DerivativeInvestments:Options,Swaps,andInterestRateandCredit

Derivatives
TestID:7441879

Question#1of172

QuestionID:464184

Inordertocomputetheimpliedassetpricevolatilityforaparticularoption,aninvestor:
A) musthaveaseriesofassetprices.
B) musthavethemarketpriceoftheoption.
C) doesnotneedtoknowtheriskfreerate.
Explanation
Inordertocomputetheimpliedvolatilityweneedtheriskfreerate,thecurrentassetprice,thetimetoexpiration,theexercise
price,andthemarketpriceoftheoption.

Question#2of172

QuestionID:464214

Thefixedratepayerinaninterestrateswaphasapositionequivalenttoaseriesof:
A) longinterestputsandshortinterestratecalls.
B) shortinterestrateputsandlonginterestratecalls.
C) longinterestrateputsandcalls.
Explanation
Thefixedratepayerhasprofitswhenshortratesriseandlosseswhenshortratesfall,equivalenttowritingputsandbuying
calls.

Question#3of172

QuestionID:464097

Referringtoputcallparity,whichoneofthefollowingalternativeswouldallowyoutocreateasyntheticEuropeancalloption?
A) SellthestockbuyaEuropeanputoptiononthesamestockwiththesame
exercisepriceandthesamematurityinvestanamountequaltothepresent
valueoftheexercisepriceinapurediscountrisklessbond.
B) BuythestockbuyaEuropeanputoptiononthesamestockwiththesameexercise
priceandthesamematurityshortanamountequaltothepresentvalueofthe
exercisepriceworthofapurediscountrisklessbond.
C) BuythestocksellaEuropeanputoptiononthesamestockwiththesameexercise
priceandthesamematurityshortanamountequaltothepresentvalueofthe
exercisepriceworthofapurediscountrisklessbond.
Explanation
AccordingtoputcallparitywecanwriteaEuropeancallas:C0=P0+S0X/(1+Rf)T

Wecanthenreadofftherighthandsideoftheequationtocreateasyntheticpositioninthecall.Wewouldneedtobuythe
Europeanput,buythestock,andshortorissuearisklesspurediscountbondequalinvaluetothepresentvalueofthe
exerciseprice.

Questions#49of172
SteveMillerisaseniorfixedincometraderforalargehedgefundbasedinNewYork.MillerhasrecentlyhiredC.D.Johnson
toassistMillerinimplementingsomederivativebasedtrades.MillerwouldliketoensurethatJohnsonunderstandsthebasics
ofinterestratederivativesbeforeallowinghimtobeinvolvedintosomemorecomplicatedtradingstrategies.Millercreatesa
hypotheticalbondscenarioforJohnsontoanalyzeinorderforhimtoevaluateJohnson'sexpertiseinthearea.Millerinstructs
JohnsontoconsidertheLondonInterbankOfferedRate(LIBOR)interestrateenvironmentinTable1.

Table1
90DayLIBORForwardRatesandImpliedSpotRates
Period(inmonths) LIBORForwardRates ImpliedSpotRates
03

5.500%

5.5000%

36

5.750%

5.6250%

69

6.000%

5.7499%

912

6.250%

5.8749%

1215

7.000%

6.0997%

1518

7.000%

6.2496%

4851

8.100%

7.1228%

5154

8.200%

7.1826%

5457

8.300%

7.2413%

5760

8.400%

7.2992%

6063

8.500%

7.3563%

6366

8.600%

7.4127%

6669

8.700%

7.4686%

6972

8.800%

7.5240%

7275

8.900%

7.5789%

7578

9.000%

7.6335%

7881

9.100%

7.6877%

8184

9.200%

7.7416%

8487

9.300%

7.7953%

8790

9.400%

7.8487%

MillersuggeststoJohnsontoexaminetheinstrumentsshowninTable2usingtheinformationinTable1.Millerinstructs
Johnsontouse0.25yearsforeachquarterandtonotconcernhimselfwithactualdaycounts.

Table2
InterestRateInstruments
DollarAmountofFloatingRate

$30,000,000

Bond
FloatingRateBondSpreadover

0.50%

LIBOR
TimetoMaturity(years)

CapStrikeRate

6.00%

FloorStrikeRate

5.00%

InterestPayments

quarterly

Question#4of172

QuestionID:464266

Johnsonwantstoevaluatetheeffectofanincreaseinratesontheinceptionvalueofaplainvanillapay,fixedinterestrate
swap.Specifically,ifinterestratesincreaseacrossallmaturitiesinTable1,howwouldtheinceptionvalueoftheswapbe
affected?Theinceptionvalueoftheswapwould:
A) decrease.
B) staythesame.
C) increase.
Explanation
Thevaluestaysthesamebecausetheinceptionvalueofallplainvanillainterestratesswapsiszerobydesign.
Anincreasewould,however,becorrectforanexistingpayfixedswap.Thecounterpartyreceivesthefloatingratewhilepaying
thefixedrate.Therefore,itwouldreceiveahigherinterestratebutwouldstillhavetopaythesamefixedinterestrate.
Therefore,thevalueoftheswapwouldincrease.(StudySession17,LOS54.a,c)

Question#5of172

QuestionID:464267

MillerasksJohnsontohedgeahypotheticalshortpositioninthefloatingratebondinTable2.Whichofthefollowingisthe
besthedgeforthisposition?
A) Sellaninterestratecap.
B) Buyaninterestratecap.
C) Buyaninterestratefloor.
Explanation
Aninterestratecapprovidesapositivepayoffwheninterestratesareabovethecapstrikerate.Therefore,thebuyerofthisinstrumentis
abletohedgehimselfagainstrisinginterestrates.

Incorrectanswerexplanations:
Sellinganinterestratecapisnotahedgeagainstrisinginterestrates.
Buyinganinterestratefloorhedgestheriskofdecreasinginterestrates.

(StudySession17,LOS55.a)

Question#6of172

QuestionID:464268

MillernowasksJohnsontocomputethepayoffofthecapandfloorinTable2assumingthatLIBORhasrisento7%at
expiration.Specifically,MillerwantsJohnsontodeterminethenetpayoffofthecorrespondingshortcollar(buyingthefloorand
sellingthecap)forthetotaloutstandingamountofthefloatingratebond.WhichofthefollowingistheclosesttoJohnson's
answer?
A) $300,000.
B) $300,000.
C) $450,000.
Explanation
Thefloorexpiresworthlesswhilethecapisexercisedandthesellerhastopaythedifferencebetweenthecapstrikerateand
LIBORwhichis1%inthiscase.Hencethecalculationisasfollows:
NetPayoff=(6.00%(7.00%))$30,000,000=$300,000
Theanswer$450,000isincorrectbecausethepayoffisdeterminedbytheLIBORrate,notbythespreadoverLIBORforthe
floatingratebond.(StudySession17,LOS55.b)

Question#7of172

QuestionID:464269

Next,MillerasksJohnsontodeterminethenetpayoffofthecorrespondinglongcollar(buyingthecapandsellingthefloor)for
thetotaloutstandingamountofthefloatingratebond.AssumethatLIBORhasrisento8%atexpiration.Whichofthefollowing
istheclosesttoJohnson'sanswer?
A) $600,000.
B) $900,000.
C) $600,000.
Explanation
Thefloorexpiresworthlesswhilethecapisexercisedandthesellerhastopaythedifferencebetweenthecapstrikerateand
LIBORwhichis2%inthiscase.Hencethecalculationisasfollows:
NetPayoff=(8.00%(6.00%))$30,000,000=$600,000
(StudySession17,LOS55.b)

Question#8of172

QuestionID:464270

MillerasksJohnsonwhichofthefollowingstrategiesallowsaninvestortobenefitfrombothincreasinganddecreasinginterest
rates?

 A) Buyanatthemoneycapandanatthemoneyfloor.
B) Sellanatthemoneycapandanatthemoneyfloor.
C) Buyanatthemoneycapandsellanatthemoneyfloor.
Explanation
Thisisastraddleoninterestrates.Thecapprovidesapositivepayoffwheninterestratesriseandthefloorprovidesapositive
payoffwheninterestratesfall.
Incorrectanswerexplanations:
Sellanatthemoneycapandanatthemoneyfloor.Inthiscasetheinvestorwouldsufferfromincreasinganddecreasing
interestratessincethecapletsandfloorletswouldbeexercisedagainsthim.
Buyanatthemoneycapandsellanatthemoneyfloor.Inthiscasetheinvestorwouldsufferfromdecreasinginterest
ratessincethefloorletswouldbeexercisedagainsthim.
(StudySession17,LOS55.a)

Question#9of172

QuestionID:464271

JohnsonnowconsidersthefloatingratebondshowninTable2.Specifically,Johnsonconsidersthisnotefromtheperspective
oftheissuer.Iftheissuerdecidedtohedgetheinterestrateriskassociatedwiththisliabilitywhichofthefollowingisthemost
appropriatehedge?
A) Buyinganinterestratefloor.
B) Sellinganinterestratefloor.
C) SellingEurodollarfutures.
Explanation
IfashortpositioninEurodollarfuturesisaddedtotheexistingliabilityinthecorrectamount,theinterestriskishedged.
Incorrectanswerexplanations:
Buyinganinterestratefloorisahedgeagainstdeclininginterestratesifonehasalongpositioninafloatingratebond.
Sellinganinterestratefloorisnotahedgeagainstchanginginterestrates.
(StudySession17,LOS55.a)

Question#10of172
Foraninterestrateswap,theswapspreadisthedifferencebetweenthe:
A) swaprateandthecorrespondingTreasuryrate.
B) fixedrateandthefloatingrateinagivenperiod.
C) averagefixedrateandtheaveragefloatingrateoverthelifeofthecontract.
Explanation
TheswapspreadistheswaprateminusthecorrespondingTreasuryrate.

QuestionID:464254

Question#11of172

QuestionID:464208

Thefloatingratepayerinasimpleinterestrateswaphasapositionthatisequivalentto:
A) aseriesoflongforwardrateagreements(FRAs).
B) aseriesofshortFRAs.
C) issuingafloatingratebondandaseriesoflongFRAs.
Explanation
Thefloatingratepayerhasaliability/gainwhenratesincrease/decreaseabovethefixedcontractratetheshortpositioninan
FRAhasaliability/gainwhenratesincrease/decreaseabovethecontractrate.

Question#12of172

QuestionID:464119

ForachangeinwhichofthefollowinginputsintotheBlackScholesMertonoptionpricingmodelwillthedirectionofthe
changeinaput'svalueandthedirectionofthechangeinacall'svaluebethesame?
A) Volatility.
B) Exerciseprice.
C) Riskfreerate.
Explanation
Adecrease/increaseinthevolatilityofthepriceoftheunderlyingassetwilldecrease/increasebothputvaluesandcallvalues.
Achangeinthevaluesoftheotherinputswillhaveoppositeeffectsonthevaluesofputsandcalls.

Question#13of172

QuestionID:464227

Considerafixedratesemiannualpayequityswapwheretheequitypaymentsarethetotalreturnona$1millionportfolioand
thefollowinginformation:
180dayLIBORis4.2%
360dayLIBORis4.5%
Div.yieldontheportfolio=1.2%
Whatisthefixedrateontheswap?
A) 4.5143%.
B) 4.3232%.
C) 4.4477%.
Explanation

=0.0222392=4.4477%

Question#14of172

QuestionID:464235

Aninvestorwhoanticipatestheneedtoexitapayfixedinterestrateswappriortoexpirationmight:
A) buyapayerswaption.
B) buyareceiverswaption.
C) sellapayerswaption.
Explanation
Areceiverswaptionwill,ifexercised,provideafixedpaymenttooffsettheinvestor'sfixedobligation,andallowhimtopay
floatingratesiftheydecrease.

Question#15of172

QuestionID:464168

Comparedtothevalueofacalloptiononastockwithnodividends,acalloptiononanidenticalstockexpectedtopaya
dividendduringthetermoftheoptionwillhavea:
A) highervalueonlyifitisanAmericanstyleoption.
B) lowervalueonlyifitisanAmericanstyleoption.
C) lowervalueinallcases.
Explanation
Anexpecteddividendduringthetermofanoptionwilldecreasethevalueofacalloption.

Question#16of172

QuestionID:464212

Writingaseriesofinterestrateputsandbuyingaseriesofinterestratecalls,allatthesameexerciserate,isequivalentto:
A) ashortpositioninaseriesofforwardrateagreements.
B) beingthefixedratepayerinaninterestrateswap.
C) beingthefloatingratepayerinaninterestrateswap.
Explanation
Ashortpositionininterestrateputswillhaveanegativepayoffwhenratesarebelowtheexerciseratethecallswillhave
positivepayoffswhenratesexceedtheexerciserate.Thismirrorsthepayoffsofthefixedratepayerwhowillreceivepositive
netpaymentswhensettlementratesareabovethefixedrate.

Question#17of172

QuestionID:464182

Whichofthefollowingstatementsregardinganoption'spriceisCORRECT?Anoption'spriceis:
A) adecreasingfunctionoftheunderlyingasset'svolatilitywhenithasalong
timeremaininguntilexpirationandanincreasingfunctionofitsvolatilityifthe
optionisclosetoexpiration.
B) anincreasingfunctionoftheunderlyingasset'svolatility.
C) adecreasingfunctionoftheunderlyingasset'svolatility.
Explanation
Sinceanoptionhaslimitedriskbutsignificantupsidepotential,itsvaluealwaysincreaseswhenthevolatilityoftheunderlying
assetincreases.

Question#18of172

QuestionID:464218

AU.S.firm(U.S.)andaforeignfirm(F)engageina3year,annualpayplainvanillacurrencyswapU.S.isthefixedrate
payerinFC.Thefixedrateatinitiationwas5%.Thevariablerateattheendofyear1was4%,attheendofyear2was6%,
andattheendofyear3was7%.Atthebeginningoftheswap,$2millionwasexchangedatanexchangerateof2foreign
unitsper$1.Attheendoftheswapperiodtheexchangeratewas1.75foreignunitsper$1.
Attheendofyear1,firm:
A) FpaysfirmU.S.$200,000.
B) U.S.paysfirmF$200,000.
C) U.S.paysfirmF200,000foreignunits.
Explanation
Aplainvanillacurrencyswappaysfloatingondollarsandfixedonforeign.Fixedonforeign0.05$2,000,0002foreign
unitsper$1=200,000foreignunitspaidbytheU.S.firm.

Questions#1924of172
MarkWashington,CFA,isananalystwithBIC,aBermudabasedinvestmentcompanythatdoesbusinessprimarilyintheU.S.
andCanada.BIChasapproximately$200millionofassetsundermanagement,thebulkofwhichisinvestedinU.S.equities.
BIChasoutperformeditstargetbenchmarkforeightofthepasttenyears,andhasconsistentlybeeninthetopquartileof
performancewhencomparedwithitspeerinvestmentcompanies.WashingtonisapartoftheLiabilityManagementgroupthat
isresponsibleforhedgingtheequityportfoliosundermanagement.TheLiabilityManagementgrouphasbeenauthorizedto
usecallsorputsontheunderlyingequitiesintheportfoliowhenappropriate,inordertominimizetheirexposuretomarket
volatility.Theyalsomayutilizeanoptionsstrategyinordertogenerateadditionalreturns.
Oneyearago,BICanalystspredictedthattheU.S.equitymarketwouldmostlikelyexperienceaslightdownturndueto
inflationarypressures.Theanalystsforecastadecreaseinequityvaluesofbetween3to5%overtheupcomingyearandone
half.Baseduponthatprediction,theLiabilityManagementgroupwasinstructedtoutilizecallsandputstoconstructadelta
neutralportfolio.Washingtonimmediatelyestablishedoptionpositionsthathebelievedwouldhedgetheunderlyingportfolio

againsttheimpendingmarketdecline.
Aspredicted,theU.S.equitymarketsdidindeedexperienceadownturnofapproximately4%overatwelvemonthperiod.
However,portfolioperformanceforBICduringthosetwelvemonthswasdisappointing.TheperformanceoftheBICportfolio
laggedthatofitspeergroupbynearly10%.Uppermanagementbelievesthatamajorfactorintheportfolio's
underperformancewastheoptionstrategyutilizedbyWashingtonandtheLiabilityManagementgroup.Managementhas
decidedthattheLiabilityManagementgroupdidnotproperlyexecuteadeltaneutralstrategy.Washingtonandhisgrouphave
beentoldtoreviewtheiroptionsstrategytodeterminewhythehedgedportfoliodidnotperformasexpected.Washingtonhas
decidedtoundertakeareviewofthemostbasicoptionconcepts,andexploresuchelementarytopicsasoptionvaluation,an
option'sdelta,andtheexpectedperformanceofoptionsundervaryingscenarios.Heisgoingtoexamineallfacetsofadelta
neutralportfolio:howtoconstructone,howtodeterminetheexpectedresults,andwhentouseone.Managementhasgiven
Washingtonandhisgrouponeweektoimmersethemselvesinoptionstheory,reviewthebasicconcepts,andthentopresent
theirfindingsastowhytheportfoliodidnotperformasexpected.

Question#19of172

QuestionID:464149

Whichofthefollowingbestexplainsadeltaneutralportfolio?Adeltaneutralportfolioisperfectlyhedgedagainst:
A) smallpricechangesintheunderlyingasset.
B) allpricechangesintheunderlyingasset.
C) smallpricedecreasesintheunderlyingasset.
Explanation
Adeltaneutralportfolioisperfectlyhedgedagainstsmallpricechangesintheunderlyingasset.Thisistruebothforprice
increasesanddecreases.Thatis,theportfoliovaluewillnotchangesignificantlyiftheassetpricechangesbyasmallamount.
However,largechangesintheunderlyingwillcausethehedgetobecomeimperfect.Thismeansthatoverallportfoliovalue
canchangebyasignificantamountifthepricechangeintheunderlyingassetislarge.(StudySession17,LOS53.e)

Question#20of172

QuestionID:464150

Afterdiscussingtheconceptofadeltaneutralportfolio,Washingtondeterminesthatheneedstofurtherexplaintheconceptof
delta.Washingtondrawsthepayoffdiagramforanoptionasafunctionoftheunderlyingstockprice.Usingthisdiagram,how
isdeltainterpreted?Deltaisthe:
A) levelintheoptionpricediagram.
B) curvatureoftheoptionpricegraph.
C) slopeintheoptionpricediagram.
Explanation
Deltaisthechangeintheoptionpriceforagiveninstantaneouschangeinthestockprice.Thechangeisequaltotheslopeof
theoptionpricediagram.(StudySession17,LOS53.e)

Question#21of172

QuestionID:464151

Washingtonconsidersaputoptionthathasadeltaof0.65.Ifthepriceoftheunderlyingassetdecreasesby$6,thenwhich
ofthefollowingisthebestestimateofthechangeinoptionprice?
A) $3.90.
B) +$3.90.

 C) $6.50.
Explanation
Theestimatedchangeinthepriceoftheoptionis:
Changeinassetpricedelta=$6(0.65)=$3.90
(StudySession17,LOS53.e)

Question#22of172

QuestionID:464152

Washingtonistryingtodeterminethevalueofacalloption.Whentheslopeoftheatexpirationcurveisclosetozero,thecall
optionis:
A) inthemoney.
B) outofthemoney.
C) atthemoney.
Explanation
Whenacalloptionisdeepoutofthemoney,theslopeoftheatexpirationcurveisclosetozero,whichmeansthedeltawillbe
closetozero.(StudySession17,LOS53.e)

Question#23of172

QuestionID:464153

BICowns51,750sharesofSmith&Oates.Thesharesarecurrentlypricedat$69.AcalloptiononSmith&Oateswithastrike
priceof$70issellingat$3.50,andhasadeltaof0.69Whatisthenumberofcalloptionsnecessarytocreateadeltaneutral
hedge?
A) 75,000.
B) 0.
C) 14,785.
Explanation
Thenumberofcalloptionsnecessarytodeltahedgeis=51,750/0.69=75,000optionsor750optioncontracts,each
covering100shares.Sincethesearecalloptions,theoptionsshouldbesoldshort.(StudySession17,LOS53.e)

Question#24of172

QuestionID:464154

Whichofthefollowingstatementsregardingthegoalofadeltaneutralportfolioismostaccurate?Oneexampleofadelta
neutralportfolioistocombinea:
A) longpositioninastockwithashortpositioninacalloptionsothatthevalue
oftheportfoliochangeswithchangesinthevalueofthestock.
B) longpositioninastockwithashortpositionincalloptionssothatthevalueofthe
portfoliodoesnotchangewithchangesinthevalueofthestock.
C) longpositioninastockwithalongpositionincalloptionssothatthevalueofthe
portfoliodoesnotchangewithchangesinthevalueofthestock.
Explanation

Adeltaneutralportfoliocanbecreatedwithanyofthefollowingcombinations:longstockandshortcalls,longstockandlong
puts,shortstockandlongcalls,andshortstockandshortputs.(StudySession17,LOS53.e)

Questions#2530of172
RachelBarlowisarecentgraduateofColumbiaUniversitywithaBachelor'sdegreeinfinance.Shehasacceptedapositionat
alargeinvestmentbank,butfirstmustcompleteanintensivetrainingprogramtogainexperienceinseveraloftheinvestment
bank'sareasofoperations.Currently,sheisspendingthreemonthsatherfirm'sDerivativesTradingdesk.Oneofthetraders,
JasonColeman,CFA,isactingashermentor,andwillbegivinghervariousassignmentsoverthethreemonthperiod.
OneofthefirstprojectsColemanasksBarlowtodoistocomparedifferentoptiontradingstrategies.Colemanwouldlike
Barlowtopayparticularattentiontostrategycostsandtheirpotentialpayoffs.Barlowisnotverycomfortablewithoption
models,andknowssheneedstobeabletofullyunderstandthemostbasicconceptsinordertomoveon.Shedecidesthat
shemustfirstinvestigatehowtoproperlypriceEuropeanandAmericanstyleequityoptions.ColemanhasgivenBarlow
softwarethatprovidesavarietyofanalyticalinformationusingthreevaluationapproaches:theBlackScholesmodel,the
Binomialmodel,andMonteCarlosimulation.Barlowhasdecidedtobeginheranalysisusingavarietyofdifferentscenariosto
evaluateoptionbehavior.ThedatashewillbeusinginherscenariosisprovidedinExhibits1and2.Notethatalloftherates
andyieldsareonacontinuouscompoundingbasis.
Exhibit1
StockPrice(S)

$100.00

StrikePrice(X)

$100.00

InterestRate(r)

7.0%

DividendYield(q)

0.0%

TimetoMaturity
(years)
Volatility(Std.Dev.)
ValueofPut

0.5
20.0%
$3.9890

Exhibit2
StockPrice(S)

$110.00

StrikePrice(X)

$100.00

InterestRate(r)

7.0%

DividendYield(q)

0.0%

TimetoMaturity
(years)
Volatility(Std.Dev.)
ValueofCall

0.5
20.0%
$14.8445

N(d1)

0.8394

N(d2)

0.8025

Exhibit3
StockPrice(S)

$115.00

StrikePrice(X)

$100.00

InterestRate(r)

7.0%

DividendYield(q)
TimetoMaturity
(years)
Volatility(Std.Dev.)

0.0%
0.5
20.0%

ValueofCall

$19.2147

ValueofPut

$0.7753

Question#25of172

QuestionID:464171

BarlownoticesthatthestockinExhibit1doesnotpaydividends.Ifthestockbeginstopayadividend,howwillthepriceofa
calloptiononthatstockbeaffected?Thepriceofthecalloption:
A) willincrease.
B) mayeitherincreaseordecrease.
C) willdecrease.
Explanation
Thecalloptionvaluewilldecreasesincethepaymentofdividendsreducesthevalueoftheunderlying,andthevalueofacall
ispositivelyrelatedtothevalueoftheunderlying.(LOS53.g)

Question#26of172

QuestionID:464172

BarlowcalculatedthevalueofanAmericancalloptiononthestockshowninExhibit2.Whichofthefollowingisclosesttothe
valueofthiscalloption?
A) $14.84.
B) $15.12.
C) $15.41.
Explanation
ThevalueoftheAmericanstylecalloptionisthesameasthevalueoftheequivalentEuropeanstylecalloption.Sincethe
underlyingstockdoesnotpayadividend,itisneveroptimaltoexercisetheAmericanoptionearly.Hencetheearlyexercise
optioniembeddedintheAmericanstylecallhasnovalueinthiscase.ThismakestheAmericanoptionworthexactlythesame
astheEuropeanoption.(LOS53.g)

Question#27of172

QuestionID:464173

UsingtheinformationinExhibit2,BarlowcomputesthevalueofaEuropeanputoption.Whichofthefollowingisclosesttothe
valueofthisoption?
A) $1.97.
B) $4.84.
C) $1.41.
Explanation

UsingtheinformationinExhibit2,thisvaluecanbedeterminedfromputcallparityasfollows:
Put=Call+Xert S

SowehavePut=$14.8445+$100.00e(7.00%0.5)$110.00=$1.4050
(LOS53.a)

Question#28of172

QuestionID:464174

BarlownoticesthatthestockinExhibit2doesnotpaydividends.Ifthestockstartstopayadividend,howwillthepriceofaput
optiononthatstockbeaffected?
A) Decrease.
B) Increase.
C) Increaseordecrease.
Explanation
Theputoptionvaluewillincreasesincethepaymentofdividendsreducesthevalueoftheunderlying,andthevalueofaputis
negativelyrelatedtothevalueoftheunderlying.(LOS53.g)

Question#29of172

QuestionID:464175

Ifthepriceoftheunderlyingstockincreasesfromthe$110.00priceshowinginexhibit2to$115.00,theapproximateprice
changeaspredictedbydeltausingthedatafromexhibit2is:
A) morethantheactual$19.2147valueofthecallbecauseofgamma.
B) lessthantheactual$19.2147valueofthecallbecauseofgamma.
C) ispreciselytheactual$19.2147valueofthecallbecauseofgamma.
Explanation
Theapproximatechangeinvalueusingdeltafor$1.00ofchangeisN(d1)=0.8394.Foranincreaseof$5.00inthestock,the
approximatevalueis:50.8394=$4.1972.Addthistothevalueofthecallof$14.8445gives=$19.0416.Thisvalueisless
thantheactualvalueof$19.2147showninexhibit3.Thechangeindelta,(gamma,effects)haveincreasedthevalueofthe
callgreaterthantheestimatedchange.(LOS53.e)

Question#30of172

QuestionID:464176

Ifthemarketpriceofallcallsandputsaregreaterthanthepredicatedoptionprices,theimpliedvolatilityis:
A) greaterthanthecurrentstandarddeviationof20.0%.
B) calculatedfromhistoricalvolatility.
C) lessthanthecurrentstandarddeviationof20.0%.
Explanation
Bothcallsandputshavehighervalueswhenexpectedvolatilityishigher.Vega,thechangeinoptionpricerelativetochange
involatility,ispositiveforbothcallsandputs.Asstandarddeviationincreases,callandputpricesincrease.Ifthemarket
valuesbothcallsandputshigherthanourcalculatedvalues,themarketimpliedvolatilitymustbehigherthanthevalueswe

areusinginourcalculations.Historicalstandarddeviationasestimatedmaybehigherorlowerthantheimpliedvolatility.(LOS
53.d)

Question#31of172

QuestionID:464209

Whichofthefollowingisequivalenttoaplainvanillareceivefixedcurrencyswap?

A) Alongpositioninaforeignbondcoupledwiththeissuanceofadollardenominated
floatingratenote.

B) Ashortpositioninaforeignbondcoupledwiththeissuanceofadollardenominatedfloating
ratenote.

C) Ashortpositioninaforeignbondcoupledwithalongpositioninadollardenominatedfloating
ratenote.

Explanation
Alongpositioninafixedrateforeignbondwillreceivefixedcouponsdenominatedinaforeigncurrency.Theshortfloatingratenote
requiresU.S.dollardenominatedfloatingratepayments.Combined,thesearethesamecashflowasaplainvanillacurrencyswap.

Question#32of172

QuestionID:464100

Astockispricedat38andtheperiodicriskfreerateofinterestis6%.WhatisthevalueofatwoperiodEuropeanputoption
withastrikepriceof35onashareofstockusingabinomialmodelwithanupfactorof1.15andariskneutralprobabilityof
68%?
A) $0.57.
B) $0.64.
C) $2.58.
Explanation
Givenanupfactorof1.15,thedownfactorissimplythereciprocalofthisnumber1/1.15=0.87.Twodownmovesproducea
stockpriceof380.872=28.73andaputvalueattheendoftwoperiodsof6.27.Anupandadownmove,aswellastwoup
movesleavetheputoptionoutofthemoney.Youaredirectlygiventheprobabilityofup=0.68.Thedownprobability=0.32.
Thevalueoftheputoptionis[0.3226.27]/1.062=$0.57.

Question#33of172
Aninstantaneouslyrisklesshedgedportfoliohasadeltaof:
A) anythinggammadeterminestheinstantaneousriskofahedgeportfolio.
B) 0.
C) 1.
Explanation

QuestionID:464138

Arisklessportfolioisdeltaneutralthedeltaiszero.

Question#34of172

QuestionID:464162

Whichofthefollowingisthebestapproximationofthegammaofanoptionifitsdeltaisequalto0.6whenthepriceoftheunderlying
securityis100and0.7whenthepriceoftheunderlyingsecurityis110?

A) 1.00.
B) 0.01.
C) 0.10.
Explanation
Thegammaofanoptioniscomputedasfollows:
Gamma=changeindelta/changeinthepriceoftheunderlying=(0.70.6)/(110100)=0.01

Question#35of172

QuestionID:464225

90daysagotheexchangeratefortheCanadiandollar(C$)was$0.83andthetermstructurewas:

180days 360days
LIBOR

5.6%

6%

CDN

4.8%

5.4%.

Aswapwasinitiatedwithpaymentsof5.3%fixedinC$andfloatingratepaymentsinUSDonanotionalprincipalofUSD1
millionwithsemiannualpayments.
90dayshavepassed,theexchangerateforC$is$0.84andtheyieldcurveis:

90days 270days
LIBOR

5.2%

5.6%

CDN

4.8%

5.4%

Whatisthevalueoftheswaptothefloatingratepayer?
A) $10,126.
B) $3,472.
C) $2,708.
Explanation
ThepresentvalueoftheUSDfloatingratepaymentis:

(1.028/1.013)=1.014808
1.0148081,000,000=$1,014,808
ThepresentvalueofthefixedC$paymentsper1CDNis:

(0.0265/1.012)+(1.0265/1.0405)=1.012731andforthewholeswapamount,inUSDis1.0127310.84(1,000,000/
0.83)=$1,024,932
1,014,808+1,024,932=$10,126

Question#36of172

QuestionID:464165

Gammaisthegreatestwhenanoption:
A) isdeepoutofthemoney.
B) isdeepinthemoney.
C) isatthemoney.
Explanation
Gamma,thecurvatureoftheoptionprice/assetpricefunction,isgreatestwhentheassetisatthemoney.

Question#37of172

QuestionID:464118

Whichofthefollowingoptionsensitivitiesmeasuresthechangeinthepriceoftheoptionwithrespecttoadecreaseinthetimeto
expiration?

A) Theta.
B) Delta.
C) Gamma.
Explanation
Thetadescribesthechangeinoptionpriceinresponsetothepassageoftime.Sinceoptionholderswouldpreferthatvaluenotdecaytoo
quickly,anoptionwithalowthetavalueisdesirable.

Question#38of172

QuestionID:464294

5year,5%ZillonCorp.bondscurrentlytradeat$980reflectingcreditspreadof3%.A5yearCDSforZillonbondshasa

couponrateof5%.ThedurationoftheCDS=4.
Theupfrontpaymentmade/receivedbytheprotectionbuyerona$4millionnotionalCDSisclosestto:
A) $400,000receivedbytheprotectionbuyer.
B) $300,000paidbytheprotectionbuyer.
C) $320,000receivedbytheprotectionbuyer.
Explanation
Upfrontpayment=(CDSspreadCDScoupon)durationnotionalprincipal

=(0.030.05)44,000,000=$320,000

Theprotectionbuyerwillreceiveanupfrontpremiumof$320,000.

Question#39of172

QuestionID:464139

Thedeltaofanoptionisequaltothe:
A) dollarchangeintheoptionpricedividedbythedollarchangeinthestock
price.
B) dollarchangeinthestockpricedividedbythedollarchangeintheoptionprice.
C) percentagechangeinoptionpricedividedbythepercentagechangeintheasset
price.
Explanation
Thedeltaofanoptionisthedollarchangeinoptionpriceper$1changeinthepriceoftheunderlyingasset.

Question#40of172

QuestionID:464238

Whichofthefollowingisleastlikelytobeauseofaswaption?
A) Hedgingtheriskofacurrentfixedratecommitment.
B) Exitinganoffsettingswapattheexercisedate.
C) Hedgingtheriskofananticipatedfloatingrateobligation.
Explanation
Swaptionswillnotbeagoodhedgeforacurrentobligationsincetheswaptionisforaswapinthefuture.

Questions#4146of172
FrankPotter,CFA,afinancialadviserforStarFinancial,LLChasbeenhiredbyJohnWilliamson,arecentlyretiredexecutivefromReston
Industries.OvertheyearsWilliamsonhasaccumulated$10millionworthofRestonstockandanother$2millioninacashsavings
account.PotterhasanumberofunconventionalinvestmentstrategiesforWilliamson'sportfoliomanyofthestrategiesincludetheuseof
variousequityderivatives.

Potter'sfirstrecommendationinvolvestheuseofatotalreturnequityswap.PotteroutlinesthecharacteristicsoftheswapinTable1.In
additiontotheequityswap,PotterexplainstoWilliamsonthattherearenumerousoptionsavailableforhimtoobtainalmostanyrisk
returnprofilehemightneed.PottersuggestthatWilliamsonconsideroptionsonbothRestonstockandtheS&P500.Pottercollectsthe
informationneededtoevaluateoptionsforeachsecurity.TheseresultsarepresentedinTable2.
Table1:SpecificationofEquitySwap
Term

3years

Notionalprincipal

$10million

Settlementfrequency

Annual,commencingatendofyear1

Fairfaxpaystobroker

TotalreturnonRestonIndustriesstock

BrokerpaystoFairfax

TotalreturnonS&P500StockIndex

Table2:OptionCharacteristics
Reston

S&P500

Stockprice

$50.00

$1,400.00

Strikeprice

$50.00

$1,400.00

Interestrate

6.00%

6.00%

Dividendyield

0.00%

0.00%

0.5

0.5

40.00%

17.00%

BetaCoefficient

1.23

Correlation

0.4

Timetoexpiration(years)
Volatility

Table3:RegularandExoticOptions(OptionValues)
Reston

S&P500

Europeancall

$6.31

$6.31

Europeanput

$4.83

$4.83

Americancall

$6.28

$6.28

Americanput

$4.96

$4.96

Table4:RestonStockOptionSensitivities
Delta
Europeancall

0.5977

Europeanput

0.4023

Americancall

0.5973

Americanput

0.4258

Table5:S&P500OptionSensitivities
Delta
Europeancall

0.622

Europeanput

0.378

Americancall

0.621

Americanput

0.441

Potterhasalsobeenaskedtoevaluatetheinterestrateriskofanintermediatesizebank.Thebankhasalargefloatingrate
liabilityof$100,000,000onwhichitpaystheLondonInterBankOfferedRate(LIBOR)onaquarterlybasis.Potteris
concernedaboutthesignificantinterestrateriskthebankincursbecauseofthisliability:sincemostofthebank'sassetsare
investedinfixedrateinstrumentsthereisaconsiderabledurationmismatch.Someofthebank'sassetsarefloatingratenotes

tiedtoLIBOR,however,thetotalparvalueofthesesecuritiesissignificantlylessthantheliabilityposition.
Potterconsidersbothswapsandinterestrateoptions.Theinterestrateoptionsare2yearcapsandfloorswithquarterly
exercisedates.Potterwishestohedgetheentireliability.
Potterhasobtainedthepricesforanatthemoney6monthcapandfloorwithquarterlyexercise.TheseareshowninTable6.
Table6:
AttheMoney0.5yearCapandFloor
Values
PriceofatthemoneyCap

$133,377

PriceofatthemoneyFloor

$258,510

Question#41of172

QuestionID:464257

WilliamsonwouldliketoconsiderneutralizinghisRestonequitypositionfromchangesinReston'sstockprice.Usingtheinformationin
Tables3and4howmanystandardRestonEuropeanoptionswouldhavetobebought/soldinordertocreateadeltaneutralportfolio?

A) Sell497,141putoptions.
B) Sell370,300calloptions.
C) Buy497,141putoptions.
Explanation
Numberofputoptions=(RestonPortfolioValue/StockPriceReston)/DeltaPut
Numberofputoptions=($10,000,000/$50.00)/0.4023=497,141meaningbuy497,141putoptions.

(LOS53.e)

Question#42of172

QuestionID:464258

Williamsonisveryinterestedinthetotalreturnswap.HeasksPotterhowmuchitwouldcosttoenterintothistransaction.Whichofthe
followingisthemostlikelycostoftheswapatinception?

A) $45,007.
B) $340,885.
C) $0.
Explanation
Swapsarepricedsothattheirvalueatinceptioniszero.

(LOS54.e)

Question#43of172

QuestionID:464259

WilliamsonlikesthecharacteristicsoftheswaparrangementinTable1butwouldliketoconsidertheoptionsinTable3beforemakingan
investmentdecision.GivenWilliamson'scurrentsituationwhichofthefollowingoptiontradesmakesthemostsenseintheshortterm(all
optionsareonRestonstock)?

A) Buyoutofthemoneycalloptions.
B) Sellatthemoneycalloptions.

 C) Buyatthemoneyputoptions.
Explanation
BuyingatthemoneyputoptionsgreatlyreducesWilliamson'sdownsiderisk.Sellingcalloptionsyieldsanoptionpremiumtothesellerbut
doesnotdeliveranydownsideprotectionandlimitstheupsidepotentialoftheportfolio.

(LOS53.a)

Question#44of172

QuestionID:464260

Potteranalyzesalternativehedgingstrategiestoaddresstheriskofthebank'slargefloatingrateliability.Whichofthe
followingisthemostappropriatetransactiontoefficientlyhedgetheinterestrateriskforthefloatingrateliabilitywithout
sacrificingpotentialgainsfrominterestratedecreases?
A) Buyaninterestratecollar.
B) Sellaninterestratecap.
C) Buyaninterestratecap.
Explanation
Buyingacap,combinedwithafloatingrateliability,limitstheexposuretointerestrateincreases(i.e.noexposuretointerest
rateincreasesabovestrikerate).Thefloatingrateborrowerwillstillbenefitfrominterestratedecreases.
(LOS55.a)

Question#45of172

QuestionID:464261

Potternowwantstocomputethecosttoconvertthebank'sfloatingrateliabilitytoafixedrateliabilityfor6months.What
wouldbethecashflowrequiredtoimplementthishedgeusingatthemoneyinterestrateoptions?
A) $125,133.
B) $246,894.
C) +$125,133.
Explanation
Thisisthedifferencebetweenthe0.5yearcapandthe0.5yearfloor,bothwithastrikerateof5.000%.Seethevaluesshown
inTable2.
Sowehavecashflowtoconvertfloatingtofixed=$133,377+$258,510=$125,133
(LOS55.a)

Question#46of172

QuestionID:464262

Potterisnowconsideringsomeofthebank'sfloatingrateassets.Whichofthefollowingtransactionsisthemostappropriateto
minimizetheinterestrateriskoftheseassetswithoutsacrificingupsidegains?
A) Buyafloor.
B) Buyacap.

 C) Buyacollar.
Explanation
Buyingafloorcombinedwithafloatingrateassetslimitstheexposuretointerestratedecreases(i.e.noexposuretointerest
ratedecreasesbelowstrikerate)whilethefloatingrateholderisstillabletobenefitfrominterestrateincreases.Ideally,Potter
shouldconsidermatchingthebank'sassetpositionagainstthebank'sliabilityposition.
(LOS55.a)

Question#47of172

QuestionID:464249

Aswapspreadisthedifferencebetween:
A) LIBORandthefixedrateontheswap.
B) thefixedrateonaninterestrateswapandtherateonaTreasurybondofmaturity
equaltothatoftheswap.
C) thefixedrateandfloatingratepaymentratesattheinceptionoftheswap.
Explanation
AswapspreadisthedifferencebetweenthefixedrateonaninterestrateswapandaTreasurybondofmaturityequaltothat
oftheswap.

Question#48of172

QuestionID:464292

GillWestmoreisthefixedincomeportfoliomanagerforAlliedInsurance.Westmorehasboughtprotectionusinga2yearCDS
onCDXIG(125constituent)index.Thenotionalis$200million.CompanyX,anindexconstituentdefaultsandtradesat25%
ofpar.
ThepayoffontheCDSonaccountofdefaultofXandthenotionalprincipaloftheCDSafterdefaultareclosestto:
Payoff

Notional

A) $1.5million

$198million

B) $1.6million

$200million

C) $1.2million

$198.4million

Explanation
NotionalprincipalattributabletobondsofcompanyX=$200million/125=$1.6million.
PayoffontheCDS=$1.6million(0.25)($1.6million)=$1.2million.
Afterdefault,theCDScontinueswith(2001.6)$198.4millionofnotionalprincipal.

Question#49of172

QuestionID:464290

Assumethatathreeyearsemiannuallysettledcapwithastrikerateof8%andanotionalamountof$100millionisbeinganalyzed.The
referencerateissixmonthLIBOR.LIBORforthenextfoursemiannualperiodsisasfollows:
Period

LIBOR

7.5%

8.2%

8.1%

8.7%

Whatisthepayoffforthecapforperiod4?

A) $350,000.
B) $700,000.
C) $0.
Explanation
Thepayoffforeachsemiannualperiodiscomputedasfollows:
Payoff=notionalamount(sixmonthLIBORcaprate)/2soforperiod4:
=$100million(8.7%8.0%)/2=$350,000.

Question#50of172

QuestionID:464194

Attheinceptionofamarketrateplainvanillaswap,thevalueoftheswaptothefixedratepayeris:
A) positive.
B) zero.
C) eitherpositiveornegative.
Explanation
Amarketrateswapispricedsothatthevaluetoeithersideiszeroattheinceptionoftheswap.

Question#51of172

QuestionID:464215

Iftheoneyearspotrateis5%,thetwoyearspotrateis5.5%,andthethreeyearspotrateis6%,thefixedrateona3yearannualpay
swapisclosestto:
A) 1.99%.
B) 5.65%.
C) 4.50%.
Explanation

Thefixedrateontheswapis:

=0.1525/2.7008=0.0565

Question#52of172

QuestionID:464163

TwocalloptionshavethesamedeltabutoptionAhasahighergammathanoptionB.Whenthepriceoftheunderlyingassetincreases,
thenumberofoptionAcallsnecessarytohedgethepriceriskin100sharesofstock,comparedtothenumberofoptionBcalls,isa:
A) smaller(negative)number.
B) largerpositivenumber.
C) larger(negative)number.
Explanation
Forcalloptionslargergammameansthatastheassetpriceincreases,thedeltaofoptionAincreasesmorethanthedeltaofoptionB.
Sincethenumberofcallstohedgeis(1/delta)x(numberofshares),thenumberofcallsnecessaryforthehedgeisasmaller(negative)
numberforoptionAthanforoptionB.

Question#53of172

QuestionID:464282

Anissuerwhowishestoissueafloatingratenotewithacollarwouldbeequivalentlyissuingthenoteand:
A) buyingacapandafloor.
B) sellingacapandbuyingafloor.
C) buyingacapandsellingafloor.
Explanation
Issuingafloatingratenotewithacollar(acapandafloor)isequivalenttoissuingthenote,buyingacaptoputanupperlimitonthe
interestcost,andsellingafloorwhichwouldputaminimumoninterestexpenseandoffsetthecostofthecaptosomeextent.

Question#54of172
Atwoperiodinterestratetreehasthefollowingexpectedoneperiodrates:

t=0

t=1

t=2

7.12%
6.83%

6.00%

6.84%

QuestionID:464101

6.17%

6.22%
ThepriceofatwoperiodEuropeaninterestratecalloptionontheoneperiodratewithastrikerateof6.25%andaprincipalamountof
$100,000isclosestto:

A) $449.33.
B) $423.89.
C) $725.86.
Explanation
1. CalculatethepayoffsonthecallinpercentforI++andI+(=I+):
I++value=(0.07120.0625)/1.0712=0.00812173.
I+value=(0.06840.0625)/1.0684=0.00552228.
Rememberthatthepayoffonthecallvalueisthepresentvalueoftheinterestratedifferencebasedontheraterealizedatt=2
becausethepaymentisreceivedatt=3.

2. Calculatethet=1values(theprobabilitiesinaninterestratetreeare50%):
Att=1thevaluesareI+=[0.5(0.00812173)+0.5(0.00552228)]/1.0683=0.00638585.
Att=1thevaluesareI=[0.5(0)+0.5(0.00552228)]/1.0617=0.00260068.

3. Calculatethet=0value:
Att=0theoptionvalueis[0.5(0.00638585)+0.5(0.00260068)]/1.06=0.004238930.00423893100,000=$423.89.

Question#55of172

QuestionID:464273

Acaponafloatingratenote,fromthebondholder'sperspective,isequivalentto:
A) writingaseriesofinterestrateputs.
B) writingaseriesofputsonfixedincomesecurities.
C) owningaseriesofcallsonfixedincomesecurities.
Explanation
Forabondholder,acap,whichputsamaximumonfloatingrateinterestpayments,isequivalenttowritingaseriesofputsonfixed
incomesecurities.Thesewouldrequirethebuyertopaywhenratesriseandbondpricesfall,negatinginterestrateincreasesabovethe
caprate.Writingaseriesofinterestratecalls,notputs,wouldbeanequivalentstrategy.Callsonfixedincomesecuritieswouldpaywhen
ratesdecrease,notwhentheyincrease.

Questions#5661of172
GinaDavalos,CFAisaportfoliomanagerfortheHerronInvestments.Sheisinterestedinhedgingtheequityriskofoneofherclients,
LouGier.Gierhas200,000sharesofastockwiththesymbolQJXthathebelievescouldtakeadiveinthenext9months.Davalos
gathersthefollowinginformationtosuggestpotentialstrategiestooffsetthepotentialloss.

GeneralInformation:
QJXCurrentStockPrice

$100.00

Riskfreerate

5.0%

QJXDividendYield

0.0%

TimetoMaturity(years)

0.75

OptionInformation:
StrikePrice

$100.00

ValueofCall

$12.09

DeltaonCallOption

0.6081

ValueofPut(years)

$8.41

EquitySwapInformation:
Terms

9months

Settlementfrequency

Quarterly

Fixedrate
ReturnonQJX

6.0%
Variable

FuturesInformation:
Terms
CurrentFuturesPrice

9months
$105.50

Question#56of172

QuestionID:464142

ThenumberofcalloptioncontractsthatDavaloswouldneedtotradetocreateadeltaneutralhedgeisclosestto:
A) 2,000contracts.
B) 328,920contracts.
C) 3,289contracts.
Explanation
Thenumberofcalloptionsneededis200,000/0.6081=328,920optionsorapproximately3,289contractsof100shares.SinceGieris
longthestock,Davalosshouldshortthecalls.(LOS53.e)

Question#57of172

QuestionID:464143

Inordertocreateadeltaneutralhedgeusingputoptioncontracts,Davaloswouldmostaccuratelyneedto:
A) Buy5,103contracts.
B) Buy2,000contracts.
C) Sell510,271contracts.
Explanation
Thedeltaofaputoptionisthedeltaofthecorrespondingcalloptionminus1.ThedeltaofaQJXputoptionisthus0.3919.Thenumber
ofputoptionsneededis200,000/0.3909=510,271optionsorapproximately5,103contractsper100shares.Gierislongthestock,to
hedgewithputsDavalosshouldalsotakealongpositionintheputs.(LOS53.e)

Question#58of172

QuestionID:464144

Whenadeltaneutralhedgehasbeenestablishedusingcalloptions,whichofthefollowingstatementsismostaccurate?Asthepriceof
theunderlyingstock:
A) increases,someoptioncontractswouldneedtobesoldinordertoretainthedelta
neutralposition.
B) changes,nochangesareneededinthenumberofcalloptionspurchased.
C) increases,someoptioncontractswouldneedtoberepurchasedinordertoretainthedelta
neutralposition.
Explanation
Theinitialdeltahedgeisestablishedbysellingcalloptions(i.e.takingashortpositionincalls).Asthestockpriceincreases,thedeltaof
thecalloptionincreasesaswell,requiringfewer(short)optioncontractstohedgeagainsttheunderlyingstockpricemovements.
Therefore,someoptionscontractsmustberepurchasedinordertomaintainthehedge.(Purchasingoptioncontractswilldecreasethe
numberofcalloptionsthatweareshort.)(LOS53.e)

Question#59of172

QuestionID:464145

AnequityswaptohedgetheequityriskforGierwouldresultinreceiptofa:
A) fixedrateof4.5%fortheyear.
B) variableratebasedonthetotalreturnofQJXstock.
C) fixedrateof1.5%perquarter.
Explanation
Tooffsettheequityrisk,GierwouldpayavariableratebasedonthetotalreturnofQJXandreceiveafixedrate.Thequotedrateisan
annualizedrateandsincetheswapisforthreequartersorninemonths,thefull6.0%willnotberealized.The6.0%annualizedrateis
equivalentto1.5%perquarter.(LOS54.e)

Question#60of172

QuestionID:464146

Iftheequityswapisimplementedandafter3monthsