liability management.
Choice C is incorrect. Longevity risk, which refers to the risk that policyholders live longer
than expected, can indeed affect profitability. However, it does not pose the most significant
threat for whole life insurance businesses as these policies are designed with this risk in mind
Choice D is incorrect. Currency risk could potentially impact an international life insurance
However, this risk isn't typically considered as significant for a whole life insurance business
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Q.4889 Which of the following types of property insurance poses the greatest risk of loss for an
insurer?
A. Fire insurance.
B. Theft insurance.
This type of insurance falls under Category B risks, where a single event can lead to many claims
at the same time. These risks are particularly challenging to model due to the scarcity of data
and the unpredictable nature of catastrophic events. For instance, a hurricane can either occur,
leading to most policyholders filing a claim, or not occur, resulting in no claims. This all-or-
nothing nature of natural disasters makes them the greatest risk of loss for insurers.
Choice A is incorrect. Fire insurance does pose a risk to insurers, but it is not the highest risk.
This is because fire incidents can be reasonably predicted based on historical data and the
independence of claims. Therefore, insurers can model and manage this risk effectively.
Choice B is incorrect. Theft insurance also poses a risk to insurers, but it's not the highest one
either. Similar to fire insurance, theft incidents can be reasonably predicted based on historical
data and the independence of claims which allows for effective modeling and management of this
type of risk.
Choice C is incorrect. Insurance against automobile accidents does pose a significant risk due
to its frequency; however, these risks are still manageable as they are independent events that
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Q.4890 In contrast whole life insurance premiums, health insurance premiums:
Health insurance premiums may increase from year to year or remain constant. This is because
the cost of health care can fluctuate over time due to various factors such as inflation, changes in
medical technology, and shifts in the overall health of the population. As a result, health
insurance companies may adjust their premiums to reflect these changes. However, it's also
possible for health insurance premiums to remain constant. This can occur if the insurer
determines that the current premium level is sufficient to cover anticipated health care costs. It's
important to note that while health insurance premiums can increase, they cannot be raised due
to unexpected health problems that were unknown at the time the policy was initiated. This is a
key difference between health insurance and whole life insurance, where premiums typically
Choice A is incorrect. Health insurance premiums do not always increase from year to year.
The premium amount can be influenced by various factors such as changes in health status, age,
and inflation. However, it's not a guarantee that they will always increase annually.
Choice B is incorrect. While it's true that health insurance premiums may fluctuate based on
certain factors, they typically do not decrease over time due to the increasing risk of illness with
Choice D is incorrect. Health insurance premiums do not remain constant throughout the
holder’s life unlike whole life insurance premiums which are designed to stay level for the
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Q.4891 The following data gives the mortality experience among males in Europe in 1931.
What is the probability that a man aged 30 will live to age 33?
A. 0.9454
B. 0.9971
C. 0.0255
D. 0.0029
Note: To be able to interpret this in terms of probabilities, it may be helpful to consider this as
the probability of a man living to age 33 given that they have already survived/lived to age 30.
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Q.4892 Which of the following is the best definition of variable life insurance?
B. The policyholder makes a lump sum payment to the insurer in exchange for a stream
of regular payments for a specified period of time.
D. whole life assurance with an investment component and which gives the policyholder a
lot more flexibility in terms of the premium payable.
Variable life insurance is indeed a type of whole life assurance that includes an investment
component. This means that a portion of the premium paid by the policyholder is invested in
various sub-accounts available within the policy. For instance, if a policyholder pays an annual
premium of $10,000, half of this amount could be allocated towards the sum assured (death
benefit), say $1 million, while the remaining half is invested in different financial instruments.
Consequently, the total benefit received upon the death of the policyholder would be the sum
assured plus a variable amount generated from the investment account. This feature of variable
life insurance makes it a unique and attractive option for policyholders who are not only
Choice B is incorrect. This description refers to an annuity, not a variable life insurance policy.
In an annuity, the policyholder makes a lump sum payment and in return receives regular
Choice C is incorrect. This describes term life insurance that can be renewed at the end of the
term, not variable life insurance. Variable life insurance has an investment component and
Choice D is incorrect. While it does mention whole life assurance with an investment
component which aligns with variable life insurance, it incorrectly emphasizes on flexibility in
terms of premium payable which is not a defining feature of variable life insurance.
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Q.5042 Given the information below, the operating ratio for a property-casualty insurance
company is closest to?
A. 78%
B. 88%
C. 72%
D. 85%
adding the loss ratio, expense ratio, and dividends and deducting the investment income earned
if the investment earned a positive return. If the investment had a negative return, it should be
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Q.5338 A group of insurance agents is discussing the risks facing life insurance companies. The
agents are particularly concerned about the potential for adverse selection. Which of the
following is an example of adverse selection in the life insurance market?
A. A life insurance applicant not being asked to disclose a pre-existing medical condition.
B. A life insurance policyholder lying about their age to get a lower premium.
Adverse selection occurs when policyholders with higher risk are more likely to seek insurance
coverage than those with lower risk. In the case of life insurance, adverse selection can occur
when the insurance company fails to ask the applicants to disclose pre-existing medical
C is incorrect. This is an example of the insured event occurring, which is not related to
adverse selection.
D is incorrect. This is an example of a failure of the insurance company to fulfill its obligations,
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Q.5339 An insurance company has made payouts of $15 million and $5 million in expenses over
the past year. It received premiums of $25 million over the same period. Calculate the loss ratio,
expense ratio, and combined ratio for this insurance company.
To calculate the loss ratio, expense ratio, and combined ratio for the insurance company, we'll
Losses Paid
Loss Ratio = ( Premiums ) × 100
Earned
Expenses
Expense Ratio = ( Premiums Earned
) × 100
Expenses = $5 million
Thus,
$15 million
Loss ratio = = 60%
$25 million
$5 million
Expense ratio = = 20%
$25 million
Combined ratio = 60% + 20% = 80%
Q.5341 Under Solvency II regulations, how is the relationship between the Solvency Capital
Requirement (SCR) and the Minimum Capital Requirement (MCR) best characterized for
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insurance companies?
A. The MCR is always equal to the SCR to ensure strict capital adequacy standards.
B. The SCR is a higher capital requirement, while the MCR serves as a lower threshold
that triggers supervisory intervention if breached.
C. The MCR is a higher capital requirement that focuses on risk management, while the
SCR serves as a lower threshold for capital adequacy.
D. The SCR and MCR are unrelated concepts that are independently used to assess an
insurance company's capital adequacy.
The Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR) under
Solvency II regulations are two different capital requirements that insurance companies must
meet. The SCR is a higher capital requirement that is designed to ensure that insurance
companies have sufficient capital to absorb significant losses with a 99.5% confidence level over
a one-year horizon. This requirement takes into account various risk factors, including
underwriting, market, credit, operational, and other risks. On the other hand, the MCR serves as
a lower threshold for capital adequacy. If an insurance company's capital falls below this level, it
triggers immediate supervisory intervention. The insurance company may be prevented from
taking on new business, and existing policies might be transferred to another insurance
company. Therefore, the SCR and MCR work together to ensure the solvency and financial
Choice A is incorrect. The MCR is not always equal to the SCR. While both are capital
requirements under Solvency II, they serve different purposes and are calculated differently. The
SCR reflects the capital that an insurance company needs to absorb significant losses and
continue its operations, while the MCR represents a lower limit below which policyholders and
Choice C is incorrect. Contrary to this statement, it's actually the SCR that is a higher capital
requirement focusing on risk management, while the MCR serves as a lower threshold for capital
adequacy.
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Choice D is incorrect. The SCR and MCR are not unrelated concepts; they are interconnected
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Q.5364 An insurance company has been facing financial difficulties in recent years. The
management is trying to identify the underlying issues by analyzing various financial ratios.
Which of the following scenarios is most likely to result in the company facing financial
difficulties in the long run?
A. High loss ratio, low expense ratio, and low combined ratio.
B. Low loss ratio, high expense ratio, and low combined ratio.
C. High loss ratio, high expense ratio, and high combined ratio.
D. Low loss ratio, low expense ratio, and high combined ratio.
The loss ratio measures the proportion of claims paid (losses) to the premiums earned by the
insurance company. The expense ratio shows the proportion of an insurance company's operating
expenses (such as commissions, salaries, and administrative costs) relative to the premiums
earned. The combined ratio is the sum of the loss ratio and the expense ratio.
A high loss ratio indicates that the company is paying out a significant proportion of its
premiums as claims, suggesting that the company's underwriting standards may be inadequate
or that it is not pricing its policies effectively. A high expense ratio shows that the company's
operating expenses are not being managed efficiently, which can erode profitability. A high
A company with high loss and expense ratios, as well as a high combined ratio, is likely to face
financial difficulties in the long run, as it is not generating underwriting profits and may struggle
to maintain its operations. This situation can lead to reduced financial stability and potentially
In contrast, the other scenarios (A, B, and D) depict a combination of low loss ratios, low expense
ratios, or low combined ratios, which generally indicate better financial health, profitability, and
operational efficiency.
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Reading 29: Fund Management
Q.1124 An investor joins a mutual fund and buys shares at $200 each. In the trading course, the
fund leads to a capital gain of $15 per share in the first year and a capital loss of $20 per share
in the second year. If the investor decided to sell the shares during the second year, what would
be the purchase price to calculate the capital gain/loss on the transaction during the second
year?
A. $200
B. $215
C. $195
D. $205
The investor has to declare a capital gain of $15 in the first year and a capital loss of $20 in the
second year. To avoid double counting, the purchase price must be adjusted to take into account
the capital gains or losses that have already accrued to the investor. By selling the shares in the
second year, only the $15 capital gain has accrued, and thus the purchase price would be (200 +
15) = $215.
Note: If the investor were to sell during the third year, both the capital gain of $15 and the
capital loss of $20 would have accrued, giving an adjusted purchase price of (200 + 15 – 20) =
$195
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Q.1125 Funds that are designed to track a particular equity index such as the S&P 500 are
known as: In a investment, there are various types of funds that investors can choose from, each
with its unique characteristics and investment strategies. One such type of fund is designed
specifically to mirror the performance of a particular equity index, such as the S&P 500. What
are these types of funds called?
A. Open-end funds.
B. Closed-end funds.
D. Hedge funds.
Equity index funds are used to track the performance of particular equity indexes, such as the
S& P 500 or the FTSE 100. To achieve this, all the shares in the chosen index are bought in
amounts reflective of their weight. That means if XYZ stock has a 2% weight in a particular
index, 2% of the tracking portfolio for the index would be invested in XYZ stock.
Option A is incorrect: Â In an open mutual fund, shares are traded at their net asset value,
Where,
The number of shares in an open mutual fund increases and decreases as investors buy and sell
their shares.
their net asset value (NAV), and the number of shares remains constant throughout the fund's
life. The changes in the price of its shares are determined by supply and demand.
Option D is incorrect: Hedge funds have fewer regulations than mutual funds, follow a diverse
approach of trading strategies, and are not required to disclose their holdings daily. They,
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Q.1126 Michael Bauer wishes to buy shares in a front-end loaded mutual fund. He is likely to:
A front-end load is a charge that investors pay when they purchase shares in a mutual fund, and
it is typically deducted from the initial investment. This fee is used to cover various costs
associated with the management and operation of the fund, including sales commissions,
administrative expenses, and other related costs. In the case of Michael Bauer, if he decides to
buy shares in a front-end loaded mutual fund, he will be required to pay this fee at the time of
purchase. This fee is a one-time charge and does not recur when the investor decides to sell his
shares. The front-end load is usually expressed as a percentage of the total investment, and it
can significantly impact the net return on the investment, especially in the short term. Therefore,
investors should carefully consider this fee when choosing a mutual fund.
Choice B is incorrect. A back-end purchase fee, also known as a deferred sales charge or exit
fee, is not paid at the time of purchase. Instead, it is charged when the investor sells his shares
Choice C is incorrect. A front-end fee is not charged when an investor decides to sell his
shares. It's a type of commission that's paid upfront at the time of purchase.
Choice D is incorrect. While this statement correctly describes a back-end load (it's paid when
shares are sold), it does not accurately represent what would happen if Michael Bauer invests in
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Q.1127 Describe the meaning of hurdle rate in regard to hedge funds.
B. The minimum rate of return necessary for the incentive fee to be applicable.
C. The highest peak in value that an investment fund or account has reached.
The hurdle rate in the context of hedge funds refers to the minimum rate of return that must be
achieved before the incentive fee can be applied. This is a critical aspect of the compensation
structure for hedge fund managers. The incentive fee is a performance-based fee that is typically
a percentage of the profits generated by the fund. However, this fee is only applicable if the
fund's returns exceed a specified minimum level, known as the hurdle rate. This mechanism is
designed to align the interests of the fund managers with those of the investors. It ensures that
the managers are rewarded for generating high returns, but only if they exceed a certain
Choice A is incorrect. While it might seem logical that fund managers would require a
minimum rate of return to be paid, this is not what the term 'hurdle rate' refers to in the context
of hedge funds. The hurdle rate does not directly determine the payment of fund managers but
Choice C is incorrect. This choice describes the concept of 'high watermark', not 'hurdle rate'.
A high watermark refers to the highest peak in value that an investment fund or account has
reached, which is used as a reference point for future performance and incentive fee
calculations.
Choice D is incorrect. This choice describes a situation where an investment fund or account
has reached its lowest value, which does not relate to the concept of 'hurdle rate'. The hurdle
rate pertains to setting a minimum level of return necessary for applying incentive fees, and it
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Q.1128 The following statements regarding open-end mutual funds are correct, EXCEPT:
Open-end mutual funds do not offer investors a guaranteed rate of return. The performance of a
mutual fund is largely dependent on the performance of the investments it holds. These
investments can include a variety of assets such as stocks, bonds, and other securities. The value
of these assets fluctuates with market conditions, and therefore, the return on investment from
mutual funds also varies. Unlike fixed-income securities like bonds or fixed deposits, which offer
a predetermined rate of return, mutual funds do not guarantee a specific return. Investors in
mutual funds should be aware of this risk and invest according to their risk tolerance and
investment goals.
management. This is one of the key features of these types of funds, as they are managed by
Choice C is incorrect. Shares in open-end mutual funds are indeed redeemed at net asset value
(NAV). The NAV per share is calculated daily based on the total value of all the securities in the
Choice D is incorrect. Investors in open-end mutual funds do have flexibility to sell their
holdings at will, subject to any applicable fees or charges imposed by the fund.
Q.1129 Sarah wants to invest in the financial markets but first wants to understand the
differences among open-end mutual funds, closed-end mutual funds, and exchange-traded funds
(ETFs). Which of the following statements accurately describes one of the distinguishing features
of closed-end mutual funds?
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A. Closed-end mutual funds are continuously offered to investors and allow for daily
redemptions at the net asset value (NAV).
B. Closed-end mutual funds are actively managed and trade on an exchange like
individual stocks.
C. Closed-end mutual funds issue a fixed number of shares through an initial public
offering (IPO) and trade at a premium or discount to their net asset value (NAV).
D. Closed-end mutual funds are passively managed and seek to replicate the performance
of a specific market index.
Closed-end mutual funds differ from open-end mutual funds and ETFs in several ways. Closed-
end funds issue a fixed number of shares through an initial public offering (IPO), meaning that
once the shares are sold, new shares are not continuously offered to investors. This is in contrast
to open-end mutual funds and ETFs, which can create or redeem shares on a daily basis.
Furthermore, closed-end funds trade on exchanges like stocks, and their share prices can deviate
from the net asset value (NAV), leading to them trading at a premium or discount. This price
Option A is incorrect. Closed-end mutual funds do not allow for daily redemptions at the NAV.
As mentioned earlier, closed-end funds issue a fixed number of shares through an IPO and do not
continuously offer new shares to investors. Therefore, daily redemptions at the NAV are not
possible./strong>
Option B is incorrect. The level of management, whether active or passive, is not a defining
characteristic of closed-end funds. Both actively managed and passively managed funds can be
structured as closed-end funds. The key distinguishing feature of closed-end funds is their fixed
Option D is incorrect. Closed-end funds can be either actively managed or passively managed.
While some closed-end funds may indeed seek to replicate the performance of a specific market
index, this is not a universal characteristic. The management style of a closed-end fund can vary,
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Q.1130 Proud Mutual Fund had year-end assets worth $335 million and liabilities of $68 million.
Given that there were a total of 100,000 shares outstanding, compute the NAV.
A. 120
B. 2,600
C. 1,500
D. 2,670
The Net Asset Value (NAV) is the market value of the assets of the fund minus its liabilities
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Q.1131 Brighter Market Portfolio had end-year liabilities amounting to $43 million and assets
worth $279 million. Given that the fund's NAV was $20, how many shares must have been held in
the fund?
A. 5000 shares.
B. 11,000,000 shares.
C. 11,800,000 shares.
D. 10,000,000 shares.
Using the formula used to calculate a fund’s Net Asset Value, the number of a fund’s shares can
be calculated as:
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Q.1132 When most actively managed mutual funds are compared to index funds such as the S&P
500, they:
The statement that actively managed mutual funds generally do not outperform the market is
accurate. This is a well-documented phenomenon in the world of finance. The reason behind this
is multifaceted. Firstly, actively managed funds incur higher transaction costs due to frequent
buying and selling of securities, which can eat into the returns. Secondly, predicting the market
consistently over the long term is extremely difficult, even for seasoned fund managers. Lastly,
the fees associated with actively managed funds are typically higher than those of index funds,
further reducing the net return for investors. Therefore, while some actively managed funds do
outperform the market in certain years, on average and over the long term, they do not tend to
Choice A is incorrect. Most actively managed mutual funds do not beat the market return in
most years. This is due to a variety of factors, including high fees and expenses associated with
Choice B is incorrect. While it's true that many actively managed funds underperform the
market, this statement is too broad and doesn't accurately reflect the performance of all such
funds. Some actively managed funds may indeed underperform, but others may perform on par
Choice D is incorrect. Actively managed mutual funds generally do not exceed the return
earned on index funds like S&P 500 over long periods of time due to reasons mentioned above
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Q.1134 Which of the following statements is correct regarding hedge funds?
A. Hedge funds are subject to the Investment Company Act of 1940 and the Securities
Act of 1933.
C. Hedge funds must be set up as partnerships and have to provide detailed investment
strategies to investors.
D. A majority of hedge funds commit to the use of leverage and short-selling and have a
wide investment latitude, including land, derivatives, stocks, currencies, real estate, etc.
Hedge funds are known for their wide investment latitude and the use of complex strategies such
as leverage and short-selling. Unlike mutual funds, they are not restricted to investing in certain
types of assets. They can invest in a wide range of assets, including land, derivatives, stocks,
currencies, real estate, and more. This wide investment latitude allows them to potentially
generate high returns, but it also exposes them to a higher level of risk. The use of leverage and
short-selling is a common strategy among hedge funds. Leverage involves borrowing money to
invest, which can amplify both gains and losses. Short-selling involves selling borrowed
securities with the expectation that their price will fall, allowing the fund to buy them back at a
lower price and profit from the difference. However, these strategies can also increase the risk of
losses. Therefore, investing in hedge funds is generally considered suitable for sophisticated
Choice A is incorrect. Hedge funds are not subject to the Investment Company Act of 1940 and
the Securities Act of 1933. These regulations apply to mutual funds, but hedge funds are exempt
Choice B is incorrect. While it's true that hedge funds do outline their investment strategies,
they do not typically provide a prospectus like mutual funds do. Instead, they provide a private
placement memorandum which contains information about the fund's strategies, risks and fees
Choice C is incorrect. Hedge funds can be set up in various structures including limited
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partnerships, limited liability companies or offshore corporations. They don't necessarily have to
provide detailed investment strategies as this information might be proprietary and confidential.
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Q.1135 Which of the following financial institutions must provide to all investors the information
regarding portfolio composition?
A. Mutual funds.
B. Hedge funds.
Mutual funds are investment vehicles that pool together funds from many investors to purchase
a diversified portfolio of stocks, bonds, or other securities. Due to their nature as investment
companies, mutual funds are subject to strict regulatory oversight. This includes the requirement
to disclose detailed information about their portfolio composition to all investors. The rationale
behind this requirement is to ensure transparency and protect the interests of investors. By
knowing the composition of the mutual fund's portfolio, investors can make informed decisions
about whether the fund aligns with their investment goals and risk tolerance. This transparency
also allows investors to monitor the fund's performance and the fund manager's adherence to the
Choice B is incorrect. Hedge funds are not legally obligated to disclose their portfolio
composition to all investors. They typically only provide this information to their clients or
potential investors, and even then, the level of detail can vary significantly.
Choice C is incorrect. As explained above, hedge funds are not required by law to disclose
their portfolio composition to all investors. Therefore, it cannot be both mutual funds and hedge
funds.
Choice D is incorrect. This option suggests that no financial institution has a legal obligation to
provide details about their portfolio composition which contradicts the fact that mutual funds are
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Q.1136 Which of the following best describes the long/short equity hedge fund strategy?
A. Taking a long position in undervalued stocks and a short position in overvalued stocks.
B. Taking a long position in overvalued stocks and a long position in undervalued stocks.
The long/short equity strategy involves taking a long position in stocks that are undervalued and
a short position in overvalued stocks. This strategy is based on the fund manager's ability to
accurately assess the value of stocks. In a long position, the manager buys stocks that are
undervalued with the expectation that their price will increase. On the other hand, in a short
position, the manager borrows and sells overvalued stocks with the expectation that their price
will decrease, allowing them to be bought back at a lower price for a profit. The success of this
strategy depends on the manager's ability to accurately identify overvalued and undervalued
stocks and to balance the long and short positions so that the value of the shares shorted equals
the value of those bought and both portfolios have the same sensitivity to market movements. If
executed well, this strategy can yield good returns in both bull and bear markets.
Choice B is incorrect. This choice suggests taking a long position in both overvalued and
undervalued stocks, which contradicts the basic principle of the long/short equity strategy. The
strategy involves buying undervalued stocks (long position) and selling overvalued ones (short
Choice C is incorrect. Similar to Choice B, this option also proposes taking a long position in
both overvalued and undervalued stocks. This does not align with the concept of the long/short
Choice D is incorrect. Taking a long position only in overvalued stocks would be against the
principles of value investing which forms part of the basis for a long/short equity strategy. In
such strategies, investors typically take short positions in overvalied stocks while going long on
undervalied ones.
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Q.1137 Washington Mutual Fund had year-end assets worth $240 million and liabilities of $12
million. Given that there were a total of 1,000,000 shares outstanding, which of the following is
closest to the net asset value (NAV) of the fund?
A. 240
B. 220
C. 20
D. 228
The Net Asset Value (NAV) is the market value of the assets of the fund minus its liabilities
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Q.3493 An analyst gathered the following information regarding a mutual fund:
Assets: $1,000,000.
Liabilities: $300,000.
A. 2
B. 1.4
C. 0.6
D. 0.7
The Net Asset Value (NAV) is the market value of the assets of the fund minus its liabilities
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Q.3494 Which of the following is/are the correct statements regarding similarities and
differences between exchange-traded funds and closed-end funds?
I. Both types of funds are passively managed to match a particular index.
II. In both types of funds, the market price of shares and the net asset value (NAV) can differ
significantly.
III. Both types of funds can be sold and purchased on the open market.
A. III only.
C. I & II only.
Both ETFs and closed-end funds can be bought and sold on the open market. This is a key
characteristic of these types of funds, distinguishing them from mutual funds, which are bought
and sold through the fund company. ETFs and closed-end funds are listed on stock exchanges
and their shares are traded like stocks. This provides investors with the flexibility to buy and sell
shares at any time during market hours, unlike mutual funds, which can only be bought or sold
Choice B is incorrect. While it is true that both ETFs and closed-end funds can be bought and
sold on the open market (Statement III), Statement I is not accurate for all cases. Not all ETFs
and closed-end funds are passively managed to match a specific index. Some may be actively
Additionally, while it's possible for the market price of shares and the net asset value (NAV) to
significantly differ in both ETFs and closed-end funds (Statement II), this tends to occur more
Choice D is incorrect. As explained above, Statements I and II are not universally true for all
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Q.3496 Which of the following is a correct characteristic of hedge funds?
B. Management fees are a fixed percentage of the funds under management, but
managers also collect fees based on performance.
Hedge funds typically charge a management fee and a performance fee. The management fee is
a fixed percentage of the total assets under management. This fee is used to cover the
operational costs of the fund, including salaries, office space, and administrative costs. The
performance fee, on the other hand, is a percentage of the fund's profits. This fee structure
aligns the interests of the fund managers with those of the investors. If the fund performs well,
the managers earn a higher fee. This incentivizes the managers to strive for high returns.
However, it's important to note that this fee structure can also encourage excessive risk-taking.
If the fund performs poorly, the managers do not share in the losses but simply earn a lower fee.
Choice A is incorrect. Hedge funds are not usually listed on exchanges. They are typically
private investment vehicles and their shares are not traded publicly.
Choice C is incorrect. Hedge funds are not readily available to all investors. They are typically
only accessible to accredited investors or those with a high net worth due to the risk and
Choice D is incorrect. Hedge funds are not free to advertise to the public. In many
jurisdictions, they face restrictions on advertising and solicitation activities due to regulatory
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Q.3497 Restrictions on redemptions of funds invested in hedge fund until the specific time
during which withdrawals are not allowed is called:
A. Redemption restriction.
B. Lock-up period.
C. Non-withdrawal period.
D. High-water mark.
A lock-up period in hedge funds is a predetermined time span during which investors are not
allowed to redeem or sell shares. The lock-up period is typically set at the inception of the fund
and can range from a few months to a few years. This period is implemented to give the hedge
fund manager the freedom to implement their investment strategy without the concern of
withdrawals. It also protects the fund and its investors from the potential negative effects of
large, unexpected redemptions. During the lock-up period, the fund manager can invest in less
liquid assets, which might have higher returns, without worrying about liquidity for redemptions.
After the lock-up period ends, investors can typically redeem their shares at regular intervals,
Choice A is incorrect. Redemption restriction is a broad term that refers to any limitation on
the investor's ability to withdraw their funds from an investment. While it could technically
include a lock-up period, it also includes other types of restrictions such as notice periods and
redemption fees. Therefore, it does not specifically describe the restriction mentioned in the
question.
Choice C is incorrect. Non-withdrawal period is not a term commonly used in the hedge fund
industry to describe a specific time during which investors are not allowed to withdraw their
funds.
Choice D is incorrect. High-water mark refers to a provision in hedge fund agreements that
protects investors from paying performance fees on reinvested money that has previously been
lost and recovered. It does not refer to any kind of withdrawal restriction.
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Q.3498 Anna Smith is a hedge fund manager who tries to exploit price discrepancies between
convertible bonds and common stocks of companies. The strategy that Smith uses is known as:
A. Long/short equity.
C. Distressed debt.
D. Convertible arbitrage.
involves the simultaneous buying of convertible securities and the short selling of the same
issuer's common stock. The premise of the strategy is that the convertible is sometimes priced
inefficiently relative to the stock, and this inefficiency can be exploited to generate profits. This
strategy is typically used by hedge funds and involves sophisticated risk management to handle
market movements and other risks. The strategy is known for its complexity and requires a deep
understanding of both the bond and equity markets. It is not a strategy for the average investor
Choice A is incorrect. Long/short equity strategy involves buying undervalued stocks (going
long) and selling overvalued stocks (going short). This strategy does not specifically involve
between related fixed income securities. While convertible bonds are a type of fixed income
security, this strategy does not specifically focus on the relationship between these bonds and
Choice C is incorrect. Distressed debt investing involves purchasing the debt of companies
that are in or near bankruptcy at a significant discount to face value, with the hope that a
turnaround or restructuring will increase its value. This strategy does not involve exploiting
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Q.3499 A hedge fund has a beginning year value of $200 million, 2% management fee, and 20%
incentive fee with a hurdle rate of 10%. The management fee is applied to the end-of-year assets
under management, and the incentive fee is calculated net of the management fee. If the fund's
ending value is $300 million, then what is the total fee of the hedge fund?
A. $18.8 million.
B. $20.8 million.
C. $14.8 million.
D. $6 million.
Q.3500 A hedge fund has a beginning year value of $370 million and a 2 plus 20 fee structure
with no hurdle rate or watermark. The hedge fund structure is set up such that the management
fee is calculated on the assets at the beginning of the year and that the incentive fee is
calculated net of the management fee. If the fund's ending value is $400 million, then what are
the total fees paid to the hedge fund for the period?
A. $12.4 million.
B. $11.92 million.
C. $16 million.
D. $4.4 million.
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Q.3502 Mega Star Investment is a hedge fund with $550 million initial capital and a '2 and 20'
fee structure. The 2% management fee is based on year-end assets under management and the
20% incentive fee is not independent of the management fee. The value of the fund at the end of
year one is $652 million. What is the investor's net return?
A. 0.1247
B. 0.1294
C. 0.1531
D. 0.1779
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Q.3503 Rosy Garcia is considering investing in a hedge fund or a fund of funds.
Garcia invests $50 million in the hedge fund and receives a yearly gross return of 10%. The fund
has a '2 and 20' fee structure with no hurdle rate, and management fees are calculated on an
annual basis on assets under management at the beginning of the year. Incentive fees are
calculated independently of management fees.
Garcia also invests $60 million in a fund of funds (FOF) and earns a 5% yearly gross return.
Assuming that the fund of funds fee structure is '1 and 10' and that all other fee structures in the
FOF are similar to that of the hedge fund, the return to the investor of investing directly in the
hedge fund will be:
For investing directly $50 million in the hedge fund: $50 million (10%) = $5 million profit
Management fee: $50 million (2%) = $1 million gross profit
Incentive fee: $5 million (0.20) = $1 million
Total fees = $1 million + $1 million = $2 million
Return: ($5 million - $2 million)/$50 million = 6%
For investing $60 million in the FOF: $60 million (5%) = $3 million gross profit
The FOF charges a fee of 1%: 60 million (1%) = $0.6 million and an incentive fee of $3 million
(0.10) = $0.3 million
Return: ($3 million - $0.6 million - $0.3 million)/$60 million = 3.5%
So 6% - 3.5% = 2.5%
Note that in this chapter, it is usually assumed that the management fee is calculated on the
assets at the beginning of the year and that the incentive fee is calculated after subtracting
management fees.
So, in a special case where the incentive fee is calculated independent of the management fee,
then this simply means that we will now calculate the incentive fee "independently". In other
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Q.3504 Right-Lance Capital is a hedge fund with $250 million as initial investment capital. A 2%
management fee based on assets under management is charged at the beginning of the year, and
a 20% incentive fee is charged on the performance net of management fees. In the first year of
operations, the fund earned a return of 16%.
What is the investor's effective return given this fee structure?
A. 0.1094
B. 0.112
C. 0.125
D. 0.0943
Q.3505 Clock Limited is a hedge fund with a total asset base of $10 million. The fund charges a
2% management fee based on assets under management at year-end and a 20% incentive fee in
excess of a 0.5% hurdle rate. During the first year, the fund appreciates by 15%. If incentive fees
are calculated independently and management fees are calculated at year-end, what is the
investor's return net of performance fees?
A. 0.068
B. 0.081
C. 0.098
D. 0.0852
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Q.3506 Which of the following statements correctly describes a fixed income arbitrage hedge
fund strategy?
C. This strategy involves buying a convertible bond of one issuer while selling another
issuer's common stock.
A fixed-income arbitrage strategy is classified as a relative value strategy. Relative value funds
seek to profit from a pricing discrepancy between related securities, i.e., mispricing between a
convertible bond and its component parts (the underlying bond and the embedded stock option).
Option C is incorrect. The fixed income convertible arbitrage strategy involves buying a
convertible bond of one issue and simultaneously selling the issuer's common stock.
Option D is incorrect. Global macro is a general investment strategy that involves making
investment decisions guided by the economic/political outlook of a country.
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Q.3507 Which of the following is NOT a characteristic of open-ended mutual funds?
A. Open-end funds accept new investment money and issue additional shares to existing
or new investors. Therefore, the number of outstanding shares changes after every new
investment.
B. In open-end funds, new shares are created and sold at a premium or a discount to net
assets values depending on the demand for the shares.
C. An open-end structure makes it easy to grow in size but creates pressure on the
portfolio manager to manage the cash inflows and outflows.
Open-end funds do not sell shares at a premium or a discount to net asset values depending on
the demand for the shares. Instead, new shares in open-end funds are issued at the fund's net
asset value at the time of investment. This is a key characteristic of open-end funds and
differentiates them from closed-end funds. Closed-end funds, on the other hand, typically issue
all the shares they will issue at the outset, with such shares usually being tradable between
investors thereafter. These shares are typically traded lower than their net asset value, which
can be attributed to management fees. Therefore, the statement in choice B is incorrect and does
mutual funds. Open-end funds do indeed accept new investment money and issue additional
shares to existing or new investors, which results in the number of outstanding shares changing
mutual funds. The structure of these funds does make it easy for them to grow in size, but it also
creates pressure on the portfolio manager to manage cash inflows and outflows effectively.
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Q.3509 MZJ Income Fund is a mutual fund that does not issue new shares, and its shares can
only be bought or sold like equity on exchange markets. Identify this type of fund.
A. Closed-end fund.
B. Open-end fund.
C. Exchange-traded fund.
D. Hedge fund.
Closed-end funds are a type of investment fund and exchange-traded product (ETP). They are
structured as publicly traded investment companies by the Securities and Exchange Commission
(SEC). Closed-end funds raise a prescribed amount of capital only once, through an initial public
offering (IPO), and list shares for trade on a stock exchange. Unlike open-end funds (mutual
funds), closed-end funds do not stand ready to issue and redeem shares on a continuous basis.
Instead, the shares can be purchased and sold only in the market. This is the reason why MZJ
Income Fund, which does not issue new shares and its shares can only be bought or sold like
Choice B is incorrect. An open-end fund continuously issues and redeems units or shares
based on the net asset value (NAV) of the fund. This is not consistent with MZJ Income Fund's
Choice C is incorrect. While exchange-traded funds (ETFs) are traded on exchanges like
equities, they also create and redeem shares based on demand, unlike MZJ Income Fund which
Choice D is incorrect. Hedge funds are typically private investment vehicles that have limited
liquidity and do not trade their shares publicly on exchange markets as described for MZJ
Income Fund.
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Q.3510 The Belta fund trades on the Chicago Stocks Exchange. Its most recent price is $1850,
but its NAV is $1,600. We know then that:
The Belta fund is a closed-end fund selling at a premium. Closed-end funds are a type of
investment company whose shares are traded on the open market, like stocks or ETFs. The price
of these shares fluctuates based on market demand and can deviate from the fund's Net Asset
Value (NAV). When the trading price of a closed-end fund is higher than its NAV, it is said to be
trading at a 'premium'. In this case, the Belta fund's trading price ($1850) is higher than its NAV
Choice B is incorrect. A closed-end fund selling at a discount would mean that the trading
price of the fund is less than its Net Asset Value (NAV). In this case, however, the trading price
($1850) is higher than the NAV ($1600), indicating that it's not selling at a discount.
Choice C is incorrect. Open-end funds do not trade on exchanges and their prices are not
determined by market forces of supply and demand but are instead directly related to their NAV
which is calculated at the end of each trading day. Therefore, an open-end fund cannot sell at a
premium or discount.
Choice D is incorrect. Similar to Choice C, open-end funds do not trade on exchanges and their
prices are directly related to their NAV calculated daily. Hence, they cannot sell at a premium or
discount.
A. deducting management fees from fund assets and receiving incentive bonuses for
beating a specified benchmark.
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B. deducting a percentage of any gains in asset value.
Hedge fund managers are typically compensated by deducting management fees from fund
assets and receiving incentive bonuses for beating a specified benchmark. This is often referred
to as the '2 and 20' structure, where the management fee is usually 2% of the fund's net asset
value, and the incentive fee is 20% of the fund's profits above a certain benchmark. The
management fee is meant to cover the operational costs of the fund, while the incentive fee
aligns the interests of the fund managers with those of the investors, as the managers stand to
gain significantly if the fund performs well. This structure is designed to motivate the managers
to generate high returns, but it also means that they stand to earn substantial amounts even if
the fund's performance is mediocre, as the management fee is charged regardless of the fund's
performance.
Choice B is incorrect. While hedge fund managers do often receive a percentage of the gains
in asset value, this is typically in addition to a management fee and not deducted from the gains
themselves. This compensation structure is known as "two and twenty", where the manager
Choice C is incorrect. Hedge fund managers do not typically buy shares in their own funds at a
discount as part of their compensation. While they may invest their own money into the fund to
align their interests with those of the investors, this is not considered part of their compensation
structure.
Choice D is incorrect. Charging portfolio turnover fees isn't typical for hedge funds'
compensation structures. Portfolio turnover fees are more commonly associated with mutual
funds, where they are used to cover transaction costs associated with buying and selling
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Q.4933 On January 1, 2020, a hedge fund began with $100 million in assets from investors. The
10-year Treasury, yielding 1.25% at the time, was chosen as the hurdle rate for the next five
years. In addition, the fund operates on a 2 plus 20% fee structure and is bound by a high-water
mark clause. In the first year of operation, a combination of a challenging macroeconomic
environment and some bad decisions culminated in end-of-the-year assets under management
dropping to $90 million after payment of the management fee. In 2021, the fund bounced back,
with its total assets coming at $110 million by the end of the year. Calculate the total fees earned
by the management in 2021. (Assume that the management fee is calculated on the assets at the
beginning of the year and that the incentive fee is calculated after subtracting management fees)
A. $5.8m
B. $1.8m
C. $3.5m
D. $2.94m
A high-water mark clause states that previous losses must first be recouped and hurdle rates
In the first year, the fund managers earned a management fee of $2m (= 100 * 0.02). However, it
earned $0 in incentive fees since it made a loss. Incentive fees would only have applied to any
profits earned above a 1.25% return, meaning that only an ending balance higher than $101.25
The management pocketed $1.8m in management fees in the second year (= 90 * 0.02). As per
the fund’s high-water mark clause, investors expected its total worth to be above $102.5 at the
end of year 2 before any incentive fees can be earned (i.e., 100 + 1.25 + 1.25). In other words,
the high-water mark for year 1 is $101.25m and $102.5m for year 2. At $110m, at the end of the
second year, therefore, the fund has outperformed by a margin of $7.5m (i.e.,110 – 102.5). As
such, 20% of this less the management fee [i.e., 0.2 * (7.5 – 1.8) = $1.14m] is earned as incentive
fees.
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Q.5043 The following are returns for a fund and the index it is tracking. Given the information
below, the tracking error is closest to?
A. 0.68
B. 0.79
C. 0.62
D. 0.59
The difference between the funds' returns and the index return are:
Year 1: 5%-4.5%=0.5%
Year 2: 7%-6%=1%
Year 3: -2.5%-(-1.5%)=-1.0%
Year 4: 1%-0.5%=0.5%
Q.5342 In the context of hedge funds, which of the following statements best describes the
purpose and characteristics of incentive fees?
A. Incentive fees are a fixed percentage of the fund's net asset value and are used to
align the interests of fund managers and investors.
B. Incentive fees are based on a fund's performance and serve to penalize fund managers
for poor performance.
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C. Incentive fees are performance-based fees that reward fund managers for generating
returns above a specified benchmark or hurdle rate.
D. Incentive fees are always equal to the management fees and are charged regardless of
the fund's performance.
Incentive fees in hedge funds are indeed performance-based fees that reward fund managers for
generating returns above a specified benchmark or hurdle rate. This fee structure is designed to
align the interests of the fund managers with those of the investors. By tying a portion of the
fund managers' compensation to the fund's performance, it incentivizes them to strive for
superior returns. If the fund's returns exceed the specified benchmark or hurdle rate, the fund
managers receive a percentage of those excess returns as incentive fees. This not only rewards
the fund managers for their skill and effort but also ensures that they share in the upside when
the investors do well. However, if the fund's returns do not exceed the benchmark or hurdle rate,
the fund managers do not receive any incentive fees. This ensures that the fund managers are
Choice A is incorrect. While it is true that incentive fees are used to align the interests of fund
managers and investors, they are not a fixed percentage of the fund's net asset value. Instead,
they are typically based on a percentage of the returns generated by the fund that exceed a
Choice B is incorrect. Incentive fees do not serve to penalize fund managers for poor
performance. Rather, they serve as a reward mechanism for generating superior returns above a
Choice D is incorrect. Incentive fees are not always equal to management fees and their
charge depends on the performance of the fund rather than being charged regardless of it. They
are specifically designed to provide additional compensation if the manager outperforms certain
benchmarks.
Q.5343 In the context of hedge fund strategies, which of the following statements best describes
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the primary objective and approach of a long-short equity hedge fund?
A. A long-short equity hedge fund primarily invests in undervalued equities and shorts
overvalued equities with the objective of generating consistent returns regardless of
market conditions.
B. A long-short equity hedge fund takes long positions in high-yield bonds and short
positions in lower-yielding bonds, aiming to profit from the yield spread.
C. A long-short equity hedge fund invests solely in long equity positions, while using
short positions in index futures to hedge against market risk.
D. A long-short equity hedge fund focuses exclusively on short-selling equities with poor
fundamentals and high levels of debt, seeking to profit from their price declines.
A long-short equity hedge fund primarily invests in undervalued equities and shorts overvalued
equities with the objective of generating consistent returns regardless of market conditions. This
strategy involves taking long positions in stocks that are expected to increase in value and short
positions in stocks that are expected to decrease in value. The primary objective of this strategy
and the depreciation of overvalued equities, while mitigating market risk. This approach allows
the fund to profit from both rising and falling markets, providing a level of protection against
market volatility. The fund manager uses their expertise to identify undervalued and overvalued
stocks based on a variety of factors, including financial analysis, market trends, and economic
indicators. The long-short strategy is a common approach used by hedge funds and is considered
a relatively aggressive investment strategy due to the use of short selling and leverage.
Choice B is incorrect. This choice incorrectly suggests that a long-short equity hedge fund
primarily invests in high-yield bonds and shorts lower-yielding bonds. While this could be a
strategy employed by some hedge funds, it does not accurately represent the primary objective
and methodology of a long-short equity hedge fund, which focuses on equities rather than bonds.
Choice C is incorrect. This option inaccurately states that a long-short equity hedge fund only
invests in long equity positions and uses short positions in index futures to hedge against market
risk. Although hedging against market risk can be part of the strategy, the main characteristic of
a long-short equity hedge fund is its ability to take both long and short positions in individual
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stocks based on their expected performance.
Choice D is incorrect. While short-selling equities with poor fundamentals and high levels of
debt can be part of the strategy, it's not accurate to say that a long-short equity hedge fund
focuses exclusively on this approach. The primary goal of such funds is to generate consistent
returns regardless of market conditions by taking both long positions in stocks expected to
Q.5344 Which of the following correctly explains the concept of net asset value (NAV) of an open-
end mutual fund and how it relates to the share price?
A. NAV represents the total value of all assets held by the mutual fund, minus any
liabilities, divided by the total number of shares outstanding.
B. NAV represents the price at which the mutual fund's shares are bought and sold on
the open market.
C. NAV represents the total return of the mutual fund over a specific time period.
D. NAV represents the total fees and expenses charged by the mutual fund, divided by
the total number of shares outstanding.
The Net Asset Value (NAV) of an open-end mutual fund is indeed the total value of all assets held
by the mutual fund, minus any liabilities, divided by the total number of shares outstanding. This
value is calculated at the end of each trading day based on the closing market prices of the
securities held by the fund. The NAV is used to determine the price at which shares of the mutual
fund are bought and sold. If demand for the mutual fund is high, the share price will be above
NAV, and if demand is low, the share price will be below NAV. The inverse relationship between
share price and NAV is due to the fact that new shares are issued or redeemed at NAV, but
shares are bought and sold on the open market at the prevailing market price.
Choice B is incorrect. The Net Asset Value (NAV) does not represent the price at which the
mutual fund's shares are bought and sold on the open market. Instead, it represents the per-
share value of the fund's assets, after subtracting liabilities. The buying and selling price of
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mutual fund shares in an open-end fund is determined by this NAV, not by market forces as in
case of stocks.
Choice C is incorrect. NAV does not represent the total return of a mutual fund over a specific
time period. Total return would include all changes in value during that period including capital
gains or losses and dividends or interest received, whereas NAV only reflects current value of
Choice D is incorrect. While fees and expenses do impact a mutual fund's net asset value to
some extent because they reduce its total assets, stating that NAV represents these costs divided
by total number of shares outstanding oversimplifies and misrepresents what NAV actually
stands for - which is essentially a per-share valuation based on current worth of all assets after
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Q.5345 Which measurement bias is primarily associated with voluntary reporting of performance
results by hedge funds and mutual funds?
A. Survivorship bias
B. Self-reporting bias
C. Look-ahead bias
D. Confirmation bias
Self-reporting bias is a type of measurement bias that is primarily associated with the voluntary
reporting of performance results by hedge funds and mutual funds. This bias occurs when funds
with strong performance are more likely to voluntarily report their results, while funds with poor
performance may not report or may selectively report their results. This leads to an
overestimation of performance for both types of funds, as the reported performance data may be
skewed towards better-performing funds. This bias can significantly distort the perceived
performance of these funds and can mislead investors who rely on this data to make investment
decisions. Therefore, it is crucial for investors to be aware of this bias when evaluating the
performance of hedge funds and mutual funds based on voluntarily reported data.
Choice A is incorrect. Survivorship bias refers to the tendency of failed companies being left
out of performance studies because they no longer exist. It does not directly relate to the
Choice C is incorrect. Look-ahead bias occurs when a study or simulation incorporates data
that would not have been known or available during the period being analyzed, thus skewing
results. This type of bias is not specifically associated with voluntary reporting of performance
results.
Choice D is incorrect. Confirmation bias refers to a type of selective thinking whereby one
tends to notice and look for what confirms one's beliefs, and ignore, not look for, or undervalue
the relevance of what contradicts one's beliefs. This type of cognitive bias does not pertain
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Q.5346 An investment advisor is discussing the performance of mutual funds and hedge funds
with a client. Which of the following best describes the impact of survivorship bias on
performance measurement?
Survivorship bias is a form of bias that can significantly distort the performance measurement of
funds. It occurs when the performance measurements only consider funds that have survived
over a specific time period, while excluding those that have been closed, liquidated, or merged.
This exclusion can lead to an overestimation of the average performance, as the failed or
underperforming funds are not included in the analysis. Therefore, survivorship bias tends to
overstate the performance of active funds, which include both mutual funds and hedge funds,
relative to passive funds. This is because the active funds that have performed poorly and did not
Choice B is incorrect. Survivorship bias does not understate the performance of surviving
funds by including the results of closed or liquidated funds. On the contrary, it overstates the
performance because it only considers those funds that have survived and excludes those that
Choice C is incorrect. The statement that survivorship bias has minimal or no impact on
performance measurement because it affects all types of funds equally is false. Survivorship bias
can significantly distort performance measurements as it ignores those funds that have been
closed down due to poor performance, thereby overstating average fund returns.
Choice D is incorrect. Survivorship bias does not create an accurate representation of fund
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performance because it only includes successful and surviving funds. This leads to an
overestimation of average fund returns as poorly performing, closed or liquidated funds are
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Q.5348 An investment advisor is educating clients about potential undesirable trading behaviors
in mutual funds. Which of the following is a type of undesirable trading behavior in mutual funds
that involves traders using acquired information to trade for themselves before trading for their
clients or firm?
A. Late trading.
B. Market Timing.
C. Front running.
D. Directed brokerage.
Front running is an unethical and illegal trading practice where a trader uses acquired
information to execute trades for themselves before trading for their clients or firm. This
behavior can be particularly harmful to clients, as it can result in the execution of their trades at
less favorable prices, ultimately reducing their potential returns. It is essential for investment
advisors to educate clients about this type of undesirable trading behavior to ensure they
understand the risks involved and can make informed decisions when choosing a mutual fund or
investment manager.
Choice A is incorrect. Late trading refers to the practice of placing orders after market close
but reporting them at the closing net asset value. This does not involve using acquired
information for personal gain before executing trades for clients or the firm.
Choice B is incorrect. Market Timing involves frequent buying and selling of shares in a
mutual fund to take advantage of inefficiencies in mutual fund pricing, not using acquired
information for personal gain before executing trades for clients or the firm.
directs its portfolio transactions to a particular broker in return for that broker's agreement to
promote the sale of the fund's shares. It does not involve traders using acquired information to
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Reading 30: Introduction to Derivatives
Q.27 Allan enters into a derivative contract with one of his clients. The client is expected to sell
the underlying asset to Allan at the expiration date at price P. Allan wishes to fully hedge his
position using derivatives. Which of the following can help him achieve his goal?
Selling a p-strike call and buying a p-strike put is the correct strategy for Allan to hedge his
position. This is because the client's obligation to sell the underlying asset implies that Allan is in
a long-forward position. To hedge this position, Allan needs to create a synthetic short futures
contract. This can be achieved by selling a call option and buying a put option at the same strike
price. This strategy effectively replicates a short forward position, thus hedging Allan's long-
forward position.
For instance, if an investor has entered into a long futures contract to buy crude oil at $60 a
barrel on June 30, 2022, he can create a synthetic short futures contract on oil for the same date
by buying a put with a $60 strike price and selling a call with a $60 strike price. If the asset price
is above the strike price on the expiration date, the investor will be obligated to buy at $60 under
the futures contract and sell at $60 to the short position in the call, resulting in zero loss. If the
asset price at expiration is below the strike price, the investor will be obligated to buy at $60
under the futures contract and will want to exercise the put option and sell at $60, again
resulting in no loss. Thus, the long futures position combined with the synthetic short forward
will hedge the contract and result in no loss for the investor, regardless of the direction the price
Choice A is incorrect. Selling a p-strike call would not hedge Allan's position completely. This
strategy would only limit his potential profit if the price of the underlying asset rises above P, but
it does not protect him from losses if the price falls below P.
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Choice B is incorrect. Purchasing a p-strike call and selling a p-strike put would create a
synthetic long position in the underlying asset, which is not what Allan wants. He already has an
obligation to buy the asset at price P, so this strategy would double his exposure instead of
hedging it.
Choice D is incorrect. Subscribing to a long forward contract with a forward price P means
that Allan agrees to buy the underlying asset at price P in future, which again increases his
exposure rather than hedging it as he already has an obligation to buy under his existing
contract.
Q.28 Matthew enters into a derivative position with one of his real estate customers. Under the
terms of the contract, the customer is obligated to sell the underlying asset to Matthew if the
spot price at the expiration is more than P. Matthew, on the other hand, has the right to sell the
underlying asset to the customer if the spot price at expiration is less than P. Which of the
following describes Matthew's position?
Matthew purchases a P-strike call and a P-strike put. In the context of derivative contracts, a call
option gives the holder the right, but not the obligation, to buy an asset at a specified price
within a specific time period. On the other hand, a put option gives the holder the right, but not
the obligation, to sell an asset at a specified price within a specific time period. In this scenario,
Matthew has the right to buy the underlying asset from the client if the spot price at expiration is
more than P, which is characteristic of a call option. Similarly, Matthew has the right to sell the
underlying asset to the client if the spot price at expiration is less than P, which is characteristic
of a put option. Therefore, Matthew's position can be described as purchasing a P-strike call and
a P-strike put.
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Choice A is incorrect. A short forward contract would obligate Matthew to sell the underlying
asset at a predetermined price, P, regardless of the spot price at expiration. This does not match
the conditions of the derivative contract described in the question where Matthew has rights but
Choice B is incorrect. In a long forward contract, Matthew would be obligated to buy the
underlying asset at a predetermined price, P, irrespective of its spot price at expiration. This
contradicts with the scenario given in which Matthew has options depending on whether or not
Choice D is incorrect. If Matthew purchases a P-strike call and sells a P-strike put, he would
have an obligation to buy if prices fall below P (due to selling put) and right to buy if prices rise
above P (due to buying call). This does not align with conditions mentioned in question where he
Q.587 Mehmet Emre, an FRM part 1 candidate, is preparing for his upcoming exam. From his
understanding of futures exchanges, he has concluded the following:
I. In futures exchanges, traders do not have to worry about the creditworthiness of the
counterparty
II. In futures exchanges, the trades are more standardized than they would be for similar
forwards contracts
III. In futures exchanges, participants have to deposit an initial margin with the
clearinghouse of the exchange
A. Feature II only.
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All three features that Mehmet Emre has identified are indeed accurate characteristics of futures
exchanges.
In futures exchanges, traders do not have to worry about the creditworthiness of the
counterparty. This is because the exchange's clearinghouse acts as the counterparty to all trades,
thereby eliminating counterparty credit risk. The clearinghouse guarantees the performance of
the contracts, meaning that it will fulfill the obligations of the contracts if a trader defaults.
Furthermore, futures contracts traded on exchanges are more standardized than forwards
contracts. This standardization includes aspects such as the quantity and quality of the
underlying asset, delivery time, and delivery location. Standardization facilitates liquidity and
Finally, participants in futures exchanges are required to deposit an initial margin with the
clearinghouse of the exchange. This margin acts as a form of security to cover potential future
losses on the positions. The margin requirements are typically set by the exchange and vary
Choice A is incorrect. While it is true that futures exchanges offer trades that are more
standardized than those found in similar forwards contracts (Feature II), this choice ignores the
other two accurate features of futures exchanges. Traders in futures exchanges do not need to
clearinghouse acts as a counterparty to all trades, thereby eliminating counterparty risk (Feature
I). Additionally, participants in futures exchanges are required to deposit an initial margin with
deposit an initial margin with the exchange's clearinghouse (Feature III), this choice overlooks
Choice C is incorrect. While it correctly identifies that traders in futures exchanges do not
need to be concerned about the creditworthiness of their counterparties (Feature I) and that
these trades are more standardized than those found in similar forwards contracts (Feature II), it
fails to acknowledge Feature III: Participants in these markets must deposit an initial margin
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with the exchange's clearinghouse.
Q.588 Before the credit crisis of 2007, over-the-counter (OTC) markets were not as regulated as
exchanges. However, after the credit crisis, many new important changes were brought into the
US and around the world to align the operations of OTC markets with exchange-traded markets.
Which of the following is not a change/regulation introduced after the 2007 credit crisis?
D. Participants of OTC derivatives must publicly disclose their initial and maintenance
margin positions.
Participants of OTC derivatives are not required to publicly disclose their initial and maintenance
margin positions. This statement is not a regulation that was introduced after the 2007 credit
crisis. The margin requirements for OTC derivatives are typically agreed upon privately between
the two parties involved in the transaction. These requirements are not publicly disclosed
because they can vary widely depending on the creditworthiness of the parties, the nature of the
underlying asset, and other transaction-specific factors. Therefore, there is no universal standard
or requirement for the disclosure of margin positions in OTC derivatives trades. This lack of
transparency is one of the characteristics that differentiate OTC markets from exchange-traded
markets.
Choice A is incorrect. The Dodd-Frank Act, which was introduced in the United States
following the 2007 credit crisis, mandated that standardized OTC derivatives must be traded on
swap execution facilities (SEFs). This was done to increase transparency and reduce
introduced for standardized derivatives transactions after the 2007 credit crisis. CCPs act as
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intermediaries between buyers and sellers in a derivatives contract, reducing counterparty risk.
Choice C is incorrect. Post-2007 crisis regulations also required all OTC trades to be reported
to a central registry or trade repository. This measure aimed at increasing market transparency
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Q.589 David Dillion, head of the treasury department of Dutch Monks Corp., entered into a
derivative contract to purchase ₺350 million (Turkish lira) 3-month forwards from a Lirika Bank
3-month forward exchange rate of ₺3.9 per euro. Which of the following correctly describes
Lirika Bank’s position on the euro?
Lirika Bank has a long forward contract on the Euro. In a forward contract, the party agreeing to
buy the asset in the future assumes a long position, and the party agreeing to sell the asset in the
future assumes a short position. In this case, Lirika Bank is agreeing to sell Euros in the future,
hence it is in a long position. This is because the bank will benefit if the Euro appreciates against
the Turkish Lira. The bank's long position on the Euro is offset by a short position on the Turkish
Lira. This is a common strategy used by banks and other financial institutions to hedge against
currency risk.
Choice A is incorrect. Lirika Bank does not hold a short forward contract on the euro. In a
short forward contract, the holder agrees to sell an asset at a specified future date for a price
agreed upon today. However, in this scenario, Lirika Bank has agreed to sell Turkish lira and buy
Choice C is incorrect. The bank does not hold a short futures contract either. A short futures
contract would mean that the bank agrees to sell an asset (in this case euros) at a future date for
an agreed-upon price today. But as explained above, Lirika Bank has entered into a forward
Choice D is incorrect. The bank does not have any futures contracts in this scenario; it only
has forwards contracts with Dutch Monks Corp., so any option involving futures contracts can be
ruled out.
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Q.590 A trader at Prime Investments entered into a standardized derivatives contract to
purchase one lot (or 100 troy ounces) of gold at the price of $1,200/ounce and take delivery 3
months from now. Determine the appropriate position of the trader in the derivatives contract.
The trader is in a long gold futures contract. A futures contract is a legal agreement to buy or
sell a particular commodity or asset at a predetermined price at a specified time in the future.
The trader is said to be 'long' on the futures contract because they have agreed to buy the
underlying asset in the future. In this case, the underlying asset is gold. The trader's position is a
long position because they expect the price of gold to rise in the future. If the price of gold rises
above the agreed price of $1,200 per ounce, the trader will make a profit. If the price of gold
falls below the agreed price, the trader will make a loss. The futures contract is standardized in
terms of quantity and delivery date, which is why it is a futures contract and not a forward
contract. The trader does not know the counterparty of the derivatives contract, which is another
characteristic of futures contracts. In contrast, in forward contracts, both parties know each
other.
Choice B is incorrect. A long dollar futures contract would mean the trader expects the value
of the dollar to increase. However, in this scenario, the trader is buying gold, not dollars.
Choice C is incorrect. While a long gold forward contract also involves an agreement to buy
gold at a future date, it differs from a futures contract in terms of standardization and trading
location. Futures contracts are standardized and traded on an exchange while forward contracts
are private agreements between two parties and can be customized according to their needs.
Choice D is incorrect. A short dollar forward contract would imply that the trader expects the
value of the dollar to decrease in future. This does not align with our scenario where he has
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Q.591 Which of the following equations accurately demonstrates the payoff of the short position
holder in a forwards contract?
A. K − ST
B. ST − K
C. max(0, X– ST )
D. max(0, ST − X)
The payoff for the holder of a short position in a forward contract is accurately represented by
the equation K − ST . In this equation, K represents the delivery price, which is the price agreed
upon at the inception of the contract for the delivery of the underlying asset in the future. ST
represents the spot price of the underlying asset at the time of delivery. The difference between
these two prices (K − ST ) represents the payoff for the short position holder. If the delivery price
is higher than the spot price at the time of delivery (K > ST ), the short position holder will make
a profit. Conversely, if the spot price at the time of delivery is higher than the delivery price (
ST > K), the short position holder will incur a loss. This is because the short position holder is
obligated to sell the underlying asset at the delivery price, which could be lower than the current
market price.
Choice B is incorrect. The expression ST − K represents the payoff for a long position in a
forward contract, not a short position. In this case, the holder of the contract agrees to buy an
asset at a predetermined price (K) and would benefit if the spot price at maturity (S_T) is higher
Choice C is incorrect. The expression max(0, X– ST ) represents the payoff for a long position in
a put option, not a short position in a forward contract. Here, X denotes the strike price of the
option and S_T denotes the spot price at maturity. If X > S_T (i.e., if it's more profitable to
exercise than to sell on market), then profit equals X - S_T; otherwise, it's more profitable not to
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Choice D is incorrect. The expression max(0, ST − X) represents the payoff for a long position
in call option rather than that of short forward contract holder . In this case , if ST >X , then
profit equals ST-X ; otherwise , it's more profitable not to exercise and profit equals 0.
Q.592 A number of derivatives are used to hedge the risk or earn a profit with speculation and
arbitrage strategies. Forwards, futures and options are different from each other in terms of
their properties. Which of the following statement correctly differentiates forward, futures, and
options?
A. Forward contracts and options are different from futures, as it takes a certain cost to
enter into a forward contract.
B. Options and futures are different from forwards contracts as they give an option or
futures contract holder the right, but not the obligation, to exercise the contract.
C. Forwards and futures are different from options because the holder of the forwards
and futures are obligated to buy or sell the underlying.
D. Forward contracts and options are different from futures because forwards and
options trade on OTC markets.
Forwards and futures are different from options because the holder of the forwards and futures
are obligated to buy or sell the underlying. This statement accurately captures the fundamental
difference between these types of derivatives. In a forward or futures contract, the buyer and
seller are obligated to buy or sell the underlying asset at a predetermined price on a specified
future date. This obligation exists regardless of the market price of the underlying asset at the
time of contract execution. This characteristic of forwards and futures contracts exposes the
contract holders to a significant amount of risk, especially if the market price of the underlying
On the other hand, options contracts provide the holder with the right, but not the obligation, to
buy (in the case of a call option) or sell (in the case of a put option) the underlying asset at a
predetermined price before or on the expiration date. This means that the holder of an options
contract can choose to exercise the option if it is profitable to do so, or let the option expire
worthless if it is not. This flexibility is a key feature of options contracts and is what
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differentiates them from forwards and futures contracts.
Choice A is incorrect. It is not accurate to say that it takes a certain cost to enter into a
forward contract. Forward contracts do not require an upfront payment or premium like options
do. They are agreements between two parties to buy or sell an asset at a specified future date for
Choice B is incorrect. While it's true that options give the holder the right, but not the
obligation, to exercise the contract, futures contracts also obligate the holder to buy or sell the
underlying asset at expiration, similar to forwards. Therefore, this statement does not accurately
Choice D is incorrect. Although many forward contracts and options do trade on over-the-
counter (OTC) markets, this isn't exclusively true for all such instruments and hence doesn't
serve as a distinguishing factor among them. For instance, some types of futures can also be
traded OTC.
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Q.593 Kapil Kumar is an individual investor who invests a portion of his salary in stocks and
derivatives at the beginning of every month. Kumar is interested in the stocks of Geneva
Computers Inc., which are currently trading at the price of $14. However, he believes the stock
will trade above $17 at the beginning of next month. If Kapil is interested in entering into an
options contract that gives him the right to take exposure in the stock at $17, then suggest the
most appropriate option position for Kumar.
A long call option with a strike price of $14 is the most suitable position for Kumar. This is
because a long call option gives the buyer (in this case, Kumar) the right, but not the obligation,
to buy the underlying asset (in this case, the stock of Geneva Computers Inc.) at the strike price
before the option expires. If Kumar's prediction is correct and the stock price rises above $17, he
can exercise his option to buy the stock at $14 and then sell it at the higher market price,
making a profit. The payoff in this scenario would be the difference between the market price
and the strike price, which is ($17 - $14). The profit would be this payoff minus the premium paid
for the option, which is ($17 - $14 - premium paid). Therefore, this option position aligns with
Choice B is incorrect. A short call option would obligate Kumar to sell the stock at $17 if the
option is exercised. This would not be beneficial for him if he anticipates that the stock price will
rise above $17, as he would miss out on potential profits from selling at a higher market price.
Choice C is incorrect. A long put option gives the holder the right to sell a stock at a specified
price within a certain period of time. Since Kumar expects the stock price to rise, not fall, this
strategy does not align with his expectations and hence it's not suitable for him.
Choice D is incorrect. A short put option obligates Kumar to buy more of Geneva Computers
Inc.'s stocks if they fall below $14, which contradicts his bullish outlook on the company's
shares.
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Q.594 Consider a European call option for 100 shares of Tesla, Inc., whose strike price is $870
per share and which matures 12 months from now. What does this option entitle you to do?
A. Between now and 12 months from now, you are entitled to make a phone call to the
European headquarters of Tesla, Inc., to inquire about the value of 100 shares.
B. Between now and 12 months from now, you have the right, but not the obligation to
purchase 100 shares of Tesla, Inc., for $870 per share.
C. At the maturity date, that is 12 months from now, you have the right, but not the
obligation to sell 100 shares of Tesla, Inc., for $870 per share
D. At the maturity date, that is 12 months from now, you have the right, but not the
obligation to purchase 100 shares of Tesla, Inc., for $870 per share.
A European call option gives the holder the right, but not the obligation, to purchase a specified
amount of an underlying asset at a specified price (the strike price) within a specified time
period. In this case, the underlying asset is 100 shares of Tesla, Inc., and the strike price is $870
per share. The specified time period is 12 months from now, which is when the option matures.
Therefore, at the maturity date, the holder of this European call option has the right, but not the
obligation, to purchase 100 shares of Tesla, Inc., for $870 per share. This is the fundamental
principle of a call option. The holder can decide to exercise the option and purchase the shares if
the market price of the shares is higher than the strike price at the time of maturity. If the
market price is lower, the holder can choose not to exercise the option, thereby limiting their loss
Choice A is incorrect. This choice misinterprets the concept of a call option. A call option does
not entitle the holder to make a phone call to inquire about the value of shares. It provides the
right, but not an obligation, to buy an underlying asset at a specified price within a specific time
period.
Choice B is incorrect. This choice incorrectly suggests that European options can be exercised
at any time before expiration. However, unlike American options, European options can only be
exercised at expiration.
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Choice C is incorrect. This choice describes a put option rather than a call option. A put option
gives the holder the right but not an obligation to sell an underlying asset at a specified price
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Q.595 Which of the following options requires a party to purchase the underlying asset at a
specific date?
A European short put option is a type of derivative contract that obligates the seller (writer) of
the option to buy the underlying asset at a predetermined price (strike price) on a specific date
(expiration date). This obligation arises if the buyer (holder) of the option decides to exercise the
option. The term 'short' refers to the act of selling the option, and 'European' denotes that the
option can only be exercised on the expiration date, not before. This is in contrast to 'American'
options, which can be exercised at any time up to the expiration date. The seller of a European
short put option is essentially betting that the price of the underlying asset will be higher than
the strike price on the expiration date. If this is the case, the option will not be exercised, and
the seller will profit from the premium received for selling the option. However, if the price of the
underlying asset is lower than the strike price on the expiration date, the buyer will exercise the
option, and the seller will be obligated to buy the asset at the higher strike price, resulting in a
loss.
Choice A is incorrect. A European short call option does not obligate the party to buy the
underlying asset. Instead, it gives the holder of the option (the buyer) the right, but not
Choice B is incorrect. An American short call option also does not obligate a party to buy an
underlying asset. Similar to a European short call option, it provides the holder with the right but
Choice C is incorrect. An American short put option obligates a party (the seller of put) to buy
an underlying asset if exercised by buyer but it can be exercised anytime before expiration and
Q.596 Nisha Jatoi, a lecturer at the Karachi School of Business, is delivering a lecture on the
subject of Introduction to Derivatives. While discussing the details of derivatives, specifically
options contracts, she presented the following properties of options in her slideshow:
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I. The price of a call option increases as the exercise price decreases.
II. The price of a put option increases as the exercise price increases.
III. The values of both American call and put options increase as time to maturity increases.
The price of a call option is inversely related to the exercise price. This is because the exercise
price is the price at which the holder of the option can buy the underlying asset. If the exercise
price decreases, the likelihood of the option being in the money (i.e., profitable) increases, which
in turn increases the price of the call option. Similarly, the price of a put option is directly related
to the exercise price. A put option gives the holder the right to sell the underlying asset at the
exercise price. Therefore, if the exercise price increases, the potential profit from exercising the
option also increases, which increases the price of the put option. Lastly, the value of both
American call and put options increases as the time to maturity increases. This is because the
longer the time to maturity, the greater the chance that the option will end up in the money,
Choice A is incorrect. While it correctly states that the price of a call option increases as the
exercise price decreases (Property I), and the price of a put option increases as the exercise
price increases (Property II), it fails to acknowledge that the values of both American call and
put options increase as time to maturity increases (Property III). This is an important aspect of
options pricing, known as time value, which suggests that an option with more time until
expiration has greater potential for profit, thus increasing its value.
Choice B is incorrect. Although it correctly identifies Properties II and III, it incorrectly omits
Property I. The price of a call option does indeed increase as the exercise price decreases. This is
because a lower exercise price means that the holder can buy the underlying asset at a cheaper
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rate in future if they choose to exercise their right.
Choice C is incorrect. It accurately includes Properties I and III but misses out on Property II -
The fact that the price of a put option increases as its exercise price rises. This happens because
higher strike prices provide more protection against potential declines in asset prices, making
Q.597 A trader sold five July put options, each at $7.60, pledging to buy 500 shares of Galaxy
Carpets Co. at a price of $13.50 per share. If at maturity of the contract, Galaxy Carpet’s stock is
trading at $9.30 per share, then which of the following statements accurately describes the net
cash flow of the transaction?
At initiation, the trader gets 5*7.6*100 = $3,800 from the sale of the put options. This is because
for stock options, the premium is quoted as a dollar amount per share, and most contracts
represent the commitment of 100 shares.
At maturity, the trader made a loss of ($9.3 - $13.5)*500 = $2,100
Therefore, the net cash flow for the trader is +$1,700 (3,800-2,100).
Note: On the derivatives market, options are quoted in per-share prices but only sold in 100
share lots. In other words, each put has 100 shares. In this case, for example, the put option is
quoted at $7.6, but the buyer pays $7.6 * 100 = $760 per put option. For 5 puts, that's $760 * 5
= $3,800
Q.598 Steve Hellmuth, a former derivatives trader, runs an online derivatives investment and
trading tutorial portal. Every weekend he educates hundreds of subscribers through weekly
webinars. In his last webinar, he presented the following properties of each trader type:
I. Hedgers use derivatives to guard against the risks related to future movements in market
prices of underlying variables.
II. Arbitrageurs use derivatives to bet on the direction of the market of underlying variables.
III. Speculators use derivatives to take offsetting positions in two or more instruments and
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markets to earn a profit.
A. Speculators only.
I. Hedgers use derivatives to protect against the risks associated with future fluctuations in the
market prices of underlying variables. This definition is correct as hedgers use derivatives as a
risk management tool to hedge against potential losses that could result from price changes in
II. Speculators, not arbitrageurs, use derivatives to predict the direction of the market of
underlying variables. Speculators are market participants who try to profit from market volatility.
They take on risk, betting on future price movements in the hope of making gains. They do not
III. Arbitrageurs, not speculators, use derivatives to establish offsetting positions in multiple
instruments and markets to generate profits. Arbitrageurs seek to exploit price discrepancies
between related financial instruments. They take offsetting positions in two or more instruments
or markets to lock in a risk-free profit from the price difference. Therefore, the definitions of
Speculators do use derivatives to establish positions in the market, but not necessarily offsetting
Choice B is incorrect. Hedgers were also correctly defined by Hellmuth. They use derivatives
to protect against risks associated with future fluctuations in market prices of underlying
variables.
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Choice D is incorrect. Hedgers were accurately described by Hellmuth as they utilize
derivatives to hedge against potential risks due to price fluctuations in the market.
Q.599 Donald Brown, an investment manager at a pension fund, manages a portfolio of twenty
stocks. Brown is long the stocks of Blue Blue Moon Inc., and he believes that the value of the
stock of Blue Motors Inc., which forms part of the portfolio, can decrease due to an increase in
oil prices. After analyzing the fundamentals of the stock, Brown decides to take a long position in
put options on Blue Motors Inc. stocks. The given transaction appropriately categorizes Donald
Brown as a:
A. Speculator.
B. Hedger.
C. Market maker.
D. Arbitrageur.
In the context of financial markets, a hedger is an individual or institution that uses derivative
instruments like futures and options to offset the risk of price movements in an underlying asset.
In this case, Donald Brown is using put options to hedge against the risk of a decrease in the
value of Blue Motors Inc. stocks. Put options give the holder the right, but not the obligation, to
sell the underlying asset at a predetermined price within a specified period. By taking a long
position in put options, Brown is securing the right to sell Blue Motors Inc. stocks at a fixed
price, thereby protecting himself from potential losses if the stock price decreases as he
anticipates. This strategy is a classic example of hedging, where the goal is not to make a profit
Choice A is incorrect. A speculator is someone who takes on significant risks in the hopes of
making substantial profits. In this case, Donald Brown is not taking a speculative position but
rather trying to protect his portfolio from potential losses due to anticipated market conditions.
Choice C is incorrect. A market maker provides liquidity to the market by buying and selling
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securities at publicly quoted prices. Donald Brown's actions do not involve providing liquidity or
setting prices for securities; instead, he's managing risk within his portfolio by using options as a
hedging tool.
different forms of the same financial instrument to make risk-free profits. In this scenario,
Donald Brown isn't exploiting any price discrepancies but rather protecting his portfolio from
potential losses due to rising oil prices affecting Blue Motors Inc.'s stock value.
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Q.600 Hedgers use a number of derivatives to neutralize their risk by taking long or short
positions in derivatives. These derivatives differ in costs and features. Which of the following
type of derivatives provides a type of insurance to the hedger to protect against unfavorable
movement and benefit from favorable movement in the underlying variable?
A. Forward contracts.
B. Futures contracts.
C. Options.
Options are a type of derivative that provide a form of insurance to the hedger. They offer the
right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a
specified time period. This characteristic of options allows the hedger to protect against
unfavorable movements in the price of the underlying asset. If the price moves unfavorably, the
hedger can choose not to exercise the option, thereby limiting the loss to the premium paid for
the option. On the other hand, if the price moves favorably, the hedger can exercise the option
and benefit from the favorable price movement. This dual benefit of protection against downside
risk and potential for upside gain makes options a unique and valuable tool for hedgers.
Choice A is incorrect. Forward contracts do not offer a form of insurance to the hedger. They
are agreements between two parties to buy or sell an asset at a specified future time at a price
agreed upon today. While they can be used to hedge against risk, they do not allow the hedger to
Choice B is incorrect. Futures contracts, like forward contracts, are agreements to buy or sell
an asset at a predetermined price and date. However, they also do not provide the flexibility of
profiting from favorable market movements while being protected against unfavorable ones.
Choice D is incorrect. The statement that none of the above derivatives offers insurance-like
protection and potential for profit is false because options (choice C) indeed provide such
benefits.
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Q.601 Samuel Simpson is a commodities trader at one of the largest asset management firm in
Abu Dhabi. He believes that due to a resolution passed by all members of the OPEC committee to
cut the supply of oil, the prices of oil are expected to increase. In order to capitalize on his vision,
Simpson purchased 2,000 lots of crude oil futures for the price of $45.6 per barrel. Which type of
derivatives trader is Samuel Simpson?
A. Speculator.
B. Hedger.
C. Option trader.
D. Arbitrageur.
Samuel Simpson is indeed a speculator. Speculators are individuals or entities who attempt to
profit from market inefficiencies or price fluctuations. In this case, Simpson is speculating that
the price of oil will increase due to the decision by the OPEC committee to cut oil supply. By
purchasing crude oil futures, he is betting on the future price of oil. If his prediction is correct
and the price of oil increases, he stands to make a profit. Speculators play a crucial role in the
financial markets by providing liquidity and bearing the risk that hedgers seek to avoid.
However, speculation involves a high level of risk as the markets may not move in the direction
Choice B is incorrect. A hedger is someone who enters into a derivative contract to reduce or
eliminate the risk associated with price fluctuations in an underlying asset. In this case, Samuel
Simpson is not trying to mitigate risk but rather capitalize on anticipated price movements,
Choice C is incorrect. An option trader buys and sells options contracts that give them the
right, but not obligation, to buy or sell an underlying asset at a predetermined price within a
specific time period. Samuel Simpson's activity involves futures contracts and not options; hence
markets for the same asset to make risk-free profits. Samuel Simpson's actions do not involve
exploiting such market inefficiencies; instead, he's making speculative trades based on expected
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future oil prices.
Q.602 Which of the following positions offers the most effective protective strategy against
declines in the underlying asset's price while allowing for some potential upside profit if the
price remains stable or increases?
B. Entering into a collar strategy by purchasing a put option and writing a call option on
the asset.
A collar strategy provides protection against declines in the price of the underlying asset. By
purchasing a put option, the investor has a right to sell the asset at a pre-determined price,
offering protection against price declines. Writing a call option provides premium income and
caps the potential profit if the asset's price rises significantly. This strategy provides both
A is incorrect. Writing a naked call option exposes the writer to potentially unlimited losses if
the underlying asset's price rises significantly. However, the writer benefits if the price remains
C is incorrect. Purchasing a futures contract exposes the holder to potential losses if the price
of the underlying asset declines. The holder benefits if the price increases.
D is incorrect. Writing a covered call option means holding the underlying asset and writing a
call option on it. If the price of the asset increases beyond the strike price of the call option, the
profit is capped at that strike price, minus the premium received. If the price declines, losses on
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Q.603 Assume stock K trades on the New York Stock Exchange (NYSE) and the London Stock
Exchange (LSE). The stock currently trades on the NYSE for $50 and on the LSE for £39. Given
the current exchange rate is 1.2658 $/£, determine the amount of arbitrage profit that could
possibly be earned.
A. $0.82
B. $1.25
C. $0.63
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Q.3511 Which of these is NOT a characteristic of over-the-counter options?
B. They are often used to hedge interest rate risks and currency fluctuation risks.
Over-the-counter options are not highly regulated. This is a key characteristic that distinguishes
them from exchange-traded options. While OTC options are subject to some level of regulation,
they are not as heavily regulated as their exchange-traded counterparts. This is primarily
because oTC options are traded directly between two parties, without the involvement of an
exchange or other intermediary. As a result, the parties involved in an OTC options trade have a
greater degree of freedom to negotiate the terms of the deal. However, this lack of regulation
also means that OTC options carry a higher level of risk, as there is no central clearing house to
guarantee the performance of the contract. Since the 2007-2009 financial crisis, there have been
efforts to increase the regulation of OTC markets, but they are still not considered to be highly
regulated.
