B3_Additonal question bank

FRM PART – I – FINANCIAL MARKETS AND PRODUCTS
Topic - 25
Banks [FMP-1]
Learning Objectives
Banks
LO 25 a: Identify the major risks faced by a bank, and explain ways in which these risks can arise.
LO 25 b: Distinguish between economic capital and regulatory capital.
LO 25 c: Summarize Basel Committee regulations for regulatory capital and their motivations.
LO 25 d: Explain how deposit insurance gives rise to a moral hazard problem.
LO 25 e: Describe investment banking financing arrangements including private placement, public
offering, best efforts, firm commitment, and Dutch auction approaches.
LO 25 f: Describe the potential conflicts of interest among commercial banking, securities services,
and investment banking divisions of a bank and recommend solutions to the conflict of interest
problems.
LO 25 g: Describe the distinctions between the “banking book” and the “trading book” of a bank.
LO 25 h: Explain the originate-to-distribute model of a bank and discuss its benefits and drawbacks.
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QUESTIONS
1. Which of the following risks is not one of the major risks facing a bank?
A. Credit risk
B. Market risk
C. Reputational risk
D. Operational risk
2. Which of the following statements regarding economic and regulatory capital are correct?
I. Economic capital is capital that a bank must have as required by the regulators.
II. In most instances economic capital will exceed regulatory capital.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Depositors, knowing that they are insured anyway, may not pay close attention to which banks
they are depositing their money with. They may merely deposit with the bank that offers them
the highest interest rate. This is an example of:
A. Moral hazard
B. Adverse selection
C. Risk seeking
D. Diversification
4. One way that the investment bank assists the issuer is when the investment banker acts as a
broker to sell whatever it can at a stipulated price. This is called a:
A. Best-efforts basis
B. Private placement
C. Initial public offering (IPO)
D. Indications of interest
5. Which of the following statements regarding a Dutch auction are correct?

I. A Dutch auction process starts with a much higher price then any bidder will pay and
slowly the price is reduced until the bidder agrees to pay the price.
II. The price accepted by the last bidder is the price that will be paid by all successful bidders.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
6. Which of the following statements regarding conflicts of interest at a bank are correct?
A. A bank may experience a conflict of interest when it provides several services.
B. A conflict of interest may interfere with an analyst’s independence and objectivity.
C. A conflict of interest may lead to trading on material nonpublic information.

D. A conflict of interest may lead to a Chinese wall.
7. Which of the following statements regarding conflicts of interest at a bank are correct?
I. As a result of these conflicts the regulators often require a certain degree of separation
between the various divisions within the bank.
II. Chinese walls are a type of internal control mechanism that prevents information from
being shared between divisions.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. The following was caption was found on the balance sheet of a Zed Bank - “Loans to clients”.
This is an example of:
A. The banking book
B. The trading book
C. A story book
D. The net interest margin
9. Which of the following statements regarding the bank’s trading book are not correct?
A. The trading book refers to the trading activities of the bank.
B. The trading activities of the bank will be marked to market on a daily basis based on the
current market prices of the securities.
C. In the event of a less liquid market or if the securities do not have a current market price –
a modeled price may need to be used – called marked-to-model.
D. The value of the loans are recorded at their current principal amounts plus any accrued
interest.
10. Which of the following are not advantages of the originate-to-distribute model?
A. In the past, it was difficult to gain access to the financial assets of the commercial banks.
Through securitization investors can now avoid this additional layer. In addition, the
investor can gain exposure to the specific asset that they wish to hold.
B. Investors have better legal claims against the specific underlying mortgages and portfolios
than they would have had in the past.
C. The costs of the intermediaries are increased.
D. Securitization allows the banks to increase the amount available for lending.
11. In terms of Basel I and the risk weighted assets (RWA) requirement, which of the following
statements is least likely correct?
A. When determining the capital requirements, assets are weighted by their levels of risk.
B. The RWA ratio measures capital as a percentage of risk-adjusted assets.
C. The RWA ratio was called the Cooke ratio must exceed 8%.
D. RWA only include on-balance sheet assets.

12. Which of the following liquidity ratios focuses on the bank’s ability to withstand a 30-day
reduced period of liquidity?
A. Leverage ratio
B. Liquidity coverage ratio (LCR)
C. Net stable funding ratio (NSFR)
D. Assets to equity ratio

SOLUTIONS
1. C
The three major risks facing a bank are:
Market risk – This is the risk that arises from movements in stock prices, exchange rates,
interest rates and commodity prices. This loss will arise from losses as a result of the bank’s
trading operations.
Credit risk – This is the risk of loss due to the counterparty failing to make payment on the
amount that is owed. This type of risk is also called counterparty of default risk.
Operational risk – These risks are the internal risks faced by the bank. This risk arises as a result
of people and processes that combine to produce the bank’s output.
2. B
Economic capital refers to the amount of capital that the bank believes that it needs in order to
operate based on its levels of risk. In most instances economic capital will exceed regulatory
capital.
3. A
Moral hazard is a concept that people tend to take more risks when they are insured than they
would have taken had they not been insured. In the context of a banking model, the depositors,
knowing that they are insured anyway, may not pay close attention to which banks they are
depositing their money with. They may merely deposit with the bank that offers them the
highest interest rate. In turn, the bank may make higher risk loans with the money that have
received from depositors.
4. A
Another way that the investment bank assists the issuer is through the best-efforts basis – In
this case, the investment banker acts as a broker to sell whatever it can at a stipulated price.
5. C
A Dutch auction process starts with a much higher price than any bidder will pay and slowly
the price is reduced until the bidder agrees to pay the price. The price accepted by the last
bidder is the price that will be paid by all successful bidders.
6. D
A bank may experience a conflict of interest when it provides several services. These include
commercial banking, investment banking and securities services. An example of this type of
conflict is when the investment banking division is in the process of selling an equity or bond
issue on behalf of a client. They may ask the securities division to rate the issue as a buy in
order to generate positive interest in the issue. This request interferes with an analyst’s
independence and objectivity. A further conflict may arise when certain parts of the bank are
privy to material nonpublic information. This information must be kept private and not passed
on to other parts of the bank, for example the trading division, as this would represent a
conflict.

7. C
As a result of these conflicts the regulators often require a certain degree of separation between
the various divisions within the bank. Chinese walls are a type of internal control mechanism
that prevents information from being shared between divisions.
8. A
The banking book refers to the loans that are made by the bank and are the activities of the
commercial bank.
9. D
The trading book refers to the trading activities of the bank. The trading activities of the bank
will be marked to market on a daily basis based on the current market prices of the securities
(in a liquid market). In the event of a less liquid market or if the securities do not have a current
market price – a modeled price may need to be used – called marked-to-model.
10. C
Some advantages of this model include:
 In the past, it was difficult to gain access to the financial assets of the commercial banks. In
order to do so, they would need to hold deposits, debt or equity in the bank. Through
securitization investors can now avoid this additional layer. In addition, the investor can
gain exposure to the specific asset that they wish to hold.
 Investors have better legal claims against the specific underlying mortgages and portfolios
than they would have had in the past.
 The costs of the intermediaries are reduced. This will reduce the funding costs paid by
borrowers and can enhance risk-adjusted returns to ultimate investors.
 Securitization allows the banks to increase the amount available for lending. This is due to
the fact that the securities are sold to the general public. These additional funds can now be
used to grant more loans.
11. D
Risk weighted assets (RWA).
When determining the capital requirements, assets were weighted by their levels of risk. The
RWA ratio measures capital as a percentage of risk-adjusted assets. The ratio was called the
Cooke ratio (after Peter Cooke - Bank of England) and must exceed 8%. Assets included both on
and off-balance sheet assets.
This requirement was not being met by the majority of banks at the time.
The riskier the asset category the greater the weighting assigned to that asset.
12. B
Liquidity coverage ratio (LCR)
The LCR focuses on the bank’s ability to withstand a 30-day reduced period of liquidity. The
stressed liquidity event may be as a result of a loss of deposits, a loss of funding, a degradation
in the value of the collateral etc. The LCR was implemented on 1 January 2015. The LCR ratio is
calculated as follows:

Topic - 26
Insurance Companies and Pension Plans [FMP - 2]
Learning Objectives
Insurance Companies and Pension Plans
LO 26 a: Describe the key features of the various categories of insurance companies and identify the
risks facing insurance companies.
LO 26 b: Describe the use of mortality tables and calculate the premium payment for a policy
holder.
LO 26 c: Distinguish between mortality risk and longevity risk and describe how to hedge these
risks.
LO 26 d: Describe a defined benefit plan and a defined contribution plan for a pension fund and
explain the differences between them.
LO 26 e: Calculate and interpret loss ratio, expense ratio, combined ratio, and operating ratio for a
property- casualty insurance company.
LO 26 f: Describe moral hazard and adverse selection risks facing insurance companies, provide
examples of each, and describe how to overcome the problems.
LO 26 g: Evaluate the capital requirements for life insurance and property-casualty insurance
companies.
LO 26 h: Compare the guaranty system and the regulatory requirements for insurance companies
with those for banks.

QUESTIONS
1. Which of the following types of insurance has got the longest tail risk?
A. Life insurance
B. Casualty insurance
C. Health insurance
D. Motor insurance
2. Assume that the interest rate applicable to the insurance contract is 6%. Premiums are paid at
the beginning of the year. A $1,000,000 insurance contract is being considered for a 50 year-old
female in fair health. What is the breakeven premium for one year?
A. $3,193
B. $3,012
C. $1,000
D. $3,491
3. Using the mortality table given below, what is the probability that a female that has just been
born will live to be 21 years old?
A. 99.08%
B. 0.00000436%
C. 99.12%
D. 60.67%
4. Which of the following ratios is most likely to have a declining ratio over time?
A. Loss ratio
B. Expense ratio
C. Combined ratio
D. Operating ratio
5. Which of the following statements regarding moral hazard are correct?

I. Moral hazard is a concept that people tend to take more risks when they are insured than
they would have taken had they not been insured.
II. Moral hazard is when individuals who know that they are high-risk individuals are more
likely to be the ones applying for insurance.

A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
6. Which of the following risks best defines the risk of outliving ones assets?
A. Mortality risk
B. Longevity risk
C. Operational risk
D. Health risk
7. An insurance company that wishes to make use of a natural hedge to hedge away longevity
and mortality risk, should be involved in which of the following business units?
A. Sell annuities only
B. Sell life insurance only
C. Sell life insurance and sell annuities
D. Purchase a reinsurance company
8. Which of the following statements are not correct when dealing with asset/liability
management?
A. The key objective of an insurance company is to fund the future pension liabilities with
assets.
B. The asset/liability management (ALM) perspective on risk is very important as we look at
the risk relative to the liabilities.
C. In ALM assets are managed to take into account the relative position of asset/liability
values.
D. Life insurance policies tend to have shorter durations than nonlife policies.
9. Which of the following statements regarding moral hazard are correct?

I. A guaranty system applies to both banks and insurance companies.
II. On the insurance side –the system is regulated at a state level.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. Which of the following plans places all of the risk onto the employer?
A. A defined benefit plan
B. A defined contribution plan
C. An ESOP
D. A medical aid plan

SOLUTIONS
1. B
Casualty insurance has a long tail risk as a result of certain claims only being discovered and
submitted long after the insurance coverage has ended.
2. B
One year premium:
Step one:
Look at the mortality tables. The tables tell us that a healthy, female, aged 50 has a 0.003193
chance of dying within the year. This would translate into a 99.97% chance of living (1 –
0.003193).
Step two:
Work out the expected cash outflow for the year.
3. A
4. B
Expense ratio = This ratio should approximate 25% and should decrease over time
5. A
Moral hazard is a concept that people tend to take more risks when they are insured than they
would have taken had they not been insured.
Adverse selection is when individuals who know that they are high-risk individuals are more
likely to be the ones applying for insurance. Based on this the insurance company must
perform its underwriting.
6. B
Longevity risk is the risk of outliving ones assets.

7. C
From the insurance company’s point of view, there may be a natural hedge if they deal with
both insurance and annuity products. By way of example, longevity risk is bad for the annuity
business (as they need to keep paying the annuity for a long period of time) but good for the
insurance side of the business (as payment of the life payout is delayed). Mortality risk is good
for the annuity side of the business (as payments end early) but bad for the insurance side of
the business (as the life payout occurs earlier).
8. D
The key objective of an insurance company is to fund the future pension liabilities with assets.
Based on this, the asset/liability management (ALM) perspective on risk is very important as
we look at the risk relative to the liabilities.
ALM is part of the company’s risk management process and deals with financial risks and the
interaction between assets and liabilities. What this means is that assets are managed to take
into account the relative position of asset/liability values.
9. C
A guaranty system applies to both banks and insurance companies.
On the insurance side –the system is regulated at a state level.
10. A
A defined benefit (DB) plan is where the entity promises to make payments to the employee
post their retirement. The benefit to be received is defined up front based on various factors.
For example a formula could determine the amount of the benefit based on a function of the
length of service and the final year’s compensation of the employee.
The company will make periodic payments into a fund or trust, during the life of the employee,
to ensure that when the employee retires there will be sufficient funds available to provide the
promised benefit. These assets are called plan assets and are managed to ensure that they
generate the necessary returns to ensure that the benefit can be provided upon retirement. The
risk of the benefit plan therefore rests with the employer.

Topic - 27
Fund Management [FMP - 3]
Learning Objectives
Fund Management
LO 27 a: Differentiate among open-end mutual funds, closed-end mutual funds, and exchange-
traded funds (ETFs).
LO 27 b: Identify and describe potential undesirable trading behaviors at mutual funds.
LO 27 c: Calculate the net asset value (NAV) of an open-end mutual fund.
LO 27 d: Explain the key differences between hedge funds and mutual funds.
LO 27 e: Calculate the return on a hedge fund investment and explain the incentive fee structure of
a hedge fund including the terms hurdle rate, high-water mark, and clawback.
LO 27 f: Describe various hedge fund strategies, including long/short equity, dedicated short,
distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging
markets, global macro, and managed futures, and identify the risks faced by hedge funds.
LO 27 g: Describe characteristics of mutual fund and hedge fund performance and explain the effect
of measurement biases on performance measurement.

QUESTIONS
1. Which of the following statements regarding ETF’s are correct?

I. ETF’s are required to disclose their holdings twice a day.
II. All three instruments, Open-end funds, closed-end funds and ETF’s are regulated by the
Securities and Exchange Commission (SEC).
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Which of the following is not a difference between open-end and closed-end funds?
A. Closed-end funds tend to invest in broader areas while open-end funds tend to invest in
more niche areas.
B. Open-end funds keep increasing the number of shares available while the number of shares
for a closed-end fund are fixed.
C. Closed-end funds cannot redeem their shares – they need to find an investor to purchase
their shares.
D. Open-end funds always trade at the next available NAV while a closed end fund can trade
at prices not close to their NAV’s.
3. You are provided with the following information relating to fund XY:
Total market value of fund: $90m
Trading Expenses owing: $10m
Number of shares issued: $10m
The NAV of the fund is closest to?
A. $8 per share
B. $9 per share
C. $10 per share
D. Cannot be worked out
4. Which of the following is not a difference between a hedge fund and a mutual fund?
A. Hedge funds are generally only cater to high net worth individuals, as apposed to mutual
funds that cater for all investor types.
B. The regulation surrounding hedge funds is limited and disclosure is often opaque, as
apposed to mutual funds that are highly regulated with transparent reporting.
C. Hedge funds make use of leverage and short selling. This is not allowed for a mutual fund.
D. Hedge fund investments are easier to redeem than mutual funds.
5. Assume the following information:

Investment A has a 35% probability of a 60% return and a 65% probability of a 40% loss.
Management fees are 1% of assets under management.
Incentive fees are 20% of profits after management fees.

The return attributable to the Manager is closest to?

A. 4.76%
B. 2%
C. 1.3%
D. 6.06%

Investment A has a 35% probability of a 60% return and a 65% probability of a 40% loss.
Management fees are 1% of assets under management.
Incentive fees are 20% of profits after management fees.
The return attributable to the Investor is closest to?

A. 6.06%
B. -42%
C. -11.06%
D. -27.3%
7. Which of the following hedge fund strategies is not part of a relative-value strategy?
A. Merger arbitrage
B. Fixed-income arbitrage funds
C. Convertible bond arbitrage funds
D. Asset-backed fixed-income
8. John Terry, FRM, is planning to Purchase a sizable shareholding in company XYM such that he
can affect changes to the company and increase the value of the company.
Which of the following hedge fund strategies is Terry most likely using?
A. Distressed or restructuring
B. Merger arbitrage
C. Activist shareholder
D. Special situations
9. Which of the following statements regarding the performance of hedge funds are correct?
I. Prior to 2008 hedge funds performed well relative to the S&P 500 index.
II. After 2008, hedge fund performance deteriorated relative to the S&P 500.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. Jamie Vix, FRM, is giving a presentation on the effects of bias in the hedge fund industry. She
describes the following situation to her class, “by adding the previous performance records of
firms that are recently added to a benchmark index means that only the best results are
presented”.

Which of the following biases is Jamie most likely describing?

A. Backfill bias
B. Survivorship bias
C. Stale price bias
D. Past data relevance
11. Callum Pol, FRM, describes the following practice, “Assume that prices of stocks in the market
have been rising during the day, it is likely that the shares in the mutual fund are worth more
than the current NAV. A good investment is to buy shares in the mutual fund.” This type of
practice is best described by which of the following terms?
A. Late trading.
B. Market timing.
C. Front running.
D. Directed brokerage.

