FRM

Part I Exam

By AnalystPrep

Questions with Answers - Financial Markets and Products

Last Updated: 06-10-2020

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 Table of Contents

25 - Banks 3

26 - Insurance Companies and Pension Plans 15

27 - Fund Management 26

28 - Introduction to Derivatives 51

29 - Exchanges and OTC Markets 68

30 - Central Clearing 84

31 - Futures Markets 110

32 - Using Futures for Hedging 131

33 - Foreign Exchange Markets 150

34 - Pricing Financial Forwards and Futures 172

35 - Commodity Forwards and Futures 194

36 - Options Markets 211

37 - Properties of Options 229

38 - Trading Strategies 252

39 - Exotic Options 276

40 - Properties of Interest Rates 291

41 - Corporate Bonds 323

42 - Mortgages and Mortgage-Backed Securities 339

43 - Interest Rate Futures 358

44 - Swaps 379

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 Reading 25: Banks

Q.1093 Banks face the following main risks:

I. The risk that counterparties in loan/derivative transactions will default

II. The possibility that the banks’ assets and financial instruments will decline in value
III. The possibility that internal system failures or external events will lead to significant losses

The types of risks described here are:

A. Credit risk, operational risk, and market risk respectively

B. Operational risk, market risk, and credit risk respectively

C. Market risk, operational risk, and credit risk respectively

D. Credit risk, market risk, and operational risk respectively

The correct answer is: D)

Credit risk refers to the possibility that the bank’s loan recipients and counterparties in
derivative contracts such as futures and swaps will fail to meet financial contractual agreements.
For example, a borrower may default on a loan halfway through the prepayment period.
Alternatively, the counterparty in an interest rate swap arrangement may fail to make the
required payments when the interest rate changes.

Market risk has much to do with the possibility that the value of assets and financial instruments
might be revised downwards. For example, a bank offering securitized instruments faces the risk
that the primary asset, such as a house, might decline in value.

Operational risk, widely considered to be the main type of risk facing banks, refers to the
possibility of internal failures or external events leading to losses. For example, if a popular rival
bank happens to declare bankruptcy, other banks may experience “runs” where depositors rush
to withdraw their funds out of fear that they might lose their money as well.

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Q.1094 Prime Bank, a recently licensed deposit-taking Sacco, is considering raising capital to
fund an ambitious expansion plan aimed at transforming it into a “tier one” bank within the next
five years. Which of the following statements best explains why the bank’s directors might
prefer a rights issue as opposed to subordinated long-term debt?

A. Subordinated long-term debt is more expensive than equity finance

B. Existing shareholders might block attempts to increase debt capital

C. Equity finance provides more protection against extreme events, compared to debt
finance

D. Existing shareholders have pre-emptive rights

The correct answer is: C)

Subordinate debt is debt that ranks below some other senior debt and depositors, but above
shareholders (equity financiers) in the event of default. For this reason, this type of debt might
be cheaper than equity in the long-term, since the bank will be obligated to meet both capital
and interest payments before shareholders receive a single penny. However, that’s partly why the
directors might prefer equity since debt finance will put the bank under considerable pressure,
particularly if some extreme events occur. In fact, shareholders would only be entitled to
dividends, which would be issued at the bank’s discretion.

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Q.1095 Distinguish between regulatory capital and economic capital.

A. 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

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 whereas economic is the total amount of capital held, including cash deposits and
tangible/intangible financial assets

The correct answer is: A)

In most countries, there’s an amount of capital that every deposit-taking bank must hold, in line
with regulations and rules established by the regulatory authority in charge. This is called
regulatory capital. Economic capital is the amount of capital a bank chooses to hold, as
prescribed by its own risk models.

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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 future. How might the establishment of the corporation create a moral
hazard?

A. Banks might refuse to make premium payments to the corporation, crippling it

financially in the process

B. Depositors might channel more of their savings to banks, reducing investments in

other sectors of the economy

C. Banks may increasingly venture into risky businesses that would not otherwise be
feasible

D. The corporation may encourage banks to manipulate accounts so as to appear

healthier than they actually are, hence be eligible for lower premium payments

The correct answer is: C)

The establishment of deposit insurance is, on one hand, good since depositors are assured of a
certain percentage of their deposits in the event that their preferred bank fails. For example, the
establishment of the Federal Deposit Insurance Corporation in the U.S. brought about
remarkable relief to depositors, guaranteeing a high of $250,000 per depositor per bank by the
year 2008. However, banks might start to take on risky strategies which they would otherwise
turn down. For example, they might use unusually higher interest rates to entice a bigger
number of depositors and ultimately channel the money into risky ventures, some of which might
lead to heavy losses. Without deposit insurance, banks would not make such a move since
depositors might see through the rogue strategy and withdraw their money en masse. The
possibility of such behavior on the part of banks is called moral hazard.

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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:

A. Crackdown on banks caught in paying their senior management excessive sums

B. Direct the agency to demand all details of each bank’s transactions on a regular basis

C. Direct the agency to tailor premiums payable according to each bank’s risk level

D. Abolish the deposit insurance agency altogether

The correct answer is: C)

By taking into account the risk level of a bank while calculating premiums payable, the agency
would discourage the banks from taking part in excessively risky strategies that in turn put
depositors’ funds at risk. Each bank would pay a premium proportional to the amount of the
inherent risk.

Q.1098 Losses resulting from employee fraud form part of:

A. Market risk

B. Liquidity risk

C. Credit risk

D. Operational risk

The correct answer is: D)

Employee fraud results from internal flaws in the system and therefore forms part of operational
risk.

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Q.1099 In today’s market, banks have come up with several ways to deal with credit losses,
including stricter lending standards and post-issuance follow-up to monitor the borrower’s
spending habits. In addition, banks should:

A. Reduce interest rates to reduce chances of borrower default

B. Increase interest rates to offset losses

C. Make provision for bad debt in financial statements

D. All of the above

The correct answer is: C)

Provision for bad debt entails trying to estimate the percentage of loans that are not likely to be
repaid (usually by looking at past repayment records) and deducting that amount as an expense
on the income statement.

Q.1100 Which of the following is the main activity of investment banks?

A. To offer credit to large institutional investors and financial magnates

B. To raise debt/equity financing on behalf of corporations or governments

C. To invest in government bonds and T-bills

D. To serve as clearing parties in derivative contracts

The correct answer is: B)

Investment banks mainly help institutions or governments to raise funds by originating

securities, underwriting them, and then placing them with investors. They also help to market
the securities and paint the client in a good light so as to woo potential investors.

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Q.1101 An investment bank is approached by a manufacturing company that wishes to raise
funds to finance an ambitious factory expansion plan. If the bank decides to raise the required
funds via 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

The correct answer is: B)

A private placement refers to the selling of securities to a small number of large institutional
investors such as pension funds, insurance companies or mutual funds. The investment bank
underwriting the arrangement receives a fee negotiated with the issuer, in this case, the
manufacturing company. The bank needs not to find just one investor; the issuer may prefer
more than one financier.

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. Introduction

The correct answer is: C)

A public offering involves offering securities, usually shares, to the general public. In the case of
a firm commitment public offering, an investment bank agrees to buy a specified amount of
securities from the issuer and then attempts to sell them to the public, promising to own any
securities which might not be taken up by the public. Thus, the issuer is completely certain that
they will raise the amount specified.

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Q.1103 A public offering on a best efforts basis is a security sale whereby:

A. The issuer works with multiple investment banks as underwriters

B. The underwriter does as well as they can to place securities with investors and get’s
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

The correct answer is: B)

In a best efforts offering, investment banks (working as agents/underwriters) agree to do their

best to place an issue in the hands of investors. It differs from a firm commitment offering in that
the bank does not buy the securities so as to resell them to investors. However, they may
negotiate an option giving them the right but not an obligation to buy a given amount of the
securities, even as they try to maximize sales to other investors.

Q.1104 ABC Company Limited is not publicly traded, but its directors contend the company
cannot self-fund further expansion. Directors approach an investment bank intending to create
50 million shares but haven’t yet settled on an appropriate price per share. Under these
circumstances, the company is most likely to issue a:

A. Best efforts IPO

B. Rights issue

C. Firm commitment

D. Private placement

The correct answer is: A)

A firm that’s not publicly traded issues shares in the form of an initial public offering. In most
cases, there will be considerable uncertainty regarding the public’s willingness to acquire some
stake in such a company. As such, most investments prefer to issue a best effort IPO since it
carries less risk. In general, underwriters are usually wary of firm commitments in such cases
particularly because they might be forced to own a large number of shares in the event that the
public’s response falls short.

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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:

Bidder Number of shares Price per share

A 200,000 $40.50

B 150,000 $39.50

C 400,000 $41.00

D 100,000 $39.40

E 300,000 $39.00

F 50,000 $38.75

G 120,000 $37.00

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

The correct answer is: D)

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.

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Q.1106 The Kings Bank located in State A wishes to establish its footing in State B, by acquiring
The Queens Bank. Employees and senior management of the latter do not want their business to
be enjoined to that of the former in part because they feel their bank’s future is bright. In
particular, the directors of The Queens Bank fear that the new owners may opt to kick them out
in favor of new management. The directors decide to seek advice from a reputable investment
bank on how to fend off the takeover. Assuming you were one of the advisory panel members,
which of the following would likely not form part of your advice?

A. That The Queens Bank adds to its charter a provision that if another company acquires
one-third of the shares, other shareholders have the right to sell their shares to that
company for twice the recent market price

B. That the Queens Bank grants its employees stock options that can be exercised in the
event of a takeover

C. That the Queens Bank adds to its charter a provision making it impossible for any new
owners to terminate the contracts of existing directors

D. That the Queens Bank should go to court and block the move

The correct answer is: D)

A, B, and C are all possible and realistic actions that The Queens Bank can take to discourage
other companies from acquiring the bank. Going to court might have little or no impact in light of
the information given in the question. Takeover bids are legal procedures between a willing
buyer and a willing seller. Legal proceedings would work only if the potential owners engage in
outlawed activities in an attempt to pull off the acquisition.

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Q.1107 Which of the following is the most realistic source of conflict of interest when all of
commercial banking, investment banking, and securities services are conducted under the same
corporate umbrella?

A. The three units might not get along, particularly if one or two perform very poorly
compared to the other

B. The investment segment might work with competitors to paint the commercial
segment in a bad light and therefore obtain preferential treatment from shareholders

C. In the process of lending money to a company, the commercial segment may be

tempted to share confidential information about the borrowing company with the
investment segment which may, in turn, forward the information to a potential takeover
bidder

D. None of the above

The correct answer is: C)

Conflicts of interest might emerge whenever investment banking, commercial banking, and
securities services all share the same platform. For example, the banking segment may
unlawfully pass confidential information about one of its clients to the investment segment to
help it provide crucial advice to one of its clients regarding takeover opportunities.

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Q.3492 Which of the following statements is/are accurate?

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.

A. I & IIII only

B. II & III only

C. II only

D. All of the above

The correct answer is: C)

Statement II is correct. In an "underwritten offering," the underwriter buys an issue and then
attempts to sell the issue to investors.

Statement I is incorrect. In a "best effort offering," the underwriters do not buy the issue, they
only act as a broker.

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.

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 Reading 26: 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

B. The payout time is known with certainty

C. The insured pays premium throughout their life

D. Premiums payable may increase with age

The correct answer is: B)

It’s not possible to predict exactly when the sum insured will be paid out since that only happens
one the insured has died – and time of death, as we all know, is unpredictable.

Q.1109 Under term life insurance, the sum assured is payable only if:

A. The insured dies within the specified time period

B. The beneficiary is alive at the end of the specified term

C. The insured lives beyond the specified term period

D. The beneficiary dies within the specified term period

The correct answer is: A)

Term life insurance lasts a predetermined number of years. The sum assures is payable if the
insured dies within the term of the policy, in which event the beneficiary receives the money. If
the beneficiary themselves happen to die soon after the insured has died, there are guidelines
that specify other eligible beneficiaries, usually close family members.

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Q.1110 Mike Dean, FRM, enters into a contract with an insurance company where he pays a
lump sum of $40,000 upfront, in exchange for regular yearly payments, each amounting to
$2500, for the next 25 years. This is most likely:

A. A term life insurance contract

B. An annuity contract

C. A universal life contract

D. An Endowment life insurance contract

The correct answer is: B)

In a typical annuity contract, the policyholder makes a lump sum payment to the insurer. In
exchange, the insurer commits to provide the policyholder with a stream of regular payments for
a specified period of time. In some cases, the policyholder may receive payments for the rest of
their life.

Q.1111 A noncontributory group life insurance contract is a policy where:

A. Premium payments are made only in the first year, without further payments in later
years

B. Premium payments are shared by the employer and the employee

C. The employer pays the premium in full, without financial input from employees

D. The insured company and its employees are offered free life insurance, in exchange
for free goods and services

The correct answer is: C)

A group life policy is an insurance contract written by a company on behalf of its employees,
where the insurer agrees to compensate the company, or employees whenever some kind of
tragedy strikes, for instance, death, injury, or permanent disability. Both the employer and
employees might agree to make payments towards the policy, in which case it’s called a
contributory contract. If premiums are paid by employers only, then the contract is said to be
noncontributory.

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Q.1112 The following data gives the mortality experience among males in Europe in 1931.

Age in Probability of death within one

Survival probability Life expectancy
years year

30 0.001419 0.97372 47.52

31 0.001445 0.97234 46.59

32 0.001478 0.97093 45.65

33 0.001519 0.96950 44.73

Calculate the probability of a new-born male dying between his 30th and 31st birthday.

A. 0.97372

B. 0.001234

C. 0.001419

D. 0.00138

The correct answer is: D)

From the table, the probability of a man surviving to age 30 is 0.97372. The probability of a man
surviving to age 31 is 0.97234. Therefore, the probability that the new-born dies between his
30th and 31st birthday = 0.97372 – 0.97234 = 0.00138

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Q.1113 The following data gives the mortality experience among males in Europe in 1931.

Age in Probability of death within one

Survival probability Life expectancy
years year

30 0.001419 0.97372 47.52

31 0.001445 0.97234 46.59

32 0.001478 0.97093 45.65

33 0.001519 0.96950 44.73

Calculate the probability of a man who is aged 30 dying in the second year?

A. 0.002435

B. 0.001443

C. 0.001419

D. 0.001445

The correct answer is: B)

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 he does not die in
the first year (between ages 30 and 31) multiplied by the probability that he does die in the
second year (between ages 31 and 32). This is:

(1 – 0.001419) * 0.001445 = 0.001443

Q.1114 The following data gives the mortality experience among males in Europe in 1931.

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Age in Probability of death within one
Survival probability Life expectancy
years year

30 0.001419 0.97372 47.52

31 0.001445 0.97234 46.59

32 0.001478 0.97093 45.65

33 0.001519 0.96950 44.73

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

B. 275.09

C. 283.42

D. 125

The correct answer is: B)

First, let’s calculate the present value of the expected payout:

If the man dies during the first year, the expected payout is the probability of a 30-year-old dying
within one year multiplied by the sum assured.

= 0.001419 * 100,000 = $141,90

And because we assume that the payout is made approximately half-way through the year, we
should discount the expected payout for 6 months.

=141.90 * 1.02-1 = $139.12

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

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assured.

[(1 – 0.001419) * 0.001445 * 100,000]*1.02-3 = $135.97

Hence, total expected payout = 139.12 + 135.97 = $275.09

Q.1115 The following data gives the mortality experience among males in Europe in 1931.

Age in Probability of death within one

Survival probability Life expectancy
years year

30 0.001419 0.97372 47.52

31 0.001445 0.97234 46.59

32 0.001478 0.97093 45.65

33 0.001519 0.96950 44.73

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

The correct answer is: A)

First, let’s calculate the present value of the expected payout:

If the man dies during the first year, the expected payout is the probability of a 30-year-old dying
within one year multiplied by the sum assured.

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= 0.001419 * 100,000 = $141,90

And because we assume that the payout is made approximately half-way through the year, we
should discount the expected payout for 6 months.

=141.90 * 1.02-1 = $139.12

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.

[(1 – 0.001419) * 0.001445 * 100,000]*1.02-3 = $135.97

Hence, total expected payout = 139.12 + 135.97 = $275.09

If we let P to be the annual premium payable, then the first premium is received at time zero
with a 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
has to be discounted for 12 months.

Thus, present value of premiums = p + (1 - 0.001419)p / 1.022 = 1.9598p

To calculate the value of p, we then equate the present value of expected payout to the present
value of premiums:

275.09 = 1.9598p
p = $140.37

This is the break-even premium.

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Q.1116 How does an increase in longevity risk affect the profitability of lifelong annuity
contracts?

A. It increases profits made by the insurer

B. It decreases the profits made by the insurer

C. It reduces the return on investment to the policyholder

D. It has no effect on profitability

The correct answer is: B)

Longevity risk refers to the risk that advancement in technology and improved lifestyles will lead
to people living longer. Bearing in mind that a lifelong annuity contract features a series of
regular payments made to the policyholder from a specified age until they die, it’s clear that the
insurer’s profitability will decrease if the policyholder lives longer than estimated.

Q.1117 How does increased mortality risk affect the profitability of life insurance contracts?

A. It increases profits made by the insurer

B. It decreases the profits made by the insurer

C. It reduces the return on investment to the policyholder

D. It has no effect on profitability

The correct answer is: B)

Mortality risk is the risk that epidemics such as HIV & AIDS, pandemics such as Bird Flu, and
wars will lead to people living not as long as expected. Bearing in mind that the policyholder’s
death prompts payment of the sum assured, it’s clear that an increase in mortality risk reduces
profitability of the life insurance business.

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Q.1118 Which of the following strategies presents the best way to deal with longevity and
mortality risks in the insurance business?

A. Adding a substantial risk premium to the final break-even premium payable

B. Avoiding high-risk business

C. Reinsurance

D. Using a high interest rate

The correct answer is: C)

Reinsurance is an arrangement where an insurer tries to transfer some of the pooled risks to
other parties so as to reduce the likelihood of having to pay very large payouts when the
mortality experience turns out to be worse than expected. If longevity and mortality risks
increase, the management should consider transferring some of the risks to an insurer, who, for
instance, might agree to pay claims exceeding a certain amount.

Q.1119 Richard Brad, FRM, owns a high-rise mixed-use building located in the heart of London.
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

B. Reinsure the building against large-scale loss

C. Seek property insurance

D. Seek property-casualty insurance

The correct answer is: D)

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.

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Q.1120 Which of the following is a good example of moral hazards under property insurance?

A. Faking of death

B. Legal suits filed by third parties for losses incurred the moment they realize that the
party at fault is insured

C. A tendency to leave a car unlocked after successfully insuring it against theft

D. A bank taking fewer risks after benefiting from government-sponsored deposit

insurance

The correct answer is: C)

In insurance, moral hazard is idea that a party protected in some way from risk will act
differently than if they didn't have that protection. The change in behavior might increase the
likelihood of perilous events happening or even increase the expected payouts. A tendency to
leave a personal car unlocked just because it’s insured might significantly increase the likelihood
of theft.

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

B. Poor selection

C. Adverse selection

D. Adverse risk modeling

The correct answer is: C)

Adverse selection is the challenge of distinguishing good risks from bad ones with respect to
policy applications. If an insurer fails to collect as much information about the applicant as
possible, they risk leaving out so-called “grey areas” that may make the policy too risky to
execute. For example, if the insurer fails to dig for details about one’s smoking status, they would
end up charging the same premium for smokers and non-smokers. Besides having to contend
with higher-than-expected claims and payouts, a large number of smokers – including those
turned away by other insurers – will seek to buy policies. Some insurers are known to have
incurred heavy losses this way.

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Q.1122 The main difference between a defined benefit scheme and a defined contribution
scheme is that:

A. While defined benefit schemes are employer-sponsored, defined contribution schemes

are run by employees who contribute funds for investment with no input from employers

B. Defined contribution schemes last for a maximum of 40 work-years while there’s no

time limit for defined benefit schemes

C. Defined benefit schemes are tax deductible but defined contribution schemes are not

D. A defined benefit scheme promises a specific income whereas, with a defined

contribution scheme, the income depends on factors such as the size of monthly
contributions and investment performance

The correct answer is: D)

Under a defined benefit scheme, all contributions are pooled and specified payments are made to
retirees out of the pool. Under a defined contribution plan, both the employee and the employer
make contributions. Each employee has an account to which they regularly contribute. They are
free to determine the size of their contributions. The funds may be invested in stocks, bonds or
money market instruments.

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 Reading 27: Fund Management

Q.1123 Robert Jobs, FRM, has historically invested in multiple stocks. After incurring significant
losses on his investments, he decides to liquidate most of his holdings in favor of a mutual fund.
Which of the following best explains why a mutual fund might be better than multiple
investments spread out across several industries?

A. Mutual funds are considered immune from the effects of financial crises

B. Mutual funds are more profitable than individual investments in the long-run

C. Mutual funds allow investors to diversify risks in a way multiple stock investments
cannot

D. Mutual funds are easier to manage compared to multiple stock investments

The correct answer is: C)

Mutual funds are very attractive to small investors because of the diversification opportunities
that they offer. It may be difficult to hold enough stocks to shake off all specific risks. And even
though a small investor might be able to create a well-diversified portfolio, transaction costs can
be somewhat overwhelming. A mutual fund provides an avenue where small investors can pool
their resources and realize the fruits of diversification at a low cost.

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Q.1124 An investor joins a mutual fund and buys shares at $200 each. In the course of trading,
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 for the purpose of calculating the capital gain/loss on the
transaction during the second year?

A. $200

B. $215

C. $195

D. $205

The correct answer is: B)

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

Q.1125 Funds that are designed to track a particular equity index such as the S&P 500 are
known as:

A. Open-end funds

B. Closed-end funds

C. Index funds

D. Hedge funds

The correct answer is: C)

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 2% weight in a particular index, 2% of the
tracking portfolio for the index would be invested in XYZ stock.

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Q.1126 Michael Bauer wishes to buy shares in a front-end loaded mutual fund. He is likely to:

A. Pay a front-end purchase fee at the time of purchase

B. Pay a back-end purchase fee at the time of purchase

C. Pay a front-end fee whenever he decides to sell his shares

D. Pay a back-end purchase fee when he decides to sell the shares

The correct answer is: A)

To meet management expenses, sales commissions, administrative costs, and other costs, mutual
funds charge a fee for every share sold. Those that charge a fee at the onset are called front-end
loaded mutual funds. Those that charge a fee when an investor decides to sell his holdings are
called back-end loaded mutual funds.

Q.1127 Describe the meaning of hurdle rate in regard to hedge funds.

A. The minimum rate of return necessary for fund managers to be paid

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

D. The lowest value that an investment fund or account has reached

The correct answer is: B)

The hurdle rate is the minimum rate of return that a hedge fund should earn before incentive
fees can be deducted from the net profit, after deducting management fees.

Option C refers to a high-water mark.

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Q.1128 The following statements regarding open-end mutual funds are correct, EXCEPT:

A. The funds offer investors professional management

B. The funds offer investors a guaranteed rate of return

C. Shares are redeemed at net asset value

D. Investors are free to sell their holdings at will

The correct answer is: B)

Mutual funds do not offer a guaranteed rate of return. Rather, the return is in large part hinged
on investment performance.

Q.1129 Consider the following statements regarding closed-end mutual funds:

I. Funds are redeemed at their NAVs

II. Shares at times trade at a premium to the NAV
III. Shares at times trade at a discount from the NAV
IV. The funds offer investors professional management

Which of the statements above is/are correct?

A. Only I is correct

B. Only I and II are correct

C. II, III, and IV only

D. All of the statements are correct

The correct answer is: C)

Shares of closed-end mutual funds are redeemed at their prevailing market values, not at their
NAVs.

Shares of closed-end mutual funds are redeemed at their prevailing market values, not at their
NAVs.

All other statements are correct. Shares at times trade at a discount or at a premium from the

NAV, and these funds offer investors professional management.

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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 correct answer is: D)

NAV = (335,000,000 - 68,000,000)/100,000 = $2,670

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

The correct answer is: C)

(279,000,000 - 43,000,000)/20 = 11,800,000 shares

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Q.1132 When most actively managed mutual funds are compared to a market index such as the
S&P 500, they:

A. Beat the market return in most years

B. Underperform the market

C. Generally do not outperform the market

D. Exceed the return earned on index funds

The correct answer is: C)

A large majority of mutual funds may do very well when compared to market indexes, but
generally do not outperform the market. A good explanation usually has much to do with higher
transaction costs in mutual funds.

Q.1133 Transaction costs and management expenses of money market mutual funds may include:

A. Back-end loads

B. Front-end loads

C. 12b-1 charges

D. All the above

The correct answer is: D)

Ownership of a money market mutual fund can include all of the listed expenses.

Note: A 12b-1 fee is an annual marketing or distribution fee on a mutual fund. The 12b-1 fee is
considered to be an operational expense and, as such, is included in a fund's expense ratio. It is
generally between 0.25% and 0.75% (the maximum allowed) of a fund's net assets.

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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 as well as the
Securities Act of 1933

B. Hedge funds outline their investment agenda in their prospectus

C. Hedge funds must be set up as partnerships and do not 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.

The correct answer is: D)

Unlike mutual funds, hedge funds are not subject to regulation by the Securities and Exchange
Commission. They attempt to earn a return from the use of short-selling and leverage and do not
have to produce prospectuses. In fact, the vast majority of hedge funds are very secretive about
their investment strategies.

Q.1135 Which of the following financial institutions must provide to all investors the information
regarding portfolio composition?

A. Mutual funds

B. Hedge funds

C. Both mutual funds and hedge funds

D. None of the above

The correct answer is: A)

Although hedge funds do not have to provide details about their investment compositions, mutual
funds are under stricter regulation and must keep investors abreast of strategies and portfolio
composition.

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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

C. Taking a long position in both overvalued and undervalued stocks

D. Taking a long position in overvalued stocks

The correct answer is: A)

The long/short equity strategy entails taking a long position in stocks that are undervalued and
another short position in overvalued stocks. If stocks in both classes are picked well, the strategy
gives good returns in both bull and bear markets.

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 correct answer is: D)

NAV = (240,000,000 – 12,000,000) / 1,000,000 = 228

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Q.3493 An analyst gathered the following information regarding a mutual fund:

Total shares outstanding: 500,000 shares

Assets: $1,000,000

Liabilities: $300,000

What is the fund's net asset value (NAV)?

A. 2

B. 1.4

C. 0.6

D. 0.7

The correct answer is: B)

NAV = (Market value of assets - Liabilities)/No. of shares outstanding = 1.4

NAV = (1,000,000 - 300,000)/500,000 = 1.4

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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

B. I & III only

C. I & II only

D. All of the above

The correct answer is: A)

ETFs and closed-end funds are sold and purchased on the open market rather than from the fund
itself.

Options I & II are incorrect. ETFs are passively managed to match the index while closed-end
funds are actively managed. In closed-end funds, the market price of shares and the NAV differ
significantly, whereas ETFs are designed to keep their share price close to the NAVs.

Q.3495 A hedge fund is taking directional bets on currency strategies, interest rates strategies,
and stock index strategies. This hedge fund is most likely a:

A. Market-neutral fund

B. Long-short fund

C. Global macro fund

D. Emerging markets hedge fund

The correct answer is: C)

Global macro is an investment strategy based on the interpretation and prediction of large-scale
events related to national economies, history, and international relations. The strategy typically
employs forecasts and analysis of interest rate trends, international trade and payments, political
changes, government policies, inter-government relations, and other broad systemic factors.

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Q.3496 Which of the following is a correct characteristic of hedge funds?

A. Hedge funds are usually listed on exchanges

B. Management fees are a fixed percentage of the funds under management, but
managers also collect fees based on performance

C. Hedge funds are readily available to all investors

D. Hedge funds are free to advertise to the public

The correct answer is: B)

Management fees are a fixed percentage of the funds under management, but managers also
collect fees based on performance.

However, hedge funds cannot be listed on exchanges, are not available to all investors, and
cannot advertise to the public.

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

The correct answer is: B)

A lock-up period is a time during which withdrawals are not allowed for the investors.

A hedge fund's high-water mark (HWM) ensures that the performance fee is only charged on
new profits.

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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

B. Corporate arbitrage fixed income

C. Equity market neutral strategy

D. Convertible arbitrage fixed income

The correct answer is: D)

Convertible arbitrage fixed income is a strategy of exploiting pricing discrepancies between

convertible bonds and common stocks of companies.

Q.3499 A hedge fund has a beginning year value of $200 million, 2% management fee, and 20%
incentive fee with the hurdle rate of 10%. The fees are paid at the end of the period and the
incentive fee is calculated net of management fee. If the ending value of the fund 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

The correct answer is: B)

Management fee = $300 million * 2% = $6 million

Incentive fee = ($300 million - $6 million - $200 million - ($200 million * 10%)) * 20% = $14.8
million

Total fees = Management fee + Incentive fee = $6 million + $14.8 million = $20.8 million

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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 water mark. The structure of the hedge fund is set up so that the incentive
fee is calculated net of the management fee. If the ending value of the fund is $400 million, then
what is the total fees paid to the hedge fund for the period?

A. $12.4 million

B. $15 million

C. $16 million

D. $4.4 million

The correct answer is: A)

Management fee = $400 million * 2% = $8 million

Incentive fee = ($400 million - $8 million - $370 million) * 20% = $22 million * 20% = $4.4
million

Total fees = Management fee + Incentive fee = $8 million + $4.4 million = $12.4 million

Q.3501 The effect of the survivorship bias on hedge fund risk and returns from historical results
is to:

A. Overstate both risk and expected returns

B. Overstate expected returns and understate risk

C. Overstate risk and understate expected returns

D. Understate risk and understate expected returns

The correct answer is: B)

Because poor performing hedge funds are most likely to fail, the survivorship bias causes returns
to be overstated and risk to be understated.

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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

The correct answer is: B)

Year end fund value = $652 million

Management fee = 2% * 652 = $13.04 million

Incentive fee = (652 - 550 - 13.04) * 20% = $17.79 million

Investor's net return = (652 - 550 - 13.04 - 17.79)/550 = 71.17/550 = 12.94%

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Q.3503 Rosy Garcia is considering investing in a hedge fund or in 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:

A. 2.5% greater than the return generated by investing in the FOF.

B. 2.3% greater than the return generated by investing in the FOF.

C. 3.1% greater than the return generated by investing in the FOF.

D. lower than the return generated by investing in the FOF.

The correct answer is: A)

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%

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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

The correct answer is: B)

Management fee = $250 million * 2% = $5 million

Incentive fee = ($290 million - $250 million - $5 million) * 20% = $ 7. million
Total fees to Right-Lance Capital = $5. million + $7 million = $12 million
Investor's return = ($290 million - $250 million - $12 million)/$250 million = 11.20%

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

The correct answer is: C)

Fund value at year-end = $10 million * 1.15 = $11.5 million

Management fees = $11.5 million * 0.02 = $0.23 million
Hurdle amount = $10 million * 0.005 = $0.05 million
Incentive fees = ($11.5 million - $10 million - $0.05 million) * 0.20 = $0.29 million

Total fees paid to Clock Limited = $0.23 million + $0.29 million = $0.52 million
Investor's net return = ($11.5 million - $10 million - $0.52 million)/$10 million = 9.8%

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Q.3506 Which of the following statements correctly describes a fixed income arbitrage hedge
fund strategy?

A. This strategy seeks beta-positive investment strategies

B. This strategy seeks to employ a pricing discrepancy between related securities

C. This strategy involves buying a convertible bond of one issuer while selling another
issuer's common stock

D. This strategy seeks to make investment decisions guided by the economic/political

outlook of a country

The correct answer is: B)

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 A is incorrect. A fixed income convertible arbitrage strategy is a market-neutral (zero

beta portfolio) strategy.

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.

D. None of the above

The correct answer is: B)

In open-end funds, new shares are issued at the net asset value of the fund at the time of
investment. An open-end fund is a collective investment scheme that can issue and redeem
shares at any time. An investor will generally purchase shares in the fund directly from the fund
itself rather than from the existing shareholders.

It contrasts with a closed-end fund, which typically issues all the shares it will issue at the outset,
with such shares usually being tradable between investors thereafter.

Q.3508 In an open-end fund:

A. Shares are issued and are traded in secondary markets

B. Investors can redeem their shares at any point in time at market value

C. Investors cannot redeem shares for a certain number of years that are specified at the
initiation of the contract

D. None of the above

The correct answer is: B)

In an open-end fund, investors can redeem their shares at any point in time at market value.
Note:
Redemption 'at any point in time' means "any day", but there could be strict rules regarding the
exact time of day when redemption can occur. In most jurisdictions, redemption occurs at the
close of business (4 P.M). That's because the underlying assets (shares and bonds) have values
that keep on changing throughout the day. Any purchase or sell order placed on a given day will
then be settled at the Net Asset Value determined using values at close of business.

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Q.3509 MZJ Income Fund is a mutual fund which does not issue new shares, and its shares can
only be bought or sold like equity on the over-the-counter (OTC) market. Identify this type of
fund.

A. Closed-end fund

B. Open-end fund

C. Exchange-traded fund

D. Hedge fund

The correct answer is: A)

Closed-end funds are pooled investments that do not take new investments once the fund is
established or funded.

Q.3510 John Dapper is an investor who has just purchased shares of Grande Investments, a
pooled investment vehicle, on the New York Stock Exchange (NYSE). Grande Investments is most
likely:

A. a hedge fund

B. an open-end mutual fund.

C. not a mutual fund.

D. a closed-end mutual fund.

The correct answer is: D)

Since Grande Investments is a pooled investment vehicle whose shares can be purchased from
the secondary market, it is categorized as a closed-end mutual fund. Open-end fund's shares can
only be purchased from the fund managing firm.

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Q.3511 Which of these is NOT a characteristic of over-the-counter options?

A. Large traders trade over large sums of money

B. They are often used to hedge interest rate risks and currency fluctuation risks.

C. Participants have the freedom to negotiate deals

D. They are highly regulated

The correct answer is: D)

Over-the-counter options are largely UNREGULATED. It is often the place where large players,
i.e.,: banks, hedge themselves against interest rate risks and currency fluctuation risks.