Choice A is incorrect. Large traders indeed trade over large sums of money in OTC options.
This is because OTC options are not standardized and can be tailored to meet the specific needs
Choice B is incorrect. OTC options are frequently used to hedge against interest rate risks and
currency fluctuation risks. These types of risks can be significant for businesses and investors,
and OTC options provide a flexible tool for managing these risks.
Choice C is incorrect. Participants do have the freedom to negotiate deals in OTC markets.
Unlike exchange-traded options, which have standardized contracts with fixed terms, OTC
options allow the parties involved to negotiate all aspects of the contract, including its size,
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Q.3512 Relative to over-the-counter (OTC) derivatives, exchange-traded derivatives are:
Exchange-traded derivatives are indeed transacted through a process that is verified by a central
exchange. This is one of the key distinguishing features of exchange-traded derivatives. The
central exchange acts as an intermediary between the buyer and the seller, ensuring the
integrity of the transaction. This process involves verifying the execution of the transaction and
recording the identities of the participants. The central exchange also facilitates the creation of
clearing and settlement operations, which further enhances the transparency and security of the
transaction. This is in contrast to OTC derivatives, which are traded directly between two parties
without the involvement of an intermediary. As a result, OTC derivatives are typically associated
Choice A is incorrect. While it's true that exchange-traded derivatives are often traded in
larger lot sizes than OTC derivatives, this is not a defining characteristic. The size of the lots can
Choice C is incorrect. It's not accurate to say that there is zero potential to earn arbitrage
profits in markets where exchange-traded derivatives are traded. While these markets are
typically more efficient and thus offer fewer arbitrage opportunities than less regulated OTC
markets, it's still possible for savvy traders to identify and exploit pricing inefficiencies.
Choice D is incorrect. Exchange-traded derivatives are actually less flexible and customizable
than OTC derivatives. This is because they're standardized contracts with fixed terms and
conditions, whereas OTC derivatives can be tailored to meet the specific needs of the parties
involved.
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Q.3515 If Michael Emery takes a long position in copper futures, which of the following parties
will take the opposite position to the futures contract?
A. Another investor/trader.
B. The clearinghouse.
The clearinghouse acts as the counterparty to every transaction in the futures markets. This
means that when an investor like Michael Emery takes a long position in a futures contract, the
clearinghouse takes the short position, effectively becoming the opposite party to the contract.
The role of the clearinghouse is crucial in providing stability and reducing risk in the futures
markets. It ensures that the terms of the contracts are fulfilled by both parties, thereby
eliminating counterparty risk. The clearinghouse achieves this by stepping in between the two
parties involved in the contract, agreeing to buy from the seller and sell to the buyer. This
mechanism ensures that even if one party defaults, the other party's interests are protected. The
clearinghouse, therefore, plays a pivotal role in maintaining the integrity and smooth functioning
Choice A is incorrect. While another investor or trader could theoretically take the counter
position in a futures contract, it is not typically the case in practice. Futures contracts are
standardized and traded on an exchange, where the clearinghouse acts as a counterparty to all
Choice C is incorrect. Large commercial banks may participate in futures markets, but they do
not typically act as counterparties to individual investors or traders like Michael Emery. They
might use futures for hedging their own risks or for proprietary trading, but they do not usually
Choice D is incorrect. As explained above, one of these entities does indeed act as a
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Q.3516 The everyday process of adjusting the margin for the gains and losses on the value of
futures contracts is known as:
A. Marking to market.
B. Value adjusting.
C. Clearing.
D. Initial margining.
Marking to market is the daily process of settling gains and losses on futures contracts. This
process involves adjusting the margin account to reflect the daily fluctuations in the value of the
futures contracts. The margin account is a type of collateral that is used to cover potential losses
on futures contracts. When the value of the futures contracts changes due to changes in the
prices of the underlying assets, the margin account is adjusted accordingly. This process ensures
that the margin account always reflects the current value of the futures contracts, thereby
protecting both the buyer and the seller from potential losses. Marking to market is a critical
Choice B is incorrect. Value adjusting is not a term used in futures trading to describe the
daily adjustment process of margin accounts. It may be confused with 'marking to market', but it
does not accurately represent the procedure of adjusting for gains and losses due to fluctuations
in contract values.
Choice C is incorrect. Clearing refers to the process of settling trades, which includes
transferring funds from buyer's account to seller's account and vice versa, but it does not
specifically refer to the daily adjustment of margins based on contract value fluctuations.
Choice D is incorrect. Initial margining refers to the initial deposit required by a broker when
a futures contract is first entered into. This term does not describe the daily adjustment process
that accounts for gains and losses due to changes in futures contracts' values.
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Q.3517 Which of the following best describes a forward commitment?
A forward commitment is a legally binding promise to perform some action in the future.
A forward commitment can also be defined as a contract entered into between two parties that
require both parties to transact in the future at a pre-specified price known as the forward price.
The parties and the identity and quantity of the underlying are specified as well as the date of
the future transaction (expiration) and the nature of the settlement. The parties have to transact;
they are obligated to do so. In the event of non-performance, because of the obligation of the
The payoff profiles of forward commitments are linear in nature and move upwards or
downwards in direct relation to the price of the underlying asset. Forward commitments include
Options B and C are incorrect: A forward commitment and a contingent claim are two
different things. A forward commitment creates an obligation between the transacting parties
whereas a contingent claim creates the right but not the obligation to transact at a future date.
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Q.3519 Chris Dunkins bought a put option with a strike of $59. If at expiration the stock is now
worth $42, then what is the payoff of the option at expiration?
A. $0 payoff.
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Q.3520 Which of the following statements is correct regarding the value of a forward contract to
a short party at expiration?
The value of the forward contract is:
A. Valueless.
C. Positive if the spot price of the underlying exceeds the forward price.
The value of a forward contract to a party holding a short position at expiration is indeed equal
to the value to the long party multiplied by -1. This is because the short party has agreed to sell
the underlying asset at a predetermined price, known as the forward price. If the spot price of
the asset at expiration is higher than the forward price, the short party incurs a loss, while the
long party makes a gain. Conversely, if the spot price is lower than the forward price, the short
party makes a gain, while the long party incurs a loss. Therefore, the value of the contract to the
Choice A is incorrect. The value of a forward contract to the short party at expiration is not
valueless. It depends on the difference between the spot price and the forward price at
expiration.
Choice C is incorrect. This statement contradicts how a short position in a forward contract
works. The value to the short party would be negative if the spot price of the underlying exceeds
Choice D is incorrect. The value of a forward contract to a short party at expiration does not
equal 1 divided by the value of long party. This choice seems to confuse some concepts related
with financial derivatives and does not accurately describe how this calculation should be made.
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Q.3521 Which of the following is NOT an exchange-traded derivative instrument?
A. Futures.
B. Forwards.
C. Options.
Forwards are not typically traded on an exchange. Instead, they are traded over-the-counter
(OTC). A forward contract is a private agreement between two parties to buy or sell an asset at a
specified future date for a price agreed upon today. Unlike futures contracts, which are
standardized and traded on an exchange, forward contracts are customized to the needs of the
buyer and seller, and their terms may not be made public. Therefore, they carry a higher degree
Choice A is incorrect. Futures are typically traded on an exchange. These contracts are
standardized in terms of quantity, quality, and delivery time and place to facilitate trading on a
futures exchange.
Choice C is incorrect. Options are also typically traded on an exchange. Options contracts give
the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price
Choice D is incorrect. All of the listed derivatives (futures and options) except for forwards are
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Q.3522 Which of the following factors differentiates futures contracts from forward contracts?
Futures contracts are indeed traded on regulated markets. This is one of the key differences
between futures and forward contracts. Futures contracts are standardized contracts that are
traded on organized exchanges. These exchanges act as intermediaries between the buyer and
the seller, and they provide a regulated and transparent environment for trading. The exchanges
also provide clearing and settlement services, reducing the risk of default by either party. The
standardization of futures contracts includes details such as the quantity and quality of the
underlying asset, and the date and location of delivery. This standardization facilitates liquidity
and allows the contracts to be traded on the exchange. On the other hand, forward contracts are
private agreements between two parties and are not traded on an exchange. They are
customized to the needs of the parties involved, and as such, they are not as liquid as futures
contracts. The lack of a regulated market for forward contracts also means that they carry a
Choice A is incorrect. While it's true that futures contracts can be cash-settled, this is not a
distinguishing factor between futures and forwards. Both types of contracts can be settled either
Choice B is incorrect. The statement that the value of a futures contract is derived from its
underlying asset applies to both futures and forward contracts, not just futures. Therefore, this
Choice C is incorrect. Forward contracts do not necessarily require physical assets for
settlement; they can also be cash-settled. Hence, this statement does not accurately distinguish
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Q.3523 In order to protect from the downside risk of stock prices, investors should:
Put options are financial contracts that give the option buyer the right, but not the obligation, to
sell a specified amount of an underlying security at a specified price within a specified time
frame. This is often used as a protective strategy by investors who are concerned about potential
losses in the underlying stock. When an investor buys a put option, they are essentially securing
the right to sell their stock at a set price, regardless of how far the market price falls. This means
that if the stock price does fall, the investor can exercise their put option and sell their stock at
the higher, predetermined price, thereby limiting their losses. The cost of this protection is the
premium paid for the put option. Therefore, buying put options is a strategy that can effectively
Choice B is incorrect. Selling put options would not be an appropriate strategy to protect
against a decrease in stock prices. When you sell a put option, you are obligated to buy the
underlying asset at the strike price if the buyer decides to exercise their right. If stock prices fall,
this could result in significant losses as you would be forced to buy the asset at a higher price
Choice C is incorrect. Buying call options would also not provide protection against falling
stock prices. A call option gives the holder the right but not obligation to buy an asset at a
specified price within a certain period of time. If stock prices fall, this option becomes worthless
as it would be more cost-effective for investors to purchase shares directly from the market at
Choice D is incorrect. Selling call options does not protect against downside risk either;
instead, it limits upside potential while providing some income through premiums received from
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selling these options. In case of falling stock prices, while there may be no direct loss due to this
strategy (as calls will likely expire worthless), it does nothing substantial in terms of protecting
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Q.5349 A risk manager at a large energy company is presenting at a seminar on derivative
contracts to a group of newly hired energy traders. The manager focuses on the advantages and
disadvantages of using options contracts and futures contracts for hedging in the energy
markets. Which of the following statements is correct?
A. Options contracts provide the holder more flexibility than futures contracts.
C. Options contracts have a linear payoff, while futures contracts have a non-linear
payoff.
Options contracts indeed offer more flexibility than futures contracts. The primary reason for
this is that options contracts provide the holder with the right, but not the obligation, to buy or
sell the underlying asset at a predetermined price and date in the future. This means that the
holder can choose whether or not to exercise the option, depending on market conditions. This
gives the holder more flexibility than futures contracts, which obligate both parties to fulfill the
terms of the contract. This flexibility is particularly beneficial in volatile markets, where the
ability to choose whether or not to exercise the option can help limit potential losses and
Choice B is incorrect. Options contracts are not traded exclusively in the OTC market. They
Choice C is incorrect. The statement about the payoff profiles of options and futures contracts
is reversed. Options contracts have a non-linear payoff, while futures contracts have a linear
payoff.
Choice D is incorrect. The value of an option is not independent of the volatility of the
underlying asset; rather, it's highly dependent on it. Higher volatility generally increases the
value of an option because it increases the likelihood that the option will end up in-the-money at
expiration.
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Q.5350 A Canadian-based bank signs a 3-month forward contract with a manufacturer to sell
USD 50 million in 3 months at a rate of CAD 1.25 per USD. What is the payoff for the bank from
the forward contract if the exchange rate is CAD 1.13 per USD 1 in 3 months?
A. -6,500,000
B. 6,000,000
C. 2,500,000
D. -6,000,000
The value of the contract for the bank at expiration is given by:
CAD 62 , 500, 000 − CAD 56, 500, 000 = CAD 6 , 000, 000.
Q.5351 A risk manager at a bank is trying to decide whether to use a forward or an option
contract to hedge against currency risk. The manager expects to receive a foreign currency
payment of €500,000 in three months. Which of the following statements is correct regarding the
manager's decision?
A. The manager will choose a forward contract because it allows for flexibility in
exercising the contract.
C. The manager will choose a forward contract because it has no upfront costs.
D. The manager will choose an option contract because it limits the downside risk if the
exchange rate moves unfavorably.
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The correct answer is D.
Option contracts are indeed a viable choice for the manager as they limit the downside risk if the
exchange rate moves unfavorably. By purchasing an option, specifically a put option, the
manager can secure a maximum exchange rate and limit potential losses if the exchange rate
moves in the wrong direction. This is because a put option gives the holder the right, but not the
obligation, to sell a currency at a specified rate within a certain period. If the exchange rate
moves unfavorably, the manager can exercise the option and sell the currency at the agreed rate,
thereby limiting the downside risk. If the exchange rate moves favorably, the manager can let the
option expire and exchange the currency at the prevailing market rate, thereby benefiting from
the favorable movement in the exchange rate. This flexibility to adapt to market conditions is a
Choice A is incorrect. Forward contracts do not provide flexibility in exercising the contract.
They are binding agreements that obligate the buyer to purchase an asset at a predetermined
Choice B is incorrect. While it's true that option contracts can provide a guaranteed exchange
rate, this isn't exclusive to options alone. Both forward and option contracts can lock in an
Choice C is incorrect. Although forward contracts typically do not have upfront costs, they
expose the holder to potential losses if the market moves unfavorably before maturity of the
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Reading 31: Exchanges and OTC Markets
Q.824 John Galloway has recently joined Ace Investments as an investment manager. He
previously worked as an equity trader at a small brokerage firm. His new boss told him that he
would only be trading derivatives on exchanges, and the firm does not approve the use of over-
the-counter derivatives.
Which of the following derivative instruments is he NOT allowed to trade?
I. Forwards
II. Options
III. Swaps
A. II only
B. I only
C. II and III
D. I and III
Trade Forwards and Swaps are typically traded over-the-counter (OTC), not on exchanges. OTC
markets are decentralized venues, where trading is conducted directly between parties without a
central exchange or intermediary. The products traded on these markets are often tailored to the
specific needs of the parties involved, which can lead to a higher degree of complexity and risk
as futures contracts and options, are standardized contracts traded on a regulated exchange.
These derivatives are subject to the rules of the exchange, which provides a level of transparency
and reduces counterparty risk. Therefore, given the directive from his superiors at Ace
Investments, John Galloway is only allowed to trade derivatives that are exchange-traded, which
Choice A is incorrect. Options are not exclusively traded over-the-counter (OTC). They can also
be traded on exchanges, which means John Galloway is allowed to trade them according to the
Choice B is incorrect. While it's true that forwards are typically traded OTC and would
therefore be off-limits for John, this choice does not account for swaps, which are also primarily
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OTC instruments and should likewise be prohibited under the given directive.
Choice C is incorrect. This choice incorrectly suggests that options cannot be traded on
exchanges, which contradicts the fact that they can indeed be exchange-traded. Furthermore, it
fails to include forwards in the list of prohibited instruments despite them being typically OTC-
traded.
Q.825 Diya Singh is a junior trader at Mumbai Balance Fund. She invests in derivatives with the
purpose of speculating on derivatives prices and the price trends of the underlying assets. Unlike
hedgers who trade long-dated customized derivatives, Singh intends to invest in more liquid and
more standardized derivative instruments. She has the option to invest in either exchanges or
over-the-counter markets. Considering her purpose, which of the following markets is more
suitable for Singh?
A. Over-the-counter markets.
B. Centralized exchanges.
Centralized exchanges are the most suitable markets for Diya Singh. Centralized exchanges are
characterized by their high liquidity and standardization of derivative instruments, which aligns
with Singh's investment strategy. These exchanges operate under a regulatory authority and
provide a transparent and efficient trading environment. The derivatives traded on these
exchanges are standardized contracts with fixed sizes and expiration dates. This standardization
makes the contracts more liquid, as it increases the number of market participants and the
centralized exchanges due to the presence of a clearing house, which acts as the counterparty to
all trades and guarantees the fulfillment of contracts. Therefore, considering Singh's preference
for more liquid and standardized derivative instruments, centralized exchanges are the most
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Choice A is incorrect. Over-the-counter markets are typically characterized by less liquidity
and more customization compared to centralized exchanges. This does not align with Singh's
Choice C is incorrect. While it's true that both over-the-counter markets and centralized
exchanges offer derivatives, Singh's specific preferences for liquidity and standardization make
Choice D is incorrect. It is not accurate to say that none of the markets are suitable for Singh's
investment strategy. Centralized exchanges, as explained above, align well with her preferences
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Q.826 Muhammad Amir recently completed his Ph.D. in finance and economics. After his
graduation, he started his career as a college professor. In his first lecture, he said: "Exchanges
are more efficient and more liquid than OTC markets as they minimize the risk and promote
customization." Which of the following options is correct?
Dr. Muhammad Amir's claim that exchanges promote customization is incorrect. In fact,
exchanges are known for promoting standardization rather than customization. This is primarily
because exchanges operate on a set of predefined rules and regulations that ensure uniformity in
the trading process. This standardization is crucial as it facilitates the smooth functioning of the
exchange, reduces complexity, and enhances transparency. Customization, on the other hand,
implies tailoring the trading process to meet the specific needs of individual traders, which is not
typically associated with exchanges. Therefore, Dr. Amir's assertion regarding the promotion of
Choice A is incorrect. Exchanges are indeed known for their liquidity feature. They have a
large number of buyers and sellers, which ensures that transactions can be executed quickly and
Choice B is incorrect. Exchanges are also recognized for their efficiency. The presence of many
participants in exchanges allows for competitive pricing, which leads to market efficiency.
Choice D is incorrect. Dr. Amir's claim about risk reduction in exchanges is correct as well.
Exchanges provide a centralized clearing house that guarantees the performance of contracts,
Exchanges do not typically foster customization as they deal with standardized contracts to
ensure liquidity and transparency in trading operations.
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Q.827 Exchanges perform a number of functions to enhance efficiency and promote the integrity
of financial markets. Which of the following functions is least likely performed by the exchanges?
B. Exchange provides a central venue for trading and hedging. This centralized trading
venue enhances efficiency and promotes an opportunity for price discovery.
C. Exchange provides a platform for hedgers and arbitrageurs to construct products and
transactions that fulfill their purposes.
Exchanges are least likely to provide a platform for hedgers and arbitrageurs to construct
products and transactions that fulfill their purposes. This is because hedgers typically hedge
their risk through standardized products, not customized ones. The pricing strategy of exchange-
traded products is based on the no-arbitrage opportunity principle, which means that the prices
of these products are set in such a way that there are no opportunities for arbitrage. Arbitrage is
the practice of taking advantage of a price difference between two or more markets, and it is a
strategy that is typically used by sophisticated investors and traders. If exchanges were to
provide a platform for hedgers and arbitrageurs to construct their own products and
transactions, it could potentially disrupt the pricing mechanism of the exchange and create
opportunities for arbitrage, which would be contrary to the principle of no-arbitrage opportunity.
terms of maturity dates, minimum price quotation increments, deliverable grade of the
underlying assets, delivery location of the contract, etc. This standardization helps to increase
market efficiency and liquidity by making it easier for participants to understand and trade these
contracts.
Choice B is incorrect. Exchanges indeed provide a central venue for trading and hedging. This
centralized trading venue enhances efficiency by reducing transaction costs and promotes an
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Choice D is incorrect. Exchanges also provide reporting services related to transaction prices
and volumes to trading participants, data vendors, and subscribers. This improves price
Q.828 Frau Schulz is the head of risk management at Frankfurt Money Bank. Her job is to
understand the risk structure of a transaction and the risk of the market in which the transaction
is carried out. She suggests that it is better to trade in exchanges than it is to trade in over-the-
counter markets for the following reasons:
I. One reason for trading in exchange is the central clearing feature of exchange that allows the
netting of all the outstanding trades of a specific party
II. Another reason for trading in exchanges is because it reduces counterparty risk and systemic
risk
Which of the above-mentioned reasons for trading in exchanges rather than in OTC markets
is/are incorrect?
A. Only I is incorrect
B. Only II is incorrect
Both reasons provided by Frau Schulz for preferring exchange trading over OTC markets are
indeed correct.
The first reason highlights the central clearing feature of exchanges. This feature allows for the
netting of all outstanding trades of a specific party. In other words, if a party has two opposite
outstanding positions with two different parties, then both positions of the party will be offset or
process and reduces the credit risk associated with the trades.
The second reason emphasizes the reduction of counterparty risk and systemic risk when trading
in exchanges. In bilateral clearing, which is common in OTC markets, the risk of a default by a
market participant is borne entirely by its counterparties. However, if trades are cleared through
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a central counterparty (CCP), as is the case in exchanges, the risks are shared by all members of
the CCP. This sharing of credit risk is referred to as loss mutualization. It is attractive to
regulators because it has the effect of reducing systemic risk by dispersing the impact of a
default by a market participant throughout the market. Therefore, both reasons provided by Frau
Schulz are valid and correctly highlight the advantages of exchange trading over OTC markets.
Choice A is incorrect. The first reason provided by Frau Schulz is indeed correct. Exchanges
do have a central clearing feature that allows for the netting of all outstanding trades of a
specific party, which can reduce the risk and complexity associated with multiple individual
transactions.
Choice B is incorrect. The second reason given by Frau Schulz is also accurate. Trading in
exchanges can reduce counterparty risk and systemic risk because exchanges typically require
members to post collateral or margin, which provides a buffer against potential losses.
Choice C is incorrect. As explained above, both reasons provided by Frau Schulz are correct
and valid justifications for preferring exchange trading over OTC markets.
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Q.829 The majority of the derivative transactions are a zero-sum game. Therefore, the party with
the loss is less likely to pay for its losses or fulfill its obligations. To mitigate such situations,
exchanges have developed netting and margining methods. Identify if the given definitions of
margining and netting are correct.
I. Netting is referred to as the offsetting of contracts that reduce the exposure or risk of
counterparties related to the open positions to which they are exposed. It also reduces the costs
of maintaining open positions as the parties will be required to only post margins against net
positions.
II. Margining is divided into two types - the variation margin, and the initial margin. In the
variation margin account, members receive and pay cash or other assets against gains or losses
in their positions.
III. In the initial margin account, members provide coverage against losses in case they default
on their contracts.
All the definitions are correct. Netting involves the offsetting of the contracts, which reduces the
exposure of the counterparties in the open positions and reduces the costs of maintaining open
positions as the parties will be required only to post margins against net positions. The variation
margin account only requires members to pay or receive the cash or other assets against gains
and losses in their positions, while the initial margin provides coverage against losses in case of
default in case a trader is unable to pay the variation margin.
Q.832 Mathew Perry, an investment analyst, is reading a research paper based on the evolution
of exchanges. He finds out that, before the introduction of clearinghouses, many other clearing
and netting alternatives existed in exchanges to net the positions of members in order to reduce
the risks. Which of the following clearing or netting type is most common nowadays in
exchanges?
A. Bilateral clearing
B. Central clearing
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Central clearing is the most common type of clearing in today's exchanges. Central clearing
involves the use of a central counterparty (CCP) or clearinghouse that acts as an intermediary
between the buyer and seller in a transaction. The CCP assumes the counterparty risk associated
with the transaction, effectively becoming the buyer to every seller and the seller to every buyer.
This arrangement allows for the standardization of contracts in terms of maturities, underlying
assets, delivery terms, etc., enabling the CCP to offset all transactions easily. The central
clearing mechanism significantly reduces the counterparty risk and enhances the efficiency and
Choice A is incorrect. Bilateral clearing, while still used in some over-the-counter (OTC)
markets, is not the predominant method utilized in exchanges today. This method involves two
parties directly settling their trades with each other, which can lead to increased counterparty
Choice C is incorrect. Not all types of clearing and netting are predominantly utilized in
exchanges today. As mentioned earlier, bilateral clearing is less common in modern exchanges
Choice D is incorrect. It's not true that none of the options are used in current financial
landscape. Central clearing, as indicated by choice B, has become the standard for most
exchange-traded derivatives due to its ability to reduce counterparty risk and increase market
efficiency.
Q.833 Which of the following statements are consistent with the differences between OTC
markets and exchange markets?
I. The members of OTC markets are in better positions to negotiate the terms of a contract such
as maturity, grade of the underlying assets, delivery terms, etc., than the members of exchange
markets
II. It is riskier to trade in exchanges as all the trades are cleared through only one counterparty
and the default of this party can have an effect on all the parties
A. Statement I is consistent with the differences between OTC markets and exchange
markets.
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B. Statement II is consistent with the differences between OTC markets and exchange
markets.
C. Both statements are consistent with the differences between OTC markets and
exchange markets.
D. None of the statements are consistent with the differences between OTC markets and
exchange markets.
Statement I is consistent with the differences between OTC markets and exchange markets. In
OTC markets, participants have the flexibility to negotiate the terms of the contract. This is
because OTC contracts are not standardized and can be tailored to meet the specific needs of the
parties involved. This includes aspects such as the maturity of the contract, the grade of the
underlying assets, and the terms of delivery. This level of customization is not available in
ensures that the contracts are more liquid and easier to trade, but it also means that participants
do not have the same level of flexibility to negotiate contract terms as they do in OTC markets.
Choice B is incorrect. While it's true that exchange markets clear trades through a central
counterparty, this doesn't necessarily increase risk for participants. In fact, the presence of a
central counterparty can reduce risk by providing guarantees on trade execution and settlement.
The default risk of the central counterparty is typically mitigated through various safeguards
such as margin requirements, daily mark-to-market and loss mutualization among members.
Choice C is incorrect. As explained above, Statement II does not accurately reflect the
differences between OTC markets and exchange markets because it incorrectly associates higher
Choice D is incorrect. Statement I accurately reflects a key difference between OTC markets
and exchange markets - flexibility in negotiating contract terms in OTC market which isn't
Q.834 Ellen Fraser, FRM, has recently joined Galactic Investment Bank as an investment
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manager. Fraser’s first assignment at her new job is to hedge a client’s portfolio against the
movements in interest rates. Her supervisor instructed her to hedge the portfolio with exposure
in the derivatives market while taking basis risk into considerations. Fraser has the option to
invest in either over-the-counter derivatives or exchange-traded derivatives. Which derivatives
are LEAST likely exposed to basis risk?
Over-the-counter (OTC) derivatives are least likely to be exposed to basis risk. Basis risk arises
due to the differences in the maturities of the contracts that are used for hedging the exposure.
OTC derivatives are customizable and can be negotiated to match the maturities, thereby
reducing basis risk. This is because OTC derivatives are traded directly between two parties,
without going through an exchange or other intermediaries. This allows for a greater degree of
customization in terms of the contract's terms and conditions, including its maturity date.
Therefore, it is possible to tailor an OTC derivative contract to more closely match the specific
characteristics of the exposure that is being hedged, thereby minimizing basis risk.
Choice B is incorrect. Exchange-traded derivatives are standardized contracts and hence, they
may not perfectly match the underlying asset of the hedged item in terms of quantity, quality,
timing or location. This mismatch can lead to basis risk. Therefore, exchange-traded derivatives
Choice C is incorrect. While it's true that both over-the-counter and exchange-traded
derivatives can be exposed to basis risk, the question asks for which type of derivative is least
likely exposed. Over-the-counter derivatives are typically customized contracts which can be
tailored according to the specific needs of the parties involved and thus they have a lower
Choice D is incorrect. It's not accurate that neither over-the-counter nor exchange-traded
derivatives are exposed to basis risk. As explained above, both types can potentially face this
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type of risk but due their characteristics (standardization for exchange traded vs customization
A. OTC derivatives are more flexible as they enable market participants to negotiate the
terms of the agreement.
B. In order to unwind an OTC derivatives transaction, a member must interact with the
original counterparty.
C. OTC derivatives are more efficient as they help reduce the credit risk or the systemic
risk of the transaction.
D. OTC derivatives reduce basis risk, as there are no standardized contracts in OTC
derivatives markets.
The statement that OTC derivatives are more efficient as they help reduce the credit risk or the
systemic risk of the transaction is not true. In fact, it is the exchange-traded derivatives that are
more efficient in reducing credit risk or systemic risk. This is because exchange-traded
derivatives are standardized and backed by a clearing house, which acts as the counterparty to
all trades and guarantees the performance of the contracts. This reduces the risk that a party
will default on its contractual obligations. On the other hand, OTC derivatives are not
standardized and are not backed by a clearing house. Therefore, they carry a higher degree of
counterparty risk, which can contribute to systemic risk in the financial system. Furthermore,
the lack of transparency in the OTC derivatives market can make it difficult to accurately assess
Choice A is incorrect. This statement accurately reflects the nature of OTC derivatives. They
are indeed more flexible as they allow market participants to negotiate the terms of the
Choice B is incorrect. This statement is also true about OTC derivatives. In order to unwind an
OTC derivative transaction, a member typically has to interact with the original counterparty
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because these transactions do not go through an exchange or other intermediary.
Choice D is incorrect. This statement correctly describes one of the potential benefits of OTC
derivatives - they can reduce basis risk because there are no standardized contracts in OTC
Q.836 Guanting Chen is participating in an aptitude test to enter into the summer analyst
program of the Great Britain Investment Bank (GBIB). The aptitude test was divided into three
portions, including business ethics, asset valuation, and derivatives. One of the questions in the
derivatives portion asked to note down four categories of over-the-counter derivatives.
Which of the derivative categories mentioned by Chen is NOT a type of OTC derivative?
C. Credit derivatives
D. Arbitrage derivatives
Arbitrage is a strategy used in trading and investing that seeks to exploit price differences of a
single asset or similar assets in different markets or in different forms. It is not a type of
derivative but a strategy that can be applied across various types of derivatives. The main
categories of OTC derivatives are interest rate derivatives, foreign exchange derivatives, equity
derivatives, commodity derivatives, and credit derivatives. These derivatives are traded over-the-
counter, meaning they are traded directly between two parties without going through an
exchange. Each category of OTC derivatives has its own unique characteristics and risks, and
they are used for a variety of purposes such as hedging, speculation, and arbitrage. Therefore,
the term 'arbitrage derivatives' is a misnomer as it conflates a trading strategy (arbitrage) with a
Choice A is incorrect. Interest rate derivatives are a recognized category of OTC derivatives.
They are contracts whose value is derived from one or more interest rates, financial instruments,
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or indices of interest rates.
Choice B is incorrect. Exchange rate derivatives are also a recognized category of OTC
derivatives. These types of contracts derive their value from the performance of underlying
Choice C is incorrect. Credit derivatives are another recognized category of OTC derivatives.
These financial instruments derive their value from the credit risk on an underlying loan or bond.
Q.837 Which of the following is the accurate difference between the clearing process and the
settlement process of over-the-counter derivatives?
B. The clearing process of OTC derivatives is the process by which payment obligations
between two or more parties are computed and netted, and the settlement is the process
by which the contract obligations are fulfilled.
C. The clearing process of OTC derivatives is the process by which members are required
to post cash and assets against their open positions, and the settlement is the process by
which the contract obligations are fulfilled.
D. The clearing process of OTC derivatives is the process by which payment obligations
between two or more parties are computed and netted, and the settlement is the process
by which the contract cleared through the central clearinghouse.
The clearing process of OTC derivatives is the process by which payment obligations between
two or more parties are computed and netted, and the settlement is the process by which the
contract obligations are fulfilled. Clearing is the first step in the process, where the payment
obligations of each party are calculated and netted against each other. This process involves the
calculation of the net amount that each party owes to the other, taking into account all the
transactions that have taken place between them. Once the net obligations have been
determined, the next step is settlement. Settlement is the process by which these obligations are
fulfilled. This involves the actual exchange of cash or assets between the parties, in accordance
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with the net obligations that were determined during the clearing process. Therefore, the
statement in choice B accurately describes the difference between the clearing and settlement
Choice A is incorrect. The statement has reversed the definitions of clearing and settlement.
Clearing is the process by which payment obligations between two or more parties are computed
Choice C is incorrect. While it's true that members are required to post cash and assets
against their open positions during the clearing process, this statement does not accurately
define what clearing entails in its entirety. Clearing involves computing and netting payment
Choice D is incorrect. This choice incorrectly suggests that settlement only occurs after a
contract has been cleared through a central clearinghouse. In reality, settlement refers to the
fulfillment of contract obligations regardless of whether they have been cleared through a
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Q.838 Margining is a method of creating a layer of security or resources to cover the losses
incurred during the period of a contract. In other words, margining is a process that requires
members to receive and pay cash or other assets against gains and losses in their positions,
which provides coverage against losses in case of default. In which of the following markets is
margining used?
A. Over-the-counter markets.
B. Exchanges.
Margining is used in both over-the-counter (OTC) and exchange markets. In OTC markets, both
parties bilaterally require margin as security against losses. This means that both parties to the
contract agree to set aside a certain amount of money or assets to cover potential losses. This
bilateral agreement provides a layer of security for both parties, reducing the risk of default. On
the other hand, in exchange markets, the margining process is performed by the central
counterparty (CCP). The CCP acts as an intermediary between buyers and sellers, reducing the
risk of default by ensuring that both parties fulfill their contractual obligations. The CCP requires
members to post margin as a form of security, providing coverage against potential losses.
Therefore, margining is a critical risk management practice used in both OTC and exchange
Choice A is incorrect. While it is true that margining is used in over-the-counter markets, this
choice does not fully capture the scope of its application. Margining is also used in exchange
markets to manage risk and provide a layer of security against potential losses.
Choice B is incorrect. Similar to Choice A, this option only partially covers the practice of
margining. It correctly states that margining occurs on exchanges but fails to mention its use in
Choice D is incorrect. This choice contradicts the established fact that margining is a common
practice in both over-the-counter and exchange markets for managing financial risks and
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Q.840 Clearing houses are
A. never used in futures markets but are sometimes used in OTC markets.
Clearing houses are always used in futures markets and sometimes used in OTC markets. A
always used in regulated (exchange) markets to settle trading accounts, clear trades, collect and
maintain margin monies, regulate delivery, and report trading data. Futures contracts are
exclusively traded in organized exchanges, hence the constant use of clearing houses. Although
OTC markets (decentralized markets in which market participants trade stocks, commodities,
currencies, or other instruments directly) traditionally do not involve a clearing house, they are
increasingly embracing the idea of central clearing through central counterparties (CCPs) which
are a type of clearing house. Therefore, clearing houses are sometimes used in OTC markets.
Choice A is incorrect. Clearing houses are always used in futures markets, not never. They act
as the counterparty to both sides of a futures contract - buyer and seller - reducing the risk of
default by either party. However, they are sometimes used in OTC markets, which is correctly
stated.
Choice C is incorrect. While clearing houses are always used in futures markets, they are not
always used in OTC markets. The use of clearing houses in OTC markets depends on various
factors such as the type of financial instrument being traded and the regulatory environment.
Choice D is incorrect. This choice incorrectly states that clearing houses are never used in
futures markets when they actually play a crucial role there by acting as intermediaries between
buyers and sellers to reduce default risk. Also, it's wrong to say that clearing houses are always
used in OTC markets because their usage varies depending on several factors.
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Q.841 Derivative Product Companies or DPCs are typically triple-A rated independently
capitalized entities created by one or more banks as a bankruptcy-remote subsidiary of a major
dealer. The purpose of DPCs is to provide external counterparties with a degree of protection
against counterparty risk by protecting against the default of the parent bank or parent
company. Which of the following is least likely a determinant of DPCs’ triple-A ratings?
A. The ability to mutualise the default loss amongst other counterparties and another
market participant.
B. The support from the parent company and the transferability of the risk to the well-
capitalized firm in case the parent company defaults.
The credit rating of a derivatives product company or DPC does not depend on its ability to
mutualize the loss amongst counterparties and market participants; it is the role of the central
counterparty in exchanges. The ratings of the DPC depend on three functions:
1. The support from the parent company and the transferability of the risk to the well-capitalized
firm in case the parent company defaults
2. The capability of credit risk management, and providing operation guidelines to external
counterparties to control credit quality
3. The ability of the DPC to minimize market risk
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Q.842 Which of the following correctly defines monolines?
A. Monolines are legal entities created to isolate the default risk of the counterparty in a
derivatives transaction, so the firm can receive the full settlement of its other
transactions.
B. Monolines are triple-A rated independently capitalized entities created by one or more
banks as a bankruptcy-remote subsidiary.
C. Monolines are dependent central parties in the derivatives market that act as the
counterparty in every derivative transaction.
D. Monolines are types of insurance companies with strong credit ratings that provide
credit wraps and credit default swaps to achieve diversification and better returns.
Monolines, also known as Credit Derivatives Product Companies (CPDCs), are akin to insurance
companies with strong credit ratings. They provide credit wraps (financial guarantees) and
credit default swaps (CDC) to achieve diversification and better returns. They are structured as
an extension of a Derivative Product Company (DPC) that focuses solely on credit default swaps.
This definition accurately encapsulates the role and function of monolines in the financial
market.
Choice A is incorrect. Monolines are not created to isolate the default risk of the counterparty
in a derivatives transaction. They primarily provide credit enhancement services, such as credit
wraps and credit default swaps, to improve the creditworthiness of debt securities.
Choice B is incorrect. While monolines are often highly rated and may be created by banks,
they are not necessarily bankruptcy-remote subsidiaries. The primary function of monolines is to
Choice C is incorrect. Monolines do not act as central parties in every derivative transaction.
Their role is more specific - they insure financial products against default risk which helps
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Q.843 Which of the following is a method of risk mitigation in over-the-counter markets where a
firm creates a legal entity to transfer its assets and to isolate the firm’s financial risk?
A. Central counterparty
B. Initial Margins
A Special Purpose Vehicle (SPV), also known as a Special Purpose Entity (SPE), is a separate
legal entity created by a firm to isolate itself from financial risk. The firm transfers its assets to
the SPV, thereby protecting itself from the financial risk associated with those assets. In the
context of a derivatives transaction, if a specific counterparty defaults, the firm can still receive
full settlement on its other transactions without having to net the losses on the defaulted
transactions. This is because the assets are held by the SPV, which is legally separate from the
counterparty credit risk between parties to a transaction and provides clearing and settlement
services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are
not separate legal entities created by firms to transfer their assets for risk mitigation.
Choice B is incorrect. Initial Margins are collateral that the holder of a financial instrument
has to deposit with a counterparty (most often their broker or an exchange) to cover some or all
of the credit risk posed by the holder to the counterparty. This does not involve creating a
financial institutions in order to isolate certain types of operational risks associated with
derivatives transactions, but it does not involve transferring assets into this entity as part of its
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Q.3571 Financial intermediaries securitize assets by creating Special Purpose Vehicles (SPVs)
because:
The primary reason for the creation of Special Purpose Vehicles (SPVs) by financial
intermediaries is to safeguard the SPV in the event of the financial intermediary's bankruptcy.
SPVs are separate legal entities created to isolate the financial risk of the parent company. They
are typically used to securitize assets, which means converting assets into securities that can be
sold to investors. In the event of bankruptcy of the financial intermediary, the assets of the SPV
are protected from the creditors of the financial intermediary. This is because the SPV is a
separate legal entity and its assets are not part of the bankruptcy estate of the financial
intermediary. This protection provides a level of security to the investors in the SPV, as their
investments are not directly impacted by the financial health of the intermediary.
Choice A is incorrect. While securitization might increase the overall return in some cases, it is
not the primary reason for establishing SPVs. The main purpose of creating an SPV is to isolate
financial risk.
Choice C is incorrect. As explained above, increasing the overall return isn't the primary
reason for establishing SPVs, hence 'All of the above' cannot be correct.
Choice D is incorrect. Since there exists a valid reason (i.e., protecting the SPV in case of
A. A subsidiary company with an asset/liability structure and legal status that makes its
obligations secure even if the parent company goes bankrupt
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B. A type of asset-backed security that is secured by a mortgage or collection of
mortgages
C. A structured financial product that pools together cash flow-generating assets and
repackages this asset pool into discrete tranches that can be sold to investors
A Special Purpose Vehicle (SPV) is a subsidiary company with a distinct asset/liability structure
and legal status that ensures its obligations remain secure, even if the parent company goes
bankrupt. SPVs are typically used in securitization transactions, allowing companies to isolate or
pool assets, or to allow investors to invest in a specific set of risks. The SPV's assets are typically
held off-balance sheet, which can help to protect them from the parent company's creditors. This
structure also allows the parent company to maintain a cleaner balance sheet, while also
potentially reducing the amount of capital required to be held against the assets. SPVs are often
Choice B is incorrect. While it is true that an SPV can be used to create asset-backed
securities, the definition provided in this choice refers specifically to a mortgage-backed security
(MBS), which is just one type of asset-backed security. An SPV's structure and purpose are not
Choice C is incorrect. This choice describes a Collateralized Debt Obligation (CDO), which is a
type of structured financial product that can indeed be created using an SPV. However, this
definition does not encompass all the possible uses and structures of an SPV.
Choice D is incorrect. This option describes a financial institution such as a bank or credit
union, not an SPV. An SPV does not provide deposit, lending or investment products directly to
individuals or businesses; instead, it serves as a separate legal entity created for specific
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Q.4874 Which of the following is a way in which CCPs handle credit risk?
B. Netting
Netting: This involves offsetting long and short positions against each other. It reduces the
overall exposure of the CCP to credit risk by minimizing the total amount of outstanding
obligations.
Variation Margin and Daily Settlements: Futures contracts are traded on a daily basis up to
the maturity period. A member who is trading with the CCP will have to pay the CCP if the price
of the traded commodity decreases, and vice versa. This ensures that losses (or gains) are
realized and settled on a daily basis, reducing the risk of a large, unmanageable loss at the end
Default Fund Contributions: These are additional funds that members contribute to the CCP.
They are used to cover losses that exceed the initial margin. The equity of a CCP is at risk only
after exhausting the default fund contributions of all members. This provides an additional layer
Choice A is incorrect. While Variation Margin and Daily Settlement are indeed strategies
employed by CCPs to manage credit risk, they are not the only ones. These strategies involve
adjusting the margin requirements based on changes in market prices and settling trades on a
Choice B is incorrect. Netting is another strategy used by CCPs, where they offset positive and
negative positions or streams of payments against each other to reduce the total amount of
outstanding obligations. However, this alone does not encompass all the strategies used by CCPs
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for managing credit risk.
Choice C is incorrect. Default Fund Contributions are also a part of CCP's strategy where each
member contributes to a fund that can be used in case of a member's default. But again, this
does not represent all the methods employed by CCPs for handling credit risk.
Q.4875 In the context of financial markets, Over-the-Counter (OTC) markets and exchanges are
two distinct platforms where securities are traded. Each platform has its unique advantages and
disadvantages. During a Financial Risk Management (FRM) lecture, a candidate lists the
following as advantages of OTC markets over exchanges:
Which of the following statements accurately represent the advantages of OTC markets over
exchanges?
A. III only
B. I & II only
All of the above statements are the advantages of OTC markets over exchanges.
There’s better information flow between a market maker and the customer
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Q.4876 Which of the following factors are likely to affect the initial margin for a futures contract
set by a CCP?
B. The time taken by the exchange to close out a member in case of a default.
All of the above. The initial margin for a futures contract set by a CCP is indeed influenced by
both the volatility of the futures prices and the time taken by the exchange to close out a
member in case of a default. The volatility of futures prices is a significant factor because it
reflects the potential risk associated with the futures contract. Higher volatility implies higher
risk, which would necessitate a higher initial margin to protect against potential losses. On the
other hand, the time taken by the exchange to close out a member in case of a default is also
crucial. If the exchange takes a longer time to close out a defaulting member, the risk of loss
increases. Therefore, a longer time to close out a defaulting member would also require a higher
initial margin. Thus, both these factors play a crucial role in determining the initial margin for a
Choice A is incorrect. While it is true that the volatility of futures prices can influence the
initial margin set by a CCP, this choice does not encompass all the factors that can potentially
Choice B is incorrect. The time taken by an exchange to close out a member in case of default
can indeed impact the initial margin set by a CCP. However, similar to Choice A, this option does
not include all possible influencing factors and hence cannot be deemed as entirely correct.
Choice D is incorrect. This choice suggests that none of the options listed are likely to
influence the initial margin set by a CCP for futures contracts which contradicts with established
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Q.4877 The following are funds available to a CCP to help cover for losses that may arise if a
member default:
Which of the following is the correct order in which the funds are used?
The initial margin is the first line of defense. It is the collateral that the defaulting member has
to provide to the CCP at the time of entering into a contract. If the initial margin is insufficient to
cover the losses, the CCP then uses the default fund contribution made by the defaulting
member. If the losses still exceed these resources, the CCP taps into the default fund
contributions made by other non-defaulting members. Finally, if all these resources are
exhausted, the CCP uses its own equity capital provided by the exchange.
Choice A is incorrect. The default fund contribution made by the defaulting member is not the
first resource that a CCP taps into in case of a member's default. The initial margin posted by the
Choice C is incorrect. Similar to Choice A, this sequence incorrectly places the default fund
contribution made by the defaulting member before the initial margin posted by them.
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Additionally, it also incorrectly places the contributions from non-defaulting members before
Choice D is incorrect. The sequence starts with utilizing funds from non-defaulting members
which isn't accurate as per CCP's loss allocation procedure in case of a member's default. The
resources of non-defaulting members are tapped into only after exhausting other sources such as
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Q.4878 Assume that, before the existence of CCPs, Trader X agreed to buy 10,000 bushels of
wheat for 400 cents per bushel from Trader Y for delivery in June. Three weeks later, Trader X
sold 5,000 bushels of wheat to Trader Z for 420 cents per bushel for delivery in June and another
5,000 bushels to Trader Q for 440 cents per bushel of wheat for delivery in June. What is the
expected profit or loss for Trader X?
Therefore,
Trader X sold:
i. 5,000 bushels of wheat to Trader Z for 420 cents per bushel for delivery in June
ii. 5,000 bushels to Trader Q for 440 cents per bushels of wheat for delivery in June.
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Q.4879 A trader agrees with a broker to enter into a futures contract to sell 4,000 bushels of
wheat for 500 cents per bushel. The initial margin is USD 20,000, and the maintenance margin is
USD 10,000. Which circumstances will lead to withdrawal of USD 400 from the margin account?
So, USD 400 can be withdrawn from the margin account if the price of wheat rises by 10 cents
(510-500) or more.
The trader has a short position. Thus, they will gain if the price of wheat falls and lose if the
price rises. But how much do they lose for each one-cent price increase? That would be 0.01 *
4,000 = $40. Therefore, how far would the price need to rise in order for the trader to lose $400?
Additional explanation:
In the case of a short futures position, the trader sells the futures contract with the expectation
that the price of the underlying asset will decrease. If the price of the asset increases, the value
of the short futures position will decrease, resulting in a loss for the trader. This loss will be
deducted from the margin account, reducing the amount of available margin and potentially
leading to a margin call if the margin account balance falls below the maintenance margin level.
Q.4880 All of the following parties are required to post margin by the Chicago Board Options
Exchange EXCEPT:
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B. A trader with a net short position in a put option.
A trader with a net long position in a call option is not required to post margin by the Chicago
Board Options Exchange (CBOE). This is because when a trader holds a net long position in an
exchange-traded stock option, they have no potential future liability. These positions are often
purchased upfront, and the option may or may not be exercised. Consequently, there is no reason
for the exchange to require margin from a trader who holds a long position in a call option or a
long position in a put option. The trader has already paid the premium for the option, which is
the maximum amount they can lose. Therefore, the exchange does not require any additional
Choice B is incorrect. A trader with a net short position in a put option is required to post
margin according to the rules of the CBOE. This is because when you sell (or "write") a put
option, you are obligated to buy the underlying asset at the strike price if the option holder
decides to exercise their right. This exposes you to potential losses if the price of the underlying
asset falls below the strike price, hence, margin is required as collateral for this risk.
Choice C is incorrect. Similarly, a trader with a net short position in a call option must also
post margin according to CBOE rules. When selling call options, traders are obligated to sell an
underlying asset at an agreed-upon price (the strike price) if called upon by an options holder. If
market prices rise above this level, sellers face potential losses and therefore need to provide
Choice D is incorrect. A trader who shorts stocks also needs to post margin according to CBOE
regulations. Shorting involves borrowing shares and selling them with hopes that they can be
bought back later at lower prices for profit; however, if share prices increase instead of falling as
anticipated by short sellers, they would incur losses and thus need margins as protection against
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Q.4882 1,000 shares are sold by a trader at a price of $45 per share. The initial margin and
maintenance margin are 140% and 115%. What is the initial margin required?
A. $63,000
B. $51,750
C. $45,000
D. $18,000
That is, initially, in addition to the $45,000 obtained from the selling of the shares, the trader is
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Q.5039 You sell one December Brent Crude Oil futures contract when the futures price is $108
per gallon. Each contract is on 1,000 gallons, and the initial margin per contract that you provide
is $6,000. The maintenance margin per contract is $3,000. During the next day, the futures price
rises to $109.5 per gallon. What is the balance of your margin account at the end of the day?
A. $1,500
B. $7,500
C. $4,500
D. $9,000
The price has increased by $1.5. Because you have a short position, you lose 1.5 × 1,000 or
$1,500.
The balance in the margin account, therefore, goes down from $6,000 to $4,500.
However, there is no margin call since the margin account is still above the maintenance margin
level.
Q.5353 An investor is considering buying stock on margin without using a central counterparty
(CCP) to facilitate the transaction. Which of the following factors is the most relevant when
evaluating the risks associated with this investment decision?
The creditworthiness of an investor is the most pertinent factor when buying stock on margin
without the involvement of a CCP. This is because the investor is essentially borrowing money
from a broker to buy the shares. The investor's creditworthiness will determine the interest rate
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they will be charged on the borrowed funds, the amount they can borrow, and the terms of the
margin agreement. Therefore, an investor with a high credit score may be able to borrow more
money at a lower interest rate, while an investor with a low credit score may face higher interest
rates or stricter terms. This can significantly impact the profitability of the investment and the
risk of a margin call, where the broker demands the investor deposit more money or securities
Choice A is incorrect. The stock's historical dividend yield, while important in assessing the
potential return on investment, does not directly relate to the risks associated with purchasing
shares on margin without a central counterparty. It is more relevant when considering the
Choice C is incorrect. The stock's beta coefficient measures its volatility in relation to the
market as a whole and can be useful in assessing market risk. However, it does not address the
specific risks tied to purchasing shares on margin without using a CCP such as counterparty risk
Choice D is incorrect. The stock's price-to-earnings (P/E) ratio can provide insight into whether
a stock may be overvalued or undervalued but it doesn't directly address the risks associated
with buying shares on margin without using a CCP. This metric primarily helps investors evaluate
if they are paying too much for what would essentially be future earnings of that company.
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Q.5354 An investor buys 100 shares of a stock on margin, with an initial margin requirement of
60% and a maintenance margin requirement of 40%. The purchase price is $80 per share. After
a few days, the stock price drops to $50 per share. What is the minimum amount of cash the
investor must deposit to meet a margin call?
A. $200
B. $900
C. $250
D. $1,800
The initial margin requirement is 60%, which means the investor must put up 60% of the
purchase price as initial margin. The purchase price is $80 per share, so the total cost of the
purchase is 100 shares x $80 = $8,000. Therefore, the initial margin required is 60% x $8,000 =
$4,800.
When the stock price drops to $50 per share, the market value of the shares is 100 shares x $50
= $5,000. The current equity in the investment is equal to the market value of the shares minus
The maintenance margin requirement is 40%, which means the investor must maintain equity of
at least 40% of the market value of the shares. The minimum equity required to avoid a margin
Since the current equity is only $1,800, the investor must deposit additional cash to meet the
minimum equity requirement. The minimum amount of cash the investor must deposit is the
difference between the minimum equity requirement and the current equity, which is $2,000 -
$1,800 = $200.
Q.5355 A company is considering using collateralization to mitigate risk associated with an over-
the-counter (OTC) derivatives transaction. Which of the following statements regarding the role
of collateralization in the OTC market is most accurate?
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creditworthiness to ensure performance.
C. Collateralization is used to protect against economic risk, but not counterparty credit
risk, in the OTC market.
Collateralization is used to mitigate counterparty credit risk exposure in the OTC market by
providing security for the performance of a trade. In the OTC market, collateralization is a
common practice to reduce the exposure to counterparty credit risk. Counterparty credit risk is
the risk that the counterparty to a financial contract will not live up to its contractual obligations.
In this context, collateralization involves the use of assets, such as cash or securities, pledged by
one party to a trade to provide security for the performance of the trade. If one party defaults,
the collateral can be used to cover potential losses. This practice can help to improve market
stability and reduce the likelihood of systemic risk. Systemic risk refers to the risk that the
failure of one participant in a financial market can cause a cascading failure of other participants
due to their interlinkages and interdependencies. By using collateralization, firms can protect
themselves against the potential default of their counterparties, thereby reducing their exposure
creditworthiness of counterparties can play a role in ensuring performance, it does not provide
Choice C is incorrect. This statement misrepresents the function of collateralization in the OTC
market. Collateralization serves to mitigate counterparty credit risk, not economic risk.
Economic risks are broader and include factors such as changes in interest rates, exchange
rates, or other macroeconomic conditions which are not directly addressed through
collateralization.
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Choice D is incorrect. The effectiveness of collateralization does not depend on whether a
market is exchange-traded or over-the-counter but rather on how well it's managed and enforced
by parties involved. While transparency issues may pose challenges for valuation and pricing in
OTC markets, these do not inherently make collateralization less effective as a risk mitigation
strategy.
Q.5356 A risk manager at a bank is considering using a Special Purpose Vehicle (SPV) to mitigate
counterparty and credit risk exposure in an over-the-counter (OTC) derivatives transaction.
Which of the following statements regarding the use of an SPV is correct?
B. The use of an SPV eliminates all counterparty and credit risk exposure in OTC
derivatives transactions.
C. The default of one party will not cause the SPV to default.
D. When using an SPV, assets are transferred to the SPV in exchange for shares of the
company.
SPVs are designed to be bankruptcy remote, which means that the default of one party will not
cause the SPV to default. This feature helps to mitigate counterparty and credit risk exposure in
OTC derivatives transactions, as it helps to protect the assets held by the SPV in the event of a
default.
A is incorrect. An SPV is not a type of bank. It is a non-bank financial institution that is typically
B is incorrect. The use of an SPV does not eliminate all counterparty and credit risk exposure in
OTC derivatives transactions. While it can help to mitigate this risk, there is still the potential for
D is incorrect. When using an SPV, assets are transferred to the SPV in exchange for cash, not
shares of the company. This provides the transferring party with cash liquidity while also
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Q.5357 An investor purchases $20,000 worth of stock using a margin account with an initial
margin requirement of 50% and a maintenance margin requirement of 25%. What is the
minimum amount that the investor must deposit into the margin account to meet the
maintenance margin requirement if the stock's value falls to $11,100?
A. $1.400
B. $1,675
C. $1,100
D. $7,500
The initial margin is 50%, so the broker-dealer will lend the investor $10,000, and the investor
must put up $10,000 of their own money. The maintenance margin is 25%, so the minimum value
If the stock's value falls to $11,100, the amount of equity in the account is $1,100 ($11,100 value
The margin as a percentage of the current value of the stock is 9.99% ($1100 / $11,100).
Since this is less than the 25% maintenance margin requirement, there is a margin call to bring
the margin balance up to 25% of the value of the shares, which is $1,675 ($11,100 x 25% -
$1,100).
Therefore, the investor must add $1,675 to the margin account to meet the maintenance margin
requirement. If this is not provided, the broker may sell some or all of the securities without
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Reading 32: Central Clearing
Q.844 Frank Oliver is the head of the derivatives trading unit of an investment company. Apart
from looking after derivative investments, his job description also includes the supervision of a
dozen derivatives traders. In a post-market review session, Oliver made the following points
regarding the cycle of a derivatives trade:
I. The first stage is the execution, in which parties agree to the legal obligation of buying or
selling the underlying against a cash flow determined by a variable
II. The second stage is the clearing stage, where the underlying securities and cash is exchanged
III. The third stage is the settlement, where the margins are maintained trade is settled, and the
obligation of the contract is fulfilled
A. He is only correct regarding the first stage of the derivatives trade cycle.
B. He is only correct regarding the second stage of the derivatives trade cycle.
C. He is only correct regarding the third stage of the derivatives trade cycle.
Frank Oliver is only correct regarding the first stage of the derivatives trade cycle. The execution
stage, as he described, is indeed where parties agree to the legal obligation of buying or selling
the underlying against a cash flow determined by a variable. This is the stage where the overall
parameters of trading activities are established through a bilateral master agreement. This
agreement is a document that sets out standard terms that apply to all the transactions entered
into between parties. At this stage, the derivatives desk also conducts credit reviews to establish
credit lines and trading limits. Therefore, Oliver's description of the execution stage is accurate.
Choice B is incorrect. Oliver's description of the clearing stage is not accurate. The clearing
stage in a derivatives trade cycle involves the process of updating the accounts of the parties
involved in a transaction, not exchanging underlying securities and cash. This step ensures that
both parties have sufficient funds to meet their obligations and mitigates credit risk.
Settlement refers to the actual exchange of money and securities between buyer and seller, not
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Choice D is incorrect. As explained above, Oliver's descriptions for both clearing and
settlement stages are inaccurate; therefore, he cannot be correct regarding all stages of the
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Q.845 Unlike traditional investments where the transaction takes place in two stages, derivatives
transactions are carried out in multiple stages. In which of the following stages of a derivatives
trade is the central counterparty most likely involved?
A. Execution stage
B. Clearing stage
C. Settlement stage
The clearing stage of a derivatives transaction is where the central counterparty (CCP) comes
into play. The CCP acts as an intermediary between the buyer and seller, reducing the risk of
default by either party. During the clearing process, the CCP calculates and collects margin from
both parties to cover potential future exposure. This process is known as margining. Additionally,
the CCP also performs netting, which involves offsetting the total amount of buy orders against
the total amount of sell orders, thereby reducing the overall number of transactions and the
associated transaction costs. The involvement of the CCP in the clearing stage ensures the
Choice A is incorrect. The execution stage of a derivatives transaction typically involves the
buyer and seller agreeing on the terms of the contract, such as price, quantity, and maturity
date. This stage does not usually involve a central counterparty as it primarily focuses on
Choice C is incorrect. The settlement stage refers to the actual exchange of payment and
delivery of the underlying asset in accordance with the terms agreed upon during execution.
While this process may involve various intermediaries for facilitating payment or delivery, it does
by reducing counterparty risk and providing transparency. Therefore, there will be at least one
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Q.846 Isabell Engler is a finance journalist who is currently working on a research paper focused
on the difference between the goals of central counterparties in over-the-counter markets and in
exchanges. She made the following statements in this regard:
I. One main goal of the central counterparty (CCP) is to standardize and enhance the operational
process
II. On the other hand, another goal of the central counterparty (CCP) in over-the-counter
markets is to mitigate counterparty risk and maintain liquidity
Both statements made by Isabell Engler are indeed accurate. Central counterparties (CCPs) play
different roles in exchanges and over-the-counter (OTC) markets due to the inherent
In exchanges, transactions are standardized, meaning that the terms of the contracts (such as
maturity and the grade of the underlying asset) are uniform across the board. This
standardization allows for a more streamlined operational process, which is where the CCP
comes in. The CCP's main goal in this context is to further standardize and enhance this
operational process, making transactions smoother and more efficient. This is what Statement I
refers to.
On the other hand, OTC markets are characterized by long-dated, customized, and illiquid
contracts. These features make OTC markets more susceptible to counterparty risk (the risk that
a party to a contract will not live up to their contractual obligations) and liquidity risk (the risk
that a party will not be able to exit a position without incurring significant losses). Therefore, in
OTC markets, the CCP's main goal is to mitigate these risks and maintain liquidity, as stated in
Statement II.
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Therefore, both statements accurately reflect the goals of CCPs in exchanges and OTC markets,
respectively.
Choice A is incorrect. This choice suggests that only Statement I is correct, which is not the
case. While it's true that one of the objectives of a central counterparty (CCP) is to standardize
and improve operational processes, this isn't its primary objective. The main goal of a CCP in
both over-the-counter markets and exchanges is to reduce counterparty risk and ensure liquidity.
Choice B is incorrect. This option implies that only Statement II is accurate, which isn't true
either. Although reducing counterparty risk and ensuring liquidity are indeed key objectives for
CCPs in over-the-counter markets, they also aim to standardize and improve operational
Choice D is incorrect. As explained above, both statements are correct hence this choice
Q.847 The introduction of central counterparties (CCP) changed the way the market participants
are interrelated in the financial system by making itself the center point in the transactions.
Determine the two accurate benefits of CCPs in relation to the topology of financial markets.
participants and increased transparency in the financial markets. By acting as the central point
in transactions, CCPs have reduced the direct links between market participants, thereby
decrease in systemic risk, as the failure of one participant is less likely to have a domino effect
on others.
Furthermore, CCPs have increased transparency in the financial markets. They maintain
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comprehensive records of transactions, including the notional amounts and the identities of
counterparties. This increased transparency allows for better risk management, as market
for transactions, they do not inherently decrease risk. In fact, they can potentially concentrate
the market by providing a centralized platform for transactions and information flow, this choice
does not fully capture the key advantages of CCPs. The increased interconnectedness can also
Choice D is incorrect. This choice suggests that none of the given options correctly identify the
key advantages brought by CCPs to financial markets, which contradicts with option C being
correct.
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Q.849 Margins are usually of two types – initial margins and variation margins. Both required
margins are calculated based on different variables. Which of the following is the determinant of
the initial margin?
Initial margins are primarily designed to cover the potential future exposure of a transaction
over a specified period of time. The main determinant of the initial margin is, therefore risk of
the transaction. In other words, initial margins serve as a financial buffer in the derivatives and
securities trading world. Their primary purpose is to safeguard against potential adverse price
movements that could occur over a certain time frame. In essence, they act as a form of security
deposit that is taken to ensure that parties to the transaction can meet their obligations.
Q.851 Infrastructure Bank of Congo has a long exposure of $350 million in a derivatives contract
on the Frankfurt futures exchange. Since elections recently took place in Congo and the newly
elected government canceled the projects of its predecessor, the nation’s bank is likely to default
on its obligations. Which of the following is the first alternative a central counterparty (CCP) will
apply after default?
D. Loss mutualizing.
In the event of a default, the Central Counterparty (CCP) steps in to ensure the obligations of the
contract are met. This is achieved not by the CCP directly paying the losses on behalf of the
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defaulter, but by replacing the defaulting counterparty of the contract with a new counterparty
through an auction process. This is the first step taken by the CCP to manage the default
situation. The auction process allows the CCP to transfer the risk to another party willing to take
on the contract, thereby ensuring the continuity of the contract and minimizing the impact of the
default.
Choice A is incorrect. Increasing the variation margin is not the initial step taken by a central
counterparty (CCP) to manage a default situation. Variation margin refers to payments made or
received due to changes in the price of the underlying asset, and it's typically adjusted daily.
However, in case of an expected default, simply increasing this margin would not be sufficient as
Choice C is incorrect. Requiring additional initial margin may help mitigate future risks but it's
not an immediate action taken by CCPs when a party defaults on its obligations. The initial
margin serves as collateral to cover potential future exposure arising from price changes, but
once a default has occurred, requiring more upfront collateral won't rectify the current situation.
Choice D is incorrect. Loss mutualizing involves spreading out losses among all members of
CCP which can be considered as one way to manage defaults but it's usually seen as a last resort
Q.852 The central counterparty (CCP) is the center point in the exchanges. It is the counterparty
of all the parties or members having exposure in the exchange. Suppose that one of the members
is unable to fulfill its obligation and defaults. The CCP will terminate all financial contracts and
relations with the defaulting party. The CCP has to manage ways to go about such defaults.
Which of the following has the least adverse consequences on the other members if a member
defaults?
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The strategy of replacing the defaulting member through an auction process is the most effective
way to minimize the adverse impact on other members. In this scenario, the CCP immediately
terminates all financial contracts with the defaulting member, thereby preventing any further
losses. The positions of the defaulting member are then auctioned off to other members, usually
by sub-portfolio, such as interest rate swaps. This allows other members to take over the
positions of the defaulting member, often at favorable terms. This strategy is generally well-
received by other members, as it allows them to potentially profit from the default without
incurring any negative consequences. Furthermore, it ensures that the losses from the default
are not distributed among all members through loss mutualization, which would have a more
Choice A is incorrect. Letting the defaulting member absorb the losses may not be feasible if
the member is insolvent or lacks sufficient assets to cover the losses. This could potentially lead
to a domino effect, where other members are affected by the default, thereby increasing
systemic risk.
Choice B is incorrect. If CCP pays for all losses, it might deplete its own resources and
Choice D is incorrect. Loss mutualisation involves spreading out a loss among all members of
CCP which can negatively impact even those members who were not directly involved with the
defaulting party. This can create moral hazard issues and discourage prudent risk management
Q.854 Mitigating the counterparty risk is essential to maintain liquidity and reduce systematic
risk in the financial system. As an insurance against the counterparty default, all the central
counterparty (CCP) members contribute specific resources to a pool that is used if the resources
of the defaulting counterparty are insufficient to pay off the losses. In which of the following
processes do members contribute to this type of insurance to absorb the adverse consequences
of a defaulting counterparty?
A. Novation
B. Auction
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C. Loss mutualization
D. Multilateral netting
Loss mutualization is the process where all the central counterparty (CCP) members contribute a
specific amount of resources to a pool. This pool is then used to absorb the losses if the
resources included in the initial margin, variation margin, and default fund contribution of the
defaulting counterparty are insufficient to pay off the losses. This process is a form of insurance
against the default of a counterparty and is essential in maintaining liquidity and reducing
systematic risk in the financial system. It ensures that the losses from a defaulting counterparty
are shared among all members, thereby reducing the impact on any single member and the
system as a whole.
Choice A is incorrect. Novation is a process in which the central counterparty (CCP) becomes
the buyer for every seller and the seller for every buyer, thereby eliminating counterparty risk.
However, it does not involve CCP members contributing to a pool of resources to cover losses
Choice B is incorrect. An auction is a method used by CCPs to sell off the positions of a
defaulting member to other non-defaulting members. While this can help mitigate losses, it does
due between more than two parties, reducing overall exposure and potentially mitigating some
risk. However, it does not refer to the process where CCP members contribute to an insurance
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Q.855 Which of the following is NOT a criterion for a contract/product that can be cleared in
exchanges through CCPs?
A. More standardized
B. Less complex
C. More liquid
D. More creditworthy
contract or product that can be cleared in exchanges through CCPs. The role of a Central
Counterparty (CCP) is to mitigate counterparty risk. This means that the CCP steps in between
the buyer and seller in a transaction, effectively becoming the buyer to every seller and the seller
to every buyer. This process reduces the risk that one party will default on their obligations.
Therefore, the creditworthiness of the contract or product is not a determining factor for
clearing through CCPs, as the CCP itself is designed to manage this risk.
clearing through CCPs. Standardized contracts have uniform terms and conditions, which makes
Choice B is incorrect. Less complex contracts or products are preferred for clearing through
CCPs as they are easier to understand, value, and manage risk-wise. Complexity can introduce
Choice C is incorrect. Liquidity of the contract or product also plays a crucial role in
determining its eligibility for clearing through CCPs. More liquid contracts/products are easier to
buy/sell without causing significant price changes, making them more suitable for exchange
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Q.856 Angela Oliver has recently joined a fast-growing brokerage house based in New York,
which is also a member of a central counterparty (CCP). Which of the following is not a criterion
for becoming a CCP member?
The novation process is not a criterion for becoming a member of a CCP. Novation is a legal
concept that involves replacing one party in a contract with another, or substituting one debt or
obligation with another. This process requires the consent of all parties involved and effectively
cancels the original contract, replacing it with a new one. However, this process is conducted by
the CCP itself, not its members. Therefore, a firm does not need to be able to conduct the
novation process to become a member of a CCP. This is a common misconception, and it's
important to understand the distinct roles and responsibilities of CCPs and their members. While
CCP members do have significant responsibilities, conducting the novation process is not one of
them.
Choice A is incorrect. The admission criteria such as ratings are indeed a prerequisite for a
firm to become a member of a CCP. These criteria ensure that the firm has the financial stability
Choice B is incorrect. Financial commitment through contribution to the default fund is also
necessary for membership in a CCP. This requirement ensures that all members share in the risk
essential criterion for becoming a member of a CCP. Margins act as collateral and provide
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Q.857 Adam Eger, an equity analyst, is one of the members of a panel of guests invited to discuss
the subject of the efficiency of exchange markets. While the panel supports the argument that
there should be a single global central counterparty that can increase standardization globally
and reduce counterparty risk, Eger is opposed to it. He believes that there should be more than
one central counterparty due to the following factors:
I. Geographical markets intend to have their own 'local' CCPs to clear the transactions of
regional financial institutions denominated in their local currency.
II. Regional CCPs specialize in certain products like credit default swaps, FRAs, etc. One single
CCP is not sufficient to specialize in every clearable product.
Which of the above mentioned is/are likely to support the argument of multiple CCPs?
Both factors I and II support the argument for multiple CCPs. The first factor highlights the
importance of local CCPs in clearing transactions of regional financial institutions in their local
currency. This is crucial because different regions have different currencies, and transactions
need to be cleared in the currency in which they are denominated. Having a local CCP ensures
that this process is efficient and effective. The second factor emphasizes the specialization of
regional CCPs in certain products. Financial products are diverse and complex, and it is
challenging for a single entity to specialize in all of them. Regional CCPs, by focusing on specific
products, can provide more efficient and effective clearing services. Therefore, both factors
support the argument for multiple CCPs, making choice C the correct answer.
Choice A is incorrect. While it is true that geographical markets tend to have their own 'local'
CCPs to clear transactions of regional financial institutions denominated in their local currency,
this is not the only factor supporting the argument for multiple CCPs. Factor II also supports this
argument as regional CCPs specialize in certain products like credit default swaps, FRAs, etc.,
and a single global central counterparty may not be sufficient to specialize in every clearable
product.
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Choice B is incorrect. Although Factor II does support the argument for multiple CCPs due to
specialization in certain products, it's not the sole reason. Factor I also contributes by
highlighting that geographical markets prefer having their own 'local' CCPs for clearing
Choice D is incorrect. Both factors I and II support the argument of having multiple central
counterparties (CCPs). Therefore, stating that none of these factors support the argument would
be inaccurate.
Q.858 Lindy Sago is a project manager at Toronto Fast Brokers Inc. The firm acts as a non-
clearing member in the derivatives exchange market it trades in, but the firm’s management
recently decided to become a clearing member of the exchange. The firm has assigned Sago the
task to evaluate the revenue model of the central counterparty (CCP). Which of the following is
the appropriate combination of a CCP’s revenue?
Central Counterparties (CCPs) play a crucial role in the financial markets by reducing
counterparty risk and ensuring the smooth functioning of transactions. They act as
intermediaries between buyers and sellers in a derivatives exchange, assuming the counterparty
risk involved in the transactions. To support their operations and manage the risks, CCPs have
two primary sources of revenue. The first is the fees they charge for clearing trades. These fees
are levied on each trade cleared by the CCP and are a significant source of income. The second
source of revenue is the interest earned on the margins posted by the members. These margins
are essentially collateral that members are required to deposit with the CCP to cover potential
losses in case of a default. The CCP invests these margins in low-risk, liquid assets and earns
interest on them. Therefore, the correct combination of a CCP's revenue is the fees on clearing
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Choice A is incorrect. Trading spreads are not a revenue stream for a central counterparty
(CCP). CCPs do not participate in trading activities, hence they do not earn from trading spreads.
Their primary role is to facilitate trades between parties and manage risk, not to trade
themselves.
Choice B is incorrect. Similar to choice A, trading spreads are not a source of revenue for
CCPs as they are not involved in the actual trading process. While interest on margins can be a
source of income for CCPs, it cannot be paired with trading spreads as a correct combination of
Choice D is incorrect. Although initial margins are collected by the CCP from its members as
part of its risk management process, these funds serve as collateral and aren't considered direct
sources of revenue for the CCP. The main sources of income would be fees charged on clearing
Q.859 Susanne Lange is an investment manager at London Wharf Bank. The firm acts as a non-
clearing member in the derivatives exchange market it trades in, but recently the firm has
decided to become a clearing member of the exchange. To brief the team about the new direction
of the firm, Lange has prepared the following general points related to CCPs:
I. The central counterparty does not make counterparty risk disappear, rather it centralize risk
and converts counterparty risk into different forms of financial risk
II. Unlike other financial institutions, the central counterparty cannot fail
III. The margining activity of the central counterparty decreases risk, but in some cases, it can
also increase risk
Points I and III are accurate descriptions of the role and function of Central Counterparties
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(CCPs) in the derivatives exchange market.
Point I: This point correctly states that CCPs do not eliminate counterparty risk but centralize it.
In other words, CCPs act as the counterparty to every party in a transaction, thereby centralizing
the risk. This centralization of risk does not make it disappear; instead, it transforms it into
various forms of financial risk. This transformation is a key function of CCPs and is crucial in
Point III: This point is also correct. The margining activity of CCPs does indeed reduce risk by
ensuring that parties have sufficient collateral to cover potential losses. However, in certain
circumstances, this activity can also increase risk. For example, if the margin requirements are
increased, it can absorb the liquidity of a party, potentially leading to increased counterparty risk
or even default risk. This point highlights the delicate balance that CCPs must maintain in their
Choice A is incorrect because it includes Point II, which is not a correct statement about
Central Counterparties (CCPs). While Point I is correct, as explained above, Point II is incorrect
because it states that unlike other financial institutions, CCPs cannot fail. This is not true. Like
any other financial institution, CCPs can also fail. The failure of a CCP could have significant
implications for the financial markets, as they play a crucial role in managing and mitigating
risk. Therefore, it is important to understand that while CCPs are designed to manage risk, they
Choice B is incorrect because it includes Point II, which is an incorrect statement about
Central Counterparties (CCPs). While Point III is correct, as explained above, Point II is incorrect
because it states that unlike other financial institutions, CCPs cannot fail. This is not true. Like
any other financial institution, CCPs can also fail. The failure of a CCP could have significant
implications for the financial markets, as they play a crucial role in managing and mitigating
risk. Therefore, it is important to understand that while CCPs are designed to manage risk, they
Choice D is incorrect because it includes all three points, including Point II, which is an
incorrect statement about Central Counterparties (CCPs). While Points I and III are correct, as
explained above, Point II is incorrect because it states that unlike other financial institutions,
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CCPs cannot fail. This is not true. Like any other financial institution, CCPs can also fail. The
failure of a CCP could have significant implications for the financial markets, as they play a
Q.860 A number of differences exist between CCPs and OTC CCPs. Which of the following is not
an appropriate similarity between OTC CCP markets and CCP markets?
The statement that both types of markets face equal counterparty credit risk is incorrect.
Counterparty credit risk refers to the risk that a counterparty in a financial transaction will
default on their contractual obligations. CCP markets are specifically designed to mitigate and
reduce this risk. They do this through a variety of mechanisms, including the use of a central
counterparty, which acts as the buyer to every seller and the seller to every buyer, thereby
eliminating the risk of default by any single party. In contrast, OTC CCP markets, while they also
use a central counterparty, are generally considered to be riskier. This is because OTC
transactions are typically less standardized and more complex than those in CCP markets,
making them more difficult to value and risk-manage. Furthermore, OTC markets are less
transparent and have less stringent regulatory oversight than CCP markets, which can increase
the risk of counterparty default. Therefore, it is not accurate to say that both types of markets
Choice A is incorrect. Both OTC CCP markets and CCP markets do require default fund
contributions. This is a common mechanism used in both types of markets to manage the risk of
a participant's default.
Choice B is incorrect. Posting of initial and variation margins are indeed common practices in
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both OTC CCP and CCP markets. These margins serve as collateral to cover potential future
Choice C is incorrect. While it's true that transactions are more standardized in CCP markets,
they can also be standardized in OTC CCP markets depending on the specific product or contract
being traded.
Q.861 Mohan Singh is an investment manager at Platonic Investments that has been investing in
OTC derivatives for the past 10 years. This year, the manager has proposed to buy contracts into
central counterparty (CCP) cleared markets as they tend to be more efficient. If Singh included
the following advantages of central counterparty (CCP) cleared markets in his proposal, identify
which of the following advantages he incorrectly presented in his proposal.
A. The centralized position of the CCP enables it to understand the positions and
exposures of its market participants, which increases the transparency in the market.
B. The CCP’s functions like margining, netting, and settlement potentially increases
operational efficiency and reduces costs.
C. The central auction feature of CCP may transform the large default of a clearing
member into smaller price disruptions through coordinated replacement of positions
during a crisis.
D. The function of frequently requiring greater margin requirements under a CCP may
increase the procyclicality in the economy.
The assertion that frequently requiring greater margin requirements under a CCP may increase
the procyclicality in the economy is incorrect. This is not an advantage but a disadvantage.
