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NEW QUESTION 29
Assuming zero taxes, the effect of increasing leverage in the capital structure of a firm is to:
- A. Increase the value of the business as debt is cheaper than equity
- B. Maintain the value of the business unaltered
- C. Decrease the value of the business as debt is riskier than equity
- D. either increase, decrease or leave constant the value of the business depending upon other factors
Answer: B
Explanation:
Explanation
The value of a business derives itself from the value of its cash flows, and not its capital structure. However, the availability of tax deductions on debt allow increasing the value of the business to equity holders by using the tax shield.
In the absence of taxes, there is no such advantage. Even if debt is nominally priced lower than the cost of equity, substituting debt for equity makes the remaining equity more risky and increasing the cost of equity to offset any advantage gained from the lower cost of debt. Changing the capital structure does not change the value of the firm, and this in essence is the conclusion of the Modigliani-Miller theorem.
NEW QUESTION 30
Which of the following statements are true:
I. A credit default swap provides exposure to credit risk alone and none to credit spreads II. A CDS contract provides exposure to default risk and credit spreads III. A TRS can be used as a funding source by the party paying LIBOR or other floating rate IV. A CLN is an unfunded security for getting exposure to credit risk
- A. II and IV
- B. I, III and IV
- C. II and III
- D. II, III and IV
Answer: C
Explanation:
Explanation
A CDS contract provides exposure to default risk and the credit spread for a particular credit. It does not provide an exposure to the risk of interest rates going up or down. It is an instrument that allows institutions to take a view on the price of credit risk alone. Therefore statement I is false and statement II is true.
A total return swap (TRS) exchanges the return from an asset for a fixed or floating exchange rate. It is in essence a financing arrangement where one party pays the other interest to earn a return on an asset that it does not wish to hold itself, perhaps for liquidity reasons. The financed asset is held by the party paying the asset's returns, effectively creating a 'collateral'. Therefore statement III is correct.
A credit linked note is a funded instrument where the sellers of the protection have put up the money upfront in the form of a subscription to a note in case the credit losses are realized. Therefore statement IV is not correct.
NEW QUESTION 31
Which of the following statements is false:
- A. The value of an FRA (forward rate agreement) at inception is zero.
- B. The value of an FRA at expiration is determined by the spot interest rate prevailing at expiration
- C. An FRA can be valued at anytime in its lifetime using the spot interest rate for the period to which the FRA relates
- D. Notional principals are exchanged at the start and the end of an FRA to eliminate credit risk
Answer: D
Explanation:
Notional principals are not exchanged at the start and the end of an FRA. In fact, if the notional principals were to be exchanged, it would increase credit risk and not decrease it by introducing settlement risk.
Therefore Choice 'd' is incorrect.
All other choices correctly describe various aspects of an FRA.
NEW QUESTION 32
The LIBOR square swap offers the square of the interest rate change between contract inception and settlement date. If LIBOR at inception is y, and upon settlement is x, the contract pays (x - y)2 for x > y; and
-(x - y)2 for x < y.
What of the following cannot be a value of the gamma of this contract?
- A. 0
- B. 1
- C. 2
- D. 3
Answer: C
Explanation:
Explanation
The LIBOR square is a (rare) derivative contract which pays, as mentioned in the question, the square of the interest rate move between two dates. If LIBOR at inception is y, and upon settlement is x, the contract pays (x
- y)^2 for x > y; and -(x - y)^2 for x < y.
For any question that involves calculating delta or gamma, and the payoff is described in terms of variables as is the case here, remember that delta is always the first derivative and gamma is the second derivative. For this question, let us calculate the second derivative and see what the gamma is:
If x > y, then the payoff is (x - y)^2
The first derivative wrt x is 2(x - y)
The second derivative wrt x is 2.
ie, the gamma is 2
If x < y, then the payoff is -(x - y)^2
The first derivative wrt x is -2(x - y)
The second derivative wrt x is -2.
ie, the gamma is -2
If x = y, then the payoff is 0. Both the first and the second derivatives are zero. ie the gamma is 0.
Based on the above, we see that the contract can have a gamma of either 0, +2 or -2. 1 is not a possible value for gamma, and therefore Choice 'b' is the correct answer.
NEW QUESTION 33
Which of the following statements are true:
I. Forward prices for a stock will fall if dividend expectations increase for the period the contract is alive II. Three month forward prices will decline if the 10 year rate goes up, and short term rates stay unchanged III. Futures exchanges require buyers but not sellers to deposit initial margins IV. Variation margin is to be deposited when a futures contract is entered into
V. Futures exchanges requires hedgers and speculators to deposit identical margins VI. Interest rate futures contracts carry duration but no convexity due to the daily cash settlements
- A. II and III
- B. I, II, V and VI
- C. I and IV
- D. I
Answer: D
Explanation:
Explanation
Statement I is correct - since forward prices are determined as (Spot - PV of dividends)*e^(rt), an increase in dividends will reduce forward prices.
Statement II is incorrect as forward prices will be determined by near term interest rates, specifically by the borrowing rate for the period of the contract, and will stay unchanged if near term interest rates do not change.