SOLUTIONS
1. B
ETF’s are required to disclose their holdings twice a day, thus providing increased
transparency into their holdings. Open-end funds usually only disclose their holdings once a
quarter.
Since all three instruments, Open-end funds, closed-end funds and ETF’s, obtain funds
from small retail clients, they are regulated by the Securities and Exchange Commission (SEC).
2. A
Differences between open and closed-end mutual funds
 Open-end funds tend to invest in broader areas while closed-end funds tend to invest in
more niche areas.
 Open-end funds keep increasing the number of shares available while the number of
shares for a closed-end fund are fixed.
 Closed-end funds cannot redeem their shares – they need to find an investor to purchase
their shares.
 Open-end funds always trade at the next available NAV while a closed end fund can trade
at prices not close to their NAV’s.
3. A
Fund NAV
90  10

10
= $8.00
4. D
Some of the differences between hedge funds and mutual funds include:
 Hedge funds are generally only cater to high net worth individuals, as apposed to mutual
funds that cater for all investor types.
 The regulation surrounding hedge funds is limited and disclosure is often opaque, as
apposed to mutual funds that are highly regulated with transparent reporting.
 Hedge funds make use of leverage and short selling. This is not allowed for a mutual fund.
 Hedge fund investments are more difficult to redeem than mutual funds, and often have
lock-in clauses to prevent early redemptions.
5. D
Assume that the investment does in fact generate a profit (keep in mind that there is
only a 35% probability of this occurring), the return to the manager will be as follows:
= 2% (MF) + (60% - 2%) x 20%
= 2% + 11.6%
= 13.6%

Assume that the investment generates a loss (keep in mind that there is a 65% probability of
this occurring), the return to the manager will be as follows:
= 2% (MF) + zero incentive fee
= 2%
Let us apply the probabilities to the profit and loss:
Expected return = (13.6% X 0.35) + (2% X 0.65)
Expected return = 4.76% + 1.3%
Expected return = 6.06%
6. C
Assume that the investment does in fact generate a profit (keep in mind that there is only
a 35% probability of this occurring), the return to the investor will be as follows:
= 60% - 13.6% (to the manager)
= 46.4%
Assume that the investment generates a loss (keep in mind that there is a 65% probability of
this occurring), the return to the investor will be as follows:
= -40% - 2% (man fee payable to the manager)
= -42%
Let us apply the probabilities to the profit and loss:
Expected return = (46.4% X 0.35) + (-42% X 0.65)
Expected return = 16.24% - 27.3%
Expected return = -11.06%
7. A
 Fixed-income arbitrage funds: Invest in fixed-income securities going long or short to take
advantage of mispricings in the market.
 Convertible bond arbitrage funds: Invest in convertible bonds to convert them into equities
and take advantage of mispricings between the two.
 Asset-backed fixed-income arbitrage funds: Invest in fixed-income securities going long or
short.
8. C
 Distressed or restructuring: Purchase the stock of undervalued company’s that are
undergoing a difficult time of a restructuring. Sell the stock of overvalued companies.
 Merger arbitrage: Purchase the shares of a company being acquired and sell the shares of a
company being sold.
 Activist shareholder: Purchase a sizable shareholding in the company such that you can
affect change and increase the value of the company.
 Special situations: Look out for companies that are undergoing special situations e.g. selling
off divisions, repurchasing securities, issuing new stock etc.
9. C
Taking the period further, we see that prior to 2008 hedge funds performed well relative to the
S&P 500 index. After 2008, hedge fund performance deteriorated relative to the S&P 500.

10. A
 Backfill bias, by adding the previous performance records of firms that are recently added
to a benchmark index means that only the best results are presented.
 Survivorship bias, returns from data that have been terminated are excluded from
the return results presented.
 Stale price bias, is due to infrequent pricing and the use of appraisal values. As a result,
price volatility is reduced.
 Past data relevance, is questioning the relevance of past data when assessing the skill of a
hedge fund manager.
11. B
Market timing. NAV pricing may be stale in the open-ended mutual fund market. The reason
for this, is that mutual fund trading is not active. As a result, assume that prices of stocks in the
market have been rising during the day, it is likely that the shares in the mutual fund are worth
more than the current NAV. A good investment is to buy shares in the mutual fund. On the
other side, when prices in the market are falling, it is advisable to sell shares in the mutual
fund. Such a practice is legal but may result in the value of the fund moving around
excessively. In addition, it is more costly for investors as they will need to keep excess
cash in the fund, in order to provide for redemptions.

Topic - 28
Introduction to Derivatives [FMP - 4]
Learning Objectives
Introduction to Derivatives
LO 28 a: Define derivatives, describe features and uses of derivatives, and compare linear and non-
linear derivatives.
LO 28 b: Describe the over-the-counter market, distinguish it from trading on an exchange, and
evaluate its advantages and disadvantages.
LO 28 c: Differentiate between options, forwards, and futures contracts.
LO 28 d: Identify and calculate option and forward contract payoffs.
LO 28 e: Differentiate among the broad categories of traders: hedgers, speculators, and arbitrageurs.
LO 28 f: Calculate and compare the payoffs from hedging strategies involving forward contracts
and options.
LO 28 g: Calculate and compare the payoffs from speculative strategies involving futures and
options.
LO 28 h: Calculate an arbitrage payoff and describe how arbitrage opportunities are temporary.
LO 28 i: Describe some of the risks that can arise from the use of derivatives.

QUESTIONS
1. Which of the following is not a characteristic of a forward contract in relation to a futures

contract?
A. Less regulated (informal)
B. Less transparent (more private)
C. More liquid
D. Default risk is high
2. Jed John, FRM, is giving a class on derivatives, he uses the following descriptions to describe a
certain instrument:
 The transaction is reported to certain regulatory agencies
 The price of the transaction is recorded
 The terms of the transaction are standard
 The terms of the contract are known to all parties
Which derivative instrument is Jed discussing?
A. Forward contract
B. Futures contract
C. Swap contract
D. Options contract
3. Which of the following statements regarding the payoff and profit of a put option at expiry are
correct?
I. At expiry the put option is worth the greater of: Zero, Or the difference between the
exercise price and the underlying price.
II. Profit = PT – P0
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. Assuming that an investor is long (has purchased/owns) the underlying asset, which of the
following statements regarding hedging instruments are correct?
I. He can go short or sell a forward contract.
II. He can sell a put option.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
5. Assuming that an investor is short the underlying asset, which of the following statements
regarding hedging instruments are correct?
I. He can go long or buy a forward contract.
II. He can buy a call option.

A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
6. An investor is has got $1,000,000 to invest and would like to invest his money in Apple Inc for a
period of six months. The current spot price of Apple is $200 per share. He can invest directly in
Apple stock or he could do so by purchasing futures contracts on Apple stock that expires in six
months time. The futures price of the six-month contract is $220 per share. The initial margin is
$20 per share.
Assuming that the spot price of Apple Inc at the end of six months is $230. The investor’s profit
is closest to:
A. -$50,000
B. $150,000
C. $500,000
D. -$1,500,00
7. An investor is has got $1,000,000 to invest and would like to invest his money in Apple Inc for a
period of six months. The current spot price of Apple is $200 per share. He can invest directly in
Apple stock or he could do so by purchasing a call option on Apple stock that expires in six
months time. The options price of the six- month contract is $210 per share. The initial option
premium is $10 per share.
Assuming that the spot price of Apple Inc at the end of six months is $200. The investor’s profit
is closest to:
A. $-3,000,000
B. $0
C. -$2,000,000
D. -$1,000,000
8. Assuming that an investor is short the underlying asset, Which of the following statements
regarding arbitrage are correct?
I. Arbitrage occurs when two equivalent assets sell for two different prices.
II. Arbitrage presents an opportunity to profit for no risk or cash outlay.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. Which of the following statements regarding risks of derivatives are correct?

I. There are certain risks that are attached to using derivatives.
II. Losses using derivatives can be far greater than the losses would have been had derivatives
not been used.
A. I only.
B. II only.

C. Both I and II.

D. Neither I or II.
10. An investor that aims to make a profit from taking a position on the market is referred to as a
_________
A. Hedger
B. Speculator
C. Arbitrageur
D. FCM
11. Which of the following derivative instruments is best described as being nonlinear?
A. Forwards
B. Futures
C. Options
D. Swaps
12. A French bank enters into a 6-month forward contract with an importer to sell GBP 40 million
in 6 months at a rate of EUR 1.21 per GBP. If in 6 months the exchange rate is EUR 1.16 per
GBP, what is the payoff for the bank from the forward contract?
A. EUR -2,941,176
B. EUR -2,000,000
C. EUR 2,000,000
D. EUR 2,941,176

SOLUTIONS
1. C
Less regulated (informal)
Less transparent (more private)
Less liquid
Default risk is high
2. B
In a futures contract:
 The transaction is reported to a recognized exchange (a futures exchange)
 The transaction is reported to a clearinghouse
 The terms of a futures contract are known to all parties
3. C
Payoff of a put option at expiry is worth the greater of:
i. Zero, Or
ii. The difference between the exercise price and the underlying price
PT = Max(0, X - ST)
Put option
Profit = Put option payoff – Put option premium
Profit = PT – P0
4. A
He can go short or sell a forward contract. Or He can buy a put option.
5. C
He can go long or buy a forward contract. Or He can buy a call option.
6. C
Profit =
($230 - $220) x 50,000
= $500,000
7. D
Remember that it is an option so we would choose not to exercise and as such our losses are
limited to the option premium of $10 per share x 100,000 shares = $1,000,000 loss.
8. C
Arbitrage occurs when two equivalent assets sell for two different prices. This presents an
opportunity to profit for no risk or cash outlay.

9. C
There are however certain risks that are attached to using derivatives. For example, a
speculator may use derivatives to turn a profit on a certain position that he takes in an asset. To
the extent that this position does not go the way that the speculator though it would, this may
result in large losses – far greater than the losses had derivatives not been used.
10. B
Speculators aim to make a profit from taking a position on the market. Their aim is to profit
from price movements in the underlying instrument.
11. D
A nonlinear derivative depends on the state of the underlying asset and is a function of the
change in the value of the underlying.
An example of a nonlinear derivative are most option contracts. The reason for this is that the
value of the option does not move at a constant rate when the underlying asset moves.
12. C
The value of the contract for the bank at expiration: GBP 40,000,000 * 1.21 EUR/GBP
The cost to close out the contract for the bank at expiration: GBP 40,000,000 * 1.16 EUR/GBP
The final payoff in EUR to the bank can be calculated as:

40,000,000 *(1.21 – 1.16) = EUR 2,000,000.

Topic - 29
Exchanges and OTC Markets [FMP - 5]
Learning Objectives
Exchanges and OTC Markets
LO 29 a: Describe how exchanges can be used to alleviate counterparty risk.

LO 29 b: Explain the developments in clearing that reduce risk.
LO 29 c: Describe netting and describe a netting process.
LO 29 d: Describe the implementation of a margining process and explain the determinants of initial
and variation margin requirements.
LO 29 e: Compare exchange-traded and OTC markets and describe their uses.
LO 29 f: Identify the classes of derivative securities and explain the risk associated with them.
LO 29 g: Identify risks associated with OTC markets and explain how these risks can be mitigated.
LO 29 h: Describe the role of collateralization in the over-the-counter market and compare it to the
margining system.
LO 29 i: Explain the use of special purpose vehicles (SPVs) in the OTC derivatives market.

QUESTIONS
1. Which of the following functions is not a standardized product of an exchange?

A. Maturity
B. Size
C. Location
D. Delivery
2. Which of the following functions is not a key function of an exchange?

A. Trading venue.
B. Standardized products.
C. Reporting.
D. Risk minimization
3. Which of the following statements is not correct when dealing with a clearinghouse and
marking-to-market?
A. The Clearinghouse protects itself by enforcing weekly settlement of outstanding positions
from the buyer and the seller.
B. The process of daily settlement is called marking-to-market.
C. The procedure of marking to market is essentially translating paper gains and losses into
cash gains and losses on a daily basis.
D. It is similar to terminating a contract at the end of each day and reopening it the next day.
4. Which of the following forms of clearing is the most effective?

A. Direct clearing
B. Netting
C. Complete clearing
D. Clearing ring
5. Which of the following terms best describe the ability to purchase from one party and to sell to
a different party when transacting a futures contract on an exchange?
A. Offset
B. Fungible
C. Mark-to-market
D. Cleared transaction
6. When looking at bilateral and central clearing which of the following statements are correct?
I. Bilateral clearing makes use of a master agreement with a credit support annexure (CSA).
II. Central clearing is when the two parties use a central clearinghouse to reduce exposure to
the credit risk of the transaction.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

7. Which is the biggest OTC derivative market?

A. Foreign exchange derivatives.
B. Interest rate derivatives.
C. Credit derivatives.
D. Equity derivatives
8. What method is used to value the size of the OTC derivatives market?
A. Gross notional value
B. Net notional value
C. Market value
D. DCF
9. Which of the following risk mitigating structures is he most commonly used today?
A. Special purpose vehicles (SPVs)
B. Derivative product companies (DPCs)
C. Credit derivative product companies (CDPCs)
D. Central Counterparties (CCPs)
10. Which of the following statements is not correct when dealing with CCPs?
A. CCPs prioritize OTC parties over the other parties such as bondholders. This passes risk on
to other markets.
B. CCPs are not exposed to legal risk.
C. CCPs, when managing counterparty risk are not exposed to residual risk as they match all
of their trades.
D. CCP members are required to post initial and variation margin.
11. Which of the following statements regarding margins on a futures contract are not correct?
A. The initial margin on a futures contract acts like a down payment for the commitment to
purchase the underlying at the future date.
B. The margin requirements are set by the clearinghouse.
C. In most cases the futures margin is much higher than the stock margin.
D. The margin on a futures contract are set based on historical price movements.
12. Which of the following statements regarding the role of a clearinghouse are not correct?
A. The Clearinghouse protects itself by enforcing monthly settlement of outstanding positions
B. This process of daily settlement is called marking-to-market.
D. Marking-to-market is similar to terminating a contract at the end of each day and
reopening it the next day.

13. When assessing margin requirements in centrally cleared and bilateral markets, which of
the following statements are correct?
I. Margin requirements involve the setting of initial and variation margin for OTC
transactions.
II. Margins must be posted in cash or marketable securities and act as collateral for the OTC
transaction.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
14. Which of the following types of netting result in the greatest amount of risk reduction?
A. No netting
B. Central netting
C. Bilateral netting
D. Pooled netting

SOLUTIONS
1. C
Standardized products. Standardized terms include, maturity, size, price, delivery etc.
2. D
The key functions of an exchange are:
 Trading venue. This can be a physical location or an online platform.
 Standardized products. Standardized terms include, maturity, size, price, delivery etc.
 Reporting. Prices are reported to various market participants.
3. A
The Clearinghouse protects itself by enforcing daily settlement of outstanding positions from
the buyer and the seller. This prevents form large amounts building up and not being collected.
This process of daily settlement is called marking-to-market.
This procedure of marking to market is essentially translating paper gains and losses into cash
gains and losses on a daily basis.
It is similar to terminating a contract at the end of each day and reopening it the next day.
4. C
Complete clearing. Clearing is done through the central counterparty (CCP). As apposed to
members doing their own clearing, clearing is done through an independent third party. The
CCP assumes the contractual responsibilities of the exchange members that The serves to
reduce counterparty risk. The CCP makes use of initial and variation margin to reduce risk.
5. B
Fungibility describes the ability to purchase from one party and to sell to a different party when
transacting a futures contract on an exchange.
6. C
Bilateral clearing makes use of a master agreement with a credit support annexure (CSA).
Central clearing is when the two parties use a central clearinghouse to reduce exposure to the
credit risk of the transaction.
7. B
Interest rate derivatives.
8. A
Gross notional value
9. D
The most effective method of reducing risk within the OTC market is by using CCPs.

10. B
 CCPs prioritize OTC parties over the other parties such as bondholders. This passes risk on
to other markets.
 CCPs are exposed to legal risk.
 CCPs, when managing counterparty risk are not exposed to residual risk as they match all of
their trades.
 CCP members are required to post initial and variation margin.
11. C
The initial margin on a futures contract acts like a down payment for the commitment to
purchase the underlying at the future date. This payment is like a good-faith payment
(normally less than 10% of the price). These margin requirements are set by the clearinghouse.
In most cases the stock margin is much higher than the futures margin. The margin on a
futures contract are set based on historical price movements. The margin requirement will take
into account normal price movements and the fact that accounts are marked-to-market on a
daily basis.
12. A
This process of daily settlement is called marking-to-market. This procedure of marking to
market is essentially translating paper gains and losses into cash gains and losses on a daily
basis. It is similar to terminating a contract at the end of each day and reopening it the next day.
13. C
Margin requirements involve the setting of initial and variation margin for OTC
transactions. These margins must be posted in cash or marketable securities and act as
collateral for the OTC transaction.
14. B
Central netting results in the greatest amount of risk reduction.

Topic - 30
Central Clearing [FMP - 6]
Learning Objectives
Central Clearing
LO 30 a: Provide examples of the mechanics of a central counterparty (CCP).

LO 30 b: Describe the role of CCPs and distinguish between bilateral and centralized clearing.
LO 30 c: Describe advantages and disadvantages of central clearing of OTC derivatives.
LO 30 d: Explain regulatory initiatives for the OTC derivatives market and their impact on central
clearing.
LO 30 e: Compare margin requirements in centrally cleared and bilateral markets, and explain how
margin can mitigate risk.
LO 30 f: Compare and contrast bilateral markets to the use of novation and netting.
LO 30 g: Assess the impact of central clearing on the broader financial markets.
LO 30 h: Identify and explain the types of risks faced by CCPs.
LO 30 i: Identify and distinguish between the risks to clearing members as well as non-members.

QUESTIONS
1. Which of the following is not a category of central clearing?

A. Long history of clearing.
B. No history of clearing.
C. Average history of clearing.
D. No history, but planning to be cleared in the future.
2. When assessing the mechanics of a central counterparty (CCP), which of the following
conditions need to be in place:
I. Legal and economic terms need to be standardized.
II. Level of complexity needs to be low
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following is not an advantage of central clearing of OTC derivatives?

A. Loss mutualization
B. The CCP offsets transactions resulting in improved flexibility and reduced costs.
C. Product liquidity
D. Adverse selection
4. Which of the following is not an advantage of central clearing of OTC derivatives?

A. Bifurcation.
B. Moral hazard.
C. Adverse selection.
D. Loss Mutualization
5. Which of the following regarding margin requirements in centrally cleared and bilateral
markets is not correct?
A. The margins on an OTC contract are set based on expected price movements.
B. The margin requirement will take into account normal price movements and the fact that
accounts are marked-to-market on a daily basis.
C. The clearinghouse will collect and disburse money on a daily basis.
D. By carefully setting the correct margin requirements the clearinghouse can adequately
manage the risk of default.
6. When assessing margin requirements in centrally cleared and bilateral markets, which of
the following statements are correct?
I. Margin requirements involve the setting of initial and variation margin for OTC
transactions.
II. Margins must be posted in cash or marketable securities and act as collateral for the OTC
transaction.