Procyclicality refers to the tendency of financial indicators to amplify the cyclical movements of
the macroeconomic system. In the context of CCPs, greater margin requirements during periods
of economic downturn can exacerbate the financial strain on market participants. This can lead
to a vicious cycle where financial distress leads to increased margin requirements, which in turn
leads to further financial distress. Therefore, this aspect of CCPs can potentially increase the
Choice A is incorrect. The centralized position of the CCP does indeed enable it to understand
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the positions and exposures of its market participants, which increases transparency in the
market. This is because a CCP acts as an intermediary between buyers and sellers, thereby
Choice B is incorrect. The functions like margining, netting, and settlement performed by a
CCP do increase operational efficiency and reduce costs. Margining ensures that parties have
sufficient collateral to cover potential losses; netting reduces the number of transactions by
offsetting opposing positions; and settlement simplifies the process of transferring assets
between parties.
Choice C is incorrect. The central auction feature of a CCP can indeed transform large defaults
into smaller price disruptions during a crisis through coordinated replacement of positions. This
mechanism allows for an orderly liquidation or transfer of positions in case a clearing member
defaults.
Q.862 Which of the following is NOT a disadvantage of central counterparty (CCP) cleared
markets?
A. Moral hazard has a serious effect on the counterparty risk management practices of
the market participant as they believe that, in the presence of the CCP, they do not have
to take risk into consideration.
B. The function of frequently requiring greater margin requirements under a CCP may
increase the procyclicality in the economy.
C. When the losses of the defaulting counterparties exceed the financial commitments
from the defaulter, then these losses are distributed throughout the CCP members.
D. The central counterparty is vulnerable to adverse selection, which means that since
the members trading OTC derivatives know more about the risks than the CCP itself, the
members may intentionally pass the toxic contracts or assets to the CCP.
The statement refers to the concept of loss mutualization, which is actually an advantage of CCP
cleared markets, not a disadvantage. Loss mutualization is a process where the losses of a
defaulting counterparty, which exceed the financial commitments from the defaulter, are
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distributed among the CCP members. This mechanism is designed to protect the financial system
from the domino effect that could occur if one party defaults on its obligations. By spreading the
losses among all members, the CCP ensures that no single member bears the full brunt of the
default, thereby reducing the overall risk in the market. This is a key feature of CCPs and is one
Choice A is incorrect. Moral hazard indeed poses a significant risk in CCP cleared markets.
Market participants may become complacent about their counterparty risk management
practices, believing that the presence of the CCP eliminates the need for them to consider risk.
Choice B is incorrect. The function of frequently requiring greater margin requirements under
a CCP can indeed increase procyclicality in the economy. During periods of economic downturn,
when market participants are already facing financial stress, higher margin requirements can
members trading OTC derivatives often have more information about the risks than the CCP
itself does. This information asymmetry could lead members to intentionally pass on toxic
Q.863 Ben Owen is a final-year student in a post-graduate program in the field of investing and
hedging at the University of Zurich. Owen is writing a thesis on the subject of the risk-mitigating
abilities of central counterparties. After reading a great amount of literature on the subject, he
has concluded that the properties of CCPs are as follows:
I. The counterparty risk does not disappear from the system but is transferred from one party to
the CPPs
II. CCPs are also vulnerable to failure
III. When CCPs increase the initial margin requirements in adverse economic times, the liquidity
of financial institutions with liquidity shortages is likely to worsen.
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D. Properties I, II, and III are correct.
All three properties identified by Ben Owen in his analysis of central counterparties (CCPs) are
accurate. The first property states that the counterparty risk is not eliminated from the system
but is transferred from one party to the CCPs. This is a fundamental aspect of how CCPs operate.
They act as intermediaries between parties in a transaction, assuming the counterparty risk.
However, this does not mean that the risk is eliminated from the system. Instead, it is transferred
to the CCPs.
The second property identified by Owen is that CCPs are susceptible to failure. This is also
correct. Like any other financial institution, CCPs face various risks, including operational,
credit, and liquidity risks, which can lead to their failure. There have been instances in the past
where CCPs have failed, and governments have had to intervene to bail them out.
The third property states that in times of economic adversity, when CCPs increase the initial
margin requirements, the liquidity of financial institutions already facing liquidity shortages is
likely to deteriorate further. This is because, during such times, CCPs need to ensure that they
have sufficient liquidity to meet their obligations. Therefore, they may increase the initial margin
requirements and default fund contributions. However, this can exacerbate the liquidity
Choice A is incorrect. While it is true that the counterparty risk is not eliminated but
transferred from one party to the CCPs (Property I) and that CCPs, like other financial
institutions, are susceptible to failure (Property II), this choice omits Property III. In times of
economic adversity, when CCPs increase the initial margin requirements, the liquidity of
financial institutions already facing liquidity shortages is likely to deteriorate further. This
Choice B is incorrect. Although it correctly identifies that CCPs can fail (Property II) and that
increasing initial margin requirements during economic adversity can exacerbate liquidity issues
for financial institutions (Property III), this choice fails to acknowledge Property I: The
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counterparty risk does not disappear; instead, it shifts from one party to the CCPs.
Choice C is incorrect. While it accurately includes Properties I and III - counterparty risk
transfer and potential exacerbation of liquidity issues during economic downturns respectively -
it neglectfully excludes Property II which states that like any other financial institution, a central
Q.864 Tara Denis is the spokesperson for a central counterparty in one of the largest operating
futures markets in Japan. During a Q&A session, one of the members of the public commented
that the presence of CCPs in exchanges and OTC markets is creating a moral hazard. Which of
the following is the most appropriate reference of the moral hazard pointed out by the member
of the public?
A. It is the moral hazard related to the standardization of products by the CCP. As the
CCP standardizes all the products, the market participants use more and more
alternative products that do not capture the true motive of the hedge.
C. It is the moral hazard related to the reduction in counterparty risk. Since the CCP
assumes all the counterparty risk, it becomes cheaper for parties to enter into the
contracts, which is unnecessary for them.
D. It is a moral hazard related to the creation of liquidity. As the CCP creates and
maintains liquidity in financial markets through margining, more and more participants
enter the market with the intention of speculating.
The moral hazard referred to by the member of the public is associated with the
very nature, acts as the counterparty to every transaction. This means that the parties involved
in the transaction have less incentive to invest resources in monitoring the credit quality of other
parties. This is because the CCP assumes most of the counterparty risk. This can lead to a moral
hazard as parties may engage in riskier behavior, knowing that the CCP will bear the brunt of
any potential losses. This can potentially lead to systemic risk if many parties engage in such
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behavior and the CCP is unable to cover the losses.
Choice A is incorrect. The standardization of products by the CCP does not necessarily lead to
moral hazard. While it's true that standardization can lead to market participants using
alternative products, this doesn't inherently create a moral hazard situation. Moral hazard refers
to the risk that one party has an incentive to take on excessive risk because they believe another
party will bear the cost of that risk. In this case, there's no indication that CCP's product
standardization leads parties to take on excessive risks believing that others will bear those
costs.
Choice C is incorrect. While it's true that CCPs reduce counterparty risk, which could
potentially make it cheaper for parties to enter into contracts, this doesn't necessarily constitute
a moral hazard. The reduction in counterparty risk is one of the main functions and benefits of a
CCP and does not inherently incentivize reckless behavior or excessive risk-taking.
Choice D is incorrect. The creation and maintenance of liquidity in financial markets by the
CCP through margining does not directly foster a moral hazard situation either. Although more
participants might enter the market with speculative intentions due to increased liquidity, this
isn't directly linked with them taking on undue risks believing someone else will bear those
costs.
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Q.865 For a CCP to clear a product, some conditions MUST be satisfied. Which of the following is
not one of those conditions?
A. The legal and economic terms of the product must be standard within the market.
B. There should be extensive historical data on the product price should be available
The statement that the product needs to be passively traded is incorrect. For a CCP to clear a
product, it must be actively traded. The reason for this is twofold. Firstly, if a product is not
actively traded, it may be challenging for the CCP to unwind a member's position if the member
fails to produce margin when required. This is because the lack of active trading can make it
difficult to find a buyer or seller for the product at a fair price. Secondly, it may also be difficult
to obtain up-to-date valuations for non-actively traded products. This is because the price of a
product is determined by the market, and if there is little trading activity, the market price may
not accurately reflect the true value of the product. Furthermore, CCPs will not consider it
worthwhile to develop the systems to support the clearing of a product if their members do not
trade it frequently. Therefore, the condition that a product needs to be passively traded is not a
Choice A is incorrect. The legal and economic terms of the product must indeed be standard
within the market. This ensures that all parties involved in a transaction have a clear
understanding of the product's characteristics and risks, which is crucial for maintaining market
integrity.
Choice B is incorrect. Extensive historical data on the product price should be available. This
data allows CCPs to assess potential risks associated with clearing a particular product,
Choice C is incorrect. There needs to be generally accepted models for valuing products.
These models help in determining the fair value of a financial instrument, which is essential for
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Q.866 The main goal of the central counterparty (CCP) is to reduce the counterparty risk or
default risk by acting as a central counterparty to every buyer and seller. However, apart from
the risk related to the default of the clearing member, this centralization creates other risks.
Which of the following risks is NOT likely a risk that the CCP faces?
B. Failed auction.
C. Resignation of employees.
D. Reputational risk.
The resignation of employees is not a risk that the CCP faces. The CCP's primary concern is the
risk associated with the clearing members, not its employees. The clearing members are the
ones who participate in the transactions that the CCP oversees. Therefore, their resignation or
default could have a significant impact on the CCP's operations and the overall market. However,
the resignation of employees, while it could affect the CCP's internal operations, does not pose a
direct risk to the CCP's role in the market or its ability to manage counterparty risk. Therefore, it
Choice A is incorrect. Distress of other clearing members is indeed a risk that a CCP may
encounter. If one or more clearing members become distressed, it could potentially disrupt the
Choice B is incorrect. Failed auctions are also a risk for CCPs. In case of a member's default, if
an auction (a process where the defaulter's positions are sold) fails, it can lead to significant
Choice D is incorrect. Reputational risk is another potential risk for CCPs. Any operational
failures or issues in managing counterparty risks can damage their reputation and trust among
market participants.
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Q.868 Edward Trott is a renowned anchor at a local business news channel. During a panel
discussion in an evening news bulletin, he mentioned that central counterparties (CCPs)
themselves are vulnerable to risks. One of the major risks faced by CCPs arises if the CCP does
not receive reasonable economic bids for the contracts defaulted by clearing members. It then
has to impose the significant losses of that member on another clearing member via loss
allocation methods, which may result in financial distress and potential further defaults. Which
of the following risks is the anchor referring to?
B. Failed auction.
D. Reputational risk.
The risk that Edward Trott is referring to is known as the 'failed auction' risk. This risk arises
when a central counterparty (CCP) does not receive reasonable economic bids for the contracts
that have been defaulted by clearing members. In such a situation, the CCP is forced to impose
the significant losses of the defaulting member on another clearing member through loss
allocation methods. This can lead to financial distress and potentially trigger further defaults.
The term 'failed auction' is used to describe this scenario because the CCP's attempt to auction
off the defaulted contracts has failed to attract reasonable bids. This risk is a significant concern
for CCPs as it can potentially destabilize the entire clearing system and lead to a chain reaction
of defaults.
Choice A is incorrect. While the distress of other clearing members can be a consequence of
the risk Mr. Trott is referring to, it is not the specific risk itself. The question asks for the specific
risk but it's not the direct risk being referred to in this context. The specific risk that Mr.Trott
refers to directly causes financial distress and potential defaults, which may lead some members
Choice D is incorrect. Reputational Risk might occur due to poor management or operational
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failures within CCPs but it does not directly relate with failure in receiving reasonable economic
bids for contracts defaulted by clearing members leading them into financial distress and more
defaults.
Q.869 A case study in a financial investments analysis exam stated that central counterparties
(CCP) are faced with many risks. These risks can be default-related or non-default-related. From
the following, identify the least likely default-related risk faced by CCPs.
A. Failed auction.
B. Investment losses.
D. Reputational risk.
Investment losses are typically classified as non-default-related risks for central counterparties
(CCPs). CCPs often use the funds they hold on margin to generate profits and interest. These
margin funds can be composed of both cash and securities. However, the value of these
securities can fluctuate, sometimes decreasing in value, which can lead to investment losses.
Therefore, investment losses are not directly related to default but are a result of the investment
decisions made by the CCPs. This makes investment losses a non-default-related risk.
It's important to note that while investment losses can indirectly lead to default if they are
significant enough, they are not a direct result of a default event. Instead, they are a result of
market movements and investment decisions, which are separate from the creditworthiness of
the CCP's counterparties. Therefore, investment losses are considered a non-default-related risk.
defaults, the CCP may use an auction process to transfer the defaulter's positions to other
members. If this auction fails, it can lead to significant losses for the CCP.
Choice C is incorrect. The resignation of clearing members can also be considered as a default-
related risk. Clearing members are responsible for fulfilling financial obligations in case of a
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counterparty's default. If they resign, it could potentially increase the risk of default and cause
Choice D is incorrect. Reputational risk might not directly relate to defaults but it can be
triggered by them or their mishandling by CCPs which makes it indirectly related to default
risks.
Q.871 Unlike in exchanges, the central counterparties of over-the-counter markets have to deal
with complex transactions and projects. These CCPs are exposed to the risk of inconsistency in
their margining functions. This is because the margin requirements of OTC products cannot be
derived from market sources directly, but they require complex models to carry out the mark-to-
market activities. This risk is most likely associated with:
A. Distress risk
B. Operational risk
C. Legal risk
D. Model risk
Model risk is the risk that arises from the use of financial models in business activities. In the
particularly relevant due to the complexity of OTC products. Unlike exchange-traded products,
the initial margin and variation margin requirements of OTC products cannot be derived directly
from market sources. Instead, they require the use of complex models to carry out mark-to-
market activities. If these models are not robust or standardized, the CCPs may face difficulties
in deriving the margin requirements in a timely and accurate manner. This could lead to
financial losses. Therefore, managing model risk is a critical aspect of the operations of CCPs in
OTC markets.
Choice A is incorrect. Distress risk refers to the risk that a company will default on its
obligations due to financial distress. While CCPs do face this risk, it is not directly related to the
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complexity of OTC products and their margining functions.
Choice B is incorrect. Operational risk refers to the potential for loss resulting from
inadequate or failed internal processes, people, and systems or from external events. Although
operational risks may arise in handling complex OTC products, they are not specifically
Choice C is incorrect. Legal risk pertains to the potential for loss due to legal or regulatory
action which can affect a company's operations or its financial position. This type of risk does not
directly relate with the use of intricate models for mark-to-market activities in CCPs.
Q.873 Which of the following model risks or model problems arise in the model-based initial
margin estimation?
A. In the model-based initial margin estimation, the defaulting party is unidentified until
he defaults on its obligations in the contract.
B. In the model-based initial margin estimation, the loss incurred due to the default of a
member is allocated to the other clearing members.
C. In the model-based initial margin estimation, the initial margins are estimated at a
fixed dollar amount margin requirement set by the central counterparty (CCP).
D. In the model-based initial margin estimation, the initial margins increase in proportion
to the size of the position without considering that the risk of a large and concentrated
position is adequately covered.
In the model-based initial margin estimation, the initial margins increase in proportion to the
size of the position without considering that the risk of a large and concentrated position is
adequately covered. This is a significant risk as it can lead to underestimation of the risk
associated with large and concentrated positions. The initial margin is meant to cover potential
future exposure in the event of a default. However, if the margin increases merely in proportion
to the size of the position, it may not adequately cover the risk of a large and concentrated
position. This is because the risk of such a position is not linearly proportional to its size. For
instance, a large and concentrated position may be subject to market illiquidity, making it
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difficult to liquidate without incurring significant losses. Therefore, the initial margin for such a
position should be higher to cover this additional risk. If this is not taken into account in the
model-based initial margin estimation, it can lead to significant losses for the central
Choice A is incorrect. The identification of the defaulting party is not a risk or problem that
arises in the model-based initial margin estimation. This process focuses on calculating the initial
margins for a financial contract, not identifying who might default on their obligations.
Choice B is incorrect. The allocation of loss due to a member's default to other clearing
members does not pertain to the model-based initial margin estimation process. This issue
relates more to the risk management practices of a central counterparty (CCP) rather than an
Choice C is incorrect. In model-based initial margin estimation, margins are not estimated at a
fixed dollar amount set by CCPs but are calculated based on various factors such as market
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Q.874 A risk manager at a financial institution is reviewing the risks associated with clearing
through a central counterparty (CCP). Which of the following statements about CCPs and their
exposure to liquidity risk is correct?
A. CCPs are not exposed to liquidity risk as they require their clearing members to post
initial and variation margins.
B. The default of a clearing member can lead to a loss of liquidity for the CCP.
C. CCPs can only be exposed to liquidity risk if they have not properly calculated the
margin requirements for their clearing members
D. Liquidity risk for CCPs is solely related to the operational risk of the CCP.
The default of a clearing member can indeed lead to a loss of liquidity for the CCP. When a
clearing member defaults, the CCP is obligated to fulfill the defaulted member's obligations to
the other clearing members. To do this, the CCP typically uses its own resources, such as its
capital, guaranty funds, and default funds, to make the required payments. However, in the event
of a large or unexpected default, these resources may not be sufficient to cover the losses. This
insufficiency can lead to a loss of liquidity for the CCP, as it may struggle to meet its financial
obligations. This scenario illustrates the exposure of CCPs to liquidity risk, despite the various
Choice A is incorrect. While it's true that CCPs require their clearing members to post initial
and variation margins, this does not completely eliminate their exposure to liquidity risk. For
instance, if a clearing member defaults and the value of the posted collateral falls significantly,
Choice C is incorrect. Even with properly calculated margin requirements, CCPs can still be
exposed to liquidity risk due to various factors such as market volatility or default of multiple
members which may lead to significant losses exceeding the available margins.
Choice D is incorrect. Liquidity risk for CCPs is not solely related to operational risk. It also
arises from other sources such as credit risk (default by a member), market risk (changes in
value of collateral), and even systemic risks (failure of financial institutions or disruption in
financial markets).
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Q.875 When trading standard transactions with an end user, a dealer is more likely to insist that
the transactions are cleared through a CCP even when the credit quality of the end user is low.
This is termed as:
A. Moral hazard
B. Adverse selection
C. A tear up
D. A pro-cyclical
Adverse selection is a term commonly used in economics, insurance, and risk management that
describes a situation where an individual's demand for insurance (either the propensity to buy
insurance or the quantity purchased) is positively correlated with the individual's risk of loss
(e.g., higher risks buy more insurance), and the insurer is unable to allow for this correlation in
the price of insurance. This may be because of private information known only to the individual
question, the dealer insisting on clearing the transactions through a Central Counterparty (CCP)
despite the end user's low credit quality is a classic example of adverse selection. The dealer is
aware of the higher risk associated with the end user due to their low credit quality, and
therefore insists on using a CCP to mitigate this risk. This is a strategic move by the dealer to
protect themselves from potential losses that could arise from the end user's inability to fulfill
Choice A is incorrect. Moral hazard refers to the risk that one party behaves differently from
how they would if they were fully exposed to the risk. In this case, the dealer insisting on
clearing transactions through a CCP does not represent a change in behavior due to lack of
exposure to risk.
not what's happening in this scenario. The dealer and end user are still engaging in transactions;
it's just that these transactions are being cleared through a CCP.
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Choice D is incorrect. A pro-cyclical refers to any economic quantity that is positively
correlated with the overall state of the economy i.e., it increases when economy booms and
decreases during recessions. This term doesn't apply here as we're discussing credit quality and
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Q.876 The centralization feature of the central counterparty (CCP) increases the efficiency but at
the same time also increases the operational risks for its members due to the concentration of
the whole risk on the CCP. Which of the following situations can give rise to operational risk?
C. Failed auction.
D. Infrastructure breakdown.
The operational risk in a CCP can significantly increase due to the breakdown or failure of its
infrastructure. This is because the CCP's infrastructure is the backbone of its operations,
facilitating the clearing and settlement of transactions. If this infrastructure fails, it can disrupt
the CCP's operations, leading to delays or failures in transaction processing. This can, in turn,
lead to financial losses for the CCP's members, who rely on the CCP for the efficient clearing and
Choice A is incorrect. While a default by a clearing member can indeed pose significant risks,
it is primarily a credit risk rather than an operational risk. Operational risks are associated with
failures in systems, processes, or controls, including those caused by human error or system
failures.
Choice B is incorrect. An increase in margin requirements can create liquidity pressures for
members but does not directly escalate operational risk. Margin requirements are tools used to
manage credit and market risks and do not pertain to the functioning of systems or processes.
Choice C is incorrect. A failed auction could potentially lead to losses for CCP members but
this scenario represents more of a market risk than an operational one. The failure of an auction
does not necessarily imply that there has been a failure in the CCP's systems or procedures.
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Q.877 Which of the following is the most accurate explanation of the sovereign risk faced by the
central counterparty (CCP)?
A. The sovereign risk faced by the CCP is referred to as the intervention of sovereign
governments in operation and activities of the CCP.
B. The sovereign risk faced by the CCP is due to the failure of members who have held
sovereign bonds as margin, which may have declined in value due to sovereign failure.
C. The sovereign risk faced by the CCP is referred to as the pressure and the undue
influence that can arise when one of the members of the CCP is the agency of a sovereign
fund/government.
Sovereign risk, in the context of a Central Counterparty (CCP), is primarily associated with the
potential failure of its members who have held sovereign bonds as margin. These bonds may
decline in value due to a sovereign default or failure. This situation can significantly impact the
financial stability of the CCP and its ability to manage counterparty risk. Members of a CCP often
use repo rates as a risk management tool. During the Eurozone crises, it was observed that
sovereign risk is strongly correlated with repo rates. This means that an increase in sovereign
risk can lead to an increase in repo rates, which can further exacerbate the financial strain on
CCP members holding sovereign bonds as margin. Therefore, managing sovereign risk is a
Choice A is incorrect. While it's true that government intervention can impact the operations
of a CCP, this is not what is typically referred to as 'sovereign risk'. Sovereign risk usually refers
to the risk of default on sovereign bonds, which can impact the value of these bonds when they
Choice C is incorrect. The term 'sovereign risk' does not refer to undue influence or pressure
from a member who may be an agency of a sovereign fund/government. This could potentially be
a conflict-of-interest issue, but it doesn't directly relate to sovereign risk in the context of a CCP.
Choice D is incorrect. As explained above, option B accurately describes what 'sovereign risk'
means in relation to a Central Counterparty (CCP). Therefore, saying that none of the options are
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correct would be inaccurate.
Q.878 The central counterparty (CCP) acquires banks services for the receipt and transfer of
funds to and from its clearing members due to changes in variation margins and initial margins.
These banks or large financial institutions can face technical failures or human failures that
could stop them from processing the CCP’s instructions to make cash payments and receive or
deliver securities to its members. This could create liquidity problems on the end of the CCP and
the clearing members that still have to fulfill obligations. This risk is most likely associated with:
A. Sovereign risk
B. Custodian risk
C. Model risk
D. Investment risk
The risk described in the scenario is known as Custodian risk. Custodian risk, also known as
custody risk, is associated with the inability of a custodian, in this case, the banks or large
financial institutions, to perform its operations. These institutions act as the custodians of the
CCPs, handling the receipt and transfer of funds due to changes in variation margins and initial
margins. However, they can face technical or human failures that could prevent them from
processing the CCP’s instructions to make cash payments and receive or deliver securities to its
members. This could create liquidity problems for both the CCP and its clearing members who
still have obligations to fulfill. Moreover, it can also increase the systematic risk in the market.
Despite the extensive regulatory controls that govern the custodian services of these banks, the
risk of failure still exists, making custodian risk a significant concern in financial markets.
Choice A is incorrect. Sovereign risk refers to the risk of a country defaulting on its financial
obligations or the change in a country's political or economic conditions that could adversely
affect investments made in that country. This scenario does not involve any sovereign entity,
Choice C is incorrect. Model risk pertains to the potential for different modeling assumptions
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and methodologies to produce different outputs. It arises due to errors in data, assumptions, or
model specifications which can lead to inaccurate predictions or estimates. In this scenario,
there are no models being used for predictions or estimations; rather it's about operational
Choice D is incorrect. Investment risk refers to the possibility of losing invested capital due to
various factors such as market volatility, inflation rates, interest rate changes etc., which can
negatively impact investment returns. The situation described here does not involve any
investment decisions but rather operational issues related with fund transfers and securities
delivery.
Q.1138 The default of a clearing member could create further problems, including:
The default of a clearing member would likely shake confidence in the clearinghouse's ability to
manage counterparty risk, leading to greater perceived risk in the market. This increased
counterparty risk may lead other market participants to hold back from trading, leading to a
decrease in market liquidity. This is the most immediate and direct consequence of the clearing
member's default.
A is incorrect. While a default might increase market uncertainty and potentially lead some
investors to shift towards safe-haven assets, this is not the most direct or immediate
B is incorrect. While a major default might potentially affect interest rates, it would not be an
immediate effect, and the impact would depend on many other factors such as central bank
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policies and overall market conditions.
Regulatory changes usually occur over longer time frames as they require a comprehensive
understanding and assessment of the situation, drafting of new regulations, public commentary,
Things to Remember
Central Counterparty Clearing Houses (CCPs) play a crucial role in financial markets
by managing and mitigating counterparty risk. They act as a buyer to every seller and a
Counterparty risk is the risk that a party in a transaction will default on its contractual
obligations. When a CCP member defaults, it shakes confidence in the CCP's ability to
Market liquidity refers to the ability to buy or sell assets without causing a significant
movement in the price. A decrease in liquidity could make it harder for market
The impact of a clearing member's default extends beyond the defaulting party and can
cause ripple effects through the financial system due to the interconnectedness of
financial institutions.
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Q.1140 A large hedge fund, Alpha Strategies, operates heavily in derivative markets for risk
management and speculative purposes. Due to the varying nature of their trades, Alpha
Strategies uses both bilateral markets and centrally cleared markets. The Risk Management
team at Alpha Strategies is reviewing the fund's risk exposure in light of recent market volatility.
The team is particularly focused on comparing the effect of netting in both types of markets. One
of the new members of the team, Oliver, is assigned to evaluate the benefits and differences of
netting in both types of markets. Based on his understanding of bilateral and centrally cleared
markets, Oliver should conclude that:
A. Both bilateral and centrally cleared markets offer equal levels of netting benefits due
to standardized netting procedures.
D. Neither market offers any significant netting benefits as netting is primarily influenced
by the regulatory environment rather than the market structure.
Centrally cleared markets, due to their structure and the involvement of a central counterparty
(CCP), offer superior netting benefits compared to bilateral markets. This is primarily due to
multilateral netting where a CCP aggregates and offsets all the receivables and payables from
various transactions of a participant. This can significantly reduce the participant's counterparty
A is incorrect.. While both markets utilize netting, the level of benefits is not equal due to the
different market structures. The involvement of a CCP in centrally cleared markets enables more
B is incorrect. While it is true that bilateral contracts can be custom-designed, this does not
necessarily lead to superior netting benefits. Instead, it can lead to increased counterparty risk
D is incorrect. While the regulatory environment can influence netting procedures, it is not the
primary determinant. The structure of the market - bilateral or centrally cleared - plays a crucial
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Q.1141 Central Counterparties (CCPs) play a crucial role in the financial markets by reducing
counterparty risk and enhancing market liquidity. However, they are not immune to risks
themselves. One of the significant risks they face is liquidity risk. Which of the following is the
main source of liquidity risk in CCPs?
The main source of liquidity risk in Central Counterparties (CCPs) is the varying margin
payments. Margin payments are a type of financial guarantee required by CCPs from their
members to cover potential future exposure in the period between the last margin collection and
the liquidation of positions following a member's default. These payments vary as the positions of
the members change. If a CCP does not have sufficient funds to meet these varying margin
payments, it may fail to fulfill its obligations to the surviving members promptly. This situation
can lead to liquidity risk. Therefore, CCPs must manage their liquidity risk effectively by
Choice A is incorrect. While high transaction costs can impact the profitability of CCPs, they
do not directly contribute to liquidity risk. Liquidity risk arises from the inability to meet short-
mismatches and potential solvency issues for CCPs. However, it does not directly result in
liquidity risk unless these assets cannot be easily liquidated or converted into cash without a
Choice D is incorrect. High operating costs can strain the financial resources of CCPs but they
are more related to operational efficiency rather than liquidity risk per se. These costs do not
affect the ability of CCPs to meet their short-term financial obligations unless they lead to a
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depletion of liquid assets.
Things to Remember
credit risk between parties in a transaction and aim to reduce the risk each party faces.
Liquidity Risk refers to the risk that a firm will not be able to meet its short-term
financial demands due to an inability to convert assets into cash without incurring
significant loss.
Varying margin payments can lead to liquidity risks as they can cause fluctuations in
the amount of cash or collateral required, potentially leading CCPs unable to meet their
obligations.
High transaction costs and operating costs do not directly contribute towards liquidity
risk. They might affect profitability but do not necessarily impact short-term payment
obligations.
these assets cannot be quickly liquidated during times of need. However, this is more
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Q.5358 A risk manager at XYZ bank is concerned with the advantages and disadvantages of
using central clearing for OTC derivatives trades. One advantage of central clearing is that it can
reduce systemic risk in the financial markets. Which of the following correctly describes how
central clearing accomplishes this?
A. By increasing the number of parties involved in a trade, thus spreading risk across
multiple entities.
B. By increasing the transparency of OTC derivative trades thus reducing the likelihood
of fraud or manipulation.
D. By reducing the overall volume of OTC derivative trades, thus lowering the potential
for market disruption in the event of a default.
Central clearing provides a centralized mechanism for monitoring and managing counterparty
credit risk, which in turn reduces the potential for systemic risk in the financial markets. By
pooling risk and requiring collateral to be posted, central clearing houses can help to ensure that
losses are contained and do not spread throughout the financial system. This is achieved by
acting as the counterparty to all trades, thereby reducing the risk that a default by one party will
have a domino effect on others. In addition, central clearing houses also have robust risk
Choice A is incorrect. Central clearing does not necessarily increase the number of parties
involved in a trade. Instead, it introduces a central counterparty (CCP) that stands between the
two original trading parties, thereby reducing direct exposure to each other's credit risk.
centralized mechanism for monitoring and managing counterparty credit risk, this does not
directly contribute to the reduction of systemic risk. Transparency may help prevent fraud or
Choice D is incorrect. Central clearing does not aim to reduce the overall volume of OTC
derivative trades. Rather, its primary function is to manage and mitigate counterparty credit risk
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Q.5359 A risk manager at a multinational corporation is analyzing the currency exposure of the
company's European operations. The company has receivables in euros, payables in US dollars,
and a subsidiary in Germany that has both euro-denominated assets and liabilities. Which of the
following is the most appropriate hedging strategy to manage this currency risk?
A. Buying a currency option that gives the right to sell euros and buy US dollars at a
predetermined exchange rate.
B. Buying a currency option that gives the right to buy euros and sell US dollars at a
predetermined exchange rate.
C. Entering into a forward contract to sell euros and buy US dollars at a predetermined
exchange rate.
D. Entering into a forward contract to buy euros and sell US dollars at a predetermined
exchange rate.
The company's primary concern is the potential depreciation of the euro against the US dollar,
given its receivables in euros and payables in US dollars. To hedge against this risk, the risk
manager should consider purchasing a currency option that provides the right (but not the
obligation) to sell euros and buy US dollars at a predetermined exchange rate. This strategy
offers protection against unfavorable currency movements while still allowing the company to
benefit from any favorable currency movements. Currency options provide a level of flexibility
that is particularly useful in volatile currency markets. If the euro appreciates against the US
dollar, the company can choose not to exercise the option and instead convert its euros at the
more favorable current market rate. Conversely, if the euro depreciates against the US dollar,
the company can exercise the option and convert its euros at the predetermined rate, thereby
Choice B is incorrect. Buying a currency option that gives the right to buy euros and sell US
dollars at a predetermined exchange rate would not be suitable in this scenario. This strategy
would be more appropriate if the company had payables in euros and receivables in US dollars,
Choice C is incorrect. Entering into a forward contract to sell euros and buy US dollars at a
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predetermined exchange rate might seem like an appropriate strategy as it provides certainty
about future exchange rates. However, it does not provide flexibility if the actual future spot rate
Choice D is incorrect. Entering into a forward contract to buy euros and sell US dollars at a
predetermined exchange rate would not be suitable for managing currency risk in this scenario
as it implies that company has liabilities denominated in Euros while actually company has
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Q.5360 A CRO at a large bank is reviewing the bank's risk management practices for OTC
derivatives. Which of the following is a regulatory initiative for OTC derivatives?
One of the key regulatory initiatives for the OTC derivatives market is the requirement for all
trades to be reported to a central trade repository. This initiative was put in place to provide
regulators with comprehensive information on the risks being undertaken by participants in the
OTC market. The central trade repository serves as a centralized database that collects and
maintains records of all OTC derivative transactions. This allows for increased transparency and
aids in the identification and mitigation of systemic risk. The central trade repository also
facilitates the monitoring of market abuse and manipulation, thereby promoting market integrity.
Choice A is incorrect. Not all OTC derivatives must be traded bilaterally. While bilateral
trading is a common feature of OTC derivatives, it's not a regulatory requirement for all such
instruments. Some OTC derivatives can also be cleared through central counterparties (CCPs).
Choice C is incorrect. It's not accurate to say that OTC derivatives can only be cleared through
individual banks. In fact, the post-financial crisis regulatory reforms have encouraged the
Choice D is incorrect. Although the term "over-the-counter" suggests that these instruments
are traded outside of formal exchanges, it doesn't mean they can only be traded over-the-
counter. Some types of OTC derivatives may also be traded on organized exchanges.
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Q.5361 A risk manager at a CCP is assessing the risks faced by the CCP. Which of the following is
a risk faced by CCPs that arises from the use of subjective assumptions in determining the initial
margin requirement and default fund contributions of traders?
A. Default Risk
B. Non-Default Events
C. Model Risk
D. Liquidity Risk
Model Risk is a type of risk that CCPs face, which arises from the use of models to calculate
initial margin requirements and default fund contributions. These models may not accurately
capture the risks posed by clearing members and their portfolios. This inaccuracy can stem from
the use of subjective assumptions in the models or from the models being based on historical
data that may not be representative of current market conditions. Therefore, the risk that arises
from the use of subjective assumptions in determining the initial margin requirement and default
Choice A is incorrect. Default risk refers to the risk that a party will not meet its obligations
under a financial contract. While this can be influenced by the initial margin requirement and
default fund contributions, it is not directly related to the application of subjective assumptions
deteriorates but does not reach the point of default. These events are typically driven by market
conditions and trader behavior, rather than subjective assumptions made when setting margin
Choice D is incorrect. Liquidity risk pertains to the possibility that a CCP may not have
sufficient funds available to meet its obligations as they come due. While liquidity needs can be
influenced by margin requirements and default fund contributions, this risk arises from cash flow
mismatches or market disruptions, rather than from subjective assumptions used in setting these
amounts.
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Q.5362 Which of the following statements regarding margin requirements in central clearing and
bilateral clearing is correct?
C. Margin requirements are typically the same for both centrally cleared and bilateral
markets.
D. Margin requirements are not used in either centrally cleared or bilateral markets.
Bilateral markets generally have lower margin requirements than centrally cleared markets. This
is primarily because bilateral markets involve only two parties, and their creditworthiness is
assessed by each other. This direct assessment allows for a more tailored approach to risk
management, which can result in lower margin requirements. On the other hand, in centrally
cleared markets, the credit risk is borne by all members. Therefore, margin requirements need
to be higher to cover the potential losses from a defaulting member. This is a crucial aspect of
risk management in centrally cleared markets, as the default of one member can have significant
implications for all other members. Therefore, higher margin requirements are necessary to
Choice A is incorrect. While it might seem logical to assume that centrally cleared markets,
with their added layer of security and risk management, would have lower margin requirements,
this is not the case. In fact, centrally cleared markets often have higher margin requirements
due to the increased risk associated with a larger number of participants and more complex
transactions.
Choice C is incorrect. Margin requirements are not typically the same for both centrally
cleared and bilateral markets. The level of risk involved in each type of market varies
significantly, which leads to different margin requirements. Bilateral markets generally involve
less participants and simpler transactions compared to centrally cleared markets, leading to
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lower margin requirements.
Choice D is incorrect. Margin requirements are used in both centrally cleared and bilateral
markets as a key tool for managing risk and ensuring smooth trading activities. They act as a
form of collateral that protects against potential losses from trading activities.
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Reading 33: Futures Markets
Q.605 Jack Lee, a commodities investor at Singapore Investment Bank, instructs his team of
traders to sell a September copper futures contract of 25,000 pounds in the COMEX
(Commodities exchange, a sub-division of the NYMEX). Given these instructions, a bank’s team
of floor traders at the COMEX physically met the seller of the September Copper futures
contract and determined the price of $0.05 (5 cents) per pound. Looking at the nature of the
transaction, one can say that the contract is being traded on:
A. An over-the-counter market.
C. An electronic exchange.
exchange or futures exchange typically on a trading floor. It involves shouting and the use of
hand signals to transfer information primarily about buy and sell orders. The part of the trading
floor where this takes place is called a pit. In this case, the team of floor traders physically met
the seller of the September copper futures contract to determine the price of the contract, which
that typically trade on an exchange. One party agrees to buy a given quantity of securities or a
commodity, and take delivery on a certain date. Physical meeting for price determination is a key
trading of securities, commodities, or derivatives takes place directly between two parties
without the supervision of an exchange. In this case, the transaction was executed on COMEX
where buyers and sellers transact electronically without physical interaction. However, in this
scenario, the bank's team of floor traders physically met with the seller to agree on a price which
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Choice D is incorrect. As explained above, the contract was traded on an open outcry
exchange (COMEX), hence 'None of the above' does not apply here.
Q.606 Matias, FRM, has recently joined the London office of Venture Financials as a junior
derivatives trader. Currently, Matias has an open position of gold futures contracts on the
London Exchange. According to the contract, Matias is obligated to sell 5,000 troy ounces of gold
with delivery in April. Determine the appropriate position of Matias’s trade.
Matias's position is a short futures position. In a futures contract, the investor agrees to sell the
underlying asset at a predetermined price on a specific future date. In this case, Matias has
agreed to sell 5,000 troy ounces of gold in April, which is a classic example of a short futures
position. This position allows Matias to profit if the price of gold falls before the delivery date in
April. It's important to note that futures contracts are standardized and traded on exchanges,
which provides liquidity and reduces counterparty risk. However, it also exposes the investor to
Choice A is incorrect. A hedged futures position involves taking a long and short position in
two different but related markets to reduce risk. Matias only has a single open position on gold
Choice B is incorrect. A short put option position would mean that Matias has sold the right to
another party to sell him gold at a predetermined price before the contract expires. However, as
per the question, Matias is required to sell gold in future which aligns with the definition of a
Choice D is incorrect. While both forwards and futures contracts involve an agreement to buy
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or sell an asset at a future date for an agreed price today, they are not identical. The key
difference lies in their settlement process and standardization; forward contracts are private
agreements between two parties and are not standardized, whereas future contracts are
exchange-traded and thus highly standardized. In this case, since Matias's contract is traded on
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Q.607 Jack Manchester is a summer intern at one of the well-known investment banks in Canary
Wharf. During lunch with his supervisor, Manchester was given a document pertaining to the
futures contract's specifications. The excerpt from the document reads “… the tin must be a
minimum of 99.85% purity conforming to BS EN 610:1996. All the tin deliverable against the
London Metal Exchange (LME) contracts must be LME approved.” This futures contract's
specification is most likely related to:
A. Position limits.
B. Delivery arrangements.
C. Contract size.
The excerpt from the document provided to Jack Manchester refers to the quality of the
underlying asset, in this case, tin. Futures contracts, which are traded on exchanges, have
standardized specifications. These specifications include the quality of the underlying assets,
delivery time and place, contract size, price, and quotation, among other things. In this
particular excerpt, the reference to the tin's purity and the requirement for it to be approved by
the London Metal Exchange (LME) clearly indicates that the specification is about the quality of
Choice A is incorrect. Position limits refer to the maximum number of speculative futures
contracts one can hold. The information provided in the document does not pertain to position
limits.
Choice B is incorrect. Delivery arrangements would typically include details about when and
where delivery could take place, which are not mentioned in the document.
Choice C is incorrect. Contract size refers to the amount of the underlying asset that must be
delivered upon contract expiration. The document does not provide any information regarding
this aspect.
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Q.608 Nora Schneider is an experienced derivatives trader at a German commodities investing
firm. Recently, she was given additional responsibilities to look after the trader's training
department. While training the newly employed derivatives traders, she instructed the trader to
clearly read the terms and specifications of a futures contract. Which of the following feature is
NOT specified in the contract specification details of a futures contract?
A. Position limit.
B. Delivery month.
C. Price limits.
D. Counterparty.
The counterparty is not specified in the contract specification details of a futures contract.
Futures contracts are standardized agreements that are traded on exchanges. The transactions
are managed by clearinghouses, which serve as intermediaries between the buyer and the seller.
As a result, the investors of futures contracts typically do not know the identity of the
counterparty to the transaction. This is a key feature of futures contracts that distinguishes them
from other types of financial contracts, such as forward contracts, where the parties are directly
involved with each other and are aware of each other's identities. The absence of counterparty
information in the contract specifications of a futures contract is a reflection of the role of the
Choice A is incorrect. Position limit is typically included in the contract specification details of
a futures contract. It refers to the maximum number of speculative futures contracts one can
Choice B is incorrect. Delivery month, which specifies when the commodity will be delivered,
Choice C is incorrect. Price limits are usually specified in futures contracts to prevent extreme
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Q.609 The Karachi Mercantile Exchange (KME) has set the daily price limit of rice futures
contracts to Rs.4. The closing price of the rice futures contract on Monday was Rs.140 per 100
KG. If the evening newspaper on Wednesday reads that “Rice futures contracts closed limit down
at Rs.138 per 100 KG,” then which of the following is the most likely closing price of the rice
futures contract on the preceding day?
Price limits are the maximum price movement/limit set by exchanges. Suppose the intraday
increase in the price of the futures contract is equal to the predefined price limit. In that case,
the contract is said to be limit up, whereas if the intraday decrease in the price of the futures
contract is equal to the predefined price limit, the contract is said to be limit down. Since the
newspaper reads that the price of the contract closed limit down (price decreased by Rs. 4) at
Rs. 138, the preceding day (i.e., Tuesday) price is:
Limit down close to the current day = Closing price of the preceding day – Price limit
The closing price of the preceding day = Rs. 138 + Rs. 4 = Rs. 142
Q.610 Elif Makarov, a derivatives trader at one of the largest commodities trading firms in
Moscow, is looking at a possible arbitrage trade in the copper futures contract. If the copper
futures contract price is $47.6 and the spot price of copper is $48.9, then determine the
appropriate strategy Makarov may take to earn the arbitrage profit.
A. Take a short position in the copper futures contract and buy copper at the spot price.
B. Take a long position in the copper futures contract and sell copper at the spot price.
C. Wait for copper futures contracts to converge to the spot price and then take a short
position in futures contracts.
D. Wait for copper futures contracts to converge to the spot price and then take a long
position in futures contracts.
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The optimal strategy for Makarov to secure an arbitrage profit in this scenario is to take a long
position in the copper futures contract and sell copper at the spot price. Arbitrage is a trading
strategy that involves buying and selling assets simultaneously in different markets to take
advantage of price discrepancies. In this case, the futures price of copper ($47.6) is lower than
the spot price ($48.9). This price discrepancy presents an opportunity for arbitrage. By taking a
long position in the copper futures contract, Makarov is essentially agreeing to buy copper at a
future date at the current futures price. At the same time, he can sell copper at the spot price,
which is higher than the futures price. The difference between the spot price and the futures
price represents the arbitrage profit. This strategy is known as 'cash-and-carry' arbitrage and is
commonly used in commodities markets. It's important to note that this strategy assumes that
the markets are efficient and that there are no transaction costs or restrictions on borrowing.
Choice A is incorrect. Taking a short position in the copper futures contract and buying copper
at the spot price would not result in an arbitrage profit. This is because the futures price of
copper is lower than its spot price, so selling futures (going short) and buying at the spot price
Choice C is incorrect. Waiting for copper futures contracts to converge to the spot price and
then taking a short position in futures contracts would not guarantee an arbitrage profit either.
The convergence of future prices to spot prices does not necessarily mean that future prices will
rise above current levels, which is necessary for this strategy to be profitable.
Choice D is incorrect. Similarly, waiting for copper futures contracts to converge with the spot
price before taking a long position also does not ensure an arbitrage profit. This strategy
assumes that future prices will fall below current levels after convergence, which may or may
not happen.
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Q.615 Which of the following statements regarding futures transactions is/are incorrect?
I. Speculators are subject to lower margin requirements in futures contract trades as compared
to hedgers.
II. In a spread transaction, the trader simultaneously takes a long position in futures on a
specific asset for a specific delivery time and takes a short position in futures on the same asset
for a different maturity or delivery time.
III. Futures contracts are settled on a daily basis, whereas forward contracts are settled at the
maturity date.
A. Statement I only
B. Statement II only
C. Statements I & II
Things to Remember
1. Futures contracts and forward contracts are both derivatives that derive their value from an
underlying asset. However, they have key differences in terms of their trading, settlement, and
margin requirements.
2. Futures contracts are traded on an exchange, which means they are standardized contracts.
Forward contracts, on the other hand, are private agreements between two parties and can be
3. In futures trading, the margin is a good faith deposit or an amount of capital one needs to post
or deposit to control a futures contract. The margin requirements are set by the futures
4. Hedgers and speculators are the two main types of traders in the futures market. Hedgers use
futures contracts to reduce or eliminate the risk of price changes in the underlying asset, while
speculators use futures contracts to bet on the future price movements of the underlying asset in
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Q.616 During the inauguration ceremony of a newly introduced electronic clearing system at the
Istanbul Commodities Exchange, the general manager of the operations department emphasized
the importance of clearinghouses in the exchange. He said the following:
“It is because of clearinghouses that the traders of futures markets are required to honor their
contracts. The clearinghouses act as a counterparty to every buyer and seller, allowing traders to
decrease the default risk of the counterparty. Because of clearinghouses, traders can reverse or
close their positions without having to contact the counterparty.”
A. Incorrect because the traders of futures markets have the right, but not the obligation,
to honor the contract.
B. Incorrect because the default risk pertaining to the counterparty exists in futures
markets.
C. Incorrect because traders cannot reverse their positions at any given time until the
maturity of the contract.
D. Appropriate.
The general manager's speech is indeed appropriate. Clearinghouses play a pivotal role in
futures markets by acting as a counterparty to every buyer and seller. This arrangement
significantly reduces the default risk of the counterparty. Furthermore, clearinghouses ensure
that traders fulfill their contractual obligations. This is a critical aspect of futures markets, where
contracts are binding and must be honored. Additionally, the general manager correctly stated
that traders could reverse or close their positions at any time without needing to contact the
traders to respond swiftly to market changes. Therefore, the general manager's speech
accurately and appropriately describes the role and benefits of clearinghouses in futures
markets.
Choice A is incorrect. While it's true that options contracts give the holder the right, but not
the obligation, to fulfill the contract, this does not apply to futures contracts. In futures markets,
Choice B is incorrect. The general manager correctly stated that clearinghouses serve as a
counterparty to every buyer and seller in order to reduce default risk. This doesn't mean that
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default risk is completely eliminated in futures markets; however, it's significantly reduced due
Choice C is incorrect. Traders can indeed reverse or close their positions at any time before
maturity due to the presence of clearinghouses. They don't need to contact their original
Q.619 Alisha Gomez, head of the trading department, is interviewing with one of the potential
candidates for a position as a junior trader in the derivatives units. Gomez asked the candidate to
identify which of the following prices is used for calculating daily gains, losses, and margin
requirements for the parties involved in the trading of futures contracts. Which of the following
is the appropriate answer to Alisha Gomez’s question?
A. Opening price.
B. High price.
C. Closing price.
D. Settlement price.
The settlement price is the correct answer. In futures contract trading, the settlement price is
used to calculate daily gains, losses, and margin requirements. It is not the closing price of the
contract. Instead, it is the average price at which the contract is traded during the last period or
before the end of a day's trading period. The exchange itself sets the settlement price. This is
done to prevent traders from manipulating futures prices. The settlement price is a crucial
component in futures trading as it determines the value of the contract at the end of each
trading day. It is used to mark the positions to market, which means adjusting the value of a
futures contract at the end of each trading day to reflect the profit or loss incurred on that day.
This process ensures that losses and gains are recorded and accounted for daily, providing a
Choice A is incorrect. The opening price is the price at which a security first trades upon the
opening of an exchange on a trading day; however, it is not used in the calculation of daily gains,
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losses, and margin requirements in futures contract trading.
Choice B is incorrect. The high price refers to the highest traded price of a security during a
trading day. While this information can be useful for other purposes, it does not play a role in
Choice C is incorrect. The closing price refers to the final price at which a security trades
during a regular trading session on any given day. Although important for various analyses and
calculations, it's not used specifically for determining daily gains, losses or margin requirements
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Q.620 Which of the following is NOT a method/process for terminating a position in a futures
contract?
B. By cash-settling in which futures are marked to market - based on the settlement price
of the last trading day.
C. The investor can take a position that is opposite of his current position.
D. The investor can take the exact same position in the underlying asset as in the futures
contract.
Taking the exact same position in the underlying asset as in the futures contract is not a valid
method for terminating a position in a futures contract. This is because having a long position in
the futures contract and simultaneously having a long position in the underlying asset will
double the risk and exposure in that particular asset. This does not terminate the futures
contract but rather increases the risk associated with it. Therefore, this method is not a valid
valid method for terminating a position in a futures contract. This process involves the physical
delivery of the commodity or asset that underlies the futures contract, which effectively closes
Choice B is incorrect. Cash-settling in which futures are marked to market - based on the
settlement price of the last trading day, is also an acceptable method for terminating a position
in a futures contract. In this case, no physical delivery takes place; instead, cash changes hands
based on the difference between the future's purchase price and its final settlement price.
Choice C is incorrect. The investor can indeed take an opposite position to his current one as
another way to terminate his existing position in a futures contract. This process involves
entering into another futures contract with identical terms but opposite positions (long if
currently short and vice versa), effectively neutralizing or closing out their original position.
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Q.621 Vikram Pandit, a derivatives investor from Mumbai, instructs his broker to terminate his
short position in 10 futures contracts of live cattle at Chicago’s futures exchange. The broker
proposed to him four alternatives for terminating the contract. Which of the following is the most
appropriate method?
A. Purchase cattle from Mumbai and physically deliver the cattle to the long party.
B. Take a new short position of the same size in a live cattle futures contract with a
different delivery date.
C. Find a trader with a long position in live cattle and settle up between yourselves, off
the floor of the exchange.
D. Take a long position of the same size in a live cattle futures contract with the same
delivery date.
Taking a long position of the same size in a live cattle futures contract with the same delivery
date is the most appropriate method to terminate a short position in futures contracts. This is
because futures contracts are standardized agreements that are traded on an exchange. When
an investor takes a short position in a futures contract, they are agreeing to sell the underlying
asset at a specific price on a specific date in the future. If the investor later decides to terminate
this position, they can do so by taking an exactly opposite position (a long position) in the same
futures contract with the same maturity date. This effectively cancels out the original short
position, allowing the investor to exit the contract without having to deliver the physical goods.
This method is commonly used in futures trading and is considered the most efficient and cost-
Choice A is incorrect. Physically delivering the cattle from Mumbai to the long party in
Chicago would not terminate the futures contract. The futures contract is a legal agreement to
buy or sell a particular commodity at a predetermined price at a specified time in the future.
Choice B is incorrect. Taking a new short position of the same size in a live cattle futures
contract with a different delivery date would not terminate the existing short position but rather
create an additional one. This action would increase, not decrease, Vikram's exposure to live
cattle prices.
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Choice C is incorrect. Settling up between traders off the floor of exchange might be possible,
but it's generally against exchange rules and could lead to penalties for both parties involved.
Moreover, it doesn't guarantee that Vikram's original short position will be properly closed out
Q.624 Vanesa Fredrick is a senior derivatives investment manager at Unicorn Hedge Funds.
While briefing a group of new employees in the accounting and finance unit of the fund, she
made the following two statements related to the tax treatment of different parties:
Statement I: For corporations, all capital gains from futures contract are taxed at the same rate
as their ordinary income, whereas capital losses from futures contracts are deductible only to the
extent of capital gains. A corporate entity may carry forward the capital losses indefinitely.
Statement II: For non-corporate taxpayers, short-term capital gains from futures contracts are
taxed at the ordinary income tax rate, but long-term (contracts held for more than a year) capital
gains are taxed at the capital gains tax rate of 15-20% maximum. Capital losses for non-
corporate taxpayers are non-tax deductible.
Both statements made by Vanesa Fredrick are incorrect. In the first statement, she correctly
mentions that for corporations, all capital gains from futures contracts are taxed at the same rate
as their ordinary income. However, she incorrectly states that capital losses from futures
contracts are deductible only to the extent of capital gains and that a corporate entity may carry
forward the capital losses indefinitely. In reality, a corporate entity cannot carry forward the
capital losses indefinitely. Instead, it can carry back a capital loss for three years and carry it
In the second statement, Vanesa correctly states that for non-corporate taxpayers, short-term
capital gains from futures contracts are taxed at the ordinary income tax rate and long-term
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capital gains (for contracts held for more than a year) are taxed at a maximum rate of 15-20%.
However, she incorrectly states that capital losses for non-corporate taxpayers are non-tax
deductible. In fact, capital losses of non-corporate taxpayers are tax-deductible to the extent of
capital gains plus ordinary income up to $3,000. Furthermore, these losses can be carried
forward indefinitely. Therefore, both statements made by Vanesa are incorrect, making choice D
Choice A is incorrect. Statement I is not correct because while it's true that corporations are
taxed at the same rate for capital gains from futures contracts as their ordinary income, capital
losses from these contracts can be deducted to the extent of capital gains and can be carried
forward indefinitely by the corporation. However, they can also be carried back for three years.
Choice B is incorrect. Statement II is also not accurate. For non-corporate taxpayers, short-
term capital gains from futures contracts are indeed taxed at the ordinary income tax rate but if
the contracts are held for more than a year, long-term capital gains are taxed at a maximum rate
of 15-20%. However, contrary to what Vanesa stated, capital losses for non-corporate taxpayers
are tax deductible up to $3,000 per year against other income and any excess loss can be carried
forward indefinitely.
Choice C is incorrect. As explained above both statements made by Vanesa Fredrick contain
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Q.5363 A trader wants to sell a call option on a stock in a volatile market but wants to ensure
that the option is sold above a certain price point. Which of the following order types should the
trader use to guarantee execution at or above that price point?
A. Market order
B. Stop-limit order
C. Discretionary order
D. Fill-or-kill order
A stop-limit order is an order to sell (or buy) at a specified price or better after the price has
reached a specified stop price. This type of order combines both a stop order and a limit order,
meaning that the order will be executed at a specified price or better but only after the stop
price has been reached. In this case, the trader can set the stop price at the desired price point
and the limit price at the minimum price they are willing to accept for the option. This ensures
in which the broker has the option to delay execution with the expectation of obtaining a more
favorable price.
D is incorrect. A fill-or-kill order requires immediate execution of the entire order or none at all,
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Reading 34: Using Futures for Hedging
Q.625 A Canadian importer has ordered $1,000,000 US worth of oil drilling equipment to be
delivered in six months. The current spot exchange rate is 1.3 CAD per 1.00 USD. However, the
importer fears that the Canadian dollar will depreciate to 1.35 CAD per 1.00 USD in the next 6
months. As a result, the importer enters a forward contract to purchase $1,000,000 at a forward
rate of 1.32 CAD per 1.00 USD. If the Canadian dollar depreciates to $1.35 CAD per 1.00 USD as
predicted, what is the savings to the importer from his dealings in the forward market?
A. $350,000 CAD
B. $30,000 CAD
C. $50,000 CAD
D. $20,000 CAD
The forward market will help the importer to lock in the exchange rate of 1.32 CAD per 1.00
USD. Thus, they will spend 1.32 * 1,000,000 = $1,320,000 CAD in the transaction.
Without the forward market, the importer would transact at 1.35 CAD per 1.00 USD, spending a
Total savings = 1, 350, 000 CAD − 1, 320, 000 CAD = 30 , 000 CAD
Q.627 Colin Thomson, the risk manager of a tire manufacturing company, suggests that the
company should focus its resources on its core business activities rather than investing
resources in hedging the risks faced by the company. He further added that the shareholders
have as much information as the management of the company. Therefore, shareholders can
easily hedge the risks. Lastly, he argued that the shareholders hedge the company’s stocks in
much smaller quantities. Hence, it is cheaper for the shareholders to hedge the risk as compared
to the company. Which of the following options is correct?
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C. Both arguments are correct.
None of Thomson’s arguments are correct. The first argument made by Colin Thomson is that
shareholders have as much information as the company's management. This is generally not the
case. Shareholders may not have access to all the information that the management has,
especially the internal information about the company's operations, strategies, and risk
exposure. Therefore, they may not be able to hedge the risks as effectively as the company's
management. The second argument made by Thomson is that it is cheaper for shareholders to
hedge the risk as compared to the company. This is also incorrect. While it's true that
shareholders can hedge the company's stocks in smaller quantities, the transaction costs and
commissions for these smaller transactions are usually higher. On the other hand, the company,
which hedges its risk in many transactions, pays much smaller per dollar transaction costs and
commissions. Therefore, it is usually more cost-effective for the company to hedge its risks than
Choice A is incorrect. Thomson's argument that shareholders have access to the same
information as the company's management is not valid. In reality, there are often information
asymmetries between a company's management and its shareholders due to insider knowledge
and other factors. Furthermore, his argument that it would be more cost-effective for
shareholders to hedge risks in smaller quantities is also flawed. The costs of hedging can be
substantial for individual investors due to transaction fees and other expenses, which may
Choice B is incorrect. As explained above, both of Thomson’s arguments are flawed; hence this
choice which suggests one of them being correct does not hold true.
Choice C is incorrect. As explained above, neither of Thomson’s arguments are correct; hence
this choice suggesting both being correct does not hold true.
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Q.629 A risk analyst at a mid-sized alternative investment firm is responsible for hedging the
company’s multiple exposures to alternative assets. Suppose that the analyst has taken two
positions, a long in the spot and a short in oil futures to hedge the risk of fluctuation in oil prices.
If the basis of the hedge strengthens unexpectedly, then which of the following is true?
A short position in a hedge improves as the basis of the hedge strengthens or increases
unexpectedly. The basis is defined as the difference between the spot price of the asset to be
hedged and the futures price of the contract used. An increase in the basis will improve the
company’s short position as the company will get a higher price for the asset after futures gains
or losses are considered. In contrast, a decrease in the basis will worsen the company’s short
position as the company will pay a higher price for the asset after futures gains or losses are
considered. A short hedge comprises a long position in the spot (underlying asset) and a short
position in the futures contract, so the short hedge is +S - F. It follows that the short hedge
profits whenever the basis increases: +B = +(S - F) because in this scenario, the basis 'matches'
the two positions making up the short hedge which are (I) long the spot, +S, and short the
futures, -F.
Choice B is incorrect. A strengthening basis does not necessarily improve the long positions of
the firm. The basis is defined as the difference between the spot price and futures price of an
asset. If the basis strengthens, it means that this difference is increasing, which could be due to
either an increase in spot prices or a decrease in futures prices. Since the firm has a long
position in spot market, an increase in spot prices would indeed improve its position; however, if
it's due to a decrease in futures prices, this wouldn't affect its long position.
Choice C is incorrect. Contrary to what this option suggests, if the basis of hedge strengthens
(i.e., increases), it will actually improve rather than worsen short positions of the firm. This is
because when you are short on futures contracts and there's an increase in basis (spot price -
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future price), you stand to gain as you have committed to sell at higher future prices while
Choice D is incorrect. As explained above for choices B and C, both positions will not
necessarily improve with a strengthening hedge basis since it depends on whether this change
Q.630 Melanie Angebote is an instructor at a private business school in Vienna. She has recently
begun teaching derivatives to undergraduate business management students. In one of her
lectures, she asked the students to define their understanding of the strengthening and
weakening of the basis of a hedge. Which of the following student comments is/are correct?
I. If the spot price increases relative to the futures price throughout the hedging period, the
basis is strengthening.
II. Basis risk is the risk that the volatility of a futures contract will not move in line with that of
the underlying exposure.
Only the first comment is accurate. The basis of a hedge refers to the difference between the
spot price of an asset and the futures price of a contract for that asset. When the spot price
increases relative to the futures price during the hedging period, the basis is said to be
strengthening. This is because the spot price is moving in a direction that is favorable to the
holder of the futures contract. The holder of the futures contract would be able to sell the asset
at the higher spot price and buy it back at the lower futures price, thus making a profit. This is
the essence of hedging - to protect against adverse price movements in the market. Therefore,
the first comment correctly encapsulates the concept of a strengthening basis in the context of a
hedge.
Choice B is incorrect. The second comment incorrectly defines basis risk. Basis risk is not the
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risk that the volatility of a futures contract will not move in line with that of the underlying
exposure. Instead, basis risk refers to the risk that the price difference between a futures
contract and its underlying asset (the basis) will change unpredictably over time.
where the basis would be strengthening, while comment II incorrectly defines basis risk.
Choice D is incorrect. Comment I correctly describes a situation where the spot price
increases relative to the futures price throughout the hedging period as strengthening of basis,
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Q.631 Togo Barrio, a portfolio manager at Mexico Asset Management Inc., is interviewing Linda
Farris for the position of risk analyst in the firm’s derivatives unit. To one of Barrio’s questions
related to the basis risk involved in hedging with futures contracts, Farris replied with the
following three factors that affect the basis risk:
I. Interruption in the convergence of the futures prices and spot prices
II. Changes in the component of costs involved in hedging transactions
III. A mismatch between the maturity of the cash asset and the hedged asset
A. Reason I only.
Linda Farris's response to Togo Barrio's question about basis risk in hedging with futures
contracts is accurate and relevant. All three factors she mentioned can affect basis risk:
Statement I is correct: Basis risk arises because the futures price and the spot price of the
underlying asset may not converge as expected at the expiration of the futures contract. This
divergence can be due to various factors like changes in market expectations, supply and
Statement II is correct: Costs such as transaction fees, storage costs, or financing costs can
impact the overall cost of hedging. Variations in these costs can alter the expected returns from
Statement III is correct: When the maturity of the futures contract does not align perfectly
with the timing of the exposure of the cash asset, basis risk is introduced. This mismatch can
occur because futures contracts have standardized expiration dates, which may not coincide with
p>
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Q.632 Asim Hussain has recently joined the commodities trading desk of an investment bank in
London. He is a hedger-trader who takes positions in futures contracts to earn profit from the
difference in the spot price and futures price of a contract. He hedges the bank’s exposure and
also hedges on behalf of the bank’s clients. One of the bank’s clients knows they will need to buy
oil at some time in March and believes the oil prices could fluctuate heavily by that time.
Therefore, he instructs Hussain to come up with a strategy to hedge oil with expiration in March.
Hussain knows that the delivery months of oil futures contracts are March, June, September, and
December. Which of the following contracts is most suitable for the hedge that expires in March?
The most suitable futures contract for a hedge that expires in March would be an oil futures
contract with a delivery month of June. This is because a hedger always runs the risk of having to
take delivery of the physical asset if the futures contract is held during the delivery month, which
can be inconvenient and costly. Therefore, hedgers typically select a delivery month that is as
close as possible but later than the expiration of the hedge. As the gap between the hedge
expiration date and the delivery month widens, the basis risk also increases. Basis risk refers to
the risk that the spot price of the underlying asset could significantly differ from the futures
price agreed upon in the contract at expiry, rendering the hedge ineffective and potentially
resulting in losses for the hedger. Moreover, if the expiry coincides with the delivery month, a
long hedger faces the risk of taking delivery of the physical asset. Taking delivery can be
expensive and inconvenient. Therefore, to avoid these potential issues, hedgers often choose a
delivery month that is slightly ahead of the expiration of the hedge. In this case, since the client
needs to buy oil in March, they would enter into a contract expiring in June and close out the
contract in March. Closing out means they cash in on the contract and proceed to buy oil from
their preferred supplier. This strategy allows for a convenient exit from the contract.
Choice A is incorrect. Although it may seem logical to choose a futures contract with the same
delivery month as the anticipated need, this would not provide an effective hedge. The client's
need for oil is in March, but if they were to enter into a futures contract that also expires in
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March, they would be exposed to price risk until the expiration of the contract. This could result
Choice C is incorrect. Choosing a futures contract with a delivery month later than the client's
anticipated need for oil would expose them to unnecessary risk. If oil prices rise significantly
between March and September, the client would be forced to purchase more expensive oil on
Choice D is incorrect. Similar to Choice C, choosing a futures contract with a delivery month of
December exposes the client to unnecessary risk due to potential price fluctuations between
their actual need (March) and the expiration of their contracts (December). This could lead them
having higher costs than necessary or even losses if prices increase significantly during this
period.
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Q.633 Futures contracts on jet fuel have maturity months in March, May, July, September, and
December. An airline is hedging a purchase of 1 million barrels of fuel to be made on June 15 of
this year. Which futures contract should it use?
The July contract is the most appropriate choice for the airline company. In the context of futures
contracts, most positions are closed out prior to the delivery period specified in the contract.
Therefore, a practical guideline for hedgers is to choose the futures contract with the earliest
possible maturity month following the maturity of the desired hedge. This approach helps to
avoid the volatility that often occurs during the expiration month of the contract. In this scenario,
the airline company plans to purchase the jet fuel in June. Therefore, the July contract, which is
the earliest maturity month following June, is the most suitable choice for the company's hedging
strategy.
Choice B is incorrect. The March contract would not be an appropriate choice for the airline
company as it matures before the scheduled purchase date of June 15. This would expose the
company to price risk between the maturity of the futures contract and the actual purchase date.
Choice C is incorrect. The December contract matures much later than the scheduled
purchase date, which means that it could potentially expose the company to unnecessary price
Choice D is incorrect. Although May contract matures closer to June 15, it still exposes the
airline company to a month's worth of price risk between its maturity and actual purchase date.
Therefore, July contract (option A) which matures after June 15 provides a better hedge against
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Q.634 A German electronic appliances manufacturer expects to receive 30 million Turkish Liras
at the end of March. The Lira futures contracts on the Eurex Exchange are available for the
delivery months of March, June, September, and December. The size of one contract is 10 million
Turkish Liras. The company shorts three June contracts on February 1 with the futures price of
0.6500 cents per Lira. If the futures prices and spot price on the closing date are 0.6250 and
0.6150, respectively, then calculate the effective price received in Euros for 30 million Liras.
Since the company had a short position in futures contracts and the price of the futures
contracts has decreased over the period of the hedge, the company has gained on its exposure in
the futures contracts. The effective price obtained in cents per Lira is the final spot price plus
The total amount received by the German manufacturer for the 30 million Liras is 30,000,000 *
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Q.635 Emanuel is a junior trader working in the derivatives and hedging unit of a brokerage
firm. Emanuel’s superior instructed him to take a hedged position for one of its clients who
wants to hedge its exposure in 10 million tons of plastic. Since the underlying asset is plastic and
difficult to find futures contracts with the underlying asset of plastic, the trader is advised to
take a position in rubber futures contracts. The contract size of rubber is 45 tons. If the standard
deviation of the spot prices of plastic is 0.019, the standard deviation of the futures prices of
rubber is 0.032, and the correlation coefficient between the two is 0.87, then determine what
should be the optimal hedge ratio.
A. 0.52
B. 0.59
C. 1.46
D. 1.68
σS
HR = ρ ∗ ( )
σF
Where
0.019
HR = 0.87 ∗ ( ) = 0.516.
0.032
Q.637 Melanie Gomez is a former trader and the anchor of a local business TV channel. She is
famous for her analysis and forecasts of commodities prices. She also presents a weekly
education program to educate beginner traders on complex derivatives instruments and hedging
strategies. She made the following definitions of some jargons used for hedging in her TV
program:
I. Cross-hedging occurs when two offsetting positions are opened in futures contracts with
identical underlying assets.
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II. Tailing the hedge is a process of calculating the correlation between percentage one-day
changes on the futures and spot prices to estimate the number of contracts needed to hedge over
the next day.
The definition of cross-hedging provided by Melanie Gomez is incorrect, while the definition of
tailing the hedge is correct. Cross-hedging, by definition, involves using a related but not
identical asset to hedge against price risk. If the hedging instrument is identical to the
underlying asset being hedged, it is not considered cross hedging but rather a straightforward
hedging strategy. On the other hand, the definition of tailing the hedge is accurate. Tailing the
hedge is a process conducted by analysts while hedging with futures contracts. It is the process
of calculating the correlation between the percentage of one-day changes in the futures and spot
prices in order to estimate the number of contracts needed to hedge over the next day.
asserts that Statement II is also incorrect. Cross-hedging does not involve opening two offsetting
positions in futures contracts with identical underlying assets. Instead, it involves hedging a
Choice C is incorrect. This choice incorrectly asserts that both statements are correct. As
Choice D is incorrect. While it correctly identifies that Statement I's definition of cross-
hedging is wrong, it inaccurately claims that the definition of tailing the hedge provided in
Statement II is also wrong. Tailing the hedge indeed involves determining the correlation
between percentage changes in futures and spot prices to estimate future hedging requirements.
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Q.638 A portfolio manager has constructed a portfolio that perfectly mirrors the NASDAQ-100
index. The portfolio manager is worried about the changes in the portfolio's value, so he decides
to hedge the portfolio using futures contracts on the mini NASDAQ-100 index. If the portfolio's
value is $16,165,000, the index futures price is 5,056 with each contract on $20 times the index,
then estimate the number of contracts required to hedge the portfolio.
A. 138
B. 142
C. 160
D. 101120
160 NASDAQ-100 mini futures contracts are required to hedge a portfolio that mirrors the
NASDAQ-100 index.
The number of stock contracts required to hedge the portfolio is calculated as:
Since the portfolio perfectly mirrors the index, the beta of the given portfolio is considered 1.
16, 165,000
The number of stock contracts required = 1 ∗ ( ) = 159.8 or 160 contracts.
101,120
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Q.639 Julia Lange, an investment manager, has constructed a portfolio that somewhat mirrors
the S&P 500 index. The investment manager intends to hedge the portfolio by taking a short
position in S&P 500 futures. The current worth of the portfolio is $672,000,000, and the S&P 500
index futures price is 2,906, with each contract on $250 times the index. If the portfolio's beta is
0.78, then estimate the number of contracts Lange should short to hedge her portfolio.
Since the portfolio doesn’t perfectly mirror the S&P 500 index the beta of the portfolio of 0.78
Q.640 Julia Lange, an investment manager, has constructed a portfolio with a beta of 0.78 that
somewhat mirrors the S&P 500 index. The investment manager hedged the portfolio 1 month
ago by taking a short position in the S&P 500 futures. The portfolio had a value of $672,000,000,
and the S&P 500 index futures price at the time of the purchase was 2,906, with each contract
on 250 times the index. If the S&P 500 futures contract price fell to 2,715 this month, then
estimate the number of additional contracts Lange should buy/short to hedge her portfolio,
assuming that the portfolio value does not change.
A. The manager must short an additional 50 S&P 500 futures contract to hedge the
portfolio.
B. The manager must buy 50 S&P 500 futures contracts to hedge the portfolio.
C. The manager must short an additional 2,715 S&P 500 futures contracts to hedge the
portfolio.
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D. The manager must short an additional 772 S&P 500 futures contracts to hedge the
portfolio.
The number of stock contracts required to hedge the portfolio is calculated as:
Since the portfolio doesn’t perfectly mirror the S&P 500 index, the beta of the portfolio of 0.78
The initial number of contracts that the manager short at the time of purchasing the S&P 500
A month later, when the futures price fell from 2,906, to 2,715, the new number of contracts
Therefore, the manager must short an additional 50 futures contracts on the S&P 500 index.
Q.641 The index futures contracts are not only used to hedge the risk of the portfolio but
sometimes the futures contracts are also used to change the current systematic risk or the beta
of the portfolio to a desirable level. Here are two potential strategies to reduce and increase the
beta of a portfolio:
I. If the beta of the portfolio is to increase from its current beta, a short position in a specific
number of additional futures contracts must be taken
II. If the beta of the portfolio is to reduce from its current beta, a long position in a specific
number of additional futures contracts must be taken
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A. The strategy to increase the beta is accurate, but the strategy to reduce the beta is
inaccurate.
B. The strategy to reduce the beta is accurate, but the strategy to increase the beta is
inaccurate.
C. Both strategies to increase and reduce the beta of the portfolio are accurate.
Neither of the strategies are accurate. The beta of a portfolio is a measure of its systematic risk,
or the risk that cannot be eliminated through diversification. It is a measure of the portfolio's
sensitivity to market movements. When it comes to adjusting the beta of a portfolio using futures
contracts, the strategies are reversed. To increase the beta of a portfolio, a long position in a
specific number of additional futures contracts should be taken. This is because taking a long
position in futures contracts increases the exposure of the portfolio to the market, thereby
increasing its systematic risk or beta. Conversely, to reduce the beta of a portfolio, a short
position in a specific number of additional futures contracts should be taken. This is because
taking a short position in futures contracts reduces the exposure of the portfolio to the market,
Choice A is incorrect. The strategy to increase the beta of a portfolio by establishing a short
position in additional futures contracts is inaccurate. In fact, taking a short position in futures
contracts would decrease the beta of the portfolio, not increase it. This is because shorting
Choice B is incorrect. The strategy to reduce the beta of a portfolio by establishing a long
position in additional futures contracts is also inaccurate. Contrary to this statement, taking on
more long positions would actually increase the portfolio's exposure to market movements and
Choice C is incorrect. As explained above neither strategies are accurate for increasing or
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Q.642 An investor owns a portfolio of some of the S&P 500 stocks that worth $50 million. The
systematic risk of the portfolio to the S&P 500 index is 0.96. The investor wants to remove the
systematic risk from his portfolio completely, so he decides to reduce the portfolio's beta to zero.
If the value of the S&P 500 index futures contracts is 1,111 and each index point costs $250, how
many contracts should he use to reduce the systematic risk?
The investor must short 173 S&P 500 futures contracts to reduce the beta of the portfolio from
0.96 to 0.
The negative sign implies that the investor must short 173 S&P 500 index contracts to reduce
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Q.643 Adam Ryman was taking an aptitude test to join the graduate trainee program of a
German investment bank. One of the questions in the exam asked to identify in which of the
following processes an investor closes out the existing position as the maturity of the futures
contract approaches and replaces it with another futures contract with a later delivery date or
maturity. Which of the following is the correct answer to the question?
A. Cross-over hedging.
The process described in the question is known as 'Rolling a hedge forward'. This is a common
practice in futures trading, where an investor closes out their existing position as the futures
contract approaches its maturity date, and replaces it with another futures contract that has a
later delivery date or maturity. This strategy allows the investor to maintain their position in the
market, while avoiding the delivery of the underlying asset. It is particularly useful in situations
where the investor's primary interest is in the price movements of the asset, rather than in
owning the asset itself. The new contract that replaces the old one is typically identical in all
respects except for its delivery date. This process of 'rolling forward' can be repeated
indefinitely, allowing the investor to maintain a continuous presence in the futures market.
Choice A is incorrect. Cross-over hedging refers to the practice of hedging a position in one
asset by taking a position in another asset. This is not the same as closing out a futures contract
and replacing it with another one, which is described as rolling a hedge forward.
Choice C is incorrect. Basis risk of hedging refers to the risk that the value of a futures
contract will not move in line with that of the underlying asset, leading to ineffective hedging.
This concept does not involve replacing an expiring futures contract with another one.
Choice D is incorrect. Reducing the beta of a portfolio involves adjusting its sensitivity to
market movements, typically through diversification or using derivatives like options and futures
for hedging purposes. However, this does not specifically refer to closing out an existing futures
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Q.644 A French carmaker expects to purchase 50,000 tons of copper at the end of April. The
copper futures contracts on the Eurex Exchange are available for the delivery months of March,
June, September, and December, and the size of one contract is for one ton of copper. The
company took a long position in June contracts on March 1st at a futures price of 2.450 Euros
per ton. If the futures price and spot price on the closing date are 2.42 and 2.30, respectively,
then calculate the net cost in Euros and the gain or loss on the futures contract.
A. The net cost is €116,500, and the loss on the contract is €6,000.
B. The net cost is €121,000, and the loss on the contract is €6,000.
C. The net cost is €116,500, and the loss on the contract is €1,500.
D. The net cost is €121,000, and the loss on the contract is €7,500.
Since the company has a long position in futures contracts and the futures contract price has
decreased over the period of the hedge, the company has incurred a loss on its exposure in the
futures contracts.
Note the effective price (Net cost of asset when a long hedge is used) is given by:
Where
St : Spot price of the asset being hedged at the time the hedge is closed, and
Net cost of asset when long hedge is used = 50 , 000 [2.45 + (2.30 − 2.42)] = 116, 500
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The loss (gain) for long futures is given by:
loss = Ft − F0 = 2.42 − 2.45 = −0.03 per ton ⇒ Loss in this case = −0.03 × 50 , 000 = −1, 500
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Reading 35: Foreign Exchange Markets
Q.880 Iron Cement Co. is a Pakistani company. In 2015, the company obtained a €200 million
loan facility from The Bavaria Bank (headquartered in Frankfurt, Germany). The proceeds were
used to build a new cement plant in Pakistan. Due to Pakistan’s fast-paced growth in the past few
years, the Pakistani rupee has appreciated against most of the actively traded currencies,
including the euro. Which of the following impacts is accurate, if the company pays back the loan
today?
