PRMIA 8006 Exam Questions Instant Access - No Installation Required

Question 1

Theta for a call option:

Aapproaches 1 as the expiration date draws closer

Bapproaches as the expiration date draws closer

Capproaches 0 as the expiration date draws closer

Dapproaches -1 as the expiration date draws closer

Answer : C

Theta measures time decay, ie the change in value of the option with the passage of time. When the option is close to expiry, theta is very low as the value of the option is driven by intrinsic value rather than the time value. Therefore theta approaches zero as the option comes closer to expiry.

Question 2

Which of the following is true about the early exercise of an American call option:

AAn early exercise of an American call option is advisable whenever the option is deep in the money and delta approaches 1

BAn early exercise of an American call option may be justified if an extraordinarily large dividend payment is imminent

CAn early exercise of an American call option is never a good idea as an option is always worth more alive than when it is dead

DAn early exercise of an American option, if ever to be done, should be done immediately after an ex-dividend date

Answer : B

Generally, it is not a good idea to exercise an option early as any more upside in the remaining period to expiry is being sacrificed. However, if an extraordinarily large dividend is coming due, and this dividend is larger than the interest foregone from holding the option, it may be a good idea to exercise the option early. In such cases, the exercise needs to happen before the ex-dividend date and not afterwards. Choice 'b' is therefore the correct answer.

Even if the option is deep in the money and delta is approaching 1, and exercise upon maturity is almost a certainty, it would still always be better to sell the option than exercise it . Therefore Choice 'a' is incorrect. Choice 'c' is correct in all cases except when a large dividend is coming in. Choice 'd' is not correct because an early exercise needs to happen prior to the ex-dividend date and not afterwards.

Question 3

A bank sells an interest rate swap to its client, with the client agreeing to pay the bank a fixed 4% and receive 3 month LIBOR + 100 basis points, payments due every quarter. After quarter 1, the 3 month LIBOR is 2% p

a. Which of the following payments will happen in respect of this swap, assuming the contract notional is $100m, and the rate convention is 30/360.

ABank pays customer $1,000,000 and customer pays the bank $750,000

BBank pays customer $250,000

CCustomer pays bank $250,000

DBank pays customer $1,000,000

Answer : C

In an interest rate swap, only the net payment is made. In this case,

- the customer pays the bank 4%*(3/12)*$100m

- the bank owes the customer (2% + 100bp))*(3/12)*$100m

Therefore the customer pays (4% - (2% + 100bp))*(3/12)*$100m. 3/12 represents the 3 month time interval. This is equal to a net payment of $250k from the customer to the bank. Therefore Choice 'c' is the correct answer and the rest are incorrect.

Question 4

Determine the enterprise value of a firm whose expected operating free cash flows are $100 each year and are growing with GDP at 2.5%. Assume its weighted average cost of capital is 7.5% annually.

A$4,000

B$1,000

C$1,333

D$2,000

Answer : D

The operating free cash flows can be considered a perpetual annuity with a given growth rate.

The value of a perpetuity of a periodic cash flow of 'c', with a discount rate 'r' and growth rate 'g' is given by c/(r - g). In the given case, the company can be considered as providing a perpetual annuity which provides an annual cash flow of $100 which are growing at 2.5% (equal to the GDP's growth rate, as given), and whose cost of capital, or the discount rate to use, is 7.5%

Therefore the value of the firm in this case is given by $100/(7.5% - 2.5%) = $2,000. Recall that the value of the firm is equal to the Operating Free Cash Flow/Weighted Average Cost of Capital (OFCF/WACC). Therefore Choice 'd' is the correct answer.

Question 5

What is the approximate delta of an exactly at-the-money call option?

AClose to -0.5

BClose to 0.5

CClose to 0

DClose to 1

Answer : B

The delta of an at-the-money call option is close to 0.5. It is close to 1 when it is deep in the money. It is close to 0 when it is deep out of the money. It is never negative. Therefore Choice 'b' is the correct answer.

Question 6

The relationship between covariance and correlation for two assets x and y is expressed by which of the following equations (wherecovarx,yis the covariance betweenxandy,xandyare the respective standard deviations andx,yis the correlation betweenxandy):

None of the above

AOption A

BOption B

COption C

DOption D

Answer : B

Choice 'b' is the correct answer. The other relationships are not correct.

Question 7

Which of the following is an example of a multifactor model explaining expected asset returns:

1. Arbitrage pricing theory

II. Single index model

III. Capital asset pricing model

BII

CIII

DII and III

Answer : A

The arbitrage pricing theory is a multifactor model for explaining asset returns as it can be used to incorporate multiple factors, for example inflation, GDP growth rate, employment, interest rates etc to explain asset returns. Choice 'a' is the correct answer.

The single index model, as the name implies, uses only a single factor, and so does the CAPM which uses excess returns to explain an individual security's returns. Neither of these are multi-factor models.

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