A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. Which of the following types of netting result in the greatest amount of risk reduction?
A. No netting
B. Central netting
C. Bilateral netting
D. Pooled netting
8. When making use of novation and netting, which of following statements are correct?
I. Novation is a legal process by which the CCP becomes the party instead of the original
buyer and seller.
II. This process converts central trading into bilateral trading.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. When assessing the impact of central clearing on the broader financial markets which of
following statements are correct?
I. Overall, the benefits of a CCP outweigh the disadvantages as a result of overall
systemic risk being reduced.
II. CCPs have not yet proven to be successful for long-dated OTC contracts.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. When assessing the impact of central clearing on the broader financial markets which of
I. CCPs protect the OTC market participants but this may come at the expense of creditors.
II. CCPs have not yet proven to be successful for long-dated OTC contracts.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. Which of the following statements regarding operational risk faced by the CCP are not correct?
A. Operational risks are the internal risks faced by the firm.
B. Operational risk arises as a result of people and processes that combine to produce the
firm’s output.
C. Operational risks are non-financial risks.

D. The factors that give rise to operational risk are external.
12. When assessing the loss allocation methods available to the CCP, which of the following
statements are correct:
I. Variation margin gains haircutting (VMGH) is when the full value of the amount owed is
not received by the member.
II. A tear-up is when the unmatched positions are terminated.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
13. Which of the following statements regarding liquidity risk faced by the CCP are not correct?
A. Liquidity risk is present due to the large amounts are cash received (margins) and paid out
by the CCP.
B. The CCP will invest in short-term secure investments (Treasury bills, repos, short-
term deposits) in order to reduce both credit and liquidity risk.
C. The CCP will need to have a certain amount of their investments easily convertible to cash
in the event of a payment being needed or a member defaulting.
D. The Basel I requirements set out the various capital that is required to be maintained.
14. Which of the following statements regarding model risk faced by the CCP are not correct?
A. Since OTC derivatives are not priced by the market, but rather via the use of models, they
are exposed to model risk.
B. An error in the model can be a serious matter.
C. Models tend to be nonlinear in nature, which may not be effective for a large position that
increases in a linear manner.
D. A margin multiplier may be needed to correct for model risk.
15. Which of the following risks best describes the following statement. “The risk of default and
credit exposure to the member of the CCP increase at the same time”.
A. Settlement risk
B. Concentration risk
C. Wrong-way risk
D. Sovereign risk
16. Which of the following risks best describes the following statement. “The risk of members of
the CCP and the margins related to this all residing in the same geographical region”.
A. Settlement risk
B. Concentration risk
C. Wrong-way risk
D. Sovereign risk

17. When assessing risks to clearing members as well as non-members which of the following
I. A non-member may not lose anything to the extent that their margins are segregated or
guaranteed, or segregated and guaranteed.
II. If a non-member cannot move his trade away in the event of a clearing member defaulting,
he may incur losses as a result of needing to close out his position.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
18. When assessing risks to clearing members as well as non-members which of the following
I. A non-member of the CCP does not need to contribute to the default fund.
II. A non-member may incur losses depending on the CCP’s rules of loss allocation
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

SOLUTIONS
1. C
OTC derivatives can be broken down into four categories of central clearing:
A. Long history of clearing – e.g. interest rate swaps.
B. No history (not suitable for clearing) – e.g. exotic or illiquid derivatives.
C. Short history of clearing – e.g. indexed credit default swaps.
D. No history, but planning to be cleared in the future – e.g. interest rate swaptions.
2. C
In order for an OTC product to be centrally cleared, the following conditions need to be in
place:
I. Legal and economic terms need to be standardized.
II. Level of complexity needs to be low – this includes valuation so that margining and mark-
to-market
3. D
Advantages of a CCP
 Loss mutualization is when the members of the CCP contribute towards a default fund.
The fund will cover losses that cannot be recovered from the defaulting member.
 The CCP offsets transactions resulting in improved flexibility and reduced costs.
 Product liquidity is improved as a result of daily margining and improved valuations.
 As a result of central clearing operational efficiency is improved and costs are reduced.
4. D
Disadvantages of a CCP
 Exotic derivatives are not cleared by the CCP.
 Only clearing members are allowed to clear.
 The concept of bifurcation, in other words when trading is done on instruments where
some are cleared and others are not, increases cash flow volatility for all participants.
 Moral hazard is present when clearing, as members tend to take excessive risks knowing
that hey are covered by the CCP.
 Adverse selection is when market participants with superior knowledge and skills trade
products that are underpriced by the CCP.
5. A
The margins on an OTC contract are set based on historical price movements. The margin
requirement will take into account normal price movements and the fact that accounts are
marked-to-market on a daily basis.
The clearinghouse will collect and disburse money on a daily basis. By carefully setting the
correct margin requirements the clearinghouse can adequately manage the risk of default.

6. C
Margin requirements involve the setting of initial and variation margin for OTC
transactions. These margins must be posted in cash or marketable securities and act as
collateral for the OTC transaction.
7. B
Central netting results in the greatest amount of risk reduction.
8. A
Novation is a legal process by which the CCP becomes the party instead of the original buyer
and seller.
This process converts bilateral trading into central trading.
9. C
Overall, the benefits of a CCP outweigh the disadvantages as a result of overall systemic
risk being reduced.
CCPs have not yet proven to be successful for long-dated OTC contracts.
10. C
CCPs protect the OTC market participants but this may come at the expense of creditors. CCPs
have not yet proven to be successful for long-dated OTC contracts.
11. D
Operational risks are the internal risks faced by the firm. This risk arises as a result of people
and processes that combine to produce the firm’s output. These risks are non-financial risks.
The factors that give rise to this risk may be external, but the risk is an internal one.
12. C
Examples of loss allocation methods include:
 Variation margin gains haircutting (VMGH). In this case a haircut is taken on the full
value. In other words, the full value of the amount owed is not received by the member.
 A tear-up is when the unmatched positions are terminated. Any losses can be recovered
from the defaulting party’s margin account or from the default fund.
13. D
Liquidity risk is present due to the large amounts are cash received (margins) and paid out by
the CCP. The CCP will invest in short-term secure investments (Treasury bills, repos,
short- term deposits) in order to reduce both credit and liquidity risk.
The CCP will need to have a certain amount of their investments easily convertible to cash in
the event of a payment being needed or a member defaulting.
The Basel III requirements set out the various capital that is required to be maintained.

14. C
Since OTC derivatives are not priced by the market, but rather via the use of models, they are
exposed to model risk.
Keep in mind that the values are important as they determine the amount of initial and
variation margin. Hence an error in the model can be a serious matter.
Models tend to be linear in nature, which may not be effective for a large position that increases
in a nonlinear manner. A margin multiplier may be needed for this.
15. C
The risk of default and credit exposure to the member of the CCP increase at the same time =
wrong-way risk.
16. B
The risk of members of the CCP and the margins related to this all residing in the same
geographical region = concentration risk.
17. C
A non-member may not lose anything to the extent that their margins are segregated or
guaranteed, or segregated and guaranteed. A non-member also needs to consider if he can
move his trade away in the event of a clearing member defaulting. If not, he may incur losses as
a result of needing to close out his position.
18. C
A non-member of the CCP does not need to contribute to the default fund. As such, in the event
of a CCP failure the non-member may not be impacted to the extent that the clearing member is
still solvent. However, non-members may still be impacted depending on the CCP’s rules of
loss allocation – a portion of losses due to VMGH or tear-up may be passed on to the non-
member.

Topic - 31
Futures Markets [FMP - 7]
Learning Objectives
Futures Markets
LO 31 a: Define and describe the key features of a futures contract, including the underlying asset,
the contract price and size, trading volume, open interest, delivery, and limits.
LO 31 b: Explain the convergence of futures and spot prices.
LO 31 c: Describe the rationale for margin requirements and explain how they work.
LO 31 d: Describe the role of an exchange in futures and over-the-counter market transactions.
LO 31 e: Identify the differences between a normal and inverted futures market.
LO 31 f: Explain the different market quotes.
LO 31 g: Describe the mechanics of the delivery process and contrast it with cash settlement.
LO 31 h: Evaluate the impact of different trading order types.
LO 31 i: Describe the application of marking to market and hedge accounting for futures.
LO 31 j: Compare and contrast forward and futures contracts.

QUESTIONS
1. Which of the following is not a characteristic of a futures contract?

A. The transaction is reported to a recognized exchange
B. The transaction is reported to a clearinghouse
C. The transaction is reported to certain regulatory agencies
D. The terms of the transaction are customized
2. Which of the following statements regarding the payoff and profit of a put option at expiry are
correct?
I. The basis is defined as the difference between the spot price of the asset and the futures
price.
II. As the futures contract nears expiry, the spot price and the futures price start to converge
and the basis should approach zero.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements regarding margins on a futures contract are not correct?
A. The initial margin on a futures contract acts like a down payment for the commitment to
purchase the underlying at the future date.
B. The margin requirements are set by the clearinghouse.
C. In most cases the futures margin is much higher than the stock margin.
D. The margin on a futures contract are set based on historical price movements.
4. Which of the following statements regarding the role of a clearinghouse are not correct?
A. The Clearinghouse protects itself by enforcing monthly settlement of outstanding positions
B. This process of daily settlement is called marking-to-market.
D. Marking-to-market is similar to terminating a contract at the end of each day and reopening
it the next day.
5. A platinum producer, with a December year end, sells a Dec 2021 platinum contract in June
2020. The price of the futures contract is $1,400 per ounce. Each contract is for the sale of 100
ounces of platinum. Assume the following spot prices of platinum:
 December 2020, $1,300.
 December 2021, $1,500.
What is the recorded accounting profit for the year ended 31 December 2021?
A. $20,000 gain.
B. $10,000 gain.
C. $10,000 loss.

D. $20,000 loss.
6. A platinum producer, with a December year end, sells a Dec 2021 platinum contract in
June 2020. The futures contract is sold as a hedge for expected production as at 31 December
2021.The price of the futures contract is $1,400 per ounce. Each contract is for the sale of 100
ounces of platinum. Assume the following spot prices of platinum:
 December 2020, $1,300.
 December 2021, $1,500.
What is the recorded accounting profit for the year ended 31 December 2021?
A. $20,000 gain.
B. $10,000 gain.
C. $10,000 loss.
D. $20,000 loss.
7. Which of the following statements regarding normal and inverted futures markets are correct?
I. In the event that prior settlement prices are rising over time we call this normal market.
II. In the event that prior settlement prices are dropping over time we call this an inverted
futures market.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. When dealing with a futures quote, which of the following headings most likely represents the
difference between yesterday’s closing price and the last price currently traded?
A. The high column
B. The change column
C. The last column
D. The prior settlement column
9. Which of the following methods is not a valid method for settlement of a futures contact?
A. Bilateral clearing
B. Cash settlement
C. Offsetting
D. Exchange for physicals (EFP)
10. An order to buy or sell a stock at the best current price is called a_______order.
A. Market order
B. Limit order
C. All-or-nothing order
D. Hidden orders

11. An experienced commodities risk manager is examining corn futures quotes from the CME
Group. Which of the following observations would the risk manager most likely view as a
potential problem with the quotation data?
A. The volume in a specific contract is greater than the open interest.
B. The prices indicate a mixture of normal and inverted markets.
C. The settlement price for a specific contract is above the high price.
D. There is no contract with maturity in a particular month.

SOLUTIONS
1. D
Features of a futures contract
 The transaction is reported to a recognized exchange (a futures exchange)
 The transaction is reported to a clearinghouse
2. C
The basis is defined as the difference between the spot price of the asset and the futures price.
Basis = Spot price less futures price
As the futures contract nears expiry, the spot price and the futures price start to converge and
the basis should approach zero.
3. C
The initial margin on a futures contract acts like a down payment for the commitment to
purchase the underlying at the future date. This payment is like a good-faith payment
(normally less than 10% of the price). These margin requirements are set by the clearinghouse.
In most cases the stock margin is much higher than the futures margin. The margin on a
futures contract are set based on historical price movements. The margin requirement will take
into account normal price movements and the fact that accounts are marked-to-market on a
daily basis.
4. A
This process of daily settlement is called marking-to-market. This procedure of marking to
market is essentially translating paper gains and losses into cash gains and losses on a daily
basis. It is similar to terminating a contract at the end of each day and reopening it the next day.
5. D
Profit or loss for the year ended 31 December 2020
($1,400 - $1,300) x 100 = gain of $10,000.
($1,300 - $1,500) x 100 = loss of $20,000.
6. C
Zero. The reason for this is that we delay the accounting treatment until such time as
the hedged item is produced and sold.
($1,400 - $1,500) x 100 = loss of $10,000.

7. C
The prior settlement represents the closing price from yesterday and to the extent that the
futures contract prices are increasing) we call this a normal futures market. In the event that
prior settlement prices are dropping we call this an inverted futures market.
8. B
The change column represents the difference between yesterday’s closing price and the
last price currently traded.
9. A
Physical delivery
Cash settlement
Offsetting
Exchange for physicals (EFP)
10. A
Market orders – This is an order to buy or sell a stock at the best current price.
Limit orders – The individual placing a limit order specifies the buy or sell price.
All-or-nothing orders will only be executed if the entire order can be filled.
 Hidden orders are orders where only the broker knows the full volume that is to
be traded.
11. C
The reported high price of a futures contract should reflect all prices for the day, so the
settlement price should never be greater than the high price.

Topic - 32
Using Futures for Hedging [FMP - 8]
Learning Objectives
Using Futures for Hedging
LO 32 a: Define and differentiate between short and long hedges and identify their appropriate
uses.
LO 32 b: Describe the arguments for and against hedging and the potential impact of hedging on
firm profitability.
LO 32 c: Define the basis and explain the various sources of basis risk, and explain how basis risks
arise when hedging with futures.
LO 32 d: Define cross hedging, and compute and interpret the minimum variance hedge ratio and
hedge effectiveness.
LO 32 e: Compute the optimal number of futures contracts needed to hedge an exposure, and
explain and calculate the “tailing the hedge” adjustment.
LO 32 f: Explain how to use stock index futures contracts to change a stock portfolio’s beta.
LO 32 g: Explain how to create a long-term hedge using a “stack and roll” strategy and describe
some of the risks that arise from this strategy.

What is basis risk?
Basis risk is the risk that the value of the hedging instrument will not move in line with
that of the underlying exposure. Another definition of basis risk is the risk that the hedging
instrument spread (for example, the cash futures) will widen or narrow during the time
that the hedge is in place.
QUESTIONS
1. Which of the following is not a characteristic of a short hedge?

A. The hedger sells a futures contract to hedge his position.
B. The hedger currently has a short position in the underlying asset.
C. The hedger expects the market to fall and hence the value of his long position to drop.
D. The short position in the futures contract will rise in value as the market falls thus
offsetting the losses on the long asset position.
2. Which of the following statements is not correct when looking at the disadvantages of hedging?
A. Hedging comes at a cost that often offsets some of the gains made from the underlying
transaction.
B. In the event that hedging protects the company, the question must be asked if the
shareholders could not have hedged themselves in an easier and more efficient manner.
C. There may be instances where the underlying asset is hedged by another activity within
the firm, in other words a natural hedge.
D. Hedging may be necessary to the extent that any price increases incurred by the firm as a
result of increased input costs can be passed on directly to the consumer.
3. Which of the following statements regarding the strengthening and weakening of the basis are
correct?
I. Strengthening of the basis – when the spot price of the asset increases at a faster rate than
the futures price over the time horizon.
II. Weakening of the basis – when the futures price increases at a faster rate than the spot
price of the asset over the time horizon..
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. In the in the event that a maturity mismatch exists between the asset and hedging instrument,
basis risk will exist. This is an example of a__________ mismatch.
A. Liquidity mismatch
B. Duration mismatch
C. Credit mismatch
D. Roll-over mismatch

5. Which of the following ratios best defines the optimal hedge ratio?
6. Which of the following statements regarding the coefficient of determination (R2) of the hedge
ratio, are correct?
I. The coefficient of determination (R2) can be used to determine the effectiveness of the
hedge.
II. The R2 measures how well the dependent variable (futures price) explain the
variability in the independent variable (spot prices).
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

The size of the portfolio is $100m. The Beta of the portfolio is 1.5 relative to the stock index. The
stock index futures are trading at $1,500 with a multiplier of 250.
Which of the following options in order to hedge the portfolio with futures is correct?
A. Buy 400 futures contracts.
B. Sell 400 futures contracts.
C. Buy 100,000 futures contracts.
D. Sell 100,000 futures contracts.

Initial information:
The size of the portfolio is $100m. The Beta of the portfolio is 1.5 relative to the stock index. The
stock index futures are trading at $1,500 with a multiplier of 250.
Subsequent information:
The stock index futures are trading at $1,600 with a multiplier of 250 and the spot price of the
sock index is $1,400.
The total number of futures contracts needed, after adjustment will be:
A. Buy 400 futures contracts.
B. Sell 400 futures contracts.
C. Buy 350 futures contracts.
D. Sell 350 futures contracts.
9. Manager Adjust a lot manages an equity portfolio with a market value of $10m and a beta of
0.9. He wishes to adjust the beta of the portfolio to 1.4. The current futures price is $150,000.
Calculate the number of contracts needed to adjust the portfolio to a beta of 1.4.

A. Buy 33.33 contracts

B. Sell 33.33 contracts
C. Buy 33.33 contracts
D. Sell 33.33 contracts
10. Which of the following statements regarding rollover risk, are correct?
I. In the event that the maturity of the hedge is shorter than the maturity of the underlying
asset, then the hedge will need to be rolled over when it expires, for a further period.
II. Rollover risk exists when we rollover as a result of being exposed to both the basis risk of
the initial transaction as well as the basis risk of the new transaction.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. A German housing corporation needs to hedge against rising interest rates. It has chosen to use
futures on 10-year German government bonds. Which position in the futures should the
corporation take, and why?
A. Take a long position in the futures because rising interest rates lead to rising futures prices.
B. Take a short position in the futures because rising interest rates lead to rising futures
prices.
C. Take a short position in the futures because rising interest rates lead to declining futures
prices.
D. Take a long position in the futures because rising interest rates lead to declining futures
prices.