A. The liability of the Pakistani firm has increased due to the currency appreciation.
B. The liability of the Pakistani firm has decreased due to the currency appreciation.
C. The liability of the Pakistani firm remains unaffected due to the currency appreciation.
D. The liability of the Pakistani firm has increased since the loan is denominated in Euros.
The liability of the Pakistani firm has decreased due to the currency appreciation. When a
company borrows in a foreign currency, the amount it owes is fixed in that currency. However,
the amount it will cost in the company's home currency to repay the loan can change with
exchange rate movements. If the home currency appreciates against the foreign currency, it will
take fewer units of the home currency to buy the foreign currency needed to repay the loan.
Therefore, the real value of the liability in terms of the home currency decreases. In this case,
the Pakistani rupee has appreciated against the euro, meaning it takes fewer rupees to buy each
euro. Therefore, it will cost Iron Cement Co. fewer rupees to buy the euros needed to repay the
Choice A is incorrect. The liability of the Pakistani firm would not increase due to the currency
appreciation. In fact, it's quite the opposite. When a country's currency appreciates against
another, it means that its purchasing power has increased relative to the other currency.
Therefore, in this case, as the Pakistani rupee has appreciated against the euro, Iron Cement Co.
would need fewer rupees to buy euros for repaying their loan.
Choice C is incorrect. The liability of Iron Cement Co does not remain unaffected due to
currency appreciation. Currency exchange rates have a direct impact on liabilities denominated
in foreign currencies because they determine how much of your home currency you need to
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repay those liabilities.
Choice D is incorrect. Although it's true that Iron Cement Co.'s loan is denominated in Euros,
this doesn't necessarily mean that their liability has increased due to this fact alone. As explained
above, since Pakistani Rupee has appreciated against Euro over time, it will require less amount
of Rupees now than before for repayment which effectively reduces their liability rather than
increasing it.
Q.882 In recent years, India and China have become Asia’s giants when it comes to information
technology. India is a market leader in software development, while China is leading in the sector
of IT. The two countries also have a bilateral trade agreement. India exports software to China
and China sells hardware of the IT sector to Indian firms. If the Indian rupee has appreciated
against the Chinese yuan, then determine which of the following effects of appreciation is
correct.
A. Indian goods will be cheaper for Chinese importers, while Chinese goods will become
more expensive to Indian buyers.
B. Indian goods will be more expensive for Chinese importers, while Chinese goods will
be cheaper for Indian buyers.
C. Indian goods will be cheaper for Chinese importers, and Chinese goods will also be
cheaper for Indian buyers.
D. Indian goods will be more expensive for Chinese importers, and Chinese goods will
also be more expensive for Indian buyers.
The appreciation of the Indian rupee against the Chinese yuan implies that the value of the
Indian currency has increased relative to the Chinese currency. This means that for the same
amount of yuan, a Chinese importer can now buy fewer Indian rupees. Consequently, the cost of
Indian goods, which are priced in rupees, will effectively increase for Chinese importers. This is
because they now need more yuan to buy the same amount of rupees, and hence the same
quantity of goods. On the other hand, for Indian buyers, Chinese goods will become cheaper. This
is because the Indian rupee, having appreciated, now has more purchasing power. Therefore, for
the same amount of rupees, an Indian buyer can now buy more yuan, and hence more Chinese
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goods. This dynamic is a fundamental principle of international trade and foreign exchange.
Choice A is incorrect. This choice suggests that Indian goods will be cheaper for Chinese
importers, while Chinese goods will become more expensive to Indian buyers. However, this is
not the case when the Indian rupee appreciates against the Chinese yuan. In fact, it's the
opposite: Indian goods become more expensive for Chinese importers and Chinese goods become
Choice C is incorrect. This option implies that both Indian and Chinese goods will be cheaper
for their respective importers due to currency appreciation of rupee against yuan. But this isn't
accurate as an appreciation of a country's currency makes its exports more expensive and
imports cheaper.
appreciates, its exports become more expensive while its imports get cheaper. Therefore, it's not
possible that both Indian and Chinese goods would be more expensive due to rupee appreciation
against yuan.
Q.886 Jasmine Forst is a risk manager at Lifelong Insurance Company. The company has a
number of outstanding exposures in various foreign currencies. Today, she is analyzing the
company’s current outstanding exposures in foreign currencies to derive the possible effects of
exchange rates on these exposures. Which of the following is true regarding Lifelong Insurance
Company?
A. If the company has a net short position in a specific foreign currency, then the
company’s risk increases if the value of the foreign currency depreciates against the
dollar.
B. If the company has a net short position in a specific foreign currency, then the
company’s risk increases if the value of the foreign currency appreciates against the
dollar.
C. If the company has a net long position in a specific foreign currency, then the
company’s risk increases if the value of the foreign currency appreciates against the
dollar.
D. If the company has a net long position in a specific foreign currency, then the
company’s risk increases if the value of the domestic currency depreciates against the
dollar.
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The correct answer is B.
When a company has a net short position in a specific foreign currency, it means that the
company has more liabilities than assets in that currency. In this scenario, if the value of the
foreign currency appreciates against the dollar, the company's risk increases. This is because the
company would need more dollars to purchase the foreign currency to meet its liabilities. For
example, if the company has a net short position of -€100, and the exchange rate is $1.2/€, the
company would need $120 to purchase 100 euros to meet its liabilities. However, if the euro
appreciates to $1.5/€, the company would now need $150 to purchase the same amount of euros.
Choice A is incorrect. If the company has a net short position in a specific foreign currency, it
means that the company owes more of that currency than it owns. Therefore, if the value of this
foreign currency depreciates against the dollar, Lifelong Insurance Company would actually
benefit because it would need fewer dollars to settle its obligations in that foreign currency.
Choice C is incorrect. If Lifelong Insurance Company has a net long position in a specific
foreign currency, it means that the company owns more of that currency than it owes. In this
case, if the value of this foreign currency appreciates against the dollar, Lifelong Insurance
Company's risk does not increase; instead, its potential profit increases because each unit of this
Choice D is incorrect. If Lifelong Insurance Company has a net long position in a specific
foreign currency and if the value of domestic (U.S.) dollar depreciates against this particular
foreign currency then again company's risk does not increase but rather its potential profit
increases as each unit of this particular foreign can now be exchanged for more dollars.
Q.887 Sandy Lee is a junior economist at a mid-sized asset management company based in
Boston. The company is considering making an investment in foreign bonds denominated in
Swiss francs. For this type of investment, it is vital to estimate the impact of the exchange rate
on the investment value. Which of the following is accurate?
A. If the supply for Swiss francs increases, the value of the investment of the company
will increase.
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B. If the demand for Swiss francs increases, the value of the investment of the company
will increase.
C. If the supply of the US dollar decreases, the value of the investment of the company
will increase.
D. If the demand for Swiss francs increases, the value of the investment of the company
will decrease.
The value of an investment in foreign bonds denominated in Swiss francs is directly influenced
by the exchange rate between the Swiss franc and the US dollar. When the demand for Swiss
francs increases, it leads to an appreciation of the Swiss franc against the US dollar. This
appreciation means that each Swiss franc is worth more in terms of US dollars. Therefore, the
value of the investment, when converted back to US dollars, increases. This is because the same
amount of Swiss francs now translates into a larger amount of US dollars. Hence, an increase in
the demand for Swiss francs leads to an increase in the value of the company's investment.
Choice A is incorrect. An increase in the supply of Swiss francs would typically lead to a
depreciation of the Swiss franc relative to other currencies, assuming demand remains constant.
This depreciation would decrease the value of an investment denominated in Swiss francs when
appreciation of the dollar relative to other currencies, assuming demand remains constant. This
appreciation would decrease the value of an investment denominated in Swiss francs when
Choice D is incorrect. An increase in demand for Swiss francs would typically lead to an
appreciation of the Swiss franc relative to other currencies, assuming supply remains constant.
This appreciation would increase, not decrease, the value of an investment denominated in Swiss
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Q.893 An analyst is analyzing the exchange rate of the Turkish lira in terms of U.S. dollars. The
current exchange rate is TRY 3.6 per USD, and the real interest rate in both countries is 2%.
Suppose that the prices of Turkish goods increased by 7%, and the prices of U.S goods increased
by only 5.5%, then determine which of the following statements is true.
D. There has been no impact on the exchange rates as the real interest rate is identical in
both countries.
The Turkish lira has depreciated in value against the USD. This is because the inflation rate in
Turkey is higher than that in the U.S. When inflation is higher in one country compared to
another, the value of the currency in the country with the higher inflation rate tends to
depreciate. This is because the goods in the country with higher inflation become more
expensive relative to goods in the other country. As a result, demand for the more expensive
goods decreases, which in turn decreases demand for the currency of that country. In this case,
Turkish goods have become more expensive relative to U.S goods due to the higher inflation rate
in Turkey. This has led to a decrease in demand for Turkish goods, and consequently, a decrease
in demand for the Turkish lira. This decrease in demand for the Turkish lira has caused it to
Choice B is incorrect. The Turkish lira has not appreciated in value against the USD. The
increase in the price of goods in Turkey compared to the U.S indicates inflation, which typically
Choice C is incorrect. This statement is fundamentally flawed as it suggests that the USD has
Choice D is incorrect. While it's true that identical real interest rates can influence exchange
rates, they do not negate the impact of inflation differentials on exchange rates. In this case,
higher inflation in Turkey compared to the U.S would lead to a depreciation of Turkish lira
against USD.
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Q.894 Which of the following theories suggests that the difference between the spot and the
forward rates is due to the difference in interest rates?
C. Fischer theory.
The Interest Rate Parity (IRP) theory is a key concept in the foreign exchange markets, providing
a framework for the relationship between interest rates and the exchange rate. According to the
IRP theory, the difference between the spot and forward exchange rates for a currency pair
should be equal to the difference between the interest rates of the two countries. This is because
any discrepancy between these values would provide an arbitrage opportunity, where traders
could borrow in the currency with the lower interest rate, convert to the other currency at the
spot rate, lend in the other currency, and then convert back at the forward rate, making a risk-
free profit. Therefore, in an efficient market, these arbitrage opportunities should not exist,
leading to the interest rate parity condition. This theory is fundamental to the pricing of foreign
Choice A is incorrect. The Purchasing Power Parity theory is not related to the disparity
between spot rates and forward rates due to differences in interest rates. Instead, it deals with
the concept that the exchange rate between two countries should be equivalent to the ratio of
Choice C is incorrect. The Fischer theory, also known as Fisher effect, primarily focuses on
nominal interest rates, inflation and real interest rates. It does not explain the relationship
Choice D is incorrect. As explained above, there exists a specific theory - Interest Rate Parity
Theory - which explains this relationship between spot and forward exchange rates based on
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Q.895 A foreign currency analyst based in Dubai is forecasting the forward exchange rate
USD/AED. Currently, the USD/AED spot exchange rate is 3.33. Suppose that the interest rate in
the United Arab Emirates is 2% and the interest rate in the U.S. is 4%, determine the 1-year
forward exchange rate of USD/AED.
A. 3.455
B. 3.400
C. 3.395
D. 3.266
According to the interest rate parity theorem, the forward exchange rate must be derived with
the following equation:
T
1 + RAED
F = Spot Exchange Rate × ( )
1 + RUSD
1
1.02
= 3.33 × ( )
1.04
= 3.26596
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Q.3573 Approximate the real interest rate if the nominal interest rate is 11% and inflation is
3.5%.
A. 14.5%
B. 13.5%
C. 7.5%
D. 7.25%
To approximate the real interest rate, you can use the Fisher equation, which relates the nominal
interest rate (i) to the real interest rate (r) and the inflation rate (π) as follows:
1 +i
1+r=
1+π
Now, plug these values into the Fisher equation to calculate the real interest rate (r):
1 + 0.11
1 +r =
1 + 0.035
1.11
⇒ 1 +r =
1.035
⇒ r = 1.07246 − 1 ≈ 0.07246
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Q.3575 Due to the upcoming elections, the exchange rate USD/CAD has risen from 1.17 to 1.31.
Which of the following statement is correct?
The Canadian dollar has depreciated by 10.69%. The depreciation or appreciation of a currency
is calculated based on the percentage change in its exchange rate. In this case, the exchange
rate of USD/CAD has increased from 1.17 to 1.31. This means that now you need more Canadian
dollars to buy one US dollar, indicating that the value of the Canadian dollar has decreased
relative to the US dollar. The percentage change in the CAD quote is calculated as follows:
1
1.3100
− 1 = −10.69%
1
1.1700
Choice A is incorrect. The Canadian dollar has not appreciated by 11.97%. In fact, the increase
in the exchange rate from 1.17 to 1.31 indicates that it now takes more Canadian dollars to buy
one US dollar, which means the Canadian dollar has depreciated, not appreciated.
Choice B is incorrect. The US dollar has not depreciated by 11.97%. On the contrary, as
explained above, an increase in the exchange rate signifies that it now takes more of the foreign
currency (in this case CAD) to buy one unit of USD which implies that USD has actually
appreciated.
Choice C is incorrect. The US dollar has not appreciated by 10.69%. While it's true that an
increase in exchange rate indicates appreciation of USD against CAD, but this specific
percentage change calculation does not match with given numbers and hence is inaccurate.
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Q.3579 If the exchange rate quote for the euro (EUR/USD) changes from 1.3500 to 1.2600, then
in approximate terms:
You can think of this as the change in the price of the euro expressed in US dollars. If the
exchange rate moved from 1.3500 to 1.2600, then the percentage change in the euro quote is
1.2600/1.3500 - 1 = -0.06667 or depreciation of approximately 6.7%.
Conversely, the percentage change in the indirect quote is (1/1.2600)/(1/1.3500) - 1 =
1.3500/1.2600 – 1 = 0.0714 or 7.1%.
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Q.3581 If the exchange rate quote for the Mexican peso (USD/MXN) changes from 11.9500 to
12.4000, then in approximate terms:
In the initial quote, you could buy 11.9500 pesos per US dollar.
After the change, the US dollar would buy 12.4000 pesos. The peso fell in value against the
dollar.
To determine whether the peso appreciated or depreciated and whether the dollar appreciated
Since the exchange rate went from 11.9500 to 12.4000, you now need more pesos to get one US
dollar. This means the peso has weakened, and the dollar has strengthened.
Now,
1 1
− 11.9500
12.4000
= −0.03629
1
11.9500
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Q.3814 The quote between currency X and Y is 1.3000, where currency Y is the base currency.
What is the number of units of currency X required for the exchange of 50 units of currency Y?
A. 65
B. 70
C. 85
D. 64
The base currency (in this case, Y) is always equal to one unit, and the quoted currency (in this
case, X) is what that one base unit is equivalent to in the other currency.
1.3000 × 50 = 65 units
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Q.3816 A UK-based company funds its Mexican investment by borrowing in euros (EUR) and
buying the Mexican peso (MXN), and after some time, the company exchanges the money back
to euros. What kind of transaction is this?
A. Outright transaction
B. FX swap
C. Currency futures
D. Forex forward
An FX swap is a financial instrument that involves the exchange of an agreed amount of a certain
currency for another currency, and then the reversal of this transaction at a later date. In this
scenario, the UK-based company is essentially engaging in an FX swap. They are initially
exchanging euros for Mexican pesos, and then at a later date, they are reversing this transaction
by exchanging the Mexican pesos back into euros. This is the fundamental principle of an FX
swap. The company is using the FX swap as a funding mechanism for their Mexican investment,
which allows them to mitigate any potential foreign exchange risk associated with their
investment.
Choice A is incorrect. An outright transaction involves the exchange of two currencies at a rate
agreed on the date of the contract for value or delivery at some time in the future. This scenario
does not describe an outright transaction as there is no agreement on a future exchange rate.
Choice C is incorrect. Currency futures are standardized contracts to buy or sell a particular
currency at a future date and price. In this scenario, there's no mention of any standardized
two different currencies at a specific future date and exchange rate. The company in this
scenario did not agree on any specific future date or exchange rate for converting euros into
Mexican pesos and vice versa, hence it does not represent a forex forward transaction.
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Q.3817 Firms in the foreign exchange market are exposed to risks. What is the difference
between translation and transaction risks?
A. Transaction risks are prone to transactions that are aligned to domestic currency
while translation risk arises due to transaction aligned to foreign currency
B. Transaction risks occur due to cash inflows and outflows in a foreign currency while
the translation risk occurs due to exposure to FX gains and losses when the assets and
liabilities dominated in a foreign currency are exchanged into domestic to generate
financial statements.
C. Translation risks arise due to cash inflows and outflows in a foreign currency while the
transaction risk occurs due to exposure to FX gains and losses when the assets and
liabilities dominated in a foreign currency are exchanged into domestic to generate
financial statements.
Transaction risks and translation risks are two distinct types of risks that firms operating in the
foreign exchange market often encounter. Transaction risks are associated with the cash inflows
and outflows in a foreign currency. This type of risk arises when a firm engages in financial
transactions that involve a foreign currency. The risk stems from the potential fluctuation in the
foreign exchange rate between the time the transaction is initiated and when it is settled. This
can lead to potential losses if the foreign exchange rate moves unfavorably. On the other hand,
translation risk occurs due to exposure to foreign exchange gains and losses when the assets and
liabilities dominated in a foreign currency are exchanged into the domestic currency to generate
financial statements. This type of risk arises when a firm's financial statements, which include
assets and liabilities denominated in foreign currencies, need to be converted back into the
firm's domestic currency. If the foreign exchange rate has moved unfavorably, this can lead to
Choice A is incorrect. Transaction risks are not prone to transactions that are aligned to
domestic currency. Instead, they occur due to cash inflows and outflows in a foreign currency. On
the other hand, translation risk does not arise due to transactions aligned to foreign currency but
occurs due to exposure to FX gains and losses when the assets and liabilities dominated in a
foreign currency are exchanged into domestic currency for generating financial statements.
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Choice C is incorrect. This choice incorrectly swaps the definitions of transaction risk and
translation risk. Translation risks do not arise from cash inflows and outflows in a foreign
currency; this is characteristic of transaction risks. Similarly, transaction risks do not occur due
to exposure to FX gains or losses when assets and liabilities dominated in a foreign currency are
Q.3818 Assume the USD/CAD spot quote is bid 1.2800 and ask 1.2950. The six-month forward
points quote is bid 40.60 and ask 56.50 The forward bid-ask spread is closest to:
A. 0.00565
B. 0.30065
C. 0.00406
D. 0.01659
Forward points are basis points that are added or subtracted to the spot rate to
The points can either be positive or negative, in conjunction with lower or higher
interest rates.
When points are added to the spot rate, this is called a forward premium; when points
are subtracted from the spot rate, they constitute a forward discount. In this case, we
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Q.3819 In a particular year, the inflation rate in China is higher than in the US. What is likely to
happen to the US-China exchange rate according to Purchasing power parity?
According to the Purchasing Power Parity (PPP) theory, when the inflation rate in one country is
higher than another, the currency of the country with the higher inflation rate is expected to
depreciate relative to the other country's currency. This is because a higher inflation rate
reduces the purchasing power of a country's currency. In this scenario, since the inflation rate in
China is higher than in the US, the Chinese yuan is expected to decline relative to the US dollar.
This depreciation of the yuan is necessary to maintain the equality of the price of a basket of
goods in both countries, as suggested by the PPP theory. Therefore, the Chinese currency (yuan)
Choice A is incorrect. According to the PPP theory, if inflation in China is higher than in the
United States, it means that goods and services are becoming more expensive in China relative
to the US. This would lead to a depreciation of the Chinese yuan against the US dollar, not a
Choice C is incorrect. The PPP theory suggests that changes in price levels (inflation) will
affect exchange rates. Therefore, if there's a difference in inflation rates between two countries,
Choice D is incorrect. As explained above, only one of these statements can be true according
to PPP theory and given conditions; hence all of them cannot be correct simultaneously.
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Q.3820 The spot rate for the EUR/USD is 1.3261. The interest rate in USD is 2% and in EUR is
3%. What is the 6-month EUR/USD forward rate?
A. 1.3411
B. 1.3326
C. 1.3196
D. 0.5321
T
1 + iUSD
F = S( )
1 + iEUR
1.02 0.5
= 1.3261 × ( ) = 1.3196
1.03
Q.3821 The nominal interest rate in the country is 3% and the inflation rate is 5%.
What is the value of real interest rate?
A. 10%
B. 5%
C. 2%
D. -2%
rreal ≈ 3 − 5 = −2%
Q.3822 The nominal interest rate in the country is 3% and the inflation rate is 5%.
Which of the following statements is true about this country?
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A. When an investor earns at 3%, the investor’s purchasing power decreases by 2% each
year
B. When an investor earns at 3%, the investor’s purchasing power increases by 2% each
year
When an investor earns at 3%, the investor’s purchasing power decreases by 2% each year. This
is because the real interest rate, which is the nominal interest rate adjusted for inflation, is
negative in this case. The real interest rate can be approximated by subtracting the inflation rate
from the nominal interest rate. In this scenario, the real interest rate is approximately 3% - 5% =
-2%. This means that the purchasing power of the investor's money is decreasing by 2% each
year, even though they are earning a nominal interest rate of 3%. This is because the inflation
rate is higher than the nominal interest rate, which erodes the purchasing power of money over
time. Therefore, even though the investor is earning interest, the real value of their money is
Choice B is incorrect. The investor's purchasing power does not increase by 2% each year. In
fact, it decreases due to the inflation rate being higher than the nominal interest rate. The real
interest rate (nominal interest rate - inflation) is negative (-2%), which means that the value of
Choice C is incorrect. The total return by the investor in this country is not equivalent to 8%.
This would be true if we were adding up the nominal interest and inflation rates, but this isn't
how returns work in an economy with inflation. Instead, we need to consider how much
purchasing power has changed, which involves subtracting the inflation rate from the nominal
interest rate.
Choice D is incorrect. An investor in this country should not always expect a loss of 5% per
year. While it's true that high inflation can erode purchasing power, it doesn't mean that
investors will necessarily lose money at a constant percentage each year. In this case, because
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their investment return (3%) doesn't keep pace with inflation (5%), they're effectively losing 2%
Q.3823 In a particular year, the interest rates for the EUR increase while that of the USD remain
unchanged.
What will happen to the forward exchange rate EUR/USD?
A. It will decrease.
B. It will increase.
When the EUR interest rate increases while the USD interest rate remains constant, the forward
rate, EUR/USD is expected to decrease. This relationship is explained by the interest rate parity
theory, which suggests that the difference between the forward exchange rate and the spot
exchange rate should be equal to the interest rate differential between the two currencies.
In this scenario, as the EUR interest rate increases while the USD interest rate remains
unchanged, the interest rate differential between the two currencies widens. To ensure interest
Mathematically, this concept can be illustrated using the covered interest rate parity formula:
1 + rU SD
F =S×
1 + rEU R
As the interest rate of the EUR increases, the denominator in the formula will increase, leading
This relationship is crucial for investors and businesses involved in currency trading and
hedging, as it helps them understand how changes in interest rates can impact the forward
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Q.3824 The interest rate on the Nigerian Naira (NGN) is 2%, and that of the South African rand
(ZAR) is 7%. Given that the spot rate NGN/ZAR is 1.3500, what is the 6-month forward exchange
rate quoted as points?
A. 135
B. 327
C. 365
D. 478
(1 + R Y Y Y )T
F =S
(1 + R XXX )T
(1 + R ZAR )T
=S
(1 + R N GN )T
1
(1.07) 2
= 1.3500 1
(1.02) 2
= 1.38269
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Q.3825 Which of the following statements is most likely to be incorrect?
A. The bid-offer spread is the difference between the offer price and the bid price.
B. The bid-offer spread is larger for very large transaction in the FX market
The statement that the offer price is always lower than the bid price is incorrect. In the foreign
exchange market, the offer (or ask) price is always higher than the bid price. This difference,
known as the bid-offer spread, is the profit margin for the dealer or broker facilitating the
transaction. The bid price represents the highest price a buyer is willing to pay for a security,
while the offer price is the lowest price at which a seller is willing to sell. The dealer or broker
earns their profit from this spread, providing a service to other market participants by offering
liquidity and facilitating transactions. Therefore, the offer price must always be higher than the
bid price to compensate the dealer for their services and the risks they undertake in providing
Choice A is incorrect. The bid-offer spread is indeed the difference between the offer price and
the bid price. This statement correctly defines what a bid-offer spread is in foreign exchange
markets.
Choice B is incorrect. The statement that the bid-offer spread is larger for very large
transactions in the FX market is also correct. Larger transactions often involve more risk and
uncertainty, which can lead to a wider spread as dealers seek to protect themselves from
potential losses.
Choice D is incorrect. As explained above, both choices A and B are correct statements about
factors influencing the bid-offer spread in FX markets, so it cannot be true that none of these
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Q.3826 Consider the following information
If the covered interest rate parity holds, what is the forward rate of AUD/GBP currency for one
year?
A. 0.0070
B. 0.0079
C. 0.0063
D. 0.0054
Since we have assumed that the covered interest rate parity holds, then the forward rate parity
holds. That is, a one-year spot rate should be equal to the one-year forward rate. That is,
1 + iGBP 1.0696
F AUD = S AUD ( ) = 0.0074 ( ) = 0.007856 ≈ 0.0079
GBP GBP 1 + iAUD 1.0075
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Q.3827 In a given market, the nominal rate of interest is 3% and the estimated inflation rate is
4%. Which of the following statements is correct regarding the market?
A. When an investor earns a return of 3%, the purchasing power of the investor is
reduced by 1%.
B. When an investor earns a return of 3%, the purchasing power of the investor is
reduced by 5%.
C. When an investor earns a return of 3%, the purchasing power of the investor is
increased by 1%.
D. When an investor earns a return of 3%, the purchasing power of the investor is
reduced by 7%.
The real rate of interest is calculated by subtracting the inflation rate from the nominal interest
rate. In this case, the nominal interest rate is 3% and the inflation rate is 4%. Therefore, the real
rate of interest is 3% - 4% = -1%. This means that the purchasing power of the investor is
reduced by 1%. When an investor earns a return of 3%, it is not enough to keep up with the
inflation rate of 4%. As a result, the investor's purchasing power decreases by 1%.
Choice B is incorrect. The purchasing power of the investor would not be reduced by 5%. This
would only be the case if the inflation rate was significantly higher than it is, or if the return on
Choice C is incorrect. The purchasing power of the investor does not increase in this scenario.
In fact, it decreases because the return on investment (3%) is less than the inflation rate (4%).
Choice D is incorrect. The purchasing power of an investor would not decrease by 7%. This
percentage decrease in purchasing power would require a much higher inflation rate or a much
lower return on investment than what has been given in this scenario.
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Q.3828 A USD/CAD currency rate of 1.6598 most likely implies that:
One US dollar (USD) can buy 1.6598 Canadian dollars (CAD). In the foreign exchange market,
the exchange rate is typically represented as a ratio between two currencies, where the base
currency (in this case, USD) is always equal to one unit, and the quoted currency (in this case,
CAD) is what that one base unit is equivalent to in the other currency. Therefore, a USD/CAD
currency rate of 1.6598 implies that one US dollar can buy 1.6598 Canadian dollars. This is a
fundamental concept in foreign exchange trading and is crucial for understanding how currency
Choice B is incorrect. This statement would imply that the Canadian dollar is stronger than the
US dollar, which contradicts the given exchange rate. The exchange rate of 1.6598 indicates that
one unit of the base currency (USD) can buy 1.6598 units of the quote currency (CAD), not vice
versa.
Choice C is incorrect. The given ratio does not represent an appreciation or depreciation in
value of a currency but rather it represents how much of one currency can be exchanged for
Choice D is incorrect. Similar to choice C, this option misinterprets what an exchange rate
signifies. It does not indicate appreciation or depreciation but rather it shows how much one unit
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Q.3829 A forex trader noticed the EUR/USD spot rate was 1.2960 and expected to be 1.2863
after one year. What is the euro (EUR) expected appreciation/depreciation against the US dollar
over the next year?
A. -0.748%
B. 0.748%
C. 0.651%
D. -0.651%
We know that we are dealing with EUR/USD quotes. So, we calculate as:
1.2863
− 1 = −0.00748 = −0.748%
1.2960
This was expected because clearly, there was a decrease in EUR/USD, indicating that EUR is
depreciating.
Note: The Euro is actually the base currency in line with the XXX/YYY format favored by FRM
examiners, where X is the base currency and Y the quote currency. Clearly, the euro has
depreciated against the dollar; after one year, it can only get you 1.2863USD from a previous
high of 1.296USD. Negative appreciation = depreciation
C. It represents a 4 percent depreciation in both the Chinese Yuan (CNY) and the South
African Rand.
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An appreciation in the exchange rate of two currencies implies that the base currency (the first
currency in the pair) has increased in value relative to the quote currency (the second currency
in the pair). In this case, the CNY/ZAR exchange rate refers to the amount of South African Rand
(ZAR) one can get for one Chinese Yuan (CNY). Therefore, a 4% appreciation in this exchange
rate means that the Chinese Yuan has increased in value by 4% against the South African Rand.
This implies that you would now need more South African Rands to purchase one Chinese Yuan
than you did before the appreciation. This is a fundamental concept in foreign exchange markets,
where exchange rates are constantly fluctuating due to various economic factors such as interest
Choice A is incorrect. An appreciation in the CNY/ZAR exchange rate signifies that the Chinese
Yuan (CNY) has increased in value relative to the South African Rand (ZAR), not the other way
around. Therefore, it does not represent a 4 percent appreciation in the South African Rand as
contradicts itself because if one currency depreciates, it means that it loses value against
means that Chinese Yuan has appreciated or gained value against South African Rand and not
depreciation of ZAR relative to CNY. In reality, an increase or appreciation in the exchange rate
indicates that one unit of CNY can now purchase more units of ZAR than before, meaning that
CNY has appreciated or gained value against ZAR and not vice versa.
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Q.3831 Using the table of maturity and forward points or spot rate below, what is the three-
month forward rate given that the spot exchange rate is 1.6459.
A. 1.64534
B. 1.45677
C. 1.63546
D. 1.65342
When we divide the forward points of -5.6 by 10,000, we get –0.00056. The next step is to add
this to our spot rate of 1.6459, which will lead us to a result of 1.64534.
Q.3832 The 6-month forward quote for the GBP/USD is 1.500. What is the corresponding 6-
month futures quote?
A. 0.86432
B. 0.98538
C. 0.66667
D. 0.56432
The future quote is achieved by finding the reciprocal of the forward quote. That is:
1
6-month futures quote is: = 0.66667 GBP per USD.
1.500
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Q.3833 Suppose that the quote between currency A and currency B is 1.5000 and that currency
B is the base currency. How many units of currency A should be exchanged for 200 units of
currency B?
A. 150
B. 1.5
C. 200
D. 300
A is the quote currency. The quote indicates that 1.5 units of A should be exchanged for 1 unit of
B. Thus, 300 units(1.5*200) of A are exchanged for 200 units of B
Q.3834 In India, the price index was 117 last year, and the price level index this year is 125. If
the real interest rate in India is 7.5%, what is the nominal interest rate?
A. 15.40%
B. 14.34%
C. 8.00%
D. 11.5%
Recall that
125
Expected inflation = − 1 = 0.06838 = 6.838%
117
So,
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Q.3835 A multinational uses options for hedging against FX risk on its monthly transactions.
Which of the following does the multinational need to do to minimize hedging costs?
C. Buy an option on a single exposure that applies in one time period (like one month)
Purchasing options on a basket of currencies rather than an individual currency is the most
effective strategy for a multinational corporation to minimize hedging costs. This is because the
corporation is exposed to several currencies each month, and by buying options on a collection
(basket) of currencies, it can distribute the risk, thereby minimizing it. This strategy allows the
corporation to hedge against the risk of multiple currencies simultaneously, which is more cost-
effective than hedging against each currency individually. Furthermore, this approach provides a
more diversified risk profile, which can help to further reduce potential losses.
Choice A is incorrect. Purchasing options on each currency in the market would not be a cost-
effective strategy for the corporation. This approach would require significant resources and
may expose the corporation to unnecessary risks associated with individual currency
fluctuations.
Choice C is incorrect. Buying an option on a single exposure that applies in one time period
(like one month) may not provide adequate coverage for the corporation's foreign exchange
transactions, especially if these transactions occur over multiple time periods or involve multiple
currencies.
Choice D is incorrect. While buying an option on a single exposure that applies several months
might provide some level of protection, it does not necessarily minimize costs associated with
hedging as it does not take into account potential changes in currency values over time.
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Q.4453 Consider a hypothetical world of two countries only. A fund manager borrows funds from
a country with interest rate X and invests in another country with interest rate Y, where X < Y.
He intends to generate profit from the interest differential between the two countries. The major
risk in this strategy is:
The fund manager borrows in one currency, converts the currency into another currency, and
invests the converted amount in the country with a higher interest rate. Thus, the profit
generated in the transaction can be reduced/affected in case the exchange rate changes.
Things to Remember
1. The strategy described in the question is known as a 'carry trade'. In a carry trade, an investor
borrows money in a country with a low interest rate and invests it in a country with a high
2. While the carry trade can be profitable, it is not without risks. The main risk is exchange rate
risk. If the currency of the country where the funds were borrowed appreciates against the
currency of the country where the funds were invested, the amount to be repaid in the original
3. Other risks associated with the carry trade include political risk, economic risk, and liquidity
risk. Political risk refers to the risk that a change in government policy could affect the
profitability of the trade. Economic risk refers to the risk that changes in the economic
conditions of either country could affect the trade. Liquidity risk refers to the risk that the
investor may not be able to quickly and easily convert the investment back into the original
currency.
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Q.4893 If the interest rates of currency AAA increases and that of currency BBB remains
constant, what will happen to forward rates if the exchange rate is quoted as AAA/BBB?
When the interest rate of currency AAA increases while the interest rate of currency BBB
remains constant, the forward rate for the currency pair, AAA/BBB, is expected to decrease. This
is based on the interest rate parity theory, which states that the difference between the forward
exchange rate and the spot exchange rate should be equal to the interest rate differential
In this case, since the interest rate of currency AAA has increased, and the interest rate of
currency BBB remains the same, the interest rate differential between the two currencies
widens. To maintain interest rate parity, the forward rate for AAA/BBB must decrease.
Mathematically, this can be illustrated using the covered interest rate parity formula:
As the interest rate of currency AAA increases, the denominator in the formula will increase,
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Q.4895 Which of the following is the correct difference between translation and transaction risk?
A. As compared to transaction risk, translation risk does not affect the cash flows of a
company.
B. As compared to translation risk, transaction risk does not affect the cash flows of a
company.
Translation risk and transaction risk are two types of foreign exchange risks that multinational
corporations often face. Translation risk arises when a company's financial statements, which are
in a foreign currency, are converted back into the parent company's currency. This type of risk
does not directly affect the cash flows of a company, but it can impact the reported earnings and
equity. On the other hand, transaction risk is associated with future cash flows that might change
due to changes in exchange rates. This type of risk directly affects the cash flows of a company.
Choice B is incorrect. Transaction risk does affect the cash flows of a company. It arises from
the effect of unexpected currency fluctuations on a company's future cash transactions, and can
have significant impacts on the profitability and overall financial position of a company.
Choice C is incorrect. While it's true that translation risk can be hedged using various financial
instruments, outright forward transactions and swaps are not exclusively used for this purpose.
Other hedging strategies such as money market hedges or futures contracts may also be
Choice D is incorrect. Although forward contracts can indeed be used to hedge transaction
risk, this statement is too narrow in scope as it implies that only forward contracts are used for
this purpose which isn't accurate. A variety of other derivative instruments like options or
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Q.4896 Which of the following is not a factor that determines the exchange rate?
A. Inflation.
B. Monetary policy.
The purchasing power of a country does not directly determine the exchange rate. The
purchasing power of a country is a measure of the amount of goods or services that one unit of
its currency can buy. While it is true that a country with a higher purchasing power might have a
stronger economy, this does not directly translate into a higher exchange rate. The exchange
rate is determined by the foreign exchange market through the mechanism of supply and
demand. Factors such as inflation, monetary policy, and balance of payments and trade flows can
influence the supply and demand for a currency, thereby affecting its exchange rate. However,
the purchasing power of a country's currency does not have a direct impact on these supply and
demand dynamics.
Choice A is incorrect. Inflation is a key determinant of exchange rates. Countries with lower
inflation rates exhibit a rising currency value, as purchasing power increases relative to other
Choice B is incorrect. Monetary policy also influences the exchange rate significantly. Central
banks can adjust interest rates and implement other monetary policies that affect the value of
Choice D is incorrect. The balance of payments and trade flows are crucial determinants of
exchange rates as well. If a country exports more than it imports, its currency will appreciate
due to higher demand for its goods and services (and hence its currency). Conversely, if a
country imports more than it exports, there will be less demand for its currency leading to
depreciation.
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Reading 36: Pricing Financial Forwards and Futures
Q.665 An investment manager at Galaxy Asset Management instructs his broker to short sell
2,000 shares of Solar Computer Corp. in April. The broker borrowed the shares from another
client and shorted the 2,000 shares of Solar at €456.8 per share. The manager then asked the
broker to close the short position in mid-September when the price per share got to €455.8. If
the shares paid a dividend of €1.85 per share in July, then calculate the net payoff of the
investment manager after closing out the position. (For this question, assume there are no fees,
commissions, or margins.)
The following are the cash flows of the investor during the months:
In April, the manager received a cash inflow of €913,600 as a result of shorting the 2,000 shares
In July, the shares earned a dividend of €1.85 per share, which was transferred to the lender of
the shares:
In September, the shares were purchased at a price of €455.8 to close the short position. Thus,
Q.667 Which of the following situations correctly depicts a short squeeze scenario?
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A. The prices of shares of a specific firm are continuously decreasing causing more and
more investors to short sell the shares of that firm.
B. The prices of shares of a specific firm are decreasing rapidly, and the supply of shares
is greater than its demand.
C. The prices of shares of a specific firm are increasing rapidly, forcing short sellers to
closeout their positions.
D. The process of borrowing the shares of a specific firm from a client and selling them at
the current rate with the expectation of purchasing the same shares at lower prices in
the future.
A short squeeze occurs when the prices of shares of a specific firm are increasing rapidly, forcing
short sellers to closeout their positions. Short selling is a trading strategy where investors sell
shares they do not own, with the expectation that the price will fall and they can buy the shares
back at a lower price, thereby making a profit. However, if the price of the shares increases
instead of falling, the short sellers are forced to buy back the shares at a higher price to close
their positions. This buying pressure further increases the price of the shares. This situation,
where short sellers are squeezed out of their positions due to rapidly increasing prices, is known
as a short squeeze. It is a risky situation for short sellers as they stand to incur significant losses
if they are unable to close their positions before the prices rise too high.
Choice A is incorrect. While it is true that a decrease in share prices may encourage more
investors to short sell, this does not represent a short squeeze. A short squeeze occurs when the
price of an asset increases rapidly, forcing those who have short sold the asset to buy it back at
shares in the market leading to a decrease in price. However, this does not constitute a short
squeeze which specifically refers to rapid increase in share prices causing distress for those who
Choice D is incorrect. This choice simply describes the process of short selling but does not
depict a situation of 'short squeeze'. In fact, if the expectation (of purchasing same shares at
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lower prices) mentioned here fails and instead share prices rise sharply, then that would lead to
a 'short squeeze'.
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Q.668 Brad Lee is a derivatives trader at AMG Investments based in California. Brad is analyzing
the shares of Kevin Heart Shoes Company that are currently trading at $119.4 per share. Kevin
Heart shares are comparatively new in the market, as the company’s IPO was the last quarter. A
forward contract to purchase the stock in 6-month is being offered at $122.982. If the risk-free
rate is 6% per annum, compounded semi-annually, then determine which of the following
transactions will bring positive net cash flow for Lee if he wants to close his position in exactly 6
months?
A. Borrow $119.4 at the risk-free rate to purchase the stock at the current price and then
short the stock at the forward price of $122.982.
B. Short sell the stock at the current price of $119.4, invest the proceedings at the risk-
free rate and take a long position in the forward contract to purchase the stock at
$122.982.
None of the above-mentioned transactions will bring a positive net cash flow.
Transaction A: If the investor borrows $119.4 at the risk-free rate to purchase the shares now,
the loan amount, in 6 months, will grow to:
0.06 0.5×2
119.40(1 + ) = $122.982
2
Since the investor will use the proceedings to enter into a contract to short the share at the
forward price of $122.982, the net cash flow of the trade will equal:
$122.982 − $122.982 = 0
Transaction B: If the investor short sells the stock at the current price of $119.4, and invests the
proceeds at the risk-free rate, then 6 months from now the investor will have:
119.40(1.03)0.5×2 = $122.982
Since the investor will take a long position to purchase the stock at the forward price of
$122.982, the net cash flow of the investor will equal:
$122.982 − $122.982 = 0
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Q.669 Kevin Rodriguez is a candidate for the position of a junior trader at a mid-sized investment
bank in Mexico. The bank’s hiring process is rigid, consisting of 1 written exam and 2 interviews.
Rodriguez has cleared the written exam and is currently being interviewed by the recruitment
committee. The committee asked Kevin to describe the situation where an investor can make a
risk-free profit on a forward contract. Kevin presented the following two scenarios:
I. If the forward price of the stock is greater than the current price, the investor can profit by
purchasing shares at the current price and shorting shares at the forward price.
II. If the current price of the stock is greater than the forward price, the investor can profit by
purchasing shares at the current price and shorting shares at the forward price.
Assuming that the forward price being considered differs from the forward price implied by the
spot price and the current interest rate, which of the above-mentioned scenarios will generate
profit?
C. Scenario I will generate a profit, and scenario II will also generate a profit
D. Scenario I will generate a loss, and scenario II will also generate a loss
Scenario I will generate a profit, and scenario II will generate a loss. This is because in Scenario
I, if the forward price of the stock is higher than the current price, the investor can borrow funds
at the risk-free rate to buy shares at the current price and short forward contracts to sell the
asset at the higher forward price. This strategy allows the investor to earn a risk-free return. The
investor is essentially locking in a higher selling price for the shares in the future, which, if the
shares are bought at a lower price now, will result in a profit. This is a classic example of
arbitrage, where the investor takes advantage of price discrepancies in different markets to
On the other hand, Scenario II will generate a loss. If the current price of a stock is higher than
the forward price, the investor would need to short the shares now, invest the proceeds at the
risk-free rate, and use the proceeds to take a long position in the forward contract. However, this
strategy would not result in a profit because the investor would be buying high (current price)
and selling low (forward price), which is the opposite of the profit-making strategy of buying low
and selling high. Therefore, Scenario II will generate a loss, making Choice A the correct answer.
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Choice B is incorrect. Scenario I will not generate a loss. If the forward price of the stock is
greater than the current price, an investor can profit by buying shares at the current price and
shorting shares at the forward price. This arbitrage opportunity exists because of mispricing in
the market.
Choice C is incorrect. Both scenarios will not generate a profit. In Scenario II, if an investor
buys shares at a higher current price and shorts them at a lower forward price, they would incur
Choice D is incorrect. It's not true that both scenarios will generate losses. As explained
above, in Scenario I where the forward price of stock is greater than its current spot rate, there
exists an arbitrage opportunity for risk-free profits by buying low (at spot rate) and selling high
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Q.670 Priyanka Singh is a derivative investment manager at Hind Investments based in Mumbai.
Priyanka is analyzing the shares of Cosmetic World Company that are currently trading at $76.2
per share. Cosmetic World has the largest market shares in the cosmetics market of Asia, and
the company has been profitable for over a decade. The 3-month forward contract on the stock is
being offered for the price of $86.8. Priyanka Singh wants to trade 5,000 shares of Cosmetic
World with the intention of closing the position in 3 months. If the risk-free interest rate is 5%,
then determine the arbitrage profit.
A. $77,158
B. $68,485
C. $50,798
D. $48,324
Since the forward price of the contract over Cosmetic World is higher than its current price, the
investor can profit by borrowing the funds at the current rate to purchase shares at current
prices and short forward contracts to sell the shares at higher forward prices.
If the investor borrows $76.2 dollar at the risk-free rate to purchase shares now, the loan
amount, in 3 months, will grow to:
$76.20 × (1.05)3/12 × 5,000 shares = $385, 675.72
Since the investor will use the proceedings to short a forward contract (sell the shares at the
forward price of $86.8), the cash flow from the short sell is:
$86.80 * 5,000 shares = $434,000
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Q.672 George Brown, a fixed-income investment analyst, is determining the price of a 6-month
forward contract on a unique asset. The risk-free rate of interest is 12% per year, compounded
semi-annually, whereas the dividend yield on the asset is 7% p.a, with semi-annual compounding.
If the asset price is $95, then what is the price of the forward contract?
A. $100.8
B. $97.29
C. $93.96
D. $96.13
The price of a forward contract when the underlying pays a dividend is given by:
T
1+ r
F = S( )
1+ q
where:
S= current asset price;
r = risk-free rate;
q =dividend yield paid by the underlying asset expressed on a per annum basis; and
T = time to maturity (in years) of the forward contract
The price of the forward contract is:
1.06 0.5×2
$95( ) = $97.29
1.035
Q.673 Karen Kindle is a master’s student at one of the top business schools in Taiwan. He reads
at least one book on the subject of stocks and derivatives every weekend. Last week’s book was
on the subject of pricing and valuation of forward contracts. From his understanding, he made
the two following conclusions regarding the value of forward agreements:
I. The value of the contract at the time of initiation is always zero.
II. Once the forward contract is initiated, the contract can have a positive value to both
counterparties at the same time.
A. Conclusion I is incorrect
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B. Conclusion II is incorrect
Conclusion II is incorrect. Once a forward contract is initiated, the value of the contract can be
positive to one counterparty and negative to another, but it cannot be positive to both parties at
the same time. This is because the value of a forward contract is a zero-sum game. If one party
gains, the other party must lose an equivalent amount. This is a fundamental principle of forward
contracts and derivatives in general. The value of the contract is determined by the difference
between the agreed-upon price in the contract and the current market price. If the market price
is higher than the agreed-upon price, the buyer of the contract has a gain and the seller has a
loss. Conversely, if the market price is lower than the agreed-upon price, the seller of the
contract has a gain and the buyer has a loss. Therefore, it is impossible for both parties to have a
Choice A is incorrect. Conclusion I is accurate. The value of a forward contract at the time of
initiation is indeed zero because it's an agreement to buy or sell an asset at a future date for a
price agreed upon today. No money changes hands when the contract is initiated, hence its value
is zero.
Choice C is incorrect. This choice suggests that both conclusions are incorrect, which isn't true
Choice D is incorrect. This choice implies that both conclusions are correct, which isn't true as
Conclusion II states that once the forward contract has been initiated, it can have positive value
to both counterparties simultaneously - this isn't possible in reality because if one party stands to
gain (positive value), then the other party must stand to lose (negative value). Therefore,
Q.674 Consider a forward contract on a stock index such as the S&P 500. Everything else being
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constant, which of the following statements is least accurate?
B. The forward price is directly linked to the level of the stock market index
D. The forward price will fall if dividend payments on the underlying stocks increase
The statement that the forward price will fall if interest rates rise is inaccurate. In fact, the
opposite is true. The forward price of a contract is directly influenced by the level of interest
rates. When interest rates increase, the cost of carrying the underlying asset until the delivery
date also increases. This cost is reflected in the forward price. Therefore, when interest rates
rise, the forward price also rises. This relationship is captured in the forward price formula:
F = (S − I)(1 + R)T , where F is the forward price, S is the spot price of the underlying asset, I is
the income from the asset (such as dividends), R is the risk-free interest rate, and T is the time to
maturity. As you can see from the formula, the forward price F is directly proportional to the
statement suggests.
Choice B is incorrect. The forward price is indeed directly linked to the level of the stock
market index. This is because the forward price is determined by the spot price of the underlying
asset, which in this case, is the S&P 500 index. Therefore, if there are changes in this index, it
Choice C is incorrect. If we increase time to maturity while keeping all other factors constant,
it would indeed lead to an increase in forward prices. This happens due to cost-of-carry model
where longer time periods allow for more accumulation of interest costs which are factored into
cause a decrease in forward prices rather than an increase as stated here. This happens because
higher dividends reduce expected future spot prices (as some value has been paid out as
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dividends), and hence lower future spot prices lead to lower forward prices.
Q.675 Hania Ahmed is a freelance blogger for a website that publishes articles on economics,
finance, and international business. She mostly writes about derivatives trading strategies. In
one of her latest articles regarding the relationship between forward and futures contracts, she
concluded her article with the following two statements:
I. When the prices of the underlying assets are highly positively correlated with interest rates,
the prices of forward contracts tend to be higher than the prices of futures contracts.
II. When the prices of the underlying assets are highly negatively correlated with interest rates,
the prices of futures contracts tend to be higher than the prices of forwards contracts.
Both Statements made by Hania Ahmed in her article are incorrect. The relationship between the
prices of forward and futures contracts and the correlation of the prices of the underlying assets
with interest rates is the opposite of what she stated. Specifically, when the prices of underlying
assets are highly positively correlated with interest rates, the prices of futures contracts tend to
be higher than the prices of forward contracts. This is because futures contracts are marked to
market daily, which allows the gains or losses to be realized and reinvested at the prevailing
interest rate. On the other hand, when the prices of the underlying assets are negatively
correlated with interest rates, the prices of forward contracts tend to be higher than the prices
of futures contracts. This is because forward contracts are not marked to market daily, which
means the gains or losses are not realized until the contract expires. Therefore, the impact of
changes in interest rates on the prices of forward contracts is less immediate than on futures
contracts.
Choice A is incorrect. Statement I is not correct because forward contracts do not necessarily
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tend to be priced higher than futures contracts when the prices of the underlying assets are
highly positively correlated with interest rates. The pricing of forward and futures contracts
depends on a variety of factors, including the risk-free rate, storage costs, convenience yield, and
maturity date. Therefore, it's not accurate to say that one type of contract will always be priced
higher than the other based solely on the correlation between asset prices and interest rates.
Choice B is incorrect. While statement II suggests that futures contracts tend to be priced
higher than forward contracts when asset prices are negatively correlated with interest rates,
this isn't always true either. As mentioned above, several factors influence contract pricing
Choice C is incorrect. As explained above neither Statement I nor Statement II are correct due
to multiple factors influencing contract pricing beyond just correlation between asset prices and
interest rates.
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Q.676 Ellen Harper, a portfolio manager at Deutsch Investments Group (DIG), is considering
investing in the 6-months futures contract on the German DAX-30 index. The DAX-30 is currently
valued at 12,240 with a dividend yield of 1.7% per year. If the risk-free rate in Germany is 3.2%,
then the price of the futures contract should be:
A. 12,241
B. 12,330
C. 13,080
D. 12,578
The price of the futures contract on the DAX-30 index is calculated as:
T
1+ f
Price of futures contract = Current index × ( )
1+q
1.032 0.5
Price of futures contract = 12 , 240( ) = 12 , 329.935
1.017
Q.677 Amy Damian is a portfolio manager at a local pension fund. She has recently received
great appreciation from the upper management of the fund because of her arbitrage profit of
$1.6 million on index futures. She earned arbitrage profit during the period where the prices of
futures contracts on the S&P 500 were trading lower than the current prices of the index. Which
of the following trading strategies must she have used?
A. Purchasing the stocks whose movement closely mirrors the S&P 500 index and short-
selling S&P 500 futures
B. Short-selling the stocks whose movement closely mirrors the S&P 500 index and
taking a long position in S&P 500 futures
C. Purchasing the stocks whose movement closely mirrors the S&P 500 index and taking
a long position in S&P 500 futures
D. Short-selling the stocks whose movement closely mirrors the S&P 500 index and
taking a short position in S&P 500 futures
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Amy Damian would have short-sold the stocks whose movement closely mirrors the S&P 500
index and taken a long position in S&P 500 futures. This strategy is known as 'index arbitrage'
and is used when the futures contracts are trading at a price lower than the current price of the
index. The idea behind this strategy is to exploit the price difference between the index and its
futures contract. By short-selling the stocks of the index, Amy is betting that the prices of these
stocks will fall. At the same time, by taking a long position in the futures contract, she is betting
that the price of the futures contract will rise. When the futures contract expires, the price of the
futures contract and the index should converge, allowing Amy to profit from the price difference.
It's important to note that it's not necessary to short-sell all the stocks in the index. Instead, an
investor can short-sell a representative sample of stocks whose price movements closely mirror
those of the index. This strategy is often used by institutional investors and hedge funds to
Choice A is incorrect. Purchasing the stocks whose movement closely mirrors the S&P 500
index and short-selling S&P 500 futures would not yield a profit in this scenario. This is because
when futures contracts on the S&P 500 are trading at a lower price than the current index
prices, it indicates that market participants expect future prices to be lower than current prices.
Therefore, buying stocks and short-selling futures would result in losses if future prices indeed
fall.
Choice C is incorrect. Purchasing the stocks whose movement closely mirrors the S&P 500
index and taking a long position in S&P 500 futures would also not yield a profit under these
circumstances. This strategy involves betting on an increase in both stock and future prices,
Choice D is incorrect. Short-selling the stocks whose movement closely mirrors the S&P 500
index and taking a short position in S&P 500 futures implies betting on falling stock and future
prices simultaneously. However, given that futures are already trading at a discount to spot
(current) price, further decrease may not be substantial enough to generate significant profits
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Q.680 In short-selling an investor:
A. sells an asset that he does not own with the intent of buying it back in the future at a
lower price.
B. buys an asset with the intent of selling it in the future at a higher price for profit.
C. sells an asset that he does not own with the intent of buying it back in the future at a
higher price.
D. owns the asset but sells it with the intent of buying it back at a higher price.
Short-selling is a trading strategy where an investor sells an asset that they do not own with the
intention of buying it back later at a lower price. The investor borrows the asset (usually from a
broker) and sells it on the market. Later, when the price of the asset has fallen, the investor buys
it back to return to the lender. The profit from this transaction is the difference between the
selling price and the buying price. This strategy is used when the investor believes that the price
of the asset will decrease in the future. It's a risky strategy because if the price of the asset
increases instead of decreasing, the investor will have to buy it back at a higher price, resulting
in a loss.
Choice B is incorrect. This option describes a long position, not short-selling. In a long
position, an investor buys an asset with the expectation that its price will rise in the future,
allowing them to sell it for a profit. This is fundamentally different from short-selling where the
investor sells an asset they do not own with the intent of buying it back at a lower price.
Choice C is incorrect. This choice incorrectly describes short-selling as selling an asset one
does not own with the intention of buying it back at a higher price. The goal of short-selling is to
Choice D is incorrect. This option refers to selling assets that one already owns with the
intention of buying them back at a higher price later on which contradicts the concept of short
selling where you sell assets you don't own and buy them back when their prices fall.
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Q.681 Harry McGuire is a recruitment specialist at a small size investment company that
specializes in derivatives and fixed income assets. McGuire has a basic knowledge of investing
and trading. He has prepared an informative presentation on the subject of derivatives, which is
going to be used for the purpose of recruiting on university campuses. One of the slides from
McGuire’s presentation contained the following information:
“Futures and forward contracts can be written on many assets. These assets can be investment
assets such as equities, bonds, gold, and crude oil, or consumption assets like corn, copper and
livestock.”
A. Gold
B. Crude oil
C. Copper
D. Corn
Crude oil is incorrectly categorized as an investment asset. Investment assets are those assets
whose sole purpose is to be used as investments such as equities, bonds, currencies, gold, silver,
etc. whereas consumption assets are those assets that are traded for the purpose of consumption
or processing. These assets include copper, corn, crude oil and livestock, etc.
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Q.3530 Long positions in futures contracts are more desirable to forward contracts when the
correlation between futures prices and interest rates is:
A. Zero
B. Positive
C. Negative
When the correlation between interest rates and futures prices is positive, futures contracts are
more desirable to holders of long positions than forward contracts. This is because rising prices
will lead to futures profits that are reinvested in periods of rising interest rates and falling prices
will lead to losses that occur during periods of falling interest rates. Therefore, it is far better to
receive cash flows in the interim than the expiration under such conditions. This is due to the
fact that futures contracts are marked to market daily, meaning that gains and losses are
realized and can be reinvested daily. This allows the holder of a long futures contract to
potentially earn interest on their gains, which can be particularly beneficial in a rising interest
rate environment.
Choice A is incorrect. A zero correlation between futures prices and interest rates would not
make a long position in futures contracts more desirable than forward contracts. This is because
the value of a futures contract is not influenced by changes in interest rates when there's no
correlation.
Choice C is incorrect. Negative correlation between futures prices and interest rates would
make a long position in forward contracts more desirable than futures contracts, not the other
way around. This is because as interest rates decrease (increase), the price of future contracts
Choice D is incorrect. Knowing the correlation in advance using the spot curve does not
necessarily make a long position in futures more desirable than forwards. The desirability
depends on whether this known correlation is positive or negative, rather than just knowing it.
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Q.4673 An investor considers investing in a forward contract to buy an asset currently valued at
USD 500 for USD 800 in 2 years. Given that the current interest rate is 5% with annual
compounding, what is the current value of the forward contract?
A. 346.49
B. -225.62
C. 235.62
D. -220.45
S − P V (K)
S is the current asset price, and P V (K) denotes the present value of the asset's future price.
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Q.4897 Suppose that Paul enters into a 3-year forward contract on a stock that pays no dividends
and that the current stock price is USD 35 and the annually-compounded risk-free rate is 5%
What is the forward price of this forward contract?
A. $40.52
B. $36.75
C. $30.23
D. $40.67
F = S(1 + R)T
Where,
S = Spot Price
F = Forward Price
T = Time to maturity,
Thus,
F = 35(1.05)3
= 40.5168 ≈ $40.52
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Q.4898 Suppose that John enters into a 3-year forward contract on a bond. The spot price of the
bond is USD 80. The bond is expected to provide a coupon of USD 5 at the end of the 1st year
and the 2nd year. The annually compounded risk-free rate for all maturities is 4% per year. What
is the 3-year forward price?
A. $89.99
B. $79.38
C. $84.79
D. $ 83.90
F = (S − I) (1 + R)T
Where:
S = Spot Price
F = Forward Price
T = Time to maturity
I = Income
Thus,
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Q.4899 What is the 2-year futures price on the stock index, whose value is USD 2,000, and that
the annually compounded risk-free rate is 5% per annum, and the annual dividend yield on the
index is 2%?
A. $2,119.38
B. $2,289.80
C. $2,121.80
D. $1,887.34
T
1 +R
F = S( )
1 +Q
Where:
S = Spot Price
F = Forward Price
Q = Yield
T = Time to maturity
1.05 2
F = 2 , 000( ) = USD 2119.38
1.02
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Q.4900 Paul enters into a two-year forward contract on a stock that pays no dividends and that
the current stock price is USD 33 and the annually-compounded risk-free rate is 5% per year.
Suppose that one year after the forward contract was initiated, the spot price is USD 35, and the
risk-free rate has changed to 6% per annum. What is the value of this forward contract?
A. 2.22
B. 0.68
C. 1.90
D. 2.33
The forward price, initially when the contract is initiated, is given by:
37.10 − 36.38
= 0.6792 ≈ 0.68
1.06 1
Q.4901 What would you expect when there is a negative correlation between return on assets
and interest rates?
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The forward price is greater than the futures price. This is because when there is a negative
correlation between return on assets and interest rates, it implies that when the price of an asset
rises, funds are typically invested at a lower rate. Conversely, if the asset’s price falls, funds may
be invested at a higher rate. As a result, a long futures contract is less appealing than a long
forward contract, as the futures price tends to be lower than the forward price. This is due to the
daily settlement of futures contracts, which can lead to a lower futures price compared to the
negative correlation between return on assets and interest rates, one would expect the forward
Choice B is incorrect. The forward price is not less than the futures price in this scenario. This
is because the futures price takes into account daily settlement, which can lead to a higher
overall cost due to interest rate fluctuations. In a negative correlation scenario where asset
returns increase and interest rates decrease, the futures price would typically be higher than the
forward price.
Choice C is incorrect. The forward price and futures prices are not equal in this case. While
both are derivative contracts that allow for buying or selling an asset at a future date, they differ
in how they account for interest rates and dividends. In particular, futures prices incorporate
daily settlement which can cause them to diverge from forward prices when there's volatility in
interest rates.
Choice D is incorrect. As explained above, one of the options (A) accurately describes how
negative correlation between return on assets and interest rates affects the relationship between
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Reading 37: Commodity Forwards and Futures
Q.805 Henry Luis is a commodity trader at a mutual fund that focuses on derivatives and
commodities investments. Luis was instructed to pay special attention to the storage costs and
cost of carry while valuing the commodities futures contract. Which of the following commodities
is likely to have the smallest storage costs?
A. Crude oil
B. Corn
C. Livestock
D. Gold
Gold is a precious metal that is highly valued for its properties and uses. It is a dense, soft, shiny,
malleable, and ductile metal. Gold is also a good conductor of electricity and is resistant to
corrosion and tarnish. These properties make gold an ideal commodity for storage as it does not
require special conditions or maintenance. Furthermore, gold is highly liquid and readily
available, which means that investors can easily purchase gold for delivery at the maturity of the
contract. This reduces the need for storage and consequently, the storage costs. In comparison to
other commodities like crude oil, corn, and livestock, gold has the smallest storage costs. Crude
oil requires special storage facilities to prevent leakage and environmental damage. Corn is a
perishable commodity and requires conditions that prevent spoilage. Livestock requires feed,
care, and suitable living conditions. All these factors contribute to their higher storage costs.
Choice A is incorrect. Crude oil incurs significant storage costs due to the need for specialized
storage facilities that meet safety and environmental regulations. Additionally, the cost of
for storage to prevent spoilage and infestation. This results in high storage costs.
Choice C is incorrect. Livestock also incurs high storage costs as it requires feeding, care and
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Q.806 Commodities futures markets consist of hundreds of different commodities with different
properties and attributes. Some commodities do not consider the storage costs separately
because, in those commodities, the forward price of the commodity compensates the commodity
owner for the cost of storage. Such commodity markets are referred to as:
A. Discount markets.
B. Free markets.
C. Carry markets.
D. Forwards markets.
The term 'carry' in financial markets refers to the cost of holding a financial instrument or
stored rather than being traded. This concept is akin to the financial cost of carry in financial
markets. The forward price of a commodity in a carry market compensates the owner for the cost
of storage. This becomes more apparent in the case of commodities, as the process of producing
and distributing them often involves storing them. Therefore, the term 'carry markets' accurately
describes commodity markets where the forward price of the commodity compensates the owner
Choice A is incorrect. Discount markets refer to markets where securities are bought and sold
at prices lower than their face value, which is not related to the concept of storage costs in
Choice B is incorrect. Free markets are economic systems where prices for goods and services
are self-regulated by buyers and sellers negotiating in an open market. This term does not
specifically refer to commodities that include storage costs in their forward price.
Choice D is incorrect. Forwards markets involve contracts that agree on a set price for a
future transaction, but this term does not imply whether or not storage costs are included in the
Q.807 Anton Patrick is a finance and accounting professor at the Boston Business College (BBC).
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Currently, he is teaching the subject of commodities and derivatives to first-year undergrad
finance students. During a surprise quiz, he asked some students to define the use of “lease rate”
in commodities markets. Three of the students gave the following definitions. Which one of them
is/are correct?
Student 1: “Lease rate is the risk-free rate at which a long position holder in the futures contract
can finance his position.”
Student 2: “Lease rate is widely used as an underlying asset on a futures contract.”
Student 3: “Lease rate is the rate used by short-seller of the commodity to compensate the
lender of the commodity for the lending.”
A. Student 1 is correct.
B. Student 2 is correct.
C. Student 3 is correct.
The lease rate is indeed the rate used by a short-seller of the commodity to compensate the
lender of the commodity for the lending. This definition provided by Student 3 is accurate. In
commodity markets, a lease rate is a crucial concept that is often used in futures contracts.
When a commodity is lent out, the lender is compensated by the borrower (the short-seller) at a
certain rate, known as the lease rate. This rate is essentially the cost of borrowing the
commodity. It is important to note that the lease rate is not a risk-free rate, nor is it used as an
underlying asset on a futures contract. Instead, it is a cost that the short-seller incurs to borrow
the commodity from the lender. This cost is necessary because the lender is giving up the
opportunity to use or sell the commodity during the lending period. Therefore, the lease rate
serves as a form of compensation for the lender's opportunity cost. In the context of financial
assets, a similar concept exists where the short-seller compensates the owner for dividends. In
the case of commodities, the short-seller may use the lease rate to make lease payments to the
owner of the commodity. Therefore, the definition provided by Student 3 is the most accurate
Choice A is incorrect. The lease rate is not the risk-free rate at which a holder of a long
position in the futures contract can finance his position. This definition confuses the lease rate
with the cost of carry, which includes interest rates and storage costs among other factors.
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Choice B is incorrect. The statement that 'lease rate is widely used as an underlying asset on a
futures contract' does not accurately define what a lease rate is. Rather, it misrepresents its role
in commodity markets. Lease rates are associated with commodities but they are not themselves
Choice D is incorrect. As explained above, Student 2's definition of lease rate was inaccurate,
Q.808 John Sinclair is a high net worth individual investor and the owner of a chain of
independent fossil fuel power plants in Saint Petersburgh, Russia. During a web conference with
his investment advisor from Canada’s largest investment bank, the advisor advised Sinclair to
invest in futures contracts on Crude and Brent oil. He mentioned that apart from the monetary
gains, the investor might also receive nonmonetary benefits from the physical possession of
these commodities. Which of the following benefits is the investment advisor referring to?
A. Risk-free rate
B. Lease yield
C. Convenience yield
D. Roll-over yield
The nonmonetary benefit that the investment advisor is referring to is known as the convenience
yield. This is a term used in the commodities market to describe the benefits that an investor
derives from physically holding a commodity. These benefits are nonmonetary in nature and can
include factors such as ensuring supply during shortages, avoiding costs associated with storage
and transportation, and providing a hedge against price volatility. In the context of the question,
since John Sinclair owns a business that is directly related to the underlying commodities of
Crude and Brent oil, he stands to gain from the convenience yield. For instance, in the event of a
short-term oil supply shortage, he could use the oil from his futures contracts to continue
Choice A is incorrect. The risk-free rate is not a nonmonetary benefit. It refers to the
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theoretical rate of return of an investment with no risk of financial loss, which is not applicable
in this context as investing in futures contracts on Crude and Brent oil involves significant risks.
Choice B is incorrect. Lease yield refers to the return obtained from leasing a commodity,
which does not apply here as John Sinclair's investment advisor has suggested investing in
Choice D is incorrect. Roll-over yield pertains to the gains or losses experienced when an
investor moves his position from a front month contract to another contract set for a future date.
This concept does not relate to any nonmonetary benefits that could be derived from physically
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Q.809 Busra Turkmen is a business newscaster and an economic analyst at one of the leading
business and finance-focused news channel in Germany. While writing the evening business
report, she noticed that the prices in gold forwards contracts are upward sloping, which means
the forward prices of longer maturity gold contracts are higher than the prices of shorter
maturity gold contracts. Which of the following terms can she use to define the given trend in
gold forward prices?
A. Convenience yield.
B. Backwardation.
C. Upwardation.
D. Contango.
In the context of commodity markets, the term 'Contango' is used to describe a situation where
the forward price of a commodity is higher than the spot price. This is typically observed when
the costs associated with storing the commodity (such as warehousing and insurance costs) are
significant. In such a scenario, the forward price needs to be higher than the spot price to
compensate for these costs. This results in an upward sloping forward curve, where the forward
prices of contracts with longer maturity are higher than those with shorter maturity. This is
exactly the trend that Busra Turkmen observed in the gold forwards contracts. Therefore, the
Choice A is incorrect. Convenience yield refers to the benefits or advantages that a company
gains by holding a physical commodity, instead of the contract for the commodity. It does not
Choice B is incorrect. Backwardation is a situation where the spot price is higher than the
forward price. This scenario contradicts Busra's observation where forward prices are increasing
option invalid.
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Q.810 In the United States, forward and futures contracts are available for trading on various
commodities. These commodities are classified in the categories of extractable or renewable and
primary or secondary. Which of the following commodities can be classified as renewable as well
as a primary commodity?
A. Oil
B. Copper
C. Livestock
D. Gasoline
Livestock is a renewable and primary commodity. Renewable commodities are those that can be
replenished over time through natural processes. Livestock, being a product of agricultural
activities, falls under this category. They are bred and raised, and their population can be
replenished over time, making them renewable. Primary commodities, on the other hand, are
commodities that are traded in their raw, unprocessed form. Livestock, being traded in their live
form without any processing, are considered primary commodities. Therefore, livestock is both a
Choice A is incorrect. Oil is an extractable commodity, not renewable. It is formed from the
remains of ancient marine plants and animals, a process that takes millions of years. Therefore,
Choice B is incorrect. Copper is also an extractable commodity as it comes from the earth's
Choice D is incorrect. Gasoline, although derived from oil which makes it primary in terms of
processing stage, it's not renewable because its source (oil) isn't renewable.
Q.811 Mika Singh is the head of the commodities trading unit at an investment company. Singh
has 5 years of experience in trading commodities derivative products. One of his subordinates
seems to lack knowledge about forward prices. Singh wrote an email to his subordinate that
contained the following two explanation regarding forward price:
I. The prepaid forward price for a commodity is the present value of the futures price of a
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commodity that is to be received on a specific future date
II. The forward price of a commodity is the future value of the prepaid forward price of the
commodity
Both explanations provided by Singh are correct. The forward price of a commodity is indeed the
future value of the prepaid forward price of the commodity. This is because the forward price is
the agreed upon price of a commodity to be delivered and paid for at a future date. Therefore, it
is the future value of the prepaid forward price, which is the price of the commodity if it were to
Similarly, the prepaid forward price for a commodity is the present value of the futures price of a
commodity that is to be received on a specific future date. This is because the prepaid forward
price is the price of the commodity if it were to be paid for immediately (prepaid) and delivered
at a future date. Therefore, it is the present value of the futures price, which is the agreed upon
Choice A is incorrect. Explanation I provided by Singh is correct. The prepaid forward price for
a commodity is indeed the present value of the futures price of a commodity that is to be
received on a specific future date. This concept reflects the time value of money, where the
present value of an expected future cash flow can be calculated using an appropriate discount
rate.
Choice B is incorrect. Explanation II provided by Singh is also correct. The forward price of a
commodity can be considered as the future value of its prepaid forward price, which essentially
means it's what you would have to pay in today's dollars for delivery at some point in the future.
Choice C is incorrect. As explained above, both explanations provided by Singh are accurate
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and align with standard financial theory and practice in commodities trading.
Q.813 A commodities trader at an investment bank has analyzed the forward prices of gold
contracts and realized that there might be an arbitrage profit present in gold futures contracts.
The spot price for one ounce of gold is $1,205 and the 6-month futures contract is quoted as
$1,253 per ounce. If the risk-free rate is 6% (compounded continuously), then the arbitrage
profit for trading one gold futures contract is:
A. $7.81
B. $23.61
C. $11.31
D. $10.96
The futures price of the 6-month gold contract is greater than the spot price. Therefore, an
arbitrage opportunity exists.
An investor should take the following steps at time 0:
1. Borrow $1,205 for 6 months at the risk-free rate
2. Buy gold at the spot price of $1,205
3. Take a short exposure in the 6-month gold futures contract for the futures price of $1,253
Q.814 Branden Berger is an active trader at Eclipse Funds. He has been closely monitoring the
spot prices and forward prices of corn bushel for a long time. He has noticed that the spot price
and the 1-year forward price of a corn bushel contract are identical at $6.90 per corn bushel. If
the risk-free rate is 8%, then which of the following strategy will earn him arbitrage profit?
A. Borrow the amount equal to the spot price of corn for 1 year at the risk-free rate of
8%, buy a corn bushel at the spot price, and take a short position in a 1-year corn
forward contract. At the expiration of the contract, the investor will sell the corn bushel
at the futures price and pay off the borrowed money with interest.
B. Borrow the amount equal to the spot price of the corn bushel, lend the money for one
year at the risk-free of 8%, and take a long position in a corn forward contract. After one
year, the investor will receive the lent money with interest, receive the corn bushel at the
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expiration of the contract, and deliver the corn bushel.
C. Short sell corn at the spot price of $6.90 per bushel, lend the money for one year at
the risk-free of 8% and take a long position in a corn forward contract. After one year, the
investor will receive the lent money with interest, receive the corn bushel at the
expiration of the contract, and deliver the corn bushel.
D. Since the spot price of the corn bushel is equal to the 1-year forward price of the corn
forward contract, an arbitrage profit is not possible.
The strategy outlined in choice C allows for an arbitrage profit. The trader begins by short
selling corn at the spot price of $6.90 per bushel. Short selling involves borrowing an asset and
selling it with the expectation that the price will decrease, allowing the trader to buy it back at a
lower price and return it to the lender, keeping the difference as profit. In this case, the trader
then lends the proceeds from the short sale for one year at the risk-free rate of 8%.
Simultaneously, the trader takes a long position in a corn forward contract for the price of $6.90.
After one year, the trader will receive the lent money with interest, which would amount to
$7.45. The trader will also receive the corn bushel at the expiration of the contract for $6.90, and
deliver the corn to the lender. The difference between the amount received from lending and the
Choice A is incorrect. This strategy would not generate an arbitrage profit because the spot
and forward prices are identical. Borrowing money to buy corn at the spot price and then selling
it at the same price in the future will only result in paying interest on the borrowed money,
Choice B is incorrect. This strategy involves borrowing money to lend it out again, which does
not make sense as it would just incur unnecessary transaction costs without generating any
profits. Furthermore, taking a long position in a forward contract when the spot and forward
Choice D is incorrect. While it's true that when spot and forward prices are identical there
usually isn't an arbitrage opportunity, this statement ignores other factors such as risk-free rate
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Q.815 Branden Berger is an active derivative trader at the Eclipse Funds. He has been closely
monitoring the spot prices and forward prices of corn bushel for a long time. He has noticed that
the spot price and 1-year forward price of a corn bushel contract are identical at $6.90 per corn
bushel. If the risk-free rate is 8%, then the arbitrage profit is equal to:
A. $0
B. $0.53
C. $0.55
D. $1.06
Note: Selling short comes with a fee, but we ignore that for exam purposes.
Q.816 An investor is analyzing a 6-month oil forward contract that is quoted as $54 per barrel.
The spot price of oil is $55 per barrel, and the risk-free rate is 10%. In order to earn risk-free
profits, the investor short sells oil at the spot price of $55, lends the money for 6 months at risk-
free of 10%, and takes a long position in an oil forward contract for the price of $54 per barrel.
After 6 months, the investor receives the lent money with interest equaling $57.68, purchases
the oil at the forward price of $54, and delivers the oil to earn an arbitrage profit of $2.68 per
barrel. Which of the following strategies has he most likely implemented?
B. Arbitrage-free strategy.
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The investor has implemented a reverse cash-and-carry arbitrage strategy. This strategy involves
three steps at the initial time: short selling the commodity, lending the proceeds from the short
sale at market interest rates for the duration of the forward or futures contract, and taking a
long position in the futures contract at the market price. At the expiration of the contract, the
investor collects the lent proceeds with interest, takes delivery of the commodity at the futures
price, and delivers the commodity to fulfill the short sale commitment. This strategy is typically
used when the futures price is lower than the spot price, adjusted for the cost of carry, which
includes interest on the funds used to finance the holding of the commodity and any storage
costs. In this case, the investor was able to earn an arbitrage profit of $2.68 per barrel by
Choice A is incorrect. A cash-and-carry arbitrage strategy involves buying an asset at the spot
price, storing it, and selling a forward contract on the asset. In this case, the investor is short
selling oil at the spot price and taking a long position in the oil forward contract, which is not
make risk-free profits. However, in this scenario, the investor earns an arbitrage profit of $2.68
per barrel by short selling oil at the spot price and taking a long position in the oil forward
contract.
combining positions in options and their underlying assets to exploit mispriced options for profit.
This scenario does not involve any options; hence it cannot be described as a binomial arbitrage
strategy.
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Q.818 An investor is interested in taking a long position in a 12-month cotton forward contract.
Estimate the 12-month forward price for cotton that has a spot price of $37 per pound and an
annual lease rate of 5% if the risk-free rate for the commodity is equivalent to 7.5% with annual
compounding.
A. $39.88
B. $38.89
C. $37.88
D. $36.08
The lease rate is used by the lender of the commodity to calculate the lease payment for lending
the commodity to borrow. The lease rate must be incorporated into the equation to calculate the
forward price of the commodity.
The forward price of cotton is calculated using the following equation:
1 +R T
F = S( )
1 +L
Where:
F = forward price
S = spot price
R = risk-free rate
L = lease rate
Thus,
1.075 1
F = 37( ) = $37.88 per pound
1.05
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following is true?
The market for silver is said to be in contango. In the context of commodity markets, contango is
a situation where the forward price of a commodity is higher than the spot price. This is typically
indicative of an upward sloping forward curve. The relationship between the forward and spot
prices of a commodity can be expressed using the formula: F = Se^(r - l)T, where F is the
forward price, S is the spot price, r is the risk-free rate, l is the lease rate, and T is the time to
maturity. In this scenario, given that the risk-free rate (8.2%) is higher than the lease rate (7.9%),
the forward prices will be greater than the spot prices, suggesting that the market for silver is in
contango. This is consistent with the general principle that in a contango market, investors are
willing to pay more for a commodity in the future than the actual expected price of the
commodity. This could be due to various factors such as storage costs, convenience yield, and
Choice A is incorrect. Backwardation refers to a market condition where the futures prices are
lower than the spot prices. In this case, without knowing the forward prices, we cannot
and thus does not describe any market condition for silver.