Q.3512 Relative to over-the-counter (OTC) derivatives, exchange-traded derivatives are:

A. Traded in larger lot sizes

B. Transacted through a process which is verified by a central exchange

C. Traded in markets where there is zero potential to earn arbitrage profits

D. Flexible and easily customizable

The correct answer is: B)

Exchange-traded derivatives trade on standardized exchanges which facilitate the creation of

clearing and settlement operations. Clearing is the process by which the exchange verifies the
execution of the transaction and records the participants' identities.

Option A is incorrect. OTC and exchange-traded derivatives do not differ based on the lot sizes
being traded.

Option C is incorrect. Market makers and speculators are active participants in exchange-traded
derivatives markets who stand ready to buy at one price and sell at a higher price, locking in
arbitrage profits. Similarly, OTC derivatives trade on informal exchanges where dealers can
participate on a desire to earn profits.

Option D is incorrect. OTC products are customizable and much more flexible.

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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 clearing house

C. A large commercial bank

D. None of the above

The correct answer is: B)

The clearing house act as the opposite party to each transaction in futures markets.

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

The correct answer is: A)

The process of adjusting the margin balance for gains and losses on the value of futures
contracts due to changes in the prices of underlying assets is called mark to market or marking
to market.

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Q.3517 Which of the following best describes a forward commitment?

A. A forward commitment is a legally binding promise to perform some action in the

future.

B. A forward commitment is a claim (to a payoff) that depends on a particular event.

C. A forward commitment is a contingent claim that depends on a stock price at some

future date.

D. A forward commitment is a derivative contract through which two parties exchange

the cash flows or liabilities from two different financial instruments.

The correct answer is: A)

A forward commitment is a legally binding promise to perform some action in the future.
Forward commitments include forward contracts, futures contracts, and swaps.

Option D is the definition of a swap.

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

B. $17 positive payoff

C. $17 negative payoff

D. None of the above

The correct answer is: B)

The payoff of a put option at expiration is:

PT = max(0,X - ST) = max(0, $59 - $42) = max(0, $17) = $17

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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

B. Equal to the value to the long party multiplied by -1

C. Positive if the spot price of the underlying exceeds the forward price

D. Equal to 1 divided by the value of the long party

The correct answer is: B)

The value of the forward contract to a party holding a short position can be calculated by
multiplying the value to the long party by -1.

Option A is incorrect. The forward contract most likely has a value at expiration, and this value is
equal to the difference between the forward price and the underlying current spot price.

Option C is incorrect. The value of the forward contract to the party with a short position is
positive if the futures price exceeds the spot price. This party with a short position has agreed to
deliver the obligation for a price which is higher than what would have been received if it were
sold today in the market.

Option D is incorrect. The value of the forward contract to a party holding a short position can be
calculated by multiplying the value to the long party by -1.

Q.3521 Which of the following is NOT an exchange-traded derivative instrument?

A. Futures

B. Forwards

C. Options

D. None of the above

The correct answer is: B)

Options and futures are exchange-traded instruments while forwards and swaps are traded on
over-the-counter (OTC) markets.

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Q.3522 Which of the following factors differentiates futures contracts from forward contracts?

A. Futures contracts are cash-settled contracts

B. The value of a futures contract is derived from its underlying asset

C. Forward contracts require physical assets for settlement, not cash

D. Futures contracts trade on regulated markets

The correct answer is: D)

Futures contracts trade on regulated exchange markets such as the Chicago Board of Exchange,
the Eurex Exchange, the New York Board of Trade, etc. On the other hand, forwards contracts
are unregulated and trade over-the-counter.

Q.3523 In order to protect from the downside risk of stock prices, investors should:

A. Buy put options

B. Sell put options

C. Buy call options

D. Sell call options

The correct answer is: A)

Long put options give the owner the right, but not obligation to sell the underlying asset at a
given price (strike price) when the price of the asset is lower than the strike price. This protects
investors from downside risk because the option gains value when the underlying asset's price
drops.

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 Reading 28: 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?

A. Sell a p-strike call

B. Purchase a p-strike call and sell a p-strike put

C. Sell a p-strike call and buy a p-strike put

D. Subscribe to a long forward contract with a forward price P

The correct answer is: C)

The client being obligated to sell the underlying asset implies that he is in the short position of
the contract. Therefore, Allan is in the long forward position. To hedge this position, he needs a
short forward contract. Selling a call option and purchasing a put option effectively replicates a
short forward position.

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?

A. Matthew enters into a short forward contract

B. Matthew enters into a long forward contract

C. Matthew purchases a P-strike call and a P-strike put

D. Matthew purchases a P-strike call and sells a P-strike put

The correct answer is: C)

Customer is obligated to sell the underlying asset to Matthew if …'' means that the customer is
the writer of the option. ''If the spot price at the expiration is more than P'' implies this is a call
option. ''Matthew, on the other hand, has the right to sell the underlying asset to the customer
if…'' implies Matthew is purchasing an option. ''If the spot price at expiration is less than P''
implies that Matthew actually purchases a put option. Therefore, Matthew purchases a P-strike
call and a P-strike put.

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Q.586 James Fernandez, a former derivatives trader, is currently authoring/writing an
introductory book on derivatives strategies. His book aims to cater to the beginning derivatives
traders market. Following is the excerpt from the first chapter of his book:

“Derivatives are financial instruments that trade on regulated and unregulated markets and
whose value is derived from the value of underlying financial assets and commodities. These
underlying assets are commodities such as oil, copper (physical assets) or financial assets like
bonds, or stocks. These derivatives are used for the purpose of hedging, speculation, and
arbitrage. ”

Why is James’ definition of derivatives incorrect?

A. James' definition is incorrect because derivatives do not trade on unregulated markets

B. James' definition is incorrect because the value of a specific derivative is equal to the
value of its underlying asset

C. James' definition is incorrect because the underlying variables of derivatives do not

only include financial assets and commodities, but also include any variables ranging
from interest rates to the amount of rainfall in a specific area

D. James' definition is incorrect because derivatives are only used for hedging and
speculation

The correct answer is: C)

The value of derivatives is derived from a large universe of underlying variables. These
underlying variables are not limited to financial, capital, or physical assets (commodities), but
they can also include variables like inflation, growth rates, natural disasters, election results,
rainfalls, etc. Option A is incorrect because derivatives trade on both regulated exchanges and
unregulated (OTC) markets. Option B is incorrect because the value of the derivative is not equal
to the value of its underlying, but the value of the derivative is derived from the value of its
underlying. Option D is incorrect because derivatives are not only used for hedging risk and
speculation, but they are also used for earning arbitrage profits.

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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 clearing house of
the exchange

Which of these features of futures exchanges are accurate?

A. Feature II only

B. Feature III only

C. Features I and II

D. Features I, II, and III

The correct answer is: D)

All the defined features of futures exchange are correct.

In futures exchanges:
1. Traders do not have to worry about the creditworthiness of the counterparty
2. The trades are handled by exchange’s clearinghouse
3. The participants have to deposit an initial margin with the clearing house of the exchange
4. The credit risk is lower as compared to OTC markets
5. Trades are more standardized

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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 as well as 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?

A. Standardized OTC derivatives must be traded on swap execution faculties (SEFs)

introduced in the US

B. Central counterparty (CCP) is required in standardized derivatives transactions

C. All the OTC trades must be reported to a central registry

D. Participants of OTC derivatives must publicly disclose their initial and maintenance
margin positions

The correct answer is: D)

Participants of OTC derivatives trades do not have to disclose to the public their initial and
maintenance margin requirements

Following are the three most important changes introduced in the US and other global markets
to bring OTC markets in line with exchange-traded markets:
1. In the US, it is required that standardized OTC derivatives must be traded on swap execution
faculties (SEFs). SEFs are portal where one participant can post the bid or offer and trade with
counter-participants
2. In global markets, it became a requirement to use Central counterparty (CCP) in standardized
derivatives transactions
3. All the OTC trades must be reported to a central registry

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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
at the 3-month forward exchange rate of ₺3.9 per euro. Which of the following correctly
describes Lirika Bank’s position on the Euro?

A. Short forward contract

B. Long forward contract

C. Short futures contract

D. Long futures contract

The correct answer is: B)

The bank has a long forward contract (position) on the Euro and a short forward position on the
Turkish lira, whereas Dutch Monks Corp. has a long forward position on the Turkish lira and a
short forward contract on the Euro. Options C and D are incorrect because the contract is a
forward contract as both parties entered into a derivative contract with each other without the
presence of any exchange or clearing house. In futures contracts, both parties enter into a
contract on an exchange without knowing which party is on the other side of the trade.

Q.590 A trader at Prime Investments entered into a derivatives contract to purchase 1 lot (or 100
troy ounces) of gold at the price of $1,200/ounce and take delivery in 3 months from now.
Determine the appropriate position of the trader in the derivatives contract.

A. Long gold futures contract

B. Long dollar futures contract

C. Long gold forward contract

D. Short dollar forward contract

The correct answer is: A)

The trader has a long future contract/position in gold. The derivatives contract is a futures
contract for two reasons:

1. Since the trader does not know the counterparty of the derivatives contract, it is a futures
contract, unlike forward contracts where both the parties know who the other side is.
2. The size of the trade is small and standardized in futures contracts, whereas in forward
contracts the size of the trade is comparatively large and customizable.

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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 correct answer is: A)

The appropriate payoff of the short position in a forwards contract is K - ST

Where K stands for the delivery price and ST stands for the spot price.

Since there are no costs to enter into the contract, the payoff from the contract is also the
trader’s gain/loss from the contract. Option B is incorrect because ST - K is the payoff for the
long position holder in the forward contract. Option C is incorrect because (0, X – ST) is the
payoff a put option. Option D is incorrect because (0, ST - X) is the payoff of a call option.

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Q.592 There are a number of derivatives that 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 futures 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

The correct answer is: C)

The holders of call or put options have the right, but not the obligation, to exercise the option (or
buy/sell the underlying asset). The holder of forwards and futures contracts are obligated to buy
or sell the underlying assets. Option A is incorrect because it costs nothing to enter into a
forward or futures contract. Option D is incorrect because futures and options trade on
exchange-traded markets, whereas, forwards and swaps trade on the over-the-counter market.

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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

B. Short call option with a strike price of $17

C. Long put option with a strike price of $17

D. Short put option with a strike price of $14

The correct answer is: A)

Since Kumar believes the stock will be trading higher, the most appropriate position for him is a
long call option on Geneva’s stock with the strike or exercise price of $14. A long position in a
call option gives the buyer of the option the right, but not the obligation, to buy the stock at the
strike price. The payoff in this case would be equal to $17 - $14 - premium paid, assuming the
stock hits $17 at expiration.

Q.594 Three months ago, the price of the stocks of Universal Builders was $48 per share. Three
months later (today) the price of the stock is $32 per share. Which of the following position
holders earned a profit if they entered into a contract three months ago?

A. Long position in a call option

B. Short position in a put option

C. Short position in a call option

D. None of the above

The correct answer is: C)

To be short a call means you are selling a call option. This is a bet that prices may fall.
Conversely, the call option buyer is betting that the stock price will rise. Option A is incorrect
because since the price of the stock decreased over the period, the buyer (long) of a call option
would have purchased the stock from the market, hence losing the option premium. Option B is
incorrect because the seller (short) of the put option was obligated to purchase the stock at a
higher price while the stock price was declining in the market.

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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 call option

B. American short call option

C. American short put option

D. European short put option

The correct answer is: D)

Shorting a put option means you sell the right buy the stock. In other words, you have the
obligation to buy the stock at the strike price if the option is exercised by the put option buyer.

Option A is incorrect. Selling a call obligates the investor to sell the stock at the strike price if
the option is assigned.

Options B and C are incorrect. An American option can be exercised any time before the
expiration date, while European options can only be exercised at a specific (expiration) date.

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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:

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

Which of these properties are correct?

A. Properties I and II

B. Properties II and III

C. Properties I and III

D. Properties I, II, and III

The correct answer is: D)

All of the mentioned option properties are correct.

I. The price of a call option decreases as the exercise price increases, while the price of a call
option increases as exercise or strike price decreases.
II. The price of a put option increases as the exercise price increases, whereas the price of a put
option decreases as the exercise price decreases.
III. The values of both American call and put options increase as time to maturity increases.

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Q.597 The writer of a put option sold five July put options at the bid price of $7.60 to purchase
500 shares of Galaxy Carpets Co. at the strike price of $13.50 per share. If the price of Galaxy
Carpet’s stock is $9.30 per share at expiry, then which of the following statements accurately
describes the net cash flow of the transaction?

A. The writer of the put profited $3,800 from the transaction

B. The writer of the put lost $2,100 from the transaction

C. The buyer of the put profited $2,100 from the transaction

D. The writer of the put profited $1,700 from the transaction

The correct answer is: D)

The option premium that the writer of the put option earned is greater than the loss he made on
the maturity date by purchasing the stocks at a higher price than the market.

At initiation, the writer/seller of the put option received a cash inflow of $7.6*500 = $3,800. 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 writer/seller of put option made a loss of ($9.3 - $13.5)*500 = -$2,100

Therefore, the net cash flow for the writer of the contract is +$1,700.

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. For 5 puts, that's $760 * 5 =
$3,800

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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
markets to earn a profit.

Which type of derivatives trader did Hellmuth define inappropriately?

A. Speculators only

B. Hedgers and speculators

C. Arbitrageurs and speculator

D. Hedgers and arbitrageurs

The correct answer is: C)

Steve Hellmuth inappropriately defined the properties of Arbitrageurs and Speculators.

I. Hedgers use derivatives to safeguard against the risks related to future movements in market
prices of underlying variables.
II. Speculators, not arbitrageurs, use derivatives to bet on the direction of the market of
underlying variables.
III. Arbitrageurs, not speculators, use derivatives to take offsetting positions in two or more
instruments and markets to earn a profit.

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Q.599 Donald Brown, an investment manager at a pension fund, manages a portfolio of twenty
stocks. Brown 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

The correct answer is: B)

Donald Brown is clearly interested in hedging against the risk of movements in stock prices of
Blue Motors. Put options would give him the right but NOT an obligation to sell the stocks at a
predetermined price, thus cautioning him from a price decline. Option A is incorrect because
Brown is not merely betting on the direction of the market without a reasonable basis. He
appears to engage in objective market analysis before taking the long positions. Option C is not
correct either: market makers are traders that make the market by maintaining bid and offer
prices of a specific asset in anticipation of buying and selling the asset in bulk. Option D is
incorrect because there appears to be no attempt to take advantage of price discrepancies in the
stock price of Blue Motors Inc. so as to make a risk-free profit.

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 derivative 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

D. None of the above

The correct answer is: C)

Hedgers use both forward contracts and options to hedge against the risk faced by their
exposures. Forward contracts work in a way that they neutralize the risk by fixing a buy or sell
price for the hedger to trade on the maturity date. However, options provide insurance to the
hedger to protect against unfavorable movement while at the same time allowing the hedger to
benefit from favorable movement in the prices of the underlying variable.

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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

The correct answer is: A)

Samuel Simpson is a speculator because he uses derivatives to bet on the upward direction of
market prices of crude oil (the underlying asset). Option B is incorrect because hedgers use
derivatives to safeguard against the risks related to future movements in market prices of
underlying variables. Option D is also incorrect because arbitrageurs use derivatives to take
offsetting positions in two or more instruments to earn a profit.

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Q.602 In which of the following is the holder of the derivative instrument exposed to limited
downside risk or limited losses?

A. Long futures contract

B. Short forward contract

C. Long put option

D. Short call option

The correct answer is: C)

A long position in a put option (or the buyer of the put option) has limited risk of losing the
premium paid for the purchase of the put option in case the put option is not exercised, while the
upside potential of the put option is unlimited.

Options A and B are incorrect because both long and short positions in forwards and futures
contracts are exposed to unlimited risk/losses in case of unfavorable movement in a market
variable.

Option D is incorrect because the seller of a call option is exposed to unlimited losses as the
price of stocks can increase to infinity, whereas the profit of the seller of a call option is limited
to the call premium received at the initiation of the option.

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

D. Zero: there's no opportunity for arbitrage

The correct answer is: C)

Value in dollars of K on LSE = £39 x 1.2658 $/£ = $49.37

Arbitrageur could purchase K on LSE for $49.37 and sell on NYSE for $50.
Profit per share = $50 - $49.37 = $0.63

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Q.604 Jerome Kerviel, a junior trader in Societe Generale’s Delta One unit, was responsible for
one of the biggest losses in the history of banking due to fraudulent activity. He traded equities
and futures contracts in the German, French and other European markets. Jerome’s fraudulent
activities and unauthorized positions were discovered in 2008, which led to losses of 4.9 billion
euros. Which of the following statements is appropriate regarding Jerome Kerviel?

A. He was an arbitrageur, but he traded like a speculator

B. He was a hedger, but he traded like an arbitrageur

C. He was a speculator, but he traded like an arbitrageur

D. He was an arbitrageur, but he traded like a hedger

The correct answer is: A)

Jerome Kerviel, a junior trader in Societe Generale’s Delta One unit, was an arbitrageur. His job
was to find arbitrage trades in different stocks trading in the German DAX, the French CAC 40,
and the Eurostoxx 50 indices. He speculated the direction of indices, which lead him to losses of
4.9 billion euros.

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 Reading 29: 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 told boss him that he
will 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

The correct answer is: D)

If the investment company does not approve the trading of over-the-counter derivatives, then the
trading of forwards and swaps is not allowed. Generally, forwards and swaps trade on over-the-
counter markets while futures contracts and options trade on exchanges.

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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

C. Both over-the-counter markets and centralized exchanges

D. None of the markets are suitable

The correct answer is: B)

Exchange markets or centralized exchanges are more suitable for Singh. Since the trader wants
to trade more standardized and more liquid derivatives instruments, the best option available for
the trader is to trade on exchanges. Over-the-counter markets are more suitable for the investors
that want to invest in long-dated, illiquid, customizable and more complex derivatives
instruments.

Q.826 Muhammad Amir recently completed his PhD 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?

A. Muhammad Amir is incorrect regarding the liquidity feature of exchanges

B. Muhammad Amir is incorrect regarding the enhanced efficiency of exchanges

C. Muhammad Amir is incorrect regarding the promoted customization of exchanges

D. Muhammad Amir is incorrect regarding the risk reduction of exchanges

The correct answer is: C)

Exchanges promote standardization, not customization. Due to the central clearing feature of
exchanges, exchanges are more efficient and more liquid. Exchange act as the buyer to every
seller, and seller to every buyer, which results in reduced counterparty or default risk.

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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?

A. Exchange constructs contracts that are standardized in terms of maturity dates,

minimum price quotation increments, deliverable grade of the underlying assets, delivery
location of the contract, etc.

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.

D. Exchange provides reporting services related to transaction prices and volumes to

trading participants, data vendors and subscribers, which improves the price
transparency.

The correct answer is: C)

Exchanges least likely provide a platform for hedgers and arbitrageurs to construct products and
transactions according to their needs. Hedgers can hedge their risk through standardized, not
customized products. Additionally, the pricing strategy of exchange-traded products is based on
the no-arbitrage opportunity principle.

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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 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

C. Both reasons are incorrect

D. Both reasons are correct

The correct answer is: D)

Both reasons mentioned are correct. Reason I is correct as one of the main advantage of trading
in exchanges is that it allows the netting of all the trades of a party through its central clearing
feature, which means that if a party has two opposite outstanding positions with two different
parties, then both positions of the party will be offset or netted. The second reason for trading in
exchanges is that it reduces counterparty risk and systemic risk.

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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.

A. Only statement I is correct

B. Only statement II is correct

C. Only statements II and III are correct

D. All of the statements are correct

The correct answer is: D)

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.

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Q.830 The netting function of exchanges is beneficial and cost-effective for the members as it
offsets the contracts of counterparties to reduce their exposure and it also reduces the costs of
maintaining open positions as the parties only have to post margins against net positions rather
than complete exposure. However, netting is not as simple a process as it seems; there are three
different variations of netting. Which of the following is NOT one of them?

A. Direct clearing

B. Clearing rings

C. Netted clearing

D. Complete clearing

The correct answer is: C)

There is no such variation of netting as netted clearing. In all the variations, netting and clearing
take place. In a direct clearing, two original parties bilaterally net or offset their positions. In
clearing rings, more than two parties are involved. Complete clearing, or what we refer to as
central clearing, involves a central clearing house or central counterparty (CCP) that acts as the
counterparty in all transactions.

Q.831 Before the development of the central counterparty (CCP), a specific type of netting used
to take place in exchanges. In this form of netting, two or more parties with positions in a
standardized product would agree to offset their positions with each other. Once the parties
agreed, it was binding on them to offset their positions. Which type of netting is this situation
being referred to?

A. Direct clearing

B. Clearing rings

C. Bilateral clearing

D. Complete clearing

The correct answer is: B)

Before the introduction of the central counterparty (CCP), clearing or netting used to take place
among the members themselves. In clearing rings, three or more parties with outstanding
exposure form a group and agree to offset their positions. This was possible due to the
standardization of contracts. A party could be part of more than one such groups or rings. Once
the party has entered a ring, it is binding on that party to offset their position within that ring.

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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 clearing houses, 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. Direct clearing

B. Clearing rings

C. Bilateral clearing

D. Complete clearing

The correct answer is: D)

Centrally cleared markets with CCPs or clearing houses have complete clearing features. In
these types of markets, central counterparties (or clearing houses) exist and act as the buyer to
every seller and the seller to every buyer. Since all the contracts are standardized in terms of
maturities, underlying assets, delivery terms, etc., the CCP can easily offset all transactions.

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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

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

The correct answer is: A)

Only statement I is correct because the members of OTC markets are in a better position to
negotiate the terms of the contract because OTC contracts are customizable and can be
negotiated in terms of maturity, grade of underlying assets, delivery terms, etc., while the
members of exchange markets can not negotiate the terms of the contracts as contracts are
standardized. Statement II is incorrect because it is less risky to trade in exchange markets
because the central counterparty of the exchange guarantees the clearance and fulfillment of the
obligations. On the other hand, the credit risk in a bilateral transaction in OTC markets is high.

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Q.834 Ellen Fraser, FRM, has recently joined Galactic Investment Bank as an investment
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?

A. Over-the-counter derivatives are least likely exposed to basis risk

B. Exchange-traded derivatives are least likely exposed to basis risk

C. Both over-the-counter and exchange-traded derivatives are exposed to basis risk

D. Neither over-the-counter nor exchange-traded derivatives are exposed to basis risk

The correct answer is: A)

Over-the-counter derivatives are least likely to contain basis risk. Basis risk can arise due to
differences in the maturities of the contracts that are used for hedging the exposure. Since OTC
derivatives are customizable, OTC derivatives are negotiated to match the maturities that reduce
basis risk. In contrast, exchange-traded derivatives are standardized and are more likely to
contain basis risk as it is difficult to match the maturities of exchange-traded derivatives with the
product that has to be hedged.

Q.835 Which of the following is an appropriate disadvantage of over-the-counter derivatives

instruments as compared to exchange-traded derivatives instruments?

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
systematic risk of the transaction

D. OTC derivatives give rise to basis risk, as there are no standardized contracts in OTC
derivatives markets

The correct answer is: B)

It is one of the disadvantages of over-the-counter derivatives that, in order to unwind an OTC

derivatives transaction, a member must interact with the original counterparty who can misuse
its privileged position to quote unfavorable prices.

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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.
Determine which of the derivative categories mentioned by Chen is NOT a type of OTC
derivative?

A. Interest rate derivatives

B. Exchange rate derivatives

C. Credit derivatives

D. Arbitrage derivatives

The correct answer is: D)

Arbitrage derivatives are not a category of derivatives. All types of derivatives can be used to
earn arbitrage earnings. The five main categories of the over-the-counter derivatives are:
I. Interest rate derivatives
II. Foreign exchange derivatives
III. Equity derivatives
IV. Commodity derivatives
V. Credit derivatives

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Q.837 Which of the following is the accurate difference between the clearing process and the
settlement process of over-the-counter derivatives?

A. The settlement of OTC derivatives is the process by which payment obligations

between two or more parties are computed and netted, and clearing is the process by
which the contract obligations are fulfilled

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 correct answer is: B)

Clearing and settling are two different processes. The clearing process of OTC derivatives is
related to computing the cash flow or payoff of a certain party after netting, and the settlement
is the process by which the contract obligations are fulfilled.

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

C. Both over-the-counter and exchange markets

D. None of the above

The correct answer is: C)

In OTC markets, both parties bilaterally require margin as security against losses, whereas in
exchanges, the margining process is performed by the central counterparty.

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Q.839 Over the years, over-the-counter markets have outgrown exchanges because of their
flexible regulations and customized transactions. Nevertheless, this flexibility does not come
without a cost. Over-the-counter markets are more exposed to systemic risk than the exchanges.
From the following, choose the most accurate explanation of systemic risk in the context of over-
the-counter markets.

A. Systemic risk is the risk related to the early settlement by a large market participant
that will absorb the liquidity from the entire financial market.

B. Systemic risk is the risk related to the unfavorable movement in the underlying which
can trigger the early settlement of the contract by the counterparty.

C. Systemic risk is the risk related to the complexity and negotiability of OTC contracts
that can make it difficult for the market participants to truly price the risk.

D. Systemic risk is the risk related to the default of a large market participant that
creates a chain reaction of defaults in the entire financial system.

The correct answer is: D)

Systemic risk in the context of OTC markets can be triggered by the default of a large market
participant who has multiple and sizable positions in the market. The default can spark a chain
reaction in the entire financial market. Therefore, OTC markets use different methods such as
margins and capital requirements to mitigate systemic risk.

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Q.840 Gunther Bosky is a junior investment manager at Menschen Investment Company. The
company is planning to take a large exposure in over-the-counter derivatives markets. The senior
management of the firm believes that such a big position brings together serious counterparty
risk which can affect the functionality of the company. Therefore, the management asked Bosky
to construct the transaction through a special purpose entity (SPE). Which of the following is the
best explanation of the use of an SPE in OTC markets?

A. A Special Purpose Entity (SPE) is a separate legal entity created to isolate a firm from
financial risk. The main purpose of its creation is to standardize the OTC derivatives and
improve market liquidity.

B. A Special Purpose Entity (SPE) is a separate legal entity created to isolate a firm from
financial risk. The main purpose of its creation is that if a specific counterparty defaults
in a derivatives transaction, the firm can still receive full settlement on its other
transaction.

C. A Special Purpose Entity (SPE) is a separate legal entity created to isolate a firm from
financial risk. The main purpose of its creation is that it acts as a member in the OTC
markets and provides clearing services for other firms.

D. A Special Purpose Entity (SPE) is a separate legal entity created to isolate a firm from
financial risk. The main purpose of its creation is to carry out the market making activity.

The correct answer is: B)

A Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) is a separate legal entity
created to isolate a firm from financial risk. The company forming an SPV transfers its asset to
the SPV. If a specific counterparty in a derivatives transaction defaults, the firm can still receive
full settlement on its other transactions without the netting of the losses on the defaulted
transactions.

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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

C. The capability of credit risk management, and providing operation guidelines to

external counterparties to control credit quality

D. The ability of the DPC to minimize market risk

The correct answer is: A)

The credit rating of a derivatives product company or DPC does not depend on its ability to
mutualise the loss amongst counterparties and market participant; it is the role of the central
counterparty in exchanges. The ratings of the DPC depends 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 strong credit ratings that provide credit
wraps and credit default swaps to achieve diversification and better returns

The correct answer is: D)

Monolines/Credit Derivatives Product Companies (CPDCs) are similar to insurance companies (or
financial guarantee companies) with strong credit ratings that provide credit wraps (financial
guarantees) and credit default swaps (CDC) to achieve diversification and better returns. They
are structured as an extension of a DPC that focused only on credit default swaps.

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

C. Derivative Product Company

D. Special purpose vehicles

The correct answer is: D)

A Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) is a separate legal entity
created to isolate a firm from financial risk. The company forming an SPV transfers its asset to
the SPV. If a specific counterparty in a derivatives transaction defaults, the firm can still receive
full settlement on its other transaction without the netting of the losses on the defaulted
transactions.

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Q.3571 Financial intermediaries securitize assets by creating Special Purpose Vehicles (SPVs)
because:

A. It increases the overall return

B. It protects the SPV in case the financial intermediary goes bankrupt

C. SPVs increase the liquidity of securitized assets

D. All of the above

The correct answer is: B)

Special Purpose Vehicles are created to protect the investors in case of bankruptcy of financial
intermediary (usually a bank). As the pooled assets are separate from the financial intermediary,
in the event of bankruptcy, the lenders of the financial intermediary cannot lay claim on the
SPV's assets.

Q.3572 What is the definition of a Special Purpose Vehicle (SPV)?

A. A subsidiary company with an asset/liability structure and legal status that makes its
obligations secure even if the parent company goes bankrupt

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

D. An institution providing a wide variety of deposit, lending and investment products to

individuals, businesses or both.

The correct answer is: A)

A Special Purpose Vehicle (SPV) is a subsidiary of a company which is bankruptcy remote from
the main organization. The actions of an SPV are usually very tightly controlled, and they are
only allowed to finance, buy and sell assets.

Notes: Option B is the definition of mortgage-backed securities, option C is the definition of

CDOs, and option D is the definition of a financial institution.

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 Reading 30: 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

Determine if Oliver’s comments are accurate.

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

D. He is correct regarding all stages of the derivatives trade cycle

The correct answer is: A)

1. Bilateral documentation and internal approvals

Here, the overall parameters of trading activities are established through a bilateral master

agreement. This is 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.

2. Clearing

Clearing is the management of a transaction during its life. It includes margining and netting.

3. Settlement

Settlement of a trade occurs when the trade is completed and all payments have been made and

legal obligations satisfied. Cash or other assets are exchanged per the terms of the contract.

settlement takes the form of cash or physical delivery.

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II is incorrect. The underlying securities are exchanged at the settlement stage.

III is incorrect. Margining occurs at the clearing stage.

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. Netting stage

D. Settlement stage

The correct answer is: B)

In the clearing stage of a derivatives transaction, the third party or central counterparty is
involved in clearing the trade.

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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

Which of her statements is/are correct?

A. Only statement I is correct

B. Only statement II is correct

C. Both statements are correct

D. None of the statements is correct

The correct answer is: C)

Both statements are correct. Since the exchanges are standardized in terms of maturity, grade of
the underlying, etc., the focus of the CCP is to standardize and enhance the operational process.
On the other hand, since over-the-counter markets are long-dated, customized, and illiquid, the
goal of CCPs in OTC markets is to mitigate counterparty risk and to maintain liquidity.

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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.

A. Increased interconnectedness and decrease risk

B. Decreased interconnectedness and decrease risk

C. Increased interconnectedness and increased transparency

D. Decreased interconnectedness and increased transparency

The correct answer is: D)

The two benefits of central counterparties (CCP) in changing the topology of the financial
markets is that it decreased the interconnectedness of market participants, which in turn,
reduced systematic risk. Another benefit of CCPs is that it increased the transparency, as they
maintain transaction records, including notional amounts and counterparty identities.

Q.848 Which of the following is the appropriate definition of the novation function of the CCP?

A. Novation is the act of replacing one party in a contract with another, or of replacing
one debt or obligation with another. It extinguishes (cancels) the original contract and
replaces it with another, and requires the consent of all parties involved.

B. Novation is the act of replacing one party in a contract with another, or of replacing
one debt or obligation with another. It extinguishes (cancels) the original contract and
replaces it with another, and does not require the consent of all parties involved.

C. Novation enforces that no party is allowed to replace a contract with another, or of

replacing one debt or obligation with another.

D. Novation enforces that no party is allowed to replace a contract with another, or of

replacing one debt or obligation with another.

The correct answer is: A)

Novation is the legal process in which the CCP positions itself between buyers and sellers when
one party replaces a contract with one or more other contracts. Novation transfers counterparty
risk to the CCP. Once the novation process is complete, the new contract is not legally obligated
on previous parties

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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?

A. Ratings of the borrower

B. Risk of the transaction

C. Creditworthiness of the borrower

D. Discretion of the parties involved

The correct answer is: B)

The margin requirements are solely dependent on the risk of the transaction. The CCP evaluates
the transaction and, based on the risk of the transaction, requires a certain margin from the
parties involved.

Q.850 Identify if the given definitions of margins are correct.

I. The variation margin 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.
II. The initial margin is the additional amount required from members at the inception of the
trade; it provides coverage against the losses in case one member defaults.

A. Only definition I is correct

B. Only definition II is correct

C. Both definitions are correct

D. None of the definitions are correct

The correct answer is: B)

The definition of the initial margin is correct. The definition of the variation margin is incorrect
because it is netting, not the variation margin, that involves offsetting the contracts to reduce
the exposure to counterparties. The variation margin requires members to pay or receive the
cash or other assets against gains and losses in their positions during the contract.

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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?

A. Increasing the variation margin

B. Auctioning the contract of the defaulting party

C. Requiring additional initial margin

D. Loss mutualizing

The correct answer is: B)

As the Central Counterparty (CCP) guarantees the obligation of the contract, the CCP will honor
the contract to the party if the other party defaults. This is not done by the CCP directly paying
the losses on behalf of the defaulter, but the CCP replaces the defaulting counterparty of the
contract with a new counterparty by auction.

Options A and C are wrong because the additional margin requirements are made before the
default. Option D is wrong because loss mutualisation is the last resort.

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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?

A. Let the defaulting member absorb the losses

B. Let the CCP pay for the losses

C. Let the CCP replace the defaulting member through auction

D. Let the CCP distribute loss through loss mutualisation

The correct answer is: C)

The auction has the least adverse consequences in case of default. Through the auction, the CCP
can swiftly replace the defaulting counterparty with a new party in a contract by auctioning the
contract to other members. The members should participate in the auction, or otherwise the loss
of the defaulting contract will be distributed among all members through loss mutualisation.

Q.853 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. Which of the following is the
appropriate term used for this pool?

A. Initial margin

B. Variation margin

C. Novation fund

D. Default fund

The correct answer is: D)

A default fund is similar to an insurance of all CCP members against the default risk. All the
members of the central counterparty (CCP) contribute a specific amount of resources to a pool
called a default fund. The default fund is used to pay for the losses of the defaulting counterparty
when the defaulting party’s own resources are insufficient to cover losses.

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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

C. Loss mutualization

D. Multilateral netting

The correct answer is: C)

The process of insurance and absorbing the losses of a defaulting counterparty through a
specific pool is called loss mutualization. In other words, loss mutualization is the process in
which all the central counterparty (CCP) members contribute a specific amount of resources to a
pool which is 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.

