Free Practice Questions for PRMIA 8006 Exam

The price of an interest rate cap is affected by all of the listed choices except the risk free rate. The risk free rate does not come into play in the pricing of caps, and therefore Choice 'b' is the correct answer.

Price quotes for futures where one of the currencies is the US dollar follow the convention of using the number of US dollars one unit of the foreign currency can buy. (For JPY, 100 Yen is used.)

In the forward market, the same convention as is used in the spot market is used.

In the spot market, prices are expressed as the number of units of the foreign currency that 1 USD can buy, except for GBP, EUR, AUD and NZD where it is the other way round (ie, number of USDs that 1 of each of these currencies can buy).

Statement I is not correct because the 4% bond with the same modified duration as the zero coupon bond will have a maturity much later in the future than the zero coupon, and the final repayment coming much later will cause its convexity to be greater than the equivalent duration zero coupon bond.

Statement II is not correct as the convexity of a bond increases not in a linear fashion but in proportion to the square root of time as the maturity of the bond is increased.

Statement III is not correct as mortgage based bonds bring negative convexity even in the case of long positions,

Statement IV is not correct as the duration of a zero coupon bond maturing in 10 years has a modified duration greater than that of a coupon bearing bond of the same maturity, which means its convexity is higher and not lower (note this is different from statement I where the modified durations were identical. Here, the maturity is identical which has different implications.)

Therefore none of the statements is correct and Choice 'd' is the correct answer.

The profit potential from the conversion of convertible bonds into stock is limited by the issuer's option to call the security at short notice. Generally, the convertible debt security is convertible into a certain number of shares, and the debt holder will generally not convert the security to shares unless there is a profit to be made. The 'premium' is irrelevant, because as long as the premium exists, the debt holder has no incentive to convert, as he would be better off buying the shares in the market. It is only when share prices go beyond a level that it becomes advantageous convert the security into shares. However, the prospect of granting cheap shares to the debt holders is not too appealing to the issuer, and as soon as the share price goes beyond a point where the value of the shares exceeds the face value of the debt the issuer has an incentive to exercise its option to call the security.

Therefore the profit potential from the conversion of convertible bonds into shares is limited by the issuer's option to call the security, and Choice 'a' is the correct answer. The 'premium', or interest rates, or volatility are irrelevant.

The transformation line represents the various possible combinations of the 'risky bundle' and the risk free asset. Investors can choose different combinations of the risky and risk-free asset depending upon their risk appetite. The transformation line meets the y-axis (portfolio returns) at the point equal to the risk free rate. Choice 'a' is the correct answer and the rest are incorrect.

The highest possible transformation line, ie the transformation line with the maximum slope, is the transformation line joining the risk free rate on the y-axis and the portfolio with the maximum Sharpe ratio on the efficient frontier. This line is called the 'capital markets line'. Investors can pick any point on this line according to their risk appetite, and doing so would maximize the return they can obtain for their desired level of risk. The capital markets line is tangential to the efficient frontier. The Sharpe ratio stays constant throughout the CML.

Remember that the transformation line and the capital markets lines are different from each other - there is only one CML for an efficient frontier, whereas there can be multiple transformation lines.

A high beta does not necessarily imply a high correlation with the market. The relationship

between beta and correlation can be expressed as 103.04.e2103.04.e2, where x is the market portfolio and y is the asset under consideration.

103.04.e

This means that a high market beta could be due to high volatility of the asset in question, and not because of a high correlation. Therefore statement I is not correct.Statement II is correct as correlation and covariance have the same sign. This is because correlation = covariance/product of standard deviations. Since standard deviation is always positive, correlation and covariance will have the same sign.A correlation of zero indicates the absence of a linear relationship between two variables - therefore statement III is correct.Statement IV is correct as well, because unless correlation is +1, diversification always reduces total portfolio risk.

Once the price of the stock exceeds $100, the investor would forego any additional gains as the call would be exercised. Therefore the maximum gain to the investor is $10, plus the premium earned, which is $3, making for a maximum gain of $13.

In the event the stock price declines, the investor would lose on his long stock position an amount equal to the decline, less any premium earned. The worst case price for a stock is 0, and in this case the investor would lose his $90 in the stock, offset by $3 in premiums earned (the written call would expire worthless), thereby limiting his total loss to $87.

Choice 'c' is therefore the correct answer.

A CLN is a form of a funded credit derivative. The investors in the note are the protection sellers, and receive the CDS premiums in addition to any risk free rate on their investment. If a default occurs, the money put up by the investors in the CLN is used to make good the party that has brought the protection.

Therefore if a default occurs, the investors in a CLN do not receive their entire investment back, but only what remains after fullfilling their obligations on the credit protection, plus any premiums that might have been earned. In return for this risk, the CLN yields the risk free rate plus the CDS premiums. Only Choice 'd' is correct, all other options are incorrect.

An yield curve would be meaningless if it combines, for example, the yield on a AAA bond with the yield on a bond near default on the same curve. Therefore statement I is incorrect as any typical yield curve generally refers to similar instruments, and similarity includes similarity of issuer type and credit risk profiles.

Statement II accurately describes an yield curve, and statement IV explains what the term structure is.

Statement III is incorrect as the liquidity preference theory offers an explanation for an upward sloping yield curve and not a downward sloping one.