Choice D is incorrect. Even though we do not have direct information about forward prices,
given that there's a well-established lending market for silver with a lease rate of 7.9% and risk-
free rate of 8.2%, it can be inferred that the cost of carry (risk-free rate - lease rate) is positive
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Q.820 An analyst is identifying the effects of storage cost, lease rate, and convenience yield on
the forward prices of storable commodities. After testing these effects, the analyst has concluded
the following three points:
I. The presence of a lease rate reduces the forward price of a commodity
II. The presence of a convenience yield increases the forward price of a commodity
III. The presence of storage costs reduces the forward price of a commodity
A. I & II
B. II & III
C. I & III
D. I only
The only accurate statement among the three is Statement I. The presence of a lease rate indeed
reduces the forward price of a commodity. A lease rate is essentially the return earned by the
owner of a commodity when they lease it out. When a lease rate is present, it implies that the
commodity can generate income, which reduces the need for the owner to sell the commodity in
the future. This, in turn, reduces the forward price of the commodity. Therefore, the analyst's
Choice A is incorrect. While the first statement is correct that the forward price of a
commodity decreases in the presence of a lease rate, the second statement is not. The forward
price of a commodity actually decreases in the presence of a convenience yield, not increases.
Choice B is incorrect. The second statement, as mentioned above, is incorrect because the
forward price decreases with an increase in convenience yield. Additionally, the third statement
is also wrong as it contradicts with cost-of-carry model which states that an increase in storage
Choice C is incorrect. Although it correctly states that lease rates decrease forward prices
(statement I), it incorrectly asserts that storage costs decrease these prices (statement III). As
per cost-of-carry model, higher storage costs should result in higher forward prices.
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Q.821 An analyst is analyzing the effect of storage costs and convenience yields on the forward
prices of livestock. The storage cost of the livestock is 1.3%, and the convenience yield is 2.9%.
Evaluate the final impact on the forward price of livestock if the risk-free rate is 1.4%.
A. The forward price of livestock will be greater than the spot price of livestock.
B. The forward price of livestock will be lower than the spot price of livestock.
C. The forward price of livestock will be equal to the spot price of livestock.
The forward price of livestock will be lower than the spot price of livestock. This is because the
convenience yield is greater than the storage cost and risk-free rate. This relation can be
Since the convenience yield is greater than the sum of storage cost and the risk-free rate, the net
effect will be negative, and the forward price will be lower than the spot price.
Q.822 Garry Johnson has recently joined the derivatives unit of Brilliance Investment Bank as a
research analyst. He has been assigned to focus his research on the energy sector. Johnson is
analyzing spot prices and forward prices of Crude and Brent oil contracts in the futures markets,
and he notices a trend in forward prices. The forward prices of oil contracts are in a downward
sloping curve, which means the forward prices with larger maturities are lower than the forward
prices of oil futures with shorter maturities. This trend in forward prices is referred to as:
A. Diminishing curve
B. Backwardation
C. Upwardation
D. Contango
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The term used to describe the observed trend in forward prices is 'backwardation'.
Backwardation is a situation in the futures market where the forward prices of commodities with
distant maturities are lower than the forward prices of the same commodity with shorter
maturities. This phenomenon is typically observed when the market expects the spot price of the
commodity to decrease over time. In such a scenario, market participants are willing to sell the
commodity at a lower price in the future, resulting in a downward sloping forward price curve.
This is a common occurrence in the energy sector, particularly in the oil markets, where supply
and demand dynamics can significantly influence price trends. Backwardation can provide
valuable insights into market expectations about future price movements and can be a useful tool
for traders and investors in formulating their trading and investment strategies.
Choice A is incorrect. There is no term such as "Diminishing curve" in the context of futures
markets. It seems to be a made-up term and does not describe the observed trend in forward
prices.
Choice C is incorrect. The term "Upwardation" does not exist in financial terminology related
to futures markets. This choice appears to be a play on words combining 'upward' and
Choice D is incorrect. Contango refers to an upward sloping forward curve, where future
prices are higher than spot prices, which is opposite of what Johnson observed in his analysis.
Q.823 An investment manager is analyzing the forward curve of a specific commodity, which will
help him identify if the forward price of the commodity will be higher or lower than the spot
price. Suppose that the manager has figured that the lease rate of the specific commodity is
6.5% and the risk-free rate is 6%, then determine which of the following option is true.
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Backwardation is a term used in the commodity market to describe a situation where the forward
prices of a commodity are lower than the spot prices. This is typically indicated by a downward
sloping forward curve. The relationship between the forward and spot prices of a commodity can
T
F = Se(extR isk −f reera te –extL ease rate)
In this scenario, the risk-free rate (6%) is lower than the lease rate (6.5%). According to the
formula, this would result in forward prices that are lower than the spot prices, indicating a
market in backwardation. Therefore, the investment manager's analysis suggests that the
Choice A is incorrect. The market of the commodity is not in contango. Contango occurs when
the forward price of a commodity is higher than the spot price, which typically happens when the
lease rate is less than the risk-free rate. In this case, however, we know that the lease rate (6.5%)
exceeds the risk-free rate (6%), suggesting that backwardation rather than contango should be
expected.
have enough information to determine whether it's in contango or backwardation based on given
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Q.3527 The spot price of oil is USD 95 per barrel, and the six-month futures price is USD 100 per
barrel. The cost of storing oil for six months has a present value of USD 10 per barrel, and the
risk-free rate is 5% per year.
Determine the convenience yield, Y.
A. 7.6%
B. 5.0%
C. 4.5%
D. 15.8%
1+ R T
F = (S + U) [ ]
1+ Y
where:
F = futures price
S = spot price
U = present value of the storage cost
R = risk-free rate
Y = convenience yield
T = time to maturity of futures contract
We can rewrite the above equation So that:
1
S +U T
Y =[ ] (1 + R) − 1
F
1
105 1
=[ ] 2 (1.05) − 1
100
= 0.157625
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Reading 38: Options Markets
Q.724 Jessie Leeson has spent her last semester studying abroad at the University of Vienna. She
took advanced finance and derivatives courses during her semester abroad where she studied
pricing, valuing, hedging, and trading strategies involving derivatives. During a meeting with her
colleagues, one of them asked her to outline the similarities and differences between options,
futures, and forwards. She made the following statements:
I. The cost of entering into an option or a futures contract is zero, but forward contracts have a
cost.
II. The holder of an option has a right but not an obligation to exercise the option, while the
holder of a futures/forward contract has an obligation to honor the contract.
Only statement II is correct. An option contract gives the holder the right, but not the obligation,
to buy or sell the underlying asset at a specified price within a certain period of time or on a
specific date. This means that the holder can choose to exercise the option if it is beneficial to
them, or let it expire worthless if it is not. On the other hand, futures and forward contracts
obligate the holder to buy or sell the underlying asset at a specified price on a specific future
date. This means that the holder is legally bound to fulfill the terms of the contract, regardless of
whether it is beneficial to them or not. Therefore, Jessie's statement II accurately describes the
Choice A is incorrect. Statement I is not correct. While it's true that the cost of entering into a
futures contract is typically zero, this isn't the case for options or forward contracts. Options
require an upfront premium to be paid by the buyer to the seller, and while forward contracts
don't usually require an upfront payment, they do have a cost in terms of opportunity cost or
Choice C is incorrect. As explained above, statement I is not correct which makes this choice
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incorrect as well.
Choice D is incorrect. Statement II made by Jessie Leeson is accurate - holders of options have
a right but not an obligation to exercise their option, whereas holders of futures/forward
contracts are obligated to honor their contract. Therefore, this choice stating that none of the
Q.725 Adam Smith is a former computer engineer who has been actively trading stocks and
derivatives after his early retirement from a 35-year engineering career. Smith holds 5,000
stocks of Banana Computers. He recently entered into a transaction where he has the right to
buy 1,000 stocks from another investor if the value of the stock increases beyond a predefined
price. Which of the following accurately defines the transaction?
Adam Smith is long call options. A long call option position is a strategy that an investor uses
when they believe the price of the underlying asset or security will rise. In this case, the
underlying asset is the stock of Banana Computers. The investor, Adam Smith, has bought the
right, but not the obligation, to buy a specified amount of these stocks (1,000 in this case) at a
predetermined price from another investor. This right is valid until the expiration date of the
option. If the price of the stocks increases beyond the predetermined price (also known as the
strike price), Adam can exercise his option to buy the stocks at the lower strike price and then
sell them at the current market price, making a profit. The profit would be the difference
between the market price and the strike price, minus the premium paid for the option. If the
price of the stocks does not increase beyond the strike price, Adam can choose not to exercise
his option. In this case, his loss would be limited to the premium he paid for the option. This
strategy is known as being 'long' on call options because the investor benefits from a long-term
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Choice A is incorrect. A long put option gives the holder the right, but not the obligation, to
sell a specified amount of an underlying security at a specified price within a specified time
frame. This is different from Adam's transaction where he has the right to purchase additional
stocks.
Choice B is incorrect. Being short on equity swaps means that one party agrees to pay another
party the return on an equity (like dividends and capital gains or losses), in exchange for
receiving a fixed or floating rate of interest over a certain period. This does not match with
Adam's transaction which involves having the right to buy more stocks if their value surpasses a
certain price.
Choice C is incorrect. Long on equity forwards implies that one has agreed to buy an asset at a
future date for a price agreed upon today. However, in Adam's case, he has only obtained the
right (not obligation) to purchase additional stocks if their value exceeds some predetermined
level.
Q.727 Emmy Annie, a finance student at the University of Kennesaw, regularly invests her extra
income in stocks and derivatives. She owns stocks of ABC Inc., a cleaning company, which are
currently trading at $45. She believes the stock will trade below $45 if new regulations on
cleaning companies are introduced next month. She is interested in entering an option position
that gives her the right to sell her stocks at $45. If the price of the stock goes below $45, suggest
the most appropriate option position for Annie.
A long put option with the strike price of $45 is the most suitable option for Annie. A put option
gives the holder the right, but not the obligation, to sell a specified amount of an underlying
security at a specified price within a specified time. This is known as the strike price. In this
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case, the strike price is $45. If Annie anticipates that the price of the ABC Inc. stock will fall
below $45 due to the introduction of new regulations, she can protect her investment by buying
a put option. If the stock price does fall, she can exercise her option and sell her shares at the
strike price of $45, thereby avoiding a loss. This strategy is known as a protective put. It is used
when an investor wants to protect an existing or planned purchase of a stock from falling below
the current price. The cost of this protection is the price of the put option, also known as the
premium. If the stock price does not fall as anticipated, Annie will only lose the premium paid for
the put option, but her shares will still be worth $45 each.
Choice A is incorrect. A long call option gives the holder the right to buy an asset at a specified
price within a specific time period. In this case, Annie anticipates a fall in the stock price and
hence, buying a call option would not be beneficial as it would only be profitable if the stock
price increases.
Choice B is incorrect. A short call option involves selling the right to buy an asset at a certain
price within a specific time period. This strategy could potentially expose Annie to unlimited
losses if the stock price were to increase significantly, which is not her expectation.
Choice D is incorrect. A short put option involves selling the right to sell an asset at a certain
price within a specific time period. If Annie sells (writes) put options on ABC Inc., she will have
an obligation to buy shares of ABC Inc., if they fall below $45 per share, which contradicts her
Q.728 Franky M. purchased an American put option from Lee V. on the stocks of Fast Cars Co. to
sell 2,000 shares of stock at a price of $3.30 per share. The put option has a strike price of
$31.70. If the stock price at the expiration of the option is $30, then which of the following
statements is true?
A. Franky lost $6,600 on the short position while Lee gained $6,600 on the long position.
B. Franky lost $6,600 on the long position while Lee gained $6,600 on the short position.
C. Franky lost $3,200 on the long position while Lee gained $3,200 on the short position.
D. Franky lost $3,200 on the short position while Lee gained $3,200 on the long position.
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Franky M., as the buyer of the put option, holds the long position. This means he has the right,
but not the obligation, to sell the underlying asset (in this case, the stocks of Fast Cars Co.) at
the strike price. The strike price is $31.70, and the stock price at the expiration of the option is
$30. This means that Franky can sell the stocks for $1.70 more per share than their current
market price. Therefore, his gain from exercising the option is ($31.70 - $30) * 2,000 = $3,400.
However, Franky had to pay a premium to buy the option, which cost him $3.30 per share, or
$3.30 * 2,000 = $6,600 in total. Therefore, his net loss from this transaction is $6,600 - $3,400 =
$3,200. On the other hand, Lee V., as the seller of the put option, holds the short position. He is
obligated to buy the stocks if Franky decides to exercise the option. Lee's gain from selling the
option is the premium he received, which is $6,600. However, he loses on the underlying asset
because he has to buy the stocks for more than their current market price. His loss from the
underlying asset is the same as Franky's gain, which is $3,400. Therefore, his net gain from this
Choice A is incorrect. Franky did not lose $6,600 on the short position. In fact, Franky was in a
long position as he had the right to sell the shares at a predetermined price. The amount lost
Choice B is incorrect. While it's true that Franky was in a long position and Lee was in a short
position, they did not gain or lose $6,600 respectively. The difference between the strike price
and stock price multiplied by number of shares gives us $3,400 ($1.70 * 2000), which is what
Choice D is incorrect. This choice incorrectly states that Franky was in a short position when
he actually held an American put option which puts him in a long position with rights to sell at
strike price.
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Q.729 Which of the following statements regarding the features of put and call options is
correct?
I. The long position holder in a call option is also referred to as the writer of the option
II. The short position holder in a put option is referred to as the seller of the option
Only statement II is correct. In the context of options trading, the terms 'long' and 'short' are
used to describe the positions that traders can take. A trader who buys an option is said to be
'long' on that option, while a trader who sells an option is said to be 'short' on that option.
Therefore, the individual who holds a short position in a put option is indeed referred to as the
seller of the option. This is because they have sold the right to sell the underlying asset at a
specified price (the strike price) within a specified period. The seller of the option, therefore, has
the obligation to buy the underlying asset if the option is exercised by the buyer. This statement
accurately reflects the roles and terminologies associated with put options in financial markets.
Choice A is incorrect. The first statement is not accurate. The individual who holds a long
position in a call option is known as the buyer, not the writer of the option. The writer or seller of
Choice C is incorrect. As explained above, statement I is incorrect which makes this choice
position in a put option can be identified as the seller of the option, hence this choice suggesting
Q.730 Nina Singh has recently started investing in options after watching some options investing
tutorial videos, so her knowledge of options is limited. She has analyzed that she can take one of
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the four positions in the options market. She can take either a long/buyer position or a
short/seller position in a call option. Similarly, she can also take either a long or a short position
in put options. Which of the abovementioned positions has unlimited potentials for loss?
A short position in a call option has unlimited loss potential. This is because the seller of a call
option, or the person in a short position, is obligated to sell the underlying asset at the strike
price if the buyer decides to exercise the option. If the price of the underlying asset increases
significantly, the seller will have to purchase the asset at the higher market price to fulfill their
obligation. Since there is no upper limit to how high the price of an asset can rise, the potential
loss for the seller of a call option is theoretically unlimited. This is a significant risk that sellers of
call options must be aware of when entering into such contracts. It is also why many brokers
require traders to have a certain level of experience and financial resources before they can sell
call options.
Choice A is incorrect. A long position in a call option does not carry the potential for unlimited
losses. The maximum loss that can be incurred by an investor who buys a call option (long
position) is the premium paid to purchase the option, which occurs if the option expires
worthless.
Choice C is incorrect. A long position in a put option also does not carry the potential for
unlimited losses. Similar to a long call, an investor who buys a put option (long position) can only
Choice D is incorrect. A short position in a put option carries substantial risk but it's not
unlimited. The maximum loss occurs when the price of underlying asset falls to zero and it equals
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Q.731 Franklin Cole, an investment manager at Small Lounge Investments Co., has conducted a
fundamental research on the shares of Red Hat Corp and instructed his assistant to sell put
options on the shares with a strike of $30. The assistant receives a premium of $0.50. If the price
of the stock increases from $30 to $33, determine the position's payoff and profit.
Detailed Response
It follows that the seller (short position) of a put option is the trader that promises to buy the
underlying stocks at the expiry of the contract. The buyer (long position) is the party that has a
right but not the obligation to sell the stocks at expiry. The buyer is also called the holder.
Holder:
At expiration, the holder will only benefit if the prevailing market price is less than the
exercise/strike price. The payoff is equal to P t = X − ST , i.e., strike price minus the market price.
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The holder's profit is always given as the option payoff minus the premium paid at time 0.
Seller:
At expiration, the seller will only “benefit” if the prevailing market price is greater than the
exercise/strike price. The payoff is equal to the negative value of the holder's payoff.
Also, the seller's profit will be the negative value of the holder's profit.
In short, options are a zero-sum game. What's lost by one party is gained by the other.
Franklin and his assistant sell the option; they hold a short position.
So they receive a premium of 0.50, and to their luck, the stock price actually rises, meaning that
Thus, the payoff to the buyer is zero, and the payoff to Franklin is “-0”
The holder's profit: option payoff less the premium paid, i.e., 0 - 0.50 = -0.50.
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Q.732 Management at Digi Computational Investments has analyzed that the finance and
banking sector of the U.S. is currently in turmoil. The sector has not properly recovered from the
last financial crisis, and the new variables underlying the financial sector have already started
tumbling. Taking this into consideration, Digi Computational Investments took a long position in
a European call option on the Nasdaq-100 Index (NDX) which is composed of 108 non-financial
companies at a price of $20 per index option. The strike price of the index option is 3,355, and
the option expires in March 2020. If the current index price is 3,457, then estimate the total gain
or loss for the buyer of the call option.
A. $ 102
B. $ 98
C. $ 78
D. $ 82
Since the current index price is higher than the strike price, the buyer of the call option will
exercise the index option. If the option is exercised, the gain to the buyer of the index option is:
Net gain on the call option = Gain on the option - Premium on the option
Net gain on the call option = 3,457 - 3,355 - 20 = $ 82
Q.733 A treasury manager at a large manufacturing firm believes that the price of the shares of
Bright Star Hospitals Group (HBHG) will increase by at least 30% in value in the coming 2 to 3
years. The manager, therefore, is interested in taking a long position in an option that allows him
to purchase the stock anytime it increases in value above some determined strike price, and the
option should have an expiry of at least 38 months. Which of the following options is suitable for
the manager?
Long-term equity anticipation securities (LEAPS) are the most suitable option for the manager.
LEAPS are a type of options contract with an expiration date that can extend up to 39 months.
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They allow investors to speculate on the long-term performance of a company's stock, which
aligns with the manager's investment strategy. The manager believes that the price of HBHG's
shares will increase significantly in the next 2 to 3 years, and LEAPS would provide him with the
opportunity to benefit from this potential price increase. Furthermore, LEAPS would allow the
manager to purchase the stock anytime its value exceeds a predetermined strike price, which is
exactly what the manager is looking for. Therefore, LEAPS are the most appropriate option for
Choice A is incorrect. An equity call option would allow the manager to buy the stock at a
predetermined price, but these options typically have shorter expiry periods (usually less than a
year). Therefore, an equity call option would not meet the manager's preference for a minimum
Choice B is incorrect. An index call option gives the holder the right to buy an index at a
specified price before expiration. However, this type of option wouldn't allow the manager to
capitalize on his specific prediction about Bright Star Hospitals Group's stock performance as it
Choice D is incorrect. A covered call strategy involves owning or buying shares of stock and
selling an equivalent number of call options on that same stock. This strategy does not align with
the treasury manager's objective because it limits potential upside if HBHG’s share price
Q.734 The following are the strike prices, current prices, and expiration dates for options on
equities of various companies.
If you have long positions in all of these options, then which of the following options is true?
A. The call on Sun Inc. is in the money, the call on Moon Corp. is in the money, and the
put on Pluto Co. is out of the money.
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B. The call on Sun Inc. is in the money, the call on Moon Corp. is out of the money, and
the put on Pluto Co. is in the money.
C. The call on Sun Inc. is in the money, the call on Moon Corp. is out of the money, and
the put on Pluto Co. is out of the money.
D. The call on Sun Inc. is out of the money, the call on Moon Corp. is in the money, and
the put on Pluto Co. is out of the money.
The call option on Sun Inc. is in the money, the call on Moon Corp. is out of the money, and the
put on Pluto Co. is out of the money. This is because a call option is considered 'in the money'
when the current price of the underlying asset is higher than the strike price of the option. In
this case, the current price of Sun Inc. ($111) is higher than the strike price ($109), hence the
call option is 'in the money'. On the other hand, a call option is considered 'out of the money'
when the current price of the underlying asset is lower than the strike price of the option. In this
case, the current price of Moon Corp. ($109) is lower than the strike price ($113), hence the call
option is 'out of the money'. Similarly, a put option is considered 'out of the money' when the
current price of the underlying asset is higher than the strike price of the option. In this case, the
current price of Pluto Co. ($89) is higher than the strike price ($87), hence the put option is 'out
of the money'.
Choice A is incorrect. The call option on Moon Corp. is not in the money. A call option is
considered to be in the money when the current price of the underlying asset is higher than the
strike price of the option, which does not hold true for Moon Corp.
Choice B is incorrect. While it correctly states that the call on Sun Inc. is in-the-money and
that Moon Corp.'s call option is out-of-the-money, it incorrectly states that Pluto Co.'s put option
is in-the-money. A put option would be considered as being 'in-the-money' if its strike price was
higher than current market price, which isn't true for Pluto Co.
Choice D is incorrect. This choice incorrectly states that Sun Inc.'s call option and Pluto Co.'s
put options are out-of-the-money while stating correctly about Moon Corp's position being 'in-
the-money'. For a call to be 'out-of-the-money', its strike price should be more than current
market value which isn't true for Sun Inc., and similarly for a put to be 'out-of-the-money', its
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strike price should be less than current market value which again doesn't hold true for Pluto Co.
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Q.735 Xiamen Lee has a long position in an American call option on oil futures contract with a
strike price of $40 per contract expiring in September. The current price of the oil futures
contract has increased to $46, but the investor believes that the price of the contract can further
increase. Since it is an American option, the investor can exercise the contract anytime until its
expiration in September. Which of the following is the last day on which Xiamen can trade his
call option?
A. The third Friday of August is the last trading day of the call option.
B. The third Monday of September is the last trading day of the call option.
C. The third Monday of August is the last trading day of the call option.
D. The third Friday of September is the last trading day of the call option.
The last trading day for American options, such as the one held by Xiamen Lee, is typically the
third Friday of the month in which the contract is set to expire. This is a standard practice in the
United States and most other exchanges around the world. Therefore, since Xiamen's contract is
set to expire in September, the last day he can trade his call option is the third Friday of
September. It's important to note that while the last trading day is the third Friday of the month,
the actual expiration date of the contract is the Saturday following this Friday. However, since
trading does not occur on Saturdays, the practical deadline for trading the option is the
preceding Friday.
Choice A is incorrect. The third Friday of August cannot be the last trading day for the call
option as American options can be exercised at any point until their expiration, which in this case
is September. Therefore, it would not make sense for the last trading day to be in August.
Choice B is incorrect. The third Monday of September cannot be the last trading day of the
call option because typically, options expire on the third Friday of their expiration month, not
Monday.
Choice C is incorrect. Similar to choice A, it would not make sense for the last trading day to
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Q.738 An investor is considering an option on the stock of a specific company, which has the
strike price of $29 per share and the option expiry date of March. The option is constructed in a
way that if the final per share price of the stock reaches $71 at the expiration, the option will
give a payoff of $100 to the buyer.
Which of the following best describes this type of option?
A binary call option is the correct answer. This type of option is structured in a way that the
payoff is a fixed amount of money if either (I) a specified price is reached/exceeded at the time of
expiration or (II) the option is simply in-the-money at the time of expiration. In this case, the
investor will receive a payoff of $100 if the stock price reaches $71 at the time of expiration,
which is a characteristic of a binary call option. Binary options are also known as all-or-nothing
options because they either pay the full amount or nothing at all. This type of option is often used
when an investor believes that the price of an underlying asset will reach a certain level in the
Choice A is incorrect. A European call option allows the holder to buy the underlying asset at a
specified price within a specific time period, but only on the expiration date. However, in this
scenario, the payout is not dependent on the difference between the stock price and strike price
at expiration but rather it's fixed at $100 if stock price hits $71 which aligns with characteristics
Choice B is incorrect. An American call option also allows its holder to buy an underlying asset
at a specified price before or on its expiration date. But similar to European options, their payoff
depends on difference between stock and strike prices which doesn't match with given scenario.
options that have an expiry period longer than one year. The type of payoff structure described in
this question does not relate to whether an option has long or short term maturity but rather it's
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about how payoff is calculated at expiry which makes LEAPS irrelevant here.
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Q.741 A portfolio manager at Sea Breeze bank owns 10,000 shares of PNG Corp. The manager
does not expect an appreciable price increase in the next six months. To diminish his volatility,
the manager has written an option over the shares of PNG Corp. that expires in 6 months. Which
of the following defines the manager’s position in the option?
The portfolio manager's position is a covered call option. A covered call option is a financial
strategy in which an investor sells, or 'writes', call options on an asset they already own or hold
in their portfolio. This strategy is used when the investor anticipates that the price of the
underlying asset will remain relatively stable over the life of the options contract. The investor
earns income from the premium received from selling the call option, which can help to offset
potential losses if the price of the underlying asset falls. However, the investor also limits their
potential gains if the price of the underlying asset rises, as they are obligated to sell the asset at
the strike price of the call option. In this case, the portfolio manager owns the underlying shares
of PNG Corp and has written a call option on these shares, indicating a covered call position.
Choice A is incorrect. A covered put option involves selling a put option on an asset while also
shorting the same asset. In this case, the manager owns shares of PNG Corp and has written an
option on them, which does not align with the definition of a covered put.
Choice C is incorrect. A protective put strategy involves buying a put option to hedge against
potential losses in an owned stock. The manager in this scenario has written (sold) an option, not
Choice D is incorrect. A protective call strategy would involve buying a call option to protect
against potential increases in the price of a shorted stock. However, the manager owns shares
and has written an option on them; he hasn't bought any options or shorted any stocks.
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Q.742 Which of the following is responsible for ensuring that the writer of the option must honor
the option or must fulfill the obligations determined under the terms of the option?
A. The exchange
The Options Clearing Corporation (OCC) is the entity that ensures the writer of an option fulfills
the obligations determined under the terms of the option. The OCC acts as a guarantor, ensuring
that the obligations of the contracts they clear are fulfilled. It operates as a clearinghouse for
futures markets, providing a system of guarantees that reduces the risk of default. The OCC
works with its members, who are required to maintain a specific amount of capital and a special
fund that can be used in case of default. This structure ensures the integrity of the options
Choice A is incorrect. While the exchange provides a platform for trading options, it does not
ensure that the obligations under the terms of an option are fulfilled by the writer of the option.
Choice B is incorrect. The market maker's role is to provide liquidity in the market by buying
and selling securities, including options, but they do not guarantee that obligations under an
Choice D is incorrect. The buyer of an option has no obligation to ensure that terms of an
option are fulfilled by its writer. Their only obligation is to pay for and accept delivery if they
Q.743 Harry Wilson owns a call option on the shares of Blue Company and a put option on the
shares of Green Company. Both companies belong to the booming communication sector of
Holland. The sector has been growing at a rate of 7% for the last 5 years. Blue Company recently
announced a cash dividend of $1.20 on its stock while Green Company announced a 4-for-3 stock
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split. Which of the following impacts on the options is accurate?
A. Only the call option on Blue Company will be adjusted for the cash dividend.
B. Only the put option on Green Company will be adjusted for the stock split.
C. Options on both of these companies will be adjusted for the cash dividend and the
stock split.
Only the put option on Green Company will be adjusted for the stock split. This is because
options are typically adjusted for events that change the number of shares in circulation, such as
stock splits or stock dividends. In the case of Green Company, the 4-for-3 stock split will increase
the number of shares, which will necessitate an adjustment of the put option held by Harry
Wilson. This adjustment is necessary to maintain the economic equivalence of the option contract
before and after the stock split. It ensures that the holder of the option is not disadvantaged by
the increase in the number of shares. The adjustment usually involves changing the strike price
Choice A is incorrect. While it's true that dividends can impact the price of an option, standard
exchange-traded options are not adjusted for regular cash dividends. This is because the
declaration of a dividend is usually factored into the option's price prior to its announcement.
Choice C is incorrect. As explained above, standard exchange-traded options are not adjusted
for regular cash dividends. Therefore, the call option on Blue Company will not be adjusted for
the cash dividend. Similarly, while stock splits do result in adjustments to options contracts, they
only affect the specific company's options where split has happened and not all companies'
options in general.
Choice D is incorrect. This statement contradicts with how stock splits affect options
contracts. In case of a 4-for-3 stock split announced by Green Company, there will indeed be an
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Q.3561 Jason Briggs purchased a 3-month call option by paying $0.08. The exercise price of the
option is $1.32 while the underlying is priced at $1.35.
Is the option currently in-the-money and at what price will break-even occur?
The call option is in-the-money as the underlying price is greater than the exercise price ($1.35
vs. $1.32, respectively).
Break-even price = X + C0 = $1.32 + $0.08 = $1.40
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Q.3562 Which of the following relationships is correct?
Option Premium = Intrinsic Value + Time Value. This is the standard formula used to calculate
the premium of an option. The intrinsic value is the difference between the current price of the
underlying asset and the strike price of the option. If the option is 'out of the money', meaning
the strike price is unfavorable compared to the current price, the intrinsic value is zero. The time
value, on the other hand, is the part of the premium that exceeds the intrinsic value. It
represents the value of the option's remaining time until expiration. The longer the time until
expiration, the higher the time value, as it provides the option holder with more opportunities to
benefit from favorable price movements in the underlying asset. Therefore, the option premium
Choice B is incorrect. The option premium cannot be calculated by subtracting the time value
from the intrinsic value. This would imply that as the time until expiration increases, the option
premium decreases, which contradicts with the concept of options pricing where an increase in
time to expiration generally increases the option's price due to increased uncertainty.
Choice C is incorrect. The equation for calculating an option premium does not involve
subtracting intrinsic value from time value. This would suggest that a higher intrinsic value (i.e.,
a more in-the-money option) reduces the overall premium, which is not accurate as options with
Choice D is incorrect. The price of an underlying asset has no direct subtraction relationship
with time value to determine an option's premium. In fact, it's quite opposite; both these factors
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Q.3563 Which of the following best describes the obligation of the writer of a put option?
A. The obligation to buy the underlying security at the option's strike price if the option is
exercised
B. The obligation to sell the underlying security at the option's strike price if the option is
exercised
C. The right, but not the obligation, to buy the underlying security at the option's strike
price if the option is exercised
D. The right, but not the obligation, to sell the underlying security at the option's strike
price if the option is exercised
The writer of a put option has the obligation to buy the underlying security at the option's strike
price if the option is exercised. This is because when an investor writes a put option, they are
essentially selling someone else the right to sell a security at a predetermined price (the strike
price). If the buyer of the put option decides to exercise their option, the writer is obligated to
buy the security at the agreed-upon strike price, regardless of the current market price. This
could potentially lead to a loss for the option writer if the market price of the security is lower
than the strike price at the time of exercise. However, the writer does receive a premium for
writing the option, which can offset some or all of this potential loss.
Choice B is incorrect. The obligation to sell the underlying security at the option's strike price
if the option is exercised is not correct. This describes a call option, not a put option. In a put
Choice C is incorrect. The right, but not the obligation, to buy the underlying security at the
option's strike price if the option is exercised does not describe an obligation of any kind and
hence it cannot be correct. This choice describes an aspect of options for buyers rather than
sellers or writers.
Choice D is incorrect. The right, but not the obligation, to sell the underlying security at the
option's strike price if the option is exercised also does not describe an obligation and hence it
cannot be correct either. Similar to Choice C this choice also describes aspects of options for
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Reading 39: Properties of Options
Q.744 Which of the variables given below is likely to have the smallest impact on the prices of
plain vanilla stock options?
B. Expected dividend
C. Risk-free rate
The creditworthiness of the counterparty is the least likely to affect the prices of plain vanilla
stock options. This is because these options are typically standardized and traded on exchanges,
where the Options Clearing Corporation (OCC) guarantees that the writer of the option will not
default on their obligations. Therefore, the creditworthiness of the counterparty becomes less
relevant in this context, as the risk of default is mitigated by the OCC's guarantee.
It's important to note that while the creditworthiness of the counterparty can be a significant
factor in over-the-counter (OTC) options, where the parties deal directly with each other without
an intermediary, it's not a major factor in exchange-traded options. This is one of the key
differences between OTC options and exchange-traded options, and it's crucial for financial risk
managers to understand this distinction when assessing the risks associated with different types
of options.
Choice A is incorrect. The strike price of the option has a significant impact on the price of
plain vanilla stock options. The higher the strike price, the lower the value of a call option (and
vice versa for put options). This is because the strike price represents the price at which an
Choice B is incorrect. Expected dividends also have a substantial influence on option prices. If
dividends are expected to be high, this will reduce the expected future stock price and hence
Choice C is incorrect. The risk-free rate also affects option pricing significantly as it represents
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time value of money in financial markets. Higher risk-free rates increase call prices and decrease
Q.745 Raj Kumar is an individual options investor. He recently started investing in equity options
because of his informal experience in investing in equities. He opened two options positions on
the stock of Red Horse Auto Inc. Kumar purchased a call option on the company's stock with a
specific strike price and later also purchased a put option on the same stock with the same strike
price. If the current stock price decreases, then which of the following shows the accurate effect
on option prices?
A. The price of the call option will increase while the price of the put option will
decrease.
B. The price of the call option will decrease while the price of the put option will
increase.
C. The price of the put option will increase while there will be no impact on the price of
the call option.
D. The price of the call option will increase while there will be no impact on the price of
the put option.
The price of a call option is likely to decrease while the price of a put option is likely to increase
when the current stock price decreases. This is because the value of a call option is derived from
the potential for the stock price to increase above the strike price. If the stock price decreases,
the likelihood of the stock price rising above the strike price also decreases, thereby reducing
the value of the call option. On the other hand, the value of a put option increases when the
stock price decreases. This is because a put option gives the holder the right to sell the stock at
the strike price. If the stock price decreases, the holder of the put option can still sell the stock
at the higher strike price, making the put option more valuable.
Choice A is incorrect. The price of a call option will not increase when the underlying stock
price decreases. This is because the value of a call option increases as the underlying stock price
increases, giving the holder the right to buy at a lower strike price and sell at a higher market
price. Therefore, if the stock price decreases, it reduces this potential benefit and thus reduces
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the value of the call option.
Choice C is incorrect. While it's true that put options increase in value when stock prices
decrease (as they give holders an opportunity to sell at a higher strike price), there would indeed
be an impact on Raj's call option as well. As explained above, if Red Horse Auto Inc.'s current
stock prices decrease, this would reduce Raj's potential benefit from his call option and thus its
Choice D is incorrect. Similar to Choice A, this choice incorrectly suggests that a decrease in
Red Horse Auto Inc.'s current stock prices would lead to an increase in Raj's call option value -
which contradicts basic options pricing theory. Furthermore, while it correctly states that there
will be no impact on his put option (which actually increases in such scenarios), it fails to capture
how both types of options are affected by changes in underlying asset prices.
Q.746 The prices of options on the stocks or equities are affected by a number of variables. Some
variables directly impact the options while others have an impact on the underlying stock, which
in turn also affects the prices of stock options. If the strike price of an option is increased, then
which of the following depicts the accurate impact of this increase?
A. The increase in strike price will decrease the price of European put and American put
options but increase the price of European call and American call options.
B. The increase in strike price will increase the price of European put and American put
options but decrease the price of European call and American call options.
C. The increase in strike price will increase the price of European put and American call
options but decrease the price of European call and American put options.
D. The increase in strike price will decrease the price of European put and American call
options but increase the price of European call and American put options.
The increase in the strike price of an option will have a similar impact on American and
European call options, and an opposite impact on American and European put options. An
increase in strike price will decrease the likelihood of call options to be in the money, and thus,
decrease the price of American and European call options. Conversely, an increase in strike price
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will increase the likelihood of put options to be in the money, and thus, it will increase the price
of American and European put options. This is because the strike price is the price at which the
holder of an option can buy (in case of a call option) or sell (in case of a put option) the
underlying security when the option is exercised. For a call option, a higher strike price means
that the option holder has to pay more to buy the underlying security, which makes the option
less attractive and decreases its price. For a put option, a higher strike price means that the
option holder can sell the underlying security at a higher price, which makes the option more
Choice A is incorrect. An increase in the strike price does not decrease the price of European
and American put options, but rather increases them. This is because a higher strike price makes
these options more valuable as they provide the right to sell at a higher price. Similarly, it does
not increase the prices of European and American call options; instead, it decreases them since a
higher strike price makes these options less attractive as they provide the right to buy at a
higher cost.
Choice C is incorrect. While an increase in strike price indeed increases the value of American
call options due to their early exercise feature, it does not decrease the value of European call
and American put options. Instead, it decreases the value of European call option (as explained
above) and increases that of an American put option (due to its early exercise feature).
Choice D is incorrect. An increase in strike price does not decrease both European put and
American call option prices nor does it increase both European call and American put option
prices. As explained earlier, an increased strike price will lead to increased values for both types
of put options while decreasing values for both types of call options.
Q.747 Jack Anderson, a portfolio manager at Vito Investment Company, manages an $800 million
mutual fund that invest in a large variety of financial instruments. A significant portion of the
portfolio is invested in call and put options on the S&P 500 index (SPX), NASDAQ-100 Index
(NDX), and Dow Jones Industrial Average (DJX). However, due to upcoming elections in the U.S.,
the volatility of these indices has increased. Which of the following best describes the impact on
index options?
A. The increase in volatility will increase the prices of call index options but decrease the
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prices of put index options.
B. The increase in volatility will decrease the prices of call index options but increase the
prices of put index options.
C. The increase in volatility will decrease the prices of both call and put index options.
D. The increase in volatility will increase the prices of both call and put index options.
The increase in volatility will increase the prices of both call and put index options. The reason
for this is that volatility is a key factor in the pricing of options. When volatility increases, the
potential range of movement for the underlying asset (in this case, the indices) also increases.
This means that there is a greater chance that the option will end up in the money, which makes
the option more valuable. Therefore, both call and put options will increase in price. The
downside risk for both calls and puts is limited to the premium paid, but the upside potential is
unlimited. This makes the upside risk more rewarding while limiting the downside risk.
Therefore, when volatility increases, the prices of both call and put options tend to increase.
Choice A is incorrect. The increase in volatility does not have a differential impact on call and
put options. Both types of options become more valuable as the potential range of underlying
Choice B is incorrect. This choice incorrectly suggests that increased volatility will decrease
the prices of call index options while increasing the prices of put index options. In reality, an
increase in volatility makes both call and put options more valuable due to the greater potential
Choice C is incorrect. Contrary to this choice, increased volatility does not decrease but rather
increases the prices of both call and put index options. Higher volatility implies a wider range of
possible outcomes for the underlying indices, thus making both types of options more valuable.
Q.748 Kelly Jackson is a junior research analyst at an Asian Investment Fund. The fund has a
large exposure to US stocks and options. Jackson is given the task of analyzing the impact on the
prices of call and put options if the underlying stock pays a cash dividend. Jackson came up with
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the following scenarios that show the impact of an increase in cash dividends on call and put
options. Which of the four scenarios is consistent with the principles of option pricing?
A. An increase in the expected cash dividend will increase the price of put and call stock
options.
B. An increase in the expected cash dividend will decrease the price of put and call stock
options.
C. An increase in the expected cash dividend will decrease the price of put options but
increase the price of call stock options.
D. An increase in the expected cash dividend will increase the price of put options but
decrease the price of call stock options.
An increase in the expected cash dividend will increase the price of put options but decrease the
price of call stock options. This is because the stock price typically drops by the amount of the
dividend on the ex-dividend date. Higher expected cash dividends imply lower call premiums
because the options are now more likely to be in the money, and higher put premiums because
the options are now more likely to be out of the money. The stock price reflects the value of a
company. When a company pays a cash dividend, it depletes its reserves, which reduces the
value of the firm. Consequently, the stock price also declines to reflect this reduction in value.
Additionally, the share price can be viewed as the present value of all future cash flows. Once a
dividend has been paid out, that's one less cash flow in the present value equation, which also
Choice A is incorrect. An increase in the expected cash dividend does not increase the price of
both put and call stock options. This is because when dividends increase, it reduces the stock
price which in turn decreases the value of a call option while increasing the value of a put option.
Choice B is incorrect. An increase in expected cash dividends does not decrease the price of
both put and call stock options. As explained above, an increased dividend decreases the stock's
price which increases a put option's value but decreases a call option's value.
Choice C is incorrect. While it correctly states that an increase in expected cash dividends will
decrease the price of put options, it incorrectly suggests that this would also lead to an increase
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in the price of call options. In reality, as mentioned earlier, higher dividends lower stock prices
A. Option A
B. Option B
C. Option C
D. Option D
The value of an option is influenced by several factors, including the time to expiration and the
nature of the option. As the time to expiration increases, the value of the option generally
increases or remains the same. This is because the longer the time to expiration, the greater the
chance that the underlying asset's price will move in a favorable direction, thereby increasing
the option's value. Therefore, the 9-month options (both American and European) will have a
higher value than the 3-month options. Between the 9-month American and European options,
the American option will have a higher value. This is because an American option gives the
holder the right to exercise the option at any time up to the expiration date, providing more
flexibility and potential for profit. In contrast, a European option can only be exercised at the
expiration date. This lack of flexibility can limit the potential for profit, thereby reducing the
value of the option. Therefore, the 9-month American call option (Choice D) will have the highest
value. Choice A is incorrect. Although Option A may have certain attractive features, it does
not hold the highest value. This could be due to a variety of factors such as its strike price, time
to expiration, or the volatility of the underlying asset. Choice B is incorrect. Despite any
potential benefits that Option B might offer, it does not hold the highest value among these
options. The value of an option is determined by several factors including its intrinsic value and
time value which are influenced by elements like the price of the underlying asset, strike price,
time until expiration and volatility.Choice C is incorrect. While Option C might seem appealing
for various reasons, it does not possess the highest value in comparison to other options listed
here. Factors such as its moneyness status (whether it's in-the-money or out-of-the-money),
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remaining time until expiration and implied volatility play a crucial role in determining an
option's worth.
Q.751 Upper and lower pricing bounds for American and European call and put options are
important in order to prevent investors from earning arbitrage profits. If option prices are above
the upper boundary or below the lower boundary, an investor can earn arbitrage profit by
opening a position in an options contract and in the underlying stock simultaneously. Which of
the following statements is consistent with the upper boundary limit of the American put option?
A. The price of an American put option should be equal to or higher than the current
price of the underlying stock.
B. The price of an American put option should be equal to or higher than the strike price
of the option on the underlying stock.
C. The price of the American put option should be equal to or lower than the current
price of the underlying stock.
D. The price of the American put option should be equal to or lower than the strike price
of the option on the underlying stock.
The price of an American put option should be equal to or lower than the strike price of the
option on the underlying stock. This is because the value of a put option is derived from the right
it provides to its holder to sell the underlying asset at the strike price. If the price of the put
option were to exceed the strike price, it would mean that the holder is paying more for the
option than they would receive from exercising it. This would not be rational, as the holder could
instead sell the asset in the market at a higher price. Therefore, the price of a put option should
never exceed the strike price of the option. If it does, an arbitrage opportunity would arise. An
investor could sell the overpriced put option, invest the proceeds at the risk-free rate, and make
a risk-free profit. This is why the price of an American put option should be equal to or lower
Choice A is incorrect. The price of an American put option should not be equal to or higher
than the current price of the underlying stock. This would imply that the holder could sell the
stock for its full market value and still retain a valuable put option, which contradicts no-
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arbitrage principles.
Choice B is incorrect. The price of an American put option should not be equal to or higher
than the strike price of the option on the underlying stock. If this were true, it would mean that
exercising the put option immediately would yield a profit greater than or equal to zero
Choice C is incorrect. While it's true that an American put option's value will generally
decrease as its underlying asset's price increases (all else being equal), saying that its price
"should" be lower than its underlying asset's current market value implies a stronger
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Q.752 Adam Gilbert is a risk manager that works with Global Trade Brokerage Firm in New York
City. Global Trade Brokerage is a member of the options exchange which provides brokerage
services to option traders and also works as the market maker in the exchange. Gilbert’s job
responsibility is to derive upper and lower boundaries for options so the prices are arbitrage-
free. Which of the following is an accurate estimation of the lower band for European call option
prices on a non-dividend-paying stock, if the current stock price is $92 and the strike price of the
option on that stock is $89? Suppose the option is expiring in 6 months and the risk-free rate is
8%.
A. $3
B. $3.97
C. $6.49
D. $6.36
The lower bound of the European call option on a non-dividend paying stock is equal to:
Where S = current price; K = strike price; r = risk-free rate; and t = time to expiration.
Therefore, an arbitrage opportunity exists if the value of the European call option is below
$6.3597
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Q.753 Vijay Singh works as an investment manager at Global Investment Company in New York.
Global also provides brokerage services to its clients. Therefore, it is a usual task at Global to
derive upper and lower boundaries for options so the prices are arbitrage-free. Which of the
following given options is the accurate estimation of the lower price boundary for European put
options on a non-dividend paying stock that expires in 3 months, if the current stock price is $31,
the strike price is $33, and the risk-free rate is 10% with annual compounding?
A. $2.37
B. $1.22
C. $2.80
D. $1.19
The lower bound of the European put option on a non-dividend paying stock is equal to:
Where p = put option price; S = current stock price; K = strike price; r = risk-free rate; and t =
time to expiration.
An arbitrage opportunity exists if the value of the European put option is below $1.22
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Q.755 Johanna Smith is a treasury manager at Easy Bank. She manages the treasury affairs and
also the investment advisory activities of the bank. She invests in treasury and money market
instruments to manage short-term cash, but for long-term cash management, she uses other
instruments. Currently, she has invested in a zero-coupon bond with the face value of X, and at
the same time, she has also taken a long exposure in call options on the stocks of a specific firm
with the strike price of X. Suppose that at the time of expiration of the call options, the final
price of the stock is A, which is below X. If the bond matures on the options expiration date, then
estimate the payoff of the combination of the bonds and call options.
A. The payoff is A
B. The payoff is X
The net payoff of the combination of a zero-coupon bond and a call option is X (the face value of
the bond). This is further described below:
The combination of a zero-coupon bond which pays X amount at maturity and a call option with
the strike price of X is called a fiduciary call.
The payoff of the call option, if the option is in the money, is S-X (where S is the current price
and X is the strike price). If the option is out of the money, the payoff of the option is 0.
Therefore, the payoff of a fiduciary call with an in the money option = (S –X) + X = S
And the payoff of a fiduciary call with an out of the money option = (0) + X = X
As mentioned in the question the current price of the stock is A which is below X, so the option
expired out of the money, and the payoff of the fiduciary call is X.
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Q.756 An investor has constructed a fiduciary call which consists of a Millers Corp. zero-coupon
bond with a face value of $95 and the bond is expected to mature in March 2017, and a call
option on Millers Corp.’s common stock with the strike price of $95 and the option expiring in
March 2017. Suppose that in March 2017, the current price of the stock is $90, then what is the
total cash inflow that the investor will receive at maturity?
A. $90
B. $95
C. $100
D. $185
The net payoff of the combination of a zero-coupon bond with a face value of $95 and a call
option with a strike price of $95 is $95 (the face value of the bond). This is further described
below:
The combination of a zero-coupon bond which pays X amount at maturity, and a call option with a
The zero-coupon bond will mature at its face value, which is $95. Since it's a zero-coupon bond,
it doesn't pay periodic interest but is instead sold at a discount and pays its face value at
The current price of the stock is $90, which is lower than the strike price. Since it wouldn't make
sense to exercise the option to buy the stock at $95 when it's available in the market for $90, the
option will expire worthless. Therefore, there is no cash inflow from this component of the
fiduciary call. In other words, the option is out of the money, and its payoff is (90-95) = 0.
Considering both components, the total cash inflow at maturity for the investor will be solely
from the zero-coupon bond, which is $95. The call option does not contribute to the cash inflow
Q.757 The put-call parity is an important relationship in options pricing. The put-call parity
relationship is established on the payoff of the combination of two portfolios, a fiduciary call, and
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a protective put. The fiduciary call is composed of a risk-free discount bond and a call option,
while the protective put consists of a put option and a stock. Which of the following principle
must hold true in the put-call parity?
A. The face value of the discount bond must be below the strike price of call and put
options.
B. The face value of the discount bond must be above the strike price of call and put
options.
C. The face value of the discount bond must be equal to the final price of call and put
options.
D. The face value of the discount bond must be equal to the strike price of call and put
options.
The put-call parity is a principle in options pricing that states the price of a call option implies a
certain fair price for the corresponding put option and vice versa. The put-call parity relationship
is established based on the payoff of two portfolios: a fiduciary call and a protective put. The
fiduciary call consists of a risk-free discount bond and a call option, while the protective put is
made up of a put option and the underlying stock. In this context, the face value of the discount
bond at maturity must be equal to the strike price of the call and put options at expiration. This
is because the strike price is the price at which the holder of the option can buy (in case of a call
option) or sell (in case of a put option) the underlying security when the option is exercised.
Hence, for the put-call parity to hold, the face value of the discount bond (which is the amount
that will be returned to the bondholder at maturity) must be equal to the strike price of the call
Choice A is incorrect. The face value of the discount bond being below the strike price of call
and put options would not uphold the principle of put-call parity. This is because it would imply
that the risk-free return from holding a fiduciary call (bond + call option) would be less than that
from holding a protective put (put option + stock), which contradicts the concept of arbitrage-
Choice B is incorrect. Similarly, if the face value of the discount bond were above the strike
price, it would mean that there's an opportunity for arbitrage as one could earn more by
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investing in a fiduciary call than in a protective put, which again contradicts with no-arbitrage
principle.
Choice C is incorrect. The face value of discount bond being equal to final price of options does
not make sense as final prices are uncertain and depend on various factors like underlying
asset's price at maturity, volatility etc., whereas face value of bond is known upfront and does not
Q.758 Vijay Mehta is a portfolio manager at First American Investments. He manages a portfolio
that invests in a wide variety of financial instruments. Currently, a large portion of his portfolio
consists of stocks and options. Recently, he purchased the stock of Jack Ville Inc. and at the same
time, he also took a long exposure in a put option on the stocks of Jack Ville Inc. with the strike
price of X. Suppose that, at the time of expiration, the final price of the stock, S, is below the
strike price, X, then estimate the payoff of the combination of the stock and the put option.
A. The payoff of the combination of the stock and the put option is S.
B. The payoff of the combination of the stock and the put option is X.
C. The payoff of the combination of the stock and the put option is S+X.
D. The payoff of the combination of the stock and the put option is zero.
By investing in the stock of Jack Ville Inc. and taking a long exposure in a put option on Jack Ville
Inc. stock, the portfolio manager has constructed a protective put.
A protective put consists of a stock and a put option on the same stock with a strike price of X.
The payoff of the put option if the option is in the money is X-S (where S is the current price and
X is the strike price).
The payoff of the stock will be equal to the current price or the final price of stock i.e. S
Therefore, the payoff of the protective put with in-the-money put option = (X-S) + S= X
And the payoff of a fiduciary call with an out of the money option = (0) + S = S
As mentioned in the question, the current price of the stock, S, is below X, so the option is in the
money, and the payoff of the protective put is X.
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Q.760 The put-call parity relation suggests that the portfolios with identical payoffs must sell for
the same price in order to prevent arbitrage profit or riskless gains. The put-call parity is,
therefore, constructed of the fiduciary call and protective put options. Which of the following
equation is inconsistent with the put-call parity equation?
A. S = c − p + X(1 + r)−t
B. p = c − S + X(1 + r)−t
C. X(1 + r)−t = S + c − p
D. c = S + p − X(1 + r)−t
The equation X(1 + r)−t = S + c − p is inconsistent with the put-call parity equation. The put-call
parity equation is given by c + X(1 + r)−t = S + p, where 'c' is the call price, 'p' is the put price,
X(1 + r)−t is the present value of a zero-coupon bond, and 'S' is the current price of the stock.
Rearranging this equation, we get c = S + p − X(1 + r)−t , which is the price of a call option. The
equation in choice C rearranges the terms in a way that does not represent any of the individual
securities in the put-call parity relationship, making it inconsistent with the put-call parity
equation.
Choice A is incorrect. This equation correctly represents the put-call parity principle. It states
that the price of the underlying asset (S) is equal to the price of a call option (c) minus the price
of a put option (p), plus the present value of strike price (X(1+r)^{-t}).
Choice B is incorrect. This equation also correctly represents the put-call parity principle, but
from a different perspective. It states that the price of a put option (p) equals to call option's
price (c) minus underlying asset's current market value(S), plus present value of strike
price(X(1+r)^{-t}).
Choice D is incorrect. This equation accurately reflects put-call parity as well, stating that call
option's cost(c) equals to current market value(S) plus cost of protective put(p), minus present
Q.761 Jacob Clarke is an investment manager at one of the largest investment banks in Canada.
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Clarke has a wide variety of investment options to invest in. However, he is interested in
constructing the payoff of a synthetically created long position in call options. Which of the
following positions should he take to create the payoff of a synthetic call option?
B. Long a call option, short a put option, and short a zero-coupon bond.
A synthetic call option can be created by taking a long position in a stock, a long position in a put
option, and a short position in a zero-coupon bond. This combination of positions replicates the
payoff of a long position in a call option. The underlying principle behind this strategy is the put-
call parity, which is a fundamental concept in options pricing. The put-call parity states that the
price of a call option (c) plus the present value of the strike price (X) discounted at the risk-free
rate (r) for the time to maturity (T) is equal to the price of the stock (S) plus the price of a put
equation to solve for the price of a call option, we get c =S + p - X(1+r)^{-T}. This equation
shows that a call option can be synthetically created by taking a long position in a stock, a long
position in a put option, and a short position in a zero-coupon bond. This strategy allows an
investor to replicate the payoff of a call option without actually owning the option.
Choice A is incorrect. While a long position in a stock and shorting a put option can replicate
the payoff of a call option, shorting a zero-coupon bond would not contribute to this synthetic
strategy. Shorting the bond would create an obligation to pay at maturity, which is not
Choice B is incorrect. This choice involves both long and short positions in options (call and
put respectively), which does not replicate the payoff of just one call option. Additionally,
shorting a zero-coupon bond again introduces an obligation that does not align with the desired
payoff.
Choice C is incorrect. Shorting a stock and going long on both put options and zero-coupon
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bonds do not mimic the characteristics of being long on call options. In fact, this combination
could potentially lead to unlimited losses if the stock price increases significantly - something
Q.763 Giana Greg, a Slovakian consultant, has recently graduated in finance from one of the
well-known business schools of Bratislava. She is now an independent consultant that provides
trading strategies in stocks and derivatives to individuals and corporations. While replying to an
email from one of her clients regarding the put-call parity, she stated the following:
I. The put-call parity is constructed when the strike price and the time to maturity of the put and
call options are equal.
II. Puts and calls must be American-style for the put-call parity relationship to hold true.
Which of the abovementioned statement(s) is/are inconsistent with the put-call parity
relationship?
The second statement made by Giana Greg is incorrect in the context of the put-call parity
relationship. Put-call parity is a principle that defines a relationship between the price of a
European call option and European put option, both having the same strike price and expiration
date. The key point here is that the options must be European-style, not American-style.
European-style options can only be exercised at expiration, which aligns with the maturity date
of the discount bond in the put-call parity equation. American-style options, on the other hand,
can be exercised at any time before expiration, which can disrupt the balance of the put-call
parity relationship. Therefore, the assertion that the put-call parity relationship holds true for
Choice A is incorrect. Statement I is correct. The put-call parity relationship does indeed
require the strike price and the time to maturity of the put and call options to be identical. This
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condition ensures that both options are comparable, thereby establishing a relationship between
their prices.
Choice C is incorrect. As explained above, statement I is correct, which means that not both
Choice D is incorrect. While statement I aligns with the principles of put-call parity, statement
II does not. The put-call parity relationship holds for European-style options, not just American-
style ones. Therefore, this choice suggesting that none of the statements are incorrect cannot be
true.
Q.3413 A stock is currently trading at $60 per share. A European call option having an exercise
price of $71 and one year to maturity is currently trading at $10. If the risk-free rate is 7%, per
annum, then what is the put option price?
A. $3.80
B. $16.36
C. $16.20
D. $5.06
S0 + P = C + X(1 + r)−T
P = C + X(1 + r)−T − S0
= 10 + 71 × (1.07)−1 − 60 = 16.35514 ≈ 16.36
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Q.3514 Rabi Koch took a long position in a March put option with the strike price of $65. What is
the outcome of the position if the spot price is $78 at expiration?
D. $0 payoff
Since the spot price of the put option is higher than the strike price the option is out of the
money. The payoff to the option buyer is:
PT = max(0, X-ST) = max(0, 65-78) = 0
A note on puts
A short put refers to the opening of an options trade by selling or writing a put option. The trader
who buys the put option is long that option (holds the long position), and the trader who wrote
that option is short (holds the short position).
For the long position (buyer), the option is in the money (ITM) if and only if the prevailing spot
price at expiry is less than the strike price. In such circumstances, the buyer would be able to
"cut" their loss by selling the underlying at the strike price which would be considerably higher
than the prevailing market price. Buyers of puts are bearish, i.e, they expect the underlying to
lose value over time.
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Q.3564 Which of the following conditions will create the biggest discrepancy in price between a
long-term European put option and an otherwise identical short-term put option?
B. Interest rates are lower than they have ever been in the past
C. Interest rates are higher than they have ever been in the past
D. Both A and B
When interest rates are lower than they have ever been in the past, the price discrepancy
between a long-term European put option and an otherwise identical short-term put option will
be the greatest. European options can only be exercised at their expiration date. Therefore, a
longer time to expiration implies that the option holder will have to wait longer to receive money
from the sale of the underlying asset. This waiting period represents a lost interest opportunity.
When interest rates are low, this lost interest is reduced, making the long-term option more
price discrepancy between the long-term and short-term options will be the greatest.
Choice A is incorrect. While it's true that lower volatility would decrease the price of both
options, it wouldn't necessarily increase the price discrepancy between them. The impact of
volatility on option pricing is more complex and depends on other factors such as the strike price
Choice C is incorrect. Higher interest rates could potentially increase the price discrepancy
between long-term and short-term options, but not necessarily to a greater extent than extremely
low interest rates. The relationship between interest rates and option prices isn't linear, so we
can't say definitively that higher rates will lead to a larger price discrepancy.
Choice D is incorrect. As explained above, neither low market volatility nor high interest rates
would necessarily lead to a greater price discrepancy between long-term and short-term options
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Q.3565 The value of a European put option will increase with higher:
A. Volatility
B. Carrying costs
D. Both A and C
Volatility is a measure of the degree of variation in the price of a financial instrument over time.
In the context of options, higher volatility increases the chances of the underlying asset's price
declining relative to the exercise price. This is because volatility represents uncertainty, and in
the case of a put option, this uncertainty can lead to more scenarios where the price of the
underlying asset falls below the exercise price, making the option more valuable. Therefore, an
Choice B is incorrect. Carrying costs do not directly influence the value of a European put
option. Carrying costs are associated with holding an asset over a period of time, such as storage
costs or financing charges. However, these are not directly related to the pricing of a European
put option which is primarily influenced by factors like volatility and risk-free interest rates.
Choice C is incorrect. While risk-free interest rates can have an impact on the value of options
in general, they do not have as significant an effect on the value of a European put option as
volatility does. The higher the volatility, the higher will be the premium for both call and put
Choice D is incorrect. As explained above, while both volatility (choice A) and risk-free interest
rates (choice C) can influence option values, only volatility has a significant impact on European
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Q.3566 Which of the following is NOT a factor that determines the value of an option?
The inflation rate is not a direct factor in determining the value of an option. While inflation can
indirectly influence the value of an option by affecting the overall economic environment and the
price of the underlying asset, it is not a direct factor in the pricing model of an option. The Black-
Scholes model, which is one of the most commonly used models for option pricing, does not
include inflation as a factor. Instead, it uses factors such as the price of the underlying asset, the
strike price, the risk-free interest rate, the time to expiration, and the volatility of the underlying
asset.
Choice A is incorrect. The price of the underlying asset plays a significant role in determining
the value of an option. The higher the price of the underlying asset, the more valuable a call
option (right to buy) becomes, and conversely, a put option (right to sell) becomes less valuable.
Choice B is incorrect. The volatility of the underlying asset also significantly influences an
option's value. Higher volatility increases both call and put options' values as it implies greater
uncertainty about future prices, thus increasing potential profits from exercising these options.
Choice D is incorrect. The interest rate affects an option's value through its impact on
discounting future cash flows associated with exercising or not exercising the option. Higher
interest rates make holding options more expensive due to opportunity costs, thereby reducing
their value.
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Q.3567 Which of the following conditions will increase the value of a call option?
A. A decrease in volatility
An increase in the risk-free rate will increase the value of a call option. The risk-free rate is the
theoretical rate of return of an investment with zero risk, typically associated with high-quality
government bonds. In the context of options pricing, an increase in the risk-free rate increases
the present value of the expected payoff from the option, thereby increasing the value of the
option. This is because the holder of the option can invest the money that would otherwise have
been spent on purchasing the underlying asset at the risk-free rate until the option's expiration
date. The higher the risk-free rate, the higher the potential return from this alternative
Choice A is incorrect. A decrease in volatility would not increase the value of a call option. In
fact, it's the opposite: higher volatility generally increases the value of options because it implies
a greater range of potential outcomes for the underlying asset's price, thus increasing the
Choice C is incorrect. A decrease in stock price would not lead to an increase in the value of a
call option. The value of a call option increases as the price of underlying asset (in this case,
stock) increases because it gives holder right to buy at lower specified price and sell at current
Choice D is incorrect. An increase in dividend rate would actually decrease, not increase, the
value of a call option. This is because when dividends are paid out on stocks, they reduce
company’s share prices by roughly equivalent amount which reduces potential upside for call
options holders.
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Q.3568 Leslie Hower is a junior trader at a derivatives dealer firm. During her first week at the
firm, Hower attempts to synthetically sell a risk-free bond using call and put options. She
purchases call and put options with the same exercise price and time to maturity. She
simultaneously buys the underlying.
With respect to her attempts in creating a synthetic short position in a risk-free bond, Hower is
accurate regarding her decision to:
Leslie Hower's decision to purchase call options is accurate when attempting to synthetically sell
a risk-free bond. This is based on the rearranged put-call parity formula, which is a fundamental
X
− = c 0 − p 0 − S0
(1 + r)T
where X is the strike price, r is the risk-free rate, T is the time to maturity, c0 is the price of the
call option, p0 is the price of the put option, and S0 is the price of the underlying asset. To
synthetically short sell a risk-free bond, one should purchase call options (c0), sell put options
(p0), and sell the underlying asset (S0). Therefore, Hower's decision to purchase call options
aligns with the requirements of the put-call parity formula for creating a synthetic short position
in a risk-free bond.
Choice B is incorrect. Purchasing put options would not help Leslie in creating a synthetic
short position in a risk-free bond. Put options give the holder the right to sell an asset at a
specified price within a specific time period. In this case, buying put options would mean that
Leslie expects the price of the bond to decrease, which contradicts her intention of creating a
Choice C is incorrect. Buying the underlying asset does not contribute towards creating a
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synthetic short position either. A synthetic short position involves mimicking the potential profit
and loss outcomes of selling an asset without actually selling it. Therefore, buying more of this
Choice D is incorrect. As explained above, both purchasing put options and buying more of the
underlying asset do not assist in creating a synthetic short position in a risk-free bond; therefore,
all decisions made by Leslie are not accurate for her intended purpose.
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Q.3569 According to the put-call parity, a long position in a put option can be replicated by
going:
A. Short a call option, short the underlying, and long a risk-free bond
B. Short a call option, long the underlying, and short a risk-free bond
C. Long a call option, short the underlying, and short a risk-free bond
D. Long a call option, short the underlying, and long a risk-free bond
According to the put-call parity, a long position in a put option can be replicated by going long a
call option, short the underlying, and long a risk-free bond. This is derived from the put-call
parity equation: S0 + p0 = c0 + X/(1+r)T. Rearranging the equation to solve for p0 (the price of
the put option), we get: p0 = c0 + X/(1+r)T – S0. This implies that the price of a put option is
equal to the price of a call option plus the present value of the strike price minus the price of the
underlying. Therefore, an investor can replicate a long put option position by going long a call
option (buying a call option), short the underlying (selling the underlying), and long a risk-free
Choice A is incorrect. Shorting a call option and the underlying while going long on a risk-free
bond does not create a synthetic long position in a put option according to the put-call parity.
This combination would rather create a synthetic short position in a put option.
Choice B is incorrect. Shorting a call option, going long on the underlying, and shorting a risk-
free bond also does not align with the put-call parity for creating a synthetic long position in a
put option. This combination would result in an undefined or non-standard options strategy.
Choice C is incorrect. Going long on both, the call option and shorting the underlying while
also shorting on risk-free bond does not satisfy the equation of put-call parity for creating
synthetic long position in put-option. This combination would lead to an undefined or non-
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Q.3570 A three-month call option with an exercise price of $55 is being sold for $8. A three-
month Treasury bond is being sold in the marketplace with the same face value as the option's
exercise price. The underlying is currently worth $60, and the risk-free rate is 4.30%.
Assuming the put-call parity holds, a put option is being sold for:
A. $0.73
B. $2.42
C. $12.34
D. $8.48
c 0 + X(1 + r)−T = S0 + p
⇒ p 0 = $8 + ($55(1.043)−0.25 ) − $60 = $2.4241
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Reading 40: Trading Strategies
Q.754 Johanna Smith is a treasury manager at Easy Bank. She manages the treasury affairs and
also the investment advisory activities of the bank. She invests in treasury and money market
instruments to manage short-term cash, but for long-term cash management, she uses other
instruments. Currently, she has invested in zero-coupon bonds with the face value of $100, and at
the same time, she has also taken a long exposure in call options with the strike price of $100.
Which of the following accurately depicts Smith’s strategy?
Smith has constructed a fiduciary call. A fiduciary call is a portfolio that consists of a zero-
coupon bond that pays a certain amount (X) at maturity and a call option with a strike price of X.
The payoff of the fiduciary call is X if the call option expires out of the money, and it is S (X + S −
X) if the call option expires in the money (S = current stock price). This strategy is used to
reduce and control losses using options rather than stocks. It allows the investor to control the
same amount of stocks using call options as they would have if they had bought the shares
directly. Instead of buying 100 shares of a stock using all the money, the investor buys 1 contract
of its call options (1 contract = 100 shares) with just a small fraction of the money and invests
the rest into an interest-bearing risk-free investment vehicle. This way, the investor increases
their overall profits and reduces their maximum risk exposure to just the amount of money they
Choice A is incorrect. Put-call parity is a principle that defines the relationship between the
price of European put options and calls of the same class, that is, with the same underlying
asset, strike price, and expiration date. In this scenario, Smith has not constructed a put-call
parity as she has only taken a long position in call options and invested in zero-coupon bonds.
Choice B is incorrect. A covered call strategy involves owning or buying shares of stock and
selling an equivalent number of call options on that stock. This strategy generates income from
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the premiums earned from selling call options. However, Smith's strategy does not involve
Choice D is incorrect. A protective put strategy involves purchasing a put option to hedge
against potential losses in an owned stock's value. In this case, Smith has taken a long position in
call options rather than purchasing put options; hence her strategy does not constitute a
protective put.
Q.765 Mahesh Kumar has recently joined Singapore Standard Bank, the largest investment
banks in South-East Asia. Kumar has analyzed an open position his bank has in the stock of a
Singaporean carmaker. The current value of the stock is $44, but he believes that the price of the
stock will have trouble reaching above $48 because of technical and fundamental factors. Kumar
called one of the bank’s traders and shared his analysis regarding the stock. The analyst
informed the manager that he is going to lock the profit with a covered call strategy.
How exactly is he going to apply the covered call?
A. Since the bank already owns the stocks, the trader is going to buy out-of-the-money
call options at the strike price of $48.
B. Since the bank already owns the stocks, the trader is going to sell in-the-money call
options at the strike price of $44.
C. Since the bank already owns the stocks, the trader is going to buy at-the-money call
options at the strike price of $44.
D. Since the bank already owns the stocks, the trader is going to sell out-of-the-money
call options at the strike price of $48.
A covered call strategy involves owning the underlying asset and selling call options on that
same asset. The goal of this strategy is to generate additional income from the option premium,
while also providing some protection against potential losses if the asset's price falls. In this
case, the trader believes that the stock price will not exceed $48. Therefore, he decides to sell
out-of-the-money call options with a strike price of $48. Out-of-the-money options are those with
a strike price that is higher (for call options) or lower (for put options) than the current market
price of the underlying asset. By selling these options, the trader can earn the premium, which
provides additional income. If the stock price does not exceed $48, the options will expire
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worthless, and the trader will keep the premium as profit. However, if the stock price does rise
above $48, the options will be exercised, and the trader will have to sell the stock at the strike
price. But since the trader already owns the stock, this is not a problem. The profit from selling
the stock and the premium received from selling the options will offset any potential losses. This
strategy is a common way to generate income and hedge against potential losses in the stock
market.
Choice A is incorrect. The trader would not buy out-of-the-money call options at the strike
price of $48. In a covered call strategy, the trader sells call options on an asset they already own
to generate income from the option premium. Buying a call option would not serve this purpose.
Choice B is incorrect. Selling in-the-money call options at the strike price of $44 is also not
correct because it does not align with Kumar's analysis that suggests that the stock price may
struggle to surpass $48. Selling in-the-money calls would mean that the bank believes that stock
Choice C is incorrect. Buying at-the-money call options at a strike price of $44 does not
represent a covered call strategy either as it involves buying rather than selling options and thus
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Q.766 Investments banks create customized derivative products for risk-averse retail investors.
These products have features of multiple instruments. The payoff on these customized products
depends on underlying assets like stocks, indices, and other risky assets. However, the
investments in these assets cannot decrease below the initial principal. Which of the following
products have these features?
A. Covered call
B. Protective put
D. Straddle notes
These are specialized investment products that banks create to cater to risk-averse retail
investors. The payoffs or the return on these products depends on underlying assets like stock,
indices, and other risky assets, but these products do not decrease in value beyond the principal
investment. This means that the investor's initial investment is protected, regardless of the
performance of the underlying assets. This feature makes principal protected notes particularly
Choice A is incorrect. A covered call is a financial market transaction in which the seller of call
options owns the corresponding amount of the underlying instrument, such as shares of a stock
or other securities. It does not guarantee that the investment value cannot fall below the initial
principal amount.
Choice B is incorrect. A protective put is an investment strategy that involves adding a put
option to a security that an investor already owns in order to protect against falling prices.
However, it does not ensure that the investment value will not fall below the initial principal
amount.
Choice D is incorrect. Straddle notes are complex financial products that involve buying both a
call and put option on an underlying asset with identical strike prices and expiration dates,
allowing investors to profit from large movements in either direction but do not guarantee
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Q.767 John Greenwood has recently joined A.K.K. Investment Company as a junior investment
analyst. Greenwood has very little past experience in trading options. Therefore, he frequently
has to refer to his superiors for trading strategies and terminologies. Recently Greenwood was
instructed to apply a bull spread strategy on Blue Balloon Corp. stock options. Which of the
following transactions correctly depicts the bull spread strategy?
A. Taking a long position in a European put option with a specific strike price and
simultaneously taking a short position in a European call option with a higher strike price
B. Taking a long position in a European put option with a specific strike price and
simultaneously taking a short position in a European put option with a lower strike price
C. Taking a long position in a European call option with a specific strike price and
simultaneously taking a short position in a European call option with a higher strike price
D. Taking a long position in a European call option with a specific strike price and
simultaneously taking a short position in a European call option with a lower strike price
A bull spread strategy is a type of options strategy that is used when an investor expects a
moderate rise in the price of the underlying asset. This strategy is constructed by buying a call
option with a certain strike price, and selling another call option with a higher strike price. Both
options must have the same underlying asset and expiration date. In the context of the question,
Greenwood is expected to implement a bull spread strategy on Blue Balloon Corp. stock options.
Therefore, he should take a long position in a European call option with a specific strike price
and simultaneously take a short position in a European call option with a higher strike price. This
strategy would allow Greenwood to profit from a moderate increase in the price of Blue Balloon
Corp. shares, while limiting his potential losses. The maximum profit in a bull call spread is the
difference between the strike prices, less the cost of initiating the trade. The maximum loss is
Choice A is incorrect. This choice suggests taking a long position in a European put option and
shorting a European call option with a higher strike price. This does not represent a bull spread
strategy, but rather it represents an example of straddle or strangle strategies which are used
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Choice B is incorrect. Taking a long position in a European put option and simultaneously
taking a short position in another European put option with lower strike price represents bear
spread strategy, not bull spread. In bear spreads, investors expect the price to fall and hence
they buy put options at higher strike prices and sell at lower ones.
Choice D is incorrect. As explained above, this choice suggests buying call options at one
strike price and selling call options at lower strike prices which contradicts the concept of bull
spread strategy where we expect prices to rise so we buy call options at lower prices (long) and
Q.768 An investment manager at Skyline Bank frequently invests in stocks and derivatives. He is
always testing different options strategies to maximize the value of the assets under
management. Recently, he applied a bull spread strategy on Ocean Shipping Co. stock options.
The manager applied a strategy by purchasing European call options on the stock of the firm
with a strike price of $89, and at the same time, he sold European call options on the same
stocks with a strike price of $92. Suppose that the final price of the stocks at expiration is $97,
then estimate the payoff of the strategy. Ignore the cost of the strategy.
A. $8
B. $5
C. $3
D. -$2
In a bull spread strategy, an investor buys European call options with a specific strike price ($89)
and simultaneously sells European call options with a higher strike price ($92).
If the current price ($97) is higher than the strike price of the short call option ($92), both call
options will be exercised, and the payoff of the investor will be X2-X1 or $92-$89 = $3.
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Q.769 Saddam Ahmed is a junior portfolio manager at Westend Investments. His investing
activities are focused on equities and options. Recently, he purchased a 6-month European call
option on a specific stock for $5 with a strike price of $110. At the same time, he sold a 6-month
European call option on the same stocks for $3 with a strike price of $115. Suppose that the final
price of the stock at expiration is $113, then estimate the profit/loss of the strategy.
A. -$2
B. $1
C. $3
D. $6
The investor has applied a bull spread strategy. In a bull spread strategy, an investor buys a
European call option with a specific strike price ($110) and simultaneously sells a European call
option with a higher strike price ($115).
Since the investor paid $5 to buy the call option and received $3 for selling the other call option,
the net cash outflow or the cost of the strategy is $2.
Since the current price of the stock is $113, which is higher than the strike price of the long call
option but lower than the strike price of the short call option, the payoff of the investor is:
Profit/Loss = Current price - Strike price of the long call - Net cost of the strategy
Profit/Loss = $113 - $110 - $2 = $1
Q.770 Nancy Smith is an independent individual investor. She has 5 years of experience trading
equities, bonds, and options. Smith has recently learned about spread strategies in options that
could be implemented to earn protected profits. She is particularly interested in implementing
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the bear spread strategy. Keeping in view Smith’s intended spread strategy, determine how she
can implement the bear spread strategy.
A. She can implement the bear spread strategy by buying a European put option with a
specific strike price and simultaneously selling a European put option with a higher
strike price.
B. She can implement the bear spread strategy by selling a European put option with a
specific strike price and simultaneously buying a European put option with a higher
strike price.
C. She can implement the bear spread strategy by buying a European put option with a
specific strike price and simultaneously buying a European call option with a lower strike
price.
D. She can implement the bear spread strategy by selling a European put option with a
specific strike price and simultaneously buying a European put option with a lower strike
price.
In a bear spread strategy, an investor sells a European put option with a specific strike price and
simultaneously buys a European put option with a higher strike price. This strategy is designed
to profit from a decrease in the price of the underlying asset. The sold put option (with a lower
strike price) will generate income, which helps to offset the cost of the purchased put option
(with a higher strike price). If the price of the underlying asset falls below the strike price of the
purchased put option, the investor can exercise this option, selling the asset at the higher strike
price. However, if the price of the underlying asset is above the strike price of the sold put option
at expiration, this option will be worthless, and the investor will only lose the net premium paid
for the spread. Therefore, the maximum loss for the investor is limited to the net premium paid
for the spread, while the maximum profit is the difference between the two strike prices minus
the net premium paid. This strategy is called a bear spread because it profits when the price of
the underlying asset falls, similar to how a bear market is characterized by falling prices.
Choice A is incorrect. This choice suggests buying a European put option with a specific strike
price and selling another with a higher strike price. However, this would result in a bull spread
strategy, not a bear spread. In the bear spread strategy, the investor expects the price of the
underlying asset to fall and hence would sell an option at a lower strike price while buying
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another at a higher strike price.
