8006 Exam Dumps - PRMIA PRM Certification Questions and Answers

A short position in a fixed rate bond and a long position in an FRN has the effect of paying fixed and receiving floating. The floating received offsets the floating payment on the borrowing, leaving the borrower with just a fixed rate outflow. Therefore the combination identified in statement I can be used to achieve the objective of paying fixed.

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

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

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

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

An m x n FRA is an agreement to borrow money for a period starting at time m and ending at time n at the contracted rate. Therefore, the buyer of the 3 x 6 FRA has committed to borrow $1m at the beginning of 3 months and return it at the end of 6 months, ie a total borrowing period of 3 months at a rate of 5%. Of course, the $1m is never actually exchanged, and at the beginning of the 3 month period when the next three months' interest rate is known (6%), the parties merely exchange the difference in the interest. SInce this interest was only due at the end of the 6 months and is being exchanged at the 3 month time point, it will have to be discounted to its present value.

The correct answer to this question is =(1,000,000 * (6% - 5%) * 3/12)/(1 + (6%*3/12))=$2463.05. Since interest rates rose, the borrower gained as he has the right to borrow at a lower rate, and therefore the seller will pay the borrower.

(Here:

- $1m is the notional

- 6% - 5% represents the difference between the contracted and the realized interest rates

- 3/12 is the 3 month period from month 3 to 6

- Finally, we divide by the current interest rate for 3 months to present value the payment from month 6 to month 3)

Implied volatilities are the same for calls and puts with similar exercise and strike prices. If not, it would offer an arbitrage opportunity. Therefore Choice 'b' is the correct answer.

In terms of beta, his exposure is $10m*0.7 = $7m. This exposure is long.  In order order to neutralize his long exposure, he needs to have an equal an identical short position with the same beta as this long position (of course, in the short direction).  We need to figure out how many contracts will have a beta equal to his held position.  (The beta of a futures contract is slightly different from 1 when compared to spot, but in the absence of other information in the question it is always okay to assume that the beta of the futures contract is 1.  Such precision does not matter because of other errors such as rounding etc that cannot be anyway done away with.)

He needs to short futures contracts on the index with $7m in notional value. The value of each contract is currently 1000*250 =$250,000. He therefore needs to short $7m/$250,000 = 28 contracts to become market or beta neutral.

Choice 'b' lists all the factors that affect the forward price of a physical asset and is the most complete answer. Forward prices for physical assets are not affected by volatility (only options are), nor are they arbitrarily decided by any prevailing 'views'.

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

Given covered interest parity, the currency with a lower interest rate will trade at a forward premium. Choice 'b' is the correct answer.

For an intuitive reasoning, consider a currency forward contract that matures in 3 months. The seller has agreed to sell, say JPY 1,000,000 in exchange for USD 10,000 in the future. In order to cover himself, he borrows the USD right now and converts it to JPY at spot which he puts in a JPY deposit. Assuming JPY interest rates are less than USD interest rates, he pays more on his USD borrowing than he receives on his JPY deposit. Therefore he has to price the forward contract at a premium to spot to cover the interest rate differential.

A cash or nothing call is one that pays a fixed amount if the underlying exceeds a certain threshold, or nothing. An asset or nothing call is the same as the cash or nothing call except that instead of paying a fixed amount, it 'pays' the asset. Therefore the payoff profile of a long asset or nothing call has the same payoff as a long cash or nothing call and a long vanilla call.

This is best considered by building payoff diagrams which will show how the two positions are economically equivalent. Choice 'd' is the correct answer, and the rest are not.

Average rate options will be the most cost effective in this scenario as they are cheaper than vanilla options. Writer extendible options on commodities will be even more expensive, and correlation products are irrelevant to the manufacturing company's hedging needs.

The no-arbitrage futures price for the stock is the current spot price plus the carrying cost for one year, which in this case is $100 * 10% =$10. Therefore the no-arbitrage futures price for the stock is $110. ($100*(1+10%), or $100 + $10.)