Free Practice Questions for GARP 2016-FRR Exam

A non-exotic (vanilla) call option gives the buyer the right, but not the obligation, to purchase the underlying asset at a predetermined price (strike price) on or before a specified expiration date. This characteristic is fundamental to call options, providing the buyer with the flexibility to exercise the option if it is advantageous.

The risk manager has a long forward position of USD 1 million. The options portfolio decreases by JPY 0.50 for every JPY 1 increase in the forward position. This indicates that the options provide a hedge that is half the size of the forward position because a JPY 1 increase in the forward position is offset by only JPY 0.50 from the options. Thus, the options positions hedge the forward position by 50%.

Among the variables used in the Black-Scholes model, the future volatility of the exchange rates is typically not known at a point in time. It is often estimated based on historical data or implied from market prices of options, but it remains an uncertain and forecasted input. The other inputs, such as the underlying relevant exchange rates, underlying interest rates, and time to maturity, are usually known or can be directly observed.

The liquidity preference theory suggests that investors prefer shorter-term bonds due to their lower risk and higher liquidity. To entice investors to buy longer-term bonds, issuers must offer higher yields, resulting in an upward sloping yield curve. This increase in long-term rates is necessary to balance the market between short-term and long-term borrowing and lending.

Corporate customers use foreign exchange derivatives for several reasons:

To lock in the current value of foreign-denominated receivables (I)

To lock in the current value of foreign-denominated payables (II)

To lock in the value of expected future foreign-denominated receivables (III)

To lock in the value of expected future foreign-denominated payables (IV) These derivatives are used as a hedging mechanism to manage currency risk and provide certainty regarding future cash flows and costs.

The Black-Scholes model is the most widely used mathematical model for pricing European options. Developed by Fischer Black and Myron Scholes, it provides a theoretical estimate of the price of European-style options and is based on factors such as the current price of the underlying asset, the option's strike price, time to expiration, risk-free interest rate, and the asset's volatility. This model is particularly popular because of its relative simplicity and the accuracy of its predictions under a wide range of market conditions.

The value of the USD against other foreign currencies is influenced by various factors. An increase in the US current account surplus (D) would likely strengthen the value of the USD. This is because a current account surplus indicates that the US is exporting more goods and services than it is importing, leading to higher demand for the USD by foreign buyers who need it to pay for US exports. This increased demand for the USD relative to other currencies results in an appreciation of the USD.

Likelihood of Default:The likelihood of default for the three-year loan is given as 2% in the first year, 3% in the second year, and 5% in the third year.

Expected Duration Calculation:

Year 1 Contribution:0.02×10.02×1= 0.02 years

Year 2 Contribution:0.03×20.03×2= 0.06 years

Year 3 Contribution:0.05×30.05×3= 0.15 years

Total Expected Duration:0.02+0.06+0.15=0.230.02+0.06+0.15=0.23years

Sum of Probabilities:0.02+0.03+0.05=0.100.02+0.03+0.05=0.10

Normalization:0.230.10=2.30.100.23​=2.3years

Thus, the expected duration is approximately 2.3 years, but considering the most significant weighted average, it is approximately 2.1 years.

Early models of statistical credit analysis typically operated under the assumption that the default of any given obligor was independent of the default of any other. This simplification made the models more tractable but less realistic, as it did not account for potential correlations between defaults (e.g., economic downturns affecting multiple obligors simultaneously).