MARKETS, INTERMEDIARIES AND INVESTORS

67) Which of the following is (are) not a cash market instrument? ****** a) b) c) d) e) f) d&e corporate bond mortgage spot foreign exchange forward contract to purchase Treasury bonds interest rate swap inverse floating rate note

Cash market instruments refer to the traditional securities which require cash (or some other form of) payment and actual delivery upon payment, such as stocks, bonds, commodities, real estate, etc. Forward contracts and swaps are derivatives, not cash securities. An inverse floating rate note calls for payment on the part of the investor, hence qualifies as a cash instrument, albeit a structured one.

0)

Which of the following is a false statement? a) Brokers are paid a fee for their agent services; dealers earn the bid-asked spread as principals in transactions. b) The more customized a security, the wider the bid-asked spread c) The more volatile the price of a security, the wider the bid-asked spread. d) Dealers bear the risk of price change during the search process; the customer bears the risk as the broker searches. e) none of these

e
These statements describe the role of a dealer, in contrast to a broker. The dealer acts as principal, accepting the risk of price change while searching for a counter-party to a transaction. The greater the risk, the greater the necessary compensation, in the form of wider bid-offer spreads. The more volatile a security, the greater the chance of price change. The more customized, the longer the time the dealer will likely own the security, again exposing more chance of price change. Which of the following is true of bank balance sheets? a) customer loans are assets, cash is an asset b) customer deposits are assets, borrowing from the central bank is a liability c) securities purchased are liabilities, customer deposits are liabilities

d) loans to other banks are assets, cash is a liability a Loans to customers or other banks, securities and cash (despite non-interest bearing) are assets. Deposits and, of course, borrowings, are liabilities.

2)

Which of the following is a true statement? a) Pension fund consultants help the funds allocate investment funds to various asset classes as well as evaluate performance of investment managers. b) Any investor can participate in a hedge fund. c) The net asset value of a closed end mutual fund is kept equal to the market value of the funds securities. d) The social security trust fund can invest in any asset. e) The Securities and Exchange Commission must approve all investments choices of institutional investors.

a
The others are false because: b) only accredited investors are allowed in hedge funds; c) because the number of shares in a closed end fund are fixed at any point in time, per-share price can deviate from the funds net asset value; d) the social security trust fund can hold only federal government obligations; e) institutional investors are free to choose among permitted assets. Which of the following own Treasury bonds? ****** a) b) c) d) a-e Individuals own Treasuries directly, and pension funds include government bonds as an asset class. Banks will invest more in Treasuries the more loans are deemed too risky or unprofitable. The Feds ownership of Treasuries backs its dollar liabilities, and is also used for open market operations. The Social Security Trust Fund holds Treasuries from which to pay its liabilities. individual investors banks pension funds the Federal Reserve e) The Social Security Trust Fund

RULES & REGULATIONS

Which of the following S.E.C. rules provides exemptions for hedge funds to register as an investment company? ****** a) 2a-7 b) 3c-1

c) 3c-7 d) 144a e) 415 b,c The 3c-1 exemption is for no more than 100 investors; 3c-7 for less than 500 qualified purchasers. 2a-7 is a money market mutual fund. 144a refers to private placements. Rule 415 is for shelf registration. **) Insider trading laws are covered in which of the following Acts? ***** a) b) c) d) e) b&e The Insider Trading & Securities Fraud Enforcement Act of 1988 augmented the rules first put forth in the 1934 Act. 102. Accumulation of 5% of the voting shares of a publicly traded company requires notification to all the following EXCEPT: a) the S.E.C. b) the companys board of directors c) the exchange where the shares are listed d) the Securities Administrator of the state where the company is incorporated d Rule 13d is part of federal law, hence no state notification is required. The USA and UTMA are both examples of model legislation for states. In each case, the U and A stand for: a) united and action b) uniform and act c) universal and amendment d) unincorporated and act e) unified and amendment b USA: Uniform Securities Act; UTMA: Uniform Transfer to Minors Act Securities Act of 1933 Securities Exchange Act of 1934 Investment Advisors Act of 1940 Investment Company Act of 1940 Insider Trading and Securities Fraud Enforcement Act of 1988

MACRO-ECONOMICS

17) Which of the following describes the Commerce Departments most widely followed GDP figures? ***** a) b) c) d) a, b, c, d The Commerce Departments main GDP figures cover three months of aggregate economic activity, but presented as annualized rates of change from the prior quarter, net of inflation (hence, real GDP growth). There is a release every month, because of revisions to the data. 21) Suppose GDP is near potential. Aggregate demand falls. What is likely to happen? ***** a) b) c) d) e) c, e The decline in demand elicits less production of goods and services, hence the GDP Gap widens. Productivity initially deteriorates as firms wait to see how long the downturn lasts before they lay off employees. Short-term interest rates decline since the demand for liquidity has dropped. In fact, the central bank may abet this decline by adding reserves to the financial system. Over time, if the downturn is prolonged, the unemployment rate rises. Weak product and labor demand depresses the inflation rate. 1) You own fixed-rate government bonds of your own (industrialized) country. Which of the following would, all else the same, typically reduce your rate-of-return? ******* a) b) c) d) e) an increase in the countrys macro-economic growth relative to potential a decrease in the countrys macro-economic growth relative to potential a decline in the inflation rate a depreciation of the home currency relative to that of its major trading partners none of these the GDP Gap narrows productivity improves short term interest rates decline the unemployment rate decreases inflation decelerates covers one quarter annualized rate of change net of inflation released once a month

a An increase in macro-economic growth above a countrys potential growth rate typically causes interest rates to rise in the country. Since the bind has a fixed coupon, an increase in yield reduces its price, hence an investors rate-of-return on the bond. A decline in

inflation would cause the yield to decline. Anyway, the higher growth is more likely to raise inflation, further causing yields to increase. Finally, the currency factor is irrelevant since the bond is denominated in the home currency.
1) You own fixed-rate government bonds of your own (industrialized) country. Which of the following would, all else the same, typically reduce your rate-of-return? ******* a) b) c) d) e) an increase in the countrys macro-economic growth relative to potential a decrease in the countrys macro-economic growth relative to potential a decline in the inflation rate a depreciation of the home currency relative to that of its major trading partners none of these

a An increase in macro-economic growth above a countrys potential growth rate typically causes interest rates to ruse in the country. Since the bind has a fixed coupon, an increase in yield reduces its price, hence an investors rate-of-return on the bond. A decline in inflation would cause the yield to decline. Anyway, the higher growth is more likely to raise inflation, further causing yields to increase. Finally, the currency factor is irrelevant since the bond is denominated in the home currency.
5) Which of the following is most sensitive to interest rate movements? a) b) c) d) government spending on goods and services consumer spending on durable goods exports imports

b Government spending is driven by fiscal and macro-economic policy. Exports depend on exchange rates and foreigners desire for the countrys products. Although indirectly sensitive to interest rates, since greater consumption leads to higher imports, imports are not directly influenced by interest rates, but by exchange rates and the level of domestic macro-economic activity.
) Consider the following commercial bank balance sheet. Assets 1,000 Customer deposits 800 Notes issued 25 Inter-bank borrowing 60 Borrowing from central bank 15 Liabilities

Equity

100

Which of the following is(are) true? *** a) Of the 1,000 in assets, 800 must be in the form of reserves b) The 15 borrowing from the central bank will show up as an asset of the central bank c) Checking accounts are part of customer deposits d) This bank can lend at most 45 to other banks e) If the bank makes a 100 loan from the funds deposited, and the borrower takes the cash out, customer deposits decrease to 700

b, c b) and c) are correct statements. Only a fraction of the 800 must be held as reserves. The bank is not constrained to lend only 6015 to other banks. When the bank makes the loan and the money is taken by the borrower, 100 on the asset side changes from cash to loans, and the liabilities are unaffected. 12) The ISM index fell last month to 54 from 57 the month before. This means: a) The average grade on the monthly exam administered by the ISM to manufacturing executives declined from 57 to 54. b) The US manufacturing sector has contracted from last month. c) The US manufacturing sector is still expanding, but at a slower rate than the month before. d) Spending by manufacturers on goods and services has declined from the month before. c The Institute for Supply Management surveys manufacturers each month. Responses are: expansion, contraction, or no change. The results are compiled into a diffusion index, centered around 50. A number above 50, therefore, implies that the average response was expansion, below 50, contraction.

FIXED INCOME PORTFOLIO MANAGEMENT

1) You own fixed-rate government bonds of your own (industrialized) country. Which of the following would, all else the same, typically reduce your rate-of-return? ******* a) b) c) d) e) an increase in the countrys macro-economic growth relative to potential a decrease in the countrys macro-economic growth relative to potential a decline in the inflation rate a depreciation of the home currency relative to that of its major trading partners none of these

a An increase in macro-economic growth above a countrys potential growth rate typically causes interest rates to ruse in the country. Since the bind has a fixed coupon, an increase in yield reduces its price, hence an investors rate-of-return on the bond. A decline in inflation would cause the yield to decline. Anyway, the higher growth is more likely to raise inflation, further causing yields to increase. Finally, the currency factor is irrelevant since the bond is denominated in the home currency.
2) Your client owns fixed-rate government bonds of a foreign industrialized country denominated in that countrys currency. Which of the following would, all else the same, typically reduce the rate-of-return? ******* a) b) c) d) e) a&d If the countrys growth rate increases, government bond interest rates typically rise (unless it is a developing country, where the higher growth rate reduces default risk). This pushed down the price of fixed-rate bonds, lowering the rate-of-return. A decline in the inflation rate reduces interest rates, resulting in a price increase, hence higher R.O.R. A depreciation of the countrys currency means less domestic currency, hence lower R.O.R. 114) A speculator believes interest rates are about to rise. What to do? ******* a) b) c) d) b, d An increase in market interest rates reduces the price of fixed income securities. A speculator hoping to profit from such an expected change should short Treasury bonds. (Shorting other bonds may expose the trade to other risks, such as credit, which is not the view of the speculator.) This can be accomplished by borrowing actual bonds via a reverse repurchase agreement and then selling them, or by entering into a short position in Treasury bond futures contracts. Borrow funds via repo and buy Treasury bonds Borrow Treasury bonds via reverse repo and sell them Go long Treasury bond futures Go short Treasury bond futures an increase in the foreign countrys macro-economic growth relative to potential a decrease in the countrys macro-economic growth relative to potential a decline in the countrys inflation rate a depreciation of the foreign currency relative to that of your clients home currency none of these

You are a speculator, and expect interest rates to fall imminently. You should purchase: a) short-term fixed coupon bonds

b) long-term fixed coupon bonds c) short-term floating rate notes d) long-term floating rate notes
b For bonds with equal (fixed) coupons, the longer the maturity, the greater the positive price reaction to a decline in interest rates. Floating rate notes will have minimal, if any, price responsiveness to interest rate changes, unless there is a change in the credit spread on the note.

88) An investor with a one-year horizon purchases a newly issued five-year 6.5% annual coupon bond at a 6% yield-to-maturity. On the horizon date, the bonds yield has risen to 6.25%. Which of the following is true regarding the clients Rate-of-Return from this instrument? a) b) c) d) b
If a bond is sold at a yield-to-maturity above its yield at purchase, the rate-of-return is below that yield, regardless of whether the bond is at a premium discount or par. While reinvestment of intervening coupons may alter this relationship between yield and r.o.r., this example assumes the coupon is not paid until the horizons end, so it is not a factor.

It equals 6.5% It is less than 6% because the ending yield exceeds the initial yield It is greater than 6% because, even though the yield has increased, it remains a premium bond on the horizon date It is at least 6.5% because on the horizon date the investor receives the coupon plus the bonds sale price.

10)

Suppose a five-year coupon bond has an annual coupon of 6.25% , and is yielding 6%. If the yield is 6% in one year, which of the following is true of the rate-ofreturn over that year? a) b) c) d) e) f) 6.25% due to carry, 0% due to pull-to-par 6% due to carry, 0.25% due to pull-to-par 6.18% due to carry, 0.18% due to pull-to-par 6% due to carry, 0.18% due to pull-to-par 6% due to carry, 0% due to pull-to-par 0% due to carry, 6.25% due to pull-to-par

c Since the bonds yield-to-maturity after one year is 6%, the same as it starting yield, the bonds rate-of-return is equal to that yield. In turn, yields-to-matirity is equal to carry, or current yield, plus the pull-to-par effect. A five-year bond with a 6.25% annual coupon yielding 6% is priced at 101.0531, so that its current yield is 6.25/101.0531, or 6.18%. Its pull-to-par factor must,

therefore, equal 0.18% so that the rate-of-return is 6%. (Indeed, since the bond is at a

premium, the pull-to-par must be a negative factor) 26) The one spot rate is 6% and the one year forward for next year is 7%. You have a one year horizon and buy a two year zero coupon IOU. What is your expected ROR if you expect the yield curve next year to be the same as todays? a) b) c) d)
c With the one-year spot rate at 6% and the one-year forward 7%, the spot two-year must be (approximately) 6.5%. You expect the yield curve to be static. Hence, next year, when your horizon is up, you will be selling a one-year instrument at 6%, half-percent below the initial yield. This adds 0.5% to your return, for a total R.O.R. of 7%. [Or, price=100/(1+.065)2, expected proceeds=100/(1+.06)1, and solve for ROR via: price=proceeds/(1+ROR)horiz] 37) The following bonds, all from the same issuer, mature in ten years. Bond A pays a 5% coupon, bond B pays a 10% coupon, and bond C pays no coupon. Which is the most (percentage) price sensitive to a yield change? a) b) c) d) c Among bonds of equal maturity, the lower the coupon, the greater the (percentage) price sensitivity to changes in yield-to-maturity. 1) A speculator anticipates an increase in interest rates. Which of the following would be an appropriate strategy(ies)? ******* a) b) c) d) e) b, c, d An increase in interest rates forces fixed coupon bond process to drop. Zero coupon bond prices fall most severely. A short position would profit from the price decline. So would a fixed payer purchase zero coupon bonds short sell fixed coupon bonds pay fixed and receive floating via an interest rate swap buy puts on fixed coupon bonds buy calls on fixed coupon bonds A B C Since they are all of the same maturity, they have the same price sensitivity

