PRMIA 8006 Exam Questions Instant Access - No Installation Required

Question 1

Which of the following statements is not correct with respect to a European call option:

AA increase in the risk-free rate of interest always increases the value of the option

BAn increase in the price of the underlying always increases the value of the option

CAn increase in the time to expiry always increases the value of the option

DAn increase in the volatility of the underlying always increases the value of the option

Answer : C

An increase in volatility increases the value of the option, and so do increases in the price of the underlying and the risk free rate. However, since a European option can only be exercised at expiry, an increase in the time to expiry may not necessarily increase the value of the option as it may increase the uncertainty around a more certain payout.

Consider the extreme case of a deep in the money European call option that has 1 day left to expiry, and a payout is certain. Now imagine the time to expiry is increased by say, 6 months. Now the payout is no longer certain as no one knows what the value of the underlying will end up at after 6 months. In such a case, the value of the option would decline. But this applies only to a European option. An American option, which can be exercised any time, will not be affected by this reasoning.

Question 2

Which of the following statements are true:

1. Caps allow the buyer of the cap protection against rise in interest expense

II. Floors offer investors protection from downward movement in interest rates

III. Collars can be used as hedges

IV. Both caps and collars can be used to hedge against widening credit spreads

AI, II, III and IV

BI and II

CI, II and III

DII and III

Answer : C

Interest rate caps are effectively call options on an underlying interest rate that protect the buyer of the cap against a rise in interest rates over the agreed exercise rate. As with options, the premium on the cap depends upon the volatility of the underlying rates as one of its variables. A floor is the exact opposite of a cap, ie it is effectively a put option on an underlying interest rate that protects the buyer of the floor against a fall in interest rates below the agreed exercise rate. Therefore statements I and II are correct.

A cap protects a borrower against a rise in interest rates beyond a point, and a floor protects a lender against a fall in interest rates below a point.

A collar is a combination of a long cap and a short floor, the idea being that the premium due on the cap is offset partly by the premium earned on the short floor position. Therefore a collar is less expensive than a cap or a floor.

Caps, floors and collars provide a hedge against interest rate risks. Therefore statement III is correct too. However. they do not always provide protection against spreads changing, as the rate other than the one referenced by the cap or the floor may change causing the spread to change. Therefore statement IV is incorrect.

Question 3

An asset manager holds an equity portfolio valued at $25m with a beta of 0.8. She would like to reduce the beta of the portfolio to 0.6 for the next 3 months using index futures. Index futures are curently trading at 1450, and the contract multiple is 250. How should the asset manager trade the index futures to get his desired result? Assume her portfolio is well diversified.

ASell 35 index futures contracts

BSell 55 index futures contracts

CBuy 25 index futures contracts

DSell 14 index futures contracts

Answer : D

The portfolio's beta is 0.8, and therefore in order to completely hedge the portfolio (ie reduce beta to 0), the portfolio manager would need to short 0.8 * $25m/(1450*$250) = 55.17 contracts, or 55 contracts. However, the ask here is to reduce the beta to 0.6, and not 0.

The number of contracts required to reduce the beta of a portfolio from to is give by (- ) * Value of portfolio / Value of a single contract. In this case, this calculation works out to (0.8 - 0.6) * $25m/(1450*250) = 13.8, or roughly 14 contracts.

The portfolio manager should short 14 index futures contracts to reduce the total portfolio beta to 0.6.

Question 4

A bond manager holding $1m long in a bond portfolio is concerned that interest rates might rise over the next three months. Which of the following represents the best hedging strategy for the manager?

ASell bond futures so that the notional value of the futures contracts matches that of the bonds he holds

BSell bond futures so that the dollar duration of the futures contracts matches that of the bonds he holds

CBuy bond futures so that the notional value of the futures contracts matches that of the bonds he holds

DSell bond futures so that the market value of the futures contracts matches that of the bonds he holds

Answer : B

The duration matched hedge is the best hedge for the bond manager. Matched durations in the bond portfolio and the hedge positions will ensure that any decline in the bond portfolio due to interest rate changes is matched by a rise in the futures position. Hedging dollar-to-dollar will not work unless the bonds and the futures contracts are identical in duration terms. For example, if the duration of the portfolio is 7 years, and each futures contract has a duration of 3.5 years, then selling $1m in value will only cover half the risk. Choice 'b' is the right answer.

Question 5

According to the CAPM, the beta of a risky asset depends upon:

Athe risk-free rate and the risky asset's market risk premium

Bthe return expected by investors for holding the risky asset

Ccovariance between the market portfolio and the risky asset; and the variance of the market portfolio

Dall of the above

Answer : C

The beta of a risky asset is determined solely by the covariance between the asset and the variance of the market portfolio. Recall that = covariancex, y / variancex, where x is the market portfolio and y is the risky asset. Choice 'c' is the correct answer.

Question 6

Which of the following indicate a long position on the TED (treasury-Eurodollar) spread?

AA long position in treasury bill futures and a short position in Eurodollar futures

BA long position in treasury bill futures and a long position in Eurodollar futures

CA short position in treasury bill futures and a short position in Eurodollar futures

DA short position in treasury bill futures and a long position in Eurodollar futures

Answer : A

The TED spread is a bet on the spread between treasury bill futures and Eurodollar futures. T-bill rates are lower than Eurodollar rates, as the former carries no risk. Eurodollars deposits, which are interbank deposits between the highest rated banks, carry very little risk as well. Therefore both these instruments generally trade at very narrow spreads. The spread widens, ie the Eurodollar rates rise in comparison to treasury bill rates when the market has credit risk fears.

A trader is said to be 'long' the spread when he benefits from the spread increasing, and 'short' the TED spread when he gains from the spread decreasing. A trader can buy the spread by being long t-bill futures and short Eurodollar futures. Similarly he can be short the spread by being short t-bill futures and long Eurodollar futures.

Question 7

The theta of a delta neutral options position is large and positive. What can we say about the gamma of the position?

AThe gamma must be large and positive

BThe gamma must be large and negative

CThe gamma must be small and positive

DThe gamma must be small and negative

Answer : B

The relationship between the value of an option, and its delta, gamma and theta is given by rV = + rS + 0.5(S)2, where V is the value of the option, r the risk-free rate, S the spot price of the underlying, and , & are the respective Greeks.

For a delta neutral portfolio, = 0 and this equation reduces to rV = + 0.5(S)2. Now rV is generally a small number, which means that if is large and positive, must be large and negative to offset that. Therefore Choice 'b' is the correct answer.

PRMIA Exam I: Finance Theory, Financial Instruments, Financial Markets â€“ 2015 Edition 8006 Exam Questions