SOLUTIONS
1. B
The hedger sells a futures contract to hedge his position.
The hedger currently has a long position in the underlying asset.
The hedger expects the market to fall and hence the value of his long position to drop. The
short position in the futures contract will rise in value as the market falls thus offsetting the
losses on the long asset position.
2. D
Hedging also presents the following disadvantages:
 Hedging comes at a cost that often offsets some of the gains made from the
underlying transaction.
 In the event that hedging protects the company, the question must be asked if the
shareholders could not have hedged themselves in an easier and more efficient manner.
 There may be instances where the underlying asset is hedged by another activity within
the firm, in other words a natural hedge. Thus the need for a hedge by using a
futures contract may prove to be expensive and unnecessary.
 Hedging may be unnecessary to the extent that any price increases incurred by the firm as
a result of increased input costs can be passed on directly to the consumer. In this
way there is no need to hedge as all the increased costs can be passed on to the consumer.
3. C
Strengthening of the basis – when the spot price of the asset increases at a faster rate than the
futures price over the time horizon.
Weakening of the basis – when the futures price increases at a faster rate than the spot price of
the asset over the time horizon.
4. B
 Liquidity mismatch – in the event that the asset is hedged with an illiquid hedging
instrument, basis risk will exist.
 Maturity / duration mismatch – in the event that a maturity mismatch exists between the
asset and hedging instrument, basis risk will exist.
 Credit mismatch - in the event that a credit mismatch exists between the asset and hedging
instrument, basis risk will exist.
5. B
The optimal hedge ratio can be calculated as follows:

6. A
The coefficient of determination (R2), or goodness of fit calculation, can be used to determine
the effectiveness of the hedge. In other words how well does the independent variable (futures
price) explain the variability in the dependent variable (spot prices).
7. B
The first step is to apply the formula:
Based on this we need to sell approximately 400 contracts in order to hedge our long stock
position.
8. D
The total number of futures contracts needed, will now be:
9. A
10. C
In the event that the maturity of the hedge is shorter than the maturity of the underlying asset,
then the hedge will need to be rolled over when it expires, for a further period. This is to ensure
that it matches the maturity of the underlying asset. Rollover risk exists when we rollover as a
result of being exposed to both the basis risk of the initial transaction as well as the basis risk of
the new transaction.
11. C
Government bond futures decline in value when interest rates rise, so the housing corporation
should short futures to hedge against rising interest rates.

Topic - 33
Foreign Exchange Markets [FMP - 9]
Learning Objectives
Foreign Exchange Markets
LO 33 a: Explain and describe the mechanics of spot quotes, forward quotes, and futures quotes in
the foreign exchange markets, and distinguish between bid and ask exchange rates.
LO 33 b: Calculate bid-ask spread and explain why the bid-ask spread for spot quotes may be
different from the bid-ask spread for forward quotes.
LO 33 c: Compare outright (forward) and swap transactions.
LO 33 d: Define, compare, and contrast transaction risk, translation risk, and economic risk.
LO 33 e: Describe examples of transaction, translation, and economic risks, and explain how to
hedge these risks.
LO 33 f: Describe the rationale for multi-currency hedging using options.
LO 33 g: Identify and explain the factors that determine exchange rates.
LO 33 h: Calculate and explain the effect of an appreciation/depreciation of a currency relative to a
foreign currency.
LO 33 i: Explain the purchasing power parity theorem and use this theorem to calculate the
appreciation or depreciation of a foreign currency.
LO 33 j: Describe the relationship between nominal and real interest rates.
LO 33 k: Describe how a non-arbitrage assumption in the foreign exchange markets leads to the
interest rate parity theorem, and use this theorem to calculate forward foreign exchange rates.
LO 33 l: Distinguish between covered and uncovered interest rate parity conditions.

QUESTIONS
1. Which of the following hedging instruments is the most effective instrument to manage
translation risk?
A. Forwards.
B. Futures.
C. Swaps.
D. Financing assets and liabilities in the same currency.
2. The following information is available on 31 December 2019:
What is the amount of the forward premium?

A. 16.48%
B. -16.48%
C. 0.3336
D. -0.3336
3. An entity is due a dividend from an overseas subsidiary in 2 months-time. What would the
entity be hoping for?
A. Foreign currency strength.
B. Foreign currency weakness.
C. No movement in the foreign currency.
D. Cannot be determined.
4. An entity is due to make a payment in 3 months-time to an overseas supplier. What would the
entity be hoping for?
A. Foreign currency strength.
B. Foreign currency weakness.
C. No movement in the foreign currency.
D. Cannot be determined.
5. Which type of option works on the average price of the underlying asset during the life of the
contract?
A. Asian option.
B. Knock-in option.
C. Basket option.
D. Exotic option.
6. Which theory works on the relationship between exchange rates and inflation rates
between the two countries?
A. Purchasing power parity.
B. Covered interest rate parity.

C. Uncovered interest rate parity.

D. Taylor rule.
7. Assume that an entity is exposed to three currencies, X, Y, and Z and implements the
following option strategy.
Buy an option on currency X
Buy on option on currency Y
Sell an option on currency Z
What type of option strategy us being used?
A. Asian option.
B. Knock-in option.
C. Basket option.
D. Exotic option.
8. Which of the following statements are not correct when dealing with the interest rate parity
theory?
9. Which of the following statements are correct regarding purchasing power parity?
I. There is a direct relationship between currencies and inflation rates, called the purchase
power parity theory.
II. This theory states that the difference between a spot and forward rate for a currency quote
can be attributed to the difference between the expected inflation rates (inflation rate
differential) of the two countries.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. Which of the following statements are correct when describing the relationship between
nominal and real interest rates? A base currency’s exchange rate is likely to increase if:
A. It’s short-term real exchange rate rises.
B. It’s real or nominal interest rates rise. This will attract foreign capital.
C. The foreign inflation rate increases. This will cause the foreign currency to depreciate.
D. The foreign risk premium increases. This will make foreign assets less attractive.

SOLUTIONS
1. D
The best way to mitigate translation risk is to finance the assets in a country with loans in that
country and currency.
2. C
Premium calculation
3. A
Foreign currency gains and losses occur as follows:
4. C
Foreign currency gains and losses occur as follows:

5. A
An Asian option works on the average price of the underlying asset during the life of
the contract.
6. A
Purchasing power parity (PPP)
7. C
Assume that an entity is exposed to three currencies, X, Y, and Z. A basket option involves the
following type of transaction:
Buy an option on currency X
Buy on option on currency Y
Sell an option on currency Z
8. A
 There is a direct relationship between currencies and interest rates, called the interest rate
parity theory.
 This theory states that the difference between the spot and the forward rates for a currency
quote can be attributed to the difference between the expected interest rates (interest rate
9. C
Purchasing power parity works as follows:
 There is a direct relationship between currencies and inflation rates, called the purchase
power parity theory.
 This theory states that the difference between a spot and forward rate for a currency quote
can be attributed to the difference between the expected inflation rates (inflation rate
10. A
A base currency’s exchange rate is likely to increase if:
 It’s long-term real exchange rate rises.
 It’s real or nominal interest rates rise. This will attract foreign capital.
 The foreign inflation rate increases. This will cause the foreign currency to depreciate.
 The foreign risk premium increases. This will make foreign assets less attractive.

Topic - 34
Pricing Financial Forwards and Futures [FMP - 10]
Learning Objectives
Pricing Financial Forwards and Futures
LO 34 a: Differentiate between investment and consumption assets.

LO 34 b: Define short-selling and calculate the net profit of a short sale of a dividend-paying stock.
LO 34 c: Describe the differences between forward and futures contracts and explain the
relationship between forward and spot prices.
LO 34 d: Calculate the forward price given the underlying asset’s spot price, and describe an
arbitrage argument between spot and forward prices.
LO 34 e: Distinguish between the forward price and the value of a forward contract.
LO 34 f: Calculate the value of a forward contract on a financial asset that does or does not provide
income or yield.
LO 34 g: Explain the relationship between forward and futures prices.
LO 34 h: Calculate a forward foreign exchange rate using the interest rate parity relationship.
LO 34 i: Calculate the value of a stock index futures contract and explain the concept of index
arbitrage.

QUESTIONS
1. Which of the following calculations regarding investment and consumption assets are correct?
I. An example of an investment asset would be a fixed income security.
II. An example of a consumption asset would be oil or gas.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Which of the following are not steps in the short selling process?
A. The investor buys the security from a broker
B. The investor then sells the security.
C. The investor will keep a potion of the sale proceeds on deposit with the broker as collateral
to guarantee the final repurchase of the security.
D. The investor returns the borrowed security when the sale is closed out.
3. Which of the following statements is not a characteristic of a futures contract?

A. More transparent
B. More liquid
C. High default risk
D. Value at inception = 0
4. Assume that the calculated forward price is $5,000, straight after the inception of the contract
the stock is priced at $6,000. The risk-free rate is 6%. The continuously compounded dividend
yield is 3%. The forward expires in 6 months time.
What is the value of the forward contract?
A. $5,910.67
B. $4,852,22
C. $1,058.44
D. $1,000.00
5. Which of the following relationships between forward and futures prices are correct?
I. A big difference between forwards and futures is that in futures contracts they are
marked-to-market daily and margin payments are made.
II. In the event that the interest rate is known and the T is small there is a significant
difference between the pricing of forward and futures contracts.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.


The domestic currency is the US dollar and the foreign currency is the Swiss franc.
The spot rate is $0.5987.
The contract is set to mature in 180 days.
US interest rate = 5.5%
Swiss interest rate = 4.75%
What is the price of the currency forward?
A. 0.5987
B. 0.5994
C. 0.6034
D. 0.5980
7. Which of the following statements regarding the futures price incorporating storage costs is
correct?
8. The current price of an asset is $100 and the continuously compounded interest rate is 5%. An
interim cash flow of $10 is received after 6-months into the contract. What is the price of a 9-
month forward contract?
A. $9.75
B. $93.69
C. $100.00
D. $10.00
9. Assume that the index is currently trading at 3,000 points. The risk-free rate is 6% and the
dividend yield is 3%. The term of the contract is for six months. What Is the price of the index
futures contract?
A. 3,043 points
B. 3,000 points
C. 3,045 points
D. 3,089 points
10. A risk manager deciding between buying a futures contract on exchange and buying a forward
contract directly from a counterparty on the same underlying asset. Both contracts would have
the same maturity and delivery specifications. The manager finds that the futures price is less
than the forward price. Assuming no arbitrage opportunity exists, what single factor acting
alone would be a realistic explanation for this price difference?
A. The futures contract is more liquid and easier trade.
B. The forward contract counterparty is more likely to default.
C. The asset strongly negatively correlated with interest rates.
D. The transaction costs on the futures contract are less than on the forward contract.

SOLUTIONS
1. C
An investment asset is held for the purposes of investing. Examples of such assets
include, equities, bonds, derivatives and alternative investments.
A consumption asset is held for the purpose of being consumed. An example of such an asset
may be a commodity that is consumed in a production process (such as metal) or a commodity
that is consumed as part of our daily lives (such as oil or gas).
2. A
 The investor borrows the security from a broker and then sells the security.
 The investor will keep a potion of the sale proceeds on deposit with the broker as collateral
to guarantee the final repurchase of the security.
 The investor returns the borrowed security when the sale is closed out or the
lender requests the security back. The manner in which the security is returned to the
lender is by the investor buying the security back on the market.
3. C
Futures contract characteristics:
More transparent
More liquid
Clearinghouse limits risk
Value at inception = 0
4. C
5. A
A big difference between forwards and futures is that in futures contracts they are marked-to-
market daily and margin payments are made.
In the event that the interest rate is known and the T is small there is no significant difference
between the pricing of forward and futures contracts.
6. B
Price of a currency forward:
F0 = 0.5987e(0.05 – 0.0475)0.4932
F0 = 0.5994

7. A
F0 = (S0 + U)erT
This means that the futures price equals the spot price compounded over the life of the futures
contract at the risk free rate plus the value of the storage costs over the life of the contract.
We could express the storage costs in terms on a continuous yield as follows:
F0 = S0e(r+u)T
8. B
The price of a 9-month forward contract can be calculated as follows:
I = the present value of the interim cash flows
9. A
10. C
When an asset is strongly negatively correlated with interest rates, futures prices will tend to be
slightly lower than forward prices. When the underlying asset increases in price, the immediate
gain arising from the daily futures settlement will tend to be invested at a lower than average
rate of interest due to the negative correlation. In this case futures would sell for slightly less
than forward contracts, which are not affected by interest rate movements in the same manner
since forward contracts do not have a daily settlement feature.
The other three choices would all most likely result in the futures price being higher than the
forward price.

Topic - 35
Commodity Forwards and Futures [FMP - 11]
Learning Objectives
Commodity Forwards and Futures
LO 35 a: Explain the key differences between commodities and financial assets.

LO 35 b: Define and apply commodity concepts such as storage costs, carry markets, lease rate, and
convenience yield.
LO 35 c: Identify factors that impact prices on agricultural commodities, metals, energy, and
weather derivatives.
LO 35 d: Explain the basic equilibrium formula for pricing commodity forwards.
LO 35 e: Describe an arbitrage transaction in commodity forwards, and compute the potential
arbitrage profit.
LO 35 f: Define the lease rate and explain how it determines the no-arbitrage values for commodity
forwards and futures.
LO 35 g: Describe the cost of carry model and illustrate the impact of storage costs and convenience
yields on commodity forward prices and no-arbitrage bounds.
LO 35 h: Compute the forward price of a commodity with storage costs.
LO 35 i: Compare the lease rate with the convenience yield.
LO 35 j: Explain how to create a synthetic commodity position, and use it to explain the relationship
between the forward price and the expected future spot price.
LO 35 k: Explain the relationship between current futures prices and expected future spot prices,
including the impact of systematic and nonsystematic risk.
LO 35 l: Define and interpret normal backwardation and contango.

QUESTIONS
1. Which of the following areas regarding costs of carry in a commodities forward contract are not
correct?
A. Storage costs and carrying costs are a function of the physical characteristics of the
underlying asset. Some assets are easy to store and others are more difficult.
B. The costs of storage need to be deducted from the price of the contract.
C. The lease rate is the rate that the lessor of the asset will earn from leasing out the unused
asset.
D. A nonmonetary benefit is called a convenience yield.
2. Which of the following areas regarding costs of carry in a commodities forward contract are not
correct?
A. The basic formula used to price commodity forwards assumes a no arbitrage position.
B. The forward price must equal the current spot price plus the costs of carry.
C. The costs of carry include interest costs, storage costs and the convenience yield.
D. The forward price of a commodity will equal: F0,T = Soe-rT
3. Which of the following is not a step in the reverse cash and carry arbitrage process?
A. Buy the asset
B. Sell the asset
C. Lend money
D. Buy the forward contract
4. Assume that the current spot price per ounce of silver is $14.25. The annual lease rate is 6% and
the risk- free rate is 10%. Time to maturity on the contract is 6 months. What is the price of a
forward contract?
A. $14.25
B. $14.54
C. $14.83
D. $13.97
5. Assume that the current spot price per ounce of silver is $14.25. The monthly cost of storage is
$0.15 and the effective monthly risk-free rate is 1%. Time to maturity on the contract is 2
months. Assume discrete compounding for the storage cost component. What is the price of a
forward contract?
A. $14.54
B. $0.3015
C. $14.84
D. $14.25

6. When assessing the range of forward arbitrage prices present in the market (including costs of
carry), which of the following statements are correct?
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. Which of the following statements regarding convenience yields and lease rates are not correct?
A. The lease rate is earned when the commodity is purchased and lent out.
B. The lease rate = Convenience yield – storage costs.
C. There is a negative relationship between the lease rate and the storage costs.
D. It is not possible to get a negative lease rat.
8. Which of the following commodities has the shortest storage period?

A. Gold
B. Corn
C. Oil
D. Electricity
9. Assume the following crack spread 6-4-2 applies to crude oil, gasoline and heating oil. We are
planning to produce gasoline and heating oil from the crude oil in one-month time. The 1-
month forward prices are as follows:
Crude oil = $30 per barrel
Gasoline = $60 per barrel
Heating oil = $45 per barrel
What is the crack spread per barrel?
A. $180
B. $150
C. $25
D. $30
10. Which of the following is not a reason for basis risk when dealing with commodity futures?
A. The hedging instrument is exactly the same as the underlying instrument.
B. The hedge may need to be extended post the initial hedge period.
C. The hedge may need to be liquidated prior to the end of the initial hedge period.
D. When calculating the number of contracts needed to be bought or sold, this number is often
rounded off.
11. A commodity producer is looking for a hedge for his production. Assuming that one of his
main requirements is that the hedge be cheap, which of the following hedges are most likely to
be used?
A. Stack hedge

B. Strip hedge
C. Zero cost collar
D. Caplet
12. When looking to make use of a cross-hedge for a commodity transaction, which of the
following is not a factor that needs to be considered?
A. The term and maturity of the futures contract being used.
B. The correlations between the underlying and the contract.
C. The liquidity of the contract
D. The price risk of the commodity
13. When creating a synthetic commodity position which of the following statements are correct?
I. A synthetic commodity forward price can be created by a combination of: Long
commodity forward (F0,T)) + Zero coupon bond (paying F0,T)) at T.
II. No money changes hands at the outset of the contract.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
14. A risk analyst at a commodities trading firm is examining the supply and demand conditions
for various commodities and is concerned about the volatility of the forward prices for silver in
the medium term. Currently, silver is trading at a spot price of USD 20.35 per troy ounce and
the six- month forward price is quoted at USD 20.50 per troy ounce. Assuming that after six
months the lease rate rises above the continuously compounded interest rate, which of the
following statements is correct about the shape of the silver forward curve after six months?
A. The forward curve will be downward sloping.
B. The forward curve will be upward sloping.
C. The forward curve will be flat.
D. The forward curve will be humped.

SOLUTIONS
1. B
Storage costs and carrying costs are a function of the physical characteristics of the underlying
asset. Some assets are easy to store and others are more difficult.
The costs of storage need to be added to the price of the contract.
The lease rate is the rate that the lessor of the asset will earn from leasing out the unused asset.
A nonmonetary benefit is called a convenience yield.
2. D
The basic formula used to price commodity forwards assumes a no arbitrage position. Based
on this, the forward price must equal the current spot price plus the costs of carry. The costs of
carry include interest costs, storage costs and the convenience yield.
Keeping the above in mind, the forward price of a commodity will equal:
F0,T = SoerT
3. A
Reverse cash and carry arbitrage
Borrow the asset
Sell the asset
Lend money
Buy the forward contract
4. B
Price of a forward contract:
5. C
Assume that the current spot price per ounce of silver is $14.25. The monthly cost of storage is
$0.15 and the effective monthly risk-free rate is 1%. Time to maturity on the contract is
2 months.
Price of a forward contract:
Step 1: Compute the future value of the storage costs

6. C
Range of arbitrage free prices that are present in the market:
7. D
The lease rate is earned when the commodity is purchased and lent out.
The lease rate = Convenience yield – storage costs
There is a negative relationship between the lease rate and the storage costs.
It is possible to get a negative lease rate, when storage costs are very high.
8. D
Electricity is not storable and will go to waste if not consumed.
9. C
10. A
Reasons for basis risk include:
 The hedging instrument is not exactly the same as the underlying instrument. For example,
a commodity producer may hedge his commodity with a futures contract that does not
match his commodity perfectly, for example, a New York producer may hedge his
commodity with a NYMEX future (that specifies delivery in Oklahoma) that are not an
exact matches.
 The hedge may need to be extended post the initial hedge period.
 The hedge may need to be liquidated prior to the end of the initial hedge period.
 When calculating the number of contracts needed to be bought or sold, this number is
often rounded off.
11. A
A stack hedge uses near-dated futures that are often more liquid and cheap than a strip hedge.

12. D
The following factors need to be considered when looking at a cross-hedge:
 The term and maturity of the futures contract being used.
 The correlations between the underlying and the contract.
 The liquidity of the contract (to be able to unwind quickly if need be).
13. C
A synthetic commodity forward price can be created by a combination of: Long
commodity forward (F0,T))+ Zero coupon bond (paying F0,T)) at T. No money changes hands at
the outset of the contract.
14. A
The forward price is computed as: F0,T = Soe(r + λ - c)T And the commodity lease rate () is
computed as  = c - λ. So, the forward price can alternatively be expressed in terms of lease rate
and risk-free rate as: F0,T = Soe(r - δ)T.
Therefore, as the risk-free rate falls below the lease rate (r <  = c - ), we can see from the
forward price formula above that F < S, and the forward curve will be in backwardation.

Topic - 36
Options Markets [FMP - 12]
Learning Objectives
Options Markets
LO 36 a: Describe the types, position variations, payoffs and profits, and typical underlying assets of
options.
LO 36 b: Explain the specification of exchange-traded stock option contracts, including that of
nonstandard products.
LO 36 c: Explain how dividends and stock splits can impact the terms of a stock option.
LO 36 d: Describe how trading, commissions, margin requirements, and exercise typically work for
exchange-traded options.
LO 36 e: Define and describe warrants, convertible bonds, and employee stock options.

QUESTIONS
1. Which of the following statements regarding the principles of option pricing are correct?
A. An option has a positive value at the start.
B. The buyer of the option will pay the option premium and the seller will receive this
premium in order to initiate the contract.
C. Options have symmetrical payoffs.
D. The maximum loss to the buyer (long) is the option premium.
2. Which of the following statements regarding the value of a call option at expiry are correct?
I. At expiry the call option is worth the greater of: Zero, Or the difference between the
underlying price and the exercise price.
II. At expiry the value of the call can be denoted as follows: cT = Max(0, ST – X)
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements regarding the value of a put option at expiry are correct?
I. At expiry the put option is worth the greater of: Zero, Or the difference between the
exercise price and the underlying price
II. At expiry the value of the put option can be denoted as follows: pT = Max(0, X - ST)
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. Assume that the call option exercise price on the S&P index is trading at 1900 for a June
contract. The contract multiplier is 200.
The price of the option is $3000. The S&P was trading at 1950 at the date of expiry of the
contract. What is the gain on the option?
A. $10,000
B. $7,000
C. $50
D. $1,950
5. Consider a bond on a 10-year Treasury bond. The current coupon is 2.0%, the yield is 2.70%.
The price per $1 of par value is equal to $0.9394.
Assume that a call option is issued on this bond at a price of $0.96.
The price of the bond at the expiry of the option is equal to $0.99.
The options contract covers $10m face value of bonds and is cash settled.
What is the gain on the bond option?
A. $99,000
B. $96,000

C. $300,000
D. $3,000
6. Which of the following options best describe the following option “They are predominantly
standardized however do have some customizable options. These include, changing the strike
price, changing the expiry date, European or American options.”
A. Index options
B. FLEX options
C. ETF options
D. DOOM options
7. Which of the following options best describe the following option “if the price is above the
strike price it pays out a certain amount and if not it does not pay out at all.”
A. CEBO options
B. FLEX options
C. ETF options
D. Binary options
8. Which of the following statements regarding options and dividends and stock splits are
correct?
I. Options are not adjusted for dividends.
II. Options are adjusted for stock splits.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
A. $4,000
B. $330
C. $150

D. $50
A. $6,000
B. $5,250
C. $5,070
D. $10,000
11. Company XYZ operates in the US. On April 1, 2016, it has a net trade receivable of EUR
5,000,000 from an export contract to Germany. The company expects to receive this amount on
Oct. 1, 2016. The CFO of XYZ wants to protect the value of this receivable. On April 1, 2016, the
EUR spot rate is 1.14, and the 6-month EUR forward rate is 1.13. The CFO can lock in an
exchange rate by taking a position in the forward contract. Alternatively, the CFO can sell a 6-
month EUR 5,000,000 call option with strike price of 1.14. The CFO thinks that selling an option
is better than taking a forward position because if the EUR goes up, XYZ can take delivery of
the USD at 1.14, which is better than the outright forward rate of 1.13. If the EUR goes down,
the contract will not be exercised. Therefore, XYZ will pocket the premium obtained from
selling the call option. What can be concluded about the CFO’s analysis?
A. The CFO’s analysis is correct. The company is better off whichever way the EUR rate goes.
B. The CFO’s analysis is not correct. The company will suffer if the EUR goes up sharply.
C. The CFO’s analysis is not correct. The company will suffer if the EUR moves within a
narrow range.
D. The CFO’s analysis is not correct. The company will suffer if the EUR goes down sharply.

SOLUTIONS
1. C
An option has a positive value at the start. The buyer of the option will pay the option premium
and the seller will receive this premium in order to initiate the contract. Based on this we can see
that options have asymmetric payoffs. The maximum loss to the buyer (long) is the option
premium.
2. C
At expiry the call option is worth the greater of:
iii) Zero, Or
iv) The difference between the underlying price and the exercise price
cT = Max(0, ST – X)
3. C
At expiry the put option is worth the greater of:
iii) Zero, Or
iv) The difference between the exercise price and the underlying price
pT = Max(0, X - ST)
4. B
The gain on the option will be:
Value of index at expiry 1,950
Less: contract price (1,900)
Gain on the contract 50
X multiplier $200
Gain = $10,000
Less: price paid for option ($3,000)
Net gain $7,000
5. C
Assume that a call option is issued on this bond at a price of $0.96.
The price of the bond at the expiry of the option is equal to $0.99.
The options contract covers $10m face value of bonds and is cash settled.
Gain on the bond option =
($0.99 – $0.96) X $10,000,000
= $300 000
6. B
FLEX options – FLEX options trade on an exchange with the underlying being an equity or
equity index. They are predominantly standardized however do have some customizable
options. These include, changing the strike price, changing the expiry date, European or
American options. The minimum contract size is 100 contracts.

7. D
Binary options – A binary option is an option that only has one payoff profile. For example if the
price is above the strike price it pays out a certain amount and if not it does not pay out. This is
different to normal options that continue to increase as the price moves above the strike price.
8. C
Dividends and stock splits
Options are not adjusted for dividends but are adjusted for stock splits.
9. C
Calculate the cost of the contract
Cost of the call = $40 x 100 shares
= $4,000
Cost of commission = $50 + ($4,000 x 0.7%)
= $330
The commission is limited to a maximum of $150.
10. B
Step 1: Calculate the cost of the contract
Cost of the call = $40 x 100 shares = $4,000
Cost of commission = $50 + ($4,000 x 0.7%) = $330
The commission is limited to a maximum of $150.
Step 2: Calculate the profit on the contract
($600 - $500) x 100 shares = $10,000
($600 - $500) x 100 shares = $10,000
Less commission:
On purchase = ($150)
On sale ($600 x 100 x 1%) = ($600)
Total profit = $5,250
11. D
The CFOs analysis is incorrect because there is unlimited downside risk. The option premium
received is a fixed amount, and if the EUR declines sharply, the value of the underlying
receivable goes down as well. If instead the EUR moves in a narrow range, that would be good,
but there is no guarantee of course that this will occur.

Topic 37
Properties of Options [FMP - 13]
Learning Objectives
Properties of Options
LO 37 a: Identify the six factors that affect an option’s price.

LO 37 b: Identify and compute upper and lower bounds for option prices on non-dividend and
dividend paying stocks.
LO 37 c: Explain put-call parity and apply it to the valuation of European and American stock
options, with dividends and without dividends, and express it in terms of forward prices.
LO 37 d: Explain and assess potential rationales for using the early exercise features of American
call and put options.

QUESTIONS
1. Which of the following statements regarding the vega of option pricing are not correct?
A. Volatility is the standard deviation of the continuously compounded return on the stock.
B. Volatility is an easy measure to calculate.
C. The relationship between the option price and volatility is called vega.
D. Vega is positive on both calls and puts, which means that if the volatility increases so to
will the prices of call and put options.
2. Which of the following statements regarding the rho of an option are correct?
I. Call options increase in value as the risk-free rate increases.
II. Put options decrease in value as the risk-free rate increases..
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements regarding the dividend of an option are correct?
I. The higher the exercise price – the lower the call option price.
II. The higher the exercise price – the higher the put option price.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. When looking at the minimum values for calls and puts for European and American options,
which of the following statements are not correct?
A. European call = c0≥max(0, S0 - Xe-rT)
B. American call = C0≥ max(0, S0 - Xe-rT)
C. European put = p0≥ max(0, Xe-rT - S0)
D. American put = P0≥ max(0, S0 - X)
5. When looking at the maximum values for calls and puts for European and American options,
which of the following statements are not correct?
A. European call = c0<=So
B. American call = C0<=So
C. European put = p0<= Xe-Rt
D. American put = P0<= Xe-rT
6. Assume the following:

X = 100
Risk free rate = 5%
T = 180 days
S = 90

What is the maximum value for a European call option?

A. 0
B. 90
C. 7.53
D. 97.53
7. Which of the following statements regarding the strategy of fiduciary calls are correct?
I. Buying a European call option
II. Selling a risk-free bond
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. When working with the put call parity relationship, which of the following equations are not
correct?
A. c0 + Xe-rT = p0 + S0
B. c0 = p0 + S0 - Xe-rT
C. p0 = c0 - S0 + Xe-rT
D. p0 - S0 = c0 + Xe-rT
9. When assessing early exercise of an American option, which of the following statements are
correct?
I. When the underlying makes no cash payments, C0 = c0
II. When the underlying makes cash payments during the life of the option, early exercise
may be worthwhile and C0 may be higher than c0.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. When assessing the affect of a dividend on a European option, which of the following
statements are correct?
I. c0 ≥ Max [0, [S0 – PV(D,0,T)] – Xe-rT]
II. p0 ≥ Max [0, Xe-rT + PV(D,0,T - S0]
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. The price of a six-month, USD 25.00 strike, European put option on a stock is USD 3.00. The
stock price is USD 26.00. A dividend of USD 1.00 is expected in three months. The
continuously compounded risk-free rate for all maturities is 5% per year. Which of the

following is closest to the value of a call option on the same underlying stock with a strike
price of USD 25.00 and a time to maturity of six months?
A. USD 1.63
B. USD 2.40
C. USD 3.63
D. USD 4.62
SOLUTIONS
1. B
Volatility is the standard deviation of the continuously compounded return on the stock.
Volatility is a difficult measure to calculate. The relationship between the option price and
volatility is called vega. Vega is positive on both calls and puts, which means that if the
volatility increases so to will the prices of call and put options.
2. C
Call options increase in value as the risk-free rate increases.
Put options decrease in value as the risk-free rate increases.
3. C
Dividends
The higher the exercise price – the lower the call option price.
The higher the exercise price – the higher the put option price.
4. D
Minimum values
European call = c0≥max(0, S0 - Xe-rT) American call = C0≥ max(0, S0 - Xe-rT) European put =
p0≥ max(0, Xe-rT - S0) American put = P0≥ max(0, X - S0)
5. D
Maximum values
European call = c0<=So American call = C0<=So European put = p0<= Xe-rT American put =
P0<=X
6. A
c0 ≥ Max [0, S0 – Xe-rT] c0 ≥ Max [0, 90 –100e-0.05(0.5)] c0 ≥ Max [0, 90 – 97.53] c0 ≥ Max [0, -
7.53]
7. A
Fiduciary calls:
This strategy involves:
 Buying a European call option

 Buying a risk-free bond (that matures on the options’ expiration date and has a face value
that is equal to the exercise price of the call)
8. D
c0 + Xe-rT = p0 + S0 c0 = p0 + S0 - Xe-rT p0 = c0 - S0 + Xe-Rt
9. A
When will it be better to exercise the American call option early and lose the “time value” of the
option? An obvious case would be when early exercise would result in a cash payment. An
example would be to exercise just before a stock goes ex-div.
Based on this we could say:

 When the underlying makes no cash payments, C0 = c0
 When the underlying makes cash payments during the life of the option, early exercise
may be worthwhile and C0 may be higher than c0.
10. C
The effect of cash flows on the underlying asset
When cash flows are generated on the underlying this must be taken into account. Just like
with Forwards and futures we assume that we know the cash flows attributable to the
underlying at inception and make a present value adjustment to the price – so to by options we
need to do the same.
Based on this our equations will change slightly to take into account the cash flows on the
underlying asset:
European options – lower bounds:
c0 ≥ Max [0, [S0 – PV(D,0,T)] – Xe-rT]
p0 ≥ Max [0, Xe-rT + PV(D,0,T - S0]
11. C
From the equation for put-call parity, this can be solved by the following equation: c = S0 + p -
PV (K) - PV (D)
where PV represents the present value, so that PV (K) = K x e-rT and PV(D) = D e-rT
Where:
p represents the put price, c is the call price,
K is the strike price of the put option, D is the dividend,
S0 is the current stock price.
T is the time to maturity of the option, and t is the time to the next dividend distribution.
Calculating PV(K), the present value of the strike price, results in a value of 25.00 ∗ e-0.05 x 0.5
or 24.38, while PV (D) is equal to 1.00 ∗ e-0.05 x 0.25, or 0.99. Hence c = 26.00 + 3.00 – 24.38 –
0.99 = USD 3.63

Topic 38
Trading Strategies [FMP - 14]
Learning Objectives
Trading Strategies
LO 38 a: Explain the motivation to initiate a covered call or a protective put strategy.

LO 38 b: Describe principal protected notes (PPNs) and explain necessary conditions to create a
PPN.
LO 38 c: Describe the use and calculate the payoffs of various spread strategies.
LO 38 d: Describe the use and explain the payoff functions of combination strategies.

QUESTIONS
1. Which of the following statements regarding a covered call strategy are not correct?
A. The investor writes a covered call when he believes that the market will not move too far
away from where it is trading at present.
B. The strategy involves selling an out-of-the-money call against the current stock.
C. The sale of the option generates revenue from the premium.
D. In the event that stock prices move up, this will cause a gain on the call.
2. Which of the following statements regarding a protective put strategy are correct?
I. The potential upside on the stock is maintained.
II. The investor’s initial position is equal to: Short stock + Long put option.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. A Oct bull call spread is trading at Oct 25/30 for Bully Inc.
The option premiums are as follows:
$4.00 for the $25 call.
$1.50 for the $30 call.
Assume that the price of the stock closed at $32 – what is the profit / loss on the trade?
A. Gain $2.50
B. Loss $2.50
C. Gain $5.00
D. Gain $5.00
4. Which of the following statements regarding a bear call and a bear put spread are correct?
I. A bear put trade is constructed as follows: Long a put option with a high exercise price +
Selling a put option with a low exercise price.
II. A bear call spread is constructed as follows: Selling a call option with a low exercise price +
Long a call option with a high exercise price.
A. I only
B. II only
C. Both I and II
D. Neither I or II.
5. Jon Vick is a derivatives specialist at Derive Bank. He has constructed a butterfly call spread for
Wings Inc. when the call options are trading as follows:
Call price = $5.00 at an X of $30
Assume that the price of the stock closed at $33 – what is the profit / loss on the trade?
A. Gain $2.00

B. Loss $2.00
C. Loss $1.00
D. Loss $3.00
6. The following options strategy has been suggested:

A long call at the lower strike price (XL)
A short call at the higher strike price (XH)
A long put at the lower strike price (XH)
A short put at the higher strike price (XL)
What type of strategy is this?
A. Diagonal spread
B. Box spread
C. Calendar spread
D. Bull call spread
7. Which of the following structures best describes a long straddle?

A. Long an at-the-money put option + Long an at-the-money call option.
B. Short an at-the-money put option + Short an at-the-money call option
C. Long an at-the-money x 2 put options + Long an at-the-money call option
D. Long an at-the-money x 1 put option + Long an at-the-money 2 x call options.
8. Which of the following structures best describes a short straddle?