Choice C is incorrect. This choice suggests implementing the bear spread by buying both put
and call options which is not correct. The bear spread strategy involves only put options or only
Choice D is incorrect. Selling an option at lower strike price and buying one at higher strike
does form part of bearish strategies but it forms part of Bear Call Spread Strategy rather than
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Q.771 Ahmet Gogh believes the price of the stocks of Red Bus Co. has more downside potential
than upside potential. Therefore, he has purchased a European put option on the stock of Red
Bus with a strike price of $42 and simultaneously sold a European put option with a strike price
of $38. At expiration, the final price of the stock is $43.What is the payoff of the strategy?
A. $0
B. $1
C. $4
D. $5
The payoff for each of these options at expiration can be calculated as follows:
As the stock price at expiration ($43) is higher than the strike price ($42), this option is out of
the money, and Ahmet will not exercise it. Therefore, the payoff is $0.
Again, since the stock price at expiration ($43) is higher than the strike price ($38), this option is
out of the money, and it will not be exercised by the option buyer. Therefore, the payoff for
Given these results, the total payoff for the strategy is $0 (0 + 0). This means Ahmet doesn't gain
Q.772 During a trader’s brainstorming session on the subject of spread trading strategies in
options trading, a senior trader and trainer made the following statements regarding the
definition and payoffs of a box spread strategy:
I. A box spread strategy is the combination of a bull spread strategy and a bear spread strategy
II. The payoff of the box spread strategy will always be the difference between the higher strike
price and the lower strike price (X2-X1)
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B. Only statement II is incorrect.
Both statements made by the trader regarding the box spread options strategy are accurate.
Statement I is correct because a box spread is indeed a combination of a bull spread and a bear
spread. Specifically, in a box strategy, the investor holds four positions in options: a long call and
a short put option with the strike price X1, and a short call and a long put with the strike price of
X2. This combination of positions creates a 'box' of options that can be used to hedge risk or
generate income. Statement II is also correct because the payoff of the box spread will always be
X2-X1, regardless of whether the final or current price is below X1, between X1 and X2, or above
X2. This is because the box spread is designed to have a fixed payoff, which is the difference
between the two strike prices. This makes the box spread a risk-free strategy, as the investor
knows in advance what the payoff will be, regardless of the movement in the underlying asset's
price.
Choice A is incorrect. Statement I is correct as a box spread strategy indeed involves the
combination of a bull spread and a bear spread strategy. This means that it includes both buying
and selling call options, as well as buying and selling put options, with different strike prices but
Choice B is incorrect. Statement II is also correct because the payoff of a box spread strategy
will always be equal to the difference between the higher strike price (X2) and lower strike price
(X1), regardless of how much or in which direction the underlying asset's price moves before
expiration.
Choice C is incorrect. As explained above, both statements are accurate descriptions of a box
Q.773 Phillip Harris is a senior arbitrageur investor at Dynamic Arbitrage Investment Co. He
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recently found out that if the value of a box spread is not equal to the present value of the payoff
of the box spread, an investor could earn an arbitrage profit. He also found out that if the market
value of a box spread is too high, it is profitable to sell the box spread.What positions should
Harris take in call and put options to sell a box spread?
A. Harris must buy a European call option and buy a European put option with a specific
strike price (X1), and simultaneously sell a European call option and sell a European put
option with a higher strike price (X2).
B. Harris must sell a European call option and sell a European put option with a specific
strike price (X1), and simultaneously buy a European call option and buy a European put
option with a higher strike price (X2).
C. Harris must buy a European call option and sell a European put option with a specific
strike price (X1), and simultaneously sell a European call option and buy a European put
option with a higher strike price (X2).
D. Harris must sell a European call option and buy a European put option with a specific
strike price (X1), and simultaneously buy a European call option and sell a European put
option with a higher strike price (X2).
To sell a box spread, an investor must sell a European call option and buy a European put option
with a specific strike price (X1), and simultaneously buy a European call option and sell a
European put option with a higher strike price (X2). This strategy is known as a box spread
strategy. A box spread is a complex strategy that involves four options with the same expiration
date but different strike prices. The goal of this strategy is to create a risk-free position that can
potentially generate arbitrage profits. The box spread strategy is often used by sophisticated
investors like Phillip Harris who have a deep understanding of options pricing and can identify
mispriced options in the market. When the market value of a box spread is higher than the
present value of its payoff, it indicates that the options are overpriced. By selling the box spread,
the investor can lock in a guaranteed profit regardless of the future price movements of the
underlying asset. This is because the payoff from the box spread at expiration will always be
equal to the difference between the two strike prices, regardless of the price of the underlying
asset. Therefore, if the investor can sell the box spread for more than this amount, they can earn
an arbitrage profit.
Choice A is incorrect. This choice suggests buying both a call and a put option at strike price
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X1, and selling both a call and a put option at strike price X2. This strategy would actually create
a long box spread position, not the short box spread position that Harris needs to profit from an
Choice B is incorrect. Selling both a call and put option at strike price X1, while buying both at
strike price X2 would also result in creating a long box spread position. Again, this is contrary to
Choice C is incorrect. This choice suggests buying a call and selling a put at strike price X1,
while selling another call and buying another put at higher strike price X2. However, this
combination does not form any type of box spread strategy (neither long nor short), hence it
Q.775 A Masters of Science (M.Sc.) in Finance graduate, who is also a teacher’s assistant, is
helping undergraduate students prepare for their final exams. In today’s lecture, he is giving a
presentation on spread trading strategies using options. He presented that, in a butterfly spread
trading strategy, investors take positions in three options. He also makes the following
statements regarding the payoff of butterfly spreads:
I. If the current price of the stock is less or equal to the strike price, X1 then the payoff from a
long put is equal to the difference between the strike price, X1 and the current price, ST . In other
words, if ST ≤ X1 , then Payoff = X1 − ST .
II. If the current price of the stock is greater than the strike price, X3 , then the payoff from a
long put is equal to the difference between X 3 and the current price, ST . In other words, if S > X3
, then Payoff = X 3 − ST
A. Statement I only
B. Statement II only
C. Both statements
Statement I is accurate because it correctly describes the payoff from a long put option. In
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options trading, a long put option gives the holder the right to sell a specified quantity of an
underlying asset at a specified price (the strike price) within a fixed period of time. If the current
price of the stock is less or equal to the strike price, X1, then the payoff from a long put is indeed
equal to the difference between the strike price, X1 and the current price, ST . This is because the
holder of the put option can sell the asset at the higher strike price, X 1, rather than the current
lower market price, ST . The difference between these two prices, X1 − ST , is the payoff from the
long put option. This is a fundamental concept in options trading and is crucial for understanding
Choice B is incorrect. The second statement is not correct because it misrepresents the payoff
from a long put option. If the current price of the stock, ST , is greater than the strike price, X3 ,
then the payoff from a long put would be zero, not X3 − ST . This is because an investor would not
exercise their right to sell at a lower price (X3 ) when they could sell at a higher market price (ST
).
Choice C is incorrect. As explained above, Statement II is incorrect which makes this choice
invalid.
Choice D is incorrect. This choice suggests that both statements are wrong which isn't true as
Statement I correctly describes the payoff from a long put option when ST ≤ X1 .
Q.776 An investor is interested in a spread trading where he can sell a European call option and
buy a European call. If the investor wishes for the expiration date of the long call to be greater
than the short call, then which of the following is the strategy he is interested in?
A. Bull spread
B. Bear spread
C. Butterfly spread
D. Calendar spread
A calendar spread, also known as a horizontal spread or a time spread, is a strategy that involves
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buying and selling two options of the same type (calls or puts), same underlying security, same
strike price, but with different expiration dates. The investor sells an option with a near-term
expiration date and buys an option with a longer-term expiration date. The strategy is named
'calendar spread' because it profits from the passage of time - the time decay of options. The
near-term option that the investor sells will decay (lose value) faster than the long-term option
that the investor buys. This differential decay rate is what allows the investor to potentially profit
In the context of the question, the investor is interested in selling a European call option and
buying another European call option with a longer expiration date. This aligns perfectly with the
definition and structure of a calendar spread, making choice D the correct answer.
Choice A is incorrect. A bull spread involves buying a call option with a certain strike price and
selling another call option with a higher strike price, both having the same expiration date. This
strategy is used when the investor expects a moderate rise in the price of the underlying asset.
Choice B is incorrect. A bear spread involves buying a put option and selling another put
option with a lower strike price, both having the same expiration date. This strategy is used
Choice C is incorrect. A butterfly spread involves positions in options with three different
strike prices, all having the same expiration date. It can be created by purchasing one call (put)
at the lowest (highest) strike, selling two calls (puts) at the middle strike and purchasing one
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Q.777 A calendar spread is a spread trading strategy in which an investor can invest in two
positions in European call options with the same strike price and different expiration dates.
Following are features of calendar spreads:
I. To create a calendar spread with put options, an investor must buy a long-maturity put option
and sell a short-maturity put option
II. A bullish calendar spread involves a higher strike price than the current stock price, whereas
a bearish calendar spread involves a lower strike price
Both statements are correct. A calendar spread can be created with call options as well as put
options. In a put option, the investor must buy a long-maturity put option and sells a short-
maturity put option.
On the other hand, with call options, an investor must sell a European call option on the stock
and simultaneously buy a European call option with a longer expiration date or maturity.
Q.778 A hedge fund manager sent a quarterly newsletter to its clients via email, which contained
information on the earnings and the strategies used by the manager throughout the quarter. One
of the clients inquired about the straddle combination strategy used in trading and asked for
details. The manager of the fund replied to the email with the following explanations of the
straddle trading strategy:
I. In a straddle options trading strategy, the investor buys European call and put options with the
same strike prices and expiration dates
II. The straddle trading strategy is used when a big movement in stock price is expected, but the
direction of the movement is unknown
A. Statement I is wrong.
B. Statement II is wrong.
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The correct answer is D.
Neither of the statements provided by the hedge fund manager about the straddle trading
investor purchases European call and put options with the same strike prices and expiration
dates. This is a common strategy used in options trading, particularly when the investor believes
that the price of the underlying asset will move significantly, but is unsure of the direction of the
movement. By purchasing both a call and a put option, the investor can profit regardless of
whether the price of the asset increases or decreases, as long as the price movement is
Statement II is also correct. The straddle trading strategy is indeed used when a large price
movement is expected, but the direction of the movement is uncertain. This is because the
strategy involves buying both a call option (which profits if the price increases) and a put option
(which profits if the price decreases). Therefore, as long as the price of the underlying asset
trading strategy. In this strategy, an investor purchases a call and put option with the same strike
price and expiration date. This allows the investor to profit from a significant move in either
Choice B is incorrect. Statement II correctly explains when a straddle trading strategy might
be employed. Investors typically use this strategy when they anticipate a significant shift in stock
Choice C is incorrect. As explained above, both statements I and II accurately describe aspects
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Q.779 Suppose an individual investor has implemented a straddle trading strategy. The investor
purchased a 6-month European call option with a strike price of $58 on the stock of a specific
firm for $5, and simultaneously purchased a 6-month European put option on the stock of the
same firm for $4 with a strike price of $58. If the price of the underlying stock after 6-month
period is $65, which of the following is closest to the profit of the straddle strategy?
A. $7
B. $0
C. -$2
D. -$9
In a straddle strategy, the investor buys a European call option and put option with the same
strike price and expiration. In the provided case, the investor purchased a 6-month European call
option for $5 with the strike price of $58, and at the same time, purchased a 6-month put option
for $4 with a strike price of $58.
The total cost of the straddle is the sum of the call premium and the put premium.
Q.780 Irene Schmidt has recently joined the Hessen Investments Company based in Frankfurt,
which largely invests in equities and options. Since Schmidt is new to derivatives trading
strategies, she has created a chart that explains options trading strategies. After analyzing the
chart, determine the incorrectly represented strategy.
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D. The diagonal spread strategy is incorrect.
The diagonal spread strategy, as depicted in the chart, is incorrect. In a diagonal spread strategy,
both the strike prices and the expiration dates of the calls and puts are different. This strategy
involves buying and selling options with different strike prices and expiration dates. The goal of a
diagonal spread is to profit from both time decay and price changes. It is called a 'diagonal'
spread because it combines elements of vertical and horizontal spreads. A vertical spread
involves buying and selling options with the same expiration date but different strike prices,
while a horizontal spread involves buying and selling options with the same strike price but
different expiration dates. By combining these elements, a diagonal spread can provide a trader
with a wide range of profit potential, while also limiting risk. Choice A is incorrect. The bull
spread strategy is correctly represented. This strategy involves buying an option with a lower
strike price and selling another option with a higher strike price, both of the same type and
expiration date. It's used when the trader expects a moderate rise in the price of the underlying
asset.Choice B is incorrect. The butterfly spread strategy has been accurately depicted as well.
This strategy involves buying one call at a low strike price, selling two calls at a middle strike
price, and buying one call at a high strike price (or vice versa for puts). It's used when the trader
believes that the underlying asset will not experience much volatility.Choice C is incorrect. The
calendar spread strategy has also been correctly represented on Irene's chart. In this approach,
an investor sells and buys the same type of option (calls or puts) but with different expiration
dates, while keeping the strike prices identical. This strategy takes advantage of time decay and
differing volatility between near-term and longer-term options.
Q.781 An investor has recently learned about spread trading strategies. To test one of the spread
combinations, the investor purchased a 3-month European call option on stocks of Big Corp. with
a strike price of $101. At the same time, he also took a long position in two 3-month European
put options on the stocks of Big Corp. with a strike price of $101. Which of the following
strategies is he most likely testing?
A. Straddle strategy
B. Butterfly strategy
C. Strap strategy
D. Strip strategy
The investor is most likely testing a strip strategy. A strip strategy is a type of options trading
strategy that involves purchasing a European call option and two European put options with the
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same strike prices and expiration dates. This strategy is typically used when an investor believes
that the price of the underlying asset will experience significant volatility in the near future, and
they believe that the price is more likely to fall than to rise. The two put options provide a higher
level of protection against a price drop than the single call option provides potential for profit if
the price rises. Therefore, the strip strategy is a bearish strategy that provides protection against
downside risk while still allowing for profit if the price rises.
Choice A is incorrect. A straddle strategy involves buying a call and a put option on the same
underlying asset with the same strike price and expiration date. In this case, the investor has
bought two put options, not one, which does not align with a straddle strategy.
Choice B is incorrect. A butterfly spread strategy involves buying or selling multiple options of
the same underlying asset with different strike prices but at the same expiration date. The
investor in this scenario has purchased options with the same strike price, hence it cannot be a
Choice C is incorrect. A strap strategy involves buying two call options and one put option on
the same underlying asset with identical strike prices and expiration dates. However, in this
case, it's reversed - two put options are bought instead of two call options - so it doesn't match
up to a strap strategy.
Q.782 An investment manager has realized that there is a great potential for profits in the
options market without tying up much capital. To test the potential of options trading, he
implemented a spread strategy by purchasing two 6-month European call options on stocks of a
specific firm with the strike price of X and, at the same time, buying a 6-month European put
option on the stocks of the same firm with the same strike price.
Which strategy is he most likely using?
A. Straddle strategy
B. Strip strategy
C. Strap strategy
D. Strangle strategy
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A strap strategy is an options strategy that involves holding two calls and one put with the same
strike price and expiration date. This strategy is used when the trader believes that the
underlying stock will experience significant volatility in the near term. The two calls provide
profit if the stock price increases, while the put limits the loss if the stock price decreases. In this
case, the investment manager purchased two 6-month European call options and one 6-month
European put option on the stocks of a specific firm with the same strike price. This aligns with
Choice A is incorrect. A straddle strategy involves buying a call and put option with the same
strike price and expiration date. This strategy is used when an investor believes there will be a
large price movement but is unsure of the direction. In this case, the manager bought two call
options and one put option, which does not align with a straddle strategy.
Choice B is incorrect. A strip strategy involves buying two put options and one call option with
the same strike price and expiration date. This strategy is used when an investor believes that
there will be a significant downward movement in the stock's price. However, in this scenario,
the manager bought two call options and one put option which corresponds to a strap strategy
Choice D is incorrect. A strangle strategy involves buying out-of-the-money call and put
options with different strike prices but same expiration date. The aim of this approach is to profit
from large movements in either direction of underlying asset's price while limiting potential
losses if no such movement occurs. But here, all three options purchased by investment manager
Q.783 An investment manager has realized that there is a great potential for profits in the
options market without tying up much capital. To test the potential of options trading, he
implemented one of the spread strategies by purchasing a 9-month European call option on the
stocks of Petro Co. with a strike price of $37, and at the same time, buying a 9-month European
put option on the stocks of the same firm with a strike price of $32.
Which of the following strategies is the investment manager most likely testing?
B. Straddle strategy
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C. Strip strategy
D. Strangle strategy
The investment manager is testing the Strangle strategy. In a Strangle strategy, an investor
purchases a European call and a European put option on the stock of a specific firm. These
options have the same expiration date but different strike prices. This strategy is used when the
investor believes that the stock price will experience significant movement but is unsure of the
direction. The call option allows the investor to profit if the stock price rises above the strike
price, while the put option provides profit if the stock price falls below the strike price. The
maximum loss for the investor is the total premiums paid for the options, which occurs if the
stock price at expiration is between the strike prices of the call and put options. The potential
Choice A is incorrect. A calendar spread strategy involves buying and selling the same type of
options (calls or puts) on the same underlying asset with the same strike price but different
expiration dates. In this case, both options are for 9 months and have different strike prices, so it
Choice B is incorrect. A straddle strategy involves buying a call and put option on the same
underlying asset with the same strike price and expiration date. Here, although both options are
for 9 months, they have different strike prices ($37 for call option and $32 for put option), hence
Choice C is incorrect. A strip strategy involves buying one at-the-money call option and two at-
the-money put options on the same underlying asset with identical expiration dates. In this
scenario, only one call option and one put option were purchased with differing strike prices
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Q.4623 A portfolio X consists of a five-year zero-coupon bond and a five-year call option on
portfolio Y. The current price of portfolio Y is $20,000, and the strike price of the option is also
$20,000. The interest rate is 7% per annum. To ensure no losses to a trader while still providing
the trader with room for profits, the premium paid to secure the call option should cost less than:
A. 20000
B. 5740.28
C. 15740.28
D. 14259.72
Principal Protected Notes act by reducing losses while still providing room for potential gains.
To hedge against losses, the trader should buy a zero-coupon bond that will yield, at maturity, the
Therefore, the price of the bond should be equal to the present value of the strike price.
P V = 20 , 000(1 + 0.07)−5
= 14 , 259.72
To make the portfolio profitable, the premium paid to secure the call option should cost less
than:
Q.4624 With respect to interest rates, when are Principal Protected Notes (PPNs) most
profitable?
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Principal Protected Notes (PPNs) are most profitable when interest rates increase. This is
because the profitability of PPNs is tied to the price of the option, which is less than K-PV(K),
where K is the strike price needed to purchase the underlying asset in the portfolio. As interest
rates increase, the present value (PV) of K decreases, leading to a larger difference between K
and PV(K). This larger difference translates into higher profits for PPNs. The following table
As shown in the table, the difference between K and PV(K) increases as the interest rate
Choice B is incorrect. When interest rates decrease, the profitability of PPNs does not
necessarily increase. This is because lower interest rates mean that the cost of borrowing for
companies decreases, which can lead to an increase in corporate bond prices. However, this does
not directly translate into higher profits for PPNs as they guarantee only the return of the
principal amount and not any potential gains from increased bond prices.
Choice C is incorrect. If interest rates remain constant, it doesn't necessarily yield higher
profits for PPNs. The profitability of PPNs depends on how well the underlying investment
Choice D is incorrect. Volatile interest rates do not guarantee higher profits for Principal
Protected Notes (PPNs). In fact, volatility in interest rates can introduce uncertainty and risk
into the performance of these notes as it affects both their cost structure and their returns from
underlying investments.
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Q.4625 The strike price of a three-month call and a three-month put option with the same time to
maturity is $50. The cost of the call option is $4, whereas the cost of the put option is $6. Using a
short straddle strategy of trading, by how much should the asset price move in order to incur a
loss?
A. 4
B. 6
C. 2
D. 10
The question is testing the use of the short straddle trading strategy, a trading strategy that
involves selling a call and a put option with the same strike price and time to maturity.
Upper price bound of the asset price at maturity = $50 + $10 = $60
Lower price bound of the asset price at maturity = $50 - $10 = $40
Therefore, for a loss to be incurred, the asset price at maturity should be either above $60 or
below $40.
Q.4626 Consider two call options with strike prices of $30 and $35 and two put options with
strike prices $30 and $35. How can a trader create a bear spread trading strategy using two
options?
A. Buy the put option with a strike price of $30 and sell the put option with a strike price
of $35.
B. Buy the put option with a strike price of $35 and sell the put option with a strike price
of $30.
C. Buy the put option with a strike price of $30 and sell the call option with a strike price
of $35.
D. Buy the put option with a strike price of $35 and sell the call option with a strike price
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of $30.
A bear spread strategy can be created by buying a put option with a higher strike price and
selling a put option with a lower strike price. In this case, the trader would buy the put option
with a strike price of $35 and sell the put option with a strike price of $30. This strategy is
designed to profit from a decline in the price of the underlying asset. If the price of the asset falls
below $30, the trader can exercise the $35 put option, selling the asset for $35. Meanwhile, the
$30 put option that the trader sold will either expire worthless (if the price of the asset is above
$30) or will be exercised by its owner, requiring the trader to buy the asset for $30. In either
case, the trader profits from the difference between the strike prices of the two options.
Choice A is incorrect. Buying a put option with a strike price of $30 and selling a put option
with a strike price of $35 would not create a bear spread. This strategy would actually result in
an unlimited potential loss if the underlying asset's price increases, which is contrary to the
objective of a bear spread strategy that aims to profit from declining prices.
Choice C is incorrect. Buying the put option with a strike price of $30 and selling the call
option with a strike price of $35 does not constitute as constructing a bear spread strategy. This
combination could lead to significant losses if the underlying asset's price rises above $35, as
there would be an obligation to sell at this lower strike price while having only limited potential
Choice D is incorrect. Buying the put option with a strike price of $35 and selling the call
option with a strike price of $30 also does not form an effective bear spread strategy. In this
case, if prices rise above 30$, trader will have unlimited loss due to sold call while limited gain
Q.4627 Consider two call options with strike prices of $30 and $35 and two put options with
strike prices of $30 and $35. How can a trader create a bull spread trading strategy using two
options?
A. Buy the call option with a strike price of $30 and sell the call option with a strike price
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of $35.
B. Buy the call option with a strike price of $35 and sell the call option with a strike price
of $30.
C. Buy the put option with a strike price of $30 and sell the call option with a strike price
of $30.
D. Buy the put option with a strike price of $35 and sell the call option with a strike price
of $35.
A bull spread strategy is typically constructed by buying a call option with a lower strike price
and selling a call option with a higher strike price. This strategy is used when the trader expects
a moderate increase in the price of the underlying asset. In this case, buying the call option with
a strike price of $30 and selling the call option with a strike price of $35 creates a bull spread.
The maximum profit in this strategy is the difference between the two strike prices minus the net
premium paid. The maximum loss is limited to the net premium paid for the options. This
strategy provides a trader with a way to profit from a moderate rise in the price of the
Choice B is incorrect. Buying a call option with a higher strike price and selling a call option
with a lower strike price would create a bear spread, not a bull spread. This strategy would be
profitable if the trader expects the price of the underlying asset to fall, not rise.
Choice C is incorrect. Buying a put option and selling a call option both with the same strike
price does not create any kind of spread strategy. This combination of options is known as
'straddle' which is used when high volatility in either direction is expected in the market.
Choice D is incorrect. Similar to choice C, buying and selling options (whether calls or puts) at
the same strike price does not result in any type of spread strategy but rather creates another
respectively.
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Q.4873 An investor creates a bull put spread by purchasing a put option for a premium of $25.
The put option comes with a strike price of $95 and expires in July 2022. At the same time, the
investor sells a put option for a premium of $50. The put option comes with a strike price of $140
and expires in July 2022. The underlying asset is the same and is currently trading at $145.
Determine the maximum loss.
A. 40
B. 20
C. 25
D. 15
Max loss = strike price of short put − strike price of long put − net premium received
= 140– 95– (50– 25) = 20
Note: A bull put spread is a strategy utilized by an investor when they believe the underlying
stock will exhibit a moderate increase in price. It involves purchasing an out-of-the-money (OTM)
put option and selling an in-the-money (ITM) put option with a higher strike price but with the
same underlying asset and expiration date. A bull put spread works when the market is
exhibiting an upward trend. The maximum gain is the net premium received.
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Q.4912 Peter creates a bear spread using put options with strike prices of USD 35 and USD 40
with the same time to maturity. The options cost USD 3 and USD 5, respectively under what
circumstances will Peter make a profit?
If the asset price is less than 38, Peter will make a profit. The cost of setting up the bear spread
is the net cost, which is the difference between the cost of the two options, i.e., USD 5 - USD 3 =
USD 2. When the asset price is less than 35, the payoff is 40 - 35 = USD 5. After subtracting the
cost of setting up the bear spread, we have a profit of USD 5 - USD 2 = USD 3. When the asset
price lies between 35 and 40, the payoff is 40 - S (where S is the asset price). This payoff must be
greater than 2 (the cost of setting up the bear spread) in order to make a profit. Therefore, when
the asset price is less than 38, we have a profit of 40 - S - 2. Thus, Peter will make a profit when
Choice A is incorrect. Although the asset price being less than 40 would result in both options
being in-the-money, it does not guarantee a profit for Peter. The total cost of the options is USD 8
(USD 3 + USD 5). Therefore, to realize a profit, the asset price must be sufficiently below USD
40 such that the combined payoff from both options exceeds this cost.
Choice C is incorrect. If the asset price lies between USD 38 and USD 40 at expiration, only
one of Peter's put options (the one with a strike price of USD 40) will be in-the-money. The payoff
from this option may not cover the total cost of both options (USD 8), resulting in a loss for Peter.
Choice D is incorrect. If the asset price is greater than USD 38 at expiration, neither of Peter's
put options will be in-the-money and they will expire worthless. This means that he would lose
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Q.4913 Hassan intends to create a bull spread on put options on an asset with strike prices of
USD 20 and USD 25 and the same time to maturity. The options cost USD 2 and USD 2.5,
respectively. How can Hassan create the intended bull spread?
A. Buying the option with a lower strike price and simultaneously selling the put option
with a higher strike price.
B. Buying the option with a higher strike price and simultaneously selling the put option
with a lower strike price.
C. Buying the option with a lower strike price, and at the same time, buying the put
option with a higher strike price.
A bull spread is a type of options strategy that is used when the investor expects a moderate rise
in the price of the underlying asset. This strategy is created by buying an option with a lower
strike price and simultaneously selling an option with a higher strike price. In the context of this
question, Hassan can create a bull spread by buying the put option with a strike price of USD 20
(which costs USD 2) and selling the put option with a strike price of USD 25 (which costs USD
2.5). The lower strike price put option (USD 20) is bought because hassan expects the price of
the underlying asset to increase. On the other hand, the higher strike price put option (USD 25)
is sold to offset the cost of buying the lower strike price put option. This strategy allows Hassan
to profit from a moderate increase in the price of the underlying asset while limiting his potential
loss to the net premium paid for the options (i.e., the cost of the bought option minus the income
Choice B is incorrect. Buying the option with a higher strike price and simultaneously selling
the put option with a lower strike price would not create a bull spread. This strategy would
actually result in a bear spread, as it profits when the asset's price decreases.
Choice C is incorrect. Buying both options, regardless of their strike prices, does not create a
bull spread either. This strategy is known as straddle or strangle depending on whether the
strike prices are same or different respectively, which aims to profit from large movements in
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Choice D is incorrect. As explained above, there are specific strategies to establish a bull
spread using put options and hence 'None of the above' cannot be correct.
Q.4914 Suppose a strangle is created from a call option with a strike price of USD 35, which
costs USD 1, and a put option with a strike price of USD 20, which costs USD 2. The two options
have the same time to maturity. What is the profit as a function of the asset price, ST at option
maturity, when ST ≤ 20?
A. 0
B. 17 − ST
C. -3
D. ST − 38
When ST ≤ K1 , then the payoff from a long call with a strike price K 2 = 35 , will be,
max(0, ST − 35) = 0
and the payoff from a long put option with a strike price K 1 = 20, will be,
max(0, 20 − ST ) = 20 − ST
But the total cost of setting up the strategy is USD 3; thus, the profit is given by,
20 − ST − 3 = 17 − ST
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Q.4915 A straddle is created from a call and a put with the same strike price of USD 45. If the
options have the same time of expiration and that the cost of setting up the straddle is 5, what
conditions will lead to a profit on the straddle?
A. If ST > 50 or if ST < 40
B. If ST < 40
C. ST < 10
D. 10 < ST < 50
In a straddle strategy, a profit can be made if ST > K + C or ST < K − C where ST is the asset
price at time T, K is the strike price, and C is the cost of setting up the straddle.
Note that a straddle involves two transactions on the same security, with positions that offset one
another.
A long straddle is created by purchasing a call and a put with the same strike price and
expiration. A short straddle is created by selling a call and a put with the same strike price and
expiration.
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Reading 41: Exotic Options
Q.784 Susanne Alexander is a junior investment analyst at JCB Investment Bank in Tokyo. She
has no prior experience in trading equities and derivatives. She has been assigned to the trading
unit of the bank where she is taking her initial training from the senior management of the
trading unit. In one of the training sessions, she was asked to identify the option that most likely
trades in the over-the-counter options market. Identify for Alexander the correct option.
B. Covered calls
C. European options
D. Exotic options
Exotic options are a type of derivative that are more complex than the commonly traded 'vanilla'
options. They are called 'exotic' because they are more specialized and less commonly traded
than the standard options. Exotic options are customized to meet the specific needs of the
investor, which can include different payoff structures, cost structures, or expiration dates.
Because of their complexity and customization, exotic options are typically traded in over-the-
counter (OTC) markets rather than on standardized exchanges. OTC markets allow for greater
flexibility and negotiation between the buyer and seller, which is necessary for the trading of
these complex and customized options. Therefore, Susanne Alexander should identify exotic
options as the type of option that is most likely to be traded in the OTC market.
Choice A is incorrect. Plain vanilla options are not the most likely to be traded in the over-the-
counter options market. These types of options have standard features and are usually traded on
Choice B is incorrect. Covered calls are a strategy that involves owning the underlying asset
and selling call options on that same asset. This strategy is typically used by investors who own a
stock and want to generate additional income from it, rather than being a type of option
Choice C is incorrect. European options can only be exercised at expiration, which makes them
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less flexible than American options which can be exercised at any time before expiration. While
European options do trade in over-the-counter markets, they are not the most likely type of
Q.785 In the valuation of exotic options, the yield on the underlying asset must be taken into
considerations. The yield on the underlying assets is present in different forms and variables for
different options. For instance:
I. In the valuation of exotic options on stock indices, the yield is set equal to the dividend yield on
the index
II. In the valuation of exotic options on currencies, the yield is set equal to the domestic risk-free
rate
III. In the valuation of exotic options on futures, if the domestic currency is the base currency,
then the yield would be the domestic risk-free rate
The yield measure on exotic options on currencies is incorrect. In the valuation of exotic options
on currencies, the yield is set equal to the foreign risk-free rate, not the domestic risk-free rate.
This is because the yield on the underlying asset, in this case, the currency, is influenced by the
interest rates in the foreign country. The foreign risk-free rate is the rate of return of a
hypothetical investment with no risk of financial loss, over a given period, in the foreign country.
Therefore, it is the foreign risk-free rate that should be used in the valuation of exotic options on
Choice A is incorrect. The yield measure on exotic options on stock indices is correctly stated.
When valuing exotic options on stock indices, the yield is typically set equal to the dividend yield
on the index. This reflects the fact that holders of such options are effectively exposed to the
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Choice C is incorrect. The yield measure for exotic options on futures contracts where
domestic currency serves as base currency has been correctly stated as being equivalent to
domestic risk-free rate. This reflects that holding such an option exposes one to changes in this
interest rate.
Choice D is incorrect. This choice suggests that all statements about yields are correct which
contradicts with Choice B where it was established that there was an error in defining yield
Q.786 Ryan Holland is an options trader that uses standard European calls, standard European
puts, forward contracts, cash, and the underlying asset to create exotic options known as
packages. He believes that range forward contracts have the following features. Determine
which of these features are correct.
I. A range forward contract is created with a long call and a short put or a short call and a long
put
II. In the case of the long call and the short put, the call strike price is greater than the put strike
price
III. The combination of costs from the two positions typically nets to zero
Feature I is correct. A range forward contract is created with a combination of a long call and a
Feature II is correct. In a long-range contract, the call strike price is greater than the put strike
price.
Feature III is correct. The strike prices are set in a way that the value of the call is usually equal
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Q.787 Ganesh Singh is a junior options trader at an Indian brokerage house. He was recently
promoted from the equity division to the derivatives unit of the firm. One of her clients asked
Singh to take a long position on his behalf in a Bermudan option. Since Singh is unfamiliar with
Bermudan options, describe the unique feature of these types of options.
A Bermudan option is a non-standard American option, which can only be exercised at certain
dates until its expiration. This type of option is a hybrid of American and European options. Like
American options, Bermudan options can be exercised before the expiration date. However,
unlike American options, which can be exercised at any time before expiration, Bermudan
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options can only be exercised on specific dates stipulated in the contract. This feature makes
Bermudan options more flexible than European options but less flexible than American options.
The pricing of Bermudan options is typically more complex due to this unique feature. It's
important to note that the premiums for Bermudan options are lower than those of American
Choice A is incorrect. A Bermudan option is not a non-standard European option that can be
exercised any time until its expiration. In fact, European options can only be exercised at the
Choice B is incorrect. While it's true that American options can be exercised any time until
their expiration, this does not define a Bermudan option. The distinctive feature of Bermudan
options is that they can only be exercised at certain dates until their expiration.
Choice C is incorrect. Although this choice correctly states that Bermudan options can only be
exercised at certain dates until their expiration, it incorrectly classifies them as non-standard
European options when they are actually closer to American style in terms of exercise rights.
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Q.788 Some of the exotic options that are created by brokers and traders are created with non-
standard American-style options that can be exercised at any time until expiration. These options
trade in over-the-counter markets. Which of the following features is likely present in non-
standard American options?
A. These options can have the features of both American and European options, which
allows them to be exercised at any time until their expiration.
C. The strike price of non-standard American options may change during the life of the
option.
Option A is correct because non-standard American options have the Bermudan feature, which
Option C is also correct because the strike price of non-standard American options may change
Q.789 A gap option is a non-standard option that is created with a European call option.
However, the European call option used in the construction of a gap option is different from the
regular European call option. Which of the following is the accurate difference between a gap
European call option and a regular call option?
A. A gap option has two strike prices i.e. X1 and X2 (where X2 > X1). When the final
stock price is greater than X2 (S>X2), the payoff of the gap call option is S – X1.
B. A gap option has two strike prices i.e. X1 and X2 (where X2 > X1). When the final
stock price is greater than X2 (S>X2), the payoff of the gap call option is S – X2.
C. A gap option has two strike prices i.e. X1 and X2 (where X2 > X1). When the final
stock price is greater than X1 (S>X1), the payoff of the gap call option is S – X1.
D. A gap option has two strike prices i.e. X1 and X2 (where X2 > X1). When the final
stock price is greater than X1 (S>X1), the payoff of the gap call option is S – X2.
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A gap option is a type of derivative that differs from a regular European call option in its
structure and payoff mechanism. A regular European call option has a single strike price, X. If
the final price of the underlying asset is greater than X, the payoff of the option is S - X, where S
is the final price of the underlying asset. However, a gap option has two strike prices: X1 and X2,
where X2 is greater than X1. The payoff of a gap call option is triggered when the final price of
the underlying asset is greater than X2. In this case, the payoff is S - X1. This means that the
holder of the gap option will receive the difference between the final price of the underlying
asset and the lower strike price (X1), provided that the final price of the asset is greater than the
higher strike price (X2). This structure allows the holder of the gap option to potentially realize a
higher payoff than with a regular call option, depending on the final price of the underlying
asset.
Choice B is incorrect. The payoff of a gap call option is not S - X2 when the final stock price is
greater than X2. In a gap option, the payoff is determined by subtracting the lower strike price
(X1) from the final stock price (S), not the higher strike price (X2).
Choice C is incorrect. This statement incorrectly suggests that when the final stock price
exceeds X1, then there will be a payoff for a gap call option. However, in reality, for a gap call
option to have any value at expiration, it requires that the underlying asset's final price must
exceed X2.
Choice D is incorrect. Similar to choice B, this statement incorrectly states that if S>X1 then
payoff would be S-X2 which contradicts with how Gap options work as explained above.
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Q.790 Hannah Bruce is a derivatives investment adviser at Dot Investments in New York. She
provides advisory services to retail as well as institutional investors. One of her clients, a small
size community insurance company, intended to invest in equities option that starts at some
future date and expires at an expiration date further in the future. Which of the following options
should Bruce recommend?
B. An employee option
C. A futures option
A forward start option is the most suitable choice for the client's needs. This type of option is a
non-standard option that allows the holder to exercise the option starting from a future date (T1)
and ending at another future date (T2). This type of option is often used in employee stock
options, where the employer commits to grant an at-the-money option at a future date. In this
case, the small community insurance company can benefit from the flexibility of choosing when
to exercise the option within the specified time frame. This can provide the company with the
opportunity to maximize its returns based on market conditions during the option period.
Choice A is incorrect. A European gap option is a type of exotic option that has a strike price,
but the payoff depends on the difference between the asset's price at expiration and a 'gap'
price. This does not align with the company's need for an option that begins at a future date and
Choice B is incorrect. An employee option, typically part of an employee stock ownership plan
(ESOP), allows employees to buy shares of their employer's company at a predetermined price.
This type of option does not meet the requirement specified by the insurance company.
Choice C is incorrect. A futures option gives its owner the right to buy or sell a futures
contract on an underlying asset at a specific price before it expires, but it doesn't necessarily
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Q.791 Gabriela Clarke is a senior derivatives investment manager at one of the largest
investment banks in London. She specializes in constructing complex exotic options for her
clients. Currently, she is investing in a series of call options with a strategy in which she
purchases an option with the strike price of K and expiry date of T1. She then invests in another
option that starts at T1 and expires at T2. This option will have a strike price equal to the price of
the underlying at T1. She invests in many such options with the same strategy, where one option
starts as the last option expires. The series of such options is called a:
A. Cliquet option
B. Gap option
D. Futures option
The series of options described in the question is known as a Cliquet option. A Cliquet option is
an exotic option that consists of a series of consecutive forward start options. The first option in
the series is active immediately, and the subsequent options become active as the previous one
expires. Each option is struck at the money when it becomes active. This means that the strike
price of each option is equal to the market price of the underlying asset at the time the option
becomes active. This type of option allows investors to lock in gains periodically, providing
protection against significant market downturns. However, it also limits the potential upside if
the market performs exceptionally well. The Cliquet option is particularly useful in volatile
markets, where the price of the underlying asset is expected to fluctuate significantly over the
Choice B is incorrect. A Gap option is a type of exotic option where the payoff depends on the
difference between the asset price at the time of exercise and a reference price, which could be
either the price at which it was bought or another specified price. This does not match with
Gabriela's strategy where each new option starts as soon as previous one expires.
predetermined date in future. The strike price of this type of options contract is determined after
its inception, typically based on prevailing market prices at that time. While Gabriela's strategy
involves starting new options after previous ones expire, it doesn't involve pre-determining
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future dates for these options to start.
Choice D is incorrect. Futures Option gives its holder the right but not obligation to buy or sell
a futures contract at a specific price before expiration, while Gabriela's strategy involves buying
call options with different expiry dates and strike prices equivalent to underlying asset's price
Q.792 Jiao Bu is a Chinese retail investor who has recently moved to the United States. Bu
mistakenly invested in an exotic option that has two strike prices and two exercise dates. On the
first exercise date T1, Jiao is entitled to pay the first strike price of X1 and receive a call option,
which will give her the right to purchase the underlying asset for the second strike price of X2 on
the second exercise date T2. In which of the following exotic options has she mistakenly
invested?
A. Compound option
B. Cliquet option
D. Barrier option
A compound option is an option on an option that has two strike prices and two expiration dates.
On the first exercise date T1, if the current price of the underlying asset is above X1, Bu is
entitled to pay the first strike price of X1 and receive a call option, which will give her the right
to purchase the underlying asset for the second strike price of X2 on the second exercise date
T2. This is called a call on-call compound option. Compound options can also be call on put, put
on call, and put on put options. Compound options are often used in markets where uncertainty
is high, such as in the commodities and foreign exchange markets. They provide investors with
additional flexibility to manage their risk exposure and can be tailored to meet specific
investment objectives.
Choice B is incorrect. A Cliquet option, also known as a ratchet or ladder option, is an exotic
option where the payoff is determined by the difference in the asset price at various points in
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time. It does not involve two distinct strike prices and two separate exercise dates like in Jiao
Bu's case.
Choice C is incorrect. A Forward start option is an option that starts at a future date with its
strike price determined at that future date based on some reference point. This does not match
with Jiao Bu's situation where there are two distinct strike prices and two separate exercise
dates.
Choice D is incorrect. A Barrier option becomes active or inactive if the price of the underlying
asset crosses a certain level (the barrier). This type of exotic options doesn't have features like
multiple strike prices and exercise dates as described in Jiao Bu's investment scenario.
Q.793 Compound options are exotic options in which the holder of the option has an option on
the option. The following are the features of compound options. Which of these features are
inconsistent with compound options?
I. Compound options are of four types, i.e., call on call, call on put, put on put, and put on call
II. Compound options have the same strike price, but two expiration dates
III. A call on a call gives the investor the right to buy a call option at a set price for a set period
of time.
D. None of the features are inconsistent with the definition of compound options.
The statement that compound options have the same strike price but two expiration dates is
inconsistent with the definition of compound options. Compound options, in fact, have two
distinct strike prices and two distinct expiration dates. This dual structure is what gives
compound options their unique characteristic of being 'options on options'. For instance,
consider a call on call compound option. If the current price of the underlying asset is above the
first strike price (X1) on the first exercise date (T1), the investor has the right to pay the first
strike price (X1) and receive a call option. This newly acquired call option then gives the investor
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the right to purchase the underlying asset for the second strike price (X2) on the second exercise
date (T2). Therefore, the assertion that compound options have the same strike price but two
expiration dates is incorrect and inconsistent with the nature of compound options.
Compound options are indeed 'options on options', providing an additional layer of optionality to
the holder. This means that the holder has the right, but not the obligation, to exercise another
option.
Choice C is incorrect. Feature III aligns with the definition of compound options as well. Each
type of compound option does have two distinct expiration dates and strike prices - one for the
Choice D is incorrect. Not all features are consistent with a compound option's definition as
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Q.794 Adam McGill is a hedge fund manager who is interested in purchasing an exotic option on
the stock of Turkish Airlines stocks. Turkey is currently holding a referendum and the
referendum results will either have a significantly positive or negative impact on the tourism
industry as well as the Turkish Airlines stocks. Since Adam is not sure about the direction of the
prices of the stocks, he intends to purchase an option that gives him the right to decide if the
option is a call or a put at a specific date. Determine which of the following options is suitable for
him.
B. Chooser option
C. Ratchet option
Choice A is incorrect. A call on call compound option gives the holder the right to buy another
call option at a specific future date. However, it does not provide the flexibility to choose
Choice C is incorrect. A ratchet option adjusts its strike price at specified periods based on the
underlying asset's performance. While this type of exotic option provides some level of flexibility,
it does not allow Adam to decide whether the option is a call or put at a specific future date.
Choice D is incorrect. A forward start option begins at a future date with an exercise price
determined then. Although this type of exotic option offers some degree of uncertainty
management, it still doesn't provide Adam with the ability to choose between a call and put
position as required.
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Q.796 A type of barrier option in which a regular put option on the underlying asset comes into
existence when the price of the underlying asset reaches a specific barrier, which is set equal to
or above its initial level is called a:
An up-and-in put option is a type of barrier option that comes into existence when the price of
the underlying asset reaches a specific barrier, which is set equal to or above its initial level. This
means that the put option is activated or 'knocked in' when the price of the underlying asset
rises to the barrier level. The holder of this option gains the right to sell the asset at the strike
price if the asset's price rises to the barrier level. This type of option is used by investors who
believe that the price of the underlying asset will rise to the barrier level and then fall. The up-
and-in put option provides a safety net, allowing the investor to limit potential losses if their
prediction is correct.
Choice A is incorrect. A Down-and-in put option becomes active when the price of the
underlying asset falls to a predetermined barrier level. This is not consistent with the scenario
described in the question where the barrier is set at a level equal to or higher than the initial
Choice B is incorrect. A Down-and-out put option ceases to exist when the price of an
underlying asset falls to a certain barrier level, which contradicts with our scenario where
Choice D is incorrect. An Up-and-out put option becomes inactive once it reaches or exceeds
its barrier, which does not align with our case where activation happens upon reaching or
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Q.798 Hakim Ahmed is a junior derivatives trader who has recently started trading exotic
options. A week ago, he purchased an exotic option that pays off nothing if the price of the
underlying asset exceeds the strike price at a predetermined date and pays a fixed amount if the
underlying asset price is below the strike price. Which of the following options has he
purchased?
A cash-or-nothing put is a type of binary option that pays a fixed amount if the price of the asset
is below the strike price at the expiration date and nothing if the price is above the strike price
at expiry.
Option A is incorrect: An asset-or-nothing call pays off the value of the underlying asset if the
price of the asset is above the strike price at expiration, and nothing if the asset price is less than
the strike price.
Option B is incorrect: An asset-or-nothing put binary option pays an amount equal to the asset
price if the price of the underlying asset is below the strike price at the expiration date and
nothing if the price is above the strike price at expiry.
Option C is incorrect: A cash-or-nothing call pays a fixed amount of cash if the price of the
underlying asset is above the strike price at expiration, and pays nothing if the asset price is
below the strike price.
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Q.799 In which of the following exotic options is the payoff the final current price of the asset
minus the minimum or lowest asset price that the underlying asset has achieved during the life
of the option?
The payoff of a floating lookback call option is indeed the final current price of an asset minus
the minimum or lowest asset price that the underlying asset has achieved during the life of the
option. This is because a floating lookback call option allows the holder to 'look back' over the
life of the option and select the lowest price as the strike price. This means that the holder can
benefit from the maximum possible upward movement of the asset's price. This type of option
provides a safety net for the holder, as they can choose the most favorable price during the
Choice B is incorrect. A floating lookback put option's payoff is calculated as the maximum
asset price during the life of the option minus the final current price of the asset, which does not
Choice C is incorrect. A fixed lookback call option's payoff is calculated as the final current
price of the asset minus a predetermined strike price or alternatively, it can be calculated as
maximum value of underlying asset during life of option minus strike price. This also does not
Choice D is incorrect. A fixed lookback put option's payoff would be either zero or strike price
minus minimum value of underlying asset during life of option, whichever is higher. This too
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Q.801 Katja Firos is an investment analyst at Frankfurt Securities, a brokerage and investment
company. She was instructed by the head of the investments unit to hedge the portfolio of exotic
options through static options replication. Which of the following steps should she take to
implement the static replication method?
A. The static replication method involves searching for a portfolio of the same exotic
options which other market participants are using for hedging.
B. The static replication method involves searching for a portfolio of plain vanilla options
with opposite attributes that inversely replicates the exotic options and then taking a
short position in this portfolio in order to hedge the exotic options.
C. The static replication method involves searching for a portfolio of plain vanilla options
with similar attributes that approximately replicates the exotic option and then taking a
short position in this portfolio in order to hedge the exotic options.
D. The static replication method involves searching for a portfolio of similar exotic
options with similar attributes and then taking a long position in this portfolio in order to
hedge the exotic options.
The static replication method involves searching for a portfolio of plain vanilla options with
similar attributes that approximately replicate the exotic option and then taking a short position
in this portfolio in order to hedge the exotic options. This method is used to create a portfolio
that mimics the payoff of the exotic option. By taking a short position in this replicating portfolio,
the risk associated with the exotic options can be offset. This is because the gains from the short
position in the replicating portfolio will offset the losses from the exotic options and vice versa.
Therefore, this method effectively hedges the risk associated with the exotic options.
Q.802 Exotic options are customized and designed to meet the requirements of investors, which
is why these options trade on OTC markets. These options have features that allow them to
change the expiration date and strike prices. Forward start options are also non-standard options
that allow the investor to purchase an option that will start at a future date. Which of the
following options is most similar to a forward start option?
A. Warrants
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C. Gap options
D. Employee options
Employee options are the most similar to forward start options. Forward start options are a type
of exotic option that starts at a future date, known as T1, and expires at another future date, T2.
This feature allows investors to benefit from future price movements. Employee options share a
similar characteristic. In the case of employee options, the employer pledges to grant an at-the-
money option at a future date. This means that the strike price of the option is the same as the
market price of the underlying asset at the time of the grant. This similarity in structure and
functionality makes employee options the most analogous to forward start options.
Choice A is incorrect. Warrants are a type of derivative that confers the right, but not the
obligation, to buy or sell a security – most commonly an equity – at a certain price before
expiration. The price at which the underlying security can be bought or sold is referred to as the
exercise price or strike price. While they do offer flexibility in terms of timing, they do not have
the specific feature of setting a future start date for the option like forward start options.
Choice B is incorrect. Butterfly spread options involve positions in options with three different
strike prices and are typically used when anticipating minimal movement in the price of the
underlying asset. They do not bear resemblance to forward start options as they don't allow for
Choice C is incorrect. Gap options are contracts where payout depends on whether the
underlying asset's price changes beyond a certain level (gap level). They differ from forward
start options because their payoff structure depends on whether this gap level has been reached
Q.803 Which of the following mentioned options is NOT referred to as a series of call or put
options with a strategy in which numerous options are purchased?
A. Cliquet option
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B. Ratchet option
C. Barrier options
Barrier options are a type of option where the payoff depends on whether or not the underlying
asset has reached or exceeded a predetermined price, known as the barrier level. This is
different from a series of call or put options where a strategy involves the purchase of numerous
options. Barrier options are typically used in situations where an investor wants to limit their risk
exposure to large price movements in the underlying asset. The barrier level acts as a trigger
that activates or deactivates the option's payoff. There are two main types of barrier options:
knock-in and knock-out. Knock-in options become active when the price of the underlying asset
reaches the barrier level, while knock-out options become inactive when this happens. Therefore,
the payoff of barrier options is contingent on the price of the underlying asset reaching a certain
level during a certain period of time, rather than being a series of options purchased as part of a
strategy.
Choice A is incorrect. A Cliquet option, also known as a ratchet option, is indeed a series of
call or put options. It is structured such that the strike price resets at predetermined intervals,
allowing the holder to lock in gains as the underlying asset's price increases (for a call) or
Choice B is incorrect. Similar to Cliquet options, Ratchet options are also series of call or put
options where the strategy involves purchasing numerous options. The strike price in these types
of options resets at regular intervals based on the performance of the underlying asset.
Choice D is incorrect. Strike reset option represents a series of call or put options where
strategy involves purchase of numerous options with different strike prices which reset based on
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Reading 42: Properties of Interest Rates
Q.645 Donald Gregg is a senior professor of economics at the University of Vikings. He has
authored various books on the subject of macroeconomics, financial instruments, and
derivatives. He is famous for conducting a bi-yearly informative seminar where he delivers his
analysis on finance-related topics. In his last seminar, he said that the government also borrows
funds from public institutions in exchange for their guarantee to return the funds with interest.
These transactions are considered risk-free as governments are not likely to default. Which of
the following rates do governments use to borrow funds denominated in their own currency?
A. LIBOR.
C. Repo rate.
D. Treasury rate.
The Treasury rate is the interest rate that the government pays to borrow money from investors.
This borrowing is done through the issuance of treasury bills and treasury bonds. These are
considered risk-free financial instruments as they are backed by the full faith and credit of the
government. The government sells these securities to investors to raise funds. The Treasury rate
is determined through auctions conducted by the Department of the Treasury. The rate is
influenced by various factors including the overall demand for these securities, the economic
outlook, and the monetary policy stance of the central bank. The Treasury rate serves as a
benchmark for other interest rates in the economy as it is considered the risk-free rate of return.
Choice A is incorrect. LIBOR (London Interbank Offered Rate) is a benchmark interest rate at
which major global banks lend to one another in the international interbank market for short-
term loans. It does not represent the rate at which governments borrow funds.
Choice B is incorrect. The Fed funds rate, set by the Federal Reserve, is the interest rate at
which depository institutions lend reserve balances to other depository institutions overnight on
an uncollateralized basis. While it influences other interest rates and thus borrowing costs, it's
Choice C is incorrect. The Repo (Repurchase Agreement) rate refers to the discount rate at
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which a central bank repurchases government securities from commercial banks, aiming to
regulate money supply in the economy. It's not directly related to government borrowing from
public institutions.
Q.646 Franky Johnson is a junior trader at the Beijing office of a large German investment bank.
He is an Ivy League graduate and brings with him very little experience in derivatives trading.
Today, he is instructed by his investment team to purchase the floating vs. floating interest rate
swaps in the derivatives markets. Which of the following rates is he most likely to use to value a
floating interest rate swap?
A. LIBOR.
C. Repo rate.
D. Treasury rate.
Choice B is incorrect. The Fed funds rate is the interest rate at which depository institutions
lend reserve balances to other depository institutions overnight. It's primarily used in the United
States and wouldn't be the most likely choice for a trader in a German bank's Beijing office.
Choice C is incorrect. The Repo rate, or repurchase rate, is the rate at which central banks
lend short-term money to commercial banks. While it does influence interest rates on loans and
mortgages, it isn't typically used when valuing floating interest rate swaps.
Choice D is incorrect. Treasury rates are associated with U.S government bonds and are not
typically used for valuing floating vs floating interest swaps as they represent risk-free
Q.647 Since the LIBOR rate is composed of estimates, not actual rates, it has been seen in recent
years that the banks were involved and sanctioned for manipulating the LIBOR rate. An excerpt
from a newspaper reads:
“As the LIBOR rates are published on the basis of the estimates provided by banks, the traders at
some of the larger banks conspired to provide inaccurate rates in order to manipulate the
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average of rates used for the LIBOR.”
One of the analysts at a local business news channel suggested the following two factors for the
manipulation of the LIBOR:
I. One motive for banks to manipulate the LIBOR was to make exceptional profits on instruments
like interest rate swaps, whose cash flows depend on the LIBOR.
II. Another factor that motivated banks to manipulate the LIBOR downward is that if the LIBOR
is lower, then the reserve requirement for the banks is also lower and the banks have more funds
to invest.
Which of the factors for the banks to manipulate the LIBOR is/are correct?
A. Only factor I is a correct factor that motivated banks to manipulate the LIBOR.
B. Only factor II is a correct factor that motivated banks to manipulate the LIBOR.
The first factor correctly identifies one of the reasons that motivated banks to manipulate the
LIBOR. Banks manipulated the LIBOR to earn higher profits from instruments like interest rate
swaps, which are influenced by the LIBOR. Interest rate swaps are derivative contracts in which
one party agrees to make periodic payments to another party based on a fixed interest rate, in
exchange for payments that are based on a floating interest rate (like the LIBOR). Therefore, by
manipulating the LIBOR, banks could influence the cash flows from these swaps and potentially
earn higher profits. This manipulation could be particularly profitable for banks if they had a
Choice B is incorrect. While it might seem logical that banks would want to lower the LIBOR
to reduce their reserve requirements, this is not accurate. Reserve requirements are determined
by central banks and are based on a bank's net transaction accounts, not the LIBOR rate.
Therefore, manipulating the LIBOR would not affect a bank's reserve requirements.
Choice C is incorrect. As explained above, manipulating the LIBOR does not affect a bank's
reserve requirements, so factor II is not a correct reason for banks to manipulate the LIBOR.
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Choice D is incorrect. Factor I correctly explains why some banks were motivated to
manipulate the LIBOR - they could earn extraordinary profits from instruments like interest rate
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Q.648 Xiaojun Lee is the treasury manager at the Atlanta Small Business Bank. She works in a
team that supervises all the branches of the banks in Atlanta. Her core responsibility is to look
after treasury transactions and to make sure the bank, at all time, meets its reserve
requirements with the Federal Reserve. Today, Lee has analyzed that the bank will fall short
$200 million from its reserve requirements. In order to avoid penalties, the bank must borrow
some funds from another bank. Which of the following rate must Lee use as the reference rate
for borrowing $200 million overnight?
A. Treasury rate.
C. Repo rate.
The Fed funds rate is the rate that banks use for overnight borrowing or lending of surplus funds
to meet the Federal Reserve's reserve requirements. This rate is crucial for banks to maintain
their reserve requirements and avoid penalties. In this scenario, since the Atlanta Small Business
Bank is short of its reserve requirements, it needs to borrow funds overnight. Therefore, the Fed
Choice A is incorrect. The Treasury rate is the yield on a U.S. government debt obligation (a
U.S. Treasury note or bond) that is considered risk-free as it is backed by America's full faith and
credit. It does not apply to interbank lending, which is what Lee needs for meeting the reserve
requirements.
Choice C is incorrect. The Repo rate, or repurchase rate, refers to the interest rate at which
commercial banks borrow short-term funds from a central bank by selling securities with an
agreement to repurchase them at a later date. This does not apply in this scenario as Lee needs
Choice D is incorrect. There are specific rates applicable for borrowing between banks such as
Fed funds rate and LIBOR (London Interbank Offered Rate). Therefore, 'None of the above'
cannot be correct.
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Q.649 Mohan Das is the treasury manager of a bank based in Frankfurt. He is responsible for
looking at the bank’s treasury operations and the compliance unit of the bank closely supervises
his department. Today, Das is informed by the front office that the bank has to disburse a large
fund to an institutional client which they believe will affect the bank's reserves with the central
bank. The management suggested borrowing the funds from another bank to meet the central
bank’s reserve requirements, but he argues that the bank, instead, should sell its securities to
another bank with the promise to purchase the securities back at a higher price. Which of the
following interest rates is the manager most likely to use for the given transaction?
A. LIBOR.
C. Repo rate.
D. Treasury rate.
The Repo Rate, also known as the Repurchase Agreement rate, is the interest rate that Das is
most likely referring to in this scenario. The Repo Rate is a borrowing rate used by financial
institutions when they sell their securities for a certain price and agree to buy them back at a
later date for a higher price. This type of transaction is known as a 'repurchase agreement' or
'repo'. In a repo transaction, the seller is effectively borrowing money and using the securities as
collateral, while the buyer is lending money and has the security of the collateral. The difference
between the sale price and the repurchase price represents the interest on the loan, which is the
Repo Rate. This rate is used as a short-term monetary policy instrument by central banks to
control the money supply in the economy. In the given scenario, Das is suggesting a repo
transaction to raise the necessary funds without borrowing from another bank, which aligns with
Choice A is incorrect. LIBOR (London Interbank Offered Rate) is the interest rate at which
banks offer to lend funds (in marketable size) to other banks in the London interbank market. It
Choice B is incorrect. The Fed funds rate refers to the interest rate at which depository
uncollateralized basis. While it does involve interbank lending, it doesn't specifically pertain to
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transactions involving securities repurchase agreements.
Choice D is incorrect. The Treasury rate refers to the yield on government securities,
specifically U.S Treasury bonds, notes and bills. It's not directly related with repurchase
Q.650 Gamze Goc is an independent wealth advisor that focuses on providing investment and
savings advice to professionals. She advised one of her clients to invest $10,000 for 5 years into
a government’s national saving plan which pays a monthly interest of 8% per year. This rate is
fixed regardless of the tenure of the investment. Since the client does not have an alternative
option to invest his savings, he asked what interest rates he would earn if the rate was
compounded continuously. Identify the most appropriate answer to the client’s inquiry.
The formula used to convert a rate that is compounded at a certain frequency into a continuously
compounded rate is:
Rm
R c = m ∗ ln (1 + )
m
Where
m is the compounding frequency,
R m is the compounded rate at m frequency
And R c is the continuously compounded rate
0.08
R c = 12 × ln (1 + ) = 0.07973
12
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Q.651 Ahmed Hatti is an undergrad business and finance student at the University of Millennials.
Along with his friend, he manages a small hypothetical fund from his dorm room. The fund
consists of small investments from his colleagues and family. As a fund manager, he is also
responsible for generating a quarterly income newsletter, which he has to email to all fund
contributors.
Recently, Hatti decided to invest a small portion of his fund into an interest-bearing account that
quotes an interest rate of 16% compounded continuously. In order to add the interest rate into
the quarterly newsletter, he must convert the continuously compounded rate into a quarterly
compounded rate. Which of the following is the most appropriate conversion of the rate?
The formula used to convert a continuously compounded rate into a rate that is compounded at a
certain frequency is:
Rc
R m = m {e m − 1}
Where
m is the compounding frequency,
R m is the annual rate, compounded m times a year
And R c is the continuously compounded rate
0.16
R m = 4 (e 4 – 1) = 16.32%
Q.652 A news anchor at a business TV channel made the following statements regarding bonds
and their rates.
Statement I: Zero rates are the appropriate discount rates that are used for discounting a single
cash flow at a particular future time or maturity. Zero rates correspond to zero-coupon bond
yields.
Statement II: A bond's yield, also known as spot rate, is the unique discount rate that, if applied
to all cash flows, makes the bond price equal to its market price.
Statement III: The par yield is the coupon rate that, if applied, makes the price of a bond equal to
its par value.
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B. Statements II and III are correct
Statement I is correct as it accurately describes the concept of zero rates. In the context of
bonds, a zero rate is the discount rate that is used for discounting a single cash flow at a specific
future time or maturity. This rate corresponds to the yield of a zero-coupon bond, which is a bond
that does not pay interest but is sold at a deep discount. This discount compensates for the lack
of interest payments. When the bond matures, the bondholder is paid the face value of the bond.
The yield, or the rate of return, of a zero-coupon bond is the rate that makes the present value of
the bond's future cash flows equal to its current market price.
Statement III is also correct as it accurately describes the concept of par yield. The par yield is
the coupon rate of a bond that, if applied, makes the bond price equal to its par value. The par
value of a bond is its face value, or the amount that the issuer promises to pay the bondholder
when the bond matures. The par yield is the coupon rate that makes the present value of the
bond's future cash flows, including both the periodic coupon payments and the face value
Therefore, both statements I and III accurately describe key concepts related to bonds and their
associated rates.
Choice A is incorrect. While Assertion I is correct, Assertion II is not. The yield of a bond, also
known as the yield to maturity (YTM), is indeed the discount rate that equates the present value
of a bond's future cash flows to its market price. However, it should not be confused with the
spot rate which refers to the theoretical yield of a zero-coupon Treasury security.
equates a bond's yield or YTM with the spot rate. Although Assertion III correctly defines par
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yield as being the coupon rate that makes a bond's price equal to its par value, this choice
Choice D is incorrect. This option suggests that all three statements are accurate which isn't
true because as explained above, Assertion II contains an error in its definition and
Q.653 An investor has invested $1,000 in a 7-year zero-coupon bond with continuous
compounding. If the bond is quoted as 9% per year compounded continuously, then estimate the
value of the investment at the end of 7 years.
Since the zero-coupon bond is compounded continuously, the future value of this 7-years 9% per
annum bond is:
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Q.655 The process by which traders can use the quotes of treasury bills and coupon-bearing
treasury bonds to derive a zero-coupon yield curve or spot curve is referred to as:
A. Interpolation
B. Duration
C. Bootstrapping
D. Calibration
Bootstrapping is a financial method used to derive a zero-coupon yield curve, also known as a
spot rate curve, from the rates and quotes of zero-coupon and coupon-bearing Treasury bonds.
The term 'bootstrapping' refers to the process of 'pulling oneself up by one's bootstraps', which is
a metaphor for achieving a complex task starting from basics without external help. In the
context of finance, bootstrapping is a method of constructing a yield curve. The yield curve, in
turn, is a graphical representation of the interest rates on debt for a range of maturities. It
shows the yield an investor is expected to earn if he lends money for a given period of time. The
spot rate curve or zero-coupon yield curve represents the yields of hypothetical zero-coupon
bonds. Since they are not directly observable in the market, they are derived from the yields of
Choice A is incorrect. Interpolation is a statistical method used to estimate values between two
known values. While it can be used in the process of constructing a yield curve, it is not the
Choice B is incorrect. Duration refers to the sensitivity of a bond's price to changes in interest
rates. It does not refer to the process of constructing a zero-coupon yield curve or spot curve
Choice D is incorrect. Calibration involves adjusting model parameters within certain bounds
until model outputs match observed data. Although calibration might be part of building financial
models, it does not specifically refer to the construction of a zero-coupon yield curve or spot
curve.
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Q.656 Every year, thousands of students in Turkey take the Certified Trader exam. The exam
tests in detail the knowledge of students who are willing to join the banking sector. In last year’s
exam, a question asked the students to calculate a 1-year forward rate 2 years from now. The
question also provided the following table of zero spot rates p.a:
Using the information provided in the table, which of the following is the accurate 1-year forward
rate 2 years from now?
A. 6.5%
B. 7.2%
C. 8.6%
D. 9.3%
Time2
Forward Rate = Spot Rateyear 3 + (Spot Rate year 3 − Spot Rateyear 2 ) ∗ ( )
(Time3 – Time2 )
2
Forward Rate = 0.072 + (0.072 – 0.065) ∗ ( ) = 0.086 or 8.6%
(3 − 2)
Alternative Approach
Let's start off by assuming that there are two people, each with $100
A chooses to invest his cash for 3 years straight at the 3-year spot rate.
B opts to invest his cash for 2 years at the 2-year spot rate and then reinvest his proceeds for a
In a fair market, both A and B should have the same amount of money at the end of year 3.
What that means, therefore is that the 3-year spot rate is equal to the 2-year spot rate multiplied
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by the 1-year forward rate two years from today.
In other words,
We should set the forward rate such that B ends with the same amount of money as A.
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Q.657 Beijing Shipping Corp. enters into a forward rate agreement with Geneva Bank to receive
a 7% fixed rate on the principal of $50 million based on a three-month rate beginning in six-
month time. If the three-month rate in six-month time is 6.8%, then what is the cash
inflow/outflow for the Beijing Shipping at the end of the sixth month?
The FRA’s payoff will take place in the ninth month. The net payoff will be the difference between
the receipt of the fixed rate of 7% and the floating rate payment. As given in the question, if the
floating rate is 6.8% in six months, so the payoff at the end of the ninth month is calculated as:
Although any interest should be due at the end of the FRA period (e.g., 9 months in this
question), the common practice is for the FRA to be settled at the beginning of the FRA period or
rather as soon as the floating rate becomes known. Therefore, we can find the payoff at the end
of the sixth month by discounting any payoffs for three months, with the floating rate as the
discount rate.
$25, 000
Payoff = = $24 , 582
0.068
(1 + )
4
Since the payoff is positive, Beijing Corp. will receive a cash inflow of $24,582 at the six-month
point.
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Q.660 Hina Bibi is a fixed-income analyst at Vio Investment Company. She is responsible for
analyzing the risk and return of a company’s portfolio of fixed income investments. She is
analyzing the change in the price of a hypothetical 7-year bond with the face value of 100 and
the price of 96.86. If the duration of the bond that she analyzing is 1.962, then which of the
following options presents the accurate change in the price of the bond if the yield on the bond
increases by 50 basis points?
The change in the price of a bond given the change in the yield can be predicted by duration. In
the given question, where the price of the bond is 96.86, and the duration of the bond is 1.962, a
50 basis point increase in the yield will decrease the price of the bond by:
Change in price = -Bond price * Duration * Change in yield
Change in price = -96.86 * 1.962 * 0.005 = -0.950
Therefore, the price of the bond after the 50 basis point increase in yield is 96.86 – 0.950 =
95.91.
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Q.662 There are different measures available that are used to measure the change in the price of
the bond given the change in the yield curve. Which of the following measures is used for the
purpose of estimating changes in bond prices if the changes in the yield curve are larger?
A. Duration
B. Convexity
C. Modified duration
D. Concavity
Convexity is a measure of the curvature in the relationship between bond prices and bond yields
that demonstrates how the duration of a bond changes as the interest rate changes. This
measure is used to assess the sensitivity of the price of a bond to changes in interest rates.
Convexity is particularly useful when there are larger changes in interest rates, as it provides a
more accurate estimate of bond price changes than duration alone. Convexity takes into account
the effects of changes in the yield curve on bond prices, which can be significant when the
changes in the yield curve are large. Therefore, convexity is the most appropriate measure to use
when estimating changes in bond prices due to larger changes in the yield curve.
Choice A is incorrect. Duration is a measure of the sensitivity of the price of a bond to changes
in interest rates. However, it assumes that this relationship is linear and does not account for
Choice C is incorrect. Modified duration, like duration, measures the price sensitivity of a bond
to interest rate changes but it also assumes a linear relationship between bond prices and yields.
Choice D is incorrect. Concavity isn't used as a metric in bond investing for predicting
alterations in bond prices due to yield curve fluctuations. It's rather an attribute related to
convexity which describes how the change in yield affects convexity itself.
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structure of interest rates. One day, he made the following comment:
“There is no relationship between short-term, medium-term, and long-term interest rates. These
interest rates are independently determined by the supply and demand in their specific bond
market. For instance, the short-term interest rate is determined by the supply and demand of
short-term bonds”.
A. Expectation theory
The Market Segmentation Theory is the correct answer. This theory posits that the markets for
different maturity bonds are completely segmented and that the interest rates for each segment
are determined by the supply and demand within that segment. This means that the interest
rates for short-term, medium-term, and long-term bonds are determined independently of each
other. This theory aligns with Professor Hessen's statement that there is no relationship between
short-term, medium-term, and long-term interest rates and that these rates are independently
determined by the supply and demand in their specific bond markets. The Market Segmentation
Theory also explains why certain investors, such as pension funds and insurance companies,
prefer bonds of a certain maturity and are unlikely to switch from one maturity to another based
on liquidity considerations.
Choice A is incorrect. The Expectation theory suggests that long-term interest rates are an
average of expected future short-term rates, implying a direct relationship between short,
medium and long term rates. This contradicts Professor Hessen's viewpoint which suggests these
Choice C is incorrect. The Liquidity preference theory posits that investors demand a premium
for longer term bonds due to the increased risk associated with holding assets over a longer
period of time. This implies an interrelationship between different term interest rates, which
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Choice D is incorrect. As explained above, there exists a theory in economics - the Market
Segmentation Theory - that aligns with Professor Hessen's viewpoint suggesting that different
term interest rates are independently determined by their respective bond markets' supply and
demand dynamics.
Q.664 Transactions worth billions of dollars depend on the shape of the zero rate curve. The
shape of the zero curve has gained the attention of economists, mathematicians, and investors.
Many theories exist that present their perspective about the shape of the zero curve. One of
those theories suggests that investors are likely to invest their funds for a shorter period while
borrowers are more willing to borrow the funds at long-term fixed rates. The theory also
concludes that the forward rates are greater than the future spot rates, which justifies the
empirical result that the yield curve tends to be upward sloping. Which of the following theories
provides the above-mentioned conclusion?
A. Expectation theory
The Liquidity Preference Theory is the correct answer. This theory suggests that investors prefer
to invest their funds for shorter periods, while borrowers are more inclined to borrow at long-
term fixed rates. The theory also asserts that forward rates exceed future spot rates, providing
an empirical explanation for the upward slope of the yield curve. This theory is based on the
premise that investors require a premium, or a higher return, for holding long-term securities
because they are considered riskier. The risk arises from the uncertainty about future interest
rates and inflation. Therefore, to compensate for this risk, long-term rates are generally higher
Choice A is incorrect. The Expectation theory suggests that the yields on long-term bonds are
an average of expected future short-term rates. It does not account for the preference of
investors to invest their funds for shorter periods or borrowers' inclination to borrow at long-
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Choice B is incorrect. The Market segmentation theory posits that financial markets are
segmented and each segment (short, intermediate, and long term) has its own supply and
demand dynamics influencing interest rates. This theory does not explain the preference of
Choice D is incorrect. As explained above, the description provided in the question matches
with Liquidity preference theory which makes option D - 'None of the above' incorrect.
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Q.3533 Stock IIK is currently selling for $80. The 28 analysts offering 12-month price targets for
IIK have a median target of $91. Given that the stock reaches the median target of $91 in 12
months, what is the continuously compounded return of this asset?
A. 0.1375
B. 0.1198
C. 0.1319
D. 0.1288
Where R is the continuously compounded rate of interest, and T is the time to maturity.
91 = 80eR∗1
91
⇒ eR =
80
91
⇒ R = ln ( )
80
= 0.12883
Alternatively,
ST
Holding period return = −1
S0
$91
= −1
$80
= 1.1375 − 1 = 13.75%
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Q.3534 An investor invested $154,856 into a mutual fund 5 years ago. If the investment is now
worth $201,694, what is the compound annual growth rate of the investment?
A. 6%
B. 7.9%
C. 5.4%
D. 5.9%
Q.3535 A bank advertises that it pays an annual interest of 10% with semi-annual compounding
on its savings account. What is the effective annual rate?
A. 10.375%
B. 10.25%
C. 10.5%
D. 10.42%
Compounding frequency
Annual rate
EAR = (1 + ) −1
Compounding frequency
2
= (1 + 10%/2) − 1 = 0.1025 = 10.25%
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Q.3536 The price of a stock increases from $24 to $40 in two years. What is the continuously
compounded annual return for the stock?
A. 43.10%
B. 28.00%
C. 51.08%
D. 25.54%
Q.3537 In order to have liquid cash at hand, a company always keeps $200,000 in its bank
account. The stated annual interest rate quoted by the bank is 8%. Assuming that compounding
is done continuously and there have been no withdrawals and additions, what is the balance in
the company's bank account after one year?
A. $200,321
B. $216,657
C. $202,149
D. $217,985
Using the formula for the future value with continuous compounding (N is the number of years in
the expression)
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Q.3538 Jose Calzon currently has $5,040.11 in his bank account. If he plans to buy a car for
$5,500 next year, what is the annual interest rate (compounded monthly), that a bank must pay
so that James receives a sum of $5,500 next year?
A. 0.76%
B. 9.12%
C. 0.73%
D. 8.76%
Interest rate can also be considered as the required rate of return. In the above case, James
wants his $5,040.11 to grow to $5,500. The rate required to achieve this return can be calculated
as under: Amount deposited today × (1 + Rate of interest) = Amount next year
Amount next year
Rate of interest = Amount deposited− 1
$5 ,500
= ( $5,040.11) − 1 = 0.0912 or 9.12%
To turn the annual interest rate into a monthly rate, we use the relationship:
im m
1 + i = (1 + )
m
i12 12
⇒ 1.0912 = (1 + )
12
1
⇒ m12 = [1.091212 − 1] × 12 = 0.08759
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Q.3539 An investor received $100,000 after five years from a certificate of deposit which paid
him an interest of 12% with monthly compounding. What is the sum deposited by the investor at
the beginning of the 5 years?
A. $79,670
B. $55,045
C. $56,743
D. $68,856
Given an initial investment of A that earns an annual rate R, compounded m times a year for a
total of n years, then we can compute the future value, FV, as follows:
R m×n
F V = A[1 + ]
m
60
100, 000 = A[1 + 0.12 ]
12
A = $55,045
Q.3540 A 3-year bond with a face value of $100 offers a 7% coupon rate with interest paid
annually. Assuming the following sequence of spot rates, the price of the bond is closest to:
A. 102.48
B. 106.74
C. 103.56
D. 104.2
The price of a bond is the present value of its future cash flows, which in this case are the
coupon payments and the face value return at maturity. Given the coupon rate of 7% and the face
value of 100, the annual coupon payment is 7 (100) = 7 dollars. The spot rate for each year is
given in the table. To find the present value of the cash flows, we can use the formula:
C C C F
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C C C F
PV = + + +
(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)3
Where:
7 7 107
price = + + = 104.20
1 2
(1 + 0.04) (1 + 0.05) (1 + 0.055)3
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Q.3541 An analyst has gathered the following estimated series of spot rates for a developing
country:
0.5-year: 2%
1-year: 3%
1.5-year: 3.55%
2-year: 4%
2.5-year: 4.5%
3-year: 5%
3.5-year: 5.45%
Given that the information is accurate, what is the price of a 3-year, 1,000 face value, 5% annual
coupon paying bond?
A. 1115.3
B. 995.65
C. 1001.8
D. 998.51
The general approach to bond valuation is to utilize a series of spot rates to reflect the timing of
future cash flows.
(50/1.03) + (50/1.042) + (1,050/1.053) = 1,001.80
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Q.3542 The 2-period spot rate, S2 is 9%, and the 1-period spot rate, S1 is 4%. Calculate the
forward rate for one period, one period from now, f1,1.