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

The correct answer is: D)

Increased creditworthiness is a good thing, but in terms of clearing, it does not matter as the
central counterparty (CCP) works to mitigate the counterparty risk. Options A, B, and C are
accurate criteria for contracts/products that are cleared through CCPs in exchanges.

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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?

A. Should meet admission criteria like ratings

B. Financial commitment through contribution to the default fund

C. Should be able to conduct the novation process

D. Should be able to fulfill operation requirements like posting margins

The correct answer is: C)

The member of a CCP has a lot of responsibilities as it acts as the liaison between the CCP and
the end users. Novation is a legal process that is conducted by the CCP, and is the act of
replacing one party in a contract with another, or of replacing one debt or obligation with
another. It extinguishes (cancels) the original contract and replaces it with another, requiring the
consent of all parties involved.

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Q.857 Adam Eger, an equity analyst, is one of the members of a panel of guests who are invited
to have a discussion on 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 following factors:

I. Geographical markets intend that 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?

A. Only factor I supports the argument of multiple CCPs

B. Only factor II supports the argument of multiple CCPs

C. Both factors support the argument of multiple CCPs

D. None of the factors support the argument of multiple CCPs

The correct answer is: C)

Both factors support the argument that there must be more than one CCP. Regional CCPs are
more cost-efficient and risk diverse than a single global CCP. It is easy for a regional CCP to clear
transactions with locally denominated contracts. However, it is difficult for one global CCP to
specialize in every product being traded in each global exchange.

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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?

A. Trading spreads and initial margins

B. Trading spreads and interest on the margins

C. Fees on clearing trades and interest on the margins

D. Fees on clearing trades and initial margins

The correct answer is: C)

It is necessary for CCPs to have sufficient human and capital resources to clear the million
dollars worth of transactions and reduce counterparty risk. To finance these resources, CCPs
need revenues. The two most common revenue streams of the CCPs are the fees that the charge
per trade on the members for the clearing services and the interest that they earn on the
margins posted by the members.

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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

Which of the abovementioned statements is/are correct?

A. Points I and II are correct

B. Points II and III are correct

C. Points I and III are correct

D. Points I, II, and III are correct

The correct answer is: C)

Points I and III are correct. The point I is correct because it is true that the central party doesn’t
vanish counterparty risk completely but, in fact, it centralizes the risk by acting as the
counterparty to every party. Point III is also correct. The increase of margin requirements can
absorb the liquidity of the party which can result in increased counterparty risk or default risk.
Point II is incorrect because, like any other financial institutions, CCPs can also fail.

Q.860 A number of differences exist in over-the-counter markets and central counterparty or

CCP markets. Because of these differences, CCP markets are considered less risky than OTC
markets. Which of the following is not an appropriate difference between OTC and CCP markets?

A. Bilateral trading and clearing

B. Margining practices

C. Standardization

D. Default funds

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The correct answer is: A)

Just like in OTC markets, bilateral trading and clearing also exist in CCP markets the. Therefore,
it is not a difference but a similarity between OTC and CCP markets. CCP markets are
standardized, and OTC markets are customized. Margining, including initial margins and
variation margins, are required by the CCP but are not required in all OTC markets. The default
fund is the distinctive feature of the CCP.

A note on bilateral trading<br

In traditional OTC markets, trading is bilateral, meaning that transactions occur between two

parties without the intervention of a central party. Such transactions can be between a dealer

and customer or a dealer and another dealer. Dealers act as market-makers by quoting prices at

which they will buy and sell a security, currency, or other financial products. A trade can be

executed between two participants in an OTC market without others being aware of the price at

which the transaction was completed.

However, in an attempt to reduce risk, recently passed legislation requires that almost all OTC

transactions use clearinghouses. OTC market clearinghouses operate in a similar fashion to

clearinghouses on futures exchanges. Two parties (A and B) negotiate an OTC agreement, after

which it is submitted to the clearinghouse for acceptance. Assuming the transaction is accepted,

the clearinghouse will become the counterparty to both parties A and B. Thus, the clearinghouse

assumes the credit risk of both parties in an OTC transaction. This risk is managed by requiring

the parties to post initial margin and any variation margins on a daily basis.

Thus, bilateral trading is no longer a prominent factor in OTC markets.

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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 correct answer is: D)

Requiring greater margin requirements in central counterparty (CCP) cleared markets is not an
advantage but a disadvantage. The procyclicality is referred to as the dependence on the state of
the economy. The greater margin requirements under the crises period can increase the
dependency of market participants on the economy, which increases procyclicality. Options A, B
and C are appropriate advantages of the CCPs.

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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 correct answer is: C)

The distribution of the loss or loss mutualization is an advantage, not a disadvantage of CCP
markets. Loss mutualization is referred to as the situation when the losses of the defaulting
counterparties exceed the financial commitments from the defaulter. These losses are then
distributed throughout the CCP members. Options A, B and C are appropriate disadvantages of
the CCP.

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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 it is transferred from one part to
the CPPs
II. CCPs are also vulnerable to failure
III. The margining function of CCPs is a double-edged sword; it increases the market liquidity
and decreases the liquidity position of the participants

Which of the properties of CCPs analyzed by Owen are correct?

A. Properties I and II are correct

B. Properties II and III are correct

C. Properties I and III are correct

D. Properties I, II, and III are correct

The correct answer is: D)

All three properties of CCPs are correct. The counterparty risk does not disappear from the
market, but it is transferred from one part to the central counterparty (CCP). Just like other
financial institutions, CCPs can also fail. In fact, we have seen in the past that when CCPs have
failed, governments have come to bail them out. Lastly, the margining function of the CCPs have
both advantages and disadvantages. The increased margin increases the liquidity in the market,
but it also drys up the liquidity of participating members, which could lead to default risk.

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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.

B. It is the moral hazard related to the effect of disincentivizing counterparty risk

management practices by CCP members. Since the CCP acts as the counterparty to the
transaction, the party or institution invests little resources in monitoring others parties’
credit quality.

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 are unnecessary for them.

D. It is the moral hazard related to the creation of liquidity. As the CCP creates and
maintains the liquidity in financial markets through margining, more and more
participants enter the market with the intention of speculating.

The correct answer is: B)

The moral hazard which the journalist is referring to is the moral hazard related to the effect of
disincentivizing counterparty risk management practices by CCP members. Since the CCP
assumes most of the counterparty risk of the transaction, the party or institution in the
transaction invests little time or resources in monitoring other parties credit quality. A is
incorrect because standardization does not increase the room for alternative products; it does
the opposite. By standardizing products, participants have to trade in a highly regulated set of
instruments that have some common characteristics.
C is incorrect. a CCP does not make counterparty risk disappear. What it does is centralise it and
convert it into different forms of financial risk such as operational and liquidity.
D is incorrect. There's no empirical evidence suggesting that increased liquidity increases
speculative tendencies.

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Q.865 One of the disadvantages of CCPs is that the requirement of clearing the standardized
products may create a market-based division on cleared and non-cleared trades. This division
may result in volatile cash flows for parties and mismatch of margin requirements for hedge
positions. This disadvantage most likely related to:

A. Procyclicality

B. Adverse selection

C. Bifurcation

D. Moral hazard

The correct answer is: C)

The bifurcation between cleared and non-cleared trades is created due to the requirement of
clearing the standardized products. This bifurcation results in highly volatile cash flows for
parties and mismatch of margin requirements for hedge positions.

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?

A. Distress of other clearing members

B. Failed auction

C. Resignation of employees

D. Reputational risk

The correct answer is: C)

The resignation of the clearing members, not the resignation of the employees, is the risk which
the CCP faces. Distress or default of the other clearing members once a member has defaulted is
a major risk faced by the CCP. Another risk is that if the CCP doesn’t receive reasonable bids in
an auction, then the CCP has to allocate the losses to other clearing members, which can
catalyze the financial markets. Another risk faced by the CCP is the reputation risk, which arises
after a CCP allocates losses to other clearing members after the default of a member.

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Q.867 Fiona Stan is a lecturer on the subject of derivatives at Rheinfall University. During the
lecture regarding the risk faced by the central counterparty itself, she mentioned that one the
major risks faced by the CCP is the risk that arises when allocating the default loss of one
clearing member to other clearing members. Though all members agree with this method, some
members believe it's unfair to allocate a loss to clearing members just because they have
sufficient funds and positive positions. Stan is most likely referring to the risk related to:

A. Distress of other clearing members

B. Failed auction

C. Resignation of clearing members

D. Reputational risk

The correct answer is: D)

Reputation risk or reputational risk is the risk related to gaining a bad reputation due to the loss
mutualisation or loss location methods of a CCP. Though all members agree to this method, some
members believe it's unfair to allocate a loss to clearing members just because they have
sufficient funds and positive positions. The distress or default of the other clearing members
once a member has defaulted is a major risk faced by the CCP. The resignation of the clearing
members is a risk that arises when one member defaults and the loss is allocated to another
clearing member. This results in the resignation of the members. Another risk faced by the CCP
is that if it doesn’t receive reasonable bids in an auction, then the CCP has to allocate the losses
to other clearing members, which can catalyze the financial markets.

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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?

A. Distress of other clearing members

B. Failed auction

C. Resignation of clearing members

D. Reputational risk

The correct answer is: B)

The anchor is referring to the risk faced by a central counterparty (CCP) due to failed auction.
The risk of failed auction arises when the CCP does not receive reasonable economic bids for the
defaulted contracts through an auction. In this case, the CCP has to impose significant losses of
that member on another clearing member via loss allocation methods, which may result in
financial distress and potential further 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

C. Resignation of clearing members

D. Reputational risk

The correct answer is: B)

The loss on the investments made by central counterparties is a non-default-related risk. The
funds held on margin are used by CCPs to earn profits and interests. These margin funds are
sometimes made up of cash and securities; these securities can decline in value which may also
result in investment losses. Failed auction, the resignation of clearing members, reputation risk,
and distress of other members are typical default related risks faced by central counterparties.

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Q.870 A postgraduate finance student of Dornbusch University has based its thesis on the
subject of the risks faced by central counterparties. The student has categorized the risks faced
by central counterparties in two categories i.e., default risks and non-default risks. This
categorization is consistent with the risk classifications provided in the FRM books. Which of the
following types of risk is a type of non-default risk?

A. Loss mutualisation

B. Resignation of clearing members

C. Frauds

D. Reputational risk

The correct answer is: C)

Fraudulent activities of the internal and external members of the central counterparty are types
of non-default risks. Since the default-related risks and non-default-related risks are considered
correlated, the possibility of fraudulent activities is high in financial distress and defaults.

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
its margining functions. This is due to to the fact that 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

The correct answer is: D)

Model risk is the risk associated with creating a robust and standard model that can derive the
margin requirements in a timely and standardized manner. Unlike exchange-traded products, the
initial margin and variation margins requirements of OTC product cannot be derived from
market sources directly, but they require complex models to carry out the mark-to-market
activities.

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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

The correct answer is: D)

The central counterparty is most exposed to model risk in the modeling of the initial margin
requirement. 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.

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Q.874 The central counterparties are not only exposed to default risks and operational risks, but
they are also exposed to liquidity risks. Which of the following functions of CCPs can possibly
increase the liquidity risk of the CCPs?

A. Large amount of cash that flows through the central counterparties (CCPs) due to
variation margin payments

B. Large amount of cash that flows through the central counterparties (CCPs) due to
initial margin requirements

C. Large amount of default losses that are mutualized after a clearing member of CCPs
has defaulted

D. Large amount of cash that disappears from central counterparties (CCPs) when one
clearing member has a negative balance position

The correct answer is: A)

The liquidity risk in central counterparties (CCPs) arises due to the large amount of cash that
flows through the central counterparties (CCPs) in relation to the variation margin payments.
Option B is incorrect because initial margins do not flow as frequently as variation margins.
Option C is incorrect because, in loss mutualization, the losses are allocated to clearing
members. This activity does not have a direct impact on the liquidity of CCPs. Option D is
incorrect because the loss of one party is the gain another party within the CCP market.

Q.875 The central counterparties (CCPs) are also exposed to liquidity risks due to the large
amount of cash that flows through the central counterparties (CCPs) in relation to the variation
margin payments. Apart from variation margin cash flows, there are other determinants of
liquidity risks that are faced by CCPs. Identify one of those determinants.

A. Cash outflows due to loss mutualization

B. Cash flows due to auctions

C. Basel III leverage ratio requirements

D. Initial margin requirements

The correct answer is: C)

In the Basel III leverage ratio requirements, the required leverage rate is defined as a bank's tier
one capital divided by its exposure, which should be at least 3%. This leverage requirement is
aimed to reduce excessive risk-taking by CCPs.

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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?

A. Default by a clearing member

B. Increase in margin requirements

C. Failed auction

D. Infrastructure breakdown

The correct answer is: D)

The breakdown/failure of the infrastructure of the central counterparty (CCP) and fraud can
increase the operational risk of the CCP and give rise to additional risk for its members. This is
due to the centralization feature of the CCP.

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 the 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

D. None of the above

The correct answer is: 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. Members and CCPs
frequently use repo rates. During the Eurozone crises, we noted that sovereign risk is strongly
correlated with repo rates.

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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 correct answer is: B)

The custodian risk or custody risk is associated with the inability of a custodian to perform its
operation. Banks and large financial institutions act as the custodians of the CCPs. There are
extensive regulatory controls that govern the custodian services of these banks. However, these
banks can face technical failures or human failures that could stop a bank from processing the
CCP’s instructions to make cash payments and receive or deliver securities to its members. This
could create not only liquidity problems on the end of the CCP and members but can also
increase the systematic risk in the market.

Q.1138 The default of a clearing member could create further problems, including:

A. Loss resulting from litigation

B. Fraud

C. Operational losses

D. Default or distress among other CCP members

The correct answer is: D)

If a clearing member defaults, other CCP members might experience distress due to default
correlation. Default events are unlikely to be isolated events.

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Q.1139 Since CCPs handle large amounts of cash and securities, they could potentially suffer
losses from non-default loss events. The following are good examples of such events except:

A. Business or operational failure

B. Failure or insolvency of a custodian

C. Investment losses

D. Resignations

The correct answer is: D)

Resignations are not non-default events but are actually triggered by default events. By
resignation, we are referring to the possibility of clearing members leaving a CCP in the
aftermath of a default.

Q.1140 One of the lessons learned from previous CCP failures is that:

A. Initial margin methodologies need not be updated when there’s a major shift in market
regime

B. Initial margin methodologies need to be updated when there’s a major shift in market
regime

C. Initial margin updates should be excessive

D. CCP failures cannot be avoided

The correct answer is: B)

Significant market moves should call for an update of initial margins to avoid liquidating
positions.

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Q.1141 Which of the following is the main source of liquidity risk in CCPs?

A. High transaction costs

B. Varying margin payments

C. Overinvestment in long-term assets

D. High operating costs

The correct answer is: B)

The main reason why CCPs face liquidity risk has much to do with varying margin payments.
These contractual payments keep on changing as positions change. If the CCP does not set aside
enough funds to meet margin payments, it risks failing to fulfill its obligations to surviving
members in a timely manner.

Q.1142 A potential mismatch between margin payments and cash flows in various currencies
describes:

A. FX risk

B. Concentration risk

C. Sovereign risk

D. Custody risk

The correct answer is: A)

FX risk refers to a scenario where a CCP may not have enough currency, say, U.S. dollars, to
meet dollar-denominated margin payments.

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 Reading 31: 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

B. An open outcry exchange

C. An electronic exchange

D. None of the above

The correct answer is: B)

Since the team of floor traders physically met the seller of the September copper futures
contract to determine the price of the contract, the contract is trading on a futures exchange
with an open outcry system. Option A is incorrect because Futures do not trade on over-the-
counter (OTC) markets; they only trade on exchanges. Option C is incorrect because, in
electronic exchanges, traders enter into futures contract by entering their desired trades in a
computer system that later matches the buyers and the sellers.

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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.

A. Hedged futures position

B. Short put option position

C. Short futures position

D. Short forwards position

The correct answer is: C)

A short position in futures contracts requires the investor to sell the underlying asset at a
predetermined price. Since the investor is a trader, not the producer or user of the commodity,
the positions cannot be ascertained as a hedge. Usually, the producer and the user of the
commodity use futures contract to hedge against price changes. Therefore, option A is
inappropriate. Option B is also inappropriate because a short position in put options requires the
short position holder to purchase, not sell, the underlying asset. Option D is incorrect because
forward contracts trade on over-the-counter markets whereas Matias’s gold contracts are being
traded on the London exchange.

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Q.607 Jack Manchester is a summer intern at one of the well-known investment bank 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

D. Quality of the underlying

The correct answer is: D)

The excerpt presented depicts the quality of the underlying asset (e.g. tin). Since the futures
contract traded on an exchange, the contracts have standardized specifications like the quality of
the underlying assets, delivery time and place, contract size, price and quotation, etc.

Option A is incorrect because position limits entail the maximum number of positions in futures
contracts that a speculator can hold in order to prevent speculators from manipulating markets.

Option B is correct because contract specifications related to delivery arrangements contain the
information related to the place of delivery of the underlying asset.

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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 correct answer is: D)

Since futures are standardized contracts that trade on exchanges and the trades are handled by
clearinghouses, investors of futures contracts do not usually know the counterparty to the
transaction. Following are the specifications mentioned in futures contracts agreements:
1. Quality of underlying asset
2. Contract size
3. Price and quotation
4. Delivery month
5. Delivery place
6. Positions limit
7. Price limits

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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?

A. Rs. 136 per 100/KG

B. Rs. 140 per 100/KG

C. Rs. 142 per 100/KG

D. None of the above

The correct answer is: C)

Price limits are the maximum price movement/limit set by exchanges. If the intraday increase in
the price of the futures contract is equal to the predefined price limit, 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
price is:

Limit down close to current day = Closing price of the preceding day – Price limit

The closing price of the preceding day = Rs. 138 + Rs. 4 = Rs. 142

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Q.610 Elif Makarov, a derivatives trader at one 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 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

The correct answer is: B)

The most appropriate strategy to earn arbitrage profit or risk-free profit in the given scenario is
to purchase (or take a long position) in the copper futures contract as the futures price of copper
is below the spot price, and sell copper at the spot price since the spot price is higher than the
futures price.

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Q.611 Adam Anderson is a junior officer in the settlement department of a derivatives investment
firm. He also takes a keen interest in tweeting and blogging about derivatives education and
strategies. In one of his latest blog article, he made following comments regarding operations on
a margin account:

I. The initial margin refers to the amount that must be deposited to take a position in futures
contracts
II. The variation margin refers to the minimum margin balance required to retain a position in
the futures contract
III. Marking to market is the process of purchasing a particular asset or commodity and selling
the futures contracts on that asset or commodity

Which of the comment is/are incorrect?

A. Comment I only

B. Comment III only

C. Comments I & II

D. Comments II & III

The correct answer is: D)

Comments II and III are incorrect. Comment II is incorrect because of the maintenance margin,
not the variation margin, is the minimum margin balance required to retain a position in the
futures contract. Comment III is incorrect because marking to market is a daily process of
adjusting the margin account to reflect the investor’s gain or loss.

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Q.612 Jacqueline Jolie, a derivatives trader at one of the largest hedge funds on Wall Street,
entered in a March silver futures contract on the New York Mercantile Exchange (NYMEX) to
purchase 5000 troy ounces of silver at the futures price of $17.5 per ounce. According to NYMEX
rules, the initial margin of $6,400 and maintenance margin of $3,000 is required to enter and
retain the futures position. The price of silver futures contracts dropped to $17, $16.9 and $16.7,
at the end of the first, second and third day, respectively.

What is the margin account balance at the end of the second day?

A. The margin account balance at the end of the second day is $2,500

B. The margin account balance at the end of the second day is $3,900

C. The margin account balance at the end of the second day is $3,400

D. The margin account balance at the end of the second day is $0

The correct answer is: C)

The calculation of the margin account balance for each day is presented below:

At the end of the first day, when the price of the futures contract dropped from $17.5 to $17 per
ounce, the margin account balance declined by:
($17 - $17.5) * 5000 = -$2,500

At the end of first day, the margin account balance = $6,400 - $2,500 = $3,900.

At the end of the second day, when the price of the futures contract dropped from $17 to $16.9
per ounce, the margin account balance declined by ($16.9 - $17) * 5000 = -$500

At the end of second day, the margin account balance = $3,900 - $500 = $3,400.

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Q.613 Jacqueline Jolie, a derivatives trader at one of the largest hedge funds on Wall Street,
entered in a March silver futures contract on the New York Mercantile Exchange (NYMEX) to
purchase 5000 troy ounces of silver at the futures price of $17.5 per ounce. According to NYMEX
rules, the initial margin of $6,400 and maintenance margin of $3,000 is required to enter and
retain the futures position. The price of silver futures contracts dropped to $17, $16.9 and $16.7,
at the end of the first, second and third day, respectively.

On which of the following days is Jacqueline most likely to receive her first margin call?

A. At the end of the first day

B. At the end of the second day

C. At the end of the third day

D. She will not receive a margin call

The correct answer is: C)

The balance of the margin account is below the maintenance margin at the end of the third day.
Calculations are given below:

At the end of the first day, when the price of the futures contract dropped from $17.5 to $17 per
ounce, the margin account balance declined by:
($17 - $17.5) * 5000 = -$2,500
At the end of the first day, the margin account balance = $6,400 - $2,500 = $3,900. Since the
margin account balance ($3,900) is above the maintenance margin ($3000), no margin call is
initiated.

At the end of the second day, when the price of the futures contract dropped from $17 to $16.9
per ounce, the margin account balance declined by ($16.9 - $17) * 5000 = -$500

At the end of the second day, the margin account balance = $3,900 - $500 = $3,400. Since the
margin account balance ($3,400) is above the maintenance margin ($3000), no margin call is
initiated.

At the end of the third day, when the price of the futures contract dropped from $16.9 to $16.7
per ounce, the margin account balance declined by ($16.7 - $16.9) * 5000 = -$1,000

At the end of the third day, the margin account balance = $3,400 - $1,000 = $2,400. Since the
margin account balance ($2,400) is below the maintenance margin ($3,000), the investor will
receive a margin call.

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Q.614 Jacqueline Jolie, a derivatives trader at one of the largest hedge funds on Wall Street,
entered in a March silver futures contract on the New York Mercantile Exchange (NYMEX) to
purchase 5000 troy ounces of silver at the futures price of $17.5 per ounce. According to NYMEX
rules, the initial margin of $6,400 and maintenance margin of $3,000 is required to enter and
retain the futures position. The price of silver futures contracts dropped to $17, $16.9 and $16.7,
at the end of the first, second and third day, respectively. What is the amount of variation margin
that the investor will be required to deposit?

A. $600

B. $3,000

C. $4,000

D. No variation margin is required

The correct answer is: C)

The investor is required to deposit a variation margin of $4,000 to bring the margin account
balance back up to the initial margin. Calculations are provided below:

At the end of the first day, when the price of the futures contract dropped from $17.5 to $17 per
ounce, the margin account balance declined by:
($17 - $17.5) * 5000 = -$2,500

At the end of the first day, the margin account balance = $6,400 - $2,500 = $3,900. Since the
margin account balance ($3,900) is above the maintenance margin ($3000), no margin call is
initiated.

At the end of the second day, when the price of the futures contract dropped from $17 to $16.9
per ounce, the margin account balance declined by ($16.9 - $17) * 5000 = -$500

At the end of the second day, the margin account balance = $3,900 - $500 = $3,400. Since the
margin account balance ($3,400) is above the maintenance margin ($3000), no margin call is
initiated.

At the end of the third day, when the price of the futures contract dropped from $16.9 to $16.7
per ounce, the margin account balance declined by ($16.7 - $16.9) * 5000 = -$1,000

At the end of the third day, the margin account balance = $3,400 - $1,000 = $2,400. Since the
margin account balance ($2,400) is below the maintenance margin ($3,000), the investor will
receive a margin call and require a variation margin of ($6,400 - $2,400) = $4,000 to bring the
margin account balance to the initial margin. The variation margin is the amount necessary to
bring the margin account back to the initial margin.

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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 contracts 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 contracted 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

D. Statements II & III

The correct answer is: A)

Statement I is incorrect. Hedgers, not speculators, are subject to lower margin requirements in
futures contracts trades as compared to speculators because hedgers (just like producers or
users of the specific commodity) are deemed to be less risky than speculators. Statement II is
correct. In spread transactions, the investor takes opposite positions in futures contracts on the
same assets but with different maturities. Statement III is correct because futures contracted are
settled on a daily basis, whereas forward contracts are settled at the maturity date.

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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, which allows
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.”

The speech of the general manager at the inauguration ceremony is:

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 correct answer is: D)

In the general manager’s speech, all of the features of clearinghouse are defined appropriately.
The clearinghouse guarantees that the traders of futures markets honor their obligations.
Clearinghouses act as a buyer to every seller and seller to every buyer. Since the counterparty of
a futures contract is the clearinghouse, there is no default risk. Because of the clearinghouses,
investors can close or reverse their positions in futures contracts any time they want without
having to contact the counterparty.

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Q.617 After the credit crisis of 2007-2008, the regulators have become vigilant and more
concerned to reduce the credit risk in futures and forwards markets. Regulators have introduced
many regulations in standards transactions of over-the-counter markets to make them similar to
that of standardized exchanges. Which of the following features was NOT introduced in over-the-
counter markets to diminish credit risk?

A. Central counterparty (CCP)

B. Credit support annex (CSA)

C. Clearinghouses

D. Initial margin requirements

The correct answer is: C)

Clearinghouses were not introduced to decrease the credit risk of over-the-counter markets. The
clearinghouse is a feature of futures exchanges that act as a counterparty to buyers and sellers
in order to decrease the credit risk. After the 2007-2008 crisis, regulators introduced the central
counterparty (CCP) feature to standardize transactions in OTC markets. The CCP operates in a
similar manner to the operations of clearinghouses in the futures markets. Credit support annex
(CSA) is a feature in the agreement of bilaterally cleared transactions that requires both parties
to deposit collateral for daily gains and losses. Recently, initial margins and variation margins
were also introduced for standardized transactions in OTC markets.

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Q.618 Which of the following property of over-the-counter market and futures market is/are
correct?

I. Regardless of how the transaction is being cleared, the initial margin when deposited in the
form of cash earns interest income
II. The daily variation margin in futures markets earns interest if provided in the form of cash
III. The daily variation margin, as per CCP or CSA requirements in OTC markets, does not earn
interest income

A. I only

B. II only

C. I and II

D. II and III

The correct answer is: A)

In futures and OTC markets, when the initial margin is deposited in the form of cash by members
and investors, it earns interest income. Property II is inaccurate because the daily variation
margin in futures markets does not earn interest if provided in the form of cash as futures
contracts are settled on a daily basis. Property III is incorrect because the daily variation margin,
as per CCP or CSA requirements in OTC markets, does earn interest as forward contracts are
settled at maturity.

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Q.619 Alisha Gomez, head of the trading department, is conducting an interview 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 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 correct answer is: D)

It is the settlement price that is used for calculating daily gains, losses and margin requirements
for the parties involved in futures contracts trading. The settlement price is not the closing price
of the contract, but it is the average of the price at which the contract traded on the last period
or before the end of a day's trading period. It is set by the exchange itself in order to prevent
traders from manipulating futures prices. Option A is wrong because opening prices are the first
price at which futures open for the trading session. Option B is wrong because the high price is
the highest price of a contract that traded through the day.

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Q.620 Which of the following is NOT a method/process for terminating a position in a futures
contract?

A. By delivering the underlying assets/goods of 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

The correct answer is: D)

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. Methods provided in
options A, B, and C (delivery, cash-settlement and offsetting position in the futures market) are
appropriate methods of terminating a futures contract.

A note about closeouts

In a closeout, a trader who has a long position takes an equivalent short position in the same
contract, and both the positions offset against each other. Similarly, a trader with a short position
takes a long position in the same contract to close out the position. For example, assume it's 1st
March and you are long 1 contract of May 2019 Nikkei, but on 25th March, you decide to
terminate this position. You can do so by going short 1 contract of May Nikkei, effectively
canceling the contract. What happens?
When you place a closeout order to your broker, the broker will enter the market and offer to go
short 1 contract of May Nikkei. Another (third) participant will take up the long position. That
means you have effectively canceled your position by transferring the obligation to the other
participant. It's this participant that will now be holding the long 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 contract of live cattle at the Chicago’s futures exchange. The broker
proposed 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

The correct answer is: D)

Taking an exactly opposite position (long position in the given case) in the same futures contract
with the same maturity date can reverse or terminate the contract without delivering the
physical goods.

Options A and C are incorrect because it is virtually impossible and insanely expensive to settle a
live cattle futures contract by purchasing cattle in India and delivering it in Chicago.

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Q.622 Darren Jackson has recently finished his MBA and began working at a mid-sized asset
management company. Since Darren does not have past trading experience, he pays additional
attention while placing orders to buy/sell equity. Darren has noticed that the prices of stocks of
Banana Inc. are closing higher every day. Currently, the stock is trading at $71 per share, but
Darren is unsure if the rally will continue. However, he believes that if the price increases to $75,
then the rally will continue and that will be the right time to enter the market.

Which of the following types of order is suitable for Darren if he wants to start buying the stock
when the price increases to $75 or higher and keep filling as long as the stock is not above $78?

A. Limit order

B. Fill or kill order

C. Stop-limit order

D. Market-if-touched order

The correct answer is: C)

A stop-limit order with the stop price of $75 and the limit price of $78 will serve Darren’s trading
objectives. Currently, the price of Banana Inc. is $71 but as soon as the price increases to the
stop price ($75 or higher), the order will become a limit order, and the order will start filling
until the price reaches the limit price ($78). Option A is incorrect because a limit order specifies
a specific price. When the market price reaches the limit price, only then the order can be
executed. Option B is wrong because a fill or kill order is a market order that will either be filled
immediately or be canceled.

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Q.623 Which of the following regulatory bodies is responsible for communicating futures prices
to the public and licensing the future exchanges and its members who are willing to offer futures
trading services to the public?

A. National Futures Association (NFA)

B. Commodity Futures Trading Commission (CFTC)

C. Securities Exchange Commission (SEC)

D. Federal Reserve (Fed)

The correct answer is: B)

The Commodity Futures Trading Commission (CFTC) is responsible for communicating futures
prices to the public, approving new futures contracts, revising existing contracts, and licensing
future exchanges and its members who are willing to offer futures trading services to the public.
Option A is incorrect because the National Futures Association (NFA) is not a regulatory body,
but an organization made by participants of the futures industry to prevent fraud and to ensure
the market is working in the best interest of the public. Options C and D are incorrect because
the Securities Exchange Commission (SEC) and the Federal Reserve (Fed) are only interested in
knowing how futures markets affect the prices of underlying assets in the spot market.

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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.

Which of the following is correct?

A. Only statement I is correct

B. Only statement II is correct

C. Both statements are correct

D. Both statements are incorrect

The correct answer is: D)

Both statements are incorrect. For corporations, all capital gains from futures contracts 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 cannot carry forward the
capital losses indefinitely, but it can carry back a capital loss for three years and carry it forward
for up to five years.

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 of non-corporate taxpayers
are tax-deductible to the extent of capital gains plus ordinary income up to $3,000 and the losses
can be carried forward indefinitely.

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 Reading 32: 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 CAN = $1.00 US. However, the
importer fears that the Canadian dollar will depreciate to $1.35 CAN = $1.00 US in the next 6
months. As a result, the importer purchases $1,000,000 US at today's prevailing six-month
forward rate of $1.32 CAN = $1.00 US. What is the savings to the importer from his dealings in
the forward market?

A. $350,000 CAN

B. $30,000 CAN

C. $50,000 CAN

D. $20,000 CAN

The correct answer is: B)

The forward market will help the importer to lock in the exchange rate $1.32 CAN = $1.00 US.
Thus, they will spend 1.32 * 1,000,000 = $1,320,000 CAN in the transaction.
Without the forward market, the importer would transact at $1.35 CAN = $1.00 US, spending a
total of 1.35 * 1,000,000 = $1,350,000 CAN
Total savings = $1,350,000 CAN - $1,320,000 CAN = $30,000 CAN

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Q.627 Colin Thomson, the risk manager of a tire manufacturing company, suggests that the
company should focus its resources on the company’s 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?

A. Thomson’s argument related to the availability of the company’s information to the

shareholders is incorrect. However, the argument related to the smaller costs incurred by
shareholders for hedging risks is correct.

B. Thomson’s argument related to the availability of the company’s information to the

shareholders is correct. However, the argument related to the smaller costs incurred by
shareholders for hedging risks is incorrect.

C. Both arguments are correct.

D. None of Thomson’s arguments are correct.

The correct answer is: D)

One of the arguments against hedging is that the shareholders are considered as informed as for
the management of the company, which is usually incorrect. Therefore Colin’s first argument is
incorrect. Since the company hedges its risk in a lot of transactions, the company pays much
smaller per dollar transaction costs and commission as compared to shareholders that pay
higher transaction costs and commission due to smaller transactions.

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Q.628 The island of Godiva is a small hypothetical country in the Gulf of Mexico. Godiva has its
own financial system, economic system, and laws. The only agricultural product of Godiva is rice,
which is why the government sets weekly rice prices. The retailers of rice are only allowed to
keep a maximum of 10% profit margin on the sales of rice. Coral Traders and Reef Enterprises
are the two main retailers of the island. Coral does not hedge against the risk of changes in the
price of rice while Reef hedges the risk of an increase in prices by taking a long position in rice
futures in a local futures exchange. Which of the following statements is correct?

A. Coral Traders should have smoother profit margins than Reef Enterprises

B. Reef Enterprises should have smoother profit margins Coral Traders

C. Both companies will have the same profit margins

D. None of the companies have smooth profit margins

The correct answer is: A)

One of the arguments against hedging is related to the nature of the hedging company’s
industry. The argument states that if the prices are frequently changed in the industry, and the
margins quickly adjust to new prices, the company that does not hedge against these frequent
changes has smoother profit margins. In the given case, both companies are only allowed to keep
a 10% margin on the sales of rice. Coral Traders, which does not hedge against the changes in
rice prices, will earn a certain profit regardless of the fluctuation in rice prices. Conversely, Reef
Enterprises, which has taken a long position in rice futures, will earn higher margins if the price
of rice increases and earn lower or negative margins if the prices decrease.