6% 6.5% 7% 7.5%

on an interest rate swap it would be receiving more income. And, because of the anticipated price decline for the fixed coupon bond, a put appreciates while a call depreciates. 32) Consider a (semi-annual coupon) credit-riskless bond, X. For the first five years, it pays a floating coupon equal to the six-month credit-riskless rate. Afterwards its coupon is fixed at 6%. Its current price is par. Another bond of the same is issuer, REG, pays 6% from inception. A floater of the same issuer, FRN, exists as well. All are ten-year maturities, priced at par. With respect to duration, which of the following is (are) true? ********** a) b) c) d) e) REG > X > FRN REG < X < FRN REG = X = FRN X > REG > FRN X < FRN < REG

a A floating rate notes duration is close to zero (actually equal to the time until the next repricing), since its coupon will soon adjust to the markets required yield. The ten-year fixed coupon has a long duration (around 6-7 years, depending on the yield-to-maturity), because the coupon never adjusts. The hybrid bond, X, is structured to have a partial adjustment, hence its duration is between these two.
2) dv01 is: a) b) c) d) e) the discount rate applied to exactly 1 bond effect on bond price of a 1 basis point change in yield effect on bond yield of a 1 point change in price duration of 1 basis point duration of 1 call option

b The effect of a one basis point change in yield on a bonds price is known as dv01 the dollar value of 1 bp. It also represents the present value of adding (or subtracting) and additional 1 bp to the bonds coupon, discounting it by the bonds yield-to-maturity. 123) All else the same, an investor expecting an increase in the economys growth rate (compared to consensus expectations) should: a) b) c) d) d take long-term interest rate risk, short-term credit risk take long-term interest rate risk, long-term credit risk take short-term interest rate risk, short-term credit risk take short-term interest rate risk, long-term credit risk

A strengthening economy typically leads to higher interest rates, as credit demands increase and the central bank, after a while, tightens liquidity. At the same time, improved corporate earnings from the stronger economy raises credit worthiness, hence tightens credit spreads on corporate bonds. The investor, therefore, should not lock in risk-free (Treasury) rates, rather stay short term. On the other hand, the investor should lock in the wider spreads before they narrow.
26) Compared to low duration bonds, high duration bonds: a) b) c) d) have higher yields are senior in the firms capital structure have shorter maturity are more price responsive to yield changes

d High duration bonds do not necessarily require higher yields the yield curve may be downward sloping. Position in the capital structure is irrelevant to duration (except to the extent it influences yield). And they are more likely (but not necessarily) of longer maturity. Whatever the yield change, a longer duration results in greater price reaction to change in yield. 46) You have a six-month horizon, and are considering two government bonds, one with a five-year maturity, the other a twenty-year. You are worried that yields may rise during your holding period. Is it possible for the R.O.R. of the twentyyear bond to exceed that of the five-year if yields increase for both equally? a) b) c) d) e) c An equal yield increase will cause the twenty-year bond to decline more than the fiveyear, die to its longer duration. Rate-of-return, however, includes the bonds yield (carry) as well. If the yield curve is sufficiently positively sloped, the higher yield on the twenty-year may more than compensate for its larger price decrease. No since the twenty-year has a longer maturity (and duration), its price will fall more No because of its longer maturity, the twenty-year must have a higher yield Yes the twenty-year may have a higher yield, which could more than compensate for the greater price decline Yes- the twenty-year may have a lower yield, which could more than compensate for the greater price decline Yes if yields increase equally, the twenty-years price increases more than the five-years

0)

The following bonds, all with ten year maturities, are of the same issuer: 6% coupon, non-callable; zero coupon (non-callable); 6% coupon, callable in five years. Which exhibits the least price sensitivity to a change in interest rates? a) b) c) d) the fixed coupon non-callable the zero coupon the callable all equal

c The callable bond may be paid off earlier; the latest maturity is ten years. Therefore, from a probabilistic perspective, the average expected maturity must be less than ten years, shorter than the others, hence least interest rate sensitive.
) Roll-down means: a) b) c) d) e) d Consider a positively sloped yield curve. Roll-down return reflects an assumption of a static curve. Over time, a bonds remaining maturity declines. As such, the bond rolls down the yield curves slope, hitting lower and lower yields as its remaining years to maturity decreases. Falling yields translate into price gains. A negatively sloped curve would force a roll up, with attendant price declines. earning accrued interest on a bond as time passes choosing to extend maturity along the yield curve enjoying price appreciation as a bonds yield rises over time as it moves along a static negative yield curve enjoying price appreciation as a bonds yield falls over time as it moves along a static positive yield curve enjoying price depreciation as a bonds yield rises over time as it moves along a static negative yield curve

1)

From an investors perspective, all else constant an increase in interest rate volatility will raise the value of a: ****** a) b) c) d) callable bond relative to a putable bond of equal maturity and coupon a PIK bond relative to that of a standard bond of the same issuer, maturity and coupon a barbell relative to a bullet of equal duration a coupon bond relative to a zero of equal duration

c&d A barbell portfolio is more convex than a bullet bond, hence benefits more from an increase in interest rate volatility. For the same duration, a zero coupon bond is less

convex than a bond with coupons, as the lack of cash flow dispersion reduces convexity. Both the call and put embedded in bonds rise in value as volatility increase, but the call subtracts from the bonds value, while the put increases it. Pay-in-kind bonds contain a number of options for the issuers benefit. A volatility increase, therefore, raises their values, reducing the bonds price. )
What might cause an investor to shift from a 5-year bullet to a 3-year/10-year barbell of equivalent duration? ********

a) b) c) d) e)
f) a, c

worry of an increase in volatility expectation of a decrease in volatility belief that the 5-10 year slope will increase more (decrease less) than the 3-5 year slope belief that the 5-10 year slope will decrease more (increase less) than the 3-5 year slope anticipation of a general increase in the slope of the yield curve
anticipation of a general decrease in the slope of the yield curve

The barbell is more convex, hence benefits from the anticipated increase in volatility. The belief in c) translates into the yield curve becoming less curvy (or straightening out), which calls for being long the 5-10 year sector, short the 3-5 year sector or, equivalently, replacing the 5-year with the bullet. e) & f) are not right because the trade is neutral with respect to the overall slope (in the 3-10 year region). Which of the following strategies is consistent with a view that interest rate volatility is about to increase? ****** a) b) c) d) purchase call on a government bond purchase put on a government bond write call on a government bond write put on a government bond e) invest in callable government bond f) invest in puttable government bond a,b,f This is a strategy reflecting a volatility view, as opposed to a view regarding direction of interest rates. The owner of a call or a put benefits when volatility increases, holding the level of rates constant. The writer loses. The callable bond investor is effectively a call writer; the puttable bond holder is effectively a put buyer. 13) You have a two-year horizon and purchase a three-year, single cash flow security at a spot rate of 5%. Your rate-of-return will: ******* a) always be 5%

b) c) d) e) c

equal the one-year spot rate in one year exceed 5% if the one-year spot rate in two years is 4% be lower than 5% if the two-year spot rate in one year is 6% equal 5% if the one-year spot rate in one year is 5%

With a two-year horizon, you will need to sell the security at the end of two years, when it will have a one-year remaining maturity. Because it is a zero-coupon, there is no reinvestment risk, just capital risk upon sale. Your rate-of-return will be above, below or equal to the original yieldto-maturity of 5% according to whether the one-year yield in two years is below, above or equal to, respectively, 5%. (Rates in one year are irrelevant, as there is no reinvestment and nothing will be sold in one year, hence d) & e) are incorrect.) 2) With respect to convexity, which is the proper order for the following bonds/bond strategies, assuming equal durations? a) b) c) d) e) f) b Callable bonds are negatively convex in their region of callability. Outside the region, their callability reduces the positive convexity that bonds normally enjoy. A bullet is non-callable, hence convex. A barbell of equivalent duration as the bullet will be more convex due to its greater cash flow dispersion. callable > bullet > barbell callable < bullet < barbell callable < bullet = barbell bullet > barbell > callable barbell > callable > bullet callable > barbell > bullet

INTEREST RATE FUNDAMENTALS

63) A security promises to pay a single cash flow on a specific future date. Which of the following will increase its present value? ******* a) b) c) d)
a A greater cash flow means more money, and more money to be paid in the future, all else the same, certainly raises the value of a security. A longer futurity reduces the present value, or price (this is the basic time value of money idea). And a greater spot rate means deeper discounting of future cash flows, hence lower present value.

the greater the cash flow the longer the futurity of the cash flow the greater the spot rate applied to the cash flow none of these, since only one cash flow is to be paid, rather than a sequence of coupons

11)

$100 is invested for two years. Which produces the most proceeds? a) b) c) d) 5% simple interest 4.9% compound interest, annual periodicity 4.9% compound interest, semi-annual periodicity 4.8% compound interest, monthly periodicity

c a) 100 + 2x.05x100 = 110 b) 100x(1+.049)2 = 110.0401 c) 100x(1+.049/2)4 = 110.1661 d) 100x(1+.048/12)24 = 110.0548

0) How much is $1,000 payable in ten years, at a 5% semi-annually compounded ten-year spot rate, worth today? a) b) c) d) e) e
Discounting is required, recognizing that ten years, semi-annual translates into twenty six-month periods: 1,000/(1+.05/2)20 = 610.2709. a) dispenses with discounting; b) uses ten periods; c) uses simple interest (no compounding); d) uses annual periods. 345) Consider a 5-year and a 10-year single cash flow instrument (i.e., zero coupon bond). Starting from the same (spot) interest rate, rates rise equally for both. What is the result? a) b) c) d) a Since they have the same coupon, the instruments differ solely by maturity. Hence the ten-year will exhibit greater price sensitivity to changes in interest rates, on a percentage basis. ) For instruments with fixed future cash flows (e.g., single cash flows; bonds): the price of the 10-year falls more (in percent) than that of the 5-year the price of the 5-year falls more (in percent) than that of the 10-year both prices fall by the same percentage both prices fall by the same dollar amount, but the 10-year by a greater percent since its price must be lower

$1,000 $781.1984 $666.6667 $613.9133 $610.2709

a)

As interest rates increase, prices fall; but every succeeding rate increase has a smaller (percentage) effect on price change b) As interest rates increase, prices fall; but every succeeding rate increase has a greater (percentage) effect on price change c) As interest rates increase, prices rise; but every succeeding rate increase has a smaller (percentage) effect on price change

d) As interest rates increase, prices fall; but every succeeding rate increase has a greater
(percentage) effect on price change a Prices react inversely to interest rate changes if future cash flows are fixed. Because the relationship between rates and prices is necessarily convex, every succeeding rate increase causes less of a price decline.

BOND MATH
64) A security promises to pay a single cash flow on a specific future date. Which of the following will increase its present value? ******* a) b) c) d)
a A greater cash flow means more money, and more money to be paid in the future, all else the same, certainly raises the value of a security. A longer futurity reduces the present value, or price (this is the basic time value of money idea). And a greater spot rate means deeper discounting of future cash flows, hence lower present value.

the greater the cash flow the longer the futurity of the cash flow the greater the spot rate applied to the cash flow none of these, since only one cash flow is to be paid, rather than a sequence of coupons

16)

A security promises to pay a sequence of annual coupons plus $100 at maturity. Which of the following will always increase its present value? ******** a) b) c) d) the greater the coupon the longer the maturity the greater the spot rates applied to the cash flows all of these, since a sequence of coupons is paid besides the principal

a More money always raises the value of a security, all else equal. Longer maturity affects price only if the coupon is not equal to the bonds yield. If the coupon exceeds the yield, lengthening maturity raises price; if it is below the yield, lengthening maturity lowers the price. Higher spot rates always reduce price, as future cash floes are more heavily discounted.
345) Consider a 5-year and a 10-year single cash flow instrument (i.e., zero coupon bond). Starting from the same (spot) interest rate, rates rise equally for both. What is the result? a) the price of the 10-year falls more (in percent) than that of the 5-year

b) c) d) a

the price of the 5-year falls more (in percent) than that of the 10-year both prices fall by the same percentage both prices fall by the same dollar amount, but the 10-year by a greater percent since its price must be lower

Since they have the same coupon, the instruments differ solely by maturity. Hence the ten-year will exhibit greater price sensitivity to changes in interest rates, on a percentage basis.

11)

Consider a five year bond with a 5% annual coupon. If its yield to maturity rises from 5% to 6%, the price of the bond changes from: a) b) c) d) e) f) discount to premium premium to discount par to discount discount to par par to premium none of the above

c At a yield of 5%, the bond is at par, since it pays a coupon equal to what the market demands of it. When the market demands a yield of 6%, the bond is paying less than required, because its coupon remains 5%. Hence the price must fall to a discount from par in order to yield 6%.

8) An increase in a (fixed coupon) bonds yield will: a) b) c) d) e) f) a The price of a fixed coupon (even if it is fixed at zero) bond being above, equal to or below par depends on the bonds yield-to-maturity being below, equal to or below the coupon. In any case, an increase in that yield reduces the price. reduce the price of a premium bond raise the price of a discount bond have no effect on a zero coupon bond have no effect on a par bond a) & b) all of these

14)

Bond Bs coupon equals that of A, but is of a longer maturity. What might cause Bs duration to be below As? a) b) B is callable, A not They are both zero coupon

c) d) a

The yield curve is negatively sloped Nothing its impossible

All else the same, a longer maturity bond will have a greater duration. A negative yield curve will make the duration of the longer maturity bond even greater, as the lower interest rate raises duration. A call feature in a bond reduces its effective duration, since the bond might be retired earlier than its stated maturity. 27) Which of the following statements regarding convexity is true? a) b) c) d) e) Bonds with single cash flows can have no convexity For any level of (positive) convexity, an increase in interest rate volatility raises its value For any level of (positive) convexity, an increase in interest rate volatility reduces its value Investors require a higher yield to compensate for (positive) convexity, all else the same Adding a call feature to a bond increases its convexity

b The convexity feature of a security results from the non-linear relationship between yield and price. This relationship is found in fixed cash flow instruments (even single), not floating rate. The value of convexity to investors rises with market volatility. The call feature in a bond imparts negative convexity, as this type of non-linearity benefits the issuer, rather than the investor.

Which of the following is always true of a (non-callable) perpetuity? ****** a) b) c) d) e) zero coupon priced at a discount priced at par priced at a premium current yield = yield to maturity

e Perpetual bonds can be at par, discount or premium, just like fixed maturity bonds, depending on the relationship between the coupon and yield-to-maturity. Because there is no pull-to-par (since the bond never matures), there is no difference between current yield and yield-to-maturity.
For which of the following bonds can the principal increase over time? ****

a) amortizing b) pay-in-kind c) step-up coupon d) inflation protected b&d A PIK bonds coupon is capitalized into principal should the issuer choose to PIK. Inflation protected bonds increase principal according to the past inflation rate. The step-up feature only affects coupon, not principal. Amortizing bonds pay off principal over time.

FLOATING RATE NOTES

20) A Floating Rate Note pays LIBOR plus 1%, semi-annually. It is now the re-pricing date, the note begins the day at par and the LIBOR fixing increases (and surprises the market) from 4 to 4.25%. Assume the issuers credit position is unchanged. What will happen to the notes price. a) b) c) d) a Surprisingly or not, the increase in LIBOR brings the FRNs coupon in line with what the market requires of it. Since the notes price was at par to begin with, the market believes that the 1% spread over LIBOR is adequate. The issuers credit position is unchanged. The new coupon of 4.25% equals the markets required rate, hence the note remains at par. 21) A Floating Rate Note pays LIBOR plus 2%, semi-annually. It contains a cap of 7%. It is now the re-pricing date, the note begins the day at par and then LIBOR jumps (surprising the market) by 0.25% from the day before so that the new LIBOR fixing increases to 4.25%. Assume the issuers credit position is unchanged. What will happen to the notes price. a) b) c) d) It remains at par because the coupon increases It rises above par, because the coupon increases It falls below par, because the value of the cap increases It rises above par, because the value of the cap increases It remains at par because the coupon increases It rises above par, because the coupon increases It remains at par because the coupon is unchanged It falls below par, because the coupon increases

c The investor in the capped FRN has granted a cap to the notes issuer. The caps value is reflected in the notes spread over LIBOR (along with the issuers credit risk). When LIBOR jumps, investors reassess upwards their expectations of future LIBOR. The cap

then becomes more valuable, as the chances of future LIBOR piercing 7% are now higher. Since the spread above LIBOR is fixed, it is no longer adequate, hence the FRNs price declines. 14) Which of the following is (are) true of inverse floaters? ******* a) Their duration can be higher than their maturity. b) Their cash flows rise when short term interest rates increase c) Their cash flows decline when short term interest rates decrease d) They pay a floating rate less a fixed rate a,c The coupon on an inverse floating rate note is a fixed rate less a floating rate, typically LIBOR. As such, when short-term rates, as reflected in a LIBOR increase, the inverse floaters cash flows decline. Because an increase (decrease) in market interest rates reduces (increases) the securitys future income on top of the fact that higher (lower) rates lower (raise) the present value of any future cash flow the price of an inverse floater is extremely sensitive to interest rate changes, and its duration actually exceeds its remaining maturity. 1) An investor looking to earn a higher spread on a Floating Rate Note should consider: ***** a) b) c) d) a, c A cap benefits the borrower (it consists of a series of options granted to the borrower by the lender), as it imposes a maximum interest rate. Hence, payment by the issuer is in the form of additional spread. A floor benefits the lender (a series of options granted by the lender), as it provides for am minimum interest rate. Hence, payment by the investor is in the form of accepting a lower spread. The more the credit risk of the issuer, the wider the spread. An FRN with a cap imposed An FRN with a floor provided An issuer with more credit risk An issuer with less credit risk

EQUITY DERIVATIVES
3) Comparing an (unleveraged) ETF on a stock market index and a futures contract on the index, which of the following is (are) true? *****

a. Each has a beta equal to 1 b. Each has a beta equal to 0 c. If your portfolios beta equals 1, adding ETFs with new money increases your beta d. If your portfolio beta equals 1, going long futures contracts with new money used for initial margin increases your beta a&d Because both (theoretically) move one-for-one with the market index, they each have a beta equal 1. However, the ETF requires cash payment, so adding it to the portfolio does not change portfolios beta. Futures contract requires margin as fraction of the contracts face value, hence adding it raises portfolios beta. 6) An investor is bearish on a stock, and goes short by selling shares forward, providing cash collateral. Which of the following occurs? ***** a) b) c) d)
c&d Suppose an investor sells a stock forward for 25/share. On the settlement date, if the actual cash price of the stock is 23/shre, the investor will receive 2/share (either in cash, if the forward contract is cash settled, or, if physical delivery, by purchasing the stock in the market for 23 and delivering on the contract and receiving 25). If the actual cash price is 27, the investor pays 2 (whether cash settled or physical delivery). Dividends are neither received nor paid with respect to a forward contract. 18) It is August 1. You are of the opinion that the S&P500 will significantly appreciate by the end of the month. Rather than actually purchasing all the stocks in the Index, you are considering one of the following alternatives. Which will track the Indexs performance most closely (assuming no performance or credit risk)? a) b) c) d) e) Go long the S&P500 index September futures contract Buy an at-the-money call option on the S&P500 Index, expiring at the end of August Write an at-the-money put option on the S&P500 Index, expiring at the end of August Buy the S&P500 ETF Buy a note issued by DetscheBank, maturing at the end of August, promising to pay the rate-of-return of the S&P500

the investor receives the dividends the investor pays the dividends the investor investors receives the difference between the forward settlement price and the cash price on the settlement date, if the former is higher the investor investors pays the difference between the forward settlement price and the cash price on the settlement date, if the former is lower

Equity index futures display some slippage (due to the lack of perfect arbitrage) between the contract price and that of the underlying index. The call option will not track the index below the strike. Further, the premium loses its value. The put option does not duplicate the index above the strike. The ETF tracks closely, but not perfectly, as the dynamics of creation and destruction by Authorized Participants create some basis risk. The DB note tracks the index by construction. 4) You own shares in company X, and have sold S&P futures contracts equal to (Xs beta times value of X shares/250 times price of S&P contract). What have you done? a) You have adjusted your beta to 1. b) Your portfolio is now riskless. c) You have removed market risk from your portfolio but retained specific company X risk. d) You have increased the risk of your portfolio. e) The futures contracts have increased the value of your portfolio. c Selling the proper number of S&P500 Index futures contracts (the hedge ratio as given in the question) removes the market risk from the position, hence produces a beta of 0. The non-market, or specific company X, risk is not removed. 5) You own shares in company X, and have sold S&P futures contracts equal to: [Xs beta times value of X shares]/[250 times price of S&P contract]. What have you accomplished? a) You have adjusted your beta to 1. b) Your portfolio is now riskless. c) You have removed market risk from your portfolio but retained specific company X risk. d) You have increased the risk of your portfolio. e) The futures contracts have increased the value of your portfolio. c Every stock contains overall market risk, measured by its beta, plus risk specific to the company. The beta of a stock index (and, by extension, a stock index futures contract) equals 1. Thus, selling the appropriate number of stock index futures removes market risk and retains that portion of a stocks risk specific to the company.

An equity indexed-linked note: ******** a) is a debt instrument whose coupon is fixed b) is a debt instrument whose cash flows depend upon the performance (R.O.R.) of a particular stock index c) synthesizes exposure to a particular group of stocks d) is an equity investment bit with bond-like characteristics b,c Typically issued as an obligation of financial institutions (hence debt), these notes pay coupon and/or principal according to a formula related to the performance of the underlying equity index. Because the investor is not actually purchasing stock, it is a synthetic investment. A new client has just given you a substantial sum of money to invest. As you contemplate constructing the portfolio, which may take some time, you are worried about the overall market appreciating. What can you do?
a) Buy stock index futures contracts in number equal to the funds received divided by the value of a contract, and place the funds into money market instruments. Then peel off contracts as you invest the funds. b) Buy stock index futures contracts in number equal to the funds received multiplied by the value of a contract, and place the funds into money market instruments. Then peel off contracts as you invest the funds. c) Sell stock index futures contracts in number equal to the funds received divided by the value of a contract, and place the funds into money market instruments. Then peel off contracts as you invest the funds. d) Sell stock index futures contracts in number equal to the funds received multiplied by the value of a contract, and place the funds into money market instruments. Then peel off contracts as you invest the funds.

a Entering into a long stock index futures position hedges your exposure, as it will generate profit should the overall market appreciate. The hedge ratio, as is generally so, equals the amount at risk divided by the value of the instrument employed as the hedge.
) Two mutual funds desire synthetic exposure to the equity market of Albania. The first fund enters into a one-year swap with Credit Suisse, paying three-month LIBOR and receiving the total return of the Albanian stock market, quarterly. The second purchases an ETN from Credit Suisse, whose coupon equals the total return of the Albanian stock market, paid quarterly with a one-year maturity. What is the difference between these two strategies?

a) The first fund receives more, because the second only receives the Albanian stock markets return divided by 4 b) If the total return of the Albanian stock market is zero for one of the three-month periods, the first fund will do worse because it must pay Credit Suisse LIBOR c) No difference because for both funds, besides the risk of the Albanian stock market, there is the risk that Credit Suisse will not be able to pay if the Albanian stock market increase a lot d) If the total return of the Albanian stock market is zero for the entire year, the second fund still faces the risk on its principal from Credit Suisse d

a) is wrong because only the LIBOR leg is divided by 4. b) is wrong because the first fund can invest the principal, which is not exchanged (except for collateral) as part of the swap. c) is wrong because d) is right. d) is right because an ETN is a cash investment (not a derivative).

ABS / CDO / STRUCTURED CREDIT

74) The credit tranching of asset-backed securities refers to: a) b) c) d) the government guarantee in case of default the fact that all the bond classes issued by the SPV are of equal size the creation of various classes of bonds issued by the SPV, whereby the lowest class accepts defaults until exhausted, then the next class, etc. the credit risky assets held by the SPV

c The liabilities of the Special Purpose Entity (SPV) in an asset-backed securities structure are tranched according to credit risk. That is, bonds of unequal size (and no government guarantee) are issued by the SPV. The lowest class of bonds accepts defaults
until exhausted, then the next class, etc.

75)

In the context of ABS, Sellers Interest refers to: a) b) c) d) the tranche retained by the originator the receivables retained by the issuer the loan made by the SPE to the originator the interest the IRS has in the sale of ABS

a The financial institution which originated the loans and sells them to a Special Purpose Entity will retain an interest in the deal by being an investor in the debt securities issued by the SPE. This security is usually subordinate to the other tranches.

BALANCE SHEETS / CORPORATE ACTIONS

2) A company has incurred a loss on its operation (hence pays no dividend). It issues new shares with a value exactly equal to the loss. Which of the following is true of the combined events? a) b) c) d) a The loss reduced the companys book value by that amount. Issuing new shares add to book value, compensating for the loss. Which of the following changes a firms leverage ratio? ****** a) b) c) d) e)
a,b,d,e The LBO, essentially by definition, increases the firms leverage ratio since its purpose is to replace equity with debt. A follow-on offering increases equity. (A secondary offering does not. It represents sales of existing shares by insiders or other restricted holders.) Repurchase of shares reduces equity, whether via cash or additional debt issuance, with the latter having a greater effect. 88) Target company T has a book value equal to $100mm plus outstanding debt. Acquirer A uses cash from its balance sheet plus borrows funds to pay $125mm for all of Ts shares. This creates Goodwill on As balance sheet equal to: a) b) c) d) e) $100mm $25mm $125mm Depends on how much of Ts debt A assumed Depends on the excess of As market value over its book value prior to the acquisition

Its book value is unchanged Its book value is lower Its book value is higher It depends on whether the company borrows additional funds

a leveraged buy-out a follow-on offering a secondary offering share repurchase using cash from balance sheet share repurchase by issuing debt

b Goodwill reflects the excess of the purchase price (market value) of a firm above its book value. This is independent of how the acquiring company financed the acquisition (hence d) is incorrect).

4) A company has incurred a net loss. It then issues new shares with a value exactly equal
to the loss. Which of the following is true, net? a. b. c. d. Its book value is unchanged Its book value is lower Its book value is higher It depends if the company borrows additional funds

a The loss reduces book value; the new equity issuance replaces it. Borrowing does not affect book value.
The generally accepted definition of working capital is:

a) Current liabilities less current assets b) Current assets less current liabilities
c) Ratio of current assets to current liabilities d) Current liabilities less current assets plus inventories e) Current liabilities less current assets less intangibles f) Ratio of current assets less inventories to current liabilities

b Choice c) is the definition of the current ratio, f) is the quick ratio.

EQUITIES
Assume the S&P500 Index spans the entire stock market. Investment manager I1 allocates her entire portfolio to the Index, and borrows money to purchase even more. Investment manager I2 allocates her entire portfolio to the Index. Investment manager I3 allocates her portfolio evenly across the stocks in the Dow Jones Industrial Average. Investment Manager I4 allocates threequarters of her portfolio to the Index, and keeps the rest in cash. Investment manager I5 purchases no shares, but borrows shares of a number of companies in the Index and sells them, using the funds in her portfolio as margin. Which of the following are correct characterizations? ****** a) b) c) d) I1 and I2 are long the market I1 is leveraged, I2 is indexed I2 and I4 are leveraged I3 is indexed, I4 is long the market

e) I4 and I5 are short f) I4 is long the market, I5 is short a,b,f These are simply market characterizations. I3 is not indexed, because the DJIA does not represent the market. Even though I5 is not fully invested, she is still long.

19) Which of the following are means of increasing funds (i.e., providing cash for the balance sheet) by firms? ******* a) b) c) d) e) f) a,b,c Follow-on equity sales provide cash for the balance sheet, as do retained earnings which are, in effect, sales of shares to existing shareholders. Issuing bonds provide cash even though it creates a liability. Convertible bond conversion changes a debt liability into equity, but does not provide funds for the firm. Option exercise involves a third party, not the firm. 6. Which of the following is normally paid prior to dividends? ******** a) b) c) d) a,b,c,d Dividends are paid out of after-tax profits, which accrue only after outsiders (labor, suppliers, lenders) and the government are paid. How is it possible for a companys revenue to decline yet profits to increase? a) b) c) d) e) If unit sales decline but labor becomes more productive If materials costs decline more than the price of the firms output If unit sales and/or output price decline but the companys average tax rate fall If unit sales and/or output price decline but the companys average tax rate rises Impossible labor compensation taxes cost of intermediate goods interest payment on debt retaining earnings follow-on equity sales issuing bonds investors converting their convertible bonds investors exercising call options investors exercising put options

a,b,c Revenue can decline (from a drop in sales or a fall in price of the firms output or some combination). But if input costs are reduced more than proportionately, profits can increase. Or, if the governments take is reduced, more is left for shareholders. ) A companys market value (or capitalization): ******* a) b) c) d) e) b, d b) is the definition, hence d) is also true. Market value is typically greater than book value, as the former reflects investors expectations of the companys future growth compared to the latters measure of today. Indeed, if market is below book, then the firm can theoretically be purchased at its market value and its assets sold at book value for a profit! XX) Stocks belonging to the value category (compared to the growth category): a) have a positive p/e ratio, unlike growth stocks, which have no earnings yet b) have lower price-earnings ratios than growth c) appreciate more than growth stocks when the economy expands, depreciate more than growth when the economy contracts d) because they are valuable, are included in stock indices, unlike growth b Definitionally, if stocks were ordered by their p/e ratios, the bottom half would be termed value stocks. Lower p/e ratios mean lower multiples. Hence, value stocks generally respond less to macro-economic movements than growth stocks. 12) Which of the following is a true statement concerning momentum? ****** a) Investors guided by momentum believe that a recent decrease in a stocks price suggests further near term price decreases b) Small cap stocks may display momentum because new information is not diffused instantaneously equals its book value plus cumulative retained earnings equals number of shares multiplied by latest price per share is always less than its book value can change every minute changes only when it sells new shares

c) Truly efficient market precludes profiting from momentum-style investing d) It is illegal to profit from momentum a, b, c Momentum-driven investors believe that stock price changes are likely to continue in the same direction. According to the efficient markets hypothesis all relevant information about a company and its stock price is digested by the market too quickly to allow for trading opportunities. Hence, a recent price change reveals no new information about future price changes. Small capitalization stocks, however, have less of a research following which suggests that the immediate digestion of new information does not always occur. 41. After hours, GE announces a 20% increase in profits this quarter, compared to last. Will the stock price necessarily go up when the market opens tomorrow? ****** a) Yes b) No, because this may have already been anticipated by market participants c) No, if investors that this was due to an increase in sales which simply borrowed from next quarters sales d) No, if a macro-economic statistic is released tomorrow morning which causes the market to reduce multiples across the board b,c&d All these can negate the positive effect of the announcement.

38)

Which of the following is true with respect to equity underwriting? ******* a) b) c) d) In a block transaction, the dealer purchases the shares and bears the risk of their resale to investors Shelf registration permits issuers to quickly sell stock by preregistering future offerings A follow-on offering refers to the sale of new shares subsequent to an IPO When exercising the Greenshoe, an underwriter takes additional shares from the issuer in order to deliver on the shares sold in excess of the original allotment

a,b,c,d These are all correct descriptions of the terms. *) Company X (share price 12, beta = 1.1) has offered to acquire Company Y(share price 20, beta = 1.08), paying 2 of its shares for every 1of Y. Before the merger offer

announcement, Y was at 15. Which of the following is an appropriate strategy ensuring a market neutral position? ****** a) b) c) d) e) f) g) h) a, h Based on todays price of the acquirer, X, each share of Y is worth 24. However, purchasing Y at 20 does not guarantee a profit even if the merger goes through as announced. By the time X actually acquires Y and pays for the acquisition with 2 shares, Xs market price can drop below 10. To hedge, the proper arbitrage is to short (borrow and sell) 2 shares of X for every share of Y purchased. If the arbitrageurs belief is that the merger will not go through, then the relationship between X and Y is not 2 for 1, rather is based on current market conditions. Since the arbitrageur is of the belief that Y is overvalued (because Ys jump to 20 is based solely on the markets anticipation of the merger as announced), this becomes a standard relative value trade. Y is sold short and, to ensure market neutrality, X is purchased according to the ratio of their relative prices adjusted by their relative betas. 17) Sharpe Ratio and Information Ratio are: a) b) c) d) b The Sharpe ratio measures a portfolios performance over a period of time (over a riskfree rate) relative to its volatility over that time. The Information ratio measures performance versus as index relative to the performances divergence from that index. ) A Real Estate Investment Trust: examples of hedge ratios risk-adjusted measures of portfolio performance measures of the ratio of a companys market value to book value none of the above You believe the merger will go through: long 1 share of Y, short 2 shares of X You believe the merger will go through: long 2 shares of Y, short 1 share of X You believe the merger will go through: short 1 share of Y, long 2 shares of X You believe the merger will go through: long 2x1.08 shares of Y, short 1x1.1 shares of X You believe the merger will go through: long 2x12x1.1 shares of Y, short 1x20x1.08 shares of X You believe the merger will fail: short 1 share of Y, long 2 shares of X You believe the merger will fail: short 12x1.1 shares of Y, long 15x1.08 shares of X You believe the merger will fail: short 12x1.1 shares of Y, long 20x1.08 shares of X

a) b) c) d) e) e

earns the bulk of its income from rent (or mortgages) must pay out most of its earnings as dividends is tax advantaged with respect to its profits is typically heavily leveraged all of these

These summarize the special nature of REITs.. a) is what it does. b) is necessary in order to be granted c). And since it cannot retain much earnings, it must grow via issuing debt, d).

0)

Which of the following is true of preferred stock? a) b) c) d) dividends are tax deductible for the issuer dividends are paid prior to those of common stock non-payment of dividends triggers default all of the above

b As preferred shares represent an equity interest in the company, their dividends are not tax deductible to the issuer and non-payment does not trigger default as non-payment of debt interest would. Relative to the companys common shares, preferred dividends are paid first. 1) Which of the following provides new money for companies? ******** a) follow-on equity offerings b) bond issuance c) investors converting the firm's convertible bonds d) issuing warrants e) dealers writing call options on the firm's stock f) a spin-off a,b,d a) provides funds from new or existing equityholders; b) provides funds from lenders; c) just changes the nature of the liability from debt to equity; d) provides a bit of money from the price of the warrant; e) does not involve the company; e) simply creates two companies from the first, with no net money flows.

1)

Suppose you expect the economy to accelerate next quarter (by more than the market expects) without much of an increase in interest rates. Which of the following is an appropriate response? ********

a) b) c) d) e) b

Avoid small cap stocks because they usually respond more to business cycle movements. Buy growth stocks if you believe future earnings growth will increase along with next quarters increase. Make sure your portfolio has a beta as far below 1 as possible. Purchase foreign equities. None of the above

Growth stocks, by definition, trade at a high price-to-earnings multiple. Hence, an increase in earnings will raise the stocks price smartly, unless the multiple diminishes. If future earnings are expected to be higher as well (and any interest rate increase contained), the multiple will, at worst, be stable. The other choices are wrong because: a) small cap stocks are typically more sensitive to the business cycle; c) with the economy expected to accelerate (again, with muted interest rate response), stock prices on average should rise, so a beta in excess of one is called for; d) such an economic scenario should cause the dollar to appreciate, reducing the dollar value of foreign equities, all else the same. 2) Shorting shares involves: a) b) c) d) c A speculator anticipating a fall in a stocks price wishes to sell at the current price and purchase at a later date when the price is lower. Selling now requires delivery of the stock to the buyer. Not owning it, the short seller needs to borrow the shares. Upon purchasing the shares at the later date, the seller/borrower returns the shares to the stock lender. buying and then selling the stock selling stock you already own borrowing and then selling the shares in anticipation of a price increase borrowing and then selling the shares in anticipation of a price decrease

1) Joe is a portfolio manager who has allocated his funds to a broad market index, according to their proportional representation in the index. Assume that half of the index is represented by cyclical stocks, half by non-cyclical. Sam puts his entire portfolio into cyclical, proportional to the index. He sells short all the non-cyclicals, again

proportionately. Ignoring dividends and the cost of shorting (including collateral), which of the following is(are) true? *****
a) If all stocks increase by 1%, Joes portfolio will rise in value, Sams will fall.

b) If cyclicals increase by 1% and non-cyclicals decline by 1%, Joes portfolio will fall in value, Sams will rise. c) If cyclicals increase by 1% and non-cyclicals decline by 1%, Joes portfolio will fall in value, Sams will be unchanged. d) If cyclicals increase by 1% and non-cyclicals are unchanged, Joes and Sams portfolios will rise in value equally. e) If all stocks decrease by 1%, Joes portfolio will fall in value, Sams will be unchanged.

e a) is wrong because Sams will be unchanged, as the two hedge each other. b) is wrong because the two sectors offset each other in Joes portfolio. c) ) is wrong because the two sectors offset each other in Joes portfolio, and both positions produce profits in Sams portfolio. d) is wrong because Joes portfolio will rise in value by half a percent, as only half the portfolio has increased, while Sams portfolio will rise by the full one percent because all Sams funds are allocated to cyclical. e) is correct because Sam is hedged.

1) Your portfolio is leveraged 2:1. Half of the funds are indexed to the broad equity market, half are in commodities. The equity market increases by 1%, commodities are unchanged. Ignoring the cost of borrowing, your portfolios return equals:

a) 0% b) % c) 1% d) 2%

c Without the leverage, your return would have been % because only half of the portfolio enjoyed the 1% increase. The 2:1 leverage ratio doubles the return.

ABC Technologies has posted an average beta of 1.1 over the past five years. Its current share price is 20, with 50 million shares outstanding. The company has $950 million in cash equivalents, and no debt in any form. You expect the market as a whole to fall by 10% in the next few months due solely to investors decrease in risk tolerance. Your best forecast for ABC shares price should be: a) Down approximately 11% b) Down approximately 10% c) Down no more than 5% d) Down at least 11% e) Up approximately 1% c Since your negative outlook is not due to expected earnings decline (or losses), the value of ABC should not fall below $950 million. Hence, price per share should have a floor of 19 (19x50mm shares=950mm). In other words, beta should be lower with respect to this event. 40) a) b) c) d) e) c,d,e A securitys registration is not effective for 20 days, prior to which the S.E.C. can deem it deficient. During this time the issuer (via underwriters) may solicit interest, but not offer to sell. Financial and other information is not totally complete. Which of the following is(are) true of the red herring?********** It contains more information than the final prospectus It can be used to sell securities It is provided to potential investors during the 20-day cooling off period Information contained within is subject to change It contains a discussion of the securitys risk factors

HEDGE FUNDS
Which of the following qualify as a relative value trade? ****** a) b) c) d) a, c buy the 10-yr note, short the 5-yr, in duration neutral proportion buy the 10-yr note, write a call option on it buy the cheapest-to-deliver bond underlying the futures contract, short the contract short the 5-yr note by entering a reverse repo to acquire and then sell it

a) is a relative value (yield curve trade) position, as it is duration neutral. b) is not market neutral, since the hedge ratio requires more than one call to hedge the underlying. c) is neutral (delivery option trade). d) is an outright short position.

A hedge fund has agreed to pay 2.5% for the next two years in return for receiving the consumer price inflation rate. The manager believes:
a) b) c) d) e) consumer inflation will average 2.5% over the next two years consumer inflation will exceed 2.5% on average over the next two years consumer inflation will be below 2.5% over the next two years the two-year real interest rate (stated rate less inflation) will decline the two-year real interest rate (stated rate less inflation) will rise

b The hedge will profit if the receipts from the swap exceed is/her payments; i.e., if inflation exceeds 2.5% per year on average (regardless of what happens to interest rates). ) Given the following market information: Company A share price 25, beta = 1.03; Company B share price 30, beta = 1.05. You think A will outperform B. Which of the following is an appropriate strategy, as a market neutral position? a) b) c) d) d Based on your view, you want to be long A and short B. In order for the position to be market neutral, the risk exposure of the two positions need to be equal, or hedged. Risk exposure equals the stocks beta multiplied by its price. Hence, for each share of A, the number of shares of B to sell equals 25x1.03 / 30x1.05. Equivalently, 30x1.05 of A against 25x1.03 of B.
13) The newly issued Treasury ten-year note is yielding 6.2%, while the previous one is yielding 6.3%. Which of the following is a proper evaluation and reaction? a) If you believe the spread is too wide by recent experience, buy the old and sell the new. Note the negative carry which, if the new is on special in the repo market, will be even lower. b) If you believe the spread is too wide by recent experience, buy the old and sell the new. Note the positive carry which, if the new is on special in the repo market, is even greater. c) If you believe the spread is too wide by recent experience, sell the old and buy

short 30x1.05 shares of A, long 25x1.03 shares of B, long 25x1.03 shares of A, short 30x1.05 shares of B long 30x1.03 shares of A, short 25x1.05 shares of B long 30x1.05 shares of A, short 25x1.03 shares of B

the new. Note the positive carry which, if the new is on special in the repo market, is even greater. d) If you believe the spread is too narrow by recent experience, buy the new and sell the old. Note the negative carry, unless the new is on special in the repo market, which may improve the net carry. d

If you believe the 10bps spread is too narrow, you want to sell short the old ten-year note (anticipating its yield to rise relatively) and purchase the new ten-year (anticipating its yield to fall relatively). Since you will pay 6.3% and receive 6.2%, your carry is negative. However, you must consider the repo borrowing cost to purchase the new note, and the reverse repo lending rate to short the old note. If the new is on special, the borrowing rate is low, which mitigates the negative net carry. )
What might cause an investor to shift from a 5-year bullet to a 3-year/10-year barbell of equivalent duration? ********

a) b) c) d) e)
f) a, c

worry of an increase in volatility expectation of a decrease in volatility belief that the 5-10 year slope will increase more (decrease less) than the 3-5 year slope belief that the 5-10 year slope will decrease more (increase less) than the 3-5 year slope anticipation of a general increase in the slope of the yield curve
anticipation of a general decrease in the slope of the yield curve

The barbell is more convex, hence benefits from the anticipated increase in volatility. The belief in c) translates into the yield curve becoming less curvy (or straightening out), which calls for being long the 5-10 year sector, short the 3-5 year sector or, equivalently, replacing the 5-year with the bullet. e) & f) are not right because the trade is neutral with respect to the overall slope (in the 3-10 year region).

CORPORATES
0) The yield on a corporate bond equals: a) the yield on a similar maturity Treasury bond plus a spread for credit risk b) the yield on a similar maturity Treasury bond less a spread due to default risk c) the yield on a similar maturity Treasury bond plus LIBOR d) the yield on a similar maturity Treasury bond less a spread if the bond is callable a

Corporate bonds must pay the investor for time value of money (the yield on a defaultfree Treasury issue of similar maturity) plus compensation for default risk, known as the credit spread. If the bond is callable, an additional spread would be required for cal risk. 32) A corporate bond is trading at 50 over. This means: a) its yield to maturity is 50 basis points above that of a Treasury bond of comparable maturity. b) if a Treasury bond of similar maturity is priced at 50, the corporates price is par. c) its yield to maturity is 50 basis points above that of another corporate bond with the same credit rating. d) it is intended to be sold only to middle-aged investors. a Corporate bond yields are quoted as a spread (in basis points) over the yield of benchmark Treasury bonds of comparable maturity. 123) All else the same, an investor expecting an increase in the economys growth rate (compared to consensus expectations) should: a) b) c) d) d A strengthening economy typically leads to higher interest rates, as credit demands increase and the central bank, after a while, tightens liquidity. At the same time, improved corporate earnings from the stronger economy raises credit worthiness, hence tightens credit spreads on corporate bonds. The investor, therefore, should not lock in risk-free (Treasury) rates, rather stay short term. On the other hand, the investor should lock in the wider spreads before they narrow. 58) Which of the following are considered deferred interest securities? **** a) b) c) d) e) f) step-up coupon bond PIK bond preferred stock zero coupon bond original issue deep discount bond commercial paper take long-term interest rate risk, short-term credit risk take long-term interest rate risk, long-term credit risk take short-term interest rate risk, short-term credit risk take short-term interest rate risk, long-term credit risk

a, b, d, e Deferred interest securities describe bonds which pay at least a portion of its coupons further in the future. Step-up coupon bonds begin with a below-market coupon. PIK bonds pay in kind instead of a coupon, the firm can choose to pay with additional bonds, which increases future coupon payments. Zero coupon bonds pay everything in the form of principal at maturity. The coupon on an original issue deep discount bond is below the bonds yield-to-maturity, forcing the price below par. Part of the investors compensation is in the form of the principal paid at maturity in excess of the bonds original price.
A firm issuing a bond agrees to a covenant pledging to keep leverage no higher than an agreed upon ratio. What is the result, compared to the situation without the covenant? ***** a) The bonds credit spread is wider b) The bonds credit spread is narrower c) The firms managers are less constrained in their financial decisions d) The firms managers are more constrained in their financial decisions

b&d Containing leverage reduces managers leeway in financing the company. And because higher leverage, all else the same, increases earnings volatility, bond investors expect lower volatility in the future, hence lower credit risk, and narrower credit spread.

TREASURIES / AGENCIES
69) A Treasury bill with 45 days to maturity is sold at a 4% discount rate. Which of the following is true? ****** a) b) c) d) e) a Treasury bills pay no coupons, hence their return is in the form of their price below their face value their discount rate. The discount rate is quoted as a percentage from face, and on a 360-day per year basis. Correcting for 365 days, and recalculating the discount relative to the price (money market basis) results in a greater return. Although the US Its price is below the face value because it pays no explicit interest Its price is equal to the face value because it pays no explicit interest When translated to a money market basis its interest rate would be below 4% The 4% rate assumes a 365-day year Stupid question! The US Treasury does not regularly issue bills with 45 day maturities, so the question is meaningless.

does not directly issue 45-day Treasury bills, they can be purchased in the secondary market.
98)

Agencies of the US government: a) b) c) d) e)

*******

sell debentures to investors raise funds by taxing US citizens make loans directly and indirectly to banks, homeowners, students, farmers, exporters or other sectors of the US economy they were created to support are also known as government sponsored enterprises issue Treasury bonds

a, c, d US agencies which are known as government sponsored enterprises acquire their funds for the activities in choice c) by issuing debentures to investors. They have no taxing power.

MONEY MARKET INSTRUMENTS

68) Which of the following is(are) normally quoted on a discount basis? (More than one

answer may be correct, so choose all you believe to be so.)

a) b) Treasury bills Agency discount notes Commercial paper Bank CDs Federal funds Repurchase agreements

c)
d) e) f)

a,b,c The first three are normally quoted on a discount basis, that is, the market price discounted from par as a percentage of par. The last three are on a money market basis, that is, the market price discounted from par as a percentage of price. All assume a 360day year (in the U.S.) 70) A Treasury bill with 45 days to maturity is sold at a 4% discount rate. Which of the following is true? ****** f) g) Its price is below the face value because it pays no explicit interest Its price is equal to the face value because it pays no explicit interest

h) i) j) a

When translated to a money market basis its interest rate would be below 4% The 4% rate assumes a 365-day year Stupid question! The US Treasury does not regularly issue bills with 45 day maturities, so the question is meaningless.

Treasury bills pay no coupons, hence their return is in the form of their price below their face value their discount rate. The discount rate is quoted as a percentage from face, and on a 360-day per year basis. Correcting for 365 days, and recalculating the discount relative to the price (money market basis) results in a greater return. Although the US does not directly issue 45-day Treasury bills, they can be purchased in the secondary market. 49) Which of the following does not characterize money market instruments? a) Original maturities of less than a year. b) Sourced from banks, governments, agencies, corporations and securities dealers c) Riskless d) Low price sensitivity to interest rate movements e) Purchased by investors with current income needs c Money market instruments by definition mature in at most one year. As such, they have minor (but not zero) interest rate risk, and therefore make sense for investors looking for current income without significant price volatility. Because they are issued by dealers, banks and companies (as well as the US Treasury and agencies), they present credit risk.

32)

Which of the following is true of time deposits? a) b) c) d) They take no time to mature They pay interest on an actual/360 day basis in the US Their value does not change with movements in interest rates All types are negotiable

b Tine deposits are bank deposits with a stated maturity (unlike demand deposits which have no maturity they are payable on demand.) In the U.S, the convention is to pay interest for actual days, but assuming a 360 day year. If market interest rates change, the value of the time deposit will as well, since the interest rate is fixed. But the value will

not change much, as the maturity is short. Only institutional size certificates of deposit are typically negotiable.
0) An instrument with an eight-week remaining maturity is quoted at 2.7% on a discount basis. Its money market equivalent rate is: a) b) c) 2.7% 2.71% 2.74% cannot be determined without knowledge of the issuer

d)
b

At a quoted 2.7% discount, .027 = [(100 Price)/100]x(360/56), since a 360 day year is assumed. This produces a price of 99.58. Its money market equivalent rate is [(100 99.58)/99.58x(360/56) = . 0271, or 2.71%.

2)

Which of the following is a true statement? a)Because of their short maturity, money market instruments exhibit relatively weak sensitivity to interest rate movements. b) Because of their long maturity money market instruments exhibit relatively weak sensitivity to interest rate movements. c) Because of their short maturity, money market instruments exhibit relatively strong sensitivity to interest rate movements. d) Because of their long maturity, money market instruments exhibit relatively strong sensitivity to interest rate movement.

a Price sensitivity to interest rate movements are directly related to maturity.

SWAPS
You have a five-year investment horizon and purchase three-month commercial paper whose rate equals three-month LIBOR plus 10 basis points. You intend to roll over the paper. Three-month LIBOR currently is 3.25%. You also enter into a five-year interest rate swap as a fixed rate receiver of 4.75%, paying three-month LIBOR. Which of the following is true of the net results of the combined strategy? a) b) You will receive 10 basis points more than the three-month LIBOR rate over the next five years, with no risk You will receive 10 basis points more than the three-month LIBOR rate over the next five years, as long as the paper issuers credit worthiness does not change (and the swap counterparty does not default)

c) d) e) f)

You will receive 3.35% for the next five years as long as the paper issuers credit worthiness does not change (and the swap counterparty does not default) You will receive 4.85% for the next five years, as long as the paper issuers credit worthiness does not change (and the swap counterparty does not default) You will receive 8% for the next five years, as long as the paper issuers credit worthiness does not change (and the swap counterparty does not default) None of these

d The LIBOR received from the commercial is sent out on the swap (since youre the floating rate payer), so they cancel. The 4.75% received on the swap (as long as the counter-party does not default) is augmented by the 10 basis points above LIBOR paid by the commercial paper issuer. The 10 bps is not fixed, however, as it depends on the possible change in credit worthiness of the issuer. *) You invest in a bank deposit paying LIBOR + 10bps. It matures in 6 months, but you expect to roll it over continually at the same rate for five years. You enter into a fiveyear interest rate swap as the receiver of 6%, with a notional value equal to the amount of your bank deposit. What is your annual interest rate, assuming no default risk of the bank nr swap counter-party? a) b) c) d) b The swap requires you to pay LIBOR annually, or half of the six-month LIBOR setting semi-annually. Since you receive that same LIBOR rate from the bank deposit, the LIBORs cancel, leaving you with 6% from the swap plus the extra 10 basis points from the bank deposit. 1) A company is issuing a ten-year bond callable in five years. Which of the following would recoup some of the cost to the company of the embedded option (subject to basis risk) and fix (again subject to basis risk) the interest cost for the next ten years? a) b) c) d) b sell a 5x5 payer swaption sell a 5x5 receiver swaption purchase a 5x5 payer swaption purchase a 5x5 receiver swaption 6% 6.10% LIBOR LIBOR + 0.10%

To recover some cost the company needs to sell (write) an option, producing income from the premium. With a 5x5 receiver swaption, the companys interest payments are locked in. If rates rise from current levels in five years, the bond is not called nor the swaption exercised the company continues to pay the bonds coupon. If rates decline, the company calls the bond and issues a LIBOR-based floating rate note. The swaption holder exercises, requiring the company to pay the fixed rate (fixed at the rate prevalent at issue) and receive LIBOR (which covers the FRN).

A hedge fund has agreed to pay 2.5% for the next two years in return for receiving the consumer price inflation rate. The manager believes:
a) b) c) d) e) consumer inflation will average 2.5% over the next two years consumer inflation will exceed 2.5% on average over the next two years consumer inflation will be below 2.5% over the next two years the two-year real interest rate (stated rate less inflation) will decline the two-year real interest rate (stated rate less inflation) will rise

b The hedge will profit if the receipts from the swap exceed is/her payments; i.e., if inflation exceeds 2.5% per year on average (regardless of what happens to interest rates).

A swaption is: a) b) c) d) d A payer swaption allows the holder to enter into a swap of specific term as the fixed rate payer at a fixed rate specified in the option contract. A receiver swaption allows the holder to enter a swap of specific term as the fixed rate receiver at a fixed rate specified in the contract. 0) A company has outstanding floating rate bank debt. Believing that interest rates are about to rise, it enters into a swap to pay fixed and receive floating. What has it accomplished? a) it has decreased its leverage ratio, and has hedged against a rise in rates an option to cancel an existing swap a swap where one party pays an option premium and the other party receives it an agreement to exchange a swap for a bond an option to enter into a swap at a pre-determined fixed interest rate

b) c) d) c

it has increased its leverage ratio, and will profit should rates actually rise its leverage ratio is unchanged, and it has hedged against a rise in rates its leverage ratio is unchanged, and will have lower interest expense should rates actually decline

The swap has not affected the amount borrowed, hence the leverage ratio is unchanged. By receiving the floating rate on the swap, an increase in rates which would otherwise increase the firms interest expense on its floating bank debt is offset by the swap payment.

EMERGING MARKETS
42) Developing economies are (generally) characterized by: ****** a) Relatively high savings rates b) Equity markets with diverse representation (i.e., not dominated by a small number of stocks) c) Uneven distribution of income d) Relatively low per capita GDP e) Reliance on foreign capital c, d, e Developing economies generally have low savings rates, which forces them to rely on foreign capital in order to grow. Low savings rates result from and reinforce low per capita GDP, exacerbated by uneven income distribution. Their equity markets typically are dominated by one or two, at most a handful, of industries, and firms within each industry, associated with natural resources the country is endowed with. 6) ) You own a U.S. dollar denominated bond of a developing economy. That economy strengthens, and the central bank keeps reserves steady. What happens? a) the underlying U.S. Treasury interest rate increases b) the credit spread narrows c) the credit spread widens d) the credit spread is unchanged due to the central banks response b The credit spread is a function of, among other things, investors confidence in the ability of the sovereign to service its debt. A strengthening of the countrys economy increases tax receipts and widens the tax base (as well as increase he capacity of the sovereign to refinance the debt in its home market), enhancing that ability, narrowing the spread.

3)

Your client owns fixed-rate government bonds of a foreign developing country denominated in his/her home currency. Which of the following would, all else the same, typically reduce the rate-of-return? ******* a) b) c) d) e) f) an increase in the developing countrys macro-economic growth relative to potential a decrease in the developing countrys macro-economic growth relative to potential an increase in the home countrys macro-economic growth relative to potential a decrease in the home countrys macro-economic growth relative to potential a depreciation of the developing currency relative to that of your clients home currency a depreciation of the developing currency relative to that of your clients home currency

b, e
Not a straightforward question. An increase in a developing countrys growth increases its ability to service debt, hence reduces the probability of default. In turn, this narrows the binds credit spread, raising R.O.R. On the other hand, growth significantly above potential may increase expected inflation in the country, adding to the bonds yield. The former likely dominates (as inflation in emerging markets are more likely dominated by money supply growth). c) & d) are wrong because of the bonds denomination (except to the extent that economic activity in the investors home country may influence the developing country). e) is, of course, correct, as it directly influence R.O.R.

YIELD CURVE
999)
The one-year spot rate is 4%, and the one-year forward next year is 4.5%. The three-year spot rate is also 4.5%. This implies that the one-year forward in two years is (approximately): a) b) c) d) e) c 4% 4.5% 5% 5.5% 6%

The three-year spot rate is roughly the average of the three one-year rates spanning its life (the one-year spot, the one-year forward and the one-year forward in two years). If the first two components of the average are 4% and 4.5%, the third must be 5% in order to average 4.5%.

96)

A negatively sloped yield curve usually reflects: ****** a) b) c) d) market participants (on average) expecting interest rate to decline, at least in the near future money market rates close to zero long-term rates higher than short term rates interest rates below zero

a A negatively sloped yield means that long term interest rates are below short term (but, of course, not negative). Money market rates are relatively high. This yield curve shape usually reflects expectations on the part of market participants that interest rates will decline in the not too distant future. (They may well expect rates to pick up after some years, but this will not prevent the curve from being negative.) 8) If expectations, and only expectations, drive the yield curve, what can you say about forward and expected future rates? ******* a) Forward rates equal expected future interest rates over the period in question b) Forward rates equal current spot rates c) Over all maturities where the spot yield curve is upward sloping, future rates are expected to rise d) Over all maturities where the spot yield curve is upward sloping, future rates are expected to decline e) Over the maturities where the spot yield curve is upward sloping, expected future rates are above spot rates a, e If only expectations drive the yield curve i.e., illiquidity risk, uncertainty and volatility do not play roles then forward rates implied by the yield curve equal expected future rates for those forward dates. Further, the spot curve will be upward/downward sloping in regions where the forward rates are above/below the spot rates. )
What might cause an investor to shift from a 5-year bullet to a 3-year/10-year barbell of equivalent duration? ********

a) b) c) d)

worry of an increase in volatility expectation of a decrease in volatility belief that the 5-10 year slope will increase more (decrease less) than the 3-5 year slope belief that the 5-10 year slope will decrease more (increase less) than the 3-5 year slope

e)
f) a, c

anticipation of a general increase in the slope of the yield curve

anticipation of a general decrease in the slope of the yield curve

The barbell is more convex, hence benefits from the anticipated increase in volatility. The belief in c) translates into the yield curve becoming less curvy (or straightening out), which calls for being long the 5-10 year sector, short the 3-5 year sector or, equivalently, replacing the 5-year with the bullet. e) & f) are not right because the trade is neutral with respect to the overall slope (in the 3-10 year region).

FOREIGN EXCHANGE / FOREIGN INVESTING

0) Given the following spot exchange rates: $1.65/ 85/$ $1.4/ What are the / and / exchange rates? a) 140.25 and 2.31, respectively b) 140.25 and 1.1786, respectively c) 51.5152 and 1.1786, respectively d) Information on , , & $-denominated interest rates are necessary in order to answer e) Depends on the country where the question is asked

b The cross rates are calculated by:

/ = 85/$ x $1.65/ = 14.25 / = /$1.4 x $1.65/ = 1.1786

1)

You have entered into a forward contract to buy (long) 10 million yen at 100/$. You have no position in yen at the moment. On the settlement date, the exchange rate is 90/$. Which of the following is correct? a) b) c) d) The yen has appreciated, so you incurred a loss The yen has appreciated, so you made a profit The yen has deprecated, soy you incurred a loss The yen has deprecated, so you made a profit

b You agreed to purchase yen at a rate of 100 yen per dollar, or a price of 1/100 = .01 dollars per yen. The rate then went to 90 yen per dollar i.e., it takes less yen to buy the same dollar. Or, the price of yen went from .01 dollars to 1/90 = .0111 dollars per yen the yen appreciated. Because you agreed to pay a lower price, and now the price is higher, you profit.

2)

Your client owns fixed-rate government bonds of a foreign industrialized country denominated in that countrys currency. Which of the following would, all else the same, typically reduce the rate-of-return? ******* a) b) c) d) e) an increase in the foreign countrys macro-economic growth relative to potential a decrease in the countrys macro-economic growth relative to potential a decline in the countrys inflation rate a depreciation of the foreign currency relative to that of your clients home currency none of these

a&d If the countrys growth rate increases, government bond interest rates typically rise (unless it is a developing country, where the higher growth rate reduces default risk). This pushed down the price of fixed-rate bonds, lowering the rate-of-return. A decline in the inflation rate reduces interest rates, resulting in a price increase, hence higher R.O.R. A depreciation of the countrys currency means less domestic currency, hence lower R.O.R.

100)

Two global fund managers wish to gain exposure to the equity market of a foreign country. The first buys all the stocks in that countrys market index. The second goes long a futures contract on the index. The index rises. What is the difference between the exposures of the two managers? ****** a) b) c) d) e) None If the foreign currency depreciates, the first manager does better If the foreign currency depreciates, the second manager does better If the foreign currency appreciates, the first manager does better If the foreign currency appreciates, the second manager does better

c, d The manager purchasing actual shares is exposed not only to the share prices, of course, but to the exchange rate with respect to the entire portfolio. The second manager is exposed to the share prices via the futures contract, but since he/she does not own the shares the contract only has value if there is a change in price the currency factor is relevant only to this change. Hence, a currency depreciation hurts the second manager less, and a currency appreciation helps the first manager more. 40) A central bank sells its currency to purchase foreign reserves. What does this accomplish? **** a) It puts downward pressure on the home currency, and adds liquidity to the domestic economy unless sterilized. b) It puts downward pressure on the home currency but makes imports more attractive.

c) It puts upward pressure on the home currency. d) It removes liquidity from the economy, raising interest rates and putting upward pressure on the currency. e) It adds liquidity to the economy, causing the home currency to appreciate. a A purchase of foreign currency by the central bank raises the price of the foreign currency (if the purchase is substantial enough); i.e., causes a depreciation of the home currency. This makes imports more expensive, and exports cheaper to foreigners, all else the same. Since the bank is purchasing assets with its currency, this action adds liquidity to the domestic financial system. 24) A central bank has noticed its currency depreciated versus a foreign currency. It wants the exchange rate to return to its previous position. It should: ******
a) b) c) d)

Buy the foreign currency with its own currency Sell the foreign currency for its own currency But its own currency with the foreign currency Sell its own currency for the foreign currency

b&c They constitute the same action.

1)

A central bank wishes to raise the foreign exchange value of its currency. A strategy which would work to that end is: ******** a) b) c) d) e) f) purchase foreign currency with its own liquidity purchase its own currency with foreign reserves add liquidity to raise interest rates add liquidity to reduce interest rates reduce liquidity to raise interest rates reduce liquidity to lower interest rates

b,e Purchasing its own currency to raise its value vs. foreign currencies is known as direct intervention. Raising interest rates (by, for example, reducing liquidity) makes investing in the +country by foreigners more attractive, hence increases the currencys value via indirect intervention. 30) The one-year US dollar deposit rate is 3%, while the rate in country X is 2.5%. Relative to the dollar, which of the following is true (approximately) of country Xs currency one-year forward exchange rate?

a) b) c) d) e) f) d

It will be 2.5% cheaper (at a discount) than the spot. It will be 3% more expensive (at a premium) than the spot. It will be 0.5% cheaper (at a discount) than the spot. It will be 0.5% more expensive (at a premium) than the spot. It will be 5.5% cheaper (at a discount) than the spot. It will be 5.5% more expensive (at a premium) than the spot.

Because the foreign interest rate is 0.5% below that of the U.S., in order to remove the arbitrage (borrowing the foreign curre3ncy, exchanging into dollars and lending/depositing the dollars), the one-year forward exchange rate must be at that 0.5% premium to spot.

MORTGAGES AND MORTGAGE-BACKED SECURITIES

3) Which of the following is (are) true? ******** a) b) c) d) If there is no pre-payment, the monthly cash flow of a standard mortgage consists only of the coupon, plus the principal at maturity If there is no pre-payment, the last cash flow of a standard fixed-rate mortgage is the same as the first Scheduled repayments of standard mortgages begin with the first monthly payment While pre-payment is a right, coupon and scheduled repayments are a requirement

b,c,d a): wrong, because principal is paid (plus servicing fee, real estate tax, possibly mortgage insurance). b): known as level pay mortgage; c): yes. d): unless its an interest only option mortgage. 4) The term 120 PSA for a mortgage security means: a) b) c) d) e) The mortgage pool has 120 individual mortgages in it It is expected to be fully matured in 120 months The history of prepayment speeds by the homeowners in the pool has been 120% of the standard Public Securities Association speed The investor can be assured that prepayments will come in at 120% of the standard Public Securities Association speed The coupon on the pass-thru is 120% of that of the collateral

c 120 PSA refers to the degree of pre-payments experienced by the mortgages underlying the security. It has pre-paid in the past 20% faster than the standard PSA pre-payment model. There is no assurance, of course, that the future will duplicate the past.

5)

Which of the following would make an Adjustable Rate Mortgage attractive to an investor? a) b) c) d) e) Interest rate floats, so are not stuck with a low rate if market interest rates go up Pays significantly more than T-bills Usually has an annual plus lifetime cap Prepayment risk is less than conventional fixed-rate mortgages All are US agency guaranteed

a, b, d a): attractive only to investor expecting rates to rise (up to the cap); b): due to the credit risk of the borrower, unless government guaranteed, in which case the higher rate is due to pre-payment risk and the cap; c): this feature is a detriment for the investor; d): because of its floating rate, borrower has less incentive to refinance; e): not all

CREDIT DERIVATIVES
A credit default swaps dealer has just purchased protection from a customer. The dealer does not have another customer to sell the protection to. How can the credit risk be hedged? a) b) c) d)
b

by selling the reference bond short, acquiring it through a reverse repurchase agreement by purchasing the reference bond, financed with a repurchase agreement by buying a Treasury bond whose maturity coincides with that of the credit default swap by buying a Treasury bond whose maturity coincides with that of the reference bond

Having purchased protection, the dealer is short the credit risk of the reference entity. Her risk is that the credit worthiness will improve, reducing the price of protection. Purchasing the reference hedges, as it presents a long credit exposure. (Interest rate risk is introduced, however.)

0)

Compared to owning a credit-risky bond, selling protection on it: ********* a) b) c) d) creates a similar position with respect to credit exposure presents relatively little pure interest rate risk provides no regular cash flow is an unfunded position

b, d Selling protection (via CDS) subjects the seller to the credit risk of the reference entity, similar to a corporate bond of that entity. The bond, however, pays a coupon consisting of the Treasury yield plus the entitys credit spread. Because of the Treasury, or time value of money component, the bond presents interest rate risk on top of credit risk. The CDS pays only the credit spread, hence pure interest rate risk is largely absent. Why? Because no funds (other than margin) are required of the protection seller; i.e., it is an unfunded position.

OPTIONS
1) You own two shares of stock and have written one call struck at 30. The option expires today. Which of the following stock prices will be the best outcome for you? a) b) c) d) c a) Your position is worth 2x25=50; b) 2x30=60; c) 30+35=65. Recognizing the premium doe not affect the relative positions of the choices, as they all rise by the same amount. 1) You own a stock and have written two calls struck at 30. The option expires today. Which of the following stock prices will be the best outcome for you? a) b) c) d) b In a), your position is worth 25; in b), it is worth 30; in c), 30(3530)=25 because both will be exercised. Recognizing the premia does not affect the relative positions of the choices, as they all rise by the same amount. (Since the stock with a short call is 25 30 35 cannot answer without knowing the premia received for the calls 25 30 35 cannot answer without knowing the premium received for the calls

equivalent to a written put, you can think of this position as a short straddle, where the best outcome is at the common strike.)
You purchased a put on Amazon, struck at 210, for a premium of $1. Your broker has transacted this on the CBOE with X as the counter-party. A few days later, you sell an Amazon put, with the same strike and expiration date, for a $0.75 premium. This youre your broker executed on the CBOE with counter-party Y. What is your position now? a) You own a put, written by X, to whom you can put Amazon. And you have written a put to Y, who can put Amazon to you. b) You own a put, written by Y, to whom you can put Amazon. And you have written a put to X, who can put Amazon to you. c) You are flat and you account is credited $0.25 per option contract d) You are flat and you account is debited $0.25 per option contract d Options traded on exchanges are effectively transacted with the exchange as counter-party; hence, positions are netted. Your pair of trades resulted in a loss of $0.25 per contract. ) An options delta is: a) b) c) d) e) its premium the effect of the passage of time on the premium the degree of responsiveness of the premium to a change in the price of the underlying asset the difference between the historical and future volatility factored into the options value fixed the moment the option is created

c An options delta quantifies the change in the options premium for a 1 point change in the price of the underlying security. After a change in the securitys price, there is a new delta, different from the original value. Hence, e) is incorrect. A swaption is: a) b) c) d) d A payer swaption allows the holder to enter into a swap of specific term as the fixed rate payer at a fixed rate specified in the option contract. A receiver swaption allows the an option to cancel an existing swap a swap where one party pays an option premium and the other party receives it an agreement to exchange a swap for a bond an option to enter into a swap at a pre-determined fixed interest rate

holder to enter a swap of specific term as the fixed rate receiver at a fixed rate specified in the contract. Z. All else the same, an increase in overall interest rate volatility should necessarily: a)
b) c) d) e)

increase the price of a callable bond relative to a puttable bond of the same maturity, coupon and issuer
increase the price of a payer swaption versus receiver increase the price of a (ATM forward) call on a bond relative to a put on the same bond and strike increase the price of a capped FRN relative to same FRN, uncapped increase the price of a barbell relative to a bullet of equal duration

e a) is wrong because an increase in interest rate volatility makes the call and put features more valuable, hurting the callable bonds price, and helping the puttable. b) & c) are wrong because both payer & receiver and call & put rise in value with volatility. d) is wrong because the volatility increase makes the cap more valuable, reducing the capped floaters price. e) is correct because a barbell is more convex than a bullet, and greater volatility makes convexity more valuable. 1) You purchase a 3-month call on stock X, struck at 25/share when X is 24/share. You hold the option until expiration. Your return on investment will be: ****** a) b) c) d) b&d The option is out-of-the money, hence pays off 0 on the expiration date if X ends at 25 or lower. As the premium is lost, your return is negative. 2) You purchase a 3-month call on stock X, struck at 25/share when X is 24/share. You hold the option for one day. Assuming (implied) volatility is unchanged and one days time value is insignificant, your return on investment will be: ****** a) b) c) d) a positive if X rises to 25 by days end negative if X rises to 25 by days end positive if X is at 24 by days end negative is X is at 24 by days end positive if X rises to 25 on the expiration date negative if X rises to 25 on the expiration date positive if X is at 24 on the expiration date negative is X is at 24 on the expiration date

Unlike the previous question, here the option has time value at days end. Its delta is greater than 0, hence a) is correct (and b) incorrect). If X is unchanged, a positive delta has zero effect, hence c) and d) are incorrect.
5. You own a call on X struck at 30, with two months to expiry. X is at 33. You want to purchase X now. Which is the best strategy to do so (ignoring transactions costs)? a) b) c) d) b Exercising the call throws away the two-month time value of the option (the call is worth more than 3). Selling a put would be equivalent to owning X. Finally, the history of this transaction should have no bearing on the optimal decision today. Exercise the call Sell the call and buy X Buy a put in addition to the call Depends on the premium originally paid for the call.

1)

Given that you own the stock, what is a costless collar? a) b) c) d) e) f) long a put, short a call of any exercise price long a put, short a call of the same exercise price long a put, short a call of an exercise price such that the premiums are equal long a put, short a put with higher exercise price short a put, long a call of an exercise price such that the premiums are equal short a put, long a put of the same exercise price

c The investor purchases the put as insurance against a drop in the stock price below the strike. Selling a call (with a higher strike) reduces the cost of the insurance. This constitutes a collar. If the premiums are equal, the collar is costless.
17) You buy 100 shares of SPY for 125.5. At the same time, you sell a 122/128 strangle for premia of 1.7 and 2.3 for the call and put, respectively. By expiration, you plan to be long 200 shares. Ignoring brokerage, which of the following average purchase price per 200 shares for the associated price of SPY on expiration is(are) correct? ***** SPY 112 112 122 124 avg price 116.75 121.75 121.75 121.75

a) b) c) d)

e) f) g)

124 130 132

122.75 126.75 126.75

b, c, e, f At 112, the put is exercised to you. Hence you pay 122 for 100. You already purchased 100 at 125.5, and you received 400 for the straddle. Your average cost is: (125.5 4 + 122) /2 = 121.75. At 122, the put is not exercised. Hence you pay the market price for the second 100 shares. Your average cost is still 121.75. At 124, the put is not exercised (nor is the call). Hence you pay the market price for the second 100 shares, now 124. Your average cost is (125.5 4 + 124) /2 = 122.75. At 130, the put is not exercised, but the call is. Hence you receive 128 for your 100 shares (purchased at 125.5), but you must purchase 200 shares at market. Your average cost is (125.5 4 128 + 2x130) /2 = 126.75. At 132, the same thing happens. But now you must pay 2 more per share. Your average cost is, therefore, 128.75.
Q) Which of the following strategies is consistent with a view that interest rate volatility is about to increase? ****** a) b) c) d) purchase call on a government bond purchase put on a government bond write call on a government bond write put on a government bond e) invest in callable government bond f) invest in puttable government bond a,b,f This is a strategy reflecting a volatility view, as opposed to a view regarding direction of interest rates. The owner of a call or a put benefits when volatility increases, holding the level of rates constant. The writer loses. The callable bond investor is effectively a call writer; the puttable bond holder is effectively a put buyer

TIPS
4) Assume a 3-year (ordinary) Treasury note has a coupon of 4%, and a 3-yr TIP a coupon of 2%, both at par. Which of the following is true? a) b) c) If inflation turns out to equal 2%, on average, over the three years, they both earn a nominal return of 2%. If inflation turns out to equal 2%, on average, over the three years, they both earn a real return of 2%. We can infer that the market expects inflation to average 4% over three years.

d) b

If real interest rates in the markets rise above 2%, with inflation expectations unchanged, both bond prices will increase

The nominal return of the ordinary Treasury, if held to maturity (and assuming coupons are reinvested at the same initial yield), is fixed at 4%, regardless of the actual inflation rate over the holding period. The TIPs nominal return equals its real rate plus the actual inflation rate (same assumption regarding coupons). Their real returns equal their respective nominal returns less the inflation rate. Hence, 2% inflation produces 2% real ROR for both. If real rates rise, prices of both bonds decline (prior to their maturity). The markets expected inflation rate can be inferred from the difference between the two initial nominal yields. 1) Consider a TIPS and an ordinary Treasury bond, both of 5-year maturity, issued at par. In which situation will the TIPS produce a higher Rate-of-Return over a given horizon? a) b) c) d) c The yield on an ordinary (nominal) Treasury bond consists of a real interest rate plus an additional rate reflecting the rate of inflation expected over the remaining maturity of the bond. The yield on a TIP bond of the same maturity consists of a real interest rate plus the rate of inflation that actually obtains over that maturity. Thus, if inflation turns out to be higher than the exacted rate built into the ordinary bond, its R.O.R. will be lower than that of the TIP (and if it turns out to be lower, its R.O.R. will exceed that of the TIP) If there is inflation over the horizon If the inflation rate over the horizon exceeds the rate in the year preceding the issuance If the inflation rate over the horizon exceeds the rate expected for that period as of the issuance date If there is no inflation

CONVERTIBLES
) An advantage (to investor) of a convertible relative to a non-convertible bond is: a) b) c) d) e) the investor can sell the convertible and use the funds to buy stock of the issuer the investor can sell the convertible and use the funds to buy any stock it matures earlier it is callable it may be exchanged into stock of the issuer at a fixed rate of exchange

e Even non-convertible bonds may be sold in order to purchase the issuers or any other stock. The advantage a convertible has over an otherwise similar non-convertible bond is that it can be exchanged into a fixed number of issuer shares, a real benefit if the shares rise significantly in value. (Callability is an advantage to the issuer, not investor.) 6) The price of a convertible bond or convertible preferred stock will rise if: a) b) c) d) c The embedded option in a convertible becomes less valuable if volatility decreases. The issuer has a call option on the bond (and on the embedded convertible option!). Shortening the protection period increase the value of the call option, to the detriment of the bond holder. A decline in rates raises the value of the underlying bond or preferred in the convertible. the volatility of the stock decreases the call protection period is shortened interest rates decline and the value of the underlying bond or preferred increases interest rates rise and the value of the underlying bond or preferred falls

CALLABLE BONDS
82) Consider two bonds issued by a firm, both with 6% coupons, maturing in ten years. One (NC) is not callable, the other (C) is callable at par two years prior to maturity. Which of the following is true? a) b) c) d) d they have the same yield because they are from the same issuer C will mature earlier NC has a higher yield if they have the same yield, investors would prefer NC

A callable may mature earlier, if the issuer chooses to call. Since a call will take place to the issuers advantage and to the investors disadvantage investors demand a higher yield than an otherwise similar non-callable. Without the extra yield, investors would flock to the non-callable. 25) A 5% coupon bond matures in ten years, but is callable after five. Which of the following is true? ******* a) A 5% ten year non-callable bond from the same issuer has a lower yield, even though it carries the same coupon

b) c) d) a&c

A 5% ten year non-callable bond from the same issuer has a higher yield, even though it carries the same coupon An increase in its yield will lower its price An increase in its yield will raise its price

The callable has to pay a higher yield to compensate for call risk. When yields rise, its price falls, but less than the non-callable because the possibility of call gives the callable bond an effective maturity of less than ten years. Which of the following bonds same issuer, seniority and coupon - has the highest yield? a) b) c) d) b The 10-non-callable-5 can be thought of as either a ten-year non-callable, with an option sold to the issuer granting the right to buy it in five years at par; or as a five-year noncallable, with an option sold to the dealer granting the right to sell a five-year with that coupon at par in five years. In either case, the issuer pays the investor hence, a higher yield. 24) Consider a twenty year bond, with a seven percent coupon, callable at par in ten years. You have a twenty year holding period and purchase the bond at par. You plan to consume, rather then reinvest, the coupons. If the bond is called, you expect to reinvest in the firms bonds until your horizon. Which of the following is a true statement? a) If the firms borrowing rate declines below seven percent in ten years, its likely action will reduce your rate of return below seven percent. b) If the firms borrowing rate declines below seven percent in ten years, its likely action will raise your rate of return above seven percent. c) If the firms borrowing rate rises above seven percent in ten years, its likely action will reduce your rate of return below seven percent. d) If the firms borrowing rate rises above seven percent in ten years, its likely action will raise your rate of return above seven percent. a five-year maturity ten-year, callable in five years at par ten-year maturity cannot answer question without knowledge of the yield curve

If the firms borrowing rate falls below seven percent, it will refinance at the lower rate. As you expect to reinvest in the firms new bond, your rate-of-return will drop below 7%. If the firms borrowing rate rises above 7%, you will retain your bond and earn the 7%.

3)

The following bonds, all with ten year maturities, are of the same issuer: 6% coupon, non-callable; zero coupon (non-callable); 6% coupon, callable in five years. Which exhibits the least price sensitivity to a change in interest rates? a) b) c) d) the fixed coupon non-callable the zero coupon the callable all equal

c The callable bond may be paid off earlier; the latest maturity is ten years. Therefore, from a probabilistic perspective, the average expected maturity must be less than ten years, shorter than the others, hence least interest rate sensitive.

FORWARDS / FUTURES
2) You have entered into a forward contract to sell (short) 1 million shares of PEG Public Enterprise Group (formerly Public Service Electric & Gas of NJ) at 31/share. You do not currently own the shares. On the settlement date, PEG is at 30. Which of the following is correct? a) b) c) d) You made a profit of $1,000,000 You incurred a loss of $1,000,000 a), but only if it is a physical delivery forward b), but only if it is a cash settled forward

a You sold at a higher price 31. On the settlement date you purchase at a lower price 30 for a profit of $1 for each of the million shares. This is true whether the contract calls for physical delivery (under which you would actually purchase the shares in the cash market on the settlement date for 30/share and then deliver under terms of the contract for 31/share) or is cash settled (where you receive the difference between 31 and 30 on a million shares from the buyer of the contract).

33)

You have entered into a forward contract to buy (long) 10 million yen at 100/$. You have no position in yen at the moment. On the settlement date, the exchange rate is 90/$. Which of the following is correct?

a) The yen has appreciated, so you incurred a loss b) The yen has appreciated, so you made a profit

c) The yen has deprecated, so you incurred a loss d) The yen has deprecated, so you made a profit
b You agreed to purchase yen at a rate of 100 yen per dollar, or a price of 1/100 = .01 dollars per yen. The rate then went to 90 yen per dollar i.e., it takes less yen to buy the same dollar. Or, the price of yen went from .01 dollars to 1/90 = .0111 dollars per yen the yen appreciated. Because you agreed to pay a lower price, and now the price is higher, you profit. 014) Entering into a long forward (or futures) contract to purchase stocks can be used to hedge: **** a) A planned future purchase of stocks b) A planned future sale of stocks c) Existing holdings of stocks d) Existing short position in stocks a, d In both a) and d) an increase in stock prices entails a loss a) because more money will be spent on the intended purchase; d) when a stock is sold short, the higher the price (cost) to cover the short, the greater the loss. Entering into a contract to purchase the stock at a future date at a predetermined price removes the possible loss caused by the stocks price rising above that price. 015S) You are an investment manager with 10,000 shares of Starbucks (symbol: SBUX) in your portfolio. You are worried its price declining over the next month, and are considering entering a cash-settled forward contract with SBUX as the underlying asset, assuming you can find an adequate counter-party. SBUX is at 56.75 today, while the settlement price on the one-month forward contract is 57. A proper strategy, along with the correct analysis, would be: ***** a) Go short 1-month forward contracts for 10,000 shares of SBUX; if SBUX falls to 55 on the settlement date, your $20,000 earnings from the forward contract will exactly offset your $20,000 losses from your SBUX holdings Go short 1-month forward contracts for 10,000 shares of SBUX; if SBUX falls to 55 on the settlement date, your $17,500 losses from the forward contract will exactly offset your $17,500 earnings from your SBUX holdings Go short 1-month forward contracts for 10,000 shares of SBUX; if SBUX falls to 55 on the settlement date, your $20,000 earnings from the forward contract will more than offset your $17,500 losses from your SBUX holdings Go short 1-month forward contracts for 10,000 shares of SBUX; if SBUX rises to 58 on the settlement date, your $10,000 losses from the forward contract will partially offset your $12,500 earnings from your SBUX holdings Go long 1-month forward contracts for 10,000 shares of SBUX; if SBUX falls to 55 on the settlement date, your $20,000 losses from the forward contract will add to your $17,500 losses from your SBUX holdings Go long 1-month forward contracts for 10,000 shares of SBUX; if SBUX rises to 58 on the settlement date, your $10,000 earnings from the forward contract will add to your $12,500 earnings from your SBUX holdings

b) c) d) e) f)

c&d You need to be short forward contracts. Because you are hedging a long cash position, you want the derivative to be in the reverse direction. Hence, e) and f) are wrong strategies (even though the analysis in e) is correct). The forward price on the contract exceeds the cash, or current market, price. Hence, the marking-to-market earnings or losses on the 10,000 contracts compares the price on the settlement date (55 or 58) to 57, whereas the earnings or losses on the actual stock position compares the settlement date price to 56.75. Hence, the calculations in a) and b) are wrong (on top of that, b) is wrong because a price decline is positive for a short forward position, negative for a cash stock position), c) and d) are correct, in terms of both strategy and analyses. 015S) You are an investment manager with 10,000 shares of Starbucks (Symbol SBUX) in your portfolio. You are worried about its price declining over the next month, and are considering entering a forward contract using the S&P500 as the underlying asset. SBUX is at 60 today, with the S&P index at 1500. A proper dollar hedging strategy (i.e., ignoring volatility adjustment), with the correct analysis, would be: ***** a) Go short 250,000 S&P500 1-month forward contracts; if both SBUX and the S&P500 index decline, your earnings from the forward contract will offset (possibly imperfectly) your losses from your SBUX holdings b) Go long 400 S&P500 1-month forward contracts; if both SBUX and the S&P500 index decline, your earnings from the forward contract will offset (possibly imperfectly) your losses from your SBUX holdings c) Go short 400 S&P500 1-month forward contracts; if both SBUX and the S&P500 index decline, your earnings from the forward contract will offset (possibly imperfectly) your losses from your SBUX holdings d) Go long 250,000 S&P500 1-month forward contracts; if both SBUX and the S&P500 index decline, your earnings from the forward contract will offset (possibly imperfectly) your losses from your SBUX holdings e) Go short 400 S&P500 1-month forward contracts; if both SBUX and the S&P500 index increase, your losses from the forward contract will offset (possibly imperfectly) your earnings from your SBUX holdings f) Go long 250,000 S&P500 1-month forward contracts; if both SBUX and the S&P500 index increase, your losses from the forward contract will offset (possibly imperfectly) your earnings from your SBUX holdings c&e Because you are hedging a stock held position, you need to be short forward contracts. This way, the derivative will work in the reverse direction of your cash position. Your stock exposure is 10,000x60. To create an opposite derivative position, you need to be short (or sell) 600,000/1500 = 400 units of S&P500, as each unit is worth 1500. b), d) and f) are obviously wrong strategies because they are long the derivative (this adds to the risk exposure, rather than hedges it). b) and d) are further wrong in their analysis: if you are long the forward contract, then a decrease in price of the underlying asset creates losses, not earnings. Finally, d) and f) are further wrong because their hedge ratio calculation is upside down. c) and e) are correct both

with respect to the strategy, calculation and analysis. A) has the incorrect number, though the correct strategy and analysis. Consider the following situations: Todays price Verizon 44 S&P500 1500