A. Long an at-the-money put option + Long an at-the-money call option.
B. Short an at-the-money put option + Short an at-the-money call option
C. Long an at-the-money x 2 put options + Long an at-the-money call option
D. Long an at-the-money x 1 put option + Long an at-the-money 2 x call options.
9. Which of the following statements regarding collars as an option strategy are not correct?
A. A collar can be used to reduce the cost of the hedge.
B. A collar is when options are written or sold and the income received can be used to reduce
the cost of the hedge.
C. A collar strategy would be to sell an out-of-the-money (OTM) put option (protective put)
and to buy an out-of-the-money call option (covered call).
D. The risk of a collar is that it cuts off a part of the upside return in order to secure downside
protection.
10. A borrower needs to use an interest rate option to hedge the risk on a floating rate loan with
several payments he may need to use several interest rate options to hedge this risk. In other
words, a separate option for every payment date. What is this strategy an example of?
A. Interest rate cap
B. Interest rate floor
C. Zero-cost collar
D. Floorlet

11. Jacqui Jones sells a March 2010 call on XYZ stock with an exercise price of $45 for a $3
premium. She also buys a March 2010 call on the same stock with an exercise price of $40 for a
$5 premium. Identify this option strategy and the maximum profit and loss for the investor.
A. Bear call spread, maximum profit is $3, maximum loss is $2.
B. Bull call spread, maximum profit is $3, maximum loss is unlimited.
C. Bear call spread, maximum profit is unlimited, maximum loss is $2.
D. Bull call spread, maximum profit is $3, maximum loss is $2.

SOLUTIONS
1. D
Covered call
The investor writes a covered call when he believes that the market will not move too far away
from where it is trading at present. The strategy involves selling an out-of-the-money call
against the current stock. The sale of the option generates revenue from the premium. In the
event that stock prices move up, this will cause a loss on the call. However, that gain on the
stock will offset his loss on the call option. In addition, he can use the premium written, to
offset a part of his loss.
2. A
Protective puts
A protective put is a risk-management strategy that investor can use to guard against the loss of
unrealized gains. The put option acts like an insurance policy - it costs money, which reduces
the investor's potential gains from owning the bond, but it also reduces his risk of losing money
if the stock declines in value. The potential upside on the stock is maintained. In the event that
stock prices fall, the protective put will be exercised.
The investor’s initial position is equal to:
Long stock + Long put option.
3. A
The net cost of the spread is:
$4.00 - $1.50 = $2.50.
Assume that the price of the stock closed at $32. Let us analyze the situation:
As you can see from the table, a gain of $2.50 has been made.
4. A
Bear call spread
A bear spread is a spread trade, which limits the amount of upside, when the stock, also called
the bear, falls, and also limits the downside.
The trade is constructed as follows:
Selling a call option with a low exercise price. Long a call option with a high exercise price.
Bear put spread

A bear put trade is constructed as follows: Long a put option with a high exercise price. Selling
a put option with a low exercise price.

5. A
The net cost of the spread is: $5.00 + $3.00 - $7.00 ($3.50 x 2) = $1.00
Assume that the price of the stock closed at $33. Let us analyze the situation:
6. B
Box spreads
A box spread is a combination of a bull spread and a bear spread on the same asset. Only two
strike prices will be used – in other words a high strike price (XH) and a low strike price (XL).
A bull spread = A long call at the lower strike price (XL) A short call at the higher strike price
(XH)
A bear spread = A long put at the lower strike price (XH) A short put at the higher strike price
(XL)
7. A
Long straddle
A straddle is a simple volatility trade. A long straddle strategy =
 Long an at-the-money put option +
 Long an at-the-money call option
8. B
Short straddle
A short straddle strategy =
 Short an at-the-money put option +
 Short an at-the-money call option
9. C
A collar can be used to reduce the cost of the hedge. A collar is when options are written or sold
and the income received can be used to reduce the cost of the hedge.
A collar strategy would be to buy an out-of-the-money (OTM) put option (protective put) and
to write an out-of-the-money call option (covered call). The investor is selling a call option, in
other words some of the upside potential and is using the money to pay for the long put option.
This collar protects against the downside but limits the upside to the exercise price on the call.
The risk of a collar is that it cuts off a part of the upside return in order to secure downside
protection.

10. A
When a borrower needs to use an interest rate option to hedge the risk on a floating rate loan
with several payments he may need to use several interest rate options to hedge this risk. In
other words, a separate option for every payment date. This is called an interest rate cap or
sometimes just a cap.
11. D
Bull call spread, maximum profit is $3, maximum loss is $2.
In a bull call spread, the buyer of the spread purchases a call option with a low exercise price,
XL, and subsidizes the purchase price of the call by selling a call with a high exercise price, XH.
The maximum profit will occur at any stock price over the high exercise price. For example, at a
stock price of $50: Maximum profit: 10 - 5 - 5 + 3 = $3.
The maximum loss will occur at any stock price below the low exercise price. For example, at a
stock price of $35: Maximum loss: 0 - 0 - 5 + 3 = -$2.

Topic 39
Exotic Options [FMP - 15]
Learning Objectives
Exotic Options
LO 39 a: Define and contrast exotic derivatives and plain vanilla derivatives.

LO 39 b: Describe some of the factors that drive the development of exotic derivative products.
LO 39 c: Explain how any derivative can be converted into a zero-cost product.
LO 39 d: Describe how standard American options can be transformed into nonstandard American
options.
LO 39 e: Identify and describe the characteristics and pay-off structure of the following exotic
options: gap, forward start, compound, chooser, barrier, binary, lookback, Asian, exchange, and
basket options.
LO 39 f: Describe and contrast volatility and variance swaps.
LO 39 g: Explain the basic premise of static option replication and how it can be applied to hedging
exotic options.

QUESTIONS
1. Which of the following areas are exotic options not more uncertain than versus vanilla options?
A. Value of the option
B. Payment dates of the option
C. Payment amounts of the option
D. Term of the option
2. When evaluating an exotic derivative strategy – which of the following questions is not
normally addressed:
A. Cost of the strategy.
B. Is a specific pricing model required? Does the user have the necessary model required to
assess costs and calculate exotic derivative values?
C. Does the exotic option provide an effective hedge?
D. Has market risk been adequately addressed?
3. Which of the following statements regarding a collar are correct?

I. A collar is when options are written or sold and the income received can be used to reduce
the cost of the hedge.
II. The risk of a collar is that it cuts off a part of the upside return in order to secure downside
protection.
A. I only.
B. II only.
C. Both I and II
D. Neither I or II.
4. Which of the following features will turn a standard American option into a nonstandard
American option?
I. A ‘lock out’ clause.
II. The option’s strike price may change during the life of the option.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
5. Assuming that we are dealing with a gap call option with the following details:
X2 = 110 (X2 is the trigger price)
X1 = 120
ST = 115
What is the payoff on this option?
A. 5
B. -5
C. 10
D. -10

6. What type of option is best described by the following statement? An option that only comes
into existence after a certain amount of time.
A. A gap option
B. A forward option
C. A barrier option
D. An Asian option
7. What type of option is best described by the following statement? The option allows the owner
to decide, after a period of time, whether the option is a call or put option.
A. A gap option
B. A forward option
C. A chooser
D. An Asian option
8. What type of option is best described by the following statement? The option has payoffs that
depend on the maximum and minimum prices of the underlying asset during the term of the
option contract.
A. A lookback option
B. A forward option
C. A chooser
D. An Asian option
9. Which of the following statements regarding a variance swap are not correct?
A. A variance swap is the swap of a pre-determined fixed variance rate for the actual realized
variance rate based on a notional principal amount.
B. The variance rate is calculated as the square of the volatility rate.
C. Variance swaps are easily hedged with the use of call and put options.
D. This swap is a bet on volatility as apposed to a bet on the volatility of an underlying asset’s
price.
10. Which of the following statements regarding a dynamic options replication strategy are
correct?
I. The process is often very expensive as it requires frequent trading and rebalancing.
II. The position in exotic options is hedged at the outset and remains in place for the duration
of the hedge.
A. I only
B. II only.
C. Both I and II.
D. Neither I or II.

11. A trader writes the following 1-year European-style barrier options as protection against large
movements in a non-dividend paying stock that is currently trading at EUR 40.96.
All of the options have the same strike price. Assuming the risk-free rate is 2% per annum,
what is the common strike price of these options?
A. EUR 39.00
B. EUR 40.00
C. EUR 41.00
D. EUR 42.00

SOLUTIONS
1. D
Exotic options contain uncertainty in the following areas:
 Cost of the option
 Value of the option
 Payment dates of the option
 Payment amounts of the option
 Cost of exiting the option
2. D
When evaluating an exotic derivative strategy – the following questions should be addressed:
 Cost of the strategy
 Is a specific pricing model required? Does the user have the necessary model required to
assess costs and calculate exotic derivative values?
 Does the exotic option provide an effective hedge?
 Has credit / default risk been adequately addressed?
 How would the investor exit his exotic position?
3. C
A collar can be used to reduce the cost of the hedge. A collar is when options are written or sold
and the income received can be used to reduce the cost of the hedge. The risk of a collar is that
it cuts off a part of the upside return in order to secure downside protection.
4. C
A standard American option is an option that is exchange-traded and contains standard terms
and conditions. There are certain features that will turn a standard American option into a
nonstandard American option. These features are:
 A ‘lock out’ clause. In other words the American option cannot be exercised for a certain
period of the option’s life. For example, the first three months.
 Fixed trading dates. In other words the American option cannot be exercised at any point
in time, rather at fixed periods of the option’s life. For example, the end of every month
only. This transforms the option from being an American option to a Bermudan option.
 The option’s strike price may change during the life of the option.
5. B
Case 3: X2 = 110 (X2 is the trigger price) X1 = 120 ST = 115
In such a case the payoff = (115 – 110) + (110 – 120) = -5
6. B
A forward start option is an option that only comes into existence after a certain amount of
time.

7. C
A chooser option allows the owner to decide, after a period of time, whether the option is a call
or put option.
8. A
A lookback option has payoffs that depend on the maximum and minimum prices of the
underlying asset during the term of the option contract.
9. D
A variance swap is the swap of a pre-determined fixed variance rate for the actual realized
variance rate based on a notional principal amount. The variance rate is calculated as the square
of the volatility rate. Variance swaps are easily hedged with the use of call and put options.
10. A
Dynamic options replication is the frequent adjusting of the holdings to ensure adequate
hedging. This process is often very expensive as it requires frequent trading and rebalancing.
Static options replication is when the position in exotic options is hedged at the outset and
remains in place for the duration of the hedge.
11. B
The sum of the price of an up-and-in barrier call and an up-and-out barrier call is the price of an
otherwise equivalent European call. The price of the European call is EUR 3.52 + EUR 1.24 =
EUR 4.76. The sum of the price of a down-and-in barrier put and a down-and-out barrier put is
the price of an otherwise equivalent European put. The price of the European put is EUR 2.00 +
EUR 1.01 = EUR 3.01.
Using put-call parity, where C represents the price of a call option and P the price of a put
option, C + Ke-rt = P + S K = ert (P + S – C) Hence, K = e0.02*1 * (3.01 + 40.96 – 4.76) = 40.00

Topic 40
Properties of Interest Rates [FMP - 16]
Learning Objectives
Properties of Interest Rates
LO 40 a: Describe Treasury rates, LIBOR, Secured Overnight Financing Rate (SOFR), and repo rates
and explain what is meant by the “risk-free” rate.
LO 40 b: Calculate the value of an investment using different compounding frequencies.
LO 40 c: Convert interest rates based on different compounding frequencies.
LO 40 d: Calculate the theoretical price of a bond using spot rates.
LO 40 e: Calculate the duration, modified duration, and dollar duration of a bond.
LO 40 f: Evaluate the limitations of duration and explain how convexity addresses some of them.
LO 40 g: Calculate the change in a bond’s price given its duration, its convexity, and a change in
interest rates.
LO 40 h: Derive forward interest rates from a set of spot rates.
LO 40 i: Derive the value of the cash flows from a forward rate agreement (FRA).
LO 40 j: Calculate zero-coupon rates using the bootstrap method.
LO 40 k: Compare and contrast the major theories of the term structure of interest rates.

QUESTIONS
1. Which of the following is not a characteristic of a repurchase agreement?

A. A repurchase agreement is the sale of a security by a dealer to an investor with a
commitment by the dealer to buy the same security back from the investor at a specified
price at a specified future date.
B. The seller of the bond will receive cash for selling the bond and will agree to buy it back at a
lower price at a certain date in the future.
C. The rate of the transaction (10% in this case) is called the repo rate.
D. Institutional investors in the bond market use this type of a transaction as a form of
financing.
2. If the nominal/stated interest rate is 8%, what is the effective annual rate assuming monthly
compounding?
A. 8.00%
B. 8.24%
C. 8.30%
D. 8.15%
3. Which of the following calculations regarding discrete and continuous rates are correct?
I. Assume that the continuous rate was 9.53%. The discrete rate would be = 10%.
II. Assume that the discrete rate was 12%. The continuous rate would be = 11.3%
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. Consider the following information about Bond P:

Coupon payments: semi-annual
Maturity: One and a half years
Annual coupon: $5
Annual spot yields:
Period 1 7%
Period 2 8%
Period 3 ?
Price of the bond: $94.2777.
What is the spot rate for Bond P in period 3?
A. 7%
B. 9%
C. 9.5%
D. 10%

5. A bond has a coupon rate of 5% and a maturity value of $100 in two years time. Assume that
the appropriate spot rates are:
Year 1 6.7%
Year 2 7.1%
What is the one-year forward rate one year from now?
A. 7.2%
B. 7.5%
C. 8.0%
D. 6.2%
6. Assume that the 6-month spot rate for LIBOR is 5% and the 9-month spot rate for LIBOR is 6%.
An investor enters into a FRA agreement to earn 9% on her principal of $10m between the 6
and 9-month period.
What is the value of the FRA?
A. $194,000
B. $46,366
C. $900,000
D. $55,789
7. Which of the following calculations regarding duration calculations are correct?

I. The reason that there is a negative sign in front of the price change duration calculation is
that there is an positive relationship between price changes and yield changes.
II. The approximate dollar price change for a 100 basis point change in yield is called money
duration or dollar duration.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. Which of the following statements regarding convexity are not correct?

A. The relationship between the bond’s price and its yield is a linear one.
B. The convexity adjustment is is used to approximate the change that is not explained by
duration.
C. The longer the maturity and the lower the coupon and yield, the greater the convexity.
D. The shorter the maturity and the higher the coupon and yield, the lower the convexity.
9. Consider a 10% coupon bond. The current price is $98 with a YTM of 12%.
Assume a 50 basis points increase in yields
Duration is 12 and convexity is 80.
What is the percentage price change for the bond?
A. -6.0%
B. 0.1%
C. 5.9%
D. 0.50%

10. Which of the major theories of the term structure of interest rates would state the following
“The market wants to be compensated for the interest rate risk when holding longer term
bonds”?
A. The pure expectations theory
B. The liquidity preference theory
C. The market segmentation theory
D. The preferred habitat theory
11. Which of the following statements regarding SOFR is least likely correct?
A. SOFR is the rate on a secured overnight loan.
B. SOFR is very close to the risk-free rate.
C. SOFR is higher than both USD LIBOR and the effective federal funds rate (EFFR).
D. SOFR is derived from a universe of actual overnight Treasury repo transactions.
12. A portfolio manager controls USD 88 million par value zero-coupon bonds maturing in 5 years
and yielding 4%. The portfolio manager expects that interest rates will increase. To hedge the
exposure, the portfolio manager wants to sell part of the 5-year bond position and use the
proceeds from the sale to purchase zero-coupon bonds maturing in 1.5 years and yielding 3%.
What is the market value of the 1.5-year bonds that the portfolio manager should purchase to
reduce the duration on the combined position to 3 years?
A. USD 41.17 million
B. USD 43.06 million
C. USD 43.28 million
D. USD 50.28 million

SOLUTIONS
1. B
A repurchase agreement is the sale of a security by a dealer to an investor with a commitment
by the dealer to buy the same security back from the investor at a specified price at a specified
future date. The seller of the bond will receive cash for selling the bond (e.g. $100) and will agree
to buy it back at a higher price (e.g. $110) at a certain date in the future (assume 1 year). The rate
of the transaction (10% in this case) is called the repo rate.
Institutional investors in the bond market use this type of a transaction as a form of financing.
2. C
3. C
Assume that the continuous rate was 9.53% The discrete rate would be =
r d = erd - 1 r d = e0.0953 - 1 r d = 1.10 – 1 r d = 10% r c = 9.53%
Assume that the discrete rate was 12% The continuous rate would be =
rc = ln(1 + r) r c = ln(1 + 12%) r c = ln(1.12) r c = 11.3%
4. B
By applying the bootstrapping methodology we are able to work out the spot rate for period 3.
Keep in mind that we know the price of the three-period bond as well as the spot rates for
period 1 and period 2. By substituting X for period 3’s spot rate we can work out the spot rate
for that period, as follows:

5. B
The one year rate one year from now =
6. B
Assume that the 6-month spot rate for LIBOR is 5% and the 9-month spot rate for LIBOR is 6%.
An investor enters into a FRA agreement to earn 9% on her principal of $10m between the 6 and
9-month period.
The value of the FRA is equal to:
Step 1: Calculate the forward rate:
Step 2: Apply quarterly compounding to the forward rate
7. B
The reason that there is a negative sign in front of the price change duration calculation is that
there is an inverse relationship between price changes and yield changes.
The approximate dollar price change for a 100 basis point change in yield is called money
duration or dollar duration.

8. A
The relationship between the bond’s price and its yield is a convex one. Based on this we need
to add another approximation to the duration measure – this is called the convexity adjustment.
This is used to approximate the change that is not explained by duration. The longer the
maturity and the lower the coupon and yield, the greater the convexity. The shorter the
maturity and the higher the coupon and yield, the lower the convexity.
9. C
Duration effect = - modified duration (Δy) = - 12 X 0.005 = -0.06 = - 6% Convexity effect = 1 2
(Convexity) (Δy) 2 = 1 2 (80) (0.005)2 = 0.0010 = 0.1% Total % price change: = -6% + 0.1% = -5.9%
10. B
Liquidity preference theory The problem with the pure expectations theory is that it does not
consider the risks associated with investing in bonds. This theory states that the market wants to
be compensated for the interest rate risk when holding longer term bonds. The longer the
maturity the greater the price volatility when interest rates change.
11. C
SOFR is the rate on a secured overnight loan and as such it is very close to the risk-free rate. It is
lower than both USD LIBOR and the effective federal funds rate (EFFR). SOFR is derived from a
universe of actual overnight Treasury repo transactions.
12. A
In order to find the proper amount, we first need to calculate the current market value of the
portfolio (P), which is: P = 88 * exp (-0.04 * 5) = 72.05 million. The desired portfolio duration
(after the sale of the 5-year bond and purchase of the 1.5 year bond) can be expressed as: [5 * (P-
X) + 1.5* X]/P = 3 where X represents the market value of the zero-coupon bond with a
maturity of 1.5 years. This equation holds true when X = (4/7) * P, or 41.17 million.

