PRMIA 8006 Exam Practice Test Instant Access

Question 1

A corn farmer has committed to sell 20,000 bushels of corn in November. The spot price has a standard deviation of 20 cents per bushel, and its correlation with the December futures prices is 0.9. The futures contract is for 5000 bushels and has a standard deviation of 24 cents per bushel. What should the corn producer do if he/she wishes to hedge the risk of price movements between now and November?

ABuy 4 December corn futures contracts, and close these out in November when he/she sells the corn

BSell 4 December corn futures contracts, and close these out in November when he/she sells the corn

CSell 3 December corn futures contracts, and close these out in November when he/she sells the corn

DBuy 3 December corn futures contracts, and close these out in November when he/she sells the corn

Answer : C

We calculate the minimum variance hedge ratio as 0.9*20/24 = 0.75; and multiply this by the ratio of the [units required to be hedged] to the [units per futures contract], ie 0.75*20000/5000 = 3. Therefore the right quantity of contracts to sell is 3 contracts. Since the corn farmer has an obligation to sell in November, he or she can sell the futures now and lock a price in. The price locked in will be equal to the futures price, plus the basis (ie the difference between the spot and the futures price) in November.

Therefore the correct answer is to sell 3 December corn futures contracts and close these out prior to delivery in November when the November spot price will be realized. If prices have fallen, the loss on the spot trade will be made up by the profit on the hedge in the form of the futures, and also the other way round.

Question 2

The zero rates for 1, 2 and 3 years respectively are 2%, 2.5% and 3% compounded annually. What is the value of an FRA to a bank which will pay 4% on a principal of $10m in year 3?

A$732.90

B$800.25

CNone of the above

D$670.70

Answer : D

In this case, we need to determine the value today of an FRA where the bank has to pay 4% from year 2 to 3 in exchange for the then prevailing LIBOR. We do this by using the forward rate from year 2 to 3, and comparing it to the fixed rate. The forward rate is determined from the zero rates as =(1.03^3 / 1.025^2) - 1 = 4.0073%. The bank is committed to paying 4%, therefore the value of the FRA at the end of year 3 = (4.0073% - 4%) * $10m = $732.90. But this is the value at the end of year 3, and needs to be discounted to the present using the 3 year zero rate. Therefore the value of the FRA is $732.90/(1.03^3) = $670.70.

Question 3

Which of the following statements are true:

1. All investors regardless of their expectations face the same efficient frontier which is always the market portfolio

II. Investors will have different efficient frontiers based upon their views of expected risks, returns and correlations

III. Investors risk appetite will determine their choice of the combination of risk-free and risky assets to hold

IV. If all investors have identical views on expected returns, standard deviation and correlations, they will hold risky assets in identical proportions

AIII and IV

BII, III and IV

CI and II

DI, II, III and IV

Answer : B

Investors have differing view of the market, which means differing view of expected returns, correlations and volatilities. Not only do they have differing views, these views change frequently as new information reveals itself. Accordingly, each investor has their own version of the efficient frontier. Once investors have determined their efficient frontiers, they will determine the extent of risk they wish to hold. If they had identical views, they would have held the same portfolio. But they do not, and if they did, there would be very little trading in the markets.

All the above statements are true except statement I which is false due to differing investor expectations.

(Re statement IV: If investors have different risk appetites, their portfolio will vary in the split between the risky and the riskfree assets. But inside the 'risky' assets bundle the proportion of the assets will be identical. Ie, they would express their varying risk appetites by varying how much of the risky bundle and the riskfree asset they hold, but inside the risky bundle the proportion of the different risky assets will be the same.)

Question 4

The objective function satisfying the mean-variance criterion for a gamble with an expected payoff of x, variance var(x) and coefficient of risk tolerance is is:

AOption A

BOption B

COption C

DOption D

Answer : D

Choice 'd' represents the mean-variance function to be maximized for selecting between mutually exclusive gambles. The other choices are incorrect.

(The mean-variance criterion is a fairly complex subject, and this question is only intended to make sure that you know, and can identify the function that is being maximized. A complete explanation/derivation of the mean-variance criterion, that links together expected returns, volatility and the risk tolerance of the investor to arrive at the efficient frontier is beyond the scope of the PRM syllabus.)

Question 5

Which of the following does not explain the shape of an yield curve?

AMarket segmentation theory

BThe expectations hypothesis

CThe efficient markets hypothesis

DThe liquidity preference theory

Answer : C

The efficient markets hypothesis states that all known information is captured in the prices of a security. It does not explain the shape of the yield curve.

The expectations hypothesis, the LPT and the market segmentation theory are all attempts to explain the shape of the term structure of interest rates.

Therefore Choice 'c' is the correct answer as it does not explain the shape of the yield curve.

Question 6

Euro-dollar deposits refer to

AA deposit denominated in the ECU

BA US dollar deposit outside the US

CA Euro deposit convertible into dollars upon maturity

DA Euro deposit in the USA

Answer : B

Eurodollar deposits refer to US dollar denominated deposits outside the US, for example in a banking center such as London, and held by a non-US bank or a foreign branch of a US bank. Choice 'b' is the correct answer.

Question 7

A large utility wishes to issue a fixed rate bond to finance its plant and equipment purchases. However, it finds it difficult to find investors to do so. But there is investor interest in a floating rate note of the same maturity. Because its revenues and net income tend to vary only predictably year to year, the utility desires a fixed rate liability. Which of the following will allow the utility to achieve its objectives?

AIssue a floating rate note and hedge the risk of movements in interest rates by entering into an interest rate swap to pay fixed and receive floating

BBuy a floating rate note and hedge the risk of movements in interest rates by entering into an interest rate swap to pay fixed and receive floating

CIssue a floating rate note and immediately buy a similar floating rate note, together with a long position in interest rate futures

DIssue a floating rate note and hedge the risk of movements in interest rates by entering into an interest rate swap to pay floating and receive fixed

Answer : A

Choice 'a' is the correct answer as the issue of the floating rate note will provide the utility with the funds it needs, and the interest rate swap would offset the floating rate payment and leave it with a net fixed payment.

Choice 'd' is incorrect as the swap is in the wrong direction.

Choice 'c' is incorrect as buying and selling a floating rate bond would mean the utility will not have any funds that it wants to issue the note for, and combining it with interest rate futures would be just absurd.

Choice 'b' is incorrect as buying a floating rate note would use funds while the utility is trying to raise funds.

PRMIA 8006 Exam I: Finance Theory, Financial Instruments, Financial Markets – 2015 Edition Exam Practice Test