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Exceptional Practice To Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition Pass the First Time
NEW QUESTION 63
What is the running yield on a 6% coupon bond selling at a clean price of $96?
- A. 6.00%
- B. 6.30%
- C. 6.25%
- D. 5.70%
Answer: C
Explanation:
Explanation
The 'running yield' refers to the coupon rate divided by the current price. In this case, it is 6/96 = 6.25%.
Remember that the running yield is also called the current yield.
NEW QUESTION 64
The underlying objective in decisions relating to capital structure is to:
- A. maximize shareholder value
- B. maximize value for all stakeholders
- C. maximize value for shareholders and debt holders
- D. minimize the tax burden
Answer: A
Explanation:
Explanation
The objective of decisions relations to capital structure is to maximize the value to shareholders. The management of the company is entrusted with the job of maximizing shareholder value, and this objective is generally achieved by attempting to maximize enterprise value. Enterprise value includes the value of both debt and equity, and since debt has a fixed claim on the assets of the business, maximizing enterprise value also maximizes the value of equity.
NEW QUESTION 65
The yield offered by a bond with 18 months remaining to maturity is 5%. The coupon is 3%, paid semi-annually, and there are two more coupon payments to go in addition to the interest payment made at maturity. The zero rate for 6 months is 2%, that for 12 months is 3%. What is the 18 month zero rate?
- A. 4.03
- B. 6.03%
- C. 5.03%
- D. 4.81%
Answer: C
Explanation:
Explanation
This is a two step problem:
First, calculate the bond price using the yield information, then
Second, once you know the bond price, calculate the 18 month zero rate using the bootstrap method.
Step 1: Bond valuation: All variables required for pricing the bond are known. The coupon payments will be
$1.50 in 6 months and 1 year from now, and a final paymento of $101.50 will be received in an year's time.
This can be discounted at the yield provided as follows, and summed together to get the bond price of $97.14.
Step 2: Boot strapping: Discount the 6 month and 12 month coupons at the zero rates for those periods, and subtract the total of these PVs from the bond price. These work out to 1.5/(1+2%/2) = 1.485, and
1.5/(1+3%/2)^2=1.456. That gives us the present value, $97.14 - $1.485 - 1.456 = $94.203, which grows to the final payment of $101.50 at the end of 18 months. The zero rate inherent in this price can then be worked out as we know that (1+r/2)^3 = 101.5/94.203, or r = 5.03%.
NEW QUESTION 66
The price of an interest rate cap is determined by:
I. The period to which the cap relates
II. Volatility of the underlying interest rate
III. The exercise or the strike rate
IV. The risk free rate
- A. I, II and III
- B. I, II and IV
- C. I, II, III and IV
- D. II, III and IV
Answer: A
Explanation:
Explanation
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.
NEW QUESTION 67
Backwardation in commodity futures is explained by:
- A. storage costs
- B. contango
- C. convenience yields
- D. risk free rate or the cost of futures funding
Answer: C
Explanation:
Explanation
Backwardation is said to occur when futures prices are lower than the current spot prices. This would happen only when carrying costs are negative. Carrying costs are equal to interest, plus storage costs and less any
'convenience yield'. The existence of large convenience yields may explain backwardation in commodity futures prices. Therefore Choice 'd' is the correct answer.
Contango is the 'normal' market situation where forward prices are higher than spot prices. Storage costs explain contango, not backwardation. Risk free rates, or the cost of funding for the futures position, are always positive and do not explain backwardation.
NEW QUESTION 68
For a pair of correlated assets, the achievable portfolio standard deviation will be the lowest when the correlation is:
- A. = 0.33
- B. = 1
- C. = 0
- D. = -0.33
Answer: D
Explanation:
Explanation
The lowest achievable standard deviation will be lowest when the assets are perfectly negatively correlated, ie when correlation = -1. In the case of the above choices, the lowest correlation is -0.33, which is the correct choice.
NEW QUESTION 69
Gamma risk can be hedged by:
- A. a short stock position determined by the delta of the option
- B. a bank deposit which at maturity will be worth the strike price
- C. gamma cannot be hedged
- D. an option position with an identical but numerically opposite gamma
Answer: D
Explanation:
Explanation
Gamma risk is unique to options. Therefore gamma risk can only be hedged using options, and Choice 'a', ie an option position that offsets any existing gamma in the portfolio, is the only way to hedge gamma.
Positions in stock or bank deposits do not carry gamma and therefore cannot be used to hedge gamma risk.
NEW QUESTION 70
What is the standard deviation (in dollars) of a portfolio worth $10,000, of which $4,000 is invested in Stock A, with an expected return of 10% and standard deviation of 20%; and the rest in Stock B, with an expected return of 12% and a standard deviation of 25%. The correlation between the two stocks is 0.6.
- A. $2,081
- B. $4,330,000
- C. $1,204
- D. $1,201
Answer: A
Explanation:
Explanation
Standard deviation of this portfolio can be calculated as SQRT(4000^2*20%^2 + 6000^2*25%^2 +
2*0.6*4000*6000*20%*25%), which is equal to $2,081. Choice 'a' is the correct answer. The other answers are incorrect.
NEW QUESTION 71
A fund manager buys a gold futures contract at $1000 per troy ounce, each contract being worth 100 ounces of gold. Initial margin is $5,000 per contract, and the exchange requires a maintenance margin to be maintained at $4,000 per contract. What is the most prices can fall before the fund manager faces a margin call?
- A. $10 per ounce
- B. $20 per ounce
- C. $1,000 per ounce
- D. $0 per ounce
Answer: A
Explanation:
Explanation
The most loss the fund manager can bear without facing a margin call is the loss that will make his margin balance account no lower than $4,000. This means he can have a loss of upto $1,000 before a margin call is triggered, implying that prices can fall by $10 per ounce (=$1,000/100 ounces per contract) without triggering a margin call. The margin call will be to top the margin up to the $5,000 initial margin.
NEW QUESTION 72
For an investor short a bond, which of the following is true:
I. Higher convexity is preferable to lower convexity
II. An increase in yields is preferable to a decrease in yield
III. Negative convexity is preferable to positive convexity
- A. II and III
- B. I, II and III
- C. I and III
- D. I and II
Answer: A
Explanation:
Explanation
The effect of higher convexity is that when yields rise, the price decrease is lower than the increase in yields, and when yields fall, the increase in price is greater than the fall in yield. In either case, it benefits the holder of the fixed income instrument that carries such positive convexity. The converse is true for someone short a bond - such an investor would prefer lower convexity to higher convexity. Therefore statement I is not true for an investor who is short a bond.
An increase in yields makes bond prices decrease, something that would benefit the short. Therefore statement II is true for an investor short a bond.
Negative convexity has exactly the opposite effect as the one described for positive convexity for statement I above. An investor short a bond would prefer negative convexity (which by the way is exhibited by very few fixed income instruments such as mortgages) to positive convexity, therefore statement III is true for such an investor.
Choice 'b' is the correct answer.
NEW QUESTION 73
Which of the following statements is true:
I. The standard deviation of a short position is the same as the standard deviation of a long position II. The expected return of a short position is the same as that a long position in the same asset III. If two assets are perfectly positively correlated, then a short position in one and a long position in the other are negatively correlated IV. If we increase the weight of an asset in a portfolio, its correlation with other assets in the portfolio scales up proportionately
- A. II and IV
- B. I, II, III and IV
- C. II, III and IV
- D. I and III
Answer: D
Explanation:
Explanation
Statement I is true as standard deviation is the root of the squared deviations, and is always positive, and identical regardless of the positions being long or short.Statement II is false as the expected return of a long position is exactly the negative of the expected return of the short position.Statement III is correct as a correlation of +1 between two long positions implies a correlation of -1 between one long and one short position. This is the basis of hedging, for example, of spot positions with futures.Statement IV is inaccurate.
The weight of an asset in a portfolio does not change the correlation of the asset with the portfolio, or with other assets.Therefore Choice 'c' is the correct answer.
NEW QUESTION 74
The volatility of commodity futures prices is affected by
- A. the volatility of spot prices
- B. the volatility of interest rates that drive the funding cost of the futures positions
- C. all of the above
- D. the volatility of the convenience yields
Answer: C
Explanation:
Explanation
All the choices list inputs into the determination of futures prices. Therefore volatility in any of them affects the volatility of futures prices. Of course, the largest contributor to the volatility is the volatility of the spot price of the underlying. Choice 'd' is the correct answer.
NEW QUESTION 75
Credit derivatives can be used for:
I. Reducing credit exposures
II. Reducing interest rate risks
III. Earn credit risk premiums
IV. Get market exposure without taking cash market positions
- A. I and IV
- B. I, II and III
- C. I, III and IV
- D. II, III and IV
Answer: C
Explanation:
Explanation
Credit derivatives can indeed be used for reducing credit exposures, earning credit risk premiums and getting market exposure without taking cash market positions. They cannot be used for reducing interest rate risks, as they pay out only when agreed 'credit events' take place. Changes in interest rates are not a credit event.
Therefore Choice 'b' is the correct answer.
NEW QUESTION 76
Which of the following statements are true:
I. All investors regardless of their expectations face the same efficient frontier which is always the market portfolio II. Investors will have different efficient frontiers based upon their views of expected risks, returns and correlations III. Investors risk appetite will determine their choice of the combination of risk-free and risky assets to hold IV. If all investors have identical views on expected returns, standard deviation and correlations, they will hold risky assets in identical proportions
- A. II, III and IV
- B. I, II, III and IV
- C. I and II
- D. III and IV
Answer: A
Explanation:
Explanation
Investors have differing view of the market, which means differing view of expected returns, correlations and volatilities. Not only do they have differing views, these views change frequently as new information reveals itself. Accordingly, each investor has their own version of the efficient frontier. Once investors have determined their efficient frontiers, they will determine the extent of risk they wish to hold. If they had identical views, they would have held the same portfolio. But they do not, and if they did, there would be very little trading in the markets.
All the above statements are true except statement I which is false due to differing investor expectations.
(Re statement IV: If investors have different risk appetites, their portfolio will vary in the split between the risky and the riskfree assets. But inside the 'risky' assets bundle the proportion of the assets will be identical.
Ie, they would express their varying risk appetites by varying how much of the risky bundle and the riskfree asset they hold, but inside the risky bundle the proportion of the different risky assets will be the same.)
NEW QUESTION 77
Which of the following is NOT an assumption underlying the Black Scholes Merton option valuation formula:
- A. There are no transaction costs
- B. There is no credit risk
- C. The option can be exercised at any time up to expiry
- D. Volatility of the underlying and the risk free interest rate is constant
Answer: C
NEW QUESTION 78
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