Statement III is incorrect. Futures exchanges require both buyers and sellers to deposit initial margins as prices can move adversely for either of them.
Statement IV is incorrect, as the margin deposited when a contract is entered into is called initial margin.
Margin calls thereafter resulting from movements in prices are called variation margin.
Statement V is incorrect. Most futures exchanges distinguish between hedgers and speculators and require different margins from each.
Statement VI is incorrect. Interest rate futures behave almost identically to their bond counterparts, and carry both duration and convexity.
NEW QUESTION 34
[According to the PRMIA study guide for Exam 1, Simple Exotics and Convertible Bonds have been excluded from the syllabus. You may choose to ignore this question. It appears here solely because the Handbook continues to have these chapters.] Which of the following statements is true:
I. Knock-out options start lifeless and convert to a plain vanilla option when the barrier is hit II. Barrier options are cheaper than equivalent vanilla options III. Average price options are more expensive than equivalent vanilla options IV. Digital options have a high gamma close to the strike price
- A. I and III
- B. I, II and IV
- C. II, III and IV
- D. II and IV
Answer: D
Explanation:
Knock-out options start as plain vanilla options and are 'knocked-out', ie cease to exist, when the barrier is hit.
Knock-in options start lifeless and 'kick-in', ie come into play as plain vanilla options when the barrier is hit.
Therefore statement I is not correct.
Barrier options are certainly cheaper than equivalent vanilla options because vanilla options have a larger range of prices over which they pay out. Therefore statement II is correct.
Statement III is not correct. Average price options, also called Asian options, are less attractive to a buyer of options and therefore they are cheaper and not more expensive than vanilla options. This is because average prices are less volatile, and also when compared to a strip of equivalent vanilla options, some of the individual vanilla options in the strip may pay out whereas on the average nothing may pay out.
Digital options have a very high gamma close to the strike price as the option payout becomes uncertain and fluctuates sharply between 0 and 1. Therefore statement IV is correct.
NEW QUESTION 35
Which of the following statements are true:
I. A total return swap (TRS) helps gain an exposure without having to fund a long position II. A short position in a corporate bond can be covered using a repo III. A total return swap (TRS) is useful to eliminate counterparty risk IV. A bank borrowing funds using a repo continues to hold the underlying assets on its balance sheet
- A. I, III and IV
- B. I, II and IV
- C. I, II, III and IV
- D. III and IV
Answer: B
Explanation:
Explanation
A total return swap allows an investor or a financial institution to gain exposure to an asset or a portfolio without actually having to go long in those positions. The counterparty provides the return from the exposure and receives LIBOR plus a spread in exchange. Effectively, the counterparty has funded the investor's position for a fixed interest rate, therefore a TRS is essentially a funding arrangement. However, the structure of a TRS may also have other consequences that are relevant for tax and accounting - the assets under a TRS are not held on the balance sheet of the investor receiving the total return. Statement I is correct as the TRS helps gain an exposure without having to fund the position with cash.
Repos are useful for shorting corporate bonds. The investor desirous of shorting a corporate bond would sell the bond in the market, and immediately borrow the bond from someone else using a repo to deliver to the party he has sold the bond to. Repos are used extensively to cover short bond positions, and therefore statement II is correct.
Statement III is not correct as counterparty risk continues to exist with a TRS. The counterparty may fail to provide the agreed returns, and the risk exists.
Statement IV is correct as the bank that borrows funds using a repo continues to hold the underlying assets on its balance sheet. Therefore Choice 'd' is the correct answer.
NEW QUESTION 36
Backwardation in commodity futures is explained by:
- A. storage costs
- B. contango
- C. convenience yields
- D. risk free rate or the cost of futures funding
Answer: C
Explanation:
Explanation
Backwardation is said to occur when futures prices are lower than the current spot prices. This would happen only when carrying costs are negative. Carrying costs are equal to interest, plus storage costs and less any
'convenience yield'. The existence of large convenience yields may explain backwardation in commodity futures prices. Therefore Choice 'd' is the correct answer.
Contango is the 'normal' market situation where forward prices are higher than spot prices. Storage costs explain contango, not backwardation. Risk free rates, or the cost of funding for the futures position, are always positive and do not explain backwardation.
NEW QUESTION 37
Using a single step binomial model, calculate the delta of a call option where future stock prices can take the values $102 and $98, and the call option payoff is $1 if the price goes up, and zero if the price goes down.
Ignore interest.
- A. 1/2
- B. 1/3
- C. 1/4
- D. 0
Answer: C
Explanation:
Explanation
To solve this question, we need to revisit how delta is calculated in a single step binomial model:
Consider a portfolio with just two positions: 1 Long Call option, and Short Stock. We do not know what (Delta) is.
Now if the current price of the stock is P, which can take the value P2 (higher value) and P1 (lower value) in the future at time T, then needs to be such that the value of the portfolio is equal in both the cases. If the price goes up, the value of the option will be $1 (given) and the value of the short stock will be - P2. If the price goes down, the value of the option will be $0, and the value of the stock will be - P1.
Therefore, $1 - P2 = $0 - P1.
Solving for , we get = $1 /(P2 - P1) = $1 / ($102-$98) = 1/4.
