PRMIA Exam I: Finance Theory, Financial Instruments, Financial Markets ? 2015 Edition Exam Practice Test

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Total 287 questions
Question 1

Calculate the settlement amount for a buyer of a 3 x 6 FRA with a notional of $1m and contract rate of 5%. Assume settlement rate is 6%.

Answer : C

An m x n FRA is an agreement to borrow money for a period starting at time m and ending at time n at the contracted rate. Therefore, the buyer of the 3 x 6 FRA has committed to borrow $1m at the beginning of 3 months and return it at the end of 6 months, ie a total borrowing period of 3 months at a rate of 5%. Of course, the $1m is never actually exchanged, and at the beginning of the 3 month period when the next three months' interest rate is known (6%), the parties merely exchange the difference in the interest. SInce this interest was only due at the end of the 6 months and is being exchanged at the 3 month time point, it will have to be discounted to its present value.

The correct answer to this question is =(1,000,000 * (6% - 5%) * 3/12)/(1 + (6%*3/12))=$2463.05. Since interest rates rose, the borrower gained as he has the right to borrow at a lower rate, and therefore the seller will pay the borrower.


- $1m is the notional

- 6% - 5% represents the difference between the contracted and the realized interest rates

- 3/12 is the 3 month period from month 3 to 6

- Finally, we divide by the current interest rate for 3 months to present value the payment from month 6 to month 3)

Question 2

Buying an option on a futures contract requires:

Answer : B

An option on a futures contract is like any other option contract, and only the option premium is due upfront. If the option is exercised, then the futures contract comes into existence and futures margins become due in the normal way. Therefore Choice 'b' is the correct answer.

Question 3

A futures clearing house:

Answer : C

It is important to note the distinction between the clearing house and the exchange itself. The clearing house does not get involved with physical delivery, nor does it provide any dispute settlement services. It only makes sure that cash is settled as and when due between the members. Therefore Choice 'c' is the correct answer

Question 4

The vast majority of exchange traded futures contracts are:

Answer : A

The vast majority of exchange traded futures contracts are closed out prior to expiry by the parties acquiring offsetting positions. Very few contracts are settled by delivery. Since P&L on futures contracts is settled daily, 'cash settlement' really does not mean much as only the previous day's P&L is due or receivable on any given day.

Question 5

Profits and losses on futures contracts are:

Answer : D

Profits and losses on futures contracts are settled daily. (P&L on forward contracts is often settled upon the expiry of the contract, and may even be collateralized.) Therefore Choice 'd' is the correct answer.

Question 6

A currency with a lower interest rate will trade:

Answer : B

Given covered interest parity, the currency with a lower interest rate will trade at a forward premium. Choice 'b' is the correct answer.

For an intuitive reasoning, consider a currency forward contract that matures in 3 months. The seller has agreed to sell, say JPY 1,000,000 in exchange for USD 10,000 in the future. In order to cover himself, he borrows the USD right now and converts it to JPY at spot which he puts in a JPY deposit. Assuming JPY interest rates are less than USD interest rates, he pays more on his USD borrowing than he receives on his JPY deposit. Therefore he has to price the forward contract at a premium to spot to cover the interest rate differential.

Question 7

Using covered interest parity, calculate the 3 month CAD/USD forward rate if the spot CAD/USD rate is 1.1239 and the three month interest rates on CAD and USD are 0.75% and 0.4% annually respectively.

Answer : A

Forward rates can be calculated from spot rates and interest rates using the formula Spot x (1+domestic interest rate)/(1+foreign interest rate), where the 'Spot' is expressed as a direct rate (ie as the number of domestic currency units one unit of the foreign currency can buy). In this case the forward rate will be 1.1239 * (1 + 0.75%*90/360) / (1 + 0.4%*90/360) = 1.1249.

It can be confusing to determine which interest rate should be considered 'domestic', and which 'foreign' for this formula. For that, look at the spot rate. Think of the spot rate as being x units of one currency equal to 1 unit of the other currency. In this case, think of the spot rate 1.1239 as 'CAD 1.1239 = USD 1'. The currency that has the '1' in it is the 'foreign' and the other one is 'domestic'.

It is also important to remember how exchange rates are generally quoted. Most exchange rates are quoted in terms of how many foreign currencies does USD 1 buy. Therefore, a rate of 99 for the JPY means that USD 1 is equal to JPY 99. These are called 'direct rates'. However, there are four major world currencies where the rate quote convention is the other way round - these are EUR, GBP, AUD and NZD. For these currencies, the FX quote implies how many US dollars can one unit of these currencies buy. So a quote of '1.1023' for the Euro means EUR 1 is equal to USD 1.1023 and not the other way round.

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