Topic 41
Corporate Bonds [FMP - 17]
Learning Objectives
Corporate Bonds
LO 41 a: Describe features of bond trading, and explain the behavior of bond yield.
LO 41 b: Describe a bond indenture and explain the role of the corporate trustee in a bond
indenture.
LO 41 c: Define high-yield bonds, and describe types of high-yield bond issuers and some of the
payment features unique to high yield bonds.
LO 41 d: Differentiate between credit default risk and credit spread risk.
LO 41 e: Describe event risk and explain what may cause it in corporate bonds.
LO 41 f: Describe the different classifications of bonds characterized by issuer, maturity, interest
rate, and collateral.
LO 41 g: Describe the mechanisms by which corporate bonds can be retired before maturity.
LO 41 h: Define recovery rate and default rate, differentiate between an issue default rate and a
dollar default rate, and describe the relationship between recovery rates and seniority.
LO 41 i: Evaluate the expected return from a bond investment and identify the components of the
bond’s expected return.

QUESTIONS
1. When assessing a bond’s indenture which of the following is not an example of a positive
covenant? Co
A. To pay interest and principal on a timely basis
B. To pay all taxes and other claims when due
C. A restriction on the borrower’s ability to incur further debt
D. To maintain all properties used useful in the borrower’s business in good working order
2. When assessing a bond’s maturity date and how it impacts bond retirements. which of the
I. Bonds with maturities of less than 1 year are called money market securities.
II. Bonds with maturities of greater than 1 year are called capital market securities.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. James Jack, FRM, is participating in a fixed income conference. The speaker describes a bond
using the following description “The coupon on this type of bond can be paid by increasing the
principal amount owing on the bond”. What type of bond is the speaker describing?
A. A PIK bond
B. A reset bond
C. A participating bond
D. A fixed payment bond
4. Which of the following statements are not correct when describing a zero-coupon bond?
A. A zero-coupon (ZC) bond pays the face-value of the bond at maturity – no coupon
payments are made on the bond.
B. Original issue discount (OID) = Face value of the bond less the price of the bond
C. The rate of interest will grow based on time to maturity and the size of the OID.
D. A disadvantage of the ZC bond is that it does not contain any reinvestment risk as there are
no coupons that are received.
5. Which of the following statements are not correct when describing a Equipment trust
certificates (ETCs)?
A. Equipment trust certificates (ETCs) are when a specific piece of equipment underlies the
bond issue.
B. The effective transaction is that the trustee purchases the equipment from the proceeds of
the bond issue and then leases it to the user.
C. The user pays rent to the trustee who passes this rental income on to the ETC holder.
D. ETC are bonds are issues that rank behind secured debt and after debenture bonds.

6. Which of the following mechanisms is not a mechanism to retire a bond issue?

A. Call option
B. Sinking fund provision
C. Tender offer
D. Put option
7. When dealing with the yield on a bond, which of the following statements are correct?
The yield on a bond is made up of two components:
I. The yield on a default-free bond (i.e. the yield on a U.S. Treasury), and
II. A premium above the yield on the default-free bond to compensate the holder for the
increased risk associated with this specific issue.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. Which of the following is not an example of an event risk?

A. A natural disaster or industrial accident
B. A takeover or corporate restructuring
C. A regulatory change
D. A corporate default
9. Jacqui Jack, FRM, is participating in a fixed income conference. The speaker describes a bond
using the following description “a high yield bond that initially had an investment grade rating
but due to certain circumstances has their rating has fallen to non investment grade”. What
type of bond is the speaker describing?
A. A story bond
B. A fallen angel
C. A reset bond
D. A restructured bond
10. When dealing with credit risk and defaults, which of the following statements is not correct?
A. Loss given default is the risk that the issuer will fail to satisfy the terms of the obligation
with respect to the timely payment of interest and principal.
B. The estimated percentage out of a group of bonds that is likely to default is called the
default rate.
C. The issuer default rate is the number of issuers that have defaulted over a year by the total
number of issuers (at the beginning of the year).
D. The dollar default rate is the par value of the defaulted bonds that have defaulted over a
year by the total par value of bonds (at the beginning of the year).
11. Which of the following equations dealing with loss given default and expected loss is correct?
A. Loss given default = 1 + recovery rate.
B. Expected loss = Probability of default - loss given default.

C. Expected loss = Probability of default X loss given default.

D. Loss given default = Probability of default - recovery rate.
12. The following details relate to Bond P:

 Credit spread over the risk-free rate = 2%.
 Default probability = 0.5% per annum.
 Recovery rate = 40%
What is the expected return on Bond P?
A. 1.7%
B. 1.6%
C. 2.0%
D. 1.5%
13. Which of the following statements regarding the trustee named in a corporate bond indenture
is correct?
A. The trustee has the authority to declare a default if the issuer misses a payment.
B. The trustee may action beyond the indenture to protect bondholders.
C. The trustee must act at the request of a sufficient number of bondholders.
D. The trustee is paid by the bondholders or their representatives.

SOLUTIONS
1. C
Affirmative covenants – these set out what the borrower promises to do, and will include:
 To pay interest and principal on a timely basis
 To pay all taxes and other claims when due
 To maintain all properties used useful in the borrower’s business in good working order
 To submit reports to the trustee stating that the borrower is in compliance with the loan
agreement
A restriction on the borrower’s ability to incur further debt is an example of a negative
covenant.
2. C
Bonds with maturities of less than 1 year are called money market securities. Bonds with
maturities of greater than 1 year are called capital market securities.
3. A
A payment-in-kind (PIK) bond
The coupon on this type of bond can be paid by increasing the principal amount owing on the
bond. i.e. paying coupon interest with principal.
4. D
Zero-coupon bonds
A zero-coupon (ZC) bond pays the face-value of the bond at maturity – no coupon payments
are made on the bond. Original issue discount (OID) = Face value of the bond less the price of
the bond The rate of interest will grow based on time to maturity and the size of the OID. One
advantage of the ZC bond is that it does not contain any reinvestment risk as there are no
coupons that are received.
5. D
Equipment trust certificates (ETCs) are when a specific piece of equipment underlies the bond
issue. The effective transaction is that the trustee purchases the equipment from the proceeds of
the bond issue and then leases it to the user. The user pays rent to the trustee who passes this
rental income on to the ETC holder.
6. D
Put option
7. C
The yield on a bond is made up of two components:
 The yield on a default-free bond (i.e. the yield on a U.S. Treasury), +
 A premium above the yield on the default-free bond to compensate the holder for the
increased risk associated with this specific issue.

8. D
 A natural disaster or industrial accident
 A takeover or corporate restructuring
 A regulatory change
9. B
A fallen angel is a high yield bond that initially had an investment grade rating but due to
certain circumstances has their rating has fallen to non investment grade.
10. A
Credit risk is the risk that the issuer will fail to satisfy the terms of the obligation with respect to
the timely payment of interest and principal. The estimated percentage out of a group of bonds
that is likely to default is called the default rate. The issuer default rate is the number of issuers
that have defaulted over a year by the total number of issuers (at the beginning of the year).
The dollar default rate is the par value of the defaulted bonds that have defaulted over a year
by the total par value of bonds (at the beginning of the year).
11. C
The loss given default is the amount that the investor stands to lose in the event of default by
the issuer. This can be calculated as follows: Loss given default = 1 – recovery rate. The
expected loss is the amount that the investor expects to lose as a result of the default. This can
be calculated as follows: Expected loss = Probability of default X loss given default.
12. A
Expected loss rate = 0.5% x (1 – 0.40) Expected loss rate = 0.3% Expected bond return = Risk-
free rate + credit spread – expected loss rate. Expected bond return = 2% – 0.3% Expected bond
return = 1.7%.
13. A
According to the Trust Indenture Act, if a corporate issuer fails to pay interest or principal, the
trustee may declare a default and take such action as may be necessary to protect the rights of
bondholders.
Trustees can only perform the actions indicated in the indenture, but are typically under no
obligation to exercise the powers granted by the indenture even at the request of bondholders.
The trustee is paid by the debt issuer, not by bond holders or their representatives.

Topic 42
Mortgages and Mortgage-Backed Securities [FMP - 18]
Learning Objectives
Mortgages and Mortgage-Backed Securities
LO 42 a: Describe the various types of residential mortgage products.

LO 42 b: Calculate a fixed rate mortgage payment, and its principal and interest components.
LO 42 c: Describe the mortgage prepayment option and the factors that influence prepayments.
LO 42 d: Summarize the securitization process of mortgage backed securities (MBS), particularly
formation of mortgage pools including specific pools and to-be-announceds (TBAs).
LO 42 e: Calculate weighted average coupon, weighted average maturity, single monthly mortality
rate (SMM), and conditional prepayment rate (CPR) for a mortgage pool.
LO 42 f: Describe the process of trading of pass-through agency MBS.
LO 42 g: Explain the mechanics of different types of agency MBS products, including collateralized
mortgage obligations (CMOs), interest-only securities (IOs), and principal-only securities (POs).
LO 42 h: Describe a dollar roll transaction and how to value a dollar roll.
LO 42 i: Explain prepayment modeling and its four components: refinancing, turnover, defaults,
and curtailments.
LO 42 j: Describe the steps in valuing an MBS using Monte Carlo simulation.
LO 42 k: Define Option Adjusted Spread (OAS), and explain its challenges and its uses.

QUESTIONS
1. When describing the various types of residential mortgage products which of the following is
not a characteristic of a prime loan?
A. FICO score of 660 and below
B. Low rates of default.
C. Borrowers have a strong repayment history.
D. Borrowers have stable and sufficient income
2. When assessing a fixed rate mortgage repayments which of the following statements are not
correct?
A. In the early years of the loan, the majority of the monthly payments consist of interest.
B. In the later years of the loan, the majority of the monthly payments consist of principal.
C. The point at which the interest and principal components of the monthly payment are equal
is called the crossover point.
D. The longer the amortization period, the greater the principal component as a portion of the
total monthly payment in the early period.
3. When assessing the factors that influence prepayments which of the following is not a factor
that will influence prepayments?
A. Current interest rates
B. Size of the mortgage pool
C. Housing prices
D. Seasonality
4. Which of the following statements regarding the securitization process of mortgage backed
securities (MBS) is not correct?
A. MBS are pass-through mortgage securities.
B. The weighted average coupon (WAC) is the weighted average of all the coupon rates in the
pool.
C. In order to be included in the agency pool, the mortgages must meet certain criteria.
D. The mortgages in the pool are called conforming loans.
5. What is the CPR and SMM for month 10 for 200 PSA?
A. 2% and 0.0017
B. 2% and 0.0034
C. 4% and 0.0017
D. 4% and 0.0034
6. When assessing a bond’s maturity date and how it impacts bond retirements. which of the
I. The motivation for creating a CMO is to distribute the prepayment risk among the different
classes of bonds.

II. A sequential pay CMO will seek to pay off the entire principal on the ‘first’ tranche before
any principal is repaid on the ‘other’ tranches.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. When modeling prepayments and specifically refinancing due to refinancing, which of the
following statements are not correct?
A. Refinancing burnout is when the mortgage holder will not refinance since he has already
refinanced one time before when rates dropped previously.
B. In most cases, a 2% drop in rates will incentivize mortgage holders to refinance their debt.
C. When the value of the property increases substantially, the mortgage holder will refinance
his mortgage with a new provider at a much higher value to extract equity value.
D. Cash-out refinancing is when the mortgage holder will not refinance since he has already
refinanced one time before when rates dropped previously.
8. Which of the following is not a step in valuing an MBS using Monte Carlo simulation?
A. The interest rate and refinancing paths need to be simulated.
B. Cash flows for each path needs to be forecasted.
C. Calculate the present values for each path.
D. Calculate the value of the MBS by summing all the present values from step 3.
9. Which of the following statements is not a challenge to using the option adjusted spread (OAS)
measure?
A. Since OAS is effectively a by-product of MCS, it will suffer from the same modeling risk
that MCS suffers from.
B. OAS assumes that the OAS is dynamic over the entire time period of the model.
C. OAS is dependent on the prepayment model – which in and of itself is a difficult model to
predict.
D. When using MCS, the interest rate paths must be adjusted to make sure that all rates or
securities that make up the benchmark curve are correctly valued.
10. When assessing the OAS ’s which of the following statements are correct?
I. The option-adjusted spread (OAS) takes the dollar difference between the fair price and the
market price and converts it into a yield spread measure.
II. The OAS seeks to find a return (spread) that will equate the market price and the fair price
(value). It will do this via trial and error.
A. I only
B. II only.
C. Both I and II.
D. Neither I or II.

11. A fixed-income portfolio manager purchases a seasoned 4.5% agency mortgage-backed security
with a weighted average loan age of 60 months. The current balance on the loans is USD 24
million, and the conditional prepayment rate is assumed to be constant at 0.5% per year. Which
of the following is closest to the expected principal prepayment this month?
A. USD 1,000
B. USD 7,000
C. USD 10,000
D. USD 70,000
SOLUTIONS
1. A
Prime loans (A-grade)
 FICO score of 660 and above.
 Low rates of default.
 Borrowers have a strong repayment history.
 Borrowers have stable and sufficient income
 Low loan-to-value ratios
2. D
In the early years of the loan, the majority of the monthly payments consist of interest. In the
later years of the loan, the majority of the monthly payments consist of principal. The point at
which the interest and principal components of the monthly payment are equal is called the
crossover point. The shorter the amortization period, the greater the principal component as a
portion of the total monthly payment in the early period.
3. B
 Current interest rates – as rates move down, owners may be tempted to refinance at the
lower rates.
 Housing prices – as prices rise, owners may be tempted to prepay and refinance, in order
to get some of their equity out.
 Seasonality – as summer arrives, people tend to move and hence prepayments increase
 Age of the pool.
 Personal – peoples personal circumstances may cause them to refinance, for example a
divorce may prompt the sale of a house.
 Refinancing burnout – if there has been a lot of refinancing in the past, then the risk of
further prepayments is reduced.
4. D
MBS are pass-through mortgage securities. This means that each pass-through security that is
issued has a claim on the pool of mortgages. The mortgages in the pool are called securitized
mortgages. Since each mortgage in the pool has a different maturity, the mortgages are
weighted by their outstanding principal amount as a percentage of the total outstanding

principal of all the mortgages in the pool this is called the weighted average maturity (WAM).
The weighted average coupon (WAC) is the weighted average of all the coupon rates in the
pool.
In order to be included in the agency pool, the mortgages must meet certain criteria. e.g. certain
LTV ratios. If the mortgages meet these criteria, they can be included in the pool and are called
conforming loans.
5. D
Calculate the CPR and SMM for month 10 for 100 PSA and 200 PSA.
100 PSA: CPR – month 10 = 10 x 0.2% = 2% 100 PSA = 2% x 1 = 2% SMM = 1 – (1 – 0.02)1/12 =
0.0017
200 PSA: CPR – month 10 = 10 x 0.2% = 2% 200 PSA = 2% x 2 = 4% SMM = 1 – (1 – 0.04)1/12 =
0.0034.
6. C
The motivation for creating a CMO is to distribute the prepayment risk among the different
classes of bonds. A sequential pay CMO will seek to pay off the entire principal on the ‘first’
tranche before any principal is repaid on the ‘other’ tranches.
7. D
Refinancing. In the event that market interest rates fall, the mortgage holder is incentivized to
prepay his current mortgage and refinance a new mortgage at the lower rates. In most cases, a
2% drop in rates will incentivize mortgage holders to refinance their debt. The reason for this is
called the media effect – as the drop in rates was big enough to be reported in the media. As
part of the refinancing incentive, when the value of the property increases substantially, the
mortgage holder will refinance his mortgage with a new provider at a much higher value. This
is done in order to extract some of the equity as a result of the increased price. This is called
cash-out refinancing. Refinancing burnout is when the mortgage holder will not refinance since
he has already refinanced one time before when rates dropped previously.
8. D
The following steps are used when valuing an MBS using MCS:
 The interest rate and refinancing paths need to be simulated.
 Cash flows for each path needs to be forecasted.
 Calculate the present values for each path.
 Calculate the value of the MBS by summing all the present values from step 3 and dividing
by the total number of interest rate paths (N).
9. B
Challenges to OAS
Since OAS is effectively a by-product of MCS, it will suffer from the same modeling risk that
MCS suffers from. OAS assumes that the OAS is constant over the entire time period of the
model. OAS is dependent on the prepayment model – which in and of itself is a difficult model

to predict. When using MCS, the interest rate paths must be adjusted to make sure that all rates
or securities that make up the benchmark curve are correctly valued.
10. C
The option-adjusted spread (OAS) takes the dollar difference between the fair price and the
market price and converts it into a yield spread measure. The OAS seeks to find a return
(spread) that will equate the market price and the fair price (value). It will do this via trial and
error.
11. C
The expected principal prepayment is equal to: 24,000,000 * (1-((1-0.005)^(1/12))) = USD 10,023.

Topic 43
Interest Rate Futures [FMP - 19]
Learning Objectives
Interest Rate Futures
LO 43 a: Identify the most commonly used day count conventions, describe the markets that each
one is typically used in, and apply each to an interest calculation.
LO 43 b: Calculate the conversion of a discount rate to a price for a US Treasury bill.
LO 43 c: Differentiate between the clean and dirty price for a US Treasury bond; calculate the
accrued interest and dirty price on a US Treasury bond.
LO 43 d: Explain and calculate a US Treasury bond futures contract conversion factor.
LO 43 e: Calculate the cost of delivering a bond into a Treasury bond futures contract.
LO 43 f: Describe the impact of the level and shape of the yield curve on the cheapest-to-deliver
Treasury bond decision.
LO 43 g: Calculate the theoretical futures price for a Treasury bond futures contract.
LO 43 h: Calculate the final contract price on a Eurodollar futures contract, and compare Eurodollar
futures to FRAs.
LO 43 i: Describe and compute the Eurodollar futures contract convexity adjustment.
LO 43 j: Explain how Eurodollar futures can be used to extend the LIBOR zero curve.
LO 43 k: Calculate the duration-based hedge ratio and create a duration-based hedging strategy
using interest rate futures.
LO 43 l: Explain the limitations of using a duration-based hedging strategy.