A. 5%
B. 4.8%
C. 14.24%
D. 8.73%
V2
F =
V1
In this case,
V2 1.092
F= = = 1.1424
V1 1.04
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Q.3543 If the current 1-year spot rate is 3%, the 1-year forward rate one year from today ( f1,1) is
4%, and the 1-year forward rate two years from today ( f2,1) is 5%, then the 3-year spot rate is
closest to:
A. 4%
B. 12.5%
C. 4.2%
D. 8.42%
There is a connection between spot rates and forward rates. The accumulation amount at time k
of an investment of $1 at time t=0 is given by (1 + sk )k. If we had agreed to invest this amount at
time k for n-k years, then the accumulation at time n would be: (1 + s k)k . (1 + f [k ,n])
⇒ (1 + s k)k . (1 + f [k ,n]) = (1 + sn )n
−k (1 + sn )n
⇒ (1 + f [k,n ])n =
(1 + sk )k
For a one-period rate, f k = f k,1 . Also, define f 0 = s1 . Using the same arguments,
⇒ (1 + sn )n = (1 + f 0) (1 + f 1 ) (1 + f 2 ) … (1 + f n −1 )
Therefore,
(1 + s3 )3 = [(1.03)(1.04)(1.05)]
1
⇒ s 3 = [(1.03)(1.04)(1.05)] 3 − 1 = 3.997%
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Q.3545 A corporate bond has the following characteristics:
Coupon rate: 5%
Convexity: 101
If the credit spreads narrow by 175 basis points, then what will be the price of the bond?
A. USD 114.68
B. USD 122.13
C. USD 123.78
D. USD 117.68
The change in bond's price resulting from the change in the yield can be estimated using the
following formula:
1
ΔB = −DBΔy + CB(Δy)2
2
Where
ΔB = The change in the bond's price resulting from the change in the yield.
Δy = The change in the bond's yield.
B = the price of the bond.
C = the convexity of the bond.
D = the duration of the bond.
From the information given in the question,
1
ΔB = −7.5 × 106.50 × (−0.0175) + × 101 × 106.50 × (−0.0175)2 = 15.62522
2
The change in bond's price is positive so that the new price off the bond is:
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Q.3548 You have been provided the following information on a bond:
If the yield to maturity is 6%, then what is the modified duration of the bond?
A. 2.45 years
B. 2.65 years
C. 2.30 years
D. 2.25 years
Q.3549 Calculate the expected percentage price gain (loss) from the following data:
A. 4.87%
B. 4.59%
C. -4.6%
D. -4.0%
Percentage change in full price = [-23.657*(-0.002)] + 1/2 * [678.98 * (-0.002)2] =\approx 4.87%
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Q.3550 A 4-year semiannual corporate bond with a 3.5% coupon is priced at 104.12. This bond's
modified duration and convexity are 3.75 and 45, respectively. The bond's credit spread narrows
by 75 bps due to a credit upgrade. What is the estimated return impact without convexity
adjustment?
A. 1.42%
B. 1.59%
C. 2.95%
D. 2.81%
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Q.3551 A 4-year, 5% annual-pay bond has a face value of $1,000. The interest rate stands at 3%
per annum.
Determine the approximate modified duration?
A. 0.97
B. 7.80
C. 3.62
D. 3.73
Macaulay duration
Modified duration = y
1+ m
Where y is the yield and m is the compounding frequency per annum. We first calculate the
Macaulay duration:
Where PV(C t) is the present value of coupon payments at time t, and T is the time to maturity
50 50 50 1050
Price of the bond = + + + = 1074.34
1 2 3
1.03 1.03 1.03 1.034
Thus,
1 50 2 50 3 50 4 1050
Macaulay duration = × + × + × + × = 3.73412
1074.34 1.03 1 1074.34 1.032 1074.34 1.033 1074.34 1.034
Macaulay duration
Modified duration = y
1+ m
3.73412
= 0.03
1+ 1
= 3.62535
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Q.3552 A bond has a duration of 10.62 and a convexity of 91.46. For a 200 bps increase in yield,
what is the bond's approximate percentage price change?
A. -19.41%
B. -24.90%
C. -1.62%
D. -4.51%
Q.3553 A 9% bond has a full price of $905 and a YTM of 10%. Estimate the percentage change in
the full price of the bond for a 30 basis point increase in YTM, assuming the bond's modified
duration is 9.42, and its convexity is 68.33.
A. -2.65%
B. -2.83%
C. -2.80%
D. 2.83%
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Q.3554 A bond valued at $200,000 has a duration of 8 and a convexity of 20. Assuming that the
bond's spread relative to the benchmark curve increases by 25 basis points due to a credit
downgrade, then what is the approximate change in the bond's market value?
A. $3,988
B. $3,960
C. $3,970
D. $3,368
A. We can forecast future interest rates by looking at the term structure of interest rates
since the return on a long-term bond is, in essence, the average return on short-term
bonds over the same period.
B. We can forecast future interest rates by looking at past returns on similar instruments.
C. We can forecast future interest rates by looking at the behavior of the stock market.
D. We can forecast future interest rates by looking at the term structure of interest rates
since the return on a short-term bond is essentially the average return on long-term
bonds over the same period.
The Expectations Hypothesis, also known as the Pure Expectations Theory, posits that the return
on a long-term bond is essentially the average return on short-term bonds over the same period.
This theory asserts that expected future spot rates of interest are equal to the forward rates that
can be calculated today. In other words, the forward rates are unbiased predictors for making
expectations of future spot rates. Therefore, we can forecast future interest rates by looking at
the term structure of interest rates. The term structure of interest rates, also known as the yield
curve, is a graphical representation that shows the relationship between interest rates and the
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time to maturity of a debt for a given borrower in a given currency. The term structure reflects
expectations about future interest rates, inflation rates, and real rates of return. Hence, by
analyzing the term structure of interest rates, we can derive insights into future interest rate
movements.
Choice B is incorrect. The Expectations Hypothesis does not suggest that future interest rates
can be forecasted by looking at past returns on similar instruments. This theory posits that the
expected future interest rates are reflected in the term structure of current interest rates, not
past returns.
Choice C is incorrect. According to the Expectations Hypothesis, future interest rates are not
predicted based on the behavior of the stock market. The theory focuses on bond markets and
Choice D is incorrect. The statement contradicts the essence of Expectations Hypothesis which
suggests that long-term bond yields are an average of expected short-term yields and not vice
versa.
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Q.4822 The annual yield of a one-year government bond is 10% and the expected yield on a one-
year bond starting one year from now is 11.0%. The expected yield on a one-year bond starting
two years from now is 11.5%. According to the expectations hypothesis, what would be the
annual yield of a three-year government bond?
A. 36.14%
B. 12.04%
C. 11.04%
D. 10.83%
According to the Expectations Theory, the forward rates are unbiased predictors for making
expectations of future spot rates. We can therefore forecast future interest rates by looking at
the term structure of interest rates since the return on a long-term bond is in essence the
Note: We can as well simply find the average of the short-term rates:
(10%+11%+11.5%)
Three-year rate = = 10.83%
3
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Q.4824 Which of the following is correct?
A. The interest rates on U.S. Treasury securities feature an embedded maturity premium
primarily due to the fact that the probability of default is lower on long-term bonds than
on short-term goals.
B. Assuming that the maturity risk premium is zero and the rate of inflation is expected
to increase in the future, then the yield curve for U.S. Treasuries, other things held
constant, exhibit an upward sloping yield curve.
C. According to the market segmentation theory, the yield curve should normally have an
upward slope.
If inflation increases, interest rates will increase as lenders will simply pass on the extra loss of
A is incorrect: The interest rates on U.S. Treasury securities feature an embedded maturity
premium primarily due to the fact that the probability of default is higher on long-term bonds
than on short-term goals. The maturity premium is more for long term bonds than short term
bonds.
C is incorrect: The market segmentation theory states that the bond market is segmented into
different maturity sectors. As such, the prevailing interest rates for short, intermediate, and
long-term bonds should be viewed separately and are akin to items in different bond markets. It
propagates the idea that the return offered by a bond with a specific term structure is solely a
function of the supply and demand for that bond and is independent of the return offered by
D is incorrect: According to the liquidity preference theory, all other things being equal,
investors prefer liquid investments to illiquid ones. And that’s because investors prefer cash,
and barring that, an investment that’s as close to cash as possible. To hold a longer-term loan,
investors will demand a liquidity premium which will be built into the interest rate demanded.
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Q.4825 Four U.S. T-bonds currently on the market have the following characteristics:
Determine the one-year spot rate via the bootstrapping method, assuming semiannual
compounding.
A. 1.98%
B. 2.61%
C. 1.31%
D. 2.25%
Bootstrapping is the process of carving out spot rates from the market prices of a set of coupon-
paying bonds. The spot rates are determined in a consequential manner: after obtaining the first
spot rate, say, for six months, we use that to obtain the spot rate for one year. Then we can use
the six-month and one-year spot rates to obtain the one and a half-year spot rate, and so on.
We know that the price of a bond is the discounted value of all of its future cashflows.
(100 + 5/2)
101.5 =
Z0.5 1
(1 + )
2
Z0.5 1
101.5 [(1 + ) ] = $102.5
2
Z0.5 1 102.5
(1 + ) =
2 101.5
1
Z0.5
(1 + ) = 1.0099
2
Z0.5 = 0.0099 × 2 = 1.98%
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Thus, the six-month spot rate is 1.98% with semiannual compounding.
5.25
5.25/2 $100 + 2
102.6 = +
z 1 Z1 2
(1 + 0.5
2
) (1 + 2
)
$5.25 $5.25
$100 +
2 2
102.6 = +
1 Z1 2
0.0198
(1 + 2
) (1 + 2
)
$102.63
102.6 = $2.6 +
Z1 2
(1 + 2
)
2
Z1
100(1 + ) = $102.63
2
Z1 2
(1 + ) = 1.0263
2
Z1
(1 + ) = √1.0263 = 1.0131
2
z1
= 0.0131
2
z1 = 2.61%
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Q.4826 The main advantage of the secured overnight financing rate (SOFR) over LIBOR is that:
A. It’s based on the average borrowing rates across a larger collection of banks.
The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-
denominated derivatives and loans, which is based on actual observable transactions. Unlike
LIBOR, which is based on estimates provided by a panel of banks, SOFR is derived from the
Treasury repurchase market, which is a highly liquid and active market. This means that SOFR is
based on a large volume of actual transactions, making it a more reliable and transparent
benchmark. The use of actual transaction data reduces the risk of manipulation that was a
concern with LIBOR, which was based on estimates rather than actual transactions. Therefore,
the main advantage of SOFR over LIBOR is its basis on actual observable transactions, not
estimates.
Choice A is incorrect. While it's true that SOFR is based on a larger collection of banks, this
isn't the primary advantage of SOFR over LIBOR. The main advantage lies in its basis on actual
Choice B is incorrect. The ease of computation isn't the primary reason for the transition from
LIBOR to SOFR. Both rates involve complex calculations and require sophisticated financial
Choice D is incorrect. Although SOFR incorporates some risk measures, it does not provide a
built-in hedge against default risk. Its main advantage over LIBOR lies in its transparency and
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Q.4902 Consider a bond whose current price is USD 150 with a cash flow in one year providing a
present value of USD 50 and a cash flow in two years providing a present value of USD 100.
Suppose further that a yield of 5% with semi-annual compounding applies on the bond. What is
the value of modified duration?
A. 1.6667
B. 1.6260
C. 1.3333
D. 1.3008
⎡ Macaulay duration
⎤
Modified duration = ⎢⎢ ⎥⎥
y
⎣ (1 + n ) ⎦
n PV (C ti )
Macaulay duration = ∑ ti [ ]
i =1 P
50 100
= × 1+ × 2 = 1.6667
150 150
Where P V (C ti) = present value of cash flows at time ti and P is the price of the bond.
Thus,
1.6667
Modified duration = = 1.62604
0.05
(1 + )
2
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Q.4903 What is the main limitation of duration?
A. Duration does not provide a good approximation in case the change in the bond yield
arises from a non-parallel shift in the interest rate term structure or when the change
being considered is large.
B. Duration does not provide a good approximation of the effect of a small parallel shift in
the interest rate term structure.
Duration is a measure that provides an approximation of the effect of a small parallel shift in the
interest rate term structure on a bond's price. However, it does not provide a good
approximation when the change in the bond yield arises from a non-parallel shift in the interest
rate term structure or when the change being considered is large. This is because duration
assumes that the yield curve shifts in a parallel manner, which is not always the case in real-
world scenarios. Additionally, duration is a linear measure, which means it does not accurately
capture the effects of large changes in interest rates. For large changes, the relationship
between bond prices and yields is better captured by convexity, which considers the curvature of
Choice B is incorrect. Duration actually provides a good approximation of the effect of a small
parallel shift in the interest rate term structure. This is one of its primary uses, and it performs
Choice C is incorrect. Contrary to this statement, duration is most effective when changes in
interest rates are small. When there are large changes in interest rates, duration may not
Choice D is incorrect. As explained above, options B and C do not accurately describe the
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Q.4904 Consider a portfolio that has a bond position worth USD 10,000. Suppose the position
has a modified duration of 2 years and a convexity of 30. Assume that the term structure is flat.
By how much does the value of the position change if interest rates increase by 15 basis points?
This means that, with every increase in interest rates of 15 basis points, the bond's price will
decrease by $30
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Q.4905 Suppose the zero-coupon interest rates (semi-annually compounded) for maturities of
0.5, 1.0, and 1.5 years are 2.5%, 3.0% and 3.5%, respectively. Consider a USD 1,000 face value,
two-year bond that currently trades at USD 1,060 and pays coupons at a rate of 6% per year
every six months. If the two-year zero-coupon interest rate is R, what is the value of R?
A. 11.27%
B. 2.88%
C. 6.34%
D. 1.08%
30 30 30 1030
+ + + = 1 , 060
0.025 2 3 4
1+ (1 + 0.030
) (1 + 0.035
) (1 + R
)
2
2 2 2
1030
⇒ = 1, 060 − 87.22 = 972.78
4
R
(1 + )
2
1
R 1, 030 4
⇒ (1 + ) = ( ) = 1.0144
2 972.78
Thus,
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Q.4908 In an FRA, an annual rate of 2% will be received, in exchange for a 6-month LIBOR to be
paid on a principal of USD 2,000 for a six-month period starting in 15 months. If the six-month
forward rate in 15 months is 2.5% per annum, what is the settlement on the FRA?
1 + forward rate
n
6
(0.02 − 0.025) × 12
× 2, 000
= = −4.9383
0.025
1+ 2
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Q.4909 A three-year bond with a face value of USD 1,000 pays coupons of 8% per annum. The
yield on the bond is 6% compounded annually. What is the Macaulay duration?
A. 1.0000
B. 2.6312
C. 2.7891
D. 2.7206
80 80 1080
P = + + = 1, 053.46
1 2
1.06 1.06 1.063
n P V (Ct )
Macaulay Duration = ∑ ti [ ]
i=1 ∑ P V (C t)
80 80 1080
1.06 1 1.062 1.06 3
= ×1 + × 2+ ×3
1, 053.46 1, 053.46 1 , 053.46
= 2.7891
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Q.4910 A three-year bond with a face value of USD 1,000 pays coupons of 8% per annum. The
yield on the bond is 6% compounded annually. What is the Modified duration?
A. 2.6312
B. 2.7206
C. 2.7891
D. 1.0000
80 80 1080
P = + + = 1, 053.46
1 2
1.06 1.06 1.063
n P V (Ct )
Macaulay Duration = ∑ ti [ ]
i=1 ∑ P V (C t)
80 80 1080
1.06 1 1.062 1.06 3
= ×1 + × 2+ ×3
1, 053.46 1, 053.46 1 , 053.46
= 2.7891
2.7891
Modified Duration = = 2.6312
1.06
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Q.4911 A three-year bond with a face value of USD 1,000 pays coupons of 8% per annum. The
yield on the bond is 6% compounded annually. What is the modified convexity?
A. 7.6310
B. 8.0889
C. 2.7891
D. 7.1991
80 80 1080
P = + + = 1, 053.46
1 2
1.06 1.06 1.063
n PV (C t)
Convexity = ∑ t2i [ ]
i=1 ∑ P V (C t)
80 80 1080
1.06 1 2 1.062 2 1.06 3
= ×1 + ×2 + × 32
1, 053.46 1, 053.46 1 , 053.46
= 8.0889
Convexity
Modified Convexity =
y 2
(1 + )
m
8.0889
Modified Convexity = = 7.1991
1.062
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Reading 43: Corporate Bonds
Q.898 Judy Hamilton is a junior investment analyst in the fixed-income assets unit of Tulip
Investments Company. The senior management of TIP has decided to post a free monthly
investment recommendation list for the general public. Hamilton will be responsible for updating
the monthly list of recommended corporate bonds and potential default bonds. The potential
default bonds will have companies, which are considered in default based on specific criteria.
Which of the following criteria is/are used to consider if a company is considered in default?
I. If the company is unable to pay the par value of the bond at maturity
II. If the company misses on its coupon payment on the bond
III. If the company is unable to maintain certain required ratios
A. I and II only
D. I, II and III
A company is considered to be in default if it fails to meet any of the three listed criteria. The
first criterion, inability to pay the par value of the bond at maturity, refers to the principal
amount that the issuer of the bond is obligated to pay back to the bondholder upon the bond's
maturity. The second criterion, missing a coupon payment on the bond, refers to the periodic
interest payments that the issuer is obligated to make to the bondholder during the life of the
bond. The third criterion, inability to maintain certain required ratios, refers to the financial
ratios that the issuer is required to maintain under the terms of the bond covenants. Failure to
meet any of these obligations can lead to a default, which can have serious financial
Choice A is incorrect. This choice suggests that only criteria I and II would be used to
determine if a company is in default. However, this ignores the importance of criterion III, which
Choice B is incorrect. This option implies that only criteria I and III are necessary for
determining default risk. However, this overlooks the relevance of criterion II, which could
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provide crucial information about a company's financial health and potential for default.
Choice C is incorrect. According to this choice, only criteria II and III would be used to identify
Q.899 Joe George has recently joined the corporate trust department of Maximal Investment
Bank based in New Jersey. George is an expert in performing the duties of a trustee. These
functions include authenticating the bonds at the time of their issue, keeping track of the bonds
sold and bonds outstanding, making sure that the issuer does not exceed the authorized
principal, and making sure the issuer is maintaining required ratios. Which of the following
parties does Joe George, a trustee, represent?
A. Bond issuer
B. Bondholder
C. Government
The trustee, in this case Joe George, represents the bondholder. The role of a trustee in a bond
issuance is to act as a representative for the bondholders. This is because it can be resource-
intensive for a bondholder to monitor the activities of the bond issuer and to ensure that the
issuer is not violating the terms of the bond indenture. The trustee, therefore, steps in to perform
these duties on behalf of the bondholders. These duties include authenticating the bonds at the
time of their issue, keeping track of the bonds sold and those still outstanding, ensuring that the
issuer does not exceed the authorized principal, and verifying that the issuer is maintaining the
required ratios. By performing these duties, the trustee helps to protect the interests of the
bondholders and ensure that the bond issuer is adhering to the terms of the bond indenture.
Choice A is incorrect. The bond issuer is not represented by the trustee. The issuer is the
entity that sells the bonds to raise funds, and it's their responsibility to maintain certain ratios
and not surpass the authorized principal. The trustee's role is to ensure that these
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responsibilities are met, but they do not represent the issuer.
Choice C is incorrect. The government does not directly involve in individual bond issues and
hence does not need representation by a trustee in this context. While trustees must ensure
compliance with relevant laws and regulations, they do not represent the government.
Choice D is incorrect. An independent rating agency evaluates a bond's credit risk but does
not have a direct stake in its issuance or management, so it would be inappropriate for a trustee
to represent them.
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Q.900 Trustees are the corporate trust units of large banks that are representative of the interest
of bondholders. From which of the following parties does the trustee receives fees for its
services?
A. Governments
B. Bond issuers
C. Bondholders
Trustees are typically compensated by the bond issuers for their services. This is because the
bond issuer is the entity that benefits from the services of the trustee. The trustee acts as a
representative of the bondholders, ensuring that the bond issuer fulfills its obligations as
outlined in the bond indenture. The trustee's role is to protect the interests of the bondholders,
and they are compensated by the bond issuer for this service. It's important to note that while
the trustee represents the interests of the bondholders, they do not receive fees from the
bondholders themselves. The fees are paid by the bond issuer as part of the agreement when the
Choice A is incorrect. Trustees do not typically receive fees from governments. While
governments may issue bonds, the trustee's role is to represent the interests of bondholders and
they are compensated by the bond issuers, not the government directly.
Choice C is incorrect. Although trustees represent the interests of bondholders, they do not
receive their fees from them. The bond issuer pays for these services as part of their obligation
Choice D is incorrect. Trustees do not work independently in terms of compensation for their
services. They are paid by the entity issuing bonds, which means they cannot operate without a
Q.901 Christopher Ray is a junior research analyst in the fixed-income unit of a mid-sized
investment bank in the U.S. The fixed-income unit categorizes the bonds based on the type of
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issuers. These categories or issuer types are public utilities, transportations, industrials, banks &
finance companies, and Yankees. The analyst is given the task to categories a bond issued by a
German municipal government that has recently issued bonds in the U.S. to raise capital to
finance a new kindergarten in the center of Frankfurt. In which category should this bond be
classified?
A. Public utilities
B. Industrials
C. Yankees
The term 'Yankees' in the context of bond classification refers to bonds issued in the U.S. by
foreign entities. These entities can be sovereign governments, foreign banks, companies, or
foreign government agencies. In this case, the bond issued by the German municipal government
in the U.S. falls under the 'Yankees' category. This is because the issuer is a foreign government
entity issuing bonds in the U.S. market. The purpose of the bond issuance, which is to finance a
kindergarten, does not influence the classification of the bond. The classification is solely based
on the issuer type. Therefore, the bond issued by the German municipal government is correctly
Choice A is incorrect. Public utilities refer to bonds issued by entities that provide essential
public services such as water, electricity, and gas. The bond in question is issued by a German
municipal government for the construction of a kindergarten, which does not fall under the
this case, the issuer is a German municipal government and not an industrial company or
corporation.
Choice D is incorrect. Banks & Finance refers to bonds issued by financial institutions like
banks and finance companies. Here, the issuer of the bond is a German municipal government
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Q.902 Which of the following statements are correct?
I. The debt maturity is the date on which the bond issuers satisfy their obligation under the bond
indenture
II. The bond maturity date is the date on which the bond principal and the outstanding coupon
are paid
III. The maturity date of the bond issue cannot be altered
Statements I and II accurately describe the characteristics of bonds. The debt maturity is indeed
the date when the bond issuers fulfill their obligation as per the bond indenture. This obligation
typically involves the repayment of the bond principal and any outstanding interest or coupons.
The bond maturity date, as stated in Statement II, is the day when the bond principal and the
remaining coupon are paid. This is the date when the bond issuer has fully satisfied its
obligations to the bondholders. Therefore, both these statements are correct and accurately
Choice B is incorrect. While Statement II is correct, Statement III is not. The maturity date of
a bond issue can be changed under certain circumstances, such as when the issuer calls the
bond before its original maturity date or when there are provisions for extending the maturity
Choice C is incorrect. Although Statement I correctly describes debt maturity, Statement III
does not accurately reflect the dynamics of bonds in financial markets. As mentioned above,
Choice D is incorrect. This choice incorrectly assumes that all three statements are accurate
above, Statement III does not hold true under all circumstances.
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Q.903 Which of the following should be used to calculate the coupon on a bond?
The coupon or interest on a bond is calculated on the par value of the bond. The par value, also
known as the face value, is the amount that the bond issuer originally receives from the
bondholder and promises to repay upon the bond's maturity. The coupon rate is expressed as a
percentage of this par value. For instance, if a bond has a par value of $1,000 and a coupon rate
of 5%, the annual coupon payments would be $50. This is because the coupon rate is applied to
the par value of the bond to determine the annual coupon payments. Therefore, the par value of
the bond is the correct basis for calculating the coupon or interest.
Choice A is incorrect. The coupon or interest of a bond is not calculated on the price of the
bond. The price of a bond can fluctuate due to market conditions, but this does not affect the
calculation of the coupon or interest which is fixed at issuance based on par value.
Choice B is incorrect. While amortized value can be used in certain calculations related to
bonds, it's not used for calculating coupons or interest payments. Amortized cost accounting
involves gradually writing off an intangible asset over a period of time, which doesn't apply here.
Choice D is incorrect. Although it might seem that coupons are always fixed in dollar terms
because they are often quoted as such, this statement isn't universally true for all types of bonds.
For example, floating rate notes have variable coupons tied to reference rates like LIBOR or
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Q.904 The bonds that are issued in the United States are also classified on the basis of their
interest rates. Which of the following types of bonds are always issued at a discount price?
A. Zero-coupon bonds.
B. Straight-coupon bonds.
D. Premium bonds.
Zero-coupon bonds are a type of bond that does not pay interest (a coupon) during its life.
Instead, investors buy zero-coupon bonds at a deep discount from their face value, which is the
amount a bond will be worth when it 'matures' or comes due. When a zero-coupon bond matures,
the investor will receive one lump sum equal to the initial investment plus interest that has
accrued. This makes zero-coupon bonds unique among most types of bonds on the market, which
typically pay out interest semiannually. The discount in price effectively represents the 'interest'
the bond pays to investors. Therefore, by definition, zero-coupon bonds are always issued at a
discount price.
Choice B is incorrect. Straight-coupon bonds are not always issued at a discount price. They
pay periodic interest payments and the face value at maturity, and can be issued at par, premium
Choice C is incorrect. Floating rate bonds have variable interest rates that are tied to a
benchmark such as LIBOR or treasury bills. These bonds are not necessarily issued at a discount
Choice D is incorrect. Premium bonds are actually sold for more than their face value (at a
premium), hence they cannot be the type of bond that is invariably issued at a discount price.
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Q.905 Linda Angola is a senior asset investment advisor at Bright Partners Co., an investment
advisory firm based in Singapore. Angola is responsible for providing advisory services to a
group of small-medium institutional clients. Jaguar Tires Co. is one of the largest clients of
Angola and the management of the company intends to invest in a fixed income instrument that
pays a fixed coupon at a specific date and also gets a share of the issuer’s profit if the issuer
earns profits above a certain threshold. Which of the following should Angola recommend to
Jaguar Tires?
A. Deferred-interest bonds.
B. Zero-coupon bonds.
C. Participating bonds.
D. Straight bonds.
Participating bonds are a type of fixed income instrument that not only pays a fixed coupon at a
specific date but also allows the bondholder to share in the issuer’s profit if the issuer's profits
exceed a certain threshold. This type of bond is particularly attractive to investors who want to
benefit from the potential upside of the issuer's performance while still receiving regular fixed
income payments. The profit-sharing component of participating bonds is typically linked to the
issuer's profitability or the performance of a specific asset or index. This makes participating
bonds a unique and potentially lucrative investment option for investors like Jaguar Tires Co.
who are looking for a combination of fixed income and potential upside participation.
Choice A is incorrect. Deferred-interest bonds do not meet the requirements of Jaguar Tires
Co. These bonds defer interest payments to a future date, but they do not allow the bondholder
Choice B is incorrect. Zero-coupon bonds are also not suitable for Jaguar Tires Co.'s needs.
These bonds do not pay any interest until maturity and certainly do not provide an opportunity
Choice D is incorrect. Straight bonds, also known as plain-vanilla bonds, offer fixed interest
payments and return of principal at maturity but they don't provide any provision for profit
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Q.906 Muhammad Zubair is a retail bond investor that invests in various types of government
and corporate bonds. On June 30, 2016, he purchased a 5-year zero-coupon bond for the price of
$855. The bond was issued on July 1, 2014, at the discount price of $690 and the face value of
the bond is $1000. Based on the given information, identify which of the following options is
consistent with the definition of original issue discount (OID)?
A. In the given case, the original issue discount (OID) is the difference between $690 and
$1000.
B. In the given case, the original issue discount (OID) is the difference between $690 and
$855.
C. In the given case, the original issue discount (OID) is the difference between $855 and
$1000.
D. In the given case, the original issue discount (OID) is the difference between the
current amortized value and $1000.
The original issue discount (OID) is a term used in the bond market to represent the difference
between the face value of a bond and its original issue price. In the context of zero-coupon
bonds, which do not pay periodic interest, the OID essentially represents the total return an
investor will receive upon the bond's maturity. In this scenario, the bond was originally issued at
a price of $690, and it carries a face value of $1000. Therefore, the OID is the difference
between the face value and the original issue price, which is $1000 - $690 = $310. This amount
represents the total return that the original bondholder will receive if they hold the bond until
maturity.
Choice B is incorrect. The original issue discount (OID) is not the difference between the
purchase price of $690 and the price at which Muhammad Zubair bought it ($855). The OID is
determined at the time of initial issuance, not when it was purchased by Zubair.
Choice C is incorrect. The original issue discount (OID) cannot be calculated as the difference
between Zubair's purchase price ($855) and face value ($1000). Again, OID refers to the
discount at which a bond was originally issued, not its subsequent purchase prices.
Choice D is incorrect. The original issue discount (OID) does not involve any current amortized
value in its calculation. It solely depends on the initial issuance price and face value of a bond.
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Q.907 Sam Denis is a junior fixed-income analyst that is analyzing a number of corporate bonds
to recommend to one of his clients. The bonds under analysis are classified by the type of
issuers, type of risk, and expected return. Which of the following categories of bonds will have
the lowest interests rates?
A. Corporate Bonds.
B. Debenture issues.
C. Mortgage bonds.
Mortgage bonds have the lowest interest rate and the highest price among the four types of
bonds. Because of the fact that mortgage bonds are secured by mortgage liens, the interest rate
on these bonds is low and the prices are higher. Options A and D are incorrect because
Corporate Bonds offer a higher yield relative to a government bond due to the higher risk of
insolvency. Straight-coupon discount bonds are sold at discount prices. Thus, the interest rate on
such bonds is high. Option B is also incorrect because debenture issues are unsecured bonds.
Due to higher risk, the price of the bonds is lower, and the interest is higher.
Q.909 Debentures are unsecured bonds issued by companies that do not have any pledge
security or asset as collateral. While investors prefer secured bonds, the larger portion of bonds
is dominated by debentures. Analyze and determine which of the following points regarding the
rights of debenture holders is incorrect.
A. Debenture bondholders have a general claim on assets that are not pledged against
secured debt.
B. Debentures are unsecured bonds; therefore, the debenture bondholders have no right
over the assets of the issuer.
C. Debenture bondholders have a right to the pledged assets if the value of the pledge
assets exceeds the claims of secured bondholders.
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The statement that debenture bondholders have no right over the assets of the issuer is
incorrect. Despite being unsecured, debenture bondholders do have rights to the issuer's assets,
albeit in a specific order of priority. In the event of a default, the assets of the issuer are
liquidated to repay the creditors. Secured creditors, who have specific assets pledged against
their loans, are paid first. However, if there are any remaining assets or funds after the secured
creditors have been paid, these are used to repay unsecured creditors, including debenture
bondholders. Therefore, while debenture bondholders do not have a direct claim on specific
assets as collateral, they do have a general claim on any remaining assets after secured creditors
have been paid. This right is particularly important in situations where the issuer has significant
unpledged assets or where the proceeds from the sale of pledged assets exceed the amount owed
to secured creditors.
Choice A is incorrect. Debenture bondholders do have a general claim on assets that are not
pledged against secured debt. This means that in the event of liquidation, after the secured
creditors have been paid off, debenture holders can claim any remaining assets.
Choice C is incorrect. Debenture bondholders do not have a right to the pledged assets if the
value of these assets exceeds the claims of secured bondholders. The rights to these pledged or
collateralized assets belong solely to the secured creditors until their claims are fully satisfied.
Choice D is incorrect. In absence of pledged assets or secured creditors, it's true that
debenture bondholders' claim would be equal to other unsecured creditors'. However, this does
not mean they will necessarily receive an equal distribution as it depends on bankruptcy laws
and proceedings.
Q.911 Ohio Automotive Inc. raised capital to finance its expansion into the SUVs market. A year
ago, the firm issued a 4-year 6% semi-annual coupon bond. The bond has a special provision that
allows the issuer to call its bond before the maturity of the bond. Which of the following options
is consistent with the properties of a callable bond?
A. It is beneficial for the issuer to call the bond in an increasing interest rate
environment.
B. It is beneficial for the issuer to call the bond in a decreasing interest rate environment.
C. It is beneficial for the bondholder if the bond is called in a decreasing interest rate
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environment.
A callable bond provides the issuer with the advantage of redeeming the bond before its
maturity, especially in a decreasing interest rate environment. When interest rates decrease,
bond prices increase. This allows the issuer to call back the previously issued bonds, which were
issued at higher interest rates, and replace them with new bonds at the current lower interest
rates. This strategy allows the issuer to save on interest payments, making it beneficial for them.
Therefore, in a decreasing interest rate environment, it is advantageous for the issuer to call the
bond.
Choice A is incorrect. It is not beneficial for the issuer to call the bond in an increasing interest
rate environment. When interest rates increase, the cost of borrowing increases for issuers.
Therefore, they would prefer to keep paying lower coupon payments on existing bonds rather
Choice C is incorrect. It is not beneficial for the bondholder if the bond is called in a
decreasing interest rate environment. When a bond is called, it means that it's bought back by
the issuer before its maturity date. In a decreasing interest rate environment, if a bond gets
called, then investors will have to reinvest their money at lower prevailing market rates which
Choice D is incorrect. While it might seem beneficial for a bondholder if the bond was called in
an increasing prices environment because they would receive more money upfront; however, this
scenario does not align with benefits of having callable bonds from issuer's perspective as calling
back bonds when prices are high would mean higher costs for them.
Q.912 Hauser Corp., a German portable house construction firm, is raising $500 million through
7-year 9% semi-annual coupon bonds. Classico Investment Company is interested in purchasing
33% of Hauser’s total bond issue, but it has put forward a condition that requires the issuer to
retire a portion of the principal of the debt each year until maturity rather than paying the whole
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capital at maturity. This condition is most likely associated with the:
The sinking fund provision is the correct answer. This provision is a protective covenant in the
bond indenture that requires the issuer to retire a certain portion of the bond issue each year.
The issuer can achieve this by either buying back a certain number of bonds in the open market
or using a lottery system to select which bonds to retire. The sinking fund provision is designed
to reduce the risk to bondholders by ensuring that the issuer does not default on the entire bond
issue at maturity. It also helps to reduce the potential impact of a default on the bondholders.
The sinking fund provision is beneficial to the bondholders as it provides a form of repayment
rate environment, as the issuer may have to retire the bonds at a premium. In the context of the
question, Classico Investment Company's condition that requires Hauser Corp. to retire a portion
of the principal of the debt each year until maturity is most likely associated with the sinking
fund provision.
Choice A is incorrect. A fixed-price call provision allows the issuer to buy back a portion or all
of the bonds before maturity at a predetermined price. This does not align with Classico's
Choice B is incorrect. A make-whole call provision allows the issuer to pay off remaining debt
early, but it requires them to make bondholders whole by paying an amount that equates to the
net present value of future coupon payments that will be missed due to early repayment. This
Choice D is incorrect. A tender offer provision involves an offer by the issuing company to
purchase back its own securities from holders at a specified price during a short period time. It
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doesn't necessarily involve retiring part of principal annually until maturity as required by
Classico.
Q.913 Matthias Schmidt is the Chief Financial Officer of Caribbean Shipping & Logistics
Company. Three years ago, the company raised $600 million through 5-years 5% coupon bonds
to finance its two new vessels that will sail in the Arabian Sea. Due to abrupt growth in emerging
economies like Pakistan, Bangladesh, and India, the company grew exponentially in the last
three years. The firm's senior management informed the CFO that they should retire the debt
before maturity as the firm now has enough funds to pay for further expansions. If the indenture
of the bond did not include any mechanism for early retirement in its indenture, then determine
which of the following mechanisms could be used.
A tender offer provision is a mechanism that allows for the early retirement of debt, even if it is
not included in the bond's indenture. In a tender offer, the issuer of the bond sends an offering
circular to the bondholders of record. This circular presents the price that the issuer is willing to
pay to buy back the bond, as well as the window of time during which bondholders can sell their
bonds back to the issuer. This mechanism is particularly useful in situations where the issuer has
sufficient funds to retire the debt before its maturity, as is the case with Caribbean Shipping &
Logistics Company. By using a tender offer, the company can effectively manage its debt and
Choice A is incorrect. A fixed-price call provision allows the issuer to retire part or all of the
bond issue at a predetermined price before maturity. However, in this case, it was mentioned
that the bond's indenture did not include any mechanism for early retirement, which implies that
Choice B is incorrect. A sinking fund provision requires the issuer to retire a portion of the
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bond issue each year by buying back bonds in the open market or through a lottery system.
Again, since there was no such provision included in Caribbean Shipping & Logistics Company's
Choice D is incorrect. There isn't any standard financial instrument known as a "replacement
fund provision." This seems to be an invented term and does not apply to this situation.
Q.914 Pamela Simpson is the fixed-income investment manager at Nordend Investment Bank.
During a seminar on the risks attached to fixed income assets, which was organized to train
junior analysts, Simpson made the following statements about the credit default risk of bonds:
I. Credit default risk is the risk of financial loss, or the underperformance of a portfolio, that
arises due to movements in the credit spreads used in the marking to market of bonds
II. Investors rely on rating agencies to evaluate the credit default risk of the issuer
III. According to S&P and Fitch, a BBB-rated bond is considered a junk bond.
Statement II is the only correct statement as the bondholders and investors rely on the rating of
the issue and the issuer, which is provided by rating agencies.
Statement I is incorrect because the credit spread risk, not the credit default risk, is the risk of
financial loss or the underperformance of a portfolio that arises due to movements in the credit
spreads used in the marking to market of bonds.
Statement III is also incorrect because, according to S&P and Fitch, a BBB-rated bond is
considered an investment bond. All bonds that fall below BBB- are considered junk bonds.0
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Q.915 Investors use default rates and recovery rates to forecast the non-investment grade bonds
that have the potential to default or upgrade to investment grade. Which of the following options
are least consistent with the properties of recovery rates?
B. Recovery rates are not based on the size of the bond issue.
The assertion that recovery rates are lower in asset-intensive industries is not consistent with
the properties of recovery rates. In fact, the opposite is true. Recovery rates tend to be higher in
asset-intensive industries. This is because these industries have a substantial amount of tangible
assets that can be sold off in the event of a default, thereby increasing the recovery rate. The
recovery rate is a measure of the amount that can be recovered from a defaulted bond, and in
asset-intensive industries, the presence of tangible assets increases the likelihood of recovering
a significant portion of the investment. Therefore, the statement that recovery rates are lower in
asset-intensive industries is incorrect and inconsistent with the properties of recovery rates.
Choice A is incorrect. It is generally observed that recovery rates are lower in an economic
downturn. This is because during a downturn, the value of assets (which are used to recover the
Choice B is incorrect. Recovery rates are indeed not based on the size of the bond issue. They
depend on factors such as the quality of assets, industry type and economic conditions but not
Choice C is incorrect. Recovery rates and default rates do have an inverse relationship most
times. When default rates increase due to worsening credit conditions, recovery rates tend to
decrease as it becomes more difficult for lenders to recover their funds from defaulting
borrowers.
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Q.916 Iron Partners Co. is a private equity firm that invests in distressed firms through various
investment vehicles. Recently, the company acquired a mid-size paper manufacturing company
through a leveraged buy-out (LBO). Initially, the equity firm acquired loans from commercial and
investment banks to purchase the company. However, the company now issues bonds to pay off
the debt of these banks. This activity of issuing debt to retire initial debt is called:
A. Payment-in-kind (PIKs).
B. Multi-term notes.
C. Bridge financing.
Bridge financing is a short-term financing option used by companies before they can secure
permanent financing. It 'bridges' the gap between when a company's money is set to run out and
when it can expect to receive an inflow of funds later. In this case, Iron Partners Co. used bridge
financing to acquire the paper manufacturing company. Initially, they borrowed funds from
commercial and investment banks to facilitate the leveraged buy-out. However, to repay these
initial loans, they decided to issue bonds, a strategy known as bridge financing. This strategy is
often used in leveraged buyouts and mergers and acquisitions to cover the period between when
the deal is closed and when the target company can generate cash flow or the acquirer secures
long-term financing.
Choice A is incorrect. Payment-in-kind (PIKs) refers to a type of financing where the interest or
dividends are paid in a form other than cash, often in additional securities. This does not align
with the scenario described where new debt is issued to retire initial debt.
Choice B is incorrect. Multi-term notes refer to a type of bond that has multiple maturity
dates, which allows for periodic return of principal over the life of the bond. This does not match
with the strategy used by Iron Partners Co., as they are issuing new bonds to repay their initial
Choice D is incorrect. Rolling stock certificates are financial instruments related to railroads
and do not have any relevance in this context where a private equity firm issues bonds to repay
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Q.917 McMillan Electronics Company issued four types of debt to raise the capital of $730
million. The debt includes $400 million raised through secured bonds, $110 million through
subordinate bonds, $40 million through unsecured loans, and $180 million through debenture
bonds. If the company defaults, the total value of the assets to be distributed is $670 million.
Determine the total claim that the debenture bondholders will receive.
A. $180 million
B. $160 million
C. $120 million
D. $0
The debenture bondholders have the claim over the issuer’s assets after the claim of secured
bondholders is satisfied. Though debenture bonds do not have pledged assets or collaterals, the
residual funds after satisfying the secured debt (and before satisfying the claims of creditors) are
distributed among debenture bondholders.
Since the total value of the firm's asset is $670 million:
The secured bondholders will receive $400 million;
The debenture bondholders will receive $180 million;
The banks will receive $40 million; and
The subordinate bondholders will receive $50 million.
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Q.3582 The coupon reinvestment risk is directly correlated with which of the following?
A. Coupon rate
B. Reinvestment horizon
C. Both A and B
Both the coupon rate and the reinvestment horizon directly influence the coupon reinvestment
risk. The coupon rate is the interest rate that the bond issuer agrees to pay to the bondholder
annually, and it is expressed as a percentage of the bond's face value. The higher the coupon
rate, the higher the amount of cash flows that need to be reinvested, thereby increasing the
reinvestment risk. The reinvestment horizon refers to the time period over which the coupon
payments are to be reinvested. The longer the reinvestment horizon, the greater the uncertainty
about the future interest rates at which these coupon payments can be reinvested, thereby
increasing the reinvestment risk. Therefore, both the coupon rate and the reinvestment horizon
Choice A is incorrect. While the coupon rate does impact the reinvestment risk, it is not the
only variable that directly influences this risk. The coupon rate determines the amount of cash
flows that need to be reinvested, and thus higher coupon rates may lead to higher reinvestment
risk if interest rates fall in future. However, this alone does not fully capture all aspects of
reinvestment risk.
Choice B is incorrect. Similarly, while the reinvestment horizon also impacts the reinvestment
risk, it cannot be considered as a standalone factor influencing this type of risk. Longer
investment horizons typically increase exposure to potential changes in interest rates which can
Choice D is incorrect. This option suggests that neither coupon rate nor investment horizon
influence coupon reinvestment risk which contradicts with standard fixed income securities
principles where both these factors play a significant role in determining such risks.
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Q.3583 Which of the following statements about reinvestment risk is INCORRECT?
A. A fixed coupon bond investor can eliminate reinvestment risk by holding a coupon
bond until maturity
B. A bond's yield calculation assumes that the coupons and the principal can be
reinvested at the yield to maturity
The statement that a fixed coupon bond investor can eliminate reinvestment risk by holding a
coupon bond until maturity is incorrect. This is because the investor will receive periodic
coupons during the life of the bond. These coupons will need to be reinvested, and there is a risk
that the rate at which they can be reinvested will be lower than the original yield of the bond.
This is the essence of reinvestment risk. Holding the bond until maturity does not eliminate this
risk because the coupons are received and reinvested before maturity. Therefore, the investor is
Choice B is incorrect. The yield calculation of a bond does indeed assume that the coupons and
the principal can be reinvested at the yield to maturity. This assumption is inherent in the
Choice C is incorrect. An investor concerned about reinvestment risk would indeed be most
worried about a decrease in interest rates. Lower interest rates mean lower returns on
Choice D is incorrect. Zero-coupon bonds do not have any reinvestment risk because they do
not pay periodic coupon payments that need to be reinvested. Instead, they are issued at a
discount and redeemed at face value upon maturity, eliminating any concern for reinvestment
risk.
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Q.3584 A callable bond is a bond that:
A. Gives the issuer the right to redeem all or part of the bond before the maturity date
B. Gives the bondholder the right to sell the bond back to the issuer at a predetermined
price before maturity
C. Gives the bondholder the right to exchange the bond for a specific number of common
shares
A callable bond indeed gives the issuer the right to redeem all or part of the bond before the
maturity date. This feature is particularly beneficial for the issuer, especially in a declining
interest rate environment. When interest rates fall, the issuer can call back the bond, pay off
their obligation, and reissue new bonds at a lower interest rate. This can result in significant cost
savings for the issuer. However, for the bondholder, this feature introduces reinvestment risk, as
they may not be able to reinvest the proceeds at the same rate of return.
Choice B is incorrect. This describes a puttable bond, not a callable bond. A puttable bond
gives the holder the right, but not the obligation, to sell the bond back to the issuer at a
Choice C is incorrect. This describes a convertible bond, not a callable bond. A convertible
bond gives the holder the right to convert it into common shares of stock in the issuing company.
Choice D is incorrect. As explained above, each choice represents different types of bonds and
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Q.5352 A portfolio manager is considering purchasing a bond with a face value of $1,000, a
coupon rate of 5%, and a maturity of 5 years. Which of the following statements is most likely
correct regarding the bond's price and yield if market interest rates increase?
A. The bond's price will increase, and its yield will decrease.
B. The bond's price will decrease, and its yield will increase.
When market interest rates rise, the price of a bond decreases, and its yield increases. This is
because the fixed coupon rate of the bond becomes less attractive when compared to newly
issued bonds that offer higher coupon rates. The yield of a bond is calculated by dividing the
bond's coupon payments by its market price. Therefore, when bond prices increase, bond yields
decrease, and vice versa. In this scenario, the increase in market interest rates would make the
bond's fixed coupon rate less attractive, leading to a decrease in the bond's price and an increase
in its yield.
Choice A is incorrect. An increase in market interest rates would not cause the bond's price to
increase and its yield to decrease. In fact, the opposite is true. When market interest rates rise,
the price of existing bonds falls because they become less attractive compared to new bonds that
are issued with higher coupon rates (interest payments). Consequently, the yield on these
Choice C is incorrect. It's not accurate that both the bond's price and yield will increase if
there is an increase in market interest rates. As explained above, when market interest rates
Choice D is incorrect. This choice suggests that both the bond's price and yield will decrease
with an increase in market interest rates which contradicts basic principles of bond pricing and
yields. As previously mentioned, when market interest rates rise, it results in a decrease in bond
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Reading 44: Mortgages and Mortgage-Backed Securities
Q.918 Mortgage-backed loans played a significant role in the 2007-2009 financial crisis. After the
crisis, the importance of securitization of these loans increased furthermore. In the United
States, there are multiple entities that securitize mortgage loans. Which of the following types of
loans is securitized through the Federal National Mortgage Association?
B. Non-agency loans.
C. Jumbos.
D. Agency loans.
Agency loans, also known as conforming loans, are typically residential loans that are securitized
through entities like the Federal National Mortgage Association (FNMA), Government National
Mortgage Association (GNMA), and Federal Home Loan Mortgage Corporation (FHLMC). These
loans conform to the guidelines set by these government-sponsored entities (GSEs). The GSEs
buy these loans from lenders, package them into mortgage-backed securities (MBS), and
guarantee the timely payment of principal and interest to the MBS investors. This process helps
to provide liquidity to the mortgage market, enabling lenders to make more loans. The FNMA,
commonly known as Fannie Mae, is one of the leading agencies in this process.
Choice A is incorrect. Adjustable-rate mortgage loans are not typically securitized through the
Federal National Mortgage Association (FNMA). While FNMA does deal with adjustable-rate
Choice B is incorrect. Non-agency loans are those that are not backed by government
primarily deals with agency loans and does not typically securitize non-agency loans.
Choice C is incorrect. Jumbos or jumbo loans exceed the conforming loan limits set by the
Federal Housing Finance Agency (FHFA), and hence, they are not usually securitized through
FNMA which primarily deals with conforming loans within the set limits.
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Q.919 Mohan Singh, a sales manager at a retail chain, has recently moved to Minnesota with his
wife. He purchased a studio apartment with a mortgage loan of $140,000 at 5% for 20 years.
Which of the following is the most appropriate estimation of the monthly installments on this
loan?
A. $1,004.61
B. $923.94
C. $763.84
D. $340.60
The monthly installments of $923.93 for the monthly periods of 20 years (12x20=240) at the rate
The easiest way to solve this problem is with the help of the financial calculator:
This installment can also be calculated with the simple annuity formula as follows:
[1 − (1 + r)−n ]
P V = installment
r
Since the annual rate of interest is 5%, the monthly rate can be approximated as 5%/12 =
0.004167 or 0.4167%
[1−1.004167−240 ]
Thus, 140, 000 = installment 0.004167
140, 000
Installment = = $923.94
[1−1.004167−240 ]
{ }
0.004167
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Q.920 Which of the following is the accurate explanation of a mortgage loan with a prepayment
option?
A. It allows the lender to demand the repayment before the maturity of the loan.
B. It restricts the borrower from repaying the mortgage before the maturity date.
C. It allows the borrower to demand the disbursement of the mortgage loan before the
agreed disbursement date.
D. It allows the borrower to repay the mortgage loan before the maturity date of the loan.
A mortgage loan with a prepayment option indeed allows the borrower to repay the mortgage
loan before the maturity date of the loan. This option provides the borrower with the flexibility to
manage their finances more effectively. If the borrower comes into a financial windfall or
manages to save enough money, they can choose to repay the loan early, thereby saving on
future interest payments. This option is particularly beneficial in a declining interest rate
environment. If interest rates decline, the present value of future payments will be higher.
Hence, the borrower can choose to retire the mortgage early, thereby saving on future interest
payments. However, it's important to note that some lenders may charge a prepayment penalty
to compensate for the loss of interest income. Therefore, borrowers should carefully read the
Choice A is incorrect. This statement is not accurate because the prepayment option in a
mortgage loan does not allow the lender to demand repayment before the maturity of the loan.
Choice B is incorrect. This statement contradicts with what a prepayment option offers. The
prepayment option does not restrict but allows borrowers to repay their mortgage loans before
Choice C is incorrect. The disbursement of a mortgage loan before its agreed date has nothing
to do with a prepayment option. Prepayment refers specifically to repaying part or all of a debt
obligation earlier than its due date, and not about demanding disbursement earlier.
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Q.921 Alison Garry and her partner have recently secured a mortgage to buy a condominium in a
beach town in Costa Rica. The purchase price of the condo was $40,000, and the mortgage has
an interest rate of 3.25% for a period of 10 years. The mortgage also includes a prepayment
option. In light of these circumstances, which of the following statements would be the most
accurate regarding the appropriate use of the prepayment option?
A. The use of the prepayment option is appropriate if the mortgage rate increases to
3.75%.
B. The use of the prepayment option is appropriate if the mortgage rate remains at
3.25%.
C. The use of the prepayment option is appropriate if the mortgage decreases to 3.0%.
A prepayment option mortgage loan allows the mortgage borrower to pay back the outstanding
principal before its predefined maturity date. A mortgage borrower can benefit from the
prepayment option if the interest rates decline. The prepayment option is valuable for the
borrower when the mortgage rates decline. As the rates will decline, the present value of the
remaining monthly payments will be greater than the principal outstanding. Hence, the borrower
can gain by paying the principal outstanding in exchange for not having to make further
mortgage payments.
Think of this along the lines of refinancing. If rates fall, you can pay off the existing mortgage
and take on a new one that will come with lower coupon payments.
Q.922 Ahmed Saeed has recently graduated from the Frankfurt Finance School with a Bachelor’s
degree. He was invited by a small-size audit firm that provides audit services to small-medium
companies and startups to take a test in order to join the firm as a junior risk analyst. In the test,
he was asked to identify the definition of securitization. Which of the following is the appropriate
definition of securitization?
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The correct answer is D.
future cash flows on the assets, into units of marketable securities. This process is often carried
out by financial institutions, such as banks, to transfer the risk associated with these assets to
the market. By doing so, these institutions are able to generate funds for their business
operations. The securitization process involves the creation of a special purpose vehicle (SPV) or
special purpose entity (SPE), which purchases the assets from the originator. The SPV/SPE then
issues securities that are backed by these assets, which are sold to investors. The cash flows
generated by the underlying assets are used to service the securities. This process allows the
originator to remove these assets from their balance sheet, thereby improving their financial
position.
Choice A is incorrect. Securitization does not involve securing the mortgage with a security or
collateral. This definition is more aligned with the concept of a secured loan, where the borrower
its purpose isn't to issue bank loans to individual borrowers. Rather, this entity's purpose is to
for acquiring asset-backed securities (ABSs). In reality, securitization involves creating ABSs
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Q.924 Billy Clark is an investment manager at the Sachsenhausen Investment Bank based in
Dusseldorf. Clark manages a pool of mortgages and the assets constructed with the pool. If the
pool prepaid 1.1% of its principal above its amortizing principal as the percentage of total
outstanding principal in the month of February, then which of the following is the appropriate
annualized constant prepayment rate he can come up with?
A. 0.0302
B. 0.1243
C. 0.132
D. 0.1402
If the pool prepaid 1.1% of its principal above its amortizing principal as the percentage of total
outstanding principal in the month, then its single monthly mortality rate or SMM is 1.1%.
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Q.925 The superior of an investment analyst made the following statements to differentiate
between prime and sub-prime mortgages. In prime mortgages:
I. The mortgage borrower has a lower front income ratio
II. The mortgage borrower has a higher back-end income ratio
III. Loan-to-value ratios are lower
A. Statement I only.
B. Statement II only.
The statement that 'The mortgage borrower has a higher back-end income ratio' in the context of
prime mortgages is incorrect. Prime mortgages are typically characterized by borrowers with
lower back-end income ratios. The back-end income ratio is a measure that calculates the total
monthly debt expenses, which can include debt payment, credit card payments, interest
expenses, and insurance expenses, as a percentage of total income. The lower these ratios, the
lower the probability of default on the mortgage. Therefore, prime mortgages, which are
considered less risky, typically involve borrowers with lower back-end income ratios, contrary to
Choice A is incorrect. Statement I is correct. Prime mortgage borrowers typically have a lower
front-end income ratio, which means they spend a smaller proportion of their income on housing
Choice B is incorrect. As explained above, prime mortgage borrowers generally have lower
front-end and back-end ratios, meaning they spend less of their income on debt obligations
overall.
Choice D is incorrect. All the statements are not correct as statement II is incorrect because
prime mortgage borrowers generally have lower back-end ratios, not higher ones.
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Q.926 Pooja Rao has recently joined Green Oceans Hedge Fund that invests in non-conventional
investment assets and securities. Rao was instructed by the fund manager to evaluate four
mortgage-backed securities of four different banks, and identify the riskiest MBS. Identify for
Rao which of these MBSs has the highest risk.
Subprime adjustable-rate mortgages (ARMs) are considered to be the riskiest type of mortgage-
backed securities (MBSs). This is primarily due to the nature of the borrowers and the structure
of the loans. Subprime mortgages are typically extended to borrowers who have poor
creditworthiness, which is often reflected in higher loan-to-value (LTV) and debt-to-income (DTI)
ratios. These borrowers are more likely to default on their loans, making the securities backed by
these mortgages riskier. Additionally, the adjustable-rate structure of these mortgages adds
another layer of risk. Unlike fixed-rate mortgages, ARMs have interest rates that can fluctuate
over time. If interest rates rise, the borrowers' mortgage payments can increase significantly,
further increasing the likelihood of default. Therefore, among the four options, subprime ARMs
Choice A is incorrect. Prime fixed-rate MBSs are generally considered to be less risky than
their subprime counterparts. This is because prime borrowers have a lower risk of defaulting on
their loans, which reduces the overall risk of the MBS. Additionally, the fixed rate nature of these
securities means that they are not subject to interest rate fluctuations, further reducing their
risk profile.
Choice B is incorrect. Subprime fixed-rate MBSs carry more risk than prime fixed-rate MBSs
due to the higher likelihood of default by subprime borrowers. However, they still have a lower
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Choice C is incorrect. While prime adjustable-rate mortgages do carry some additional interest
rate risks compared with fixed-rate mortgages, they are still less risky than subprime ARMs due
Q.927 Adam Levy teaches the finance and investment courses at the Mumbai College of
Economics. During one of his lectures on the subject of mortgages and mortgage-backed
securities, he mentioned the following four features of a fixed rate level payment mortgage:
I. The amount of interest payment in a fixed-rate mortgage decreases as the maturity date of the
mortgage approaches
II. The amount of principal payment on a fixed-rate mortgage decreases as time passes
III. Service fees in a fixed-rate mortgage decline as time passes
IV. The prepayment risk to the lender of the mortgage increases as the mortgage rates decrease
Which of the above-mentioned features is/are inconsistent with the features of fixed-rate level
payment mortgages?
A. I only.
B. II only.
C. I and III.
D. II and III
payment remains constant throughout the life of the mortgage. This means that the borrower
pays the same amount of principal with each installment, but the interest portion decreases over
Statement III is incorrect. Service fees in a fixed-rate level payment mortgage typically do not
decline as time passes. These fees, which include administrative and servicing costs, remain
relatively stable over the life of the mortgage. They are not tied to the passage of time but rather
Statement I is correct.In a fixed-rate level payment mortgage, the interest payment decreases
over time because the interest is calculated based on the outstanding principal balance. As the
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borrower makes regular payments, the outstanding balance reduces, leading to lower interest
costs.
When mortgage rates decrease, borrowers are more likely to refinance their existing mortgages
to take advantage of lower rates. This prepayment risk can affect lenders, as they may receive
Q.928 Boris Arkarov is a Russian real estate investor based in California. He has been investing
in the real estate sector of California for the past 20 years and is famous for selling some
luxurious villas to well-known Hollywood celebrities. In a magazine interview, Mr. Arkarov
expressed that he wants to borrow to finance his personal residential estate in the suburbs of L.A
that costs $10.5 million. If the loan-to-value ratio is 78%, calculate the amount of monthly
payment that Mr. Arkarov has to pay on a 20-year mortgage at the rate of 9%.
A. $94,471.22
B. $73,687.56
C. $45,750
D. $34,890.74
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Total Payments = Loan Term in Years × 12
= 20 × 12
= 240
r ×PV
P =
1 − (1 + r)−n
0.0075 × $8 , 190 , 000
=
1 − (1 + 0.0075)−240
≈ $73 , 687.56
So, with a loan amount of $8,190,000, a monthly interest rate of 0.0075, and 240 total payments,
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Q.929 Karen Jacobs, a final year undergraduate student made the following points regarding
mortgage pass-through securities. Which of Jacobs' statements is incorrect?
C. The cash flows forwarded to those that have invested in a pass-through security
exactly match the cash flows generated by the underlying mortgage pool.
This is primarily due to timing differences. Mortgage providers may not pass the revenue stream
receipt. This delay can cause a discrepancy between the cash flows generated by the underlying
pool of mortgages and the cash flows forwarded to the investors of the pass-through security.
Therefore, it is not accurate to say that these cash flows 'exactly match'.
against a pool of mortgages. This means that the investors have a right to receive payments from
Choice B is incorrect. It's true that all investors in one pool receive the same return. The rate
of return on mortgage pass-through securities is typically equal for all investors as they all share
in the interest and principal payments from the underlying mortgage pool.
Choice D is incorrect. Pass-through securities do have prepayment risk, which refers to the
risk that borrowers may pay off their mortgages earlier than expected, usually when interest
rates fall. This can reduce future cash flows for investors as they will not receive as much
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Q.930 An analyst is analyzing the speed of the prepayments of mortgages in a specific city that
are pooled into a mortgage-backed security. Suppose that the Public Securities Association (PSA)
prepayment benchmark in the city is 100%, and the monthly conditional prepayment rate (CPR)
of 20-year mortgages is expected to increase at the rate of 0.5% from the origination until the
end of the 12th year. Then, the CPR is expected to increase at the rate of 0.7% until the maturity
of the mortgage. Which of the following is the appropriate estimation of a single monthly
mortality rate (SMM) for the 40th month?
A. 0.0004
B. 0.9313
C. 1.248
D. 0.01842
Conditional prepayment rate (CPR) of the 40th month with 100% PSA benchmark = 40 * 0.5% *
1 = 0.2
1
Single monthly mortality rate (SMM) = 1 − (1 − CP R) 12
1
SMM = 1 − (1 − 0.2)12 = 0.01842
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Q.931 Fixed-rate mortgage pass-through securities or the fixed-rate mortgage pool can trade in
both specified pool markets and to-be-announced (TBA) markets. Which of the following
differences between specified pool markets and to-be-announced markets of pass-through
securities is/are incorrect?
I. Specified pool markets identify the number and the balance of the pool prior to the trade,
whereas, in TBA markets, the number and the balance are not revealed until the settlement
II. TBA markets of pass-through securities are more liquid than specified pool markets
III. Specified pools with high loan balances trade for lower prices
A. Statement I is incorrect.
B. Statement II is incorrect.
Statement II is correct. TBA markets of pass-through securities are more liquid than specified
pool markets.
Statement III is correct. Specified pools with high loan balances trade for lower prices.
Further information:
Agency mortgage-backed securities trade simultaneously in a market for specified pools (SPs)
and in the to-be-announced (TBA) forward market. TBA trading creates liquidity by allowing
thousands of different MBS to be traded in a handful of TBA contracts.
Q.932 A dollar roll transaction takes place when an investor purchases an MBS for a specific
settlement month and simultaneously sells the MBS for a different settlement month. Dollar rolls
are trading “special” when the implied financing rate is below current market rates, which
means the implied repo rate is lower than the rate of the repurchase market. Which of the
following is NOT a factor that causes dollar rolls to trade “special”?
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A. An increase in the number of settlement transactions for the back-month date by the
originators of the MBS.
An increase in the supply of the front-month settlement MBS is not a factor that causes dollar
rolls to trade 'special.' The concept of a dollar roll trading 'special' is rooted in the difference in
the purchasing rate for the back-month settlement MBS. This situation arises when an investor
can acquire the back-month settlement MBS at an implied repo rate that is lower than the rate in
the repurchase market. Therefore, any factors that elevate the front-month settlement price and
reduce the back-month settlement price are contributors to a dollar roll trading 'special.'
However, an increase in the supply of the front-month settlement MBS would lead to a decrease
in the price of the front-month settlement MBS, which contradicts the conditions for a dollar roll
to trade 'special.' Hence, Choice C is not a factor that causes dollar rolls to trade 'special.'
Choice A is incorrect. An increase in the number of settlement transactions for the back-month
date by the originators of the MBS can contribute to a dollar roll trading 'special'. This is
because an increase in settlements implies that there are more securities available for trade,
which can lead to a decrease in their price and hence a lower implied financing rate.
Choice B is incorrect. An increase in the price of MBS for front-month settlement does not
make dollar roll trade 'special'. In fact, it contributes to making it special as higher prices imply
lower yields or financing rates, which makes them attractive compared to prevailing market
rates.
Choice D is incorrect. A shortage of MBSs in the market for delivery in front-month also
contributes to making dollar roll trade 'special'. When there's a shortage, demand exceeds
supply leading to higher prices and thus lower implied repo rates than repurchase market rate.
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Q.933 Anna Henderson is a high net-worth individual investor with Galaxy Investments Inc. Anna
has recently learned about the investments and returns of mortgage-backed securities. Jacob
Glen, a dedicated investment manager, briefed Henderson that she does not need to concern
about the contraction risk of mortgage pool as their investment products are designed to
mitigate risk. Which of the following is the most appropriate explanation for the contraction risk?
A. Contraction risk is the risk related to the increase in the expected life of a mortgage
pool due to falling interest rates and higher prepayment rates.
B. Contraction risk is the risk related to the increase in the expected life of a mortgage
pool due to increasing interest rates and lower prepayment rates.
C. Contraction risk is the risk related to the decrease in the expected life of a mortgage
pool due to falling interest rates and higher prepayment rates.
D. Contraction risk is the risk related to the decrease in the expected life of a mortgage
pool due to increasing interest rates and lower prepayment rates.
Contraction risk in the context of mortgage-backed securities refers to the risk associated with
the decrease in the expected life of a mortgage pool. This decrease is typically triggered by
higher prepayment rates, which are often a result of falling interest rates. When interest rates
fall, borrowers are more likely to refinance their mortgages at these lower rates, leading to a
higher rate of prepayments. This, in turn, reduces the expected life of the mortgage pool, hence
the term 'contraction risk'. This risk is a significant concern for investors in mortgage-backed
securities as it can impact the timing and amount of their expected cash flows.
Choice A is incorrect. This choice incorrectly states that contraction risk is related to the
increase in the expected life of a mortgage pool due to falling interest rates and higher
prepayment rates. In reality, falling interest rates and higher prepayment rates lead to a
decrease in the expected life of a mortgage pool, which is known as contraction risk.
Choice B is incorrect. This choice inaccurately describes contraction risk as being associated
with an increase in the expected life of a mortgage pool due to increasing interest rates and
lower prepayment rates. However, these conditions actually result in extension risk, not
contraction risk.
Choice D is incorrect. This option wrongly suggests that contraction risk involves a decrease in
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the expected life of a mortgage pool due to increasing interest rates and lower prepayment rates.
These circumstances would actually cause extension risk rather than contraction risk.
Q.934 Adam and Jack are participants in the Green Investment Bank university challenge. The
program consists of presentations and strategies related to the complex investment instruments
of the bank. The winning team is offered a 6-month internship at the bank. Adam and Jack
presented an explanatory presentation on the features of collateralized mortgage obligations
(CMOs). Which of the following features from the presentation are incorrect?
B. The cash flows of the CMOs are allocated to a number of different tranches.
C. Each tranche has an equal claim against the cash flows of the mortgage pools.
D. Each tranche of CMO has different extension risks and contraction risks.
The claim that each tranche has an equal claim against the cash flows of the mortgage pools is
incorrect. In reality, each tranche of a CMO has a different claim on the cash flows of the
mortgage pools. This is because tranches are structured in a way that allows for different levels
of risk and return. The structuring of tranches is done in such a way that some tranches receive
the principal payments before others. This is done to attract a wide range of investors with
different risk appetites. The tranches that receive the principal payments first are considered to
be less risky, while those that receive them later are considered to be more risky. Therefore, the
claim that each tranche has an equal claim against the cash flows of the mortgage pools is
incorrect.
Choice A is incorrect. Collateralized mortgage obligations (CMOs) are indeed securities issued
against mortgage pools. This is a fundamental characteristic of CMOs, and Adam and Jack have
Choice B is incorrect. The cash flows of the CMOs are allocated to a number of different
tranches. This allocation process is known as "tranching," which allows for the creation of
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securities with different risk profiles from the underlying mortgages. Therefore, this statement
Choice D is incorrect. Each tranche of a CMO does indeed have different extension risks and
contraction risks due to varying structures, maturities, and prepayment characteristics among
tranches within a single CMO issue. Thus, Adam and Jack's explanation on this aspect was
accurate.
Q.935 The Planned Amortization Class (PAC) is the most common and most widely traded
tranche of collateralized mortgage obligations (CMOs). Which of the following features is the
most inconsistent feature of a PAC tranche?
I. The amortization of a PAC tranche is based on the sinking fund schedule that must prepay the
tranche within initial PAC collars
II. A PAC tranche is available with a support tranche, which is created from the original
mortgage pool
III. If prepayment rates are higher than the upper repayment rate of PAC collars, then the
support tranche absorbs the excess principal, and the PAC tranche receives the scheduled
principal
A. Feature I is inconsistent.
B. Feature II is inconsistent.
None of the features are inconsistent. The Planned Amortization Class (PAC) tranche is a
characterized by certain features that define its structure and functioning. The principal
repayment of the PAC is based on a sinking fund amortization schedule, which comes along with
the initial PAC collars that set the prepayment rates. Every PAC tranche comes with a support
tranche which absorbs the excess principal if the actual prepayment rate of the principal is
greater than the defined prepayment rate of the PAC tranche collar and vice versa. Therefore,
none of the features listed in the question are inconsistent with the actual features of a PAC
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tranche.
Choice A is incorrect. The amortization of a PAC tranche is indeed based on the sinking fund
schedule that must prepay the tranche within initial PAC collars. This feature ensures that the
principal repayment of a PAC tranche is predictable and less sensitive to changes in prepayment
rates.
Choice B is incorrect. It's true that a PAC tranche comes with a support tranche, which is
created from the original mortgage pool. The support tranches are designed to absorb any
variability in prepayments, thereby protecting the PAC tranches from prepayment risk.
Choice C is incorrect. If prepayment rates are higher than the upper repayment rate of PAC
collars, then it's correct that the support tranche absorbs excess principal and the PAC tranche
receives only its scheduled principal amount. This mechanism helps maintain stability in cash
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Q.936 GrossHaus Investment Bank is one of the largest German investment banks that has more
than 38% market share in financing residential and commercial properties. GrossHaus is not
only involved in the mortgage business, but it also issues securities to its investors against
mortgage pools. Robin Frazer has recently purchased a security from a bank that gives him a
claim to the principal portion of a mortgage payment on a mortgage pool. Which of the following
securities has Frazer has purchased from the bank?
C. A strip.
A strip is a type of security that allows an investor to separately purchase the principal portion
and interest portion of the mortgage payments on a mortgage pool. In the context of the
question, Robin Frazer has purchased a principal-only strip (PO) from GrossHaus Investment
Bank. These PO strips are typically sold at a discount and increase in size over time as the
principal component of the mortgage grows. This is in contrast to interest-only (IO) strips, which
decrease in size over time as the principal due on the mortgage decreases. Therefore, the
security that Frazer has purchased is a strip, making choice C the correct answer.
security that is designed to protect investors from prepayment risk. It does not entitle the
investor to the principal portion of a mortgage payment on a mortgage pool, but rather provides
pools together mortgages and then issues tranches to investors based on the risk profile and
cash flow needs. While it does involve mortgages, it doesn't specifically entitle an investor to the
mortgage loans made by financial institutions. It does not specifically provide entitlement to the
principal portion alone as it includes both principal and interest payments from homeowners.
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Q.937 Since the mortgage borrowers have the option to prepay the underlying securities at any
time, the valuation of the mortgage securities with this embedded options is not possible with
the traditional valuation model. One of the mortgage securities valuation model uses probability
distributions to value securities. In other words, it values the securities by allocating different
probabilities to the multiple variables like future interest rate, shape of the yield curve, default
rate, prepayment rate, etc. Which of the following models uses this approach?
D. Black-Scholes Model.
The Monte Carlo simulation is a computational algorithm that relies on repeated random
sampling to obtain numerical results. In the context of mortgage-backed securities (MBS), the
Monte Carlo simulation is used to value these complex financial instruments. The model does
this by assigning different probabilities to various factors that can affect the value of the MBS.
These factors include future interest rates, the shape of the yield curve, default rates,
prepayment rates, recovery rates, and interest rate volatility. By considering these variables and
their associated probabilities, the Monte Carlo simulation generates a range of possible
outcomes. The average of these outcomes is then taken as the estimated value of the MBS. This
approach allows for a more nuanced and accurate valuation of MBS, taking into account the
embedded prepayment option and the various factors that can influence the value of these
securities.
Choice A is incorrect. The Binomial model approach is a method used for the valuation of
options and other financial instruments. It constructs a recombining binomial lattice (tree) for
the short rate, from which one can calculate the price of fixed income securities. However, it
does not assign probabilities to various factors such as future interest rates, yield curve shape,
default rates, prepayment rates etc., which are crucial in valuing mortgage-backed securities.
Choice B is incorrect. The Best guess approach relies on subjective judgment rather than
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probabilistic modeling to estimate values and risks associated with financial instruments. This
approach lacks the systematic and comprehensive analysis provided by probabilistic models like
Choice D is incorrect. The Black-Scholes Model is used primarily for pricing European options
and does not incorporate multiple risk factors or their probabilities as required in MBS valuation.
It assumes markets are efficient with no transaction costs or taxes; these assumptions may not
A. I
B. I, II & III
Mortgage-Backed Securities (MBS) are exposed to all four types of risks mentioned: Interest rate
Interest rate risk is the risk that the value of the MBS will decrease due to changes in interest
rates. When interest rates rise, the value of the MBS falls because the fixed interest payments of
Pre-payment risk is the risk that the mortgage borrower will prepay the mortgage in part or in
full ahead of schedule, usually in a declining interest rate environment. This can lead to
reinvestment risk for the MBS investor as they may have to reinvest the proceeds at a lower
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interest rate.
Default risk is the risk that the mortgage borrower will be unable to make the required payments
on their mortgage. This could lead to a loss for the MBS investor if the default is not covered by
mortgage insurance.
Credit risk is the risk that the borrower will default on their mortgage payments due to financial
distress. This risk is usually mitigated by credit enhancement techniques such as over-
Choice A is incorrect. It suggests that investors in Mortgage-Backed Securities (MBS) are only
exposed to Interest rate risk. While interest rate risk is indeed a significant factor, it's not the
only one. Investors also face pre-payment risk, default risk, and credit risk.
Choice B is incorrect. This option includes Interest rate risk, Pre-payment risk and Default
Risk but omits Credit Risk which is an important aspect of MBS investments. The
creditworthiness of the borrowers whose mortgages back the security can significantly impact its
value.
Choice D is incorrect. This choice excludes Interest Rate Risk which plays a crucial role in
MBS investments as changes in interest rates can affect both the yield on these securities and
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Q.3456 Suppose that an investor owns a pass-through security with an initial principal of $500
million. The remaining mortgage balance at the beginning of a certain month is $400 million.
Assuming that the SMM is 0.4125% and the scheduled principal payment is $5 million, the
estimated prepayment for the month is:
A. $1.65 million
B. $1.25 million
C. $2.04 million
D. $1.63 million
Note: We only take into account the remaining mortgage balance, not the initial amount of
principal.
Q.3457 A fund holds $10 million nominal of the GNMA 5.5% 30-year bond. It enters into a one-
month dollar roll with a repo dealer bank in which it sells the security at a price of 100-08 and
buys it back at a forward price of par. Assuming that the security experiences a 2% paydown
(scheduled principal plus prepayments) during the term of the trade, estimate the value of the
drop.
A. $225,000
B. $22,500,000
C. $800,000
D. $250,000
Drop is the price difference between the front month, i.e., month of sale, and the back month,
i.e., the month of purchase.
The bonds are sold for 100-08, hence proceeds = $10m(100 + 8/32)/100 = $10 , 025, 000
Purchasing the security at par in the back month, bearing in mind that the security has
experienced a 2% paydown, will cost:
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Q.3458 Consider a pool of mortgages that were issued exactly 16 months ago at an effective
interest rate of 6% p.a(they are beginning the 17th month). What is the CPR, and what is the
SMM assuming 150 PSA?
150 PSA implies that CPR (at the beginning of month 17) = 1.5 × 3.2% = 4.8%
Note: The Public Securities Association model prepayment benchmark is one of the models used
to estimate the monthly rate of prepayment. It is based on the assumption that rather than
remaining constant, the monthly repayment rate gradually increases as a mortgage pool ages.
The model assumes that:
(I) CPR = 0.2% for the first month after origination, increasing by 0.2% every month up to 30
months
(II) CPR = 6% for months 30 to 360
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Q.3459 TBA prices of the Freddie Mac 5% for June 10 and July settlements are $104.20 and
$103.00, respectively. The accrued interest to be added to each of these prices is $0.160. The
expected total principal paydown (scheduled principal plus prepayments) is 2% of the
outstanding balance and the prevailing short-term rate is 1.5%. Also, assume that the actual/360-
day convention is applied. An investor wishes to roll a balance of $10 million. Determine the
value of the role.
A. $436,000
B. $13,045
C. $109,680
D. $97,698
Proceeds from selling the June 10 TBA are: $10m × (104.20 + 0.160)/100 = $10 , 436, 000
Investing these proceeds to July 10 at 1.5% interest earns interest of:
$10 , 436, 000 × 30/360 × 1.5% = $13 , 045
Purchasing the July 10 TBA, which has experienced a 2% paydown, will cost:
$10m × (1– 2%) × (103.0 + 0.160)/100 = $10 , 109, 680
Net proceeds from the roll therefore are: $10 , 436, 000 + $13 , 045 − $10, 109, 680 = $339 , 365
If the investor does not roll, the net proceeds are the coupon plus principal paydown:
$10m × (5%/12 + 2%) = $241, 667
Value of the roll = net proceeds from the roll – net proceeds without roll: =
$339, 365 − $241, 667 = $97, 698
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A. 4.5%
B. 5.1%
C. 4.9%
D. 4.0%
The weighted average coupon (WAC) is the weighted-average interest rate of mortgages that
underlie a mortgage-backed security (MBS) at the time the securities were issued. It represents
the average interest rate of a pool of mortgages with varying interest rates.
Total value of portfolio = $140,000 + $100,000 + $50,000 + $60,000 = $350,000
The percentage values of each mortgage are then multiplied by their respective interest rates:
40% * 5% = 2%
28.6% * 4% = 1.1%
14.3% * 6% = 0.9%
17.1% * 3% = 0.5%
The resulting figures are then totaled to produce a WAC of approx. 4.5%.
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Mortgage 3: $50,000 in current value, 4% interest rate, 3 years remaining duration
A. 4.4
B. 5.1
C. 4.9
D. 4.0
Weighted average maturity (WAM) is the weighted average amount of time until the maturities
on mortgages in an MBS.