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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 and a short in oil futures to hedge the risk of fluctuation in oil prices. If the
basis of the hedge strengthens, then which of the following is true?

A. If the basis of the hedge strengthens, the short positions of the firm will improve

B. If the basis of the hedge strengthens, the long positions of the firm will improve

C. If the basis of the hedge strengthens, the short positions of the firm will worsen

D. If the basis of the hedge strengthens, both the firm’s positions will improve

The correct answer is: A)

A short position in a hedge improves as the basis of the hedge strengthens or increases. The
basis is defined as:

Basis = Spot price of the asset to be hedged - 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.

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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 faster than the futures price over the duration of the hedging
period, the basis is said to be 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.

A. Only comment I is correct

B. Only comment II is correct

C. Both comments are correct

D. None of the comments are correct

The correct answer is: A)

Only comment 1 is accurate. The correct evaluation of the basis risk of the hedge is:

1. If the spot price increases faster than the futures price over the duration of the hedging
period, the basis is said to be increasing or strengthening.
2. Basis risk is the risk that the value of a futures contract will not move in line with that of the
underlying exposure.

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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 the 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. Mismatch between the maturity of the cash asset and the hedged asset

Which of the factors provided by Linda affect the basis risk?

A. Reason I only

B. Reasons II and III

C. Reasons I and III

D. Reasons I, II, and III

The correct answer is: D)

All three reasons provided by Linda affect or change the basis risk. Basis risk is the difference
between the spot price and the futures price of the underlying instrument. If the spot price and
future price do not converge to a specific level during the maturity of the contract, it can give
rise to basis risk. For example, if the spot price (future prices) increases faster than the futures
price (spot price) over the duration of the hedging period, the basis is said to be strengthening
(weakening). Changes in the component costs such as storage costs, insurance costs, etc. can
also lead to the basis risk. Lastly, sometimes it is difficult to find a hedge asset that matches
closely to the cash asset or the asset that is being hedged, which also leads to an increase or
decrease in basis risk.

Q.632 Asim Hussain has recently joined the commodities trading desk of an investment bank in
London. He is a hedger-trader that takes positions in futures contracts to earn profit arising 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 prices of oil 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?

A. Oil futures contracts with the delivery month of March

B. Oil futures contracts with the delivery month of June

C. Oil futures contracts with the delivery month of September

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 D. Oil futures contracts with the delivery month of December

The correct answer is: B)

The closest possible alternative to a hedge that expires in March is the futures contracts with the
delivery month of June. Futures contracts with delivery in March are unsuitable because a
hedger always has 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 expensive. Therefore, the
hedgers choose a delivery month that is as close as possible but later than the expiration of the
hedge. As the difference between the hedge expiration date and the delivery month increases,
the basis risk also increases.

Additional Explanation
Why choose a delivery month that's slightly ahead of the expiration of the hedge? The answer is
basis risk.
Basis risk refers to a host of problems that could come up even with a good hedge in place,
particularly the risk that at expiry, the spot price of the underlying could be significantly
different from the futures price agreed upon in the contract used. This would render the hedge
ineffective, and the hedger would still be faced with losses. Moreover, if the expiry matches the
delivery month, a long hedger runs the risk of having to take delivery of the physical asset.
Taking delivery can be expensive and inconvenient. This is what we see in the question.
That the client needs to buy oil; the broker would have to go long on a futures contract, meaning
the client would be obliged to buy oil. At expiry, the short position can either deliver the physical
oil or cash-settle. But in practice, the long would rather see the contract be cash-settled than
receive oil. Why? Come to think of it. The long would possibly have to transport the oil from an
inconvenient location, incurring extra costs in the process. Remember that the long and the
short transact through their broker and barely know each other, and therefore there's little or no
room for negotiations.
For this reason, the trick hedgers use is to choose a delivery month that is as close as possible to,
but later than, the expiration of the hedge. If the client wishes to buy oil in March, they will enter
into a contract expiring in June but then close out the contract in March. Closing out means they
cash in on the contract and proceed to buy oil from their preferred supplier. It's all about exiting
the contract conveniently.

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Q.633 FINWISE is a finance and economics magazine published by the students and members of
the finance and economics society of the University of Ankara. Last month’s publication of the
magazine contained a detailed article about the hedging strategies and the risks in hedging with
futures contracts. The article summed the factors that increase the basis risk arising in hedging
with futures. Following is an excerpt taken from the article:

“As the difference between the expiration of the hedge and the delivery month of the contract
increases, the basis risk also increases. However, as the liquidity of the hedge assets and the
assets to be hedged decreases, the basis risk increases. Hence, the liquidity of assets is inversely
proportional to the basis risk.”

Which of the analyses provided in the article is/are accurate?

A. The analysis regarding the increase in the difference between the expiration of the
hedge and the delivery month is accurate, but the analysis regarding the inverse
relationship between the liquidity of assets and the basis risk is inaccurate

B. The analysis regarding the increase in the difference between the expiration of the
hedge and the delivery month is inaccurate, but the analysis regarding the inverse
relationship between the liquidity of assets and the basis risk is accurate

C. The analysis regarding the increase in the difference between the expiration of the
hedge and the delivery month is accurate, and the analysis regarding the inverse
relationship between the liquidity of assets and the basis risk is accurate

D. None of the analyses are correct

The correct answer is: C)

Both analyses provided in the article are accurate. There is a positive proportional relationship
between the difference in hedge expiration and delivery month, and the basis risk. The basis risk
increase as the difference between the expiration of the hedge and the delivery month of the
contract widens. On the other hand, the liquidity of the hedged assets is inversely proportional to
the basis risk.

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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 with the intention of closing the contract. 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.

A. The effective price is Euro 10,500

B. The effective price is Euro 192,000

C. The effective price is Euro 187,500

D. The effective price is Euro 184,500

The correct answer is: B)

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 gain on the futures:
0.6150 + (0.6500 - 0.6250) = 0.6400
The total amount received by the German manufacturer for the 30 million Liras is 30,000,000 *
0.6400 cents = 19,200,000 cents or 192,000 Euros.

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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
it is 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

The correct answer is: A)

The optimal hedge ratio is calculated as:

HR = ρ * (σS / σF)

Where
σS is the standard deviation of the prices of the hedge asset;
σF is the standard deviation of the prices of futures asset; and
ρ is the correlation coefficient.

HR = 0.87*(0.019/0.032) = 0.516.

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Q.636 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
it is 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 the
optimal number of rubber futures contracts required to hedge the exposure in plastic.

A. The optimal number of 5,200,000 rubber contracts is required.

B. The optimal number of 325,615 rubber contracts is required.

C. The optimal number of 114,791 rubber contracts is required.

D. The optimal number of 96,568 rubber contracts is required.

The correct answer is: C)

The optimal number of contracts required is calculated as:

Number of contracts = (Hedge ratio * Value of hedged asset) / Value of futures contract

The optimal hedge ratio is calculated as:

HR = ρ * (σS / σF) = 0.87*(0.019/0.032) = 0.51656.

The number of rubber futures contract required to hedge the exposure of 10 million tons of
plastic is:
Number of contracts = (0.51656 * 10,000,000) / 45 = 114,791 contracts

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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 where she educates beginners traders on complex derivatives instruments
and hedging strategies. In her TV program, she made the following definitions of some jargons
used for hedging:

I. Cross hedging occurs when two offsetting positions are opened in futures contracts with
identical underlying assets.
II. Tailing the hedge is a process of calculating the correlation between percentage one-day
changes on the futures and spot prices in order to estimate the number of contracts needed to
hedge over the next day.

Which of the following is correct?

A. Statement I is correct while statement II is incorrect

B. Statement I is incorrect while statement II is correct

C. Statement I is correct and statement II is also correct

D. Statement I is incorrect and statement II is also incorrect

The correct answer is: B)

The definition of tailing the hedge is accurately defined. 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 one-day changes in the futures and spot prices in order to estimate the
number of contracts needed to hedge over the next day. However, the definition of cross-hedging
is incorrect because a crossover hedge takes place when the asset to be hedged is different from
the underlying asset of the futures contract.

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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 value of the portfolio, so he
decides to hedge the portfolio using futures contracts on the mini NASDAQ-100 index. If the
value of the portfolio 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

The correct answer is: C)

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:
Number of stock contracts = Beta of the portfolio * (Value of the portfolio / Futures price *
Contract multiplier)

Since the portfolio perfectly mirrors the index, the beta of the given portfolio is considered 1.

The number of stock contracts required = 1* (16,165,000/101,120) = 159.8 or 160 contracts.

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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 beta of the
portfolio is 0.78, then estimate the number of contracts Lange should short to hedge her
portfolio.

A. 1,455 S&P 500 futures contracts

B. 925 S&P 500 futures contracts

C. 876 S&P 500 futures contracts

D. 722 S&P 500 futures contracts

The correct answer is: D)

The number of contracts required to hedge the portfolio is calculated as:

Number of stock contracts = Beta of the portfolio * (Value of the portfolio / Futures price *
Contract multiplier)

Since the portfolio doesn’t perfectly mirror the S&P 500 index the beta of the portfolio of 0.78
will be considered in the calculation.

The number of contracts required = 0.78* (672,000,000/726,500) = 722 contracts.

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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 contracts price fell to 2,715 this month, then
estimate the number of additional contracts Lange should buy/short to hedge her portfolio.

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

D. The manager must short an additional 772 S&P 500 futures contracts to hedge the
portfolio

The correct answer is: A)

The number of stock contracts required to hedge the portfolio is calculated as:
Number of contracts = Beta of the portfolio * (Value of the portfolio / Futures price * Contract
multiplier)

Since the portfolio doesn’t perfectly mirror the S&P 500 index, the beta of the portfolio of 0.78
will be considered in the calculation.

The initial number of contracts that the manager short at the time of purchasing the S&P 500
futures contract was:
The number of contracts required = 0.78*[672,000,000/(2,906*250)] = 722 contracts.

A month later, when the futures price fell from to 2,715, the new number of contracts required to
hedge the portfolio is now:

= 0.78*[672,000,000/(250*2,715)] = 772 contracts

Therefore, the manager must short an additional 50 futures contracts on the S&P 500 index.

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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

Which of the potential strategies is/are accurate?

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

D. Neither strategies are accurate

The correct answer is: D)

None of the strategies are accurate. In order to increase the beta of a portfolio, a long position in
a specific number of additional futures contracts must be taken. If the beta of the portfolio is to
reduce from its current beta, a short position in a specific number of additional futures contracts
must be taken.

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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 beta of the portfolio 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?

A. The investor must buy 173 index futures contracts

B. The investor must short 173 index futures contracts

C. The investor must buy 180 index futures contracts

D. The investor must short 180 index futures contracts

The correct answer is: B)

The investor must short 173 S&P 500 futures contracts to reduce the beta of the portfolio from
0.96 to 0.

Number of contracts = (Target beta – Portfolio beta)*(Value of the portfolio / Futures price *
Contract multiplier)
= (0 - 0.96) * (50,000,000/277,750) = -173 contracts

The negative sign implies that the investor must short 173 S&P 500 index contracts to reduce
the beta of the portfolio to 0.

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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

B. Rolling a hedge forward

C. Basis risk of hedging

D. Reducing the beta of the portfolio

The correct answer is: B)

Rolling a hedge forward is the process by which a trader or investor closes out the existing
position as the maturity of the futures contract approaches and replace it with another futures
contract with a later delivery date or maturity. Option A is incorrect because a crossover hedge is
defined as the process in which the asset to be hedged is different from the underlying asset of a
futures contract that is used for hedging. Option C is incorrect because basis risk arises due to
an interruption in the convergence of the spot price and the futures price during the period of
the hedge. Option D is also incorrect.

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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 effective price paid in Euros and the gain or loss on the futures contract.

A. The effective price is €116,500 and the loss on the contract is €6,000

B. The effective price is €121,000 and the loss on the contract is €6,000

C. The effective price is €116,500 and the loss on the contract is €1,500

D. The effective price is €121,000 and the loss on the contract is €7,500

The correct answer is: C)

Since the company has a long position in futures contracts and the price of the futures contract
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 long hedge is used) is given by:

Net cost of asset when long hedge is used = F0 + (St − Ft )

= F0 + bt

Where
F0 : Futures price at the time the hedge is initiated,
Ft : Futures price at the time the hedge is closed,
St : Spot price of asset being hedged at the time the hedge is closed, and
bt = St − Ft= Basis at time t
So in this case we have: F0 = 2.45 , Ft = 2.42 and St = 2.30. Thus: and

Net cost of asset when long hedge is used = 500, 000[2.45 + (2.30 − 2.42)] = 116, 500

The loss (gain) for long futures is given by:

loss = Ft − F0 = 2.42 − 2.45 = −0.03 per ton ⇒ Loss in this case = −0.05 × 50 , 000 = 1, 500

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 Reading 33: Foreign Exchange Markets

Q.879 Armada is an American tech company that manufactures internet routers with artificial
intelligence. These routers have the capability of automatically connecting to the employees of
certain organizations without password verification. Armada sells its products worldwide, but its
largest market is Germany and its sales are denominated in Euros. Which of the following
options is correct?

A. If US dollar strengthens, the revenue of Armada will rise

B. If US dollar strengthens, the revenue of Armada will fall

C. If US dollar weakens, the revenue of Armada will fall

D. The revenue of Armada will remain unaffected as the sales are denominated in Euros

The correct answer is: B)

If the US dollar per euro exchange rate strengthens against the Euro, then it will take fewer
dollars to convert the Euro into the US dollar. For instance, if the initial exchange rate was USD
1.5 per euro when the sales of Armada were 100 Euros, the total revenue in US dollars was
USD150. If the USD strengthens against the Euro from, $1.5/€ to, let’s say, $1.35/€, the revenue
will fall from $150 to $135.

Q.880 Iron Cement Co. is a Pakistani company that obtained funding of €200 million to finance
its new cement plant from the Bavaria Bank headquartered in Frankfurt. Due to Pakistan’s fast-
paced growth in past few years, the Pakistani Rupee has appreciated against most of the actively
traded currencies. Which of the following impacts is accurate?

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 as the loan is denominated in Euros

The correct answer is: B)

The appreciation of Pakistani Rupee will result in costing fewer Rupees to purchase Euros.
Therefore, the liability of the Pakistan-based firm will decrease. For instance, when the funding
of $200 million was obtained, the exchange rate was, let’s say, PKR 110/€. After the appreciation
of the PKR, the exchange rate might have dropped to PKR 105/€. Therefore, the liability of the
firm dropped from PKR 22 billion to PKR 21 billion.

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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 correct answer is: B)

The appreciation in value of the Indian currency will make the Indian goods more expensive for
foreign buyers, while the foreign buyers will be able to sell more goods to Indian buyers as the
foreign goods will be cheaper. Option A is incorrect because if the Indian currency had
depreciated, instead of appreciating, then the Indian goods have become cheaper for Chinese
importers, and Chinese goods have become more expensive to Indian buyers.

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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

The correct answer is: B)

If the company has a net short position, then the risk related to the foreign exchange increases
as the foreign currency rises in value. For instance, suppose the company has a net short
position of -€100, and the exchange rate is $1.2/€. The firm can purchase 100 euros for 120
dollars to balance the equation. Now suppose the euro appreciates to $1.5/€, and it becomes
more expensive to buy euros in terms of dollars. Then, the company has to spend $150 to
balance the equation. Therefore, the company’s risk increases.

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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.

B. If the demand for Swiss francs increases, the value of the investment of the company
will increase.

C. If the supply for 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 correct answer is: B)

When the demand for Swiss francs increases, the Swiss franc appreciates, and the dollar
depreciates. When the dollar depreciates, the value of the investment in Swiss francs therefore
increases.

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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 the 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.

A. The Turkish lira has depreciated in value against the USD

B. The Turkish lira has appreciated in value against the USD

C. The USD has depreciated in value against the USD

D. There has been no impact on the exchange rates as the real interest rate is identical in
both countries

The correct answer is: A)

The Turkish lira has depreciated against the dollar due to higher interest rates.

Nominal interest rate = Inflation rate + Real interest rate

Interest rate in Turkey = 7% + 2% = 9%

Interest rate in the U.S. = 5.5% + 2% = 7.5%

The demand for the currency of the country with higher inflation or interest rate will result in
depreciation of that country’s currency.

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?

A. Purchasing power parity theory

B. Interest rate parity theory

C. Fischer theory

D. None of the above

The correct answer is: B)

The interest rate parity theory suggests that the forward exchange rates of a pair of currencies
can be derived from the interest rates of these countries, which means the difference between
spot and forward rates is due to the difference between the interest rates of these countries.

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Q.895 A foreign currency analyst based in Dubai is forecasting the forward exchange rate
UAE/USD. Currently, the spot exchange rate is AED 3.33 per USD. Suppose that the interest rate
in the United Arab Emirates is 4% and the interest rate in the U.S. is 2%, determine the 1-year
forward exchange rate of AED per USD.

A. AED 3.45 per USD

B. AED 3.40 per USD

C. AED 3.27 per USD

D. AED 3.19 per USD

The correct answer is: B)

According to interest rate parity theorem, the forward exchange must be derived with the
following equation:
Forward exchange rate of AED per USD = Spot exchange rate * (1 + USD interest rate)/(1 +
AED interest rate)
Forward exchange rate of AED per USD = AED 3.33 * (1.02/1.04) = AED 3.3953 per USD

Q.3573 Estimate 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%

The correct answer is: C)

Nominal interest rate = Real interest rate + Inflation.

⇒Real interest rate = 11% - 3.5%=7.5%

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Q.3575 Due to the upcoming elections, the exchange rate of CAD for USD has risen from 1.17 to
1.31. Calculate the percentage change in the value of the USD in terms of CAD.

A. 0.1068

B. 0.1196

C. -0.1068

D. -0.1196

The correct answer is: B)

To calculate the percentage change in the value of the USD in terms of the CAD, we can simply
calculate the change 1.31/1.17 - 1 = 0.1196.

This shows that the USD has appreciated 11.96% against the CAD. However, we can not say the
CAD has depreciated 11.96% against the USD.

Q.3579 If the exchange rate quote for the euro (EUR/USD) changes from 1.3500 to 1.2600, then
in approximate terms:

A. The euro depreciated by 6.7%, and the dollar appreciated by 7.1%

B. The dollar depreciated by 6.7%, and the euro appreciated by 7.1%

C. The euro appreciated by 7.1%, and the dollar depreciated by 6.7%

D. The euro depreciated by 7.1%, and the dollar appreciated by 6.7%

The correct answer is: A)

You can think of this as the change in the price of the euro expressed in US dollars. If the
exchange rate moved from the 1.3500 to 1.2600, then the percentage change in the euro quote is
1.2600/1.3500 - 1 = -0.06667, or a 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.3580 If the USD/BRL exchange rate changes from 3.1625 to 3.5000, then in approximate
terms:

A. The real depreciated by 9.6%, and the dollar appreciated by 10.7%

B. The dollar depreciated by 9.6%, and the real appreciated by 10.7%

C. The dollar appreciated by 9.6%, and the real depreciated by 10.7%

D. The real appreciated by 9.6%, and the dollar depreciated by 10.7%

The correct answer is: A)

The percentage change in the dollar is calculated as 3.5000/3.1625 - 1 = 0.1067 or 10.7%.

The change in the real is (1/3.5000)/(1/3.1625) - 1 = -0.0964 or a depreciation of 9.6%.

Q.3581 If the exchange rate quote for the Mexican peso (USD/MXN) changes from 11.9500 to
12.4000, then in approximate terms:

A. The peso depreciated by 3.8%, and the dollar appreciated by 3.6%

B. The dollar depreciated by 3.8%, and the peso appreciated by 3.6%

C. The peso appreciated by 3.8%, and the dollar depreciated by 3.6%

D. The dollar appreciated by 3.8%, and the peso depreciated by 3.6%

The correct answer is: D)

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. In percentage terms, it fell by 11.9500/12.4000 - 1 = -0.036 or 3.6%.

The dollar appreciated by 12.4000/11.9500 - 1= 0.0377 or 3.8%.

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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 is required for the exchange of 50 units of currency Y?

A. 65

B. 70

C. 85

D. 64

The correct answer is: A)

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.

So, the number of units of currency X in this case is:

1.3000 × 50 = 65 units

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Q.3815 The 6-month forward foreign exchange is stated as bid 25.9 and ask 35.8. Which of the
following statements true?

A. Given that the spot bid rate is 1.6432, then the 6-month bid exchange rate is 1.6445

B. Given that the spot bid rate is 1.6432 and spot ask rate is 1.7432 then the 6-month bid-
ask spread is the exchange rate is 0.64479

C. Given that the spot bid rate is 1.6432, then the 6-month bid exchange rate is 1.64579

D. Given that the spot ask rate is 1.6532, then the 6-month exchange rate is 1.6555

The correct answer is: C)

Recall that forward exchange rates are quoted with the same base as the spot exchange rates
but rather as points that are multiplied by 1/10,000 then added to the spot exchange rate.

Since we are given the spot bid rate as 1.6432, then the 6-month forward bid rate is:

1
1.6432 + × 25.9 = 1.6432 + 0.00259 = 1.64579
10 , 000

Option A is incorrect since it contradicts C.

Options B and D are incorrect since:

Given that the spot bid rate is 1.6432 and spot ask rate is 1.7432, then the 6-month bid-ask

spread is:

1 1
(1.7432 + × 35.8) − (1.6432 + × 25.9) = 0.10099
10 , 000 10, 000

Also given that the spot ask rate is 1.6532, then the 6-month exchange rate is

1
(1.6532 + × 35.8) = 1.65678
10 , 000

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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

The correct answer is: B)

An FX swap is a contract to buy (sell) a certain amount of a currency at one time and sell (buy) it
at another later time. The description in the question fits the FX swap since the company
borrows in the domestic currency, then converts to Mexican pesos, and after some time, the
company exchanges the money back to euros.

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.

D. None of the above

The correct answer is: B)

Translation comes up when an institution’s assets and liabilities are in a foreign currency, which
must be valued in the institution’s domestic currency when the financial statements are made.

Transaction risk is associated with received and paid capital; cash inflows and outflows in a

foreign currency.

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Q.3818 South Africa increases its exports to Britain. What is the likely scenario that might
happen between the South African rand and British Pound Sterling?

A. South African rand will tend to get stronger relative to British Pound Sterling

B. The British Pound Sterling will tend to get stronger relative to South African rand

C. The British Pound Sterling will appreciate relative to south African rand

D. All of the above

The correct answer is: A)

South African rand will tend to get stronger relative to the British Pound Sterling since the
Britain importers will be forced to buy South African rand to pay for the goods.

Option B incorrect since it contradicts A. Option C is incorrect since the British Pound Sterling

will depreciate with respect to the South African rand.

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?

A. The currency of US will weaken with respect to Chinese yuan

B. The US dollar will appreciate with respect to the US dollar

C. The Chinese currency (yuan) will decline relative to the US dollar

D. All of the above

The correct answer is: C)

The purchasing parity theorem, implies that the strength of Chinese yuan will decrease so that it
covers for the equality of the price of a basket of goods in the two countries.

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Q.3820 The spot rate for the USD/EUR is 1.3261, and the 6-month forward point is 150. What is
the 6-month EUR/USD forward rate ?

A. 1.3411

B. 0.4532

C. 0.7457

D. 0.53211

The correct answer is: C)

We need to compute the 6-month forward rate USD/EUR and then find the reciprocal of the same
to get EUR/USD. So, the 6-month forward USD/EUR is

1
1.3261 + × 150 = 1.3411,
10 , 000

so, EUR/USD 6-month spot rate is

1
= 0.7457
1.3411

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%

The correct answer is: D)

Recall that the real interest rate is approximated as:

rreal ≈ rnominal − rinflation

So, in this case:

rreal ≈ 3 − 5 = −2%

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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?

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

C. The total return by the investor in this country is equivalent to 8%

D. An investor in this country should always expect a loss of 5% per year.

The correct answer is: A)

We need to first calculate the real interest rate. That is:

rreal ≈ rnominal − rinflation

So, in this case:

rreal ≈ 3 − 5 = −2%

So, this implies that, when an investor earns at 3%, the investor’s purchasing power decreases
by 2% each year due to inflation.

Q.3823 In a particular year, the interest rates for USD increases while that of the euro remain
unchanged. What will happen to the forward exchange rate USD/EUR?

A. It will increase.

B. It will decrease.

C. It will appreciate.

D. None of the above.

The correct answer is: B)

When the interest rates on the USD increases, it weakens in the forward market. Since the
exchange rates are expressed as the number of units of EUR that are needed to buy one unit of
USD, it will, therefore, take fewer units of EUR to buy one unit of USD in the forward market and
thus the forward rate would decrease.

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Q.3824 The interest rate on the Nigerian Naira (NGN) is 2%, and that of 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. 300

B. 365

C. 478

D. 327

The correct answer is: D)

Recall that:

(1 + id )T
Ff =Sf ( )
d d (1 + if )T

So that:

1
(1 + idZAR )T 1.07 2
F NGN = S NGN ( ) = 1.3500 × 1 = 1.3827
ZAR ZAR (1 + ifNGN )T 1.02 2

So, the points are given by:

10 , 000 × (1.3827 − 1.3500) = 327

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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

C. The offer price is always smaller the bid price

D. None of the above

The correct answer is: C)

The offer price should always be higher than the bid price since the bid-offer spread is the
compensation that the involved parties seek for providing foreign exchange to other market
participants.

Option B is a correct statement. For example, let's say you can an investment bank and want to
trade 100 lot of CAD/USD futures. They'll give you a bid-ask spread. Let's now say you want to
trade a 100,000 lot of CAD/USD futures, the investment bank will give you a wider quote. Why?
Because they'll have to push the market higher or lower while executing your order. For a small
transaction, they'll have to hit the bid of the ask once to complete the transaction. For a larger
transaction, they'll have to hit the big or the ask multiple times to complete the transaction.

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Q.3826 Consider the following information

Currency Libor (annualized) Currency Spot Rate

Combinations
CAD 0.62% CAD/GBP 2.4812
GBP 6.96% AUD/GBP 0.0074
AUD 0.75% AUD/CAD 73.8618

If the uncovered 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

The correct answer is: B)

Since we have assumed that the uncovered 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 GBP = S AUD ( ) = 0.0074 ( ) = 0.007856 ≈ 0.0079
AUD GBP 1 + iAUD 1.0075

Q.3827 A higher interest rate and increasing money supply in a country with low levels of public
and private debt is most likely to cause:

A. An indeterminate effect on the currency

B. Currency appreciation

C. Currency depreciation

D. None of the above

The correct answer is: C)

Higher interest rates will most likely cause capital flows to high yielding markets leading to
currency depreciation which offsets the high yields, bringing the return of the two investments
to the same level.

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Q.3828 A USD/CAD currency rate of 1.6598 most likely implies that:

A. One US dollar (USD) can buy 1.6598 Canadian dollars (CAD).

B. One Canadian dollar (CAD) can buy 1.6598 US dollars (USD).

C. The US dollar (USD) appreciates by 1.6598.

D. The Canadian dollar (CAD) appreciates by 1.6598

The correct answer is: A)

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. So, USD/CAD
currency rate of 1.6598 implies One US dollar (USD) can buy 1.6598 Canadian dollars (CAD).

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%

The correct answer is: A)

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.

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Q.3830 What does a 4% appreciation in the ZAR/CNY exchange rate imply?

A. It represents a 4 percent appreciation in the South African Rand (ZAR) as compared to

the Chinese Yuan.

B. It represents a 4 percent appreciation in the Chinese Yuan (CNY) as compared to the

South African Rand.

C. It represents a 4 percent depreciation in both the Chinese Yuan (CNY) and the South
African Rand.

D. It represents a 4 percent depreciation in the South African Rand as compared to the

Chinese Yuan (CNY)

The correct answer is: A)

A 4% appreciation in the exchange rate ZAR/CNY represents an appreciation of the base

currency against the price currency. In this case, the South African Rand appreciates against the
Chinese Yuan. Thus, the appreciation represents a 4 percent increase in the South African Rand
relative to the yuan.

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. $ \begin{array}{c|c}
\textbf{Maturity} & \textbf{Spot rate or forward points} \ \hline
\text{One week} & {-0.2} \ \hline
\text{One month} & {-1.0} \ \hline
\text{Three months} & {-5.6} \ \hline
\text{Six months} & {-12.7} \ \hline
\text{Twelve months} & {-25.3} \
\end{array}
$

A. 1.64534

B. 1.45677

C. 1.63546

D. 1.65342

The correct answer is: A)

When we divide the forward points of -5.6 by 10,000, we get –0.00056. The next step is to
subtract this from our spot rate of 1.6459, which will lead us to a result of 1.64534.

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Q.3832 The 6-month forward quote for the USD/CAD is 1.500. What is the corresponding future
quote?

A. 0.86432

B. 0.98538

C. 0.66667

D. 0.56432

The correct answer is: C)

The future quote is achieved by finding the reciprocal of the forward quote. That is:

1
6-month futures quote is: 1.500 = 0.66667 USD per CAD

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

The correct answer is: D)

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 of A are exchanged for 200 units of B

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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%

The correct answer is: B)

Recall that

rreal ≈ rnominal − rinflation

⇒ rnominal = rreal + rinflation

According to the information given in the question:

125
Expected inflation = − 1 = 0.06838 = 6.838%
117

So,

rnominal = 7.5% + 6.838% = 14.338%

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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 needs to do to minimize hedging costs?

A. Purchasing options on each currency in the market.

B. Purchasing options on basket of currencies rather than individual currency

C. Buy an option on a single exposure that applies in one time period (like one month)

D. Buy an option on a single exposure that applies several months

The correct answer is: B)

Since the multinational is exposed to several currencies each month, it can hedge itself from FX
risk buying am option on a collection (basket) of currencies instead of just one currency. By
doing this, the multinational distributes the risk and hence minimizing it.

Alternatively, the company can purchase an option on the average exposure that applies to many

months rather than buying an option that exposes the company to risk each month.

Q.4453 A fund manager borrows fund 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 existing between the two countries. The major risk in this strategy is:

A. None – it’s a riskless strategy

B. The interest differential may increase

C. The exchange rate of the currencies may change

D. None of the above

The correct answer is: C)

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.

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 Reading 34: 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.)

A. The investment manager will receive a cash inflow of €913,600

B. The investment manager will pay a cash outflow of €911,600

C. The investment manager will receive a net cash outflow of -€1,700.

D. The investment manager will pay a cash outflow of €3,700

The correct answer is: C)

Following are the cash flows of the investor during the months:

In April, the manager received the cash inflow of €913,600 as a result of shorting the 2,000
shares of Solar Computers Corp.
2,000 Short shares * €456.8 per share = €913,600

In July, the shares earned the dividend of €1.85 per share, which was transferred to the lender of
the shares
2000 shares * €1.85 = €3,700

In September, the shares were purchased at the prices of €455.8 to close the short position.

Thus, the cash outflow for the September is €911,600.

And the net cash flow of the investor is:
€913,600 – €3,700 – €911,600 = -€1,700.

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Q.666 Short-selling is considered as the influencer of market volatility in times of financial crises
as we have witnessed in the 2008 credit crisis where short-selling was banned in some countries.
More recently, we have seen it in the Chinese crisis of 2014-15 where short-selling was banned
for more than a year. The Securities Exchange Commission has introduced many rules regarding
short-selling to maintain the volatility in financial markets. Which of the following rules truly
describes the “alternative uptick rule” that was introduced by the SEC in February 2010?

A. This rule only allows investors to short-sell the shares if the most recent movement in
the share price was an increase

B. This rule only allows the investor to short-sell the shares if the prices of the closest
alternatives of the share increased in its latest movement

C. This rule restricts the investor from short-selling shares for a two days window if the
price of the shares decreased by more than 10% in a single day

D. This rule allows the SEC to ban short-selling in times of financial crises

The correct answer is: C)

The “alternative uptick rule” that was introduced in the US by the SEC in 2010 stating that the
investors of the shares are restricted to short-sell the shares for the two continuous trading days
if the prices of those shares decreased by more than 10% in a single trading day. Option A is
incorrect because it was the definition of the “uptick rule” of 1938, which was abolished by the
SEC in 2007, that only allowed investors to short-sell shares if the most recent movement in the
share price was on an increase.

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Q.667 Which of the following situations correctly depicts a short squeeze scenario?

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.

The correct answer is: C)

When the prices of the shares of a specific firm increase rapidly, it forces short sellers to close
down their positions. When more and more short sellers purchase the shares to close their
positions, the demand for the shares is greater than its supply, thus, increasing the prices
further. This situation is known as a short squeeze, where the short sellers are squeezed out
(closed out) of their positions.

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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 the $122.93. If the 6-
months risk-free interest rate is 6%, 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 $122.93.

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
$122.93

C. Both of the above-mentioned transactions will bring positive net cash flows

D. None of the above-mentioned transactions will bring positive net cash flows

The correct answer is: D)

None of the above-mentioned transaction 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: 119.40(1.06)0.5 = $122.93

Since the investor will use the proceedings to enter into a contract to short the share at the
forward price of $122.93, the net cash flow of the trade will equal:
$122.93 - $122.93 = 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(1.06)0.5 = $122.93

Since the investor will take a long position to purchase the stock at the forward price of $123.04,
the net cash flow of the investor will equal:
$122.93 - $122.93 = 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.

Which of the above-mentioned scenarios will generate profit?

A. Scenario I will generate a profit, and scenario II will generate a loss

B. Scenario I will generate a loss, and scenario II will generate a 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

The correct answer is: A)

Scenario I will generate a positive cash inflow. If the price of the forward contract is higher than
the current price of the share, then the investor can borrow the funds at the risk-free rate to
purchase shares at the current price and short sell forward contracts to sell the asset at the
higher forward price, thus earning a risk-free return.

Scenario II is incorrect because if the current price of a stock is greater than the forward price,
the investor must short sell the shares now, invest the proceedings at the risk-free rate, and use
the proceedings to take a long position in the forward contract.

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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

The correct answer is: D)

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

The arbitrage net cash flow is $434,000 - 385,675.72 = $48,324.28

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Q.671 Harry Gayle is a fixed investment analyst at one of the biggest investment banks in
Boston. He is analyzing forward contracts on the bond of Cube Corp. The current price of Cube
Corp is $950, and the bond pays a semiannual coupon of 12% on the face value of $1,000. The
forward contract on Cube Corp’s bond is available for the price of $960 with maturity in 6
months, while the coupon on the bond is expected to be received in 3 months. If the risk-free
rates for 3-month and 6-month treasuries are 3% and 4.2%, respectively, then determine the net
gain or loss from the contract.