QUESTIONS
1. Assume that the bonds in question pay interest semi-annually and that the payment dates are
end of June and December every year. Compute the accrued interest for each instrument type,
assuming that the bond was sold on the 14th of March and that the accrued interest for the six
months was $10,000. What is the accrued interest assuming that the bond is a corporate bond?
A. $3,978
B. $4,000
C. $6,000
D. $4,056
2. Assume that the annual rate of interest on a 180 day T-bill is 10% and the face value is $100.
What is the real rate of interest?
A. 5.00%
B. 10.00%
C. 5.26%
D. 10.52%
3. Assume that the full price of a bond is equal to $102 713.73 and was sold 60 days into the period
(semi - annual payments). Total coupon for the period was $3,000. What is the clean price of the
bond?
A. $101,724
B. $100,000
C. $102,713
D. $989
4. Which of the following statements regarding a bond futures conversion factor are correct?
I. The conversion factor can be obtained from the CBOT on a daily basis.
II. The conversion factor is calculated as follows: Conversion factor =
Bond price  accrued int erest
Face value of the bond
A. I only.
B. II only
C. Both I and II.
D. Neither I or II.
5. Assume that the short needs to deliver a bond to the long and the last quoted futures price was
$96. There are two bonds that are available for delivery:
Bond A: Bond price = 101, conversion factor = 1.05
Bond B: Bond price = 110, conversion factor = 1.10
Which bond is the cost to deliver of bond A?
A. 0.20
B. 4.40

C. 1.05
D. 1.10
6. Which of the following statements are not correct when dealing with CTD bonds?
A. If the yield curve is sloping upwards – CTD bonds have longer maturities.
B. If the yield curve is sloping downwards – CTD bonds have shorter maturities
C. If yield exceed 6% then CTD bonds are longer maturity and higher coupon bonds.
D. If yields are less than 6% then CTD bonds are shorter maturity and higher coupon bonds.
7. Which of the following statements regarding a Treasury bond futures contract are correct?
I. The present value of the interim cash flows will need to be deducted from the spot price
prior to working out the futures price.
II. The futures contract pricing equation that pays interim cash flows: F0 = (S0 – I)erT
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. Assume that the rate priced into a Eurodollar futures contract contract is 6.25%. What is the
futures price?
A. $937,500
B. $6.25
C. $1,000,000
D. $984,375
9. Which of the following statements regarding a Eurodollar futures contract is not correct?
A. This contract is based on the rate of a 90-day dollar denominated time deposit issued by a
London Bank.
B. The T-Bill is a discount instrument.
C. The rate is the 180-day forward LIBOR rate.
D. The futures contract is based on a 90-day $1m U.S. T-bill.
10. Which of the following statements regarding a Treasury bond futures contract are correct?
I. A LIBOR spot rate curve can be produced by using the convexity adjusted Eurodollar
futures numbers.
R forward T2  T1   R1 T1
II. To solve for the spot rate, the following equation could be used: R2 =
T2
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. Assume a 3-month hedging period. The value of the portfolio is equal to #200m. The 3-month
bond contract is quoted at 102. The size per contract is $100,000. The duration of the portfolio is

9 and the duration on the futures contract is 13. How many contracts are needed in order to
hedge this position?
A. Buy 1,357 contracts
B. Sell 1,357 contracts
C. Buy 2,832 contracts
D. Sell 2,832 contracts
12. Which of the following statements regarding the limitation of using a duration-based hedging
strategy are correct?
I. The duration measure implies that all yields are perfectly correlated.
II. When yield changes are large and non-parralel then the effect of a duration hedge is
minimized.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II

SOLUTIONS
1. D
Days Jan – 30 days Feb – 30 days March – 13 days Total – 73 days
Total days Jan – 30 days Feb – 30 days March – 30 days April – 30 days May – 30 days June- 30
days Total – 180 days
73
 $10,000  $4,055.56
180
2. C
The price of the t-bill, or Y, is calculated as follows:
Y = 100 – (100 x 10% x 180/360)
Y = 100 – 5 Y = 95
The t-bill discount rate is equal to 10%, but the real rate of interest is calculated by dividing by
the price of 95, as follows:
Real interest rate = 5 / 95
= 5.26%
3. A
We first need to calculate the accrued interest. The first step is to calculate the days in the
accrued interest period.
AI = Semi-annual coupon payment X 60/182
= $3,000 X 0.3297 = $989.01
Based on this the clean price of the bond will be:
= Dirty price – accrued interest = $102,713.73 - $989.01 = $101,724.72
4. C
The conversion factor can be obtained from the CBOT on a daily basis. The conversion factor is
calculated as follows:
Bond price  accrued interest
Conversion factor =
Face value of the bond
5. A
Cost of delivery of Bond A = 101 – (1.05 x 96) = 0.20 Cost of delivery of Bond B = 110 – (1.1 x 96)
= 4.40
6. C
A basic guideline that can be used when working with CTD bonds is as follows:
 If the yield curve is sloping upwards – CTD bonds have longer maturities.
 If the yield curve is sloping downwards – CTD bonds have shorter maturities.
 If yield exceed 6% then CTD bonds are longer maturity and lower coupon bonds.
 If yields are less than 6% then CTD bonds are shorter maturity and higher coupon bonds.

7. C
The present value of the interim cash flows will need to be deducted from the spot price prior
to working out the futures price.
The futures contract pricing equation that pays interim cash flows:
F0 = (S0 – I)erT
8. D
The quoted price will be: Z = 100 – 6.25 = 93.75. The futures price will be: $1,000,000 [1 –
0.0625(90/360)] = $984,375
9. C
This contract is based on the rate of a 90-day dollar denominated time deposit issued by a
London Bank. This deposit is called a Eurodollar time deposit and the rate is referred to as
LIBOR. The T-Bill is a discount instrument. The rate is the 90-day forward LIBOR rate. The
futures contract is based on a 90-day $1m U.S. T-bill.
10. C
A LIBOR spot rate curve can be produced by using the convexity adjusted Eurodollar futures
numbers. time periods If we wanted to solve for the spot rate, the equation could be rearranged
as follows:
R forward T2  T1   R1 T1
R2 =
T2
11. B
A duration hedge can be set up as follows:
P  DP
N
F  DF
200,000,000  9
N
100,000  102   13
N  1,357.47
12. B
The duration measure implies that all yields are perfectly correlated. As such, when yield
changes are large and non-parralel then the effect of a duration hedge is minimized.

Topic 44
Swaps [FMP - 20]
Learning Objectives
Swaps
LO 44 a: Explain the mechanics of a plain vanilla interest rate swap and compute its cash flows.
LO 44 b: Explain how a plain vanilla interest rate swap can be used to transform an asset or a
liability and calculate the resulting cash flows.
LO 44 c: Explain the role of financial intermediaries in the swaps market.
LO 44 d: Describe the role of the confirmation in a swap transaction.
LO 44 e: Describe the comparative advantage argument for the existence of interest rate swaps and
evaluate some of the criticisms of this argument.
LO 44 f: Explain how the discount rates in a plain vanilla interest rate swap are computed.
LO 44 g: Calculate the value of a plain vanilla interest rate swap based on two simultaneous bond
positions.
LO 44 h: Calculate the value of a plain vanilla interest rate swap from a sequence of forward rate
agreements (FRAs).
LO 44 i: Explain the mechanics of a currency swap and compute its cash flows.
LO 44 j: Explain how a currency swap can be used to transform an asset or liability and calculate the
resulting cash flows.
LO 44 k: Calculate the value of a currency swap based on two simultaneous bond positions.
LO 44 l: Calculate the value of a currency swap based on a sequence of forward exchange rates.
LO 44 m: Identify and describe other types of swaps, including commodity, volatility, credit default,
and exotic swaps.
LO 44 n: Describe the credit risk exposure in a swap position.

QUESTIONS

Notional principal = $10m
The dealer agrees to pay the floating rate and the end-user pays a fixed rate.
Floating rate = 6.25% (LIBOR) at the beginning of the period.
Fixed rate = 7.00%
Days per year in floating calculation = 360
Days per year in fixed calculation = 365
Days in the settlement period = 180
Calculate the net amount to be settled at the end of the settlement period.
A. $10,000,000
B. $312,500
C. $345,205
D. $32,705
2. Which of the following statements regarding a plain vanilla swap are correct?
I. A plain vanilla swap is an interest rate swap in which one party pays a fixed rate and the
other pays a floating rate.
II. In a plain vanilla swap both sets of payments are made in the same currency.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements regarding the role of financial intermediaries in the swaps
market are not correct?
A. The market is similar to that of the futures market.
B. It is made up of dealers (banks, investment banks) and counterparties (normally end-users
or other dealers).
C. The dealers make markets in swaps by quoting bid and ask prices and rates. In return, the
dealer or bank that acts as the intermediary will charge a spread for bringing the parties
together and taking on the risk.
D. The dealer will typically offset his risk by making transactions in other markets.
4. Which of the following statements regarding the role of financial intermediaries in the swaps
market are not correct?
A. When a swap is initiated neither party will pay the other party anything. Therefore at
inception the value of a swap is zero.
B. A swap is a customized instrument with very little regulation in the market. As such the
risk of default is high.
C. The majority of the participants in the market are small institutions.
D. An agreement by the International Swaps and Derivatives Association (ISDA) that provides
details of the swap arrangement and is called a confirmation.

5.
How much is the comparative advantage?

A. 200 bps
B. 110 bps
C. 400 bps
D. 90 bps
6. Which of the following statements regarding the discount rates in a plain vanilla interest rate
swap are correct?
I. A swap is just a series of future cash flows whose value we can determine by present
valuing them back to todays date.
 T1 
II. The formula to calculate the forward rates is: R f  R2    R2  R1   
 T1  T2 
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. Consider an interest rate swap with a notional principal of $100m. The swap is based on 6-
month LIBOR and is a one-year swap agreement. The fixed rate on the loan is 10%. We are 3
months into the swap.
The following spot LIBOR rates are applicable:
LIBOR at last payment date: 7%
LIBOR at the 6-month date: 8%
LIBOR at the 12-month date: 9%
What is the value the fixed payment?
A. $100,000,000
B. $103,047,404
C. $1,596,841
D. $101,450,563
8. Which of the following statements are not correct regarding calculating the value of a plain
vanilla interest rate swap from a sequence of forward rate agreements (FRAs)
 T1 
A. The forward rates will be calculated as follows: R f  R2    R2  R1   
 T1  T2 
B. Once we have the forward rate, we will use it to calculate the fixed cash flows.
C. These floating cash flows will be deducted from the fixed rate cash flows and present
valued to todays date.

D. The sum of these present values is equal to the value of the swap.
What is the value of the BZAR?

A. R101,341,791
B. R106,008,487
C. -R4,666,696
D. $101,341,791
10. The following two companies have two different rates that are available to these companies to
borrow at:
Company Y has a comparative advantage of bps

A. 200 bps
B. 100 bps
C. 400 bps
D. 300 bps

What is the value of the swap?

A. R101,341,791
B. R106,008,487
C. -R4,666,696
D. $101,341,791
12. Assume that the ZAR yield is 10% and the USD yield is 2%.
The current exchange rate is ZAR 15: USD 1.
Calculate the forward rate in one years time.
A. 15:1
B. 16.24:1
C. 13.84:1
D. 16.50:1
13. Which of the following statements regarding the credit risk exposure in a swap position are
correct?
I. The swap market is almost all over-the-counter (OTC) traded.
II. The OTC market reduces the issue of default risk.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
14. Which of the following statements are not correct regarding a swaption?
A. A swaption is an option to enter into a swap
B. The most common swaption is an interest rate swaption.
C. An interest rate swaption gives the option to pay the fixed rate and to receive the floating
rate or the other way round.
D. A receiver swaption allows the holder to enter to enter into a swap as the fixed-rate payer
and floating rate receiver.

15. Savers Bancorp entered into a swap agreement over a 2-year period on August 9, 2014, with
which it received a 4.00% fixed rate and paid LIBOR plus 1.2% on a notional amount of USD6.5
million. Payments were to be made every 6 months. The table below displays the actual annual
6-months Libor rates over the 2-year period:
Date 6 - month LIBOR
Aug 9,2014 3.11%
Feb 9, 2015 1.76%
Aug 9,2015 0.84%
Feb 9, 2016 0.39%
Aug 9,2016 058%
Assuming no default, how much did savers Bancorp receive on August 9, 2016
A. USD 72,150
B. USD 78,325
C. USD 117,325
D. USD 156,650

SOLUTIONS
1. A
Fixed rate payment: $10,000,000 X 7.00% X 180/365 = $345,205 Floating rate payment:
$10,000,000 X 6.25% X 180/360 = $312,500 The fixed rate payer will pay the floating rate payer
the net amount, = $345,205 - $312,500 = $32,705.
2. C
A plain vanilla swap is an interest rate swap in which one party pays a fixed rate and the
other pays a floating rate – with both sets of payments being in the same currency.
3. A
The market is similar to that of the forward and OTC options market. It is made up of dealers
(banks, investment banks) and counterparties (normally end-users or other dealers). The
dealers make markets in swaps by quoting bid and ask prices and rates. In return, the dealer
or bank that acts as the intermediary will charge a spread for bringing the parties together and
taking on the risk. The dealer will typically offset his risk by making transactions in other
markets.
4. C
When a swap is initiated neither party will pay the other party anything. Therefore at
inception the value of a swap is zero. A swap is a customized instrument with very little
regulation in the market. As such the risk of default is high. The majority of the participants in
the market are large institutions. An agreement by the International Swaps and Derivatives
Association (ISDA) that provides details of the swap arrangement and is called a
confirmation.
5. C
Good credit enjoys an absolute advantage in both fixed and floating borrowing rates.
However, on a comparative basis Cantgeta loan enjoys an advantage. The comparative
advantage is the difference in borrowing rates between the two companies in the fixed and
floating markets – in other words 200 bps less 110 bps = 90 bps.
6. A
A swap is just a series of future cash flows whose value we can determine by present valuing
them back to todays date.
The formula to calculate the forward rates is:
 T 
R f  R2    R2  R1   1 
 T1  T2 
7. B
Value the fixed payment BFIXED = PFIXED X e-r(t) BFIXED = 5,000,000 X e-0.08(0.25) +
105,000,000 X e-0.09(0.75) BFIXED = $4,900,993 + $98,146,411 BFIXED = $103,047,404.

8. C
 T 
R f  R2    R2  R1   1 
 T1  T2 
Once we have the forward rate, we will use it to calculate the floating cash flows. These
floating cash flows will be deducted from the fixed rate cash flows and present valued to
todays date. The sum of these present values is equal to the value of the swap.
9. A
BZAR = (12,000,000 + 100,000,000) x e-0.10(1)
BZAR = R101,341,791
10. B
Company X has absolute advantage on interest rates over Company Y. However, on a
comparative basis there is a 100 bps (200bps – 100 bps) advantage to be shares between the
parties.
11. C
BZAR = (12,000,000 + 100,000,000) x e0.10(1) BZAR = R101,341,791 BUSD = (210,000 +
7,000,000) x e0.02(1) BUSD = $7,067,232 Convert the BUSD of $7,067,232 to ZAR at the spot
rate of 15:1 = R106,008,487 VSWAP (X)= BZAR – (S0 X BUSD) VSWAP (X)= R101,341,791 –
R106,008,487 VSWAP (X)= -R4,666,696
12. B
Forward rate1 = 15e(0.10 – 0.02)1 Forward rate1 = R16.24: USD1
13. A
The swap market is almost all over-the-counter (OTC) traded. This raises the issue of default
risk.
14. D
Swaptions
A swaption is an option to enter into a swap. The most common swaption is an interest rate
swaption. This is a swaption to pay the fixed rate and to receive the floating rate or the other
way round.
Basic characteristics of swaptions
A payer swaption allows the holder to enter to enter into a swap as the fixed-rate payer and
floating rate receiver.
15. B
The proper interest rate to use is the 6-month LIBOR rate at February 9, 2016, since it is the 6-
month LIBOR that will yield the payoff on August 9, 2016. Therefore, the net settlement
amount on August 9th, 2016 is as follows:
Savers receives: 6,500,000 * 4.00% * 0.5 years, or USD 130,000 Savers pays 6,500,000 * (0.39% +
1.20%) * 0.5, or USD 51,675. Therefore, Savers would receive the difference, or 78,325.

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FRM PART – I – FINANCIAL MARKETS AND PRODUCTS

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5. Which of the following statements regarding a Dutch auction are correct?

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D. A conflict of interest may lead to a Chinese wall.

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Insurance Companies and Pension Plans

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5. Which of the following statements regarding moral hazard are correct?

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9. Which of the following statements regarding moral hazard are correct?

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1. Which of the following statements regarding ETF’s are correct?

5. Assume the following information:

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The return attributable to the Manager is closest to?

6. Assume the following information:

The return attributable to the Investor is closest to?

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Which of the following biases is Jamie most likely describing?

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1. Which of the following is not a characteristic of a forward contract in relation to a futures

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9. Which of the following statements regarding risks of derivatives are correct?

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C. Both I and II.

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The final payoff in EUR to the bank can be calculated as:

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Exchanges and OTC Markets

LO 29 a: Describe how exchanges can be used to alleviate counterparty risk.

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1. Which of the following functions is not a standardized product of an exchange?

2. Which of the following functions is not a key function of an exchange?

4. Which of the following forms of clearing is the most effective?

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7. Which is the biggest OTC derivative market?

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LO 30 a: Provide examples of the mechanics of a central counterparty (CCP).

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1. Which of the following is not a category of central clearing?

3. Which of the following is not an advantage of central clearing of OTC derivatives?

4. Which of the following is not an advantage of central clearing of OTC derivatives?

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D. The factors that give rise to operational risk are external.

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