Total value of portfolio = $150,000 + $100,000 + $50,000 + $80,000 = $380,000
The percentage values of each mortgage are then multiplied by the remaining duration until
maturity:
The resulting figures are then totaled to produce a WAM of approx. 4.4 years
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Q.3462 A mortgage-backed security has the amortization schedule:
Given that the conditional prepayment rate (CPR) is 4%, determine the anticipated prepayment
for month 2 in dollars.
A. $831.40
B. $825.75
C. $834.55
D. $840.20
Month i)
Where SMM is the single monthly mortality rate, i.e., CPR expressed monthly
1 1
SMM = 1 − (1 − CP R) 12 = 1 − (1 − 0.04) 12 = 0.3396%
Note:
(I) CPR is always expressed as a percentage, compounded annually.
(II) The beginning balance in the second month is also the ending balance in month 1, i.e.,
$247,409.04. In the same vein, $244,818.08 is the ending balance in month 2 (or the beginning
balance in month 3).
Note also that
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Annual rate of interest: 5.5% (fixed)
Term: 10 years
If payments are made monthly, what is the amortized amount for the 10-year loan?
A. $5,520.00
B. $5,426.21
C. $5,225.50
D. 4,834.55
A fixed-rate mortgage is a mortgage loan that has a fixed interest rate for the entire term of the
loan. Equal payments are made over the life of the mortgage.
Principal
PMT =
−n
1−(1+r)
( )
r
Where:
P MT = amortized amount for each month
500, 000
P MT = = $5, 426.21
1−(1+0.004583) −120
( )
0.004583
On a financial calculator,
n = 120;
I /Y = 0.4583 (5.5/12);
P V = -500,000;
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F V = 0;
CP T ⇒ PMT = $5,426.21
Q.3464 A 30-year $150,000 mortgage has a fixed mortgage rate of 6 percent compounded
monthly. What portion of the first payment is the principal?
A. $150
B. $149.33
C. $500
D. $750
A fixed-rate mortgage is a mortgage loan that has a fixed interest rate for the entire term of the
loan. Equal payments are made over the life of the mortgage.
Principal
PMT =
−n
1−(1+r)
( )
r
Where:
P MT = amortized amount for each month
150, 000
P MT = = $899.33
1−(1+0.005) −360
( )
0.005
On a financial calculator,
N = 360;
I /Y = 0.5 % (6/12%);
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P V = -150,000;
F V = 0;
CP T ⇒ PMT = $899.33
The interest portion for a month is equal to the mortgage balance at the beginning of the month
($150,000 in this case) multiplied by the interest rate per month.
The remaining portion of the payment, $899.33 - $750 = $149.33, goes to reduce the principal
balance.
Q.3465 Consider a 15-year $500,000 mortgage with a 6 percent interest rate. After 10 years, the
borrower (the mortgage issuer) pays off the outstanding principal. How much will the lender
receive?
A. $180,000
B. $220,000
C. $6,313
D. $218,245
Principal
PMT =
−n
1−(1+r )
( )
r
Where:
PMT = amortized amount for each month
500, 000
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500, 000
PMT = = $4, 219.28
1−(1+0.005) −180
( )
0.005
On a financial calculator,
n = 180;
I/Y = 0.5 (6/12); (when using the financial calculator, we input the rates in percentage form. In
this case, 0.005 =0.5%)
PV = -500,000;
FV = 0;
From this point, there are two ways to go: First. We could construct an amortization table for the
mortgage, but this would consume a lot of time. But there’s a simpler approach. After 10 years,
we can treat this mortgage as though it were a 5-year mortgage with payments of $4,219.28 and
an interest rate of 6 percent. We can then solve for the outstanding principal balance using the
same formula.
Outstanding Principal
4 , 219.28 =
1−(1+0.005) −60
( )
0.005
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Q.3466 Which of the following statements about fixed-rate mortgages is false, from the investor's
perspective?
B. Scheduled monthly payments are constant over the life of the mortgage
C. Actual monthly payments may vary over the life of the mortgage
D. Absent of defaults, the actual monthly payments are never higher than scheduled
monthly payments
The statement that 'Absent of defaults, the actual monthly payments are never higher than
scheduled monthly payments' is false. This is because prepayments can occur, which are
Prepayments can speed up principal repayments and reduce the amount of interest paid over the
life of the mortgage. This can adversely affect the amount and timing of cash flows from the
payments can indeed be higher than the scheduled monthly payments, even in the absence of
defaults.
Choice A is incorrect. The statement that 30-year mortgages have lower monthly payments
than 15-year mortgages is true. This is because the principal amount of the loan is spread over a
Choice B is incorrect. The statement that scheduled monthly payments are constant over the
life of the mortgage is also true for fixed-rate mortgages. Since the interest rate does not
Choice C is incorrect. The assertion that actual monthly payments may vary over the life of a
mortgage can be true in certain circumstances such as when there are changes to insurance or
taxes which are often escrowed into mortgage payment, but this does not relate directly to
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Q.3467 Consider a 15-year $500,000 mortgage with a rate of 6 percent. Ten years into the
mortgage, rates have fallen to 5 percent. What would be the monthly saving to a homeowner
from refinancing the outstanding mortgage balance at the lower rate? (Round your answer to the
nearest unit.)
A. $265
B. $101
C. $0
D. $111
Principal
PMT =
1−(1+r )−n
( )
r
Where:
500, 000
PMT = = $4, 219.28
1−(1+0.005) −180
( )
0.005
On a financial calculator,
n = 180;
P V = -500,000;
F V = 0;
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CPT ⇒ PMT = $4,219.28
From this point, there are two ways to go: First. We could construct an amortization table for the
mortgage, but this would consume a lot of time. But there’s a simpler approach. After 10 years,
we can treat this mortgage as though it were a 5-year mortgage with payments of $4,219.28 and
an interest rate of 6 percent. We can then solve for the mortgage balance using the same
formula.
Principal
4 , 219.28 =
1−(1+0.005) −60
( )
0.005
For comparability, we calculate the new payments assuming a loan of $218,245, a 5-year life, and
a rate of 5 percent.
218, 245
PMT = = $4, 118.59
1−(1+0.004167)−60
( )
0.004167
Note: it would be misleading to compare the payments on the old loan to a new, 15-year loan.
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Q.3585 The Public Securities Association (PSA) prepayment benchmark assumes that the
monthly prepayment rate for a mortgage pool:
A. remains constant for the first 30 months and then increases by 0.2% for months 30 to
360
D. remains constant for the first 30 months and then decreases by 0.2% for months 30 to
360
The Public Securities Association (PSA) prepayment benchmark assumes that the monthly
prepayment rate for a mortgage pool increases as it ages (becomes seasoned). The PSA is
expressed as a monthly series of Conditional Prepayment Rates (CPRs). The model assumes that:
CPR = 0.2% for the first month after origination, increasing by 0.2% every month up to
30 months; and
A mortgage pool whose prepayment speed (experience) is in line with the assumptions of the
PSA model is said to be 100% PSA. Similarly, a pool whose prepayment experience is two times
the CPR under the PSA model is said to be 200% PSA (or 200 PSA).
Choice A is incorrect. The PSA prepayment benchmark does not assume that the monthly
prepayment rate remains constant for the first 30 months and then increases by 0.2% for months
30 to 360. Instead, it assumes that the rate increases by 0.2% every month up to the first 30
months.
Choice C is incorrect. The PSA model does not assume a decrease in the monthly prepayment
rate over time, but rather an increase of 0.2% each month until it reaches a certain point (usually
Choice D is incorrect. Similar to choice A, this option incorrectly assumes that the monthly
prepayment rate remains constant for an initial period and then decreases afterwards, which
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Q.3586 During periods of falling interest rates, the refinancing of mortgage loans will:
D. Decelerate prepayments, but and decreases the average life of the MBS
During periods of falling interest rates, homeowners are more likely to refinance their mortgage
loans. Refinancing allows homeowners to replace their existing mortgage with a new one that
has a lower interest rate. This process accelerates prepayments because homeowners are paying
off their old mortgage faster than originally planned. Prepayments are the early return of
principal on a mortgage security. When prepayments accelerate, the average life of the
mortgage-backed security (MBS) reduces. The average life of an MBS is the weighted-average
time to the return of a dollar of principal, measured in years. When homeowners prepay their
mortgages, the principal is returned sooner, reducing the average life of the MBS.
Choice B is incorrect. Falling interest rates typically encourage borrowers to refinance their
mortgage loans, which accelerates prepayments. This in turn reduces the average life of the
Choice C is incorrect. While it's true that falling interest rates accelerate prepayments due to
increased refinancing activity, this actually reduces the average life of the MBS rather than
increasing it. The faster prepayment speed means that investors receive their principal back
sooner than expected, thus shortening the average life of the security.
Choice D is incorrect. This choice incorrectly suggests that falling interest rates decelerate
prepayments and decrease the average life of MBS. In reality, lower interest rates lead to an
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Q.3587 Which of the following are considered as weights while determining the weighted
average maturity of a mortgage pass-through security?
assigning weights to the remaining life of each mortgage in the pool. The weight assigned to
each mortgage, denoted as wi , is determined by the ratio of the remaining principal of the ith
mortgage (P i) to the total remaining principal of all mortgages in the pool. This is mathematically
represented as: w i = P i / ∑ni=1 P i. This method of weighting ensures that mortgages with larger
remaining principals have a greater impact on the WAM, reflecting the fact that these mortgages
will take longer to be fully repaid and thus have a greater effect on the average maturity of the
security.
Choice A is incorrect. The time to maturity as a percentage of the total life of the security is
not used as weights in calculating WAM. Instead, it's the remaining principal balance of each
Choice C is incorrect. The absolute value of coupon payments due does not serve as weights
for calculating WAM. This would be more relevant in determining cash flows rather than the
Choice D is incorrect. While the remaining number of months to maturity for each mortgage
loan does play a role in determining WAM, it's not used as weights in its calculation. Rather,
these are multiplied by their respective weights (i.e., remaining principal balances) to arrive at
WAM.
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Reading 45: Interest Rate Futures
Q.685 Tony Ingram is a junior portfolio analyst at BBV Pension Fund Inc. The pension fund
invests in assets such as Treasury bonds, municipal bonds, and other less risky assets. BBV’s
portfolio contains a Treasury bond of the U.S. government that pays semiannual interest of 7%
on January 1st and July 1st. If Ingram wants to calculate the interest earned on the Treasury
bond between July 1st and October 11th, 2021, then which of the following day count convention
is most suitable?
The most suitable day count convention for calculating the interest earned on a Treasury bond
between July 1st and October 11th is 102 days / 181 days. This is because the actual number of
days between July 1st and October 11th is 102 days, and the actual number of days between the
semiannual interest payment dates (July 1st and January 1st) is 181 days. The day count
convention is a method used in finance to calculate the amount of accrued interest or the present
value when the next payment is due. When dealing with Treasury bonds, the actual/actual day
count convention is used, which takes into account the actual number of days in the accrual and
Choice A is incorrect. The numerator of 100 days is not accurate as it does not correctly
represent the number of days from July 1st to October 11th. The correct number of days should
be 102.
Choice B is incorrect. While the denominator correctly uses a day count convention of 180
days, which is common for Treasury bonds, the numerator again incorrectly states that there are
only 100 days between July 1st and October 11th when there are actually 102.
Choice C is incorrect. Although this choice correctly identifies that there are indeed 102 days
between July and October, it incorrectly uses a day count convention of only 180 in the
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denominator. For U.S Treasury bonds, a semiannual basis (two periods per year) should be used
which means we need to consider actual/actual day count convention i.e., actual number of
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Q.686 An investment manager at Galaxy Investments Co. is analyzing the interest earned on the
corporate bond of Aero Supermarts, a chain of grocery stores. The bond pays semiannual
interest of 13% on March 1st and September 1st. Using the appropriate day count convention,
determine the interest earned on the bond between September 1st and February 12th.
A. 6.5%
B. 5.92%
C. 5.81%
D. 5.87%
For measuring the interest earned on municipal bonds and corporate bonds, we use the 30 days
Days between September 1st and February 12th (30 days convention) = 161 days
Days between September 1st and March 1st (30 days convention) = 180 days
161
6.5% ∗ = 5.81%
180
To measure the interest earned/accrued on Treasury bonds, we use the actual number of days
between the dates/actual number of days between reference periods. For measuring interests
earned on money market instruments, we use the actual days divided by 360 days per year
convention and, in some countries, 365 days per year is also used.
In all-day count conventions, the last day is always excluded. In this case, we are interested in
Therefore, we will assume that the months of Sept, Oct, Nov, Dec, and Jan have 30 days each and
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Q.687 Fahim Zakaria, a fund manager based in Qatar, manages a sovereign fund for the Qatari
government. The fund has more than $12.6 billion in assets under management. The fund invests
only in the shares of blue-chip firms and the sovereign bonds/bills of different countries. If the
manager wants to include a 164-days U.S. Treasury bill which is quoted as 9, then what is the
cash price of the bill?
A. $96
B. $95.9
C. $93.7
D. $91
The cash price of the bill can be calculated with the following formula:
Note that,
360
Q= (100 − C)
n
n
C = 100 − Q
360
n
So, following the last formula, Discount = Q
360
Where
C=Cash price
Q= Quoted price
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Q.688 Silvia Hank is the head of the fixed-income investment unit of a large investment bank in
Malaysia. The human resources department has recently hired a junior analyst under
supervision. The junior analyst has no experience in the investment industry, but he is a skilled
statistician, which can be useful for conducting quantitative research. Hank instructed the
analyst to calculate the cash prices of Treasury bills based on their quoted prices. However, she
believes that the cash price and the quoted price that the junior analyst provided may be
incorrect. Which of the following prices and quotes is/are incorrect?
I. The price of the 136-day Treasury bill which is quoted as 8 is $98
II. The price of a 90-day Treasury bill which is quoted as 13 is $96.75
C. The price of both the 136-day and the 90-day Treasury bills are incorrectly calculated
D. The price of both the 136-day and the 90-day Treasury bills are correctly calculated
The price of 136-day Treasury bills is incorrectly calculated. The following is the formula used to
calculate the cash price of Treasury bills:
The relationship between cash prices and quoted prices can be verified through the following
formula:
360
Quoted Price = (100 − Cash price)
no. of days to maturity
360
= (100 − 96.97)
136
=8
Q.689 Lucy Anderson is working for one of Canada’s largest investment banks, where she is
responsible for the training of a new batch of fixed-income investment analysts. During the
training session on the subject of Treasury bills and Treasury bonds, she made the following two
statements regarding the price of Treasury bonds:
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I. The clean price of the bond includes the quoted price plus the accrued interest on that bond,
which is why sellers of the bond prefer clean price quotes.
II. The dirty price of the bond is equal to the clean price minus accrued interests. The dirty price
is also considered as equal to the quoted price. Since it doesn’t pay accrued interest to the seller
of the bond, it is regarded as a dirty price.
Which of Anderson’s statements is/are inconsistent with the definition of clean price and dirty
price?
Both the definitions of clean and dirty prices provided by Lucy Anderson are incorrect. The clean
price of a Treasury bond is the quoted price, not the sum of the quoted price and the accrued
interest. It can also be calculated as the dirty price minus the accrued interest since the last
coupon date. On the other hand, the dirty price of a Treasury bond is the sum of the quoted price
and the accrued interest, not the clean price minus the accrued interest. The dirty price is the
total amount that a buyer pays to the seller, including the price of the bond and the interest that
has accrued since the last coupon payment. Therefore, both statements made by Anderson are
inconsistent with the standard definitions of clean and dirty prices in the context of Treasury
bonds.
Choice A is incorrect. The definition of the clean price is indeed incorrect, but this choice does
not account for the fact that the definition of dirty price is also incorrect. The clean price of a
bond does not include accrued interest; it refers to the price of a bond excluding any interest
Choice B is incorrect. While it's true that Anderson's definition of dirty price is wrong, this
option doesn't acknowledge her erroneous explanation about clean prices. Dirty prices do
Choice D is incorrect. Both definitions provided by Anderson are inconsistent with standard
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definitions in finance literature and practice. Therefore, it cannot be said that none of the
Q.690 An analyst wishes to estimate the dirty price of a $100,000 face value Treasury bond with
an annual coupon of 8% paid semiannually on December 10th and on June 10th. The bond was
purchased on April 8, 2017, when the quoted price was 93-8. If the Treasury bond's maturity
date is December 10th, 2020, what is the bond’s dirty price?
A. $93,250
B. $94,865
C. $95,125
D. $95,865
We will calculate the dirty price of the bond using the following steps:
Let’s assume the face value of the bond is $100, and an 8% coupon bond will pay $4 on June 10th
and December 10th.
Since the bond was purchased on April 8th, 2017, the last coupon was paid on December 10th,
2016.
The number of actual days from December 10th to April 8th is 119 days.
The number of actual days between December 10th and June 10th is 182 days.
The quoted price of 93-8 is equal to $93+8/32, as the Treasury bond prices are quoted in dollars
and thirty-seconds of a dollar.
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Q.691 Futures contracts on Treasury bonds are well-known investment instruments for large
investment banks and sovereign funds. Such futures include a large variety of Treasury bonds
with maturities ranging from 15 to 25 years. Since the deliverable bonds under the futures
contracts have different market values, the exchanges have taken a measure for adjusting the
price received by the short position holder in the futures contracts according to the specific
Treasury bond or note delivered.
Which of the following is that measure?
A. Dirty price
B. Convexity adjustment
C. Conversion factor
D. Clean price
The measure that exchanges have implemented to adjust the prices of Treasury bond futures is
the conversion factor. This factor is used to calculate the price received by the short party of the
bond. The quote price applicable for the bond delivered is the product of the conversion factor
and the futures contract's most recent settlement price. The formula to calculate the cash
received by the short party is: (Most recent settlement price * Conversion factor) + Accrued
interest. This ensures that the short party receives a fair price for the bond, regardless of its
market value.
Choice A is incorrect. The dirty price of a bond includes the accrued interest in addition to its
market price. It does not adjust the price received by the holder of the short position in futures
Choice B is incorrect. Convexity adjustment refers to a correction made to account for changes
in interest rates and their impact on bonds with different durations and maturities. While it's an
important concept in fixed income securities, it doesn't directly relate to adjusting prices for
Choice D is incorrect. The clean price of a bond excludes any accrued interest, representing
only its market value. Similar to dirty price, it does not serve as a measure for adjusting prices
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Q.692 Amy Jackson, a fixed investment manager at Flaxes Investment Company headquartered
in Toronto, has a short position in 15-year Treasury bond contracts with a $100,000 face value
for each contract. The last quoted price of the contract is 91-28, while the accrued interest on
the bond is $3.29 (for $100 face value). If the conversion factor for the deliverable bond under
the contract is 1.471, then which of the following is true?
Cash received by the short-position party = (Most recent settlement price ∗ Conversion factor) + Accrued inte
28
= (91 + ) ∗ 1.471 + $3.29 = $138, 438
32
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Q.693 An investor with a short position is about to deliver a bond and has four bonds to choose
from which as listed in the following table. The last settlement price (quoted futures price) is
$96.25. Determine which bond is the cheapest-to-deliver.
A. Bond 1
B. Bond 2
C. Bond 3
D. Bond 4
Where:
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Bond 1 is the cheapest to deliver with a cost of delivery of $0.83.
Q.694 Matias Agrov runs an independent investment advisory and investment education services
business in Moscow. His investment advisory services are focused on fixed-income investments
and interest rate futures, which he renders to high net worth individuals and small corporations.
He also conducts weekly free webinars to educate beginner investors on interest rates futures
and derivatives. In one of his weekly webinars, he made the following statements in order to get
rid of any confusion about prices of Treasury bond derivatives:
I. The cash price of a Treasury bond is also the dirty price of the same bond
II. The quoted price of a Treasury bond is also the clean price of the same bond
Both statements are correct. The cash price of a Treasury bond is also the dirty price of the same
Treasury bond, and the quoted price of a Treasury bond is also the clean price of the same bond.
Q.695 Since there is a large universe of Treasury bonds and futures contracts on those bonds,
there is a large number of Treasury bonds available to be delivered at any point in a month.
However, due to the imperfection of conversion factors used by exchanges, at times it is cheaper
to deliver one bond as compared to another bond. Which of the following options truly defines
the cheapest-to-deliver option?
A. The cheapest-to-deliver option allows the long position holder of the futures contract
on a Treasury bond to choose which is the cheapest bond to receive.
B. The cheapest-to-deliver option allows the long position holder of the futures contract
on a Treasury bond to choose which is the cheapest bond to deliver.
C. The cheapest-to-deliver option allows the short position holder of the futures contract
on a Treasury bond to choose which is the cheapest bond to receive.
D. The cheapest-to-deliver option allows the short position holder of the futures contract
on a Treasury bond to choose which is the cheapest bond to deliver.
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The correct answer is D.
The cheapest-to-deliver option allows the short position holder of the futures contract on a
Treasury bond to choose which is the cheapest bond to deliver. In futures contracts, the party
holding the short position is obligated to deliver the underlying asset, in this case, a Treasury
bond, at the contract's expiration. The 'cheapest-to-deliver' option refers to the most cost-
effective bond that the short position holder can deliver to fulfill their obligation under the
contract. This is primarily due to the imperfect nature of conversion factors used by exchanges,
which can sometimes make it more economical to deliver one bond over another. Therefore, the
short position holder has the discretion to choose the bond that is cheapest for them to deliver,
Choice A is incorrect. The long position holder of the futures contract on a Treasury bond does
not have the option to choose which bond to receive. This choice lies with the short position
Choice B is incorrect. Again, it's a misunderstanding of roles in futures contracts. The long
position holder does not deliver bonds; they are on the receiving end of this transaction.
Choice C is incorrect. While it correctly identifies that the short position holder has an option,
it incorrectly states that they choose which bond to receive. In reality, they decide which bond to
Q.696 Henry Louis is a derivative investment manager at the Global First Investment Bank in
Singapore. He manages a portfolio of fixed income assets and interest rate futures. He currently
has a short position in a futures contract on GILTS (U.K. equivalent to U.S. Treasury securities).
As the delivery month is approaching, the manager has to choose the cheapest-to-deliver bond
from the four available bonds. If the last settlement price is 95-16, which of the following bond is
the cheapest to deliver?
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A. Bond A
B. Bond B
C. Bond C
D. Bond D
The cheapest-to-deliver bond among the four available bonds is Bond C. To find out cheapest-to-
deliver bond, we will use the following formula:
Cost of delivery = Quoted bond price − (Last settlement price ∗ Conversion factor)
Q.697 Paula Sigel is the head of the interest rate futures unit of Thomson Investment Company.
Thomson has traditionally only invested in equities and currencies, but it has recently set up a
new division that only focuses on the investments in futures contracts on Treasury bonds. It has
come to Paulina’s attention that due to a lack of familiarity with derivatives trading, her team is
having difficulty determining the cheapest to deliver bonds. To overcome this difficulty, Sigel
came up with the following guidelines to better identify the cheapest-to-deliver bonds:
I. When the yield is greater than 6%, the cheapest-to-deliver bonds tend to be low-coupon with
shorter maturities
II. When the yield is less than 6%, the cheapest-to-deliver bonds tend to be high-coupon with
longer maturities
III. When the yield curve is upward sloping, the cheapest-to-deliver bonds tend to have shorter
maturities
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All three guidelines proposed by Paula Sigel are incorrect in the context of identifying the
I. When the yield is greater than 6%, the cheapest-to-deliver bonds tend to be low-coupon bonds
with longer maturities. This is because when yields are high, investors prefer bonds that pay less
interest over a longer period, as they can reinvest the proceeds at higher rates.
II. When the yield is less than 6%, the cheapest-to-deliver bonds tend to be high-coupon bonds
with shorter maturities. This is because when yields are low, investors prefer bonds that pay
more interest over a shorter period, as they can reinvest the proceeds at higher rates when they
become available.
III. When the yield curve is upward sloping, the cheapest-to-deliver bonds tend to have longer
maturities. This is because an upward-sloping yield curve indicates that long-term interest rates
are higher than short-term rates, making longer-maturity bonds more attractive to deliver.
IV. When the yield curve is downward sloping, the cheapest-to-deliver bonds tend to have shorter
maturities. This is because a downward-sloping yield curve indicates that short-term interest
rates are higher than long-term rates, making shorter-maturity bonds more attractive to deliver.
Choice A is incorrect. Statement III is indeed incorrect as it suggests that bonds with shorter
maturities tend to be the cheapest-to-deliver when the yield curve is upward sloping. However,
this isn't necessarily true as the cheapest-to-deliver bond depends on factors such as its price,
time to maturity, and coupon rate rather than just its maturity. But statement I and II are also
Choice B is incorrect. While it correctly identifies that statements I and II are incorrect, it fails
to recognize that statement III is also not accurate in identifying the cheapest-to-deliver bonds.
Choice C is incorrect. This option incorrectly assumes that statement I is correct while
statements II and III are not. In reality, all three statements proposed by Sigel are inaccurate in
Choice D (Statements I, II, and III are all incorrect) This option correctly identifies that all
three guidelines proposed by Sigel for identifying the cheapest-to-deliver bonds are inaccurate.
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Q.698 According to recent data, the most frequently traded futures contract in the United States
is the 3-month Eurodollar futures contract that is traded on the Chicago Mercantile Exchange
(CME). Which of the following is the appropriate and complete definition of a Eurodollar futures
contract?
C. It is the interest rate futures contract on Eurodollars or on the U.S. dollars deposited
outside of the U.S. The underlying interest rate of the contract is the 3-month U.S. risk-
free rate.
D. It is the interest rate futures contract on Eurodollars or on the U.S. dollars deposited
outside of U.S. The underlying interest rate of the contract is the 3-month forward
LIBOR.
A Eurodollar futures contract is an interest rate futures contract on Eurodollars, which are U.S.
dollars deposited outside of the U.S. The underlying interest rate of the contract is the 3-month
forward London Interbank Offered Rate (LIBOR). The face value of the contract is $1 million, and
the price change in the futures contract is a minimum of $25, which is equal to the change of one
tick or one basis point. This contract allows investors to hedge against interest rate risk, and its
popularity can be attributed to its high liquidity and the transparency of the LIBOR.
Choice A is incorrect. While it correctly identifies the Eurodollar futures contract as a foreign
currencies futures contract, it incorrectly states that the underlying interest rate of the contract
is the 3-month forward LIBOR. The Eurodollar futures contract is not based on euros/dollars but
Choice B is incorrect. This choice also misidentifies the Eurodollar futures contract as a
foreign currencies futures contract and further complicates this misunderstanding by adding
that both the 3-month forward LIBOR and 3-month U.S. risk-free rate are underlying interest
Choice C is incorrect. Although it correctly identifies that a Eurodollar futures contracts are
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based on U.S dollars deposited outside of U.S., it incorrectly states that its underlying interest
rate is the 3-month U.S risk-free rate when in fact, it's based on the 3-month forward LIBOR.
Q.699 Alina Escobar is a junior derivatives analyst at the derivatives investment unit of a
financial institution. The company holds a mid-day meeting where managers discuss investment
strategies according to recent trends in the market. Escobar’s manager asked her to estimate
the price of a March Eurodollar futures contract that is quoted as 94.25. Estimate the effective
dollar price that the firm will have to pay if the firm ultimately decides to invest in the March
Eurodollar futures contract.
A. $942,500
B. $985,625
C. $991,750
D. $1,050,870
The (%) price of EDF contacts is quoted as 100 - R, where R is the annualized LIBOR rate. This is
also known as the index price. For example, an EDF with a quoted price of 94.25 implies that R,
It follows that that to get the actual or effective dollar price of the contract given the index price,
So if the quoted (index) price is 94.25, here's how we get the effective price:
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Thus, effective price = 98.5625/100 * $1,000,000 = $985,625
Note: the quoted price is initially in percentages, but the effective price is in dollars.
Note also that, any Eurodollar futures contract consists of a eurodollar time deposit, whose
This information need not necessarily be provided in the question, so there is a need to
memorize this.
Q.700 Cristiano Christopher is a portfolio manager at Blue Waters Hedge Fund. During a
networking event held for all the junior and senior hedge fund and mutual funds manager,
Christopher argued with one of his colleagues that there are significant differences between
Eurodollar futures contracts and forward rate agreements (FRAs). Here are the two differences
that Christopher mentioned:
I. The Eurodollar futures contract is similar to a forward rate agreement (FRA). However,
Eurodollar futures contracts are settled daily whereas FRAs are not settled daily.
II. Eurodollar futures contracts are traded on major exchanges, while FRAs are OTC derivatives.
Nevertheless, his colleagues refuse to agree with him as they believed these differences are
incorrect. Determine which of his statement(s) is/are correct?
A. Statement I is correct.
B. Statement II is correct.
Statement I: Eurodollar futures contracts and forward rate agreements (FRAs) are similar in
many ways, but one key difference lies in their settlement process. Eurodollar futures contracts
are settled daily. This means that the gains or losses are calculated and paid out on a daily basis.
This daily settlement process, also known as 'marking to market', helps to reduce the credit risk
associated with these contracts. On the other hand, FRAs are not settled daily. Instead, they are
settled at the end of the contract period. The gains or losses are calculated based on the
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difference between the agreed-upon rate and the prevailing market rate at the end of the
contract period.
Statement II: Another significant difference between Eurodollar futures contracts and FRAs is
where they are traded. Eurodollar futures contracts are traded on major exchanges like the
Chicago Mercantile Exchange (CME). This provides transparency, liquidity, and standardization.
Conversely, FRAs are traded over-the-counter (OTC). OTC trading allows for more flexibility and
customization but comes with increased counterparty risk as these trades are not regulated by
an exchange.
Choice A is incorrect. While it is true that Eurodollar futures contracts are settled daily, this
statement alone does not fully capture the differences between these contracts and FRAs. The
which allows for greater liquidity and price transparency compared to OTC derivatives like FRAs.
However, this statement fails to acknowledge that FRAs also have a form of settlement process,
Choice B is incorrect. Although it's correct that Eurodollar futures contracts are traded on
major exchanges while FRAs are traded as over-the-counter (OTC) derivatives, this statement
alone doesn't provide a comprehensive understanding of the differences between these two
financial instruments. For instance, it doesn't mention other key distinctions such as the fact that
Eurodollar futures can be more easily standardized and commoditized due to their exchange-
traded nature compared to OTC derivatives like FRAs which tend to be more bespoke in nature.
Choice D is incorrect. As explained above both statements made by Christopher about the
differences between Eurodollar futures contracts and forward rate agreements (FRAs) are
correct.
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Q.701 As the Eurodollar futures contracts are marked to market on a daily basis, the Eurodollar
futures contract can result in differences between actual forward rates and those implied by
futures contracts. Generally, in the longer maturities Eurodollar futures contracts, the implied
forward rates (futures interest rates ) are greater than the actual forward rates. Which of the
following is useful in reducing the mentioned above difference between the implied forward
rates and the actual forward rates?
A. Convexity adjustment.
B. Conversion factor.
C. Duration adjustment.
D. Dirty price.
Convexity adjustment is a method used by analysts and managers to reduce the difference
between the implied forward rates by the futures and the actual forward rates. This discrepancy
arises due to the daily settlement feature of Eurodollar futures contracts. In contracts with
longer maturities, the implied forward rates are often greater than the actual forward rates. The
convexity adjustment method helps to reduce this difference, making it a useful tool in the
Choice B is incorrect. The conversion factor is a tool used in bond futures contracts to account
for differences in the characteristics of different bonds, such as coupon rates and time to
maturity. It does not have any direct relevance to the discrepancy between implied forward rates
adjust the sensitivity of their bond portfolios to changes in interest rates. While it can help
manage interest rate risk, it does not directly address the issue of discrepancies between implied
Choice D is incorrect. The dirty price of a bond includes accrued interest while clean price
excludes it. This concept applies primarily to bonds and has no direct impact on minimizing the
difference between implied forward rates and actual forward rates in Eurodollar futures
contracts.
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Q.702 Xiaoping Yu is an investment manager at Shanghai Derivatives Investors Lounge, an
investment company that solely invests in derivatives. At the beginning of the current fiscal year,
Yu and her team constructed a hedge with interest rates futures contracts by taking long
positions in futures contracts. Yu believes that the interest rates will start to increase in the
foreseeable future. Which of the following actions should Yu take in order to protect her
position?
A. As the prices of interest rate futures contract will increase, Yu should take a long
position in interest futures contracts.
B. As the prices of interest rate futures contract will decrease, Yu should take a long
position in interest futures contracts.
C. As the prices of interest rate futures contract will increase, Yu should take a short
position in interest futures contracts.
D. As the prices of interest rate futures contract will decrease, Yu should take a short
position in interest futures contracts.
As interest rates rise, the prices of interest rate futures contracts fall. This is due to the inverse
relationship between interest rates and the price of interest rate futures contracts. An investor
who has taken a long position in futures contracts stands to lose money if interest rates increase.
Therefore, to hedge their portfolio against this risk, an investor should take a short position in
interest rate futures contracts. This strategy allows the investor to profit from the falling prices
of the futures contracts, thereby offsetting the losses from their long position. This is a common
risk management strategy used in derivative trading to protect against adverse price
movements.
Choice A is incorrect. This choice suggests that Yu should take a long position in interest
futures contracts as the prices will increase. However, this is not correct because when interest
rates rise, the prices of interest rate futures contracts typically decrease. Therefore, taking a
Choice B is incorrect. While it correctly states that the prices of interest rate futures contract
will decrease with rising interest rates, it incorrectly suggests taking a long position in these
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contracts. A long position would mean buying more contracts expecting their price to increase
which contradicts with the given scenario where we expect prices to fall due to rising interest
rates.
Choice C is incorrect. This choice incorrectly assumes that the prices of interest rate futures
contract will increase when in fact they are expected to decrease with rising interest rates as per
our scenario. Hence, taking a short position based on this assumption would not be beneficial for
Yu.
Q.703 Anil Kumar has recently joined Axe Investment Bank as a junior analyst through a global
analyst recruitment program. In order to impress the management of the asset management unit
of the bank, Kumar decides to create a combined position in interest rate futures contracts that
does not change in value with small changes in yield. Which of the following can help him create
such a position?
A. Convexity-hedging.
B. Duration-based hedging.
D. DV01 hedging.
Duration-based hedging is a strategy that involves adjusting the duration of a portfolio to hedge
against interest rate risk. Duration is a measure of the sensitivity of the price of a bond or a bond
portfolio to a change in interest rates. In this context, Anil Kumar can use duration-based
hedging to create a combined position in interest rate futures contracts that does not change in
value with small changes in yield. This is achieved by creating a position that has zero duration.
When the position has zero duration, it means that the value of the position does not change due
to small changes in yield. This is exactly what Anil Kumar wants to achieve. Therefore, duration-
Choice A is incorrect. Convexity-hedging is a strategy that aims to protect against large yield
changes, not minor fluctuations. It involves managing the curvature of the price-yield
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relationship of a bond portfolio, which becomes significant when interest rates change
dramatically.
Choice C is incorrect. Hedging with FRAs (Forward Rate Agreements) primarily protects
against changes in short-term interest rates and does not necessarily remain unaffected by minor
yield fluctuations. FRAs are more suitable for hedging specific future interest rate exposures
Choice D is incorrect. DV01 hedging involves adjusting a portfolio to make its dollar value
change by one basis point for each basis point change in yield, which means it would be affected
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Q.704 Anil Kumar has recently joined Axe Investment Bank as a junior analyst through a global
analyst recruitment program. In order to impress the management of the asset management unit
of the bank, he decided to create a combined position in interest rate futures contracts that does
not change in value with small changes in yield. With the help of a duration-based hedging
strategy, he created a combined position of a portfolio and interest rate futures contracts that
has zero duration, which means the value of the position will not change with the small changes
in yield. However, his manager did not like the idea of using duration-based hedging or duration
as a single risk measurement tool because of its limitation. His manager mentioned the following
limitations of duration:
I. Since duration only measures the linear approximation of the relationship between two
variables, it is inappropriate to use duration since the price/yield relationship of a bond is
convex.
II. Duration implies that the yields are non-correlated. However, in the long run, when the
changes in interest rates are non-parallel or non-correlated, the use of duration is limited.
Only the first limitation is accurately defined. The use of duration as a single risk measure tool is
limited because duration only measures the linear approximation of the relationship between two
variables. Therefore, it is inappropriate to use duration since the price/yield relationship of a
bond is convex.
Limitation II is incorrect because the duration implies that the yields are correlated, not non-
correlated. Thus, in the long run, when the changes in interest rates are non-parallel or non-
correlated, the use of duration is limited.
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Q.3555 A 3.125% government bond is priced for settlement on April 12, 2016. The bond makes
quarterly coupon payments on June 30th, September 30th, December 31st, and March 31st.
What is the bond's accrued interest per 100 of par value?
A. 0.672
B. 0.1030
C. 0.4121
D. 0.1713
Government/Treasury bonds make use of the actual/actual day count convention. In other words,
we compare the actual number of days that have elapsed since the last coupon payment date and
the actual number of days between the coupon dates.
Here, the coupon dates of interest are 31 March and 30th June; we have 91 days (30 days on
April, 31 in May, and 30 in June)
The number of days that have elapsed since 31st March is 12.
Thus, the accrued interest = 12/91 * 3.125/4 = 0.1030%
Per $100 face value, that's $0.1030
Note: 3.125% is an annual rate, that's why we have to divide by 4 to get the quarterly (3-month)
rate
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Q.4916 Suppose that the continuously compounded forward rate for the period between year 2
and year 4 is 2.5%. Suppose further that the continuously compounded interest rate of the two-
year zero-coupon is 5.5%. What is the continuously compounded 4-year zero-coupon interest
rate?
A. 8%
B. 4%
C. 2.625%
D. 3.375%
The 4-year zero-coupon interest rate is calculated by making R2 the subject of the formula in the
F (T 2 − T1 ) + R1 T 1
R2 =
T2
0.025 (4 − 2) + 0.055 × 2
= = 0.04 = 4%
4
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Q.4918 Suppose a firm has a $20,000,000 portfolio of Treasury bonds with a portfolio duration of
5. Suppose further that the cheapest to deliver bond has a duration of 3 and that the six-month
treasury bond futures price is $200,000. What is the number of futures contracts to fully hedge
the portfolio?
P × DP
N =−
F C × DF
Where:
Thus,
$20,000, 000 × 5
N= = −166.6667 ≈ −166
$200, 000 × 3
The negative sign implies that the number of contracts taken up must be the opposite of the
original position. If the investor is short a portfolio, for example, they must long N contracts to
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Q.4919 A Treasury bond pays coupons at the rate of 12% per year on March 1 and September 1.
What is the accrued interest between March 1 and April 30 per USD 100 of face value?
A. 1.9891
B. 0.9783
C. 1.9565
D. 0.9946
12% coupon rate per year implies a coupon of $6 on each of these dates. If we want to compute
the accrued interest as of April 30, we will have to determine the actual number of days between
April 30 and the last coupon date, i.e., March 1. We have 60 days (= 30 + 30, in March and April,
respectively).
Thus,
60
Accrued interest = × 6 = 1.9565
184
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Q.4920 A corporate bond pays coupons at the rate of 12% per year on March 1 and September 1.
What is the accrued interest between March 1 and April 30 per USD 100 of face value?
A. 0.9833
B. 0.9779
C. 1.0000
D. 1.9667
In the case of a corporate bond, we use the 30/360-day count convention. 12% coupon rate per
Based on the 30/360 convention, the number of days between March 1 and April 30
The reference period, March 1 to September 1, has 180 days(= 29 + 30+ 30+ 30+ 30+ 30+ 1,
Thus,
59
Accrued interest = × 6 = 1.9667
180
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Q.4921 Suppose a Treasury bill lasts for 230 days and has a quoted price of 5.5 What is the cash
price of the Treasury bill?
A. 91.2717
B. 96.4861
C. 96.5342
D. 91.3913
We know that,
360
P = (100 − Y )
n
Where P is the quoted price, and Y is the corresponding cash price per USD 100 of face value.
Pn
Y = 100 −
360
5.5 × 230
= 100 − = 96.4861
360
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Q.4922 A Treasury bond pays coupons at the rate of 10% per year on June 1 and December 1.
What is the accrued interest between June 1 and July 31 per USD 100 of face value (rounded to
two decimal places)?
A. $1.64
B. $1.5
C. $1.62
D. $1.66
The number of days between June 1 and December 1 is 183 (29, 31, 31, 30, 31, 30, 1 in June,
The number of days between June 1 and July 31 is 60 (29, 31 in June and July, respectively). The
60
× 5 = 1.639
183
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Q.4923 Suppose that the bond that will be cheapest to deliver in a Treasury bond futures
contract pays coupons of 6% per annum on March 1 and September 1 and will be delivered on
July 1. Suppose further that the bond's quoted price on June 1 is 120.00, and its conversion
factor is 1.2424. If all interest rates are 5 % continuously compounded, what is the clean futures
price on July 1?
A. 121.50
B. 121.33
C. 120.99
D. 123.51
We have 92 days(=30+30+31+1 in March, April, May, and June respectively) between March 1
and June 1 and 184 days( =30+30+31+30+31+31 +1 in March, April, May, June, July, August,
We know that,
There are no coupon payments for the 30-day period between June 1 and July 1.
30
121.50e 365×0.05 = 122.00
We have 62 days(=30+31 and 1 in July, August, and September, respectively) between July 1 and
Sep 1.
62
3× = 1.0109
184
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Q.4924 Suppose that the bond that will be cheapest to deliver in a Treasury bond futures
contract pays annual coupons of 6% per annum on March 1 and September 1 and will be
delivered on July 1. Suppose further that the bond's quoted price on June 1 is 120.00, and its
conversion factor is 1.2424. If all interest rates are 5 % continuously compounded, what is the
estimated futures price on July 1?
A. 98.78
B. 120.00
C. 97.66
D. 122.00
We have 92 days(=30+30+31+1 in March, April, May, and June respectively) between March 1
and June 1 and 184 days( =30+30+31+30+31+31 +1 in March, April, May, June, July, August,
We know that,
There are no coupon payments for the 30-day period between June 1 and July 1.
30
121.50e 365×0.05 = 122.00
We have 123 days(=30+31+31 and 1 in June, July, August, and September, respectively) between
June 1 and Sep 1.
123
3× = 0.6685
184
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Thus, the futures price can be estimated by
Q.4926 Suppose that a nine-month interest is expected to be paid on a USD 30,000,000 bond.
Suppose further that three-month Eurodollar futures contracts are used to hedge the nine-month
interest and that the nine-month period starts at the maturity of the futures contract that will be
used. How many three-month Eurodollar futures contracts are necessary to hedge the nine-
month interest? (Ignore the differences between Eurodollar futures and FRAs)
A. 30
B. 45
C. 90
D. 60
The change in the value of the instrument for a 1-basis point parallel shift in the interest rate is
9
USD 30, 000, 000 × × 0.0001 = USD 2250
12
We know that the interest rate per three months changes by 0.0025%, which is equivalent to
USD 25 on a principal of USD 1 million. In other words, a Eurodollar contract is designed in such
a way that one basis point(0.01) move in the futures price leads to a profit or loss of $25.
Thus, the number of three-month Eurodollar futures contracts necessary to hedge the nine-
month interest is
2250
= 90
25
Q.4927 Suppose that a bond portfolio of USD 1,000,000 has a duration of 5. Suppose further that
the current Treasury bond futures price is USD 104 and that the cheapest to deliver bond has a
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duration of 5 at maturity. What is the number of contracts that should be traded to fully hedge
the portfolio?
A. 52
B. 96
C. 10
D. 100
Note that, futures contract involves the delivery of bonds with a face value of USD 100,000.
The number of contracts that should be traded (with a negative number indicating a short
EV
−
EF
EF is the increase in value of one futures contract for a 1-basis point downward parallel shift in
EV is the increase in value of a trader's position for a 1-basis point downward parallel shift in the
zero curve.
Thus, the increase in value of a trader's position for a 1-basis point downward parallel shift in the
Similarly, the increase in value of one futures contract for a 1-basis point downward parallel shift
Q.4928 Paul Shawn, an FRM candidate, made the following comments regarding SOFR.
A. I only
B. I and II
C. II only
Both statements made by Paul Shawn are indeed accurate. The Secured Overnight Financing
Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by
Treasury securities. It is indeed the overnight repo rate for loans and derivatives denominated in
the US dollar. Repos, or repurchase agreements, are a form of short-term borrowing mainly in
government securities. The dealer sells the government securities to investors, usually on an
overnight basis, and buys them back the following day. The SOFR is based on actual transactions
in the Treasury repurchase market, where investors offer banks overnight loans backed by their
bond assets.
As for the second statement, it is also correct. To settle the three-month futures, the rate that
would have been earned over the past three months is calculated by rolling an investment
forward day-by-day at the SOFR rate. This is a common practice in the financial markets,
especially in the context of futures contracts. A futures contract is a legal agreement to buy or
sell a particular commodity or asset at a predetermined price at a specified time in the future.
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The futures price is determined by the spot price and the interest rate. Therefore, the SOFR rate,
being an overnight rate, is used to roll forward the investment day-by-day to calculate the rate
that would have been earned over the past three months.
Choice A is incorrect. While it's true that SOFR is the overnight repo rate, this choice only
acknowledges one of Paul Shawn's statements as accurate. However, both of his statements are
correct.
Choice C is incorrect. This choice only recognizes the second statement as accurate - that an
investment can be rolled forward day-by-day at the SOFR rate to calculate the rate that would
have been earned over a three-month period. However, it fails to acknowledge that SOFR is
indeed the overnight repo rate, which makes Paul Shawn's first statement also correct.
Choice D is incorrect. This option suggests that neither of Paul Shawn's statements about
SOFR are accurate, which contradicts with what we know about SOFR - it being an overnight
repo rate and its use in calculating rates over a certain period by rolling investments forward
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Q.4929 Suppose that the bond that will be cheapest to deliver in a Treasury bond futures
contract pays annual coupons of 6% per annum on March 1 and September 1 and will be
delivered on June 1. Suppose further that the bond's clean futures price is 121.4848 on June 1,
and its conversion factor is 1.2424. If all interest rates are 5% continuously compounded, what is
the dirty price on June 1?
A. 121.99
B. 119.46
C. 123.00
D. 123.51
We have 184 days( =30+30+31+30+31+31 +1 in March, April, May, June, July, August, and
September, respectively)
We have 92 days between March 1 and June 1(= 30 + 30 + 31 + 1 in March, April, May, and
June, respectively)
92
3× = 1.5
184
We know that,
Thus,
Dirty Futures Price = Clean Futures Price + Accrued Interest = 121.4848 + 1.5 = 122.9848 ≈ 123
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Q.4930 Three bonds, A , B, and C, all eligible for delivery, have quoted prices of 90-115, 105-120,
and 110-230, respectively. The conversion factors of the bonds are 0.7174, 0.7381, and 0.9576,
respectively. Assume that the last settlement price for each of these bonds is $96.50. Which is
the cheapest to deliver?
A. Bond A
B. Bond B
C. Bond C
11.5
Bond A: 90 + = $90.3594
32
12
Bond B: 105 + = $105.375
32
23
Bond C: 110 + = $110.7188
32
Thus, the costs of delivering each of the bonds we've got is as follows:
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Q.4931 Suppose that under the terms of a futures contract, a par-value treasury bond of face-
value USD 100, will be delivered in 210 days. Suppose further that the last coupon of the bond
was paid 35 days ago, and the next coupon will be paid in 130 days. If the risk-free rate is 4%
with continuous compounding and the bond pays a coupon of 10% compounded semi-annually,
what is the futures price of the bond if the clean price is USD 102.00?
A. 103.06
B. 105.46
C. 101.50
D. 100.42
F0 = (S0 − I ) er T
Where S0 is the spot price of the bond, I is the present value of cash flows, i.e., coupons, R is the
35
S0 = 102 + × 5 = 103.0606
165
A coupon will be received in 130 days and the present value of the coupon is given by:
130
I = 5e−0.04 ×365 = 4.9293
Thus,
210
F0 = (103.0606 − 4.9293) e0.04× 365 = 100.4158 ≈ 100.42
Note that the current price S0 used is the dirty cash price of the bond. Hence, the calculated
futures price is also a dirty price.
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Q.4934 What undesirable trading behavior involves using market developments after 4 pm to
cancel or carry out a trade?
A. Late Trading.
B. Market Timing.
C. Directed Brokerage.
D. Front Running.
Late trading refers to the practice of placing orders to buy or sell securities after the close of a
trading day's official trading hours (typically 4 pm in the U.S.), but still having these orders
executed at the closing price of the same trading day. This is considered undesirable and illegal
because it allows traders to take advantage of post-close market developments and information
that are not yet reflected in the closing price, thereby creating an unfair trading environment.
Late trading is particularly problematic in the context of mutual funds, where it can lead to
dilution of the fund's assets and harm to long-term investors. It is considered a serious offense
Choice B is incorrect. Market Timing refers to the strategy of making buy or sell decisions of
financial assets (often stocks) by attempting to predict future market price movements. This
practice does not involve exploiting post-4 pm market developments for trade execution or
cancellation.
Choice C is incorrect. Directed Brokerage involves a mutual fund directing its portfolio
transactions to a particular broker in return for that broker selling more shares of the fund. It
Choice D is incorrect. Front Running refers to the unethical practice where a broker executes
orders on a security for its own account while taking advantage of advance knowledge of
pending orders from its customers; it doesn't relate to actions taken based on information after 4
pm.
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Reading 46: Swaps
Q.705 Which of the following options is a correct differentiating feature between swaps and
forward contracts?
B. Forward contract holders have an obligation, while swap holders have the right to buy
or sell the underlying security in the future.
D. There is only one exchange of cash flow at a future date in a forward contract,
whereas there are many exchanges of cash flows on multiple future dates in a swap.
A forward contract and a swap are both financial derivatives used for hedging and speculation in
financial markets. However, they differ significantly in their structure and operation. A forward
contract is a private agreement between two parties to buy or sell an asset at a specified future
date for a price agreed upon today. The key feature of a forward contract is that there is only one
exchange of cash flows that occurs at a future date. This exchange is the culmination of the
contract, where the agreed-upon asset is delivered, and the payment is made. On the other hand,
a swap is a derivative contract through which two parties exchange financial instruments. These
instruments can be almost anything, but most swaps involve cash flows based on a notional
principal amount agreed upon by both parties. Unlike forward contracts, swaps involve multiple
exchanges of cash flows on various future dates. These cash flows are often calculated over the
notional principal amount using different interest rates. Therefore, choice D accurately
Choice A is incorrect. Both forward contracts and swaps are traded over-the-counter (OTC),
not on exchanges. These instruments are typically customized to the needs of the parties
Choice B is incorrect. Both forward contract holders and swap holders have obligations, not
rights, to buy or sell the underlying security in the future. The difference lies in their structure: a
forward contract involves a single future transaction, while a swap involves multiple transactions
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over time.
Choice C is incorrect. Both forward contracts and swaps can be customized according to the
needs of the parties involved. This flexibility is one of their key features that make them popular
in financial markets.
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Q.707 Leipzig Auto Company is one of the largest auto interior maker firms in Germany. On April
1st, 2017, the company entered into a 3-year swaps contract with the Allied-Swiss Bank to pay
quarterly cash flows equal to the fixed interest rate of 5.7% on a notional principal of €30
million. In return, Allied-Swiss Bank agreed to pay the quarterly cash flow equal to the 3-months
LIBOR on the same notional principal. After reviewing the terms of the contract, determine
Allied-Swiss Bank’s position in the swap contract.
A. Fixed-rate-payer
B. Libor-receiver
C. Floating-rate-payer
D. Floating-rate-receiver
In a swap contract, the parties involved agree to exchange cash flows, which are calculated on a
notional principal amount. The cash flows are determined by different interest rates - one party
pays a fixed rate, and the other pays a floating rate. In this case, Allied-Swiss Bank has agreed to
pay the floating rate (3-month LIBOR), while receiving the fixed rate (5.7%) from Leipzig Auto
Company. Therefore, Allied-Swiss Bank is the floating-rate-payer in this swap contract. This
position allows the bank to hedge against the risk of falling interest rates. If the LIBOR
decreases, the bank's payments will also decrease, while it continues to receive the fixed rate
Choice A is incorrect. Leipzig Auto Company, not Allied-Swiss Bank, is the fixed-rate-payer in
this swap contract. They are obligated to make quarterly payments at a fixed interest rate of
Choice B is incorrect. This choice incorrectly identifies Allied-Swiss Bank as the receiver of the
LIBOR-based payments. In fact, it's Leipzig Auto Company that will receive these floating-rate
Choice D is incorrect. While it might seem logical to assume that since Allied-Swiss Bank isn't
receiving fixed-rate payments they must be receiving floating-rate ones, this isn't correct either.
The bank's role in this swap contract is to pay out based on the 3-month LIBOR rate, making
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Q.708 Swaps are customizable derivative contracts between two parties that trade in the over-
the-counter (OTC) markets around the world. Financial intermediaries and companies have used
swaps for multiple purposes. The most popular and basic swap agreement, which is used
worldwide, is called the plain vanilla swap. Which of the following is the underlying variable of
plain vanilla swaps?
B. Interest rates
C. Volatility
D. Equities
The underlying variable of plain vanilla swaps is interest rates. Plain vanilla swaps, also known
as interest rate swaps, are the most common type of swap agreement used worldwide. In these
swaps, one party agrees to pay cash flows equal to a fixed interest rate set at a predetermined
time, in exchange for a floating interest rate. This allows the parties involved to hedge against
interest rate risk. The interest rate is the key variable that determines the cash flows in these
Choice A is incorrect. While currency exchange rates are indeed an underlying variable in
certain types of swaps, specifically currency swaps, they are not the underlying variable in plain
vanilla swaps. Plain vanilla swaps typically involve the exchange of a fixed interest rate for a
Choice C is incorrect. Volatility is not the underlying variable in plain vanilla swaps. It might
be an important factor to consider when pricing or valuing derivatives such as options, but it
Choice D is incorrect. Equities can be an underlying asset for some types of derivative
contracts like equity swaps or equity options, but they are not associated with plain vanilla
interest rate swap agreements which primarily deal with exchanging cash flows based on
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Q.709 Kevin Bernard, the head of the derivatives trading department at Savers Bank, entered
into a 3-year swap agreement on September 30, 2015, with Moon Traders. In the agreement,
Savers Bank agreed to pay Moon Traders an interest rate of 5%, paid semiannually on the
principal of $100 million. In return, Moon Traders agreed to pay Savers the LIBOR rate on the
same principal. If the LIBOR prevailing on March 30, 2016, is 4.95% paid semiannually, which of
the following statements is true?
A. Savers Bank will pay $25,000 to Moon Traders on March 30, 2016.
B. Savers Bank will receive $25,000 from Moon Traders on March 30, 2016.
C. Savers Bank will pay $25,000 to Moon Traders on September 30, 2016.
D. Savers Bank will receive $25,000 from Moon Traders on September 30, 2016.
Savers Bank will pay $25,000 to Moon Traders on September 30, 2016.
On the other hand, Moon Traders will pay $2.475 million to Savers Bank.
5%
Savers Bank's cash outflow = ∗ 100 million = −$2.5 million
2
4.95%
Savers Bank's cash inflow = ∗ 100 million = $2.475 million
2
Net cash flow on September 30, 2016 = 2, 475, 000 − 2, 500, 000 = −25 , 000
One crucial element of plain vanilla swaps is that the exchange of funds related to a particular
Libor (floating rate) takes place one period (six months in the case of our example) after the
Libor rate is observed. In other words, at the beginning of each period, both payments for the
end of the period - fixed and floating - are known. This allows both parties to budget for their
future payments.
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Q.710 Muhammad Ali is a credit risk manager at Green Flag Investment Company. Recently,
Green Flag Investment Company borrowed $50 million from another investment bank at the rate
of the 6-month LIBOR plus 50 basis points. Ali worries that the LIBOR can significantly increase
due to the current economic situation of the country, which can increase the investment
company’s liability. If Ali intends to change the floating rate liability into a fixed rate liability,
which of the following positions can transform the floating rate liability into a fixed rate liability?
A fixed-rate payer position in a swap is the correct choice because it allows the transformation of
a floating rate liability into a fixed rate liability. In a swap contract, two parties agree to
exchange one stream of cash flows against another stream. In this case, Ali would enter into a
swap contract where he agrees to pay a fixed rate and receive a floating rate. The floating rate
he receives from the swap contract would offset the floating rate he has to pay on the initial loan.
Therefore, his net payment would be the fixed rate from the swap contract, effectively
transforming the floating rate liability into a fixed rate liability. This strategy is often used by
investors and companies to hedge against the risk of interest rate fluctuations.
Choice B is incorrect. Taking a short position in interest rate futures would not transform the
floating rate liability into a fixed one. Instead, it would be used to hedge against falling interest
rates, which is not Ali's concern here. He is worried about rising rates.
Choice C is incorrect. A long position in a forward rate agreement (FRA) allows the holder to
lock in an interest rate for borrowing or lending money in the future. However, this does not
convert a floating-rate liability into a fixed-rate one as it only hedges against future changes in
Choice D is incorrect. A short position on call options gives the holder the right to sell an asset
at an agreed price before a certain date but does not provide any transformation from floating to
fixed-rate liabilities.
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Q.711 Assume that you are a swap dealer and have just acted as a counterparty in an interest
rate swap. The notional principal for the swap was $7.5 million and you are now obligated to
make five annual payments of 8 percent interest. The floating rate that you will receive is 8.2
percent, and the floating payments to you are annual as well.
If the floating rate remains unchanged for the first two years and then falls by 1.5 percent for the
remainder of the contract, what will be your net payments for the five years?
A. $62,000
B. $30,500
C. $203,500
D. $262,500
You will receive a total of $30,000 for the first two years [$7,500,000 * (0.082 - 0.080) * 2].
The new floating rate afterward that you will receive is 8.2% - 1.5% = 6.7%.
You will pay a total of $292,500 for the last three years [$7,500,000 * (0.067 - 0.08) * 3 years].
Thus, your net payment over the five years will be $262,500 ($30,000 - $292,500 = -$262,500).
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Q.712 Hygiene Foods Inc. is one of the largest fast-moving consumer goods (FMCG) company in
Malaysia. Last year, it entered into a 3-years swap agreement to pay semiannual cash flows equal
to the 6-months LIBOR plus 20 basis point on the notional principal of $400 million. Which of the
following parties is most likely the counterparty of the given swap agreement?
A. The exchange
B. A clearinghouse
C. Financial intermediaries
Financial intermediaries are typically the counterparties in swap agreements. Swap agreements
bear resemblance to forward contracts in terms of their customizability, lack of regulation, and
over-the-counter (OTC) nature. However, the key difference lies in the involvement of financial
earn a spread of 3 to 5 basis points in the transaction between the two parties. In exchange for
this spread, they guarantee the execution of the agreement even if one party defaults. In the
context of the swap agreement entered into by Hygiene Foods Inc., a financial intermediary is
most likely the counterparty, ensuring the agreement's fulfillment even in the event of a default.
Exchanges are platforms where securities, commodities, derivatives and other financial
financial markets, ensuring that transactions are conducted smoothly and efficiently. However,
Choice D is incorrect. The central bank does not engage directly with individual companies for
such transactions like swaps; instead it implements monetary policy and provides regulatory
Q.713 Sunil Kumar is a professor on the subject of financial derivatives and hedging mechanics
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at the Delhi School of Finance (DSF). During one of his lectures that emphasized the roles and
responsibilities of financial intermediaries in swaps, he mentioned the following:
I. Financial intermediaries ensure that the obligation of swap agreements is honored even when
the opposite party of the swaps defaults
II. Financial intermediaries can enter into two offsetting transactions in a swap agreement
without letting know the two parties of the swap
III. Financial intermediaries can also act as market makers
Which of the following mentioned roles of financial intermediaries are appropriately described?
All three roles and responsibilities of financial intermediaries in a swap agreement are
accurately defined. Financial intermediaries play a crucial role in swap agreements. They ensure
that the obligations of the swap agreements are honored, even if the counterparty defaults. This
is a significant role as it provides a safety net for the parties involved in the swap agreement.
Secondly, financial intermediaries can enter into two offsetting transactions in a swap agreement
without the knowledge of the two parties involved. This is possible because financial
intermediaries have a broad network and can find parties willing to enter into swap agreements
on similar terms and notional principal. Lastly, financial intermediaries can act as market
makers. When counterparties for a specific swap agreement over a specific notional principal are
not available, financial intermediaries can step in and act as the counterparty to this agreement.
This process is known as market making. Therefore, all three roles - I, II, and III - are correctly
ensure the obligation of swap agreements is honored even in the event of a default by one party,
Role II is not exclusive to them. Financial intermediaries do have the ability to enter into two
offsetting transactions in a swap agreement without the knowledge of both parties involved, but
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Choice B is incorrect. Although Roles II and III are correctly attributed to financial
intermediaries, this choice omits Role I which also falls under their responsibilities. As
mentioned earlier, financial intermediaries ensure that obligations of swap agreements are
Choice C is incorrect. While it correctly identifies Roles I and III as responsibilities of financial
intermediaries, it incorrectly excludes Role II - entering into two offsetting transactions without
the knowledge of both parties involved - which can also be performed by these entities.
Q.714 Faheem Salami has recently joined a large investment bank that acts as a financial
intermediary in a number of swaps agreements. The bank also acts as the market maker when
the counterparties to swaps are unavailable. Salami’s boss asked him to calculate the swap rate
of the 6-month interest rate swap when the 6-month LIBOR is 4.3%.
Salami also knows that the 6-month risk-free rate is 3.9%, and the bid and offer rates for the
swap are 4.02 and 4.08, respectively.
Which of the following rates is the accurate swap rate for the specific swap agreement?
A. 3.90%
B. 4.05%
C. 4.10%
D. 4.30%
A swap rate is the average of the bid-and-offer rates (4.02 and 4.08) of the swap agreement.
Financial intermediaries post these bid and offer rates when making the market for these swaps.
Due to the versatility of swap agreements, it is difficult to find two counterparties with uniform
terms. Therefore, financial intermediaries take the position of the counterparty in all swaps
agreement.
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Q.715 Otto Cornell is the head of the finance department of Easy Home Appliances Inc. The firm
intends to enter into a swap agreement to convert its outstanding floating-rate liability into a
fixed rate liability. Therefore, the firms decided to enter into a fixed-rate payer position in a 2-
year swap rate agreement to pay the quarterly cash flow equal to a 6% fixed rate to the Great
Spanish Bank (GSB). In return, GSB agreed to pay quarterly cash flow equal to 3-month LIBOR
to the firm. Since, it is the first transaction of this nature, the head of the financial department
does not know who is required to facilitate the preparation of the confirmation of swap or the
master agreement. Which of the following is most likely to facilitate the confirmation?
B. Financial intermediaries.
The International Swaps and Derivatives Association or ISDA has been facilitating the
preparation of the confirmation or the master agreement for swap agreements. The confirmation
of the swap agreement consists of the definition of clauses and terminologies, consequences in
case of default, notional principals, day counts convention, rates, etc.
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Q.717 Fabian Fabio is a former currency trader at Global FX Corp. He recently joined Baltic
Investments Company as the head of currency derivatives. After joining Baltic, he circulated an
informative email regarding terms and terminologies of currency swaps to his team. His email
contained the following details regarding currency swaps:
I. Unlike other derivatives, the value of currency swaps is non-zero at the initiation of currency
swaps
II. Each periodic exchange of interest rate in a currency swap is equal to a forward foreign
exchange contract
III. Currency swaps are used to transform debt denominated in one currency into debt
denominated in another currency
Which of the mentioned attributes of currency swaps are correctly defined in the email?
A. Attributes I & II
Attribute I is incorrect. The value of any derivative including currency swaps agreements is zero
at the inception of the contract. A non-zero initial value can give rise to arbitrage profit.
Attribute II is correct because although, swap contracts generally require the exchange of
principal amount, in some swap contracts, however, only the transfer of interest is required. In
such cases, every interest payment under currency swap agreements is similar to a forward
foreign currency contract. Â
Attribute III is also correct because currency swaps are used to transform liabilities and assets.
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Q.718 Cherry Inc. and Sang Wang are the two market leaders in the tablet PC market. Cherry
Inc. is an American company while Sang Wang is headquartered in Japan. Both companies are
considering taking on debt in either USD or Yen. The following table shows the borrowing rates
for both companies.
USD Yen
Cherry Inc. 3.5% 9%
Sang Wang 5.5% 10.4%
Considering the comparative advantage argument, estimate the total gain both companies can
have if they enter into a currency swaps contract.
A. 4.7%
B. 2.2%
C. 1.4%
D. 0.6%
The table suggests that the interest rate in the Japanese Yen is higher than the U.S dollar. As per
the comparative argument, Cherry has an absolute advantage in both USD and Yen.
The total gain as per the comparative advantage is equal to the difference of the difference:
Difference in USD = (5.5% - 3.5%) = 2.0%
Difference in Yen = 10.4% - 9% = 1.4%
Total gain for both companies = (5.5% - 3.5%) – (10.4% - 9%) = 0.6%
Q.719 Black Corporation and UK Fabrics have entered into a 3-year currency swap agreement
with periodic annual payments, where Black agreed to pay 5% in British pound (GBP) on the
principal amount of GBP 100 million to UK Fabrics. In addition, UK Fabrics agreed to pay 7% to
Black on the principal of $120 million. The currency exchange rate at the initiation of the swap
was USD 1.26 per GBP. If the interest rate in the United States and Great Britain are flat at 5.5%
and 6.8%, respectively, but the dollar has appreciated in value against the GBP, then determine
which of the following is true.
D. The value of the swap will be unaffected by subsequent changes in exchange rates.
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The correct answer is A.
The value of the swap to Black Corporation will increase. This is because Black Corporation has
to pay interest in GBP, and with the appreciation of the US dollar against the GBP, it will need
fewer dollars to purchase the necessary pounds. This effectively reduces the cost of the swap for
Black Corporation, thereby increasing its value. Furthermore, the increase in the value of the
dollar also increases the risk of default for UK Fabrics, as it will need more pounds to purchase
the necessary dollars to meet its interest payment obligations. This further increases the value of
Choice B is incorrect. The value of the swap to UK Fabrics will not increase if the US dollar
appreciates against the GBP. This is because UK Fabrics has agreed to pay a 7% interest rate in
USD, and if the USD appreciates, it would mean that they would have to pay more in GBP terms.
Therefore, an appreciation of the USD against the GBP would decrease rather than increase the
Choice C is incorrect. The value of a currency swap does not necessarily increase for both
parties when exchange rates fluctuate. In this case, Black Corporation benefits from an
appreciation of USD as it receives payments in this currency while paying out in GBP. Conversely,
UK Fabrics suffers from an appreciation of USD as it pays out in this currency while receiving
payments in GBP.
Choice D is incorrect. The value of a currency swap can be affected by subsequent changes in
exchange rates because these changes alter how much each party must pay or receive at each
payment date and at maturity when principal amounts are exchanged back again.
Q.721 Green Grass Co. intends to enter into a 5-year fixed for floating interest rate swap with
MNG Bank. Green agrees to pay annual cash flow equal to a fixed interest rate of 5% on the
principal of €140 million to the bank in exchange for receiving the annual cash flow equal to 1-
year LIBOR plus 50 basis points on the same notional principal from the bank. However, Green
Grass does not want to exchange the notional principal at the inception of the swap. Instead, it
wants to decrease the principal in a predetermined manner. Which of the following swaps is most
suitable for this transaction?
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A. Basis swap
B. Amortizing swap
C. Deferred swap
D. Step up swap
An amortizing swap is a type of interest rate swap where the notional principal amount is
reduced over time, typically in line with the decrease in the outstanding amount of a loan. In this
case, Green Grass Co. does not want to exchange the notional principal at the inception of the
swap, but instead, it wants to decrease the principal in a predetermined manner. This is a
decreases over time, which can be beneficial for a company like Green Grass Co. that wants to
gradually reduce its exposure to interest rate risk. The reduction in the principal amount can be
structured to match the amortization schedule of the underlying loan, making it a suitable choice
Choice A is incorrect. A basis swap involves exchanging one type of floating rate payments for
another type of floating rate payments. It does not involve a reduction in the principal amount
Choice C is incorrect. A deferred swap refers to a situation where the start date of the swap
agreement is postponed to a future date, but it does not involve reducing the principal amount
over time.
Choice D is incorrect. In a step-up swap, the interest rate increases over time according to a
predetermined schedule, but it does not involve reducing the principal amount over time as
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Q.722 Heidelberg Brewery wants to enter into a 3-year swap agreement with Everest Investment
Co. Heidelberg intends to pay semiannual cash flows equal to the 10-year swap rate on the
principal of €100 million to the Everest Investment in exchange for receiving semiannual cash
flows from the investment company equal to the 6-month LIBOR on the same notional principal.
Which of the following swaps is most suitable for this transaction?
A. LIBOR-to-floating swap
B. Step-up swap
A constant maturity swap (CMS) is a derivative with a payoff that is linked to a reference rate,
typically a swap rate such as the LIBOR. In a CMS, one party pays a series of fixed payments
while receiving a series of floating payments indexed to a swap rate (constant maturity). The
swap rate is reset periodically, typically every six months, and is usually tied to the rate of a
specific maturity of swap. In this case, Heidelberg Brewery is planning to pay semiannual cash
flows equal to the 10-year swap rate and receive semiannual cash flows equal to the 6-month
LIBOR. This is exactly how a CMS works, making it the most suitable swap for this transaction.
Choice A is incorrect. A LIBOR-to-floating swap would involve exchanging a fixed interest rate
for a floating interest rate based on the LIBOR. However, in this case, both sides of the swap are
floating rates: one side is the 10-year swap rate and the other side is the 6-month LIBOR.
Choice B is incorrect. A step-up swap involves an agreement where one party makes payments
that increase over time while receiving a fixed or floating rate in return. This scenario does not
Choice D is incorrect. In a LIBOR in arrears swap, one party pays a fixed or floating rate and
receives the LIBOR determined at the end of each period rather than at its beginning (i.e., "in
arrears"). This situation doesn't match with Heidelberg Brewery's proposed arrangement as they
expect to receive semiannual payments equivalent to 6-month LIBOR without any delay or
"arrear" condition.
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Q.723 Henry Coelho, the Chief Financial Officer of Imperial Hotels & Resorts, intends to enter
into a 4-year interest rate swap with a financial institution. Imperial agrees to pay quarterly cash
flow equal to the 3- month LIBOR rate on the notional principal of $200 million to the financial
institution in exchange for receiving the annual cash flow equal to 550 basis points on the same
notional principal from the financial institution. However, Coelho does not want to enter into a
swap at the moment, but he wants to purchase an instrument that allows him to enter into the
swap agreement on specified terms at a predetermined date. Which of the following instruments
is most suitable for Coelho?
A. Extendable Swap
B. Callable Swap
C. Swaption
A swaption is an option that gives the holder the right to enter into a swap agreement with a
predetermined fixed rate in exchange for a floating rate at a future time. This instrument is most
suitable for Coelho's situation as it allows him to enter into the swap agreement on specified
terms at a predetermined date. Swaptions are essentially options on forward swap agreements.
They provide the holder with the right, but not the obligation, to enter into a swap agreement at
a future date. This gives the holder flexibility and protection against adverse movements in
interest rates. Swaptions can be used for a variety of purposes, including hedging interest rate
risk, speculating on future interest rate movements, and enhancing portfolio yield. They are
Choice A is incorrect. An extendable swap allows the holder to lengthen the duration of an
existing swap at a predetermined date, which does not align with Coelho's need to enter into a
Choice B is incorrect. A callable swap gives one party the right but not the obligation to
terminate the contract before its maturity, which again does not meet Coelho's requirement of
Choice D is incorrect. A constant maturity swap involves swapping fixed interest payments for
floating rate payments linked to an interest rate index with a continuously changing (or
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"constant") maturity, such as 1-year LIBOR or 5-year Treasury notes. This type of instrument
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Q.3556 What is the difference between a fixed-for-floating swap and a forward contract?
A. The payment date would be unlikely to match in a fixed-for-floating swap while the
exact expiration date is known as a forward contract.
B. All the fixed-rate payments in a swap are equal, while in a forward contract, only one
fixed payment is made on the settlement date.
C. The floating-rate payments in a swap are known at the start of the contract while
future payments in a forward contract unknown at the contract initiation.
A fixed-for-floating swap and a forward contract are both financial derivatives used for hedging
and speculation. However, they differ significantly in their structure and payment terms. In a
fixed-for-floating swap, there are multiple settlement periods, and at each of these periods, equal
fixed-rate payments are made. This is a key characteristic of swaps - they involve a series of cash
flows over time, and in the case of a fixed-for-floating swap, these cash flows are fixed. On the
other hand, a forward contract has only one settlement period at the end of the contract. At this
time, a single payment is made, which was agreed upon at the initiation of the contract.
Therefore, while swaps involve multiple, equal fixed-rate payments, forward contracts involve a
Choice A is incorrect. The payment dates in a fixed-for-floating swap are predetermined and
known to both parties at the start of the contract, similar to a forward contract where the
expiration date is also known at the outset. Therefore, it's not accurate to say that payment dates
Choice C is incorrect. In a fixed-for-floating swap, floating-rate payments are not known at the
start of the contract as they depend on future interest rates or other variables that can change
over time. Similarly, future payments in a forward contract are also unknown at initiation
Choice D is incorrect. As explained above, there are key differences between fixed-for-floating
swaps and forward contracts which have been correctly identified in choice B.
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Q.3557 Tiara Enterprises (TIEN) has just announced its plans to establish a facility in New York,
USA, to meet the increased demand for its products. TIEN plans to fund the expansion with debt
and in order to hedge the risk of borrowing, TIEN has entered into a plain vanilla interest rate
swap with a notional principal of $50 million. TIEN would make semiannual payments at the rate
of 12% with the counterparty making floating rate payments at the Euribor rate.
Assuming a 360-day year, if the Euribor was 13.5% on the last settlement date and is 11.0% on
the current settlement date, what is the amount that TIEN would receive on the last settlement
date?
A. $250,000
B. $625,000
C. $465,000
D. $375,000
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Q.3558 Company X seeks a 4-year fixed-rate US dollar funding while Company Y seeks a 4-year
fixed-rate Japanese yen funding. Company X’s direct borrowing all-in-cost is 10.50% in dollars
and 8% in Japanese yen. Company Y’s direct borrowing all-in-cost is 9.30% in dollars and 9% in
Japanese yen. What is the maximum gain for all parties involved through this swap?
A. 2.2%
B. 1%
C. 1.2%
D. 0.2%
X Y Difference
Dollar 10.5% 9.3% 1.2%
Yen 8% 9% −1%
ΔDollar − ΔYen
= 1.2% − −1% = 2.2%
Q.3559 Consider the following statement: "A currency swap exposes parties to two sources of
risk – interest rate and currency risk – while provides protection against default risk."
The statement is INCORRECT with respect to:
A. Default risk
B. Currency risk
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A currency swap is a financial instrument that involves the exchange of interest—and in many
cases principal—in one currency for the same in another currency. The parties involved in a
currency swap are exposed to two primary types of risk: interest rate risk and currency risk.
Interest rate risk arises from the possibility of changes in the interest rates that can affect the
cash flows of the swap. Currency risk, on the other hand, arises from potential changes in the
exchange rate between the two currencies involved in the swap. However, contrary to the
assertion in the question, a currency swap does not provide protection against default risk.
Default risk, also known as credit risk, is the risk that one party will not fulfill its contractual
obligations under the swap agreement. In a currency swap, there is no clearinghouse or other
intermediary to guarantee the payments, so if one party defaults, the other party bears the loss.
Choice B is incorrect. Currency risk is indeed a type of risk that parties are exposed to in a
currency swap. This is because the exchange rates between the two currencies involved in the
swap can fluctuate over time, which can lead to losses if the exchange rate moves unfavorably.
Choice C is incorrect. Interest rate risk also exists in currency swaps as each party has to pay
interest on the principal amount they have borrowed in their respective currencies. If interest
rates change, this could affect the amount of interest payments and hence expose them to risk.
Choice D is incorrect. As explained above, both currency and interest rate risks are inherent
parts of a currency swap transaction, so it's not correct to say that parties are shielded from all
types of risks.
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Q.3560 If Core Bank sells a swaption, it has:
B. The right, but not the obligation to enter into a swap if the swaption is exercised
D. The right, but not the obligation to make a payment to the counterparty if the
swaption is exercised
When Core Bank sells a swaption, it essentially takes on the obligation to enter into a swap if the
swaption is exercised. A swaption, being a type of option, gives the buyer the right, but not the
obligation, to enter into a swap agreement. The seller of the swaption, in this case, Core Bank, is
obligated to honor the terms of the swap if the buyer decides to exercise the swaption. This is
similar to the obligation of an option seller who must fulfill the terms of the option contract if the
buyer exercises their right. In the context of a swaption, the swap agreement could involve
exchanging fixed interest payments for floating interest payments, or vice versa, depending on
Choice B is incorrect. Core Bank, as the seller of the swaption, does not have a right but an
obligation. If the swaption is exercised by the holder, Core Bank must enter into a swap
Choice C is incorrect. While it's true that entering into a swap might involve making payments
to the counterparty depending on how interest rates move, selling a swaption specifically results
in an obligation to enter into a swap if it's exercised by the holder, not merely making a payment.
Choice D is incorrect. Similar to Choice B, this option incorrectly suggests that Core Bank has
some sort of right or choice in this scenario. As the seller of the swaption, Core Bank would be
obligated to enter into a swap if it's exercised; they do not have any rights or options here.
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