A. Net gain of $51.05

B. Net loss of $10.16

C. Net gain of $49.84

D. Net loss of $42.57

The correct answer is: A)

Since the forward price is higher than the current price, the investor will borrow to purchase the
stock at the current price.

As the bond pays a coupon of $60 ($1,000 * 0.12/2) in 3 months, which will be used to pay the
loan, the amount to be borrowed for three months is:

$60 ∗ (1.03)−3/12 = $59.56

The amount to be borrowed for 6 months is:

$950– $59.56 = $890.44

The remaining portion of the loan that will grow in 6 months at the rate of 4.2% is:

$890.44(1.042)6/12 = $908.946

Thus, the net cash flow at the end of the contract will be:

$960 − $908.95 = $51.05

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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 whereas the
semiannual dividend yield on the asset is 7%. If the asset price is $95, then what is the price of
the forward contract?

A. $100.8

B. $98.32

C. $97.14

D. $96.13

The correct answer is: C)

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

Since the asset gives a 7% semiannual dividend yield, the annual dividend yield on the asset is:
(1 + 0.07/2)2 − 1 = 0.071225

Therefore, the price of the forward contract is:

1.12 0.5
$95( ) = $97.138
1.071225

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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.

Which of the conclusion is incorrect?

A. Conclusion I is incorrect

B. Conclusion II is incorrect

C. Both conclusions are incorrect

D. None of the conclusions are incorrect

The correct answer is: B)

Conclusion II is incorrect because, once the forward is initiated, the value of the contract can be
positive to one counterparty and negative to another, but the values cannot be positive to both at
the same time.

Conclusion I is correct because the value of a forward contract is always zero at the initiation of
the contract in order to remove arbitrage profit.

Q.674 Consider a forward contract on a stock index such as the S&P 500. Everything else being
constant, which of the following statements is least accurate?

A. The forward price will fall if interest rates rise

B. The forward price is directly linked to the level of the stock market index

C. If the time to maturity is increased, the forward price will rise

D. The forward price will fall if dividend payments on the underlying stocks increase

The correct answer is: A)

Increasing the level of interest rates, r, makes the forward contract more appealing to investors.
Thus, the forward price will increase.

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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.

Which of the following options is correct?

A. Statement I is correct, while statement II is incorrect

B. Statement I is incorrect, while statement II is correct

C. Statement I is correct, and statement II is also correct

D. Statement I is incorrect, and statement II is also incorrect

The correct answer is: D)

Both statements regarding the relationship between forward and futures contracts are incorrect.
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. Conversely,
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.

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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 correct answer is: B)

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

Where f is risk-free rate and q is the annual dividend yield.

1.032 0.5
Price of futures contract = 12 , 240( ) = 12 , 329.935
1.017

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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 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

The correct answer is: B)

If the prices of futures index contracts are lower than the current price of the index, an investor
can earn arbitrage profit by short-selling the stocks of the underlying index and taking a long
position in the index futures contract. As it is costly to purchase all the stocks underlying an
index, an investor can purchase a small sample of the stocks whose movement closely mirrors
the movement of the index.

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Q.678 Muhammad Zubair is the investment manager of an investment company based in Chicago
that invests in almost all financial instruments such as equities, derivatives, currencies, etc.
Today, he is considering investing 10 million euros in 1.5-year currency futures contracts on the
U.S. dollar. The 1-year risk-free interest rates in the Eurozone and the U.S are 1.25% and 1.5%,
respectively. If the spot exchange rate is 1.098 USD per Euro, then determine the 1.5-year
futures exchange rate.

A. 0.998 USD per Euro

B. 1.070 USD per Euro

C. 1.102 USD per Euro

D. 1.110 USD per Euro

The correct answer is: C)

To calculate the forward or futures currency exchange, we will use the following formula:

1+ r T
F = Spot rate × ( )
1+ f

Where:

r=US risk-free rate.

f=foreign risk-free rate

1.015 1.5
F = 1.098 × ( ) = 1.102069 USD per Euro
1.0125

Since the U.S risk-free rate is greater than the foreign risk-free interest rate, the futures

exchange rate must be greater than the spot exchange rate. We can also solve this question by

eliminating options A and B in which the futures exchange rates are smaller than the current

rate or spot rate.

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Q.679 Muhammad Zubair is the investment manager of an investment company based in Chicago
that invests in almost all financial instruments such as equities, derivatives, currencies, etc.
Today, he is considering investing 1000 Euros in 1.50-year currency futures contracts on the U.S.
dollar. The 1.5-year risk-free interest rates in the Eurozone and the U.S. are 1.25% and 1.5%,
respectively, and the spot exchange rate is 1.098 USD per Euro. According to the given data, the
futures exchange rate should be 1.102 USD per Euro. However, the 1.5-year futures exchange
rate is quoted at 1.100 USD per Euro. Using this information, calculate the arbitrage gain or
loss.

A. Arbitrage gain of $2.1

B. Arbitrage loss of $15.8

C. Arbitrage loss of $1.8

D. Arbitrage loss of $7.9

The correct answer is: A)

Since the actual 1.5-year futures exchange rate is lower than the calculated/estimated futures
exchange rate, the investor should borrow €1000 for 1.5 years at the rate of 1.25% and convert
the €1000 into USD at the current exchange rate:
€1000 * 1.098 = $1098

Then, the investor will invest the $1098 at the U.S risk-free rate of 1.5% for 1.5 years:

$1098 × (1.015)1.5 = $1, 122.7974

After 1.5 years the euro loan payable will equal

€1000 × (1.0125)1.5 = €1018.81

The futures contract to buy €1018.81 at the futures exchange rate of 1.100 USD per EUR costs
€1018.808* 1.100 = $1120.69

The risk-free profit at the end of 1.5 years is $1,122.80 - $1,120.61 = $2.11

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Q.680 Martin Cleveland is a senior derivative investor and forex currencies analyst. During a live
TV show related to movements in the futures and forward contracts on the local U.S. currency,
he made the following two comments (where the foreign currency is the base currency):

Comment 1: If the foreign risk-free interest rates are lower than the U.S. risk-free interest rate,
then the future prices of these currencies will decrease.
Comment 2: If the foreign risk-free interest rates are higher than the U.S. risk-free interest rate,
then the future prices of these currencies will increase.

Which of the comments is/are correct?

A. Only comment 1 is correct

B. Only comment 2 is correct

C. Both comments are correct

D. None of the comments are correct

The correct answer is: C)

If we have the pair Yen/USD with a rate R, If the US Interest rate will be higher than the base
currency's(Japanese Yen), then this rate will DECREASE, as the investors will buy more USD and
sell more foreign currency,(the USD will appreciate over the Foreign currency), thus one unit of
Foreign currency will be worth less than R.

If the US Interest rate will be lower than the base currency's(Japanese Yen), then this rate will

INCREASE, as the investors will buy more Foreign currency and sell more USD (the USD will

depreciate over the Foreign currency), thus one unit of Foreign currency will be worth more than

R.

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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
pork bellies.”

Which of the assets are incorrectly categorized?

A. Gold

B. Crude oil

C. Copper

D. Pork bellies

The correct answer is: B)

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, pork bellies, livestock, etc.

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Q.682 A producer of corn has a short position in corn forward contracts to deliver 5,000 tons of
corn in three months. The producer has analyzed that the cost of carrying the underlying asset of
the contract is lower than its convenience yield. Therefore, which of the following actions is most
suitable for the producer?

A. The producer should deliver the contract early, as the futures price is expected to
decrease

B. The producer should deliver the contract early, as the futures price is expected to
increase

C. The producer should delay the delivery of the contract, as the futures price is expected
to decrease

D. The producer should delay the delivery of the contract, as the futures price is expected
to increase

The correct answer is: C)

The futures price is expected to decreases. When the cost of carrying the asset (storage cost plus
interest paid) is lower than the convenience yield (benefit from holding the physical asset), then
the prices of futures contracts are expected to decrease. Therefore, the investor with a short
position in the contract should delay the delivery of the position to earn higher returns.

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Q.683 On January 3rd, Mr. Anand entered into a March futures contract on crude oil to purchase
1000 barrels of crude. At the time of initiation, the price of a futures contract was $86 per barrel.
On the 13th of February, the price of the futures contract had decreased from $87 to $79 as the
maturity of the contract changed from March to September. Which of the following given
scenarios could be a factor for the decrease in price?

A. The storage cost of the asset must be greater than the convenience yield, and the
interest paid to finance the asset must be smaller than the convenience yield

B. The interest paid to finance the asset must be greater than the convenience yield, and
the storage cost of the asset must be larger than the convenience yield

C. The convenience yield must be greater than the interest paid to finance the asset, and
the storage cost of the asset must be smaller than the convenience yield

D. None of the above

The correct answer is: C)

When the convenience yield is greater than the interest paid to finance the asset, and the
storage cost or cost of carrying the asset (storage cost plus interest paid) is smaller than the
convenience yield (benefit from holding the physical asset), the prices of futures contracts are
expected to decrease. The prices of the futures contracts increase when the convenience yield is
smaller than the carrying cost.

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Q.684 Emma Samson is the head of the derivatives department at Power Investment Bank
headquartered in Frankfurt. She conducts regular training sessions for traders from different
units. In a recent training session on the subject of the relationship between futures prices and
spot prices, she introduced the following definitions of the term backwardation and contango:

I. A situation where the futures prices are below spot prices is referred to as normal
backwardation
II. Contango is likely to occur when there are no benefits associated with holding the asset, i.e.,
zero dividends, zero coupons, or zero convenience yield

Which of the following definitions is/are correct?

A. Only the definition of normal backwardation is correct

B. Only the definition of contango is correct

C. Both definitions are correct

D. None of the definitions are correct

The correct answer is: C)

Both definitions are correct. Backwardation refers to a situation where the futures price is
below the expected spot price. It occurs when the benefits of holding the asset outweigh the
opportunity cost of holding the asset as well as any additional holding costs. A backwardation
commodity market occurs when the lease rate is greater than the risk-free rate.

Contango refers to a situation where the futures price is above the expected spot price. It is
likely to occur when there are no benefits associated with holding the asset, i.e., zero dividends,
zero coupons, or zero convenience yield. A contango commodity market occurs when the lease
rate is less than the risk-free rate.

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Q.3524 Which of the following expressions refer to the non-monetary benefits of holding an
asset?

A. Convenience yield

B. Cost of carry

C. Storage cost

D. Income yield

The correct answer is: A)

Sometimes there are benefits to holding an asset that may be monetary or non-monetary. Non-
monetary benefits are referred to as 'convenience yields.'

Q.3525 A situation where futures prices are lower than the spot prices because of high
convenience yields is called:

A. Backwardation

B. Contago

C. Roll yield

D. Convenience yield

The correct answer is: A)

In backwardation, the convenience yield is high, and futures prices are lower than the spot
prices.

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Q.3526 Julie Anderson is researching the European futures market. During her research,
Anderson discovers that the oil futures market was in backwardation.

The most likely explanation for this observation is that the:

A. Spot prices are high

B. The storage cost for oil is high

C. The convenience yield for oil is low

D. The cost of carry for oil is low

The correct answer is: D)

Backwardation (futures prices being lower than spot prices) occurs when the convenience yield
is high, or storage costs are low. In other words, the cost of carry is low.

Q.3528 The forward curve for gasoline futures is sloping upwards. This indicates that:

A. There is no cost of carry

B. The roll yield is positive

C. The futures market is in a state of contango

D. The benefits of holding the asset outweigh the opportunity cost of holding the asset as
well as any additional holding costs

The correct answer is: C)

When the forward curve is upward sloping, the market is in a state of contango.

Option A is incorrect. When the futures market is in a state of contango, there is little to no
convenience yield. However, it is not correct to state that the cost of carry is negligible.

Option B is incorrect. The roll yield is the difference between the spot price and futures price of
a contract. When the forward curve is upward sloping, the futures price is higher than the spot
price, and the roll yield is negative.

Option D is incorrect. Backwardation refers to a situation where the futures price is below the
spot price. It occurs when the benefits of holding the asset outweigh the opportunity cost of
holding the asset as well as any additional holding costs.

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Q.3529 The theory of storage asserts that:

A. Buyers of futures contracts forgo storage costs by not purchasing the commodity today

B. The roll yield should always be zero in efficient markets

C. The difference between spot and futures prices is determined by user preferences and
risk premiums

D. Investors contract a positive roll yield as a result of convergence between the spot and
futures price

The correct answer is: D)

The theory of storage asserts that if the convenience yield is high enough to position the futures
price below the spot price, the price of the futures contract will roll up to the spot price as the
expiration date of the futures contract approaches. This price convergence earns the bearer of
the futures contract a positive roll yield.

Hedging pressure hypothesis - an alternative theory - suggests that the difference between the
spot and futures price is determined by user preferences and risk premiums.

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

D. Known in advance using the spot curve

The correct answer is: B)

When the correlation between interest rates and futures prices is positive, futures contracts are
more desirable to holders of long positions than forward contracts. The reason is that 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.

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Q.3531 Assuming all else is held constant, when a commodity stock is in short supply, investors
can expect a:

A. Positive cost of carry

B. High convenience yield

C. Positive expected return

D. High storage cost

The correct answer is: B)

Since the commodity is believed to be short in supply, investors should expect to earn a high
convenience yield. In such a scenario, the holder of a commodity has the benefit of holding a
commodity if market conditions suggest that the commodity should be sold.

Option A is incorrect. Assuming all else is held constant, high convenience yields should
decrease the cost of carry. The cost of carry measures the net cost of carrying an asset and is
equal to storage costs minus convenience yield.

Option C is incorrect. If the commodity is in short supply, the holders of the commodity may even
expect to earn a price premium that is higher than otherwise justifiable in well-functioning
financial markets. The spot price of the commodity can rise above the market's expectation of its
futures price and result in a negative expected implied return.

Option D is incorrect. The storage cost does not increase as a result of the commodity being in
short supply.

Q.3577 The GBP/USD spot exchange rate is 0.6985. Assuming a 1-year forward rate quoted as
+9.5 point, what is the 1-year forward GBP/USD rate?

A. 1.6485

B. 0.7081

C. 0.6995

D. 0.8166

The correct answer is: C)

Each quoted point in a forward exchange rate is equal to 0.0001 or 1/10,000. Therefore, +9.5 =
0.00095, and the forward USD/GBP rate is 0.6985 + 0.00095 = 0.69945.

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 Reading 35: Commodity Forwards and Futures

Q.804 Commodity futures and forward markets have been growing at an exponential rate in
terms of size in the past years. It is said that more contracts are traded on commodities than
there are trades on the commodities themselves. In the United States, the futures contracts are
available on almost every commodity except two. Identify these two commodities which are
prohibited in futures markets by law.

A. Potatoes and Onions

B. Movie receipts and lottery receipts

C. Onions and movie receipts

D. Potatoes and lottery receipts

The correct answer is: C)

In the United States, futures contracts are available on almost all tradable commodities except
for two, onions and movie receipts of the box office. Violation of the law can end up in fines up to
$5,000.

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

The correct answer is: D)

The storage cost in gold futures contracts is small as compared to the other given commodities.
The properties of gold closely match with a financial contract where the storage cost is not
considered in the valuation of contracts. Due to liquidity and availability of gold, the investor can
readily purchase the gold for delivery at the maturity of the contract.

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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. Cost-free markets

C. Carry markets

D. Forwards markets

The correct answer is: C)

A commodity is said to be in carry when it is being stored rather than traded. The concept is
similar to financial markets where this term is called the financial cost of carry. In the case of
commodities, this becomes more obvious since the process of producing and distributing them
involves storing them as well.

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Q.807 Anton Patrick is a finance and accounting professor at the Boston Business College (BBC).
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 a variable which is widely used as an underlying variable for the
futures”
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

D. Students 2 and 3 are correct

The correct answer is: C)

Only student 3 is correct. The lending rate is the rate used for payments by the short seller of the
commodity future to compensate the lender of the commodity for lending it. In the case of a
financial asset, the short seller uses the lending rate to compensate the owner for the dividends.
In the case of commodities, the short seller may use the rate to make lease payments to the
owner of the commodity.

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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 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 correct answer is: C)

The nonmonetary benefit received by the owner of the commodities future due to physical
possession of the underlying commodity is called the convenience yield. In the given case, since
the investor also has a business that is related to the underlying commodities of Crude oil and
Brent oil, the owner can gain nonmonetary benefit like using the oil to produce power during, for
instance, a short-term shortage of oil supply.

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 contract 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

The correct answer is: D)

If the forward prices curve of the commodities is upward sloping, the market of the commodity is
said to be in contango. In other words, in contango, the forward price of the distant maturity
contract is higher than the forward price of the shorter maturity contract. The forward prices of
gold, soybeans, and corn are traditionally in contango.

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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 a renewable as
well as a primary commodity?

A. Oil

B. Copper

C. Livestock

D. Gasoline

The correct answer is: C)

Commodities can be classified as extractable or renewable. Extractable commodities are those

commodities that are obtained by drilling or mining i.e. oil, natural gas, gold, copper, iron, etc.
On the other hand, renewable commodities are obtained through agricultural means. Soybean,
cotton, corn, livestock, pork bellies, and lumber are examples of renewable commodities.
Secondary commodities are those that have been processed like gasoline while primary
commodities are those that are traded unprocessed like soybean, oil, gold, livestock, etc.

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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 current price of a 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

Which of the above-mentioned explanation is incorrect?

A. Only explanation I is incorrect

B. Only explanation II is incorrect

C. Both explanations are incorrect

D. None of the above

The correct answer is: D)

Both the forward price and the prepaid forward price explanations are correctly defined. The
forward price of a commodity is the future value of the prepaid forward price of the commodity.
Alternatively, the prepaid forward price for a commodity is the current price of a commodity that
is to be received on a specific future date. In other words, it is the present value of the
commodity on a future date.

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Q.812 A commodity trader at an investment bank has analyzed the forward prices of gold
contracts and realized that there might be an arbitrage profit opportunity present in gold futures
contracts. The spot price for one ounce of gold is $1,205 and a 6-month futures contract is
quoted as $1,253 per ounce. If the risk-free rate is 6%, then what steps should the trader take to
realize arbitrage profit.

A. Borrow the amount equal to the futures price of gold for 6 months at the risk-free rate
and take a short exposure in a 6-month gold futures contract. At the expiration of the
contract, sell the gold at the futures price and pay the borrowed money with interest.

B. Short sell gold today and take a long position in a 6-month gold futures contract. Then,
lend the money at the risk-free rate for 6 months. At the expiration of the contract,
receive the money with interest and buy back gold at the futures price and deliver the
gold.

C. Short sell gold today and take a long position in a 6-month gold futures contract.
Borrow money at the risk-free rate for 6 months. At the expiration of the contract, receive
the money with interest and buy back gold at futures price and deliver the gold.

D. Borrow the amount equal to the spot price of gold for 6 months at the risk-free rate to
buy gold in the spot market and take a short exposure in a 6-month gold futures contract.
At the expiration of the contract, sell gold at futures price and pay the borrowed money
with interest.

The correct answer is: D)

The futures price of the 6-month gold contract is greater than the spot price. An investor can
borrow $1,205 for 6 months at the risk-free rate and take a short exposure in a 6-months gold
futures contract for the futures price of $1,253. After 6 months, he can sell gold at the futures
price of $1,253 and pay the borrowed money with interest for $1,241.70. The cash-and-carry
arbitrage profit is equal to $1253 – $1241.7 = $11.3.

Borrowed fund = 1,205e0.06*0.5 = 1,241.69

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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%, then the arbitrage profit for trading one gold
futures contract is:

A. $7.81

B. $23.61

C. $11.31

D. $10.96

The correct answer is: C)

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

At the expiration of the futures contract:

1. Sell gold at the futures price of $1,253
2. Pay the borrowed money with interest of $1,205e0.06*0.5 = 1,241.69
3. Earn the cash-and-carry arbitrage profit of ($1,253 – $1,241.69) = $11.31

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Q.814 Branden Berger is an active derivatives 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
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 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, arbitrage profit is not possible.

The correct answer is: C)

An investor can earn arbitrage profit if the trader short sells corn at the spot price of $6.90 per
bushel, lends the money for one year at risk-free of 8%, and takes a long position in a corn
forward contract for the price of $6.90. After one year, he will receive the lent money with
interest equal to $7.47, receive the corn bushel at the expiration of the contract for $6.90, and
deliver the corn.

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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. $0.57

D. $1.06

The correct answer is: C)

The investor should take the following steps at time 0:

1. Short sell corn at the spot price of $6.90 per bushel

2. Lend the $6.90 for 1 year at the risk-free rate
3. Take a long position in a 1-year corn forward contract

At the expiration of the futures contract:

1. Receive the lent money with interest for $6.90e0.08*1 =$7.47

2. Purchase the corn bushel at the forward price of $6.90 and deliver the corn bushel
3. Earn the reverse cash-and-carry arbitrage profit of ($7.47 – $6.9) = $0.57

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Q.816 An investor is analyzing a 6-month oil forward contract that is quoted as $55 per barrel.
The spot price of oil is $54 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 $54, 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 $55 per barrel.

After 6 months, the investor receives the lent money with interest equaling $56.76, purchases
the oil at the forward price of $55, and delivers the oil to earn an arbitrage profit of $1.76 per
barrel. Which of the following strategies has he most likely implemented?

A. Cash-and-carry arbitrage strategy

B. Arbitrage-free strategy

C. Reverse cash-and-carry strategy

D. Binominal arbitrage strategy

The correct answer is: C)

The investor implemented the reverse cash-and-carry arbitrage strategy to earn arbitrage profit.
In a reverse arbitrage strategy, the investor follows these steps:
At the time 0:

1. Short sell the commodity

2. Lend the short sale proceeds at market interest rates for the duration of the forward or
futures contract
3. Take a long position in the futures contract at market price

At contract expiration:
1. Collect the lent proceeds with interest
2. Take delivery of the commodity for the futures price and deliver the commodity in the short
sale commitment

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Q.817 Salona West is a portfolio manager at Global Hedge Fund Inc. She received an email from
a junior investment analyst, suggesting that a reverse cash-and-carry arbitrage opportunity
exists in 6-month gold futures contracts as the spot prices of gold are higher than the
corresponding forward prices. West believes that such an opportunity would be unlikely in gold
contracts due to the following reasons:

I. The suggested transaction doesn’t include the consideration of a lease payment

II. Since an active lending market in the gold market exists, the lender uses the forward price to
determine the lease rate, and a no-arbitrage pricing will be established

Which of the West’s justification for no-arbitrage pricing is/are correct?

A. Statement I

B. Statement II

C. Both statements I and II

D. Neither statement I nor statement II

The correct answer is: C)

When the lease rate is considered in the pricing of the forward contract, the arbitrage
opportunity vanishes. The lease rate is the rate used to calculate the lease payment to the lender
of the commodity. In shorting a commodity, the commodity is required to be borrowed, and
therefore, the lender of this commodity will demand a lease payment. The lease payment in
commodity forwards pricing is similar to the dividend yield in stocks.

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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 continuously compounding annual risk-free rate for the commodity
is equivalent to 7.5%.

A. $39.88

B. $38.89

C. $37.93

D. $36.08

The correct answer is: C)

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:

F = S e(Risk-free rate – Lease rate)T
F = 37*e(0.075 - 0.05)1 = $37.93 per pound

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Q.819 Ahmet Abdullah is a research analyst at Klosky Investment Company. He is interested in
analyzing the forward price curve trend of silver prices. Due to a lack of trading, he is unable to
get the forward prices for silver. However, he found out that there is an established lending
market for silver and the silver lease rate is 7.9%. If the risk-free rate is 8.2%, then which of the
following is true?

A. The market for silver is said to be in backwardation

B. The market for silver is said to be in contango

C. The market for silver is said to be in upwardation

D. It cannot be ascertained without forward prices

The correct answer is: B)

The market is said to be contango if the forward curve of commodity prices is upward sloping.
This also suggests that the forward prices of the commodity are higher than the current spot
prices. The relation between forward and spot prices can be analyzed using the following
equation:
F = S e(Risk-free rate – Lease rate)^T

If the risk-free rate is higher than the lease rate, the forward prices will be greater than spot
prices and the market will be in contango.

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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

Which of the above statements are correct?

A. I & II

B. II & III

C. I & III

D. I only

The correct answer is: D)

Statments II and III are incorrect. II is incorrect because the presence of a convenience yield
reduces the forward price of a commodity. III is incorrect because storage costs increase the
forward price of a commodity.

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

D. The forward price of livestock cannot be ascertained

The correct answer is: B)

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
demonstrated with this equation.

F = S*e(Risk-free rate + Storage cost – Convenience yield)

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.

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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

The correct answer is: B)

The downward-sloping curve in the forward market is referred to as backwardation. In

backwardation, the forward prices of the commodities with distant maturities are lower than the
forward prices of the same commodity with shorter maturities.

In contrast, in a contango market, the forward prices of the distant maturity contracts are higher
than the forward prices of shorter maturity contracts.

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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.

A. The market of the commodity is in contango

B. The market of the commodity is in backwardation

C. The market of the commodity is in upwardation

D. It could not be ascertained without established forward quotes

The correct answer is: B)

The market is said to be in backwardation when the forward curve of commodity prices is
downward sloping. This also suggests that the forward prices of the commodity are lesser than
the current spot prices. The relation between forward and spot prices can be analyzed using the
following equation:
F = S e(Risk-free rate – Lease rate)^T

If the risk-free rate is lower than the lease rate, the forward prices will be lower than spot prices
and the market will be in backwardation.

Q.3527 According to the theory of storage, the return on a passive investment in commodity
futures is expected to be equal to the:

A. Roll yield

B. Convenience yield net of storage costs

C. Sum of collateral returns plus a risk premium

D. Convenience yield plus storage costs

The correct answer is: B)

According to the theory of storage, the return on a passive investment in commodity futures is
expected to be equal to the convenience yield net of storage costs.

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 Reading 36: 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.

Which of the following is correct?

A. Only statement I is correct

B. Only statement II is correct

C. Both statements are correct

D. None of the statements is correct

The correct answer is: B)

Only statement II is correct. Statement II is correct because an option gives the right but not an
obligation to the holder to exercise the option. For example, a holder of a call option has the
right, not the obligation, to purchase the underlying asset at a specific price and time whereas
the holder of futures/forward contracts has an obligation to honor the contract. Statement I is
incorrect because entering into all the aforementioned derivative contacts usually requires initial
transaction costs.

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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 an obligation
to sell 1,000 stocks to another investor if the value of the stock increases beyond a predefined
price. Which of the following accurately defines the transaction?

A. Smith is long put options

B. Smith is short on equity swaps

C. Smith is long on equity forwards

D. Smith is short call options

The correct answer is: D)

A short call is a bearish position taken by traders which requires the trader to sell the underlying
asset to the holder at a specified (strike) price. The party that's short the call (short position) is
effectively the seller/writer of the contract. The strike price is usually more than the market
price prevailing at the time of writing the contract. The decision of whether or not to exercise
rests with the holder (long position), and the short position has an obligation to honor the
contract if it is exercised.

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Q.726 Colin Francis purchased an American call option to buy 1,000 shares of Thai Healthcare
Corp. for the price of $2.70 per option to purchase each share. The option expires in 6 months,
and the current stock price is $24.69. If the strike price of the contract is $22.50, then which of
the following statements is true?

A. The total cost of the option is $22,500

B. The option can only be exercised at expiration

C. The call option is at the money

D. If the option is exercised, the total loss is $510

The correct answer is: D)

If the option is exercised, the net cash inflow from the option will be (($24.69 - $22.5) × 1,000) =
$2,190, which will minimize the cost of the option of ($2.7 × 1000) = $2,700.

The net loss will be ($2,190 - $2,700) = $510.

Option A is incorrect. The cost of the option of ($2.7 × 1000) = $2,700.

Option B is incorrect. An American call option can be exercised any time before or at expiration.

Option C is incorrect. The current stock price is $24.69 and the strike price is $22.50. The option
is in the money and not at the money. The option would be at the money if the current stock
price would be equal to the strike price.

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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. A long call option with the strike price of $45

B. A short call option with the strike price of $45

C. A Long put option with the strike price of $45

D. A short put option with the strike price of $45

The correct answer is: C)

Emmy Annie should purchase a put option or take a long position in a put option on the stocks of
ABC Inc. The put option should have a strike price of $45 (hypothetically), so if the price of the
stock falls below the strike price of $45, Annie can exercise her right to sell her stocks at the
price of $45 per share.

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

The correct answer is: C)

Franky is the purchaser of the put option or the long position holder in a put option so his gain
for the option (($31.70 - $30) * 2,000 = $3,400) is offset by the cost of the purchasing the option
($3.30 * 2,000 = $6,600). His net loss is -$3,200.

Lee is the seller or the short position holder in the put option. His gain on the sale of the put
option ($3.30 * 2,000 = $6,600) is reduced due to the loss on the underlying (($31.70 - $30) *
2,000 = $3,400). His total gain is $3,200.

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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

A. Only statement I is correct

B. Only statement II is correct

C. Both the statements are correct

D. None of the statements are correct

The correct answer is: B)

Statement I is incorrect. The long position in a put or call option is the buyer of the option, not
the writer of the put/call option.

Statement II is correct because the short position holder in a put/call option is known as the
writer or seller of the put option.

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
the four positions in the options market. She can take either a long/buyer position or 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 of loss?

A. Long position in a call option

B. Short position in a call option

C. Long position in a put option

D. Short position in a put option

The correct answer is: B)

The seller of a call option or the short position in a call option has unlimited loss potential. As the
price of the underlying asset has an infinite potential of increase, the difference between the
strike price and the stock price at any given time also has an unlimited potential to increase.
Options A and C are incorrect because the loss potential of a long call and long put is limited to
the premium or initial cost at the time of the purchase of the option. Option D is incorrect
because the price of an asset cannot be negative. Therefore the loss potential of a short put is
limited to zero.

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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

A. payoff = 0; profit = $0.5

B. payoff = 0.5; profit = $0.5

C. payoff = 0; profit = $0

D. payoff = 3; profit = $0.5

The correct answer is: A)

Payoff to the long position = PT = max(0, X - ST)

= max(0, $30 - $33) = 0
To the short position, payoff = -PT = -0 = 0
Profit to the short position = P0 - PT
where P0 is the option premium
profit = $0.50 - 0 = $0.50

Detailed Response

In option contracts, there are always two parties:

(I) the buyer, who takes the long position, and

(II) the seller (writer) who takes the short position

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:

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At expiration, the holder will only benefit if the prevailing market price is less than the

exercise/strike price. The payoff is equal to Pt = X - ST, i.e, strike price minus the market price. If

the stock stays at X or above, the payoff will be zero.

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

the buyer cannot exercise their right to sell.

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.

The seller's profit is - (-0.50) = 0.5

Again, the zero-sum game is at play here.

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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
an American call option on the Nasdaq-100 Index (NDX) which is composed of 108 non-financial
companies for the price of $7 per index. The strike price of the index option is 3,355, and the
option expires in March 2018. 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. $95

C. $10,200

D. $9,500

The correct answer is: D)

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 - 7) * 100 = 9,500

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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?

A. Equity call option

B. Index call option

C. Long-term equity anticipation securities

D. Covered call option

The correct answer is: C)

Long-term equity anticipation securities (or LEAPS) are a type of option that has an expiration
date of up to 39 months.

Options A and B are incorrect because call and put options usually expire in 3, 6, 9 or 12 months.

Option D is incorrect because a covered call is a protective call option with an expiration
identical to other traditional options.

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Q.734 The following are the strike prices, current prices, and expiration dates for options on
equities of various companies.

Call option on Sun Inc. Call option on Moon Corp. Put option on Pluto Co.

Strike price $109 Strike price $113 Strike price $87

Current price $111 Current price $109 Current price $89

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

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 correct answer is: C)

A call option is in the money if the current price of the option is greater than the strike price. In
contrast, if the current price is lower than the strike price, the call option is considered out of
the money. In the case of put options, the option is considered in the money if the current price is
lower than the strike price, whereas if the current price is higher than the strike price, the
option is referred to as out of the money. In both call and put options, the option is considered at
the money if the strike price is equal to the current price.

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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 correct answer is: D)

In exchanges in the United States and most other exchanges, the last trading day of put and call
options is the third Friday of the month in which the specific contract is expiring. For instance,
the buyer of a September put option can trade the option until the third Friday of September.
The exact expiration date of the contract is the Saturday after the third Friday of September.

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Q.736 Hessen Jersey is a final year student in the undergraduate finance and investing program
at the Hockenheim University. During the derivatives class at university, the lecturer asked him
to define the portions of the option premium. Hessen gave the following definitions:

I. Option premiums consist of two portions, the intrinsic value, and the time value
II. The intrinsic value of a call option is the difference between the strike price and the current
price of the underlying asset
III. The time value of a call option is the part of the premium which is in excess of intrinsic value

Which of Jersey’s definition is/are incorrect?

A. Definition I is incorrect

B. Definition II is incorrect

C. Definition III is incorrect

D. None of the definitions are incorrect

The correct answer is: D)

None of Jersey’s definitions regarding option premiums are incorrect.

The intrinsic value of a call option is the current price minus the strike price, and an in the
money call option has an intrinsic value. Conversely, the intrinsic value of a put option is equal to
strike price minus current price of the underlying, and an in the money put option has an
intrinsic value. The part of the option premium which is in excess of the intrinsic value is called
the time value of an option. Therefore,
Option premium (or total value) of an option = Intrinsic value + Time value

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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. European call option

B. American call option

C. Binary call option

D. LEAPS call option

The correct answer is: C)

A binary call option is an option structured such that the payoff is the fixed amount of money if
either (I) a specified price is reached/exceeded as of the expiration or (II) the option is simply in-
the-money as of the expiration.

Options A and B are incorrect because the payoff in American and European call options is not
fixed to $100, rather the pay of the American and European option is equal to the maximum of
zero or the difference between the final price and the strike price.

Option D is incorrect: LEAPS (long-term equities anticipation securities) are options that have
the same characteristics as standard options but with expiration dates of up to 39 months.

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Q.740 Which of the following mentioned features of the market makers in options markets is
inconsistent with the actual definition and features of market makers in options markets?

I. The bid price is the price at which market makers are willing to sell the option and the offer
price is the price at which the market maker is willing to buy the option.
II. Market makers increase the liquidity in the options market.
III. Market makers profit from the bid-offer spread or difference between the bid and the offer
price.

A. Feature I is inconsistent

B. Feature II is inconsistent

C. Feature III is inconsistent

D. None of the features are inconsistent

The correct answer is: A)

Market makers in the options market quote the bid and offer prices on various options. The bid
price is the price at which market makers are willing to buy the option and the offer price is the
price at which market makers are willing to sell the option. The offer price is always higher than
the bid price. Features II and III are correct because market makers increase the liquidity in the
options market and profit from the bid-offer spread or difference between the bid and the offer
price.

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Q.741 A portfolio manager at Sea Breeze bank owns 10,000 shares of PNG Corp. The manager
believes that the price of the shares will increase by 20% in the next 6 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?

A. Covered put option

B. Covered call option

C. Protective put option

D. Protective call option

The correct answer is: B)

The portfolio manager has a covered call position. When the writer of the call option owns the
underlying shares of the option, the option is said to be a covered call option. Covered call
options are less risky than naked options because you both own the asset (long position) and
write (sell) a call option (short position).

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

B. The market maker

C. The options clearing corporation

D. The buyer of the option

The correct answer is: C)

The options clearing corporation (OCC) guarantees that the writer of the option must honor the
option or must fulfill the obligations determined under the terms of the option. It works as the
clearing house in futures markets. The OCC works with the help of its members; all orders
processed through members are required to carry a specific amount of capital and a special fund
that can be used in case of default.

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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 dividend of $1.20 on its stock while Green Company announced a 4-for-3 stock 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

D. None of the companies’ options will be adjusted

The correct answer is: B)

Options are only adjusted for stock splits or stock dividends, as in both the cases the number of
shares/stocks will increase. On the other hand, call/put options are not adjusted for cash
dividends. The consequences of cash dividends are incorporated in option valuation models.

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?

A. In-the-money: No; Break-even price: $1.27

B. In-the-money: Yes; Break-even price: $1.40

C. In-the-money: Yes; Break-even price: $1.35

D. In-the-money: No; Break-even price: $1.40

The correct answer is: B)

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?

A. Option Premium = Intrinsic Value + Time Value

B. Option Premium = Intrinsic Value - Time Value

C. Option Premium = Time Value - Intrinsic Value

D. Option Premium = Price - Time Value

The correct answer is: A)

Option Premium = Intrinsic Value + Time Value. The time value of an option is the amount by
which the option premium exceeds the intrinsic value.

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 correct answer is: A)

When you write (sell) a put option, you receive the premium and, in exchange, you have the
obligation to purchase the underlying security at the option's strike price if the option is
exercised.

The buyer of an option (either a call or a put) has "the right, but not the obligation" whereas the
writer (seller) of an option has an obligation.

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 Reading 37: 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?

A. Strike price of the option

B. Expected dividend

C. Risk-free rate

D. Creditworthiness of the counterparty

The correct answer is: D)

The creditworthiness of the counterparty in a plain vanilla stock option least likely affects the
prices of options. Since plain vanilla stock options are usually standardized and are traded on
exchanges, the options clearing corporation (OCC) guarantees that the writer of the option does
not default on their obligations.

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 a different
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 correct answer is: B)

If the current stock price (or the final stock price) of a specific share decrease, the stock price of
a put option on the stock will increase as the option is most likely to be on the money. In
contrast, if the current stock price or the final stock price of a specific share decrease, the stock
price of a call option on the stock will decrease as the option is most likely to be out of the
money.

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Q.746 The prices of options on the stocks or equities are affected by a number of variables. Some
variables have a direct impact on 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 correct answer is: B)

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
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.

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Q.747 Jack Anderson, a portfolio manager at Vito Investment Company, manages an $800 million
mutual funds 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
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 call index options and the prices of
put index options

D. The increase in volatility will increase the prices of call index options and the prices of
put index options

The correct answer is: D)

The increase in the volatility of stocks prices or the index prices will increase the prices of
European/ American call options and European/American put options. As the volatility increases,
the variation of the up and down potential of index prices increases. In turn, this will increase
the prices of call and put options as both options are likely to be in the money.

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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 to analyze the impact on the
prices of put and call stock options if the underlying stock pays an expected dividend. Jackson
came up with the following scenarios that show the impact of call and put options if future
dividends increase. Which of the four scenarios is consistent with the principles of option
pricing?

A. An increase in expected dividend will increase the price of put and call stock options.

B. An increase in expected dividend will decrease the price of put and call stock options.

C. An increase in expected dividend will decrease the price of put options but increase
the price of call stock options.

D. An increase in expected dividend will increase the price of put options but decrease
the price of call stock options.

The correct answer is: D)

An increase in future or expected dividends on the underlying stock will increase the price of put
options on this stock and decrease the price of call options on the underlying stock. This can be
further verified by the fact that when a specific stock pays dividends, the price of that stock
decreases. Therefore, when an underlying stock pays a dividend, the price of the stock
decreases, and price of the put options increase as these put options are then more likely to be in
the money. The opposite effect happens for call options.

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Q.749 Mehmet Orkan, a junior investment analyst at an Istanbul-based investment company, is
analyzing various call options on U.S. stocks. He has obtained the following call options quotes
on some blue-chip companies in the U.S consumer goods sector. Which of the following options
has the highest value?

Name Nature of the option Expiration date

A European call option 3 months

B European call option 9 months

C American call option 3 months

D American call option 9 months

A. Option A

B. Option B

C. Option C

D. Option D

The correct answer is: D)

As the time to expiration increases, the price of the option increases or stays the same.
Therefore, the 9-month American call and 9-month European call will be worth more than the 3-
month options. Among the 9-month European and 9-month American call options, the 9-month
American call option will have the highest price because the buyer of the option has a right to
exercise his option any time until the expiration date, while the buyer of the European call option
can only exercise the option at expiry.

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Q.750 Andrew Cogo is an Ivy League graduate and a participant in the 4-month global graduate
trainee program at one of the largest American investment banks. After the completion of his
education and traineeship, Cogo moved back to his home country, Uganda. Uganda has recently
introduced an options trading exchange, but due to the limited knowledge of the exchange
participants, the options prices in the Ugandan exchange has some discrepancies. For instance, a
call option on the stock of a Ugandan shipping company is trading for 1.98 with the strike price
of 2.25 (all the amounts are in Ugandan Shillings). If the current price of the stock is 1.70,
determine the transaction in which Cogo can make instant arbitrage earnings.

A. Cogo can sell a call option and purchase the underlying stock. If the option is
exercised, he will earn arbitrage a gain equal to the difference between the current stock
price and strike k price.

B. Cogo can sell a call option and purchase the underlying stock. If the option is
exercised, he will earn an arbitrage gain equal to the difference between the option price
and the current stock price.

C. Cogo can buy a call option and sell the underlying stock. If the option is exercised, he
will earn an arbitrage gain equal to the difference between the option price and the
current stock price.

D. Cogo can buy a call option and sell the underlying stock. If the option is exercised, he
will earn an arbitrage gain equal to the difference between the current stock price and
the strike price k.

The correct answer is: B)

If the option value is higher than the current price of the stock, an arbitrage profit opportunity
exists. In the given case, Cogo can sell a call option for 1.98 (cash inflow) and buy the underlying
stock for 1.70 (cash outflow). The (instant) net cash flow of the transaction is 1.98 - 1.7 = 0.28.
Regardless of subsequent price movements in the underlying, the arbitrageur has already locked
in a risk-less 0.28 shillings. The upper band limit of a call option price should always be equal or
lower than the current price of a stock, i.e., c ≤ S.

Additional explanation
Whenever the value of a call is higher than the value of the underlying stock, there's an
opportunity to make immediate risk-free profits. Arbitrageurs would sell the call and buy the
stock, earning an instant risk-free profit in the process. In this case, that would amount to $0.28
(= 1.98 - 1.70). Whatever happens after that is really not arbitrage: (I) The stock can appreciate
but fall short of the 2.25 strike, in which case the arbitrageur stands to make a capital gain.
(II) The stock can appreciate and soar above the strike price, in which case the arbitrageur
would have to sell it to the call option buyer.
(III) The stock can depreciate, rendering the arbitrageur worse off.
All the three possible outcomes have an element of market risk. Whatever profit that may come
out of subsequent movements is really not risk-free.

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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 or higher than the current price
of the underlying stock

B. The price of an American put option should be equal or higher than the strike price of
the option on the underlying stock

C. The price of the American put option should be equal or lower than the current price
of the underlying stock

D. The price of the American put option should be equal or lower than the strike price of
the option on the underlying stock

The correct answer is: D)

The price or the value of an American or European put option should not be worth more than the
strike price of the option. In other words, the price of an American or European put option
should only be equal or lower than the strike price of the option. If the price of a put option on a
stock is greater than the strike price, the investor can sell the put option, invest the proceeding
at the risk-free rate, and earn arbitrage profits.

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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. $7.16

The correct answer is: C)

The lower bound of the European call option on a non-dividend paying stock is equal to:
S – Ke-rt = 92 – 89*e(-0.08*0.5) = 6.489

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
$6.489.

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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%?

A. $2.37

B. $2

C. $1.91

D. $1.18

The correct answer is: D)

The lower bound of the European put option on a non-dividend paying stock is equal to:
Ke-rt - S = (33 e-0.1*0.25) - 31= 1.185

Where S = current 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 $1.18

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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?

A. Smith has constructed a put-call parity

B. Smith has constructed a covered call

C. Smith has constructed a fiduciary call

D. Smith has constructed a protective put

The correct answer is: C)

A fiduciary call is a combination (or portfolio) consisting of a zero-coupon bond that pays X
amount at maturity and a call option with the 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 (current price) if the call option expires in
the money. Option A is incorrect because the put-call parity is the combination of a fiduciary call
and a protective put. Option B is incorrect because a covered call is a strategy where the owner
of the stock writes a call option on the stock, so if the price of the stock is above the strike price,
he will simply forfeit the stocks. If the current price of the stock is below the strike price, he will
earn a call premium. Option D is incorrect because a protective put refers to owning the stock
together with a put option.

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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 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. If at the time of expiration of the call options the final price of the stock is
A, which is below X, then estimate the payoff of the combination of the bonds and call options.

A. The payoff is A

B. The payoff is X

C. The payoff is A+X

D. The payoff is zero

The correct answer is: B)

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 zero-coupon bond at the maturity is X.

The payoff of the call option, if the option is in the money, is S-X (where S is current price and X
is 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 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 is testing the relationship of a put-call parity for which he has constructed a
fiduciary call and a protective put. His fiduciary call consists of a Millers Corp. zero-coupon bond
with a face value of $95 and the maturity date of 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 determine the total cash
inflow the investor will receive at maturity.

A. $90

B. $95

C. $100

D. $185

The correct answer is: B)

The net payoff of the combination of a zero-coupon bond with a face value of $95 and a call
option with the 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
the strike price of X is called a fiduciary call.

The payoff on the zero-coupon bond at maturity is $95.

The payoff of the call option, since the option is out of money = (90-95) =0

And the payoff of the fiduciary call with an out of the money option = (0) + X = (0) + 95 = $95

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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
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 correct answer is: D)

Since the put-call parity relationship is derived from the payoffs of the fiduciary call (that is
composed of a discount bond and a call option), and a protective put, which is constructed off a
put option and an underlying stock, the face value of the discount bond at maturity must be
equal to the strike price of a call option and a put option at expiration.

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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 is S, which is below
the 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

The correct answer is: B)

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).

If the option is out of the money, the payoff of the option is 0.

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 is S which 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 + Xe-rT

B. p = c - S + Xe-rT

C. Xe-rT = S + c - p

D. c = S + p - Xe-rT

The correct answer is: C)

The equation described in C is inconsistent with the put-call parity equation.

The put-call parity equation holds true when both sides of the following equation are equal:
c + Xe-rT = S + p

Where,
c = call price
p = put price
Xe-rT = PV of zero-coupon bond
S = Current price of stock.
Thus, Xe-rT = S + p - c
A, B, and D are all equivalencies for each of the individual securities in the put-call parity
relationship

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Q.761 Jacob Clarke is an investment manager at one of the largest investment banks in Canada.
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?

A. Long a stock, short a put option, and short a zero-coupon bond

B. Long a call option, short a put option, and short a zero-coupon bond

C. Short a stock, long a put option, and long a zero-coupon bond

D. Long a stock, long a put option, and short a zero-coupon bond

The correct answer is: D)

To create the synthetic payoff of a long position in a call option, an investor should take a long
position in a stock, a long position in a put option, and a short position in a zero-coupon or
discount bond. This relation can be constructed through the put-call parity equation.

Since c + Xe-rT = S + p

The synthetic call is c = S + p - Xe-rT

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Q.762 An investment manager is looking for the price of a 3-month put option to trade on the
stock of AWWE, but due to infrequent trading of put options on this specific stock, the price
quote for the put option is unavailable. Suppose that the investor has found a price quote of $4.5
for a 3-month call option with an exercise price of $75, and the current price of the stock that is
$76.5, then estimate the price of the 3-month put option if the risk-free rate of 8%.

A. $3

B. $2.78

C. $1.52

D. $1.43

The correct answer is: C)

Since both sides of the put-call parity equation are equal, we can rearrange the put-call parity, to
find the put price.

c + Xe-rT = S + p
p = c - S + Xe-rT
OR put = call - stock + Xe-rT

Put = $4.5 - $76.5 + $75*e-rT = $1.52

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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 face value of the discount bond and the strike price
of 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 statements is/are inconsistent with the put-call parity relationship?

A. Only statement I is incorrect

B. Only statement II is incorrect

C. Both statements are incorrect

D. None of the statements are incorrect

The correct answer is: B)

Statement II is inconsistent with the assumptions underlying the put-call parity. For the put-call
parity relationship to hold true, the puts and calls should be European-style that can only be
exercised at expiration which is consistent with the maturity date of the discount bond.

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 continuous risk-free rate
is 7%, then what is the put option price?

A. $3.80

B. $4.14

C. $16.20

D. $5.06

The correct answer is: C)

Using the put call-parity equation:

S0 + P = C + Xe−r T

P = C + Xe−rT − S0

P = 10 + 71 × e−0.07 ×1 − 60 = 16.20

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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?

A. $11 positive payoff

B. $13 negative payoff

C. $13 positive payoff

D. $0 payoff

The correct answer is: D)

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?

A. The volatility in the market is low

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

The correct answer is: B)

A long-term European put option will be worth a lot more than an otherwise identical short-term
put option if interest rates are lower and volatility is higher. Since European options can only be
exercised on their expiration date, a longer time to expiration suggests that the option holder
will need to wait longer to receive money from the sale of the underlying. The lost interest will
be a disadvantage of the additional time; lower interest rates will reduce this lost interest.
Higher volatility will increase the chances that the underlying price will move in favor of the
option holder.

Q.3565 The value of a European put option will increase with higher:

A. Volatility

B. Carrying costs

C. risk-free interest rates

D. Both A and C

The correct answer is: A)

Higher volatility will increase the value of a European put option because it increases the
chances of the underlying price declining relative to the exercise price.

Option B is incorrect. Carrying costs will raise the effective cost of holding or shorting the asset.
Holding put options will make it more expensive to participate in the movements of the
underlying than by short selling because short sellers benefit from carrying costs, which are
borne by the owners of the assets.

Option C is incorrect. A higher risk-free interest rate will lower the present value of the receipt
to the exercise price upon exercise. This will decrease the value of a European put.

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Q.3566 Which of the following is NOT a factor that determines the value of an option?

A. The price of the underlying asset

B. The volatility of the underlying asset

C. The inflation rate

D. The interest rate

The correct answer is: C)

The price and volatility of the underlying asset and the risk-free interest rate all play an
important role in determining the value of an option.

Q.3567 Which of the following conditions will increase the value of a call option?

A. A decrease in volatility

B. An increase in risk-free rate

C. A decrease in stock price

D. An increase in the dividend rate

The correct answer is: B)

An increase in risk-free rate, increase in volatility, or increase in stock price will increase the
value of a call option. As the dividend increases, the value of a call decreases.

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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:

A. Purchase call options

B. Purchase put options

C. Buy the underlying short

D. All of the above

The correct answer is: A)

Based on the rearranged put-call parity (see below), in order to synthetically short sell (issue) a
risk-free bond, call options should be purchased while the underlying and put options should be
sold short.

-X/(1 + r) T = c0 - p0 - S0

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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

The correct answer is: D)

The put-call parity is represented by the equation:

S0 + p0 = c0 + X/(1+r)T

Rearranging the equation:

p0 = c0 + X/(1+r)T – S0

Therefore, a long put option position can be replicated by going long a call option, short the
underlying, and long a risk-free bond.

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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. $2.41

C. $12.34

D. $8.48

The correct answer is: B)

Put-call parity = c0 + Xexp-rT = S0 + p0

p0 = $8 + [$55exp-0.043 * 0.25] - $60 = $2.41

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 Reading 38: Trading Strategies

Q.764 Adam Ponting, an Australian investment manager at Sydney Grand Investments, is

managing a portfolio of equities of American blue-chip companies. The largest portion of the
portfolio is a 35% exposure to the stocks of Black Cola Inc. Black Cola has recently faced
significant operational and managerial changes, which is why it is difficult to estimate the
direction of the price trend in its stocks. Ponting is interested in using options to construct a
position which would help him gain if the price of the stock increases, but also limit losses in
case the price of the stock decreases. Which of the following strategy will serve this purpose?

A. Straddle put

B. Protective put

C. Covered call

D. Fiduciary call

The correct answer is: B)

A protective put is a strategy that can protect the portfolio’s value.

In other words, in a protective put, the investor who owns the asset buys a put option on those
stocks in exchange for a put premium. If the price of the stock increases, the investor will make
slightly smaller gains as the value of the portfolio increases but if the value of the stock
decreases, the put option will be exercised and the investor will limit its losses to the strike price
of the put option.

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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

The correct answer is: D)

In order to lock the profit or bound the upside potential of the stock, the investor can write or
sell call options. In the given case, since the manager believes that the stock does not have the
potential to increase beyond $48, the trader will sell out-of-the-money call options with the strike
price of $48.

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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

C. Principal protected notes

D. Straddle notes

The correct answer is: C)

Principal Protected Notes 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.

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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

The correct answer is: C)

Spread trading strategies require taking positions in two or more options at the same time with
the same expiration date. The bull call spread strategy is a spread trading strategy in which an
investor buys a European call option with a specific strike price (X1) and simultaneously sells a
European call option with a higher strike price (X2). If the current price is below X1, the payoff
of the investor is zero. If the current price is between X1 and X2, the payoff of the investor is the
current price minus X1. If the current price of the stock is higher than X2, the payoff of the
investor is X2-X1.
We can also have have a bull put strategy which consists of one short put with a higher strike
price and one long put with a lower strike price. Both puts have the same underlying stock and
the same expiration date.

Note: In a bull spread strategy, both options have to be calls or puts (There cannot be a call and
a put)

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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 the strike price of $89, and at the same time, he sold European call options on the same
stocks with the 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

The correct answer is: C)

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 the 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 correct answer is: B)

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

Additional explanation on how bull spread strategies work

In a bull-spread strategy, this is what happens:
(I) You buy a call option- giving you the right to buy the underlying at some point in the future at
a specified strike price x. To do so, you pay a premium A
(II) You sell a call option - requiring you to sell the underlying at some point in the future at a
specified strike price y, where y>x. Here, you receive a premium B
This is a bullish strategy meaning you expect the stock price to rise. If that happens, you will
exercise the call option (I), i.e. buy low and sell the underlying at the prevailing market price,
making a profit. However, your profit has a ceiling. If the market price soars above the strike
price of the short position, you will not make any more money because the holder of the second
option will most likely exercise the right to buy (and you will have no choice but to sell to them).
The maximum loss, on the other hand, is equal to B-A; the net cost of the two positions; the
difference between what you receive for the short position (B) and what you pay for the long
position (A).

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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
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

The correct answer is: B)

Spread trading strategies require taking positions in two or more options at the same time with
the same expiration date. In the bear spread strategy, an investor sells a European put option
with a strike price (X1) and simultaneously buys a European put option with a higher strike price
(X2.). If the current price of the stock is below the X1, the payoff of the investor is (X2-X1). If the
current price is between X1 and X2, the payoff of the investor is X1 minus the current price. If
the current price of the stock is higher than X2, the payoff of the investor is zero.

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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 the strike price of $42 and simultaneously sold a European put option with the strike
price of $38. At expiration, the final price of the stock is $43. Calculate the payoff of the strategy.

A. $0

B. $1

C. $4

D. $5

The correct answer is: A)

The payoff always ignores the cost of the option(s).

The investor has applied a bear spread strategy by buying a European put option with a strike
price of $42 and simultaneously selling a European put option on the stock with the strike price
of $38.
Since the current price of the stock is $43, which is higher than the strike price of both the long
put option and the short put option, the payoff of the investor is zero.

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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)

Identify the incorrect statement(s).

A. Only statement I is incorrect

B. Only statement II is incorrect

C. Both statements are incorrect

D. None of the statements are incorrect

The correct answer is: D)

Both statements mentioned by the trader in regards to the definition of the box spread options
strategy are correct. Statement I is correct because a box spread is a combination of a bull
spread and a bear spread. In other words, in a box strategy, the investor has 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. Statement II is also correct because no matter whether the final or
current price is below X1, between X1 and X2, or above X2, the payoff of the box spread will
always be X2-X1, where X2 is the higher strike price, and X1 is the lower strike price.

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Q.773 Phillip Harris is a senior arbitrageur investor at Dynamic Arbitrage Investment Co. He
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 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. Determine 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).

The correct answer is: D)

In order 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).

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Q.774 Matt Solomon is a junior investment analyst at Atlantic Investments firm. Solomon was
instructed by his superior to open a position in European options using spread trading strategies.
His superior particularly asked Solomon to purchase a European call option on with the strike
price of X1, sell two European call options with a slightly higher strike price of X2, and lastly, buy
another European call option with a higher strike price of X3. Determine which spread trading
his boss is referring to.

A. Bull spread

B. Bear spread

C. Box spread

D. Butterfly spread

The correct answer is: D)

The given structure of the transaction in options is a butterfly spread. In a butterfly spread,
investors take three positions in the options market. First, investors purchase a European call
option with the strike price of X1, then sell two European call options with a slightly higher
strike price of X2, and lastly, buy another European call option with a further higher strike price
of X3.

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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 three positions in the options market. He also makes the
following statements regarding the payoff of butterfly spreads:

I. If the current price of the stock is lower than the lower band or X1 of the butterfly spread, the
payoff of the butterfly spread is equal to zero. In other words, S < X1, then payoff = 0.
II. If the current price of the stock is above the highest band or X3 of the butterfly spread, the
payoff of the butterfly spread is equal to the difference between X3 and the current price. In
other words, if S > X3, then payoff = X3 – S.

Which statement(s) is/are correct?

A. Statement I only

B. Statement II only

C. Both statements

D. None of the statements

The correct answer is: A)

Statement 1 is correct because if the current price of the stock is lower than the lower band or
X1 of the butterfly spread, the payoff of the butterfly spread is equal to zero (if S < X1, then
payoff = 0) and all three options will expire unexercised. On the other hand, if the current price
of the stock is above the highest band or X3 of the butterfly spread, the payoff of the butterfly
spread is again equal to 0 (if S > X3, then payoff = 0).

Note
There's a difference between the terms "payoff" and "profit." Payoff is the future cash flow
associated with the contract.
Profit = payoff - initial investment.
Payoff ignores the premium, but profit doesn't

Example
An investor could create a butterfly spread by buying one call at $10 with a $65 strike price,
buying one call at $5 with a $75 strike price, and selling two calls each at $7 with a $70 strike
price.
It costs $10 + $5 - (2 x $7) = $1 to create the spread. If the stock price in 6 months is greater
than $75 or less than $65, the total payoff is zero, and the investor incurs a profit of -$1 (net loss
of $1). If the stock price is between $66 and $74, a profit is made.

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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. Dynamic spread

D. Calendar spread

The correct answer is: D)

In a calendar spread trading strategy, the investor must sell a European call option and
simultaneously buy a European call option with a longer expiration date or maturity date.

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

Which of the following statements is/are correct?

A. Statement I is correct only

B. Statement II is correct only

C. Both the statements are correct

D. None of the statements is correct

The correct answer is: C)

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 longer expiration date or maturity.

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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 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

Which of the explanatory statements is/are wrong?

A. Statement I is wrong

B. Statement II is wrong

C. Both statements are wrong

D. None of the statements are wrong

The correct answer is: D)

None of the statements are wrong. In a straddle combination options trading strategy, an
investor buys European call and put options with the same strike prices and expiration dates.
Statement II is also correct, the straddle trading strategy is used when a large move in price is
expected, but the direction of the price is uncertain.

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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 the 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 the strike price of $58. If the current price of the underlying stock is $65,
which of the following is closest to the profit of the straddle strategy?

A. $7

B. $0

C. -$2

D. -$9

The correct answer is: C)

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.

Cash outflow (cost) = $5 + $4 = $9

Payoff on a put option = (X-S, 0) = 0
Payoff on a call option = (S-X, 0) = (65-58) = $7
Profit of the straddle = $7 - $9 = -$2

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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.

Strike price of calls and

Option Strategy Expiration date of calls and puts
puts

Bull spread strategy Different Same

Butterfly spread strategy Different Same

Calendar spread
Same Different
Strategy

Diagonal spread strategy Same Different

A. The bull spread strategy is incorrect

B. The butterfly spread strategy is incorrect

C. The calendar spread strategy is incorrect

D. The diagonal spread strategy is incorrect

The correct answer is: D)

In the diagonal spread strategy, the strike price of calls and puts is different. Moreover, the
expiration date of calls and puts is also different. Option A is correct because, in the bull spread
strategy, the strike price of calls is different, but the expiration date is identical. Option B is also
correct because, in the butterfly spread strategy, the strike price of calls and puts is different,
but they all expire at the same date. Option C is also correct because, in the calendar spread, the
options strike price is the same, but the expiration is different.

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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 the 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 correct answer is: D)

A strips options trading strategy is implemented by purchasing a European call option and
purchasing two European put options with the same strike prices and expiration dates.

Option A is incorrect because, in a straddle strategy, the investor buys a European call option
and put option with the same strike prices and expiration dates.

Option B is incorrect because, in the butterfly spread strategy, the investor takes three positions
in the options market. Firstly, the investor purchases a European call option on a stock with the
strike price X1, then sells two European call options with a slightly higher strike price (X2), and
lastly, buys another European call option with a further higher strike price (X3).

Option C is incorrect because, in a strap trading strategy, the investor purchases two European
call options and also purchases one European put option with the same strike prices and
expiration dates.

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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. Determine the strategy he is
most likely using.

A. Straddle strategy

B. Strip strategy

C. Strap strategy

D. Strangle strategy

The correct answer is: C)

In a straps trading strategy, the investor purchases two European call options and buys one
European put option with the same strike prices and expiration dates.

Option A is incorrect because, in a straddle strategy, the investor buys a European call option
and a put option with the same strike prices and expiration dates.

Option B is incorrect because a strip options trading strategy is implemented by purchasing a

European call option and purchasing two European put options with the same strike prices and
expiration dates.

Option D is incorrect because a strangle trading strategy is implemented by buying a European

call and a European put option on the stock of a specific firm with the same expiration dates but
different strike prices.

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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 the strike price of $33, and at the same time, buying a 9-month
European put option on the stocks of the same firm with the strike price of $37. Which of the
following strategies is the investment manager most likely testing?

A. Calendar spread strategy

B. Straddle strategy

C. Strip strategy

D. Strangle strategy

The correct answer is: D)

A strangle trading strategy is implemented by buying a European call and a European put option
on the stock of a specific firm with the same expiration date but different strike prices.

Option A is incorrect because, in the calendar spread strategy, an investor buys and sells
European call options or buys and sells European put options with the same strike price but
different expiration dates. Option B is incorrect because, in the straddle strategy, the investor
buys a European call option and a put option with the same strike price and expiration. Option C
is also incorrect because the strip options trading strategy is implemented by purchasing a
European call option and purchasing two European put options with the same strike price and
expiration date.

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Q.4623 A portfolio X consists of a five-year zero-coupon bond and a three-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

The correct answer is: B)

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

$20,000 needed to buy the option.

Therefore, the price of the bond should be equal to the present value of the strike price.

PV = 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:

$20, 000 − $14, 259.72 = $5 , 740.28

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Q.4624 With respect to interest rates, when are Principal Protected Notes (PPNs) most
profitable?

A. When interest rates increase

B. When interest rates decrease

C. When interest rates remains constant

D. When interest rates are volatile

The correct answer is: A)

When using Principal Protected Notes, profits are higher when the price of the option is greater

than K-PV(K), where K is the strike price needed to purchase the underlying asset in the

portfolio.

Interest rates Time (years) K PV(K) K-PV(K)

0% 3 100 100 0
5% 3 100 86.38 13.62
10% 3 100 75.13 24.87

From the table above, we can see that the difference between K and the PV(K) increases as the

interest rate increases.

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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 correct answer is: D)

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.

Strike price = $50

Benefit of setting up the short straddle = $4 + $6 = $10

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.

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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 at $35

B. Buy the put option with a strike price of $35 and sell the put option with a strike price
of at $30

C. Buy the put option with a strike price of $30 and sell the call option with a strike price
of at $35

D. Buy the put option with a strike price of $35 and sell the call option with a strike price
of at $30

The correct answer is: B)

The question is testing the use of the bear spread strategy of trading. In a bear spread trading

strategy, the trader buys the higher strike price put option and sells at the lower strike price put

option.

FIGURE1

Option A is incorrect. Buying the lower price put option and selling the higher price put option

would create a bull put spread, as shown below:

FIGURE2

Options C and D are incorrect. Bear (and also bull) spreads are created using the same type

of options, i.e., only puts or only calls.

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Q.4627 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 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
of at $35

B. Buy the call option with a strike price of $35 and sell the call option with a strike price
of at $30

C. Buy the put option with a strike price of $30 and sell the call option with a strike price
of at $30

D. Buy the put option with a strike price of $35 and sell the call option with a strike price
of at $35

The correct answer is: A)

The question is testing the use of the bull spread strategy of trading. A bull-spread trading

strategy is where the trader buys a call option with a lower strike price and sells a call option

with a higher strike price.

FIGURE1

Option B is incorrect. Buying the higher price call option and selling the lower price put option

would create a bear call spread, as shown below:

FIGURE2

Options C and D are incorrect. Bear (and also bull) spreads are created using the same type

of options, i.e., only puts or only calls.

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 Reading 39: Exotic Options

Q.784 Susanne Alexander is a junior investment analyst at JCB Investment Bank in Tokyo. She is
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.

A. Plain vanilla options

B. Covered calls

C. European options

D. Exotic options

The correct answer is: D)

Exotic options trade in over-the-counter (OTC) markets while plain vanilla options like calls and
puts trade in exchanges. Exotic options are more customized and are designed to meet the
requirements of investor, which is why they trade on OTC markets. Vanilla options like American
and European-style calls and puts are more standardized options, which is why these options
trade in exchanges.

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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, the yield is set equal to the risk-free rate

Which of these yield measures is incorrect?

A. The yield measure on exotic options on stock indices is incorrect

B. The yield measure on exotic options on currencies is incorrect

C. The yield measure on exotic options on futures is incorrect

D. None of the exotic options have incorrect yield measures

The correct answer is: B)

In the valuation of exotic options on currencies, the yield is set equal to the foreign, not
domestic, risk-free interest rate.

Option A is incorrect because it correctly presents that the yield is set equal to the dividend yield
in the valuation of exotic options on the stock indices. Option C is also incorrect because it
correctly depicts that the yield measure is set equal to the domestic risk-free rate in the
valuation of exotic options on the futures.

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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

A. Features I and II are correct

B. Features II and III are correct

C. Features I and III are correct

D. Features I, II, and III are correct

The correct answer is: D)

Feature I is correct. A range forward contract is created with a combination of a long call and a
short put or a short call and a long put.

Feature II is correct. In the case of 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
to the value of the put.

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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. A Bermudan option is non-standard European option, which can be exercised any time
until its expiration

B. A Bermudan option is non-standard American option, which can be exercised any time
until its expiration

C. A Bermudan option is non-standard European option, which can only be exercised at

certain dates until its expiration

D. A Bermudan option is non-standard American option, which can only be exercised at

certain dates until its expiration

The correct answer is: D)

A Bermudan option is a non-standard American option whose exercise is restricted to certain

dates until its expiration date. Bermuda options are a combination of American and European
options; they are exercisable at the date of expiration, and on certain specified dates that occur
between the purchase date and the date of expiration.

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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 are unlikely 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 only at certain dates until its expiration

B. These options may be allowed to exercise early

C. The strike price of non-standard American options may change during the life of the
option

D. These options have a lockout feature, which means these options can not be used in
combination with other options

The correct answer is: D)

The lockout feature refers to the fact that some American options can only be exercised at a date
after the specific lockout period. Option A is correct because non-standard American options
have the Bermudan feature, which allows them to be exercised only at certain dates until
expiration. Option B is correct because these options may be allowed to be exercised early.
Option C is also correct as the strike price of non-standard American options may change during
the life of the option.

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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.

The correct answer is: A)

A regular European option will have a single strike price, X. If the price of the stock is greater
than X, the payoff of the option will be S - X. With a gp option, however, there are two strike
prices: a strike price X1 and a trigger strike X2, (where X2 > X1). When the current stock price
is above X2, the payoff of the gap call option is S - X1.

For example, consider a gap call option where the underlying's price is 50, the stated strike price
is 50, and the payoff/trigger strike is 55. This means that the option can be exercised when the
underlying's price reaches or crosses 50. However, it pays nothing unless the underlying reaches
or crosses 55. If the price of the underlying rises to 57, for example, the payoff of the option will
be 7 (= 57 - 50)

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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?

A. A gap European option

B. An employee option

C. A futures option

D. A forward start option

The correct answer is: D)

A forward start option is a non-standard option that allows the option to start at a future date T1
and expire at another future date T2. A forward start option is synonymous to an employee stock
options, in which the employer commits to grant an at-the-money option at a future date.

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

C. Forward start option

D. Spiral futures option

The correct answer is: A)

A cliquet option is an exotic option consisting of a series of consecutive forward start options.
The first option is active immediately. The second then becomes active when the first expires,
etc. Each option is struck at-the-money when it becomes active.

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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

C. Forward start option

D. Barrier option

The correct answer is: A)

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.

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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 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. The holder of a call on a call only purchases a plain vanilla option if on the first expiration
date T1, the price of the stock is greater than the first strike

A. Feature I is inconsistent with the definition of compound options

B. Feature II is inconsistent with the definition of compound options

C. Feature III is inconsistent with the definition of compound options

D. None of the features are inconsistent with the definition of compound options

The correct answer is: B)

Feature II is inconsistent with the definition of compound options. A compound option has two
expiry dates and two strike prices. In a call on call compound option, if the current price of
underlying asset is above X1 on the first exercise date T1, then the investor is entitled to pay the
first strike price of X1 and receive a call option, which will give him the right to purchase the
underlying asset for the second strike price of X2 on the second exercise date T2. Features I and
III are consistent with the definition of compound options.

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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 results of
the referendum 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.

A. Call on call compound option

B. Chooser option

C. Ratchet option

D. Forward start option

The correct answer is: B)

A chooser option or as you like it option is an exotic option which that the holder of the option
the right to decide whether the option is a call or a put after a specified period of time. The value
of the option is equal to the value of a call and a put option at the time when the holder makes
the decision.

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Q.795 A recent M. Sc. Finance graduate made the following two statements:

I. The down-and-out call option is a knock-out type of barrier option in which a regular call
option comes in existence when the price of underlying asset reaches a specific lower barrier
which is below the initial asset price.
II. The down-and-in call option is a knock-in type of barrier option, which ceases to exist as soon
as the price of the underlying asset reaches a specific lower barrier.

Which of the following is correct?

A. The definition of the down-and-out call knock-out option is incorrect

B. The definition of the down-and-in call knock-in option is incorrect

C. The definition of the down-and-out call and down-and-in call options are both incorrect

D. Neither the down-and-out call nor the down-and-in call options definitions are
incorrect

The correct answer is: C)

Both definitions are incorrect. The down-and-out call option is a knock-out type of barrier option
in which a regular call option ceases to exist when the price of the underlying asset reaches a
specific lower barrier which is below the initial asset price. The down-and-in call option is a
knock-in type of barrier option, in which the call option comes into existence as soon as the price
of the underlying asset reaches a specific lower barrier.

Q.796 A type of barrier option in which a regular put option on the underlying asset comes in
existence when the price of the underlying asset reaches a specific barrier, which is set equal or
above the strike price, is called a:

A. Down-and-in put option

B. Down-and-out put option

C. Up-and-in put option

D. Up-and-out put option

The correct answer is: C)

An up-and-in put is a type of barrier option where a regular put option on the underlying asset
comes in existence when the price of the underlying asset reaches a specific barrier, which is set
equal or above the strike price.

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Q.797 In which of the following barrier options will a regular call option cease to exist if the
price of the underlying asset falls below a specific barrier price for a specific number of days?

A. Down-and-out call option

B. Up-and-out call option

C. Parisian call option

D. Down-and-in call option

The correct answer is: C)

A Parisian call option is a type of barrier options, which specifies the number of days at which
the price of the underlying must stay above or below the barrier price for the option to come in
existence or to cease to exist. For the barrier feature (knock in or knock out) to be triggered,
the underlying asset has to spend a certain prescribed time beyond the barrier. This makes
manipulation of the triggering, by manipulation of the underlying asset, much harder.

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 reaches above the strike price at a predetermined date and pays a fixed amount
if the price of the underlying asset reaches below the strike price. Which of the following options
has he purchased?

A. Asset-or-nothing call binary option

B. Asset-or-nothing put binary option

C. Cash-or-nothing call binary option

D. Cash-or-nothing put binary option

The correct answer is: D)

A cash-or-nothing put is a type of binary option which pays a fixed amount if the price of the
asset is below the strike price at the expiration date and pays nothing if the price of the
underlying is above the strike price at expiry.

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 pays nothing if the price of
underlying is above the strike price at expiry.

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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?

A. Floating lookback call option

B. Floating lookback put option

C. Fixed lookback call option

D. Fixed lookback put option

The correct answer is: A)

The payoff of a lookback option depends on the maximum (high price), or the minimum (low
price) price the underlying asset has reached during the period of the option.

In a floating lookback call option, the payoff for holding the option is 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.

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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 is being used by other market participants for hedging

B. The static replication method involves searching for a portfolio of actively traded
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 actively traded
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 correct answer is: C)

The static replication method involves searching for a portfolio of actively traded 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. Option D is incorrect because taking a long
position in a replicated portfolio of actively traded options will not hedge the portfolio but
increase the exposure in risky options.

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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

B. Butterfly spread options

C. Gap options

D. Employee options

The correct answer is: D)

Forward start options are considered synonymous to employee stock options. In forward start
options, investors benefit from a feature which allows the option to start at a future date T1 and
expire at another future date T2. This is similar to employee options, in which the employer
commits to grant an at-the-money option at a future date.

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

B. Ratchet option

C. Barrier options

D. Strike reset option

The correct answer is: C)

Barrier options are options where the payoff of the options depends on the condition that the
price of the underlying asset has reached a certain level during a certain period of time. Cliquet
options are also known as ratchet or strike reset options. These are exotic options consisting of a
series of consecutive forward start options.

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 Reading 40: 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 borrow
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

B. Fed funds rate

C. Repo rate

D. Treasury rate

The correct answer is: D)

The Treasury rate is the rate the government uses to borrow funds from investors (individual and
institutional) in exchange for treasury bills and treasury bonds. Treasury bills and treasury bonds
are risk-free financial instruments that governments sell to investors in order to borrow
funds/loans. Option A is incorrect because the LIBOR (or London Interbank Offer Rate) is an
unsecured short-term borrowing rate used between banks. Option B is incorrect because the Fed
funds rate is an overnight rate used by banks to borrow or lend their surplus funds in order to
meet the Fed’s reserve requirements. Option C is also incorrect because the Repo Rate is the
borrowing rate that is used by financial institutions to sell the securities that they own for a
certain price to buy them back at a later date at a higher price.

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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 he is most likely to use to value a
floating interest rate swap?

A. LIBOR

B. Fed funds rate

C. Repo rate

D. Treasury rate

The correct answer is: A)

The LIBOR (or London Interbank Offer Rate) is an unsecured short-term borrowing rate used
between banks. It is widely used as a reference rate for the valuation and transaction of interest
rate swaps. The British Banking Association (BBA-UK) publishes the estimates of LIBOR rates on
a daily basis for the maturities ranging from one day to one year. The LIBOR is used as a
reference rate for millions of transactions. Option B is incorrect because the Fed funds rate is an
overnight rate used by banks to borrow or lend their surplus funds in order to meet the Fed’s
reserve requirement. Option C is also incorrect because the Repo Rate is the borrowing rate that
is used by the financial institutions to sell the securities that they own for a certain price to buy
them back at a later date at a higher price. Option D is incorrect because the Treasury rate is the
rate governments use to borrow funds from investors (individual and institutional) in exchange
for treasury bills and treasury bonds.

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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
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

C. Both factors motivated banks to manipulate the LIBOR

D. None of the factors motivated banks to manipulate the LIBOR

The correct answer is: A)

Factor I correctly defines one of the factors that motivated bankers to manipulate LIBOR quotes
as the banks manipulated the LIBOR to make higher gains on interest rate swaps, whose cash
flows depend on the LIBOR. Another reason than motivated banks to manipulate LIBOR is that
the banks wanted to give the impression that their bank’s borrowing rates were cheaper than
others and they were much healthier in terms of risk and return.

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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

B. Fed funds rate

C. Repo rate

D. None of the above.

The correct answer is: B)

The Fed funds rate is an overnight rate used by banks to borrow or lend their surplus funds in
order to meet the Fed’s reserve requirements. Option A is incorrect because the Treasury rate is
the rate governments use to borrow funds from investors (individual and institutional) in
exchange for treasury bills and treasury bonds. Option C is also incorrect because the Repo Rate
is the borrowing rate that is used by financial institutions to sell the securities that they own for
a certain price and buy them back at a later date at a higher price.

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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

B. Fed funds rate

C. Repo rate

D. Treasury rate

The correct answer is: C)

The Repo Rate or Repurchase Agreement rate is a borrowing rate that is used by financial
institutions to sell the securities that they own for a certain price and buy them back at a later
date for a higher price. Option A is incorrect because the LIBOR (or London Interbank Offer
Rate) is an unsecured short-term borrowing rate used between banks. Option B is incorrect
because the Fed funds rate is an overnight rate used by banks to borrow or lend their surplus
funds in order to meet the Fed’s reserve requirements. Option D is incorrect because the
Treasury rate is the rate governments use to borrow funds from investors (individual and
institutional) in exchange for treasury bills and treasury bonds.

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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 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.

A. The continuously compounded interest rate is 9.23%

B. The continuously compounded interest rate is 8.33%

C. The continuously compounded interest rate is 8.05%

D. The continuously compounded interest rate is 7.97%

The correct answer is: D)

The formula used to convert a rate that is compounded at a certain frequency into a continuously
compounded rate is:
Rc = m*ln(1 + Rm/m)

Where
m is the compounding frequency,
Rm is the compounded rate at m frequency
And Rc is the continuously compounded rate

Rc = 12*ln(1 + 0.08/12)

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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?

A. The quarterly compounded rate is 15.6%

B. The quarterly compounded rate is 16%

C. The quarterly compounded rate is 16.3%

D. The quarterly compounded rate is 17.1%

The correct answer is: C)

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,
Rm is the annual rate, compounded m times a year
And Rc is the continuously compounded rate

R m = 4 × e0.16/4 – 1 = 16.32%

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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.

Which of the statements are correct?

A. Statements I and II are correct

B. Statements II and III are correct

C. Statements I and III are correct

D. Statements I, II, and III are correct

The correct answer is: C)

Statements I and III are correct. Statement I is correct because a zero rate is the discount rate
that is used for discounting a single cash flow at a particular future time or maturity and zero
rates correspond to zero-coupon bond yields.

Statement III is correct because a par yield is the coupon rate of a bond with a certain maturity
that, if applied, makes the bond price equal its par value.

Statement II is incorrect. The yield is not also known as the spot rate. The spot rate is the price
for a transaction that is happening immediately.

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Q.653 An investor has invested $1000 in a 7-year zero-coupon bond with continuously
compounding. If the bond is quoted as 9% per year, then estimate the value of the investment at
the end of 7 years.

A. The future value of a zero coupon is $1,656.0

B. The future value of a zero coupon is $1,828.0

C. The future value of a zero coupon is $1,877.6

D. The future value of a zero coupon is $1,912.0

The correct answer is: C)

Since the zero-coupon bond is compounded continuously, the future value of this 7-years 9% per
annum bond is:
FV = Face value * erate * period

FV = 1000 * e0.09 * 7 = 1,877.6

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Q.654 John Johnson works in the fixed-income investments department of Fast Asset
Management, headquartered in London. Today, the head of the department asked Johnson to
calculate the 6-month spot rates using the quotes of zero coupon GILTs (UK Treasury bonds)
provided in the table below.

Bond Principal in (GBP) Time to Maturity (in year) Bond Price

100 0.25 99.15

100 0.5 97.80

100 1 94.25

What is the semi-annual spot rate?

A. 0.0341

B. 0.0445

C. 0.0488

D. 0.0592

The correct answer is: B)

Following is the bootstrapping method used to derive spot rates or zero rates from Treasury bills
and coupon-bearing Treasury bonds:
100 = 97.8eR*0.5
R = 0.0445 or 4.45%

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Q.655 How is called 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?

A. Forward Rate agreement

B. Duration

C. Bootstrapping

D. Calibrating term structure

The correct answer is: C)

Bootstrapping is the method of deriving the zero rate yield curve (or spot rate curve) using the
rates and quotes of zero-coupon and coupon-bearing Treasury bonds.

Option A is incorrect because a Forward Rate Agreement (FRA) is a contract designed to fix the
interest rate that will apply to either borrowing or lending a certain principal at a specific
forward date.

Option B is incorrect because duration is a bond measure that entails the time until the cash
flows from the bond are received.

Option D is incorrect because a calibrating term structure is a method of deriving a term

structure using a model whose parameters have values that are consistent with market
observations.

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:

Year Zero rates (per year)

1 6%

2 6.5%

3 7.2%

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%

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 B. 7.2%

C. 8.6%

D. 9.3%

The correct answer is: C)

The 1-year forward rate 2 years from now is calculated as:

Forward Rate = Spot Rateyear 3 + (Spot Rateyear 3 - Spot Rateyear 2)*(Time2/(Time3 – Time2))
Forward Rate = 0.072 + (0.072 – 0.065) * (2/(3-2)) = 0.086 or 8.6%

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 further year at the 1-year
forward rate at that point. 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
by the 1-year forward rate two years from today. In other words,
(1 + 3-year spot)3 = (1 + 2-year spot)2 (1 + 1-year forward)

We should set the forward rate such that B ends with the same amount of money as A.

1.0723 = 1.0652 × 1-year forward rate

1-year forward rate = 0.086

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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 the quarterly rate in six months. If the
quarterly rate in six months is 6.8%, then what is the cash inflow/outflow for the Beijing Shipping
at the end of the ninth month?

A. Cash outflow of $25,000

B. Cash inflow of $25,000

C. Cash outflow of $24,580

D. Cash inflow of $24,580

The correct answer is: B)

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:
Payoff = Principal x (Fixed rate – Floating rate) x 3/12
Payoff = 50,000,000 x (0.07 – 0.068) x 0.25 = 25,000

Since the payoff is positive, Beijing Corp. will receive a cash inflow of $25,000 at the end of the
ninth month.

Q.658 A German bank and a French bank entered into a forward rate agreement contract where
the German bank will pay a fixed rate of 4.2% compounded semiannually and receive the floating
rate on the principal of €700 million. The forward rate between 0.5 years and 1 year is 5.1%. If
the risk-free rate at the 1-year is 6% with continuous compounding, then which of the following
is the true value of the FRA contract between the two banks?

A. €6,300,000

B. €6,143,344

C. €4,005,875

D. €2,966,558

The correct answer is: D)

The value of the contract is calculated using the following formula:

Value of FRA = Principal * (Floating rate - Fixed rate) * 0.5e-R2 * T2
Value of FRA = 700,000,000 * (0.051 – 0.042) * 0.5e-0.06 * 1 = €2,966,558

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Q.659 On a graduate-level exam on to the subject of fixed income investments, students were
asked to define duration in three sentences. One of the students mentioned the following three
sentences associated with duration:

I. The duration of a zero-coupon bond is a measure that tells how long on average the holder of
the bond has to wait until the cash flow on the bond is received.
II. Since there are no coupons in a zero-coupon bond, the zero-coupon bond does not have
duration.
III. The duration of a coupon bond is equal to its time to maturity.

Which of the sentences are inconsistent with the definition of duration?

A. Statements I and II are inconsistent with the definition of duration

B. Statements II and III are inconsistent with the definition of duration

C. Statements I and III are inconsistent with the definition of duration

D. All of the statements are inconsistent with the definition of duration

The correct answer is: B)

Statement I is consistent with the definition of duration because duration defines the average
time it will take the holder of the bond to receive the cash flow on the bond. Statement II is
incorrect because the duration of a zero-coupon bond is typically equal to its time of maturity.
Statement III is incorrect because the duration of a coupon bond is shorter than its time to
maturity.

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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?

A. The price of the bond will increase by $0.95

B. The price of the bond will decrease by $0.95

C. The price of the bond will increase by $0.98

D. The price of the bond will decrease by $0.98

The correct answer is: B)

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.661 Matt Christian is a former equity trader who has recently lost his job due to the rise of
algorithmic trading. Christian is aiming to change his focus from equity trading to fixed income
assets trading. He regularly educates himself by taking online seminars on fixed income assets
and using demo accounts to trade bonds. During an online podcast, he heard the following
definitions of duration:

I. The duration of a bond entails the average time it takes the holder to receive cash flows on the
bond; it is the most suitable measure if the yield on a bond is continuously compounding.
II. Modified duration is a similar measure to duration but is more suitable when the yield on the
bond is not continuously compounded.
III. Dollar duration is defined as the duration multiplied by the price of the bond.

Which of these statements is/are INCORRECT?

A. The definition of duration is incorrect

B. The definition of modified duration is incorrect

C. The definition of dollar duration is incorrect

D. More than one definition is incorrect

The correct answer is: C)

Dollar duration is not the product of duration and the price of the bond; it is the product of the
modified duration and the price of the bond.

The definition of duration is accurate because the duration of a bond entails the average time it
takes the holder to receive cash flows on the bond. It is the most suitable measure if the yield on
a bond is continuously compounding.

The definition of modified duration is accurate as it is used when the yield on the bond is not
continuously compounded.

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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 yield curve are larger?

A. Duration

B. Convexity

C. Modified duration

D. Concavity

The correct answer is: B)

Convexity is a measure to estimate the changes in the prices of the bond given larger changes in
the yield curve. Duration only measures small changes and linear relationships whereas
convexity measures the changes in the price of the bond due to changes in the curvature of the
yield curve.

Q.663 Fredrick Hessen is a senior professor in the department of macroeconomics at Welth

Business School. In the current semester, his course focuses on interest rates and the term
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”.

Which of the following theories is associated with the professor’s comment?

A. Expectation theory

B. Market segmentation theory

C. Liquidity preference theory

D. None of the above

The correct answer is: B)

The market segmentation theory suggests that 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 for short-term bonds. Some investors such as
pension funds and insurance companies invest in bonds with a certain maturity, and they are not
likely to switch from one maturity to another based on liquidity.

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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 justify 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

B. Market segmentation theory

C. Liquidity preference theory

D. None of the above

The correct answer is: C)

The liquidity preference theory suggests that the 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
justify the empirical result that the yield curve tends to be upward sloping.

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

The correct answer is: D)

Holding period return = ST/S0 - 1 = $91/$80 - 1 = 1.1375 - 1 = 13.75%

rcontinuous = ln(1+i) = ln(1 + 13.75%) = 0.1288

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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%

The correct answer is: C)

Compound annual growth rate (CAGR) = (Ending value/Beginning value)1/n

= (201,594/154,856)1/5 - 1 = 5.4%

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%

The correct answer is: B)

Effective annual rate (EAR) = (1 + Annual rate/Compounding frequency)(Compounding frequency) - 1

EAR = (1 + 10%/2)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%

The correct answer is: D)

The continuously compounded 2-year return = ln(40/24) = 51.08%

Annually compounded rate of return = (51.08% / 2) = 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

The correct answer is: B)

Using the formula for the future value with continuous compounding (N is the number of years in
the expression)

FVN = $200,000e0.08(1)

FVN = $216,657.41

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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 monthly interest rate 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. 8.73%

The correct answer is: C)

Interest rate can also be considered as the required rate of return. In the above case, James
wants his $5,000 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

Rate of interest = (Amount next year)/(Amount deposited) - 1

= ($5,500/$5,040.11) - 1

= 0.0912 or 9.12%

To turn the annual interest rate into a monthly rate,

Monthly rate = (1 + Annual rate)(1/12) - 1

= 0.0073 or 0.73%

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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

The correct answer is: B)

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 offers a 7% coupon rate with interests paid annually. Assuming the
following sequence of spot rates, the price of the bond is closest to:

Time to Maturity Spot Rate (%)

1 4

2 5

3 5.5

A. 102.48

B. 106.74

C. 103.56

D. 104.2

The correct answer is: D)

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 correct answer is: C)

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%

The correct answer is: C)

(1 + S2)2 = (1 + S1)(1 + f1,1)

f1,1 = [(1.09)2/1.04] -1 = 14.24%

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%

The correct answer is: A)

S3 = [(1.03)(1.04)(1.05)]1/3 - 1 = 3.997%

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Q.3544 The current price of a bond is $100.

When the YTM increases by 1%, the price of the bond goes down to $98.5.

When the YTM decreases by 1%, the price of the bond reaches $103.

What is the effective duration of this bond?

A. 0.045 years

B. 2.25 years

C. 4.5 years

D. 0.225 years

The correct answer is: B)

DEffective = (P- - P+) / 2P0Δy

DEffective = ($103 - $98.5)/(2($100)0.01) = 2.25

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Q.3545 A corporate bond has the following characteristics:

Price: USD 106.50

Coupon rate: 5%

Duration: 7.5 years

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 correct answer is: B)

Return impact = (Duration * ΔSpread) + (1/2 Convexity * (ΔSpread)2)

= -(7.5 * (-0.0175)) + (1/2 101 * (-0.0175)2)
=0.1313 + 0.0155 = 0.1468 = 14.68%

Price = 106.5 * (1 + 0.1468) = 122.13

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Q.3546 Effective duration is a measure of:

A. The percent change in a bond's yield curve for a 1% change in its price

B. The percent change in a bond's price for a 1% change in its duration

C. The percent change in a bond's price for a 1% change in its modified duration

D. The percent change in a bond's price for a 1% change in its benchmark yield curve

The correct answer is: D)

Effective duration is a measure of the percent change in a bond's price for a 1% change in the
benchmark yield curve:

DEff = (P- - P+ )/ (2P0ΔCurvePV0)

Q.3547 A bond selling for par currently has a 9% yield. If the bond price increases to USD 101
when yields fall 10 basis points and the price falls to USD 98 when yields rise by 10 basis points,
then what is this bond's effective duration?

A. 3 years

B. 15 years

C. 30 years

D. 1.5 years

The correct answer is: B)

DEff = (P- - P+ )/ (2ΔCurvePV0)

= (101 - 98)/(20.001*100) = 15 years

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Q.3548 You have been provided the following information on a bond:

Period PV of cash flow (USD Mn)

1 3.7

2 4.9

3 22.3

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

The correct answer is: A)

Macaulay Duration = (1*3.7/30.9) + (2*4.9/30.9) + (3*22.3/30.9) = 2.60 years

Modified Duration = Macaulay Duration / (1 + YTM) = 2.60 / 1.06 = 2.45 years

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Q.3549 Calculate the expected percentage price gain (loss) from the following data:

Reduction in yield-to-maturity: 20bps

Annual modified duration: 23.657

Annual convexity: 678.98

A. 4.86%

B. 4.59%

C. -4.6%

D. -4.9%

The correct answer is: A)

Percentage change in full price = [-23.657*(-0.002)] + 1/2 * [678.98 * (-0.002)2] = 4.86%

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 credit upgrade. What is the estimated return impact without convexity
adjustment?

A. 1.42%

B. 1.59%

C. 2.95%

D. 2.81%

The correct answer is: D)

Return impact = -(Modified duration) * Change in spread

= -3.75 * (-0.75%) = 0.0281 or 2.81%

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Q.3551 For a 10-year, 5% annual-pay bond currently trading at 1,000, calculate the approximate
modified duration based on a change in bond yield of 25 basis points.

A. 15.6%

B. 7.8%

C. 3.9%

D. 12.2%

The correct answer is: B)

The price of the bond at a yield of 5% + 0.25% is:

N = 10; I/Y = 5.25; FV = 1,000; PMT = 50; CPT => PV = -981

The price of the bond at a yield of 5% - 0.25% is:

N = 10; I/Y = 4.75%; FV = 1,000; PMT = 50; CPT => PV= -1020

The approximate modified duration = (1,020 - 981)/(2*1000*0.0025) = 7.8

Therefore, the approximate change in price for a 1% change in YTM is 7.8%.

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%

The correct answer is: A)

The estimated price change = -(Duration)*(Change in yield) + (1/2)*(Convexity)*(Change in

yield)2
= -10.62*0.02 + 0.5*91.46*0.022 = -19.41%

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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%

The correct answer is: C)

Expected change in bond's price = ΔP/P = -Dmod * Δy + 0.5 * C * Δy2

Duration effect = -Dmod * Δy = -9.42 * 0.003 = 0.02826 = -2.826%

Convexity effect = 0.5 * C * Δy2 = 0.5 * 68.33 * 0.0032 = 0.000307 = 0.0307%

Expected change in bond's price = (-0.02826 + 0.000307) = -2.79530%

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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

The correct answer is: A)

Price Change = (-Duration * Yield change) + (0.5 * Convexity * Yield change2))

Price change = (-8 * 0.0025) + (0.5 * 20 * 0.00252) = -1.99%

The bond's value will fall by approximately 1.990% * 200,000 = $3,988.

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 Reading 41: 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

B. I and III only

C. II and III only

D. I, II and III

The correct answer is: D)

It is important for a debt issuer or a bond issuer to meet all three recommendations in order to
avoid a default. The par value is the principal value of the bond which a debt issuer is liable to
pay at the maturity of the bond. Coupon payment is the certain portion of a bond’s par value
which a debt issuer has to pay during the life of the debt. All bonds have some required ratios
under the bond covenants which the debt issuer is liable to maintain. If the bond issuer does not
meet any of these requirements, the issuer is considered in default.

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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

D. Independent rating agency

The correct answer is: B)

The trustee represents the bondholders. It is difficult in terms of resources for a bondholder to
keep track of the bond issuer’s activities and to ensure that the issuer is not violating the bond
indenture. Therefore, the trustee (i.e., the corporate trust department of banks) act as the
representative of the bondholders to perform trustee functions like 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.

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Q.900 Trustees are the corporate trust units of large banks that are the representative of the
interest of bondholders. From which of the following parties do the trustee receives fees for its
services?

A. Governments

B. Bond issuers

C. Bondholders

D. They work independently

The correct answer is: B)

The trustee receives the fees for its trustee serviced from the bond issuer, not the bondholders to
whom they have a fiduciary duty. However, the trustee represents the interest of the bondholders
and performs trustee functions on behalf of the bondholders. Trustees do not perform any
function beyond the scope of the indenture.

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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
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

D. Banks & Finance

The correct answer is: C)

Yankees or international issuers is a category of bonds classified by the issuer type that includes
the bonds issued in the U.S. by foreign sovereign governments, foreign banks, companies, and
foreign government agencies. Option A is incorrect because the public utilities category consists
of companies in fields such as electricity, gas, telecommunication and water suppliers. Option B
is incorrect because the industrials category includes manufacturing, mining, retailers, etc.
Option D is also incorrect because the banks & finance category consists of bonds issued by
banks, insurance companies, and other financial institutions.

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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 its 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

A. Statements I and II are correct

B. Statements II and III are correct

C. Statements I and III are correct

D. Statements I, II and III are correct

The correct answer is: A)

Statements 1 and 2 are correct while statement III is incorrect. Sometimes bonds can be retired
before they mature. Statements I and II are correct as the bond maturity is the date on which the
bond issuer fully repays the bond principal along with the remaining coupon to satisfy its
obligation under the bond indenture.

Q.903 Which of the following should be used to calculate the coupon on a bond?

A. The coupon or interest is calculated on the price of the bond

B. The coupon or interest is calculated on the amortized value of the bond

C. The coupon or interest is calculated on the par value of the bond

D. The coupon or interest is always fixed in dollar terms

The correct answer is: C)

The coupon payments on the bond are calculated on the basis of par (face) value. For example, a
3-year 8% semi-annual coupon bond with the face value or par value of $1000 will pay a coupon
of $40 every six months.

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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

C. Floating rate bonds

D. Premium bonds

The correct answer is: A)

Zero-coupon bonds are always issued at a discount price. Since the holder of a zero-coupon bond
does not receive any coupon payments or interest payments on the bond, he gains through
purchasing the bond at a discounted price and receiving the face value of the bond at the
maturity of the bond.

Q.905 Linda Angola is 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 get 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. Differed-interest bonds

B. Zero-coupon bonds

C. Participating bonds

D. Straight bonds

The correct answer is: C)

A participating bond is a sub-type of coupon bond that pays a coupon based on a fixed interest
rate and also pays a share of profit to its bondholders. A participating bond pays a share of the
profits to its bondholders if the profits are above a certain threshold or if the prices of the
company's assets increase beyond a certain level.

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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 current
amortized value and $1000

The correct answer is: A)

The original issue discount of a zero-coupon bond is the difference between the original issue
price of the bond and the face value of the bond. In the given case, the bond was originally
issued at $690. Two years later, the investor purchased it for $850. The current amortized value
of the bond is not given and the value of the bond at the end of the fifth year will be $1000 i.e.
the face value. The OID, in this case, is $1000 - $690 = $310.

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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?

A. Corporate Bonds

B. Debenture issues

C. Mortgage bonds

D. Straight-coupon discount bonds

The correct answer is: C)

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.

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Q.908 Silver Sun Solar Panel Company has been founded by three engineering students four
years ago in the suburbs of Toronto. The company traditionally outsourced the manufacturing of
the solar panels to a Chinese firm. However, the company has recently decided to go in the solar
panel manufacturing business for which they need financing. Currently, the company does not
own mortgages or fixed assets but holds equities and securities of other companies. If the
company wants to raise capital through secured bond issues, which of the following types of
bonds should the firm issue?

A. Mortgage bonds

B. Collateral trust bonds

C. Debenture issues

D. Senior secured bonds

The correct answer is: B)

Firms or issuers that do not own mortgage properties or the fixed assets can satisfy the
bondholders by securing the bonds by keeping other assets as collateral. These assets can be
equities, bonds, certificates, and securities of other companies that are held or owned by the
bond issuer.

Option A is incorrect because, in mortgage bonds, a mortgage is kept as collateral. Option C is

incorrect because debentures are unsecured bonds. Option D is incorrect because senior secured
bonds usually have fixed assets and mortgages as the collateral of the bond.

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Q.909 Debentures are unsecured bonds issued by the 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

D. In absences of pledged assets or secured creditors, the claim of debenture

bondholders is equal to the claims of other creditors

The correct answer is: B)

It is an incorrect statement that the debenture bondholders have no right or claim to the assets
of the issuer. If the issuer defaults, the debenture bondholders have a claim on the non-pledged
assets and also the pledged assets if the value of the pledged assets exceeds the value of secured
claims. In other words, if a default event occurs, the pledged assets are liquidated to settle the
claims of secured creditors, and debenture bondholders have a claim on any excess proceeds
that may arise from such a process.

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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
environment

D. It is beneficial for the bondholder if the bond is called in an increasing prices

environment

The correct answer is: B)

It is beneficial for the bond issuer to have a callable bond, which he can call back or retire early
when the interest rate decreases. When the interest rate decreases, the price of the bond
increases, so the bond issuer can call back previously issued bonds at higher rates and replace
them with new bonds at lower interests.

Option A is incorrect because when interest rates increase, it is inappropriate for the debt issuer
to retire the old debt at lower rates and issue new debt at higher rates. Options C and D are
virtually the same; it is not beneficial for the bondholder to return the higher interest paying
bonds for lower interest paying bonds.

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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
capital at maturity. This condition is most likely associated with the:

A. Fixed-price call provision

B. Make-whole call provision

C. Sinking fund provision

D. Tender offer provision

The correct answer is: C)

Under the sinking fund provision, the issuer is required to pay back a certain portion of the
principal amount of the debt or bonds to the bondholders along with the coupons. This pays back
the principal in portion and decreases the firm’s burden to pay whole principal at the maturity of
the bond.

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 the
emerging economies like Pakistan, Bangladesh, and India, the company grew exponentially in
the last three years. The senior management of the firm 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. Fixed-price call provision

B. Sinking fund provision

C. Tender offer provision

D. Replacement fund provision

The correct answer is: C)

A tender offer is a mechanism for the early retirement of debt (bond) that isn’t necessarily
included in the indenture of the bond. In a tender offer, the issuer of the bond sends the offering
circular to the bondholders of record that present the price the issuer is willing to pay to buy
back the bond and the window of time during which bondholders can sell their bonds to the
issuer.

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Q.914 Pamela Simpson is the fixed-income investment manager at the Nordend Investment Bank.
During a seminar on the risks attached to the 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 one of the rating agencies, a bond rated below B is a junk bond

Which of these statements is/are correct?

A. Statement I is correct only

B. Statement II is correct only

C. Statements I & III are correct

D. Statements II & III are correct

The correct answer is: B)

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 II is also incorrect because the bonds rated below triple-
B are considered junk bonds.

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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?

A. Recovery rates are lower in an economic downturn

B. Recovery rates are not based on the size of the bond issue

C. Recovery rates are inversely correlated with default rates

D. Recovery rates are lower in asset-intensive industries

The correct answer is: D)

Option D is least consistent with the properties of recovery rates because the recovery rate is
higher in asset-intensive industries as compared to other industries.

Option A is a correct statement because, during economic downturns, the recovery rate is lower
and the default rate is higher. Option B is consistent because the size of the bond issue is not
considered in the estimation of the recovery rate. Option C is consistent because recovery rate is
inversely correlated with default rate.

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

D. Rolling stock certificates

The correct answer is: C)

Bridge financing is the financing activity in which the new owners or the acquirers of a company,
through LBOs or MBOs, issues new debt or bonds in order to generate funds to retire the initial
financing or debt acquired to finance the buyout. It bridges the gap between the LBO and the
permanent financing.

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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 correct answer is: A)

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.

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

D. None of the above

The correct answer is: C)

The coupon reinvestment risk increases with a higher coupon rate and a longer reinvestment
time period.

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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

C. An investor concerned about reinvestment risk is most concerned about a decrease in

interest rates

D. Zero-coupon bonds have zero reinvestment risk

The correct answer is: A)

While an investor in a zero-coupon bond can eliminate reinvestment risk by holding the bond
until maturity, the same is not true for a fixed coupon bond. The receipt of periodic coupons
exposes the investor to the risk that he will have to invest the coupons at a lower rate. Zero-
coupon bonds have zero reinvestment risk.

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

D. None of the above

The correct answer is: A)

A callable bond gives the issuer the right to redeem all or part of the bond before the maturity
date.

Note: Option B) is a putable bond and option C) is a hybrid bond.

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 Reading 42: 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?

A. Adjustable-rate mortgage loans

B. Non-agency loans

C. Jumbos

D. Agency loans

The correct answer is: D)

Agency loans or conforming loans, which are typically residential loans, are securitized through
entities like the Federal National Mortgage Association (FNMA), Government National Mortgage
Association (GNMA) and Federal Home Loan Mortgage Corporation (FHLMC) while non-agency
or non-conforming loans like Jumbos, Alt-A and adjustable-rate mortgage (ARMs) are securitized
through private-label securitization.