NEW QUESTION 38
Two portfolios with identical Sharpe ratios will have
- A. returns identically proportionate to risk
- B. identical expected returns
- C. identical expected risk
- D. identical expected risk and returns
Answer: A
Explanation:
Explanation
The Sharpe ratio is the ratio of excess returns to risk. Excess returns are measured as the returns over the risk-free rate, and risk is measured in terms of volatility, ie standard deviation. Two portfolios with identical Sharpe ratios will certainly have the same ratio of risk and return, though the absolute levels of the return and the risk may vary. Therefore Choice 'c' is the correct answer.
NEW QUESTION 39
Which of the following expressions represents Jensen's alpha, where is the expected return, is the standard deviation of returns, rm is the return of the market portfolio and rf is the risk free rate:
- A. Option D
- B. Option B
- C. Option A
- D. Option C
- E. https://www.riskprep.com/images/stories/questions/102.12.b.png
B)
https://www.riskprep.com/images/stories/questions/102.12.d.png
C)
https://www.riskprep.com/images/stories/questions/102.12.c.png
D)
https://www.riskprep.com/images/stories/questions/102.12.a.png
Answer: B
Explanation:
Explanation
The Sharpe ratio is the ratio of the excess returns of a portfolio to its volatility. It provides an intuitive measure of a portfolio's excess return over the risk free rate. The Sharpe ratio is calculated as [(Portfolio return - Risk free return)/Portfolio standard deviation].
The Treynor ratio is similar to the Sharpe ratio, but instead of using volatility in the denominator, it uses the portfolio's beta. Therefore the Treynor Ratio is calculated as [(Portfolio return - Risk free return)/Portfolio's beta]. Therefore Choice 'a' is the correct answer.
Jensen's alpha is another risk adjusted performance measure. It considers only the 'alpha', or the return attributable to a portfolio manager's skill. It is the difference between the return of the portfolio, and what the portfolio should theoretically have earned. Any portfolio can be expected to earn the risk free rate (rf), plus the market risk premium (which is given by [Beta x (Market portfolio's return - Risk free rate)]. Jensen's alpha is therefore the actual return earned less the risk free rate and the beta return. Choice 'c' is the correct answer.
Refer to the tutorial on risk adjusted performance measures for more details.
NEW QUESTION 40
The greatest risk in energy derivatives trading comes from:
- A. interest rate risks
- B. price volatility
- C. risk of default by derivatives' counterparties
- D. hedging risk
Answer: B
Explanation:
Explanation
Energy derivative markets are still not very liquid, and experience high price volatility. This high volatility is responsible for most of the risk in these markets. Choice 'd' is the correct answer.
NEW QUESTION 41
[According to the PRMIA study guide for Exam 1, Simple Exotics and Convertible Bonds have been excluded from the syllabus. You may choose to ignore this question. It appears here solely because the Handbook continues to have these chapters.] The profit potential from the conversion of convertible bonds into stock is limited by
- A. conversion premium charged by the issuer
- B. a rise in interest rates
- C. the issuer's option to call the security at short notice
- D. volatility of the stock
Answer: C
Explanation:
Explanation
The profit potential from the conversion of convertible bonds into stock is limited by the issuer's option to call the security at short notice. Generally, the convertible debt security is convertible into a certain number of shares, and the debt holder will generally not convert the security to shares unless there is a profit to be made.
The 'premium' is irrelevant, because as long as the premium exists, the debt holder has no incentive to convert, as he would be better off buying the shares in the market. It is only when share prices go beyond a level that it becomes advantageous convert the security into shares. However, the prospect of granting cheap shares to the debt holders is not too appealing to the issuer, and as soon as the share price goes beyond a point where the value of the shares exceeds the face value of the debt the issuer has an incentive to exercise its option to call the security.
Therefore the profit potential from the conversion of convertible bonds into shares is limited by the issuer's option to call the security, and Choice 'a' is the correct answer. The 'premium', or interest rates, or volatility are irrelevant.
NEW QUESTION 42
An investor holds $1m in face each of two bonds. Bond 1 has a price of 90 and a duration of 5 years. Bond 2 has a price of 110 and a duration of 10 years. What is the combined duration of the portfolio in years?
- A. 7.75
- B. 0
- C. 7.25
- D. 7.5
Answer: A
Explanation:
Explanation
The value of Bond 1 is $900,000 and the value of Bond 2 is $1,100,000, or their respective weights in the portfolio are 45% and 55% respectively. The combined duration is the weighted average of their individual durations, ie (45% x 5) + (55% x 10) = 7.75 years
NEW QUESTION 43
Which of the following markets are characterized by the presence of a market maker always making two-way prices?
- A. OTC markets
- B. Exchanges
- C. ECNs
- D. Dark pools
Answer: B
Explanation:
Explanation
Over the counter and electronic communication networks match buyers and sellers. However, there is no market making function, ie, in periods of stress liquidity may completely disappear from these markets.
Exchanges normally have market makers that are required to present two way quotes on the securities they are making the market for. Therefore Choice 'a' is the correct answer.
NEW QUESTION 44
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