PRIMA 8006 PRM Certification - Exam I: Finance Theory, Financial Instruments, Financial Markets – 2015 Edition Online Training - Page 8 of 11

Question #71

For an investor short a bond, which of the following is true:

I. Higher convexity is preferable to lower convexity

II. An increase in yields is preferable to a decrease in yield

III. Negative convexity is preferable to positive convexity

A . I and II
B . II and III
C . I, II and III
D . I and III

Reveal Solution Hide Solution

Question #72

Which of the following markets are characterized by the presence of a market maker always making two-way prices?

A . Exchanges
B . OTC markets
C . ECNs
D . Dark pools

Reveal Solution Hide Solution

Question #73

A borrower pays a floating rate on a loan and wishes to convert it to a position where a fixed rate is paid.

Which of the following can be used to accomplish this objective?

I. A short position in a fixed rate bond and a long position in an FRN

II. An long position in an interest rate collar and long an FRN

III. A short position in a fixed rate bond and a short position in an FRN

IV. An interest rate swap where the investor pays the fixed rate

A . None of the above
B . I and IV
C . I, II and IV
D . II and III

Reveal Solution Hide Solution

Correct Answer: C
C

Explanation:

A short position in a fixed rate bond and a long position in an FRN has the effect of paying fixed and receiving floating. The floating received offsets the floating payment on the borrowing, leaving the borrower with just a fixed rate outflow. Therefore the combination identified in statement I can be used to achieve the objective of paying fixed. A collar is equivalent to a long position in an interest rate cap combined with a short position in an interest rate floor. This has the effect of setting a range within which the investor’s borrowing rate will vary. In the case where the cap and floor rates are the same, the combination of a collar and a long FRN effectively produces an outcome where the holder of such positions pays a fixed rate. Therefore, an interest rate collar can be used to convert the fixed payment to a floating rate payment. [Example: Assume current interest rate is 3%, and therefore the borrower has a liability of 3% on the FRN. Assume that the borrower now buys a collar at the strike rate of 4%. Now the borrower receives 0% (=Max(3% – 4%, 0)) on the cap part of the collar, and pays 1% on the floor part of the collar (=Max(4% – 3%, 0)). The net borrowing cost therefore is 3% paid on the FRN plus 1% paid on the collar, equal to 4%. Now if interest rates rise to say 6%, the borrower pays 6% on the FRN, and receives 2% from the collar (=Max(6% – 4%, 0) – Max(4% – 6%, 0)), creating a net cost of 6% – 2% = 4%.

A collar is often issued with an FRN to convert floating flows to fixed. Therefore combination II is an acceptable choice.

A short position in a fixed rate bond and a short position in an FRN produces a cash flow that does not produce a net fixed cash outflow when combined with the borrowing. Therefore statement III is not a valid combination.

An interest rate swap where the investor pays fixed and receives floating, when combined with a floating payment on an FRN leaves a net fixed payment, Therefore statement IV is a valid way to achieve the borrower’s objective.

Question #74

Which of the following best describes a ‘when-issued’ market?

A . where members of the syndicate bringing a bond issue to the market are obliged to not undercut the issue price till the first settlement date
B . The when-issued market is one where dealers trade in a security after its price has been set but before the bonds are available for delivery
C . The when-issued market is one where securities are traded on the OTC forward markets prior to their issue
D . The when-issues market is one where the lead manager agreed to buy an entire bond issue at an agreed price, and having done so may sell them onwards to institutional or other investors

Reveal Solution Hide Solution

Question #75

Which of the following statements is a correct description of the phrase present value of a basis point?

A . It refers to the present value impact of 1 basis point move in an interest rate on a fixed income security
B . It refers to the discounted present value of 1/100th of 1% of a future cash flow
C . It is another name for duration
D . It is the principal component representation of the duration of a bond

Reveal Solution Hide Solution

Question #76

According to the dividend discount model, if d be the dividend per share in perpetuity of a company and g its expected growth rate, what would the share price of the company be. ‘r’ is the discount rate.

A . https://riskprep.com/images/stories/questions/123.01.a.png
B . https://riskprep.com/images/stories/questions/123.01.c.png
C . https://riskprep.com/images/stories/questions/123.01.d.png
D . https://riskprep.com/images/stories/questions/123.01.b.png

Reveal Solution Hide Solution

Question #77

Which of the following statements are true?

I. The square-root-of-time rule for scaling volatility over time assumes returns on different

days are independent

II. If daily returns are positively correlated, realized volatility will be less than that calculated using the square-root-of time rule

III. If daily returns are negatively correlated, realized volatility will be less than that calculated using the square-root-of-time rule

IV. If stock prices are said to follow a random walk, it means daily returns are independent of each other and have an expected value of zero

A . I, II and IV
B . III and IV
C . I and III
D . All the statements are correct

Reveal Solution Hide Solution

Question #78

An investor enters into a 4 year interest rate swap with a bank, agreeing to pay a fixed rate of 4% on a notional of $100m in return for receiving LIBOR.

What is the value of the swap to the investor two years hence, immediately after the net interest payments are exchanged? Assume the current zero coupon bond yields for 1, 2 and 3 years are 5%, 6% and 7% respectively. Also assume that the yield curve stays the same after two years (ie, at the end of year two, the rates for the following three years are 5%, 6%, and 7%

respectively).

A . $2,749,326
B . -$2,749,326
C . $3,630,846
D . – $3,630,846

Reveal Solution Hide Solution

Correct Answer: C
C

Explanation:

The swap can be valued by valuing the two individual components of the swap. The fixed rate bond equivalent in the swap is valued at =4/1.05 + 104/(1.06^2) = $96,369,154.

The FRN component will be valued at par as we are at a point where the rate has just been reset, ie $100m.

The investor is paying the fixed rate, and is therefore short the bond. He/she is receiving LIBOR, and is therefore long the FRN. The value of the swap to the investor therefore is +$100,000,000-$96,369,154 = $3,630,846

Detailed explanation:

An Interest Rate Swap exchanges fixed interest flows for floating rate flows. The floating rate leg is tied to some reference rate, such as LIBOR. The parties exchange net cash flows periodically. Conceptually, an interest rate swap is the combination of a fixed coupon bond and a floating rate note. The party receiving the fixed rate is long the fixed coupon bond and short the FRN, and the party receiving the floating rate is long the FRN and short the fixed coupon bond.

An interest rate swap can be valued as the difference between the two hypothetical bonds. FRNs sell for par at issue time as they pay whatever the current rate is, subject to periodic resets. Therefore immediately after a payment is made on a swap, the value of the FRN component is equal to its par value. The bond can be valued by discounting its cash flows. The difference between the two represents the value of the swap. When the swap is entered into, the fixed rate leg is set in such a way that the value of the hypothetical bond is equal to that of the FRN, and therefore the swap is valued at zero. The rate at which the fixed rate leg is set is called the swap rate. Over its life, market rates change and the value of the fixed coupon bond equivalent in our swap diverges from par (whereas the FRN stays at par – at least right after payments are exchanged and the new floating rate is set for the next period). Thus the swap acquires a non-zero value.

There are two ways to value a swap. If interest rates for the future are known, the bond and the FRN can be valued and their difference will be equal to the value of the swap. Sometimes, the current swap rates are known. In such a case, the swap can be valued by imagining entering into an opposite swap at the new swap rate, which will leave a residual fixed cash flow for the remaining life of the swap. This residual cash flow can be valued and that represents the value of the swap. For example, if a 4 year swap was entered into exchanging an annual fixed 5% payment on a notional of $100m for a floating payment

equal to LIBOR, and at the end of year 1 the swap rate is 6%, then the party paying fixed can choose to enter into a new swap to receive 6% and pay LIBOR. All cash flows between the old and the new swap will offset each other except a net receipt of 1% for the next 3 years. This cash flow can be valued using the current yield curve and represents the value of the swap.

Question #79

The price of an interest rate cap is determined by:

I. The period to which the cap relates

II. Volatility of the underlying interest rate

III. The exercise or the strike rate

IV. The risk free rate

A . I, II, III and IV
B . I, II and III
C . II, III and IV
D . I, II and IV

Reveal Solution Hide Solution

Question #80

Which of the following correctly describes a "reverse repo"?

A . An asset swap that is offset by an identical but opposite swap
B . Lending cash with securities as a collateral
C . Borrowing cash while posting securities as a collateral
D . A repo with an undefined maturity period

Reveal Solution Hide Solution

PRIMA 8006 PRM Certification – Exam I: Finance Theory, Financial Instruments, Financial Markets – 2015 Edition Online Training