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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 correct answer is: B)

The monthly installments of $923.93 for the monthly periods of 20 years (12x20=240) at the rate
of 5% results in the present value of the loan that is $140,000.

The easiest way to solve this problem is with the help of the financial calculator:
N=20×12=240; I/Y=5/12=0.4167; PV=140,000; FV=0; CPT => PMT=-923.94

This installment can also be calculated with the simple annuity formula as follows:
PV = installment[1 - (1 + r)-n]/r
Since the annual rate of interest is 5%, the monthly rate can be approximated as 5%/12 =
0.004167 or 0.4167%
Thus, 140,000 = installment[1 - 1.004167-240]/0.004167
Installment = 140,000/{[1 - 1.004167-240]/0.004167} = $923.94

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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

The correct answer is: D)

A prepayment option mortgage loan allows the borrower of the mortgage loan to make a
prepayment or repay the mortgage before its predefined maturity date. In a flexible rate
mortgage, a borrower can benefit from the prepayment option if the interest rates decline. If the
interest rates decline, the present value of future payments will be higher. Hence he can retire
the mortgage early.

Q.921 Alison Garry works in a small audit firm in Costa Rica. She and her boyfriend, Peter,
recently obtained a mortgage to purchase a condo in a small beach town. The condo was
purchased for $40,000 with the mortgage at 3.25% for 10 years. The mortgage also has a
prepayment option. Which of the following statements is the most accurate?

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%

D. None of the above; prepayment is not a function of interest rates

The correct answer is: C)

A prepayment option mortgage loan allows the mortgage borrower to pay back the outstanding
principle 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.

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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?

A. Securitization is the process of securing the mortgage with a security or collateral,

which the lender can use in case of default

B. Securitization is the process of setting a bankruptcy-remote entity with the sole

purpose issuing bank loans to individual borrowers

C. Securitization is the process of setting a bankruptcy-remote entity with the sole

purpose of acquiring asset-backed securities (ABSs)

D. Securitization is the process of converting a group of nonmarketable assets, or

expected future cash flows on the assets, into units of marketable securities.

The correct answer is: D)

Securitization is the process of converting a group of nonmarketable assets, or expected future

cash flows on the assets, into units of marketable securities in order to sell the underlying assets
in the capital market to generate money for a business. Banks often carry out this process to
transfer the risk to the market.

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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

The correct answer is: B)

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%.

Constant prepayment rate or CPR = 1 - (1-SMM)12

CPR = 1-(1-0.011)12 = 0.1243

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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 higher back-end income ratio
III. Loan-to-value ratios are lower

Which of these statements is/are incorrect?

A. Statement I only

B. Statement II only

C. Statement III only

D. None of the statement are incorrect

The correct answer is: B)

Prime mortgages consist of mortgage borrowers with the lower back-end income ratios, lower
front-end income ratios, and lower loan-to-value ratios. The back-end income ratio calculates the
total monthly debt expenses including debt payment, credit card payments, interest expenses,
and insurance expenses, as the percentage of total income. The lower these ratios, the lower the
probability of default of the mortgage.

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.

A. Prime fixed rate MBS

B. Subprime fixed rate MBS

C. Prime adjustable rate mortgage

D. Subprime adjustable rate mortgage

The correct answer is: D)

Subprime adjustable rate mortgages are highly risky. Subprime mortgages consist of mortgage
loans from mortgage borrowers who have poor creditworthiness and higher loan-to-value and
debt-to-income ratios. Therefore, subprime mortgages are riskier than the prime mortgages. The
adjustable rate mortgages put the borrower at the risk of higher mortgage payments in case
mortgage rates increase. Thus, subprime adjustable rate mortgages or subprime ARMs are the
riskiest MBSs.

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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 the 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 the time passes
III. Service fees in a fixed rate mortgage decline as the 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. All of the above features are consistent with fixed-rate mortgages

The correct answer is: B)

The amount of principal payment on a fixed rate level payment mortgage increases as the time
passes. On the other hand, the interest payment and servicing fee decline as the mortgage
approaches the maturity.
Prepayment risk to the lender of the mortgage increases as the mortgage rates decrease.

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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. $73,687.55

C. $45,750

D. $34,890.74

The correct answer is: B)

Since the loan-to-value ratio (LTV) is 78%, we can derive the amount of the mortgage.

LTV = Mortgage amount / Appraised Value of property

0.78 = Mortgage amount / 10,500,000
Mortgage amount = 0.78 * 10,500,000 = 8,190,000

Since we derived the amount of mortgage, we can calculate the mortgage payment using the
financial calculator:
PV=-8,190,000, I/Y=0.75, N=240, FV=0, CPT-> PMT=73,687.55

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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?

A. The mortgage pass-through security represents an investor’s claim against a pool of

mortgages

B. The mortgage pass-through securities in the pool can have different maturities and
mortgage rates

C. The cash flows of the pass-through security exactly matches the cash flows generated
by the mortgages in the pool of pass-through securities

D. A single pool of mortgages can have different classes of pass-through mortgage

securities

The correct answer is: C)

It is not necessary that cash flows to the investors of the pass-through security exactly coincides
with the cash flows generated by the mortgages in the pool or the pass-through securities. This
is due to the difference between the timing when the mortgage providers receive the mortgage
payments, and the payment is passed through to the investor of the mortgage pool.

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 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

The correct answer is: D)

Conditional prepayment rate (CPR) of the 40th month with 100% PSA benchmark = 40 * 0.5% *
1 = 0.2

Single monthly mortality rate (SMM) = 1-(1-CPR)1/12

SMM = 1-(1-0.2) 1/12 = 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-announce 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 pools markets
III. Specified pools with high loan balances trade for lower prices

A. Statement I is incorrect

B. Statement II is incorrect

C. Statement III is incorrect

D. None of the statements are incorrect

The correct answer is: D)

None of the statements is incorrect.

Statement I is correct. Specified pool markets identify the number and the balance of the pool
prior to the trade, whereas, in TBA markets, number and balances are not revealed until the
settlement.

Statement II is correct. TBA markets of pass-through securities are more liquid than specified
pools 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.

For more information on this:

https://pdfs.semanticscholar.org/caec/42ff06ae1d8e94a805cdd21d64361da52423.pdf?

_ga=2.193127597.1227051726.1592487151-929289204.1592487151

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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”?

A. An increase in the number of settlement transactions for the back-month date by the
originators of the MBS

B. An increase in the price of the MBS for the front-month settlement

C. An increase in the supply of the front-month settlement MBS

D. A shortage of MBSs in the market for delivery in the front-month

The correct answer is: C)

Option C is not a factor that causes dollar rolls to trade “special.” A trade special in dollar roll
occurs due to the difference in the purchasing rate for the back-month settlement MBS. In other
words, it occurs when an investor can purchase the back-month settlement MBS at an implied
repo rate lower than that of the repurchase market. Therefore, all the factors that increase the
front-month settlement price and decrease the back-month settlement price are factors causing
it to trade special. The increase in the supply of the front-month settlement MBS will decrease
the price of the front-month settlement MBS. Option C is not a factor that causes dollar rolls to
trade “special.”

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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

The correct answer is: C)

Contraction risk in mortgage-backed securities is the risk that is concerned with the decrease in
the expected life of a mortgage pool due to higher prepayment rates caused by falling interest
rates. Option B is incorrect because the extension risk, not the 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. Options A and D are irrelevant.

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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?

A. Collateralized mortgage obligations (CMOs) are securities issued against mortgage

pools

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 correct answer is: C)

Each tranche of the CMO has a different claim on the cash flows of the mortgage pools. Options
A, B, and C are correct features of the CMOs. A CMO is a security securitized by another
security i.e. mortgage pool. Each tranche of a CMO has different allocations and claims on cash
flows of the mortgage pools.

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Q.935 The Planned Amortization Class (PAC) is the most common and most widely traded
tranche of the 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

C. Feature III is inconsistent

D. None of the features are inconsistent

The correct answer is: D)

Option D is correct because none of the mentioned features are inconsistent with the actual
features of the Planned Amortization Class (PAC) tranche of collateralized mortgage obligation
(CMOs). The principal repayment of the PAC is based on a sinking fund amortization schedule,
which comes along 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.

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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?

A. A planned amortization class tranche (PAC)

B. A collateralized mortgage obligation (CMO)

C. A strip

D. A mortgage back security (MBS)

The correct answer is: C)

Unlike traditional CMOs, MBSs, and PACs, strips enable the investor to separately purchase the
principal portion and interest portion of the mortgage payments on the mortgage pool. The
principal-only strips (PO) are conventionally sold at a discount. The PO strips increase in size
with the passage of time as the principal component of the mortgage grows, while the interest
only (IO) strips grow smaller with the passage of time as the principal due on the mortgage
decreases.

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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?

A. Binomial model approach

B. Best guess approach

C. Monte Carlo simulation

D. Black-Scholes Model

The correct answer is: C)

The Monte Carlo simulation is widely used to value mortgage securities with a traditional
embedded option of prepaying the mortgage before its scheduled date. The Monte Carlo
simulation uses probability distribution of the values of an MBS. 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, recovery rate, and interest rate volatility. The Monte
Carlo simulation provides a number of outcomes based on their probabilities, and the average of
these outcomes is taken as the value of the MBS.

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Q.1144 Consider the following risks:

I. Interest rate risk

II. Pre-payment risk

III. Default risk

IV. Credit risk

Mortgage-Backed Securities (MBS) are exposed to which of these risks?

A. I

B. I, II & III

C. I, II, III & IV

D. II, III & IV

The correct answer is: C)

The risks to which MBS is exposed are:

1. Interest rate risk: An increase in interest rate increases the probability of default as the
interest burden on the borrower increases
2. Prepayment risk: If the interest rate decreases, the borrower may refinance its mortgage
and prepay the existing mortgage
3. Default risk: The borrower may not repay for various reasons
4. Credit risk: The borrower may default on the debt

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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?

A. CPR = 0.2141%; SMM = 0.01786%

B. CPR = 0.3400%; SMM = 3.4%

C. CPR = 5.1%; SMM = 0.4353%

D. CPR = 3.4%; SMM = 0.2878%

The correct answer is: C)

Assuming 100 PSA

CPR(month t | t ≤ 30) =6% × t/30

CPR(month 17) = 6% × 17/30 = 3.4%

150 PSA implies that CPR (month 17) = 1.5 × 3.4% = 5.1%

SMM = 1– (1– CP R)1/12 = 1– (1– 0.051)1/12 = 0.4353%

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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

B. Increases by 0.2% every month up to 30 months

C. Decreases by 0.2% every month up to 30 months

D. Remains constant for the first 30 months and then decreases by 0.2% for months 30 to
360

The correct answer is: B)

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

CPR = 6% for months 30 to 360

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).

Q.3586 During periods of falling interest rates, the refinancing of mortgage loans will:

A. Accelerate prepayments and reduce the average life of the MBS

B. Decelerate prepayments and increase the average life of the MBS

C. Accelerate prepayments and increase the average life of the MBS

D. Decelerate prepayments, but and decreases the average life of the MBS

The correct answer is: A)

During periods of falling interest rates, the refinancing of mortgage loans will accelerate
prepayments and reduce the average life of the MBS.

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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?

A. Time to maturity as a percentage of the total life of the security

B. Original mortgage balance

C. Absolute value of coupon payments due

D. Remaining number of months to maturity for each mortgage loan

The correct answer is: D)

The weighted average maturity is determined by weighting the remaining number of months to
maturity for each mortgage loan by the amount of the outstanding mortgage balance.

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 Reading 43: 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, then which of the following day count convention is
most suitable?

A. 100 days / 184 days

B. 100 days / 180 days

C. 102 days / 180 days

D. 102 days / 184 days

The correct answer is: D)

To measure the interested earned/accrued on Treasury bonds, we use the actual number of days
between the dates/actual number of days between reference periods.

Actual days between July 1st and October 11th = 102 days
Actual days between July 1st and January 1st = 184 days

Note: For measuring the interest earned on municipal bonds and corporate bonds, we use the 30
days per month convention or the 30/360 convention. For measuring the interest earned on
money market instruments, we use the actual days divided by 360 days per year convention and,
in some countries, we also use 365 days in a year.

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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%

The correct answer is: C)

For measuring the interest earned on municipal bonds and corporate bonds, we use the 30 days
per month convention or 30/360 convention.

Days between September 1st and February 12th (30 days convention) = 161 days

Days between September 1st and March 1st (30 days convention) = 180 days

Therefore, the interest earned is:

6.5% * 161/180 = 5.81%

To measure the interested 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
the number of days between September 1st and February 12th. Therefore, we will assume that
the months of Sept, Oct, Nov, Dec, and Jan have 30 days each and then add 11 days in Feb. That
gives a total of 161 days.

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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 determine the
cash price of the bill.

A. $96

B. $95.9

C. $93.7

D. $91

The correct answer is: B)

The cash price of the bill can be calculated with the following formula:
Discount = (No. of days to maturity / 360 days) * Quoted price
Discount = (164/360) * 9 = $4.1

Cash price = Face Value – Discount = $95.9

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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 90-day Treasury bill which is quoted as 13 is $96.75

A. The price of the 136-day Treasury bill is incorrectly calculated

B. The price of the 90-day Treasury bill is incorrectly calculated

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 correct answer is: A)

The price of 136-day Treasury bills is incorrectly calculated. The following is the formula used to
calculate the cash price of Treasury bills:
Discount = No. of days to maturity / 360 days)* Quoted price

Discount = (136/360) * 8 = $3.02

Cash price = Face Value – Discount = $100 - $3.02= $96.97

The relationship between cash prices and quoted prices can be verified through the following
formula:
Quoted price = (360) / no. of days to maturity * (100 – Cash price)
Quoted price = 360/136 * (100 – 96.97) = 8

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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:

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 the dirty price.

Which of Anderson’s statements is/are inconsistent with the definition of clean price and dirty
price?

A. The definition of the clean price is incorrect

B. The definition of the dirty price is incorrect

C. Both clean and dirty price definitions are incorrect

D. None of the definitions are incorrect

The correct answer is: C)

Both definitions provided by Anderson are incorrect.

The clean price of a Treasury bond is equal to the quoted price. It can also be written as the dirty
price minus accrued interests.

Clean price = Quoted price

OR
Clean price = Dirty price - Accrued interest since last coupon date

The dirty price of a Treasury bond includes the quoted price plus the accrued interest on that
bond.

Dirty price = Quoted price (clean price) + Accrued interest

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Q.690 An analyst has estimated the dirty price of $100,000 face value 8% on a Treasury bond
that was purchased on April 8, 2017, with the quoted price of 93-8. The bond pays semiannual
coupon on December 10th and June 10th. If the Treasury bond has the maturity date of
December 10th, 2020, then which of the following is an accurate estimation of the bond’s dirty
price?

A. $93,250

B. $94,865

C. $95,125

D. $95,865

The correct answer is: D)

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.

Accrued interest = 119 / 182 * $4 = $2.615

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.

Dirty price = Quoted price + Accrued interest = $93.25 + $2.615 = $95.865

or $95,865 with the face value of $100,000

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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 correct answer is: C)

The conversion factor is that measure that the exchanges have taken for adjusting the prices of
Treasury bond futures as the deliverable bonds under the futures contracts have different
market values. The conversion factor is used to estimate the price received by the short party of
the bond. The applicable quote price for the bond delivered is the product of the conversion
factor and the futures contact's most recent settlement price.

The cash received by the short party = (Most recent settlement price * Conversion factor) +
Accrued interest

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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 amounts and statements regarding the
applicable quoted price is true?

A. The applicable quoted price paid by the short party is $138,438

B. The applicable quoted price received by the short party is $138,438

C. The applicable quoted price paid by the short party is $139,987

D. The applicable quoted price received by the short party is $139,987

The correct answer is: B)

Amy has a short position in the contract. Therefore, the applicable quoted price derived by the
conversion factor is the price Amy will receive.

The applicable quoted price received by the short party of the contract is calculated as:
Cash received by the short party = (Most recent settlement price * Conversion factor) + Accrued
interest
Cash received = (91 + 28/32) * 1.471 + $3.29 = $138,438
or $138,438 for a $100,000 face value contract

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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.

Bond Quoted bond price Conversion factor

1 99 1.02

2 122 1.22

3 107 1.1

4 112 1.15

A. Bond 1

B. Bond 2

C. Bond 3

D. Bond 4

The correct answer is: A)

The CTD bond minimizes the following:

quoted bond price - (QFP x CF)
Where:
QFP = quoted futures price (most recent settlement price)
CF = conversion factor for the bond delivered

The expression above calculates the cost of delivering the bond.

Thus, we can compute the cost of delivery of each bond as follows:
Bond 1: 99 - (96.25 x 1.02) = $0.83
Bond 2: 122 - (96.25 x 1.22) = $4.58
Bond 3: 107 - (96.25 x 1.1) = $1.13
Bond 1: 112 - (96.25 x 1.15 = $1.31

Bond 1 is the cheapest-to-deliver with a cost of delivery of $0.83.

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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

Which of his statements is/are correct?

A. Only statement I is correct

B. Only statement II is correct

C. Both statements are correct

D. None of the statements is correct

The correct answer is: C)

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.

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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.

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. This is due to the imperfection of
conversion factors used by exchanges, which at times make it cheaper to deliver one bond as
compared to another bond.

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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?

Bond Quoted Bond Price Conversion Factor

A $99 1.011

B $97 1.001

C $103 1.069

D $107 1.072

A. Bond A

B. Bond B

C. Bond C

D. Bond D

The correct answer is: C)

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)

Bond Quoted Bond Price Conversion Factor Cost of Delivery

A $99 1.011 $99-(95.5 x 1.011)=$2.45

B $97 1.001 $97-(95.5 x 1.001)=$1.40

C $103 1.069 $103-(95.5 x 1.069)=$0.91

D $107 1.072 $107-(95.5 x 1.072)=$4.62

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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 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

Determine which of Paulina’s statements is/are incorrect.

A. Only statement III is incorrect

B. Only statements I and II are incorrect

C. Only statements II and III are incorrect

D. Statements I, II, and III are all incorrect

The correct answer is: D)

All three guidelines/statements are incorrect to identify the cheapest-to-deliver bonds.

The correct rules for identifying cheapest-to-deliver bonds are the following:
I. When the yield is greater than 6%, the cheapest-to-deliver bonds tend to be low-coupon with
longer maturities.
II. When the yield is less than 6%, the cheapest-to-deliver bonds tend to be high-coupon with
shorter maturities.
III. When the yield curve is upward sloping, the cheapest-to-deliver bonds tend to have longer
maturities.
IV. When the yield curve is downward sloping, the cheapest-to-deliver bonds tend to have shorter
maturities.

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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?

A. It is the foreign currencies futures contract on euros/dollars. The underlying interest

rate of the contract is the 3-month forward LIBOR.

B. It is the foreign currencies futures contract on euros/dollars. The underlying interest

rate of the contract is the 3-month forward LIBOR and the 3-month U.S. risk-free rate.

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.

The correct answer is: D)

The Eurodollar futures contract is the interest rate futures contract on Eurodollars or on the U.S.
dollars deposited outside of the U.S. The face value of the contract is $1 million, and the price
change in the futures contract is minimum $25, which is equal to the change of one tick or one
basis point. The underlying interest rate of the contract is the 3-month forward LIBOR. Options A
and B are incorrect because a Eurodollar contract is an interest rate futures contract, not a
foreign currency contract.

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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 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 correct answer is: B)

Since the size of one Eurodollar contract is $1 million and the change of one basis point is 25, we
will use the following formula to calculate the price of the Eurodollar futures contract:
Price of the Eurodollar = 10,000 * [100 - 0.25 * (100 – 94.25)] = $985,625

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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

C. Both statements are correct

D. None of the statements is correct

The correct answer is: C)

Statement I is accurate. A Eurodollar futures contract is similar to a forward rate agreement

(FRA). However, Eurodollar futures contracts are settled daily whereas FRAs are not settled
daily.

Statement II is also accurate. The Eurodollar is traded on major exchanges, such as the Chicago
Mercantile Exchange (CME), while FRAs are OTC derivatives. The final settlement price of
Eurodollar futures is determined by the three-month London Interbank Offered Rate (LIBOR) on
the last trading day. Eurodollar futures were the first futures contract to be settled in cash,
rather than physically-delivered.

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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 are greater than the actual forward rates. Which of the following is useful in
reducing the abovementioned difference between the implied forward rates and the actual
forward rates?

A. Convexity adjustment

B. Conversion factor

C. Duration adjustment

D. Dirty price

The correct answer is: A)

Analysts and managers use the convexity adjustment to adjust/reduce the difference between the
implied forward rates and the actual forward rates. Due to a daily settlement of feature of
Eurodollar futures contracts the longer maturities Eurodollar futures contracts, has the implied
forward rates that are greater than the actual forward rates. The convexity adjustment reduces
this difference.

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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

The correct answer is: D)

As the interest rates go up, the prices of the interest rate futures contract go down, and the
investor with a long position in futures contracts will lose money with the increase in interest
rates. Therefore, investors with long positions in interest rate futures contracts should take a
short position to hedge their portfolios.

Additional explanation:
An interest rate future (IRF) is a contract with an underlying instrument that pays interest; a
contract between the buyer and seller agreeing to the future delivery of any interest-bearing
asset. The interest rate future allows the buyer and seller to lock in the price of the interest-
bearing asset for a future date. This asset can be a T-bill or T-bond.

Like bonds, interest rate futures have an inverse relationship with interest rates. When interest
rates rise, the price of IRFs fall (because the price is linked to the underlying asset's price), and
vice versa.

Why exactly do bonds have an inverse relationship with interest rates? An increase in interest
rates makes bonds already floated less attractive because new bonds pay the higher rate. (And
the opposite is true).

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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-adjusted hedge

B. Duration-based hedging

C. Hedging with FRAs

D. Conversion factor hedge

The correct answer is: B)

Duration-based hedging helps to create a combined position of a portfolio and futures contract
that has zero duration. When the position has zero duration, the value of the position does not
change due to small changes in yield.

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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.

Which of these limitations is/are accurate?

A. Only limitation I is accurate

B. Only limitation II is accurate

C. Both the limitations are accurate

D. None of the limitations are accurate

The correct answer is: A)

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, not linear.

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

The correct answer is: B)

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 in
April, 31 in May, and 30 in June)
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

Note: Another approximate approach to the calculations would be:

Accrued interest = (12/365) * (0.03125) = 0.1027

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 Reading 44: Swaps

Q.705 Which of the following options is a correct differentiating feature between swaps and
forward contracts?

A. Forward contracts trade on over-the-counter markets, while swaps trade on exchanges

B. Forward contract holders have an obligation, while swap holders have the right to buy
or sell the underlying security in the future

C. Forward contracts can be customized, but swaps are standardized

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

The correct answer is: D)

In a forward contract, the exchange of cash flows only occurs at one future date, while in a swap,
the exchange of cash flows take place at multiple futures dates. Option A is incorrect because
both forward contracts and swaps trade on over-the-counter markets. Option B is wrong because
both forward contracts and swaps require the parties to perform the contract. Option C is
incorrect because both forward contracts and swaps are customizable.

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Q.706 Susanne Milson is a chief investment manager at Dornbusch Electric Co. A year ago, her
company entered into a 5-year derivative contract with the Allied French Bank to pay quarterly
cash flows equal to the fixed interest rate of 2.7% on a notional principal of €250 million. In
return, Allied French Bank agreed to pay the quarterly cash flow equal to the 3-months LIBOR
on the same notional principal. Accurately identify the derivative instrument that is being used
by Milson’s company.

A. Futures contract

B. Forward contract

C. Call option

D. Swaps

The correct answer is: D)

Milson’s company, Dornbusch Electric Co. and Allied French Bank have entered into a (Plain
Vanilla) interest rate swap agreement, where the company agreed to pay quarterly cash flows
equal to the fixed interest rate of 2.7% on a notional principal of €250 million, in return for
receiving the quarterly cash flow equal to the 3-months LIBOR from the bank. It is not a futures
contract as the contract/agreement is fully customized and between no parties (no clearinghouse
involved). The contract is not a forward contract, as there are multiple or quarterly exchange of
cash flows in the contract. It is not a call option as it is binding on both parties to honor the
contract.

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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

The correct answer is: C)

The LIBOR is a floating interest rate that is reset on a daily basis. Since the bank has agreed to
pay the LIBOR (floating rate) in exchange for receiving a fixed rate from the company, the bank
has the “floating rate payer” or fixed-rate receiver position in the swap contract. Conversely, the
company has the position of the fixed rate payer or floating (LIBOR) receiver in the swap
contract.

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?

A. Currency exchange rates

B. Interest rates

C. Volatility

D. Equities

The correct answer is: B)

The most common and most popular swap is the plain vanilla swap or interest rate swap. Plain
vanilla swaps are similar to forward rate agreements (FRAs) where one party agrees to pay cash
flow equal to the fixed interest rate set at a predetermined time in exchange for the floating
interest rate. However, the swaps differ from FRAs as there are multiple exchanges of cash flows
in swaps.

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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% per year on the principal of $100
million, and in return, Moon Traders agreed to pay Savers the 6-month LIBOR rate on the same
principal. If the 6-months LIBOR prevailing on March 30, 2016, is 4.95%, then 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

The correct answer is: C)

Savers Bank will pay $25,000 to Moon Traders on September 30, 2016.

The floating leg payment made at the end of a period is based on the floating rate at the
beginning of that period.

Savers Banks cash outflow = 5%/2 * 100 million= -$2.5 million

Savers Banks cash inflow = 4.95%/2 * 100 million = $2.475 million

Net cash flow on September 30, 2016 = -$25,000

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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

B. Short position in interest futures

C. Long position in a forward rate agreement

D. Short position in call options

The correct answer is: A)

Ali is borrowing $50 million from another investment bank at the rate of the 6-month LIBOR plus
50 basis points. This means he has to pay a floating rate (LIBOR + 50 bps each month).

By entering into a fixed-rate payer position in a swap contract, an investor can transform the
floating rate liability into a fixed rate liability.

Ali would pay the floating on the initial loan, would receive the floating rate from the swap (these
two transactions would cancel each other out), and then he would pay the fixed-rate from the
fixed-rate payer position in the swap contract. In the end, Ali would just be paying the fixed-rate.

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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

The correct answer is: D)

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

D. The central bank

The correct answer is: C)

In every swap agreement, financial intermediaries are the counterparty to the swap agreement.
Swap agreements are a lot like forward contracts, as they are customizable, unregulated, and
OTC instruments. However, in forward contracts, financial intermediaries like brokerage houses
or banks are the counterparties. Financial intermediaries earn the spread of 3 to 5 basis point in
the transaction between the two parties. In return, financial intermediaries ensure to honor the
agreement even if the opposite party of the swap agreement defaults.

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Q.713 Sunil Kumar is a professor on the subject of financial derivatives and hedging mechanics
at the Delhi School of Finance (DSF). During one of his lectures that emphasized on 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 appropriated described?

A. Roles I and II are appropriate

B. Roles II and III are appropriate

C. Roles I and III are appropriate

D. Roles I, II, and III are appropriate

The correct answer is: D)

All three roles and responsibilities of financial intermediaries in a swap agreement are
accurately defined. Usually, it is hard for swap investors to find a counterparty in a swap
agreement that wants to enter a swap contract on similar terms and notional principal.
Therefore, these investors, which are large corporations, go to financial intermediaries for every
swap contract. If two parties are found, financial intermediaries take offsetting positions with
both parties in exchange for a spread of 3 to 4 basis point. In return, financial intermediaries
ensure to honor the obligation of the swap even if the counterparty defaults. Sometimes
counterparties for a specific swap agreement over a specific notional principal are not available,
so financial intermediaries act as the counterparty to this agreement. This process is called
market making.

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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%

The correct answer is: B)

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 that who has to facilitate the preparation of the confirmation of swap or the
master agreement. Which of the following is most likely to facilitate the confirmation?

A. Great Spanish Bank

B. Financial intermediaries

C. The International Swaps and Derivatives Association

D. The Securities and Exchange Commission (SEC)

The correct answer is: C)

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.716 Two banks, the American Dream Bank (AD) and the British Royal Bank (BR) have entered
into a 2-year currency swap agreement with annual payments, where AD agreed to pay 8% in
British pound (GBP) on the principal amount of GBP 80 million to BR. In addition, BR agreed to
pay 10% to AD on the principal of $120 million. The current exchange rate is USD 1.26 per GBP.
Suppose that the interest rate in the United States and Great Britain are flat at 5.5% and 6.8%,
respectively, determine the value of the currency swap to American Dream Bank in USD.

A. USD 120.45 million

B. USD 111.69 million

C. USD 26.98 million

D. USD 20.40 million

The correct answer is: C)

Present value of USD payment for two years

P V = 12 × (1.0551−1 ) + 132(1.055)2 = USD 129.97 million

Present value of GBP payment for two years = (6.4 × 1.068−1 ) + (86.4 × 1.0682 ) = GBP 81.74 million

Value of currency swap = PV of paymentsUSD − Spot exchange rate * PV of paymentsGBP

Value of currency swap = 129.97 − (1.26 × 81.74) = $26.98

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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 cash flows 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

B. Attributes II & III

C. Attributes I & III

D. Attributes I, II & II

The correct answer is: B)

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 every payment under currency swap agreements is similar to a
forward foreign currency contract.

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 5.7% 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. 0.8%

The correct answer is: D)

The table suggests that the interest rate in the Japanese Yen is higher than the U.S dollars. 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 = (5.7% - 3.5%) = 2.2%
Difference in Yen = 10.4% - 9% = 1.4%

Total gain for both companies = (5.7% - 3.5%) – (10.4% - 9%) = 0.8%

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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.

A. The value of the swap to Black Corporation will increase

B. The value of the swap to UK Fabrics will increase

C. The value of the swap to both the companies will increase

D. The value of the swap will be unaffected by subsequent changes in exchange rates

The correct answer is: A)

The value of the swap to Black Corporation will increase as it will have to pay fewer dollars to
purchase pounds in order to pay the interest rate in GBP. With the increase in the value of the
dollar and the value of the swap to Black, the risk of default on behalf of UK Fabric will increase.

Q.720 Aleem Dar is an investment manager at Glasgow Mutual Funds that invest in a large
variety of financial instruments. Dar is currently managing a fund that is composed of 5% bonds
of Weakling Inc. Dar believes that due to current managerial and structural changes in the
Weakling Inc. the value of the firm’s bonds can decrease by more than 60%. Therefore, he enters
into a swap agreement with a large financial bank, which agreed to pay him 60% of the firm’s
bonds value if the firm’s bonds are worth 40 cents per dollar. Determine which of the following
swaps has Dar most likely entered into.

A. Bond swaps

B. Swaption

C. Credit default swap

D. Devaluation swaps

The correct answer is: A)

Aleem Dar most likely entered into a bond swap where the reference entity is Weakling Inc. He
entered into a bond swap with a bank where the bank agreed to pay 60% of the firm’s bond value
if the firm’s value is worth 40 cents per dollar or if the firm goes into bankruptcy. The bank
agreed to this in exchange for a Credit Default Swap spread.

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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?

A. Basis swap

B. Amortizing swap

C. Deferred swap

D. Step up swap

The correct answer is: B)

In amortizing interest rate swaps, the parties have the option not to exchange the principal at
the initiation of the swap, but instead, decrease the principal over a predetermined time. They
can also agree to exchange the principal in a predetermined manner at a specific date.

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

C. Constant maturity swap

D. LIBOR in arrears swap

The correct answer is: C)

In a constant maturity swap, a firm can enter into a swap agreement with another firm where the
firm can agree to pay (receive) cash flow equal to the LIBOR on a specific notional principal in
exchange for receiving (paying) cash flow equal to the swap rate on the same notional principal.

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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 where Imperial can 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

D. Constant Maturity Swap

The correct answer is: C)

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. Option A is incorrect
because extendable swaps give an option to the swap parties to extend the life of the swap
agreement. Option D is incorrect because, in a constant maturity swap, a firm can enter into a
swap agreement with another firm where the firm can agree to pay (receive) cash flow equal to
the LIBOR on a specific notional principal in exchange for receiving (paying) the cash flow equal
to the swap rate on the same notional principal.

Q.3556 What is the difference between a fixed-for-floating swap and a forward contracts?

A. The payment date would be unlikely to match in a fixed-for-floating swap while exact
expiration date in known in 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 in on 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.

D. None of the above.

The correct answer is: B)

The difference between a fixed-for-floating swap and an equivalent series of a forward contract is
that in a fixed-for-floating swap, there are multiple settlement periods at which equal, fixed-rate
payments are made while on the other hand, a forward contract contains only a settlement
period at which single payment (agreed upon at the contract initiation) is made.

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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 current
settlement date?

A. $250,000

B. $625,000

C. $465,000

D. $375,000

The correct answer is: D)

TIEN's payment: ($50 million)(180/360)(12%) = $3,000,000

Counterparty's payment: ($50 million)(180/360)(0.135) = $3,375,000

Therefore, TIEN would receive a net amount of $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%

The correct answer is: A)

X Y Difference

Dollar 10.5% 9.3% 1.2%

Yen 8% 9% -1%

X has a comparative advantage in Yen borrowing;

Y has a comparative advantage in Dollar borrowing;

When a comparative advantage exists, the implication is that the parties involved can reduce

their borrowing costs by entering into a swap agreement. The net borrowing savings (maximum

gain) by entering into a swap is the difference between the differences,(\Delta \text{Dollar} -

\Delta \text{Yen})

= 1.2% - -1% = 2.2%

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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

C. Interest rate risk

D. None of the above

The correct answer is: A)

A currency swap involves two parties making interest payments to each other in different
currencies. Therefore, a currency swap has two sources of risk – interest rate and currency risk.
Because the parties are making payments directly to each other and there is no clearinghouse to
guarantee payments, this type of swap also exposes them to default risk.

Q.3560 If Core Bank sells a swaption, it has:

A. The obligation to enter into a swap if the swaption is exercised

B. The right, but not the obligation to enter into a swap if the swaption is exercised

C. The obligation to make a payment to the counterparty if the swaption is exercised

D. The right, but not the obligation to make a payment to the counterparty if the
swaption is exercised

The correct answer is: A)

Selling a swaption, just like an option, makes the seller obliged to enter into a swap.

Buying a swaption would make Core bank obliged to enter into a swap if the swaption is
exercised by the buyer. The buyer would have the right but not an obligation to enter into a
specified swap agreement with the bank.

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