Price in 1 year 50 1700

You own 1mm shares of Verizon, and have sold 25,000 units of the S$P500 in a forward contract to settle in one year, at a settlement price of 1520. One year from now you sell you shares, the prices are as above. What are your cash flows?

a) b) c) d) e) f)
d

+6x1mm from Verizon shares; + 200x25,000 from S&P contract +6x1mm from Verizon shares; + 200x25,000 from S&P contract +6x1mm from Verizon shares; 20x25,000 from S&P contract +6x1mm from Verizon shares; 180x25,000 from S&P contract +6x1mm from Verizon shares; 200x25,000 from S&P contract 6x1mm from Verizon shares; 20x25,000 from S&P contract

You sold 25,000 units of S&P for delivery in one year. Since you do not own it, you must purchase it in the cash market. You, therefore, pay 1700, and deliver it for a 1520 payment according to the terms of your contract, producing a negative cash flow of 180 per unit (if the forward contract is cash settled, the cash flows are this same net amount). 44) A bank has made a one-year loan to a corporate customer at a fixed rate. It has issued a sixmonth deposit to fund the loan, at a positive spread. What interest rate risk does it face, and what can it do about it? a) It is worried that interest rates will rise in six-months when it needs to roll-over the maturing deposit; it can enter into a six-month FRA settling in six months to receive the contract rate. b) It is worried that interest rates will decline in six-months when it needs to roll-over the maturing deposit; it can enter into a six-month FRA settling in six months to receive the contract rate. c) It is worried that interest rates will rise in six-months when it needs to roll-over the maturing deposit; it can enter into a six-month FRA settling in six months to pay the contract rate. d) It is worried that interest rates will decline in six-months when it needs to roll-over the maturing deposit; it can enter into a six-month FRA settling in six months to pay the contract rate. c The bank needs to issue another deposit in six months, and pay the market rate then, which might be too high to make a spread on the loan. An FRA allows it to lock in a borrowing rate.

0101) You are a speculator and have entered into a forward contract to purchase a stock in one month at a specific price. Assume the market price of the stock on the settlement fdate exceeds the contracted (settlement) price. Which of the following is(are) true on that date? ***** a) You will make a profit by priuchasing ther stock in the (cash) market abd dlovering it according to the terms of the contract b) You will make a profit by priuchasing the stock according to thje terms of the contract and selling it in the (cash) market c) You will incur a loss by priuchasing ther stock in the (cash) market abd dlovering it according to the terms of the contract b) You will incur a loss by priuchasing ther stock according to the terms of the comtract and selling it in the (cash) market b You pay the forward oprice on the settlrmrnt date, recive the stock, and sell it in the cash market at the higher price. ) How does a futures contract differ from an OTC forward? ****** a) b) c) d) e) futures necessitate initial margin and mark-to-market at least daily futures are used to hedge, forwards to speculate forwards provide more flexibility in terms of contract specifications futures settlement prices are always at a discount to cash; forwards at a discount or premium futures contract performance is guaranteed by an exchange

a,c,e Fundamentally, a futures contract is a forward contract. Hence, b) and d) are wrong. The rest are some of the ways a futures differs from a forward
89) You are a money manager, and are worried about the value of your bonds should interest rates rise. To hedge you: a) b) c) d) e) go long T-bond futures or forward contracts, to earn money should rates rise go long T-bond futures or forward contracts, to earn money should rates fall go short T-bond futures or forward contracts, to earn money should rates rise borrow money and buy more bonds, to compensate for the possible price declines exchange some existing bonds for zero coupon bonds

c You want to earn money in the event of interest rates increasing to offset your losses in such a situation on your bonds. Shorting futures or forward contracts is intuitively akin to borrowing, which is profitable if done prior to the rate increase. [d) and e) actually add rather than hedge risk.]

) Two global fund managers wish to gain exposure to the equity market of a foreign country. The first buys all the stocks in that countrys market index. The second goes long a futures contract on the index. The index rises. What is the difference between the exposures of the two managers? ****** a) b) c) d) e) c, d The manager purchasing actual shares is exposed not only to the share prices, of course, but to the exchange rate with respect to the entire portfolio. The second manager is exposed to the share prices via the futures contract, but since he/she does not own the shares the contract only has value if there is a change in price the currency factor is relevant only to this change. Hence, a currency depreciation hurts the second manager less, and a currency appreciation helps the first manager more. 71) Which of the following are true of forward contracts? ******** a) b) c) d)
a, b, c, d A forward contract (of which a futures contract is a special type, as it is transacted on a regulated futures exchange) is an agreement between to counter-parties to transaction on a future, or forward, date, not at the contracts inception. Of course, there is a risk that either party may not perform according to the terms of the contract. 31. You are short a bond futures contract. The yield on the underlying (cheapest-to-deliver) bond rises. What happens? a) b) c) d) d The settlement price falls; marking-to-market will debit your margin account The settlement price rises; marking-to-market will debit your margin account The settlement price rises; marking-to-market will credit your margin account The settlement price falls; marking-to-market will credit your margin account

None If the foreign currency depreciates, the first manager does better If the foreign currency depreciates, the second manager does better If the foreign currency appreciates, the first manager does better If the foreign currency appreciates, the second manager does better

They involve an agreement between two parties to perform a financial transaction in the future There is no actual sale of securities at the contracts inception Both parties face performance risk from each other while the contract is in place A futures contract is a special type of forward contact

Since the yield rises, the CTD bond price falls. Hence, the settlement price of the contract will likely fall as well (assuming no outsized movement in the cash-futures basis.) Because youre short the contract, a decline in settlement price is a gain, hence a credit to your account.

REPURCHASE AGREEMENTS
47) Repurchase agreements (and reverse repos) are ******: a) b) c) d) a, b, c A repo can be thought of as a short term loan, collateralized by a bond. As such, it qualifies as a money market instrument (less than 1 year maturity). Dealers use repos to finance bond inventories, and use reverse repos to acquire bonds sold short. 2) You buy a par bond with a 6% coupon, and finance it at the general collateral repo rate of 4%. What is your approximate net carry? a) 6% b) 4% c) 2% d) it depends on the reverse repo rate c Net carry equals the earnings of an asset less the financing cost of the cash used to pay for it. (2% is approximate because repo interest calculations follow money market conventions, not bond market conventions.) 2) Which of the following is a false statement about Repurchase Agreements? a) A repo consists of two transactions: a spot sale of securities, and an agreement to repurchase on a future date. b) The repo rate is a money market rate c) Most repos are overnight maturities d) Repos settle on the same day as the transaction e) The repo rate is always below the yield on the bond being repoed e a money market instrument a way to finance bond inventories used to cover shorts government obligations

Choices a) d) provide features of a repo contract. When the yield curve is inverted, repo rates may be above the yield on the underlying bond.

RETIREMENT PLANS / TAXES / MUNYS

Which of the following is(are) true regarding a Roth IRA? **** a) Qualified investments are made from pre-tax dollars b) Qualified investments are made from after-tax dollars c) Qualified withdrawals are taxable d) Qualified withdrawals are tax-free

b&d Unlike a traditional IRA, contributions to Roths are not tax deductible. Principal, therefore, can be withdrawn anytime. Earned income may be withdrawn tax-free if certain conditions (e.g., holding period) are met.
4) For which of the following situations may a penalty-free IRA (traditional) withdrawal be made prior to 59.5? ********** a) b) c) d) e) disability of owner death of spouse education expenses of grandchild education expenses of niece early retirement

a,c Those are the rules (death of owner does qualify, though!) 6) Upon converting a Traditional to a Roth IRA, you will: ******

a) pay taxes at your current rate on the amount converted b) not be required to take minimum distributions c) be allowed to re-characterize back into a Traditional d) get to deduct the converted amount once again from income a,b,c Because Roth IRAs use after-tax earnings, you must pay taxes upon conversion, but have the benefits of a Roth. And you can convert back into the Traditional and get a credit for the tax paid (but the deduction, net, is only once). 7) Which of the following will require more savings to be set aside each year for retirement? *****

a) b) c) d) e) b,c,d

pushing off retirement to later year an increase in targeted retirement funds an increase in life expectancy a decrease in expected returns on savings a decrease in marginal tax rates

Obvious. Longer retirement years means more targeted retirement funds, as do lower returns on retirement savings. Decrease in tax rates requires less savings, even in tax-advantaged accounts. This is because if investment in retirement account is with after-tax dollars, then the funds are taxed when withdrawn. If not taxed at withdrawal, then taxed when invested. 3*) You purchase a 10-yr, 5% coupon corporate bond at 82.6297 (ytm=7.5%) in the original issue (primary) market. After 1 year, its price rises to 83. At a ytm of 7.5%, its price would be 83.8494. Which of the following is true? ******

a) b) c) d) e) f) g) h)
b, f

If you do not sell the bond, you pay ordinary tax on 1.2197 If you do not sell the bond, you pay ordinary tax on 3.7197 If you do not sell the bond, you pay ordinary tax on 2.5 If you do not sell the bond, you pay no tax If you sell the bond, you pay ordinary tax on 1.2197 and capital gains tax on .3703 If you sell the bond, you pay ordinary tax on 3.7197 and have a capital loss of .8494 If you sell the bond, you pay ordinary tax on 1.2197 and have a capital loss of .8494 If you sell the bond, you pay no ordinary tax and have a capital loss of .8494

Unlike a discount bond purchased in the secondary market, where ordinary tax on accrual of the market discount is only payable at disposition, original issue discount bonds are taxable every year as the price accrues to par according to the original yield-to-maturity. The basis rises with the accrual, so that at sale (or maturity) capital gains/losses are calculated relative to the new basis. 4*) You purchase a 10-yr, 5% coupon municipal bond at 82.6297 (ytm=7.5%) in the original issue (primary) market. After 1 year, its price rises to 83. At a ytm of 7.5%, its price would be 83.8494. Which of the following is true? ******

a) b) c) d) e) f) g) h)
d, h

If you do not sell the bond, you pay ordinary tax on 1.2197 If you do not sell the bond, you pay ordinary tax on 3.7197 If you do not sell the bond, you pay ordinary tax on 2.5 If you do not sell the bond, you pay no tax If you sell the bond, you pay ordinary tax on 1.2197 and capital gains tax on .3703 If you sell the bond, you pay ordinary tax on 3.7197 and have a capital loss of .8494 If you sell the bond, you pay ordinary tax on 1.2197 and have a capital loss of .8494 If you sell the bond, you pay no ordinary tax and have a capital loss of .8494

Unlike a discount municipal bond purchased in the secondary market, where there is ordinary tax on accrual of the market discount (payable at disposition), the accrual on original issue discount municipal bonds are not taxable. However, the basis rises with the accrual (according to the original yield-to-maturity) so that at sale (or maturity) capital gains/losses are calculated relative to the new basis.

PRIVATE EQUITY
1) An action taken by a private equity manager to realize profits from an investment is
known as: a) b) c) d) e) a leveraged buyout carried interest an exit strategy the J-curve special situation financing

c Private equity exit strategies are intended to realize profits. An LBO is the beginning of an investment, not the end, as is special situation financing. Carried interest is the P.E. managers compensation until the exit. The J-curve refers to the P.E. investors cash flows over time.

LIFE INSURANCE / ANNUITIES

1) Which of the following is true? a) The longer the insured lives, the better off the insurance company; the longer the annuitant lives, the worse off the insurance company b) The longer the insured lives, the better off the insurance company; the longer the annuitant lives, the better off the insurance company c) The longer the insured lives, the worse off the insurance company; the longer the annuitant lives, the worse off the insurance company d) The longer the insured lives, the worse off the insurance company; the longer the annuitant lives, the better off the insurance company

a Life insurance proceeds are typically paid upon death; annuity payments are typically made until death.

MUTUAL FUNDS

03)

Which of the following is correct?

a) A Growth & Income Fund invests in both growth stocks and high dividend paying stocks; a Balanced Fund invests in both stocks and bonds b) A Growth & Income Fund invests in both stocks and bonds; a Balanced Fund invests in both growth stocks and high dividend paying stocks c) A Growth & Income Fund invests in stocks; a Balanced Fund invests in both growth stocks and high dividend paying stocks d) A Growth & Income Fund invests in both stocks and bonds; a Balanced Fund invests in both growth stocks and value stocks

a Definitionally so (income here refers to dividends, not interest)

HEDGE FUNDS
3) A Hedge Fund incorporating a Highwater Mark (HM) in its compensation arrangement: a) b) c) d) is paid no fees unless the HM is passed is paid no performance-based fee unless the HM is passed returns money to investors if HM is not reached none of the above

b A hedge fund will typically not receive a performance-based fee unless a new Highwater Mark is reached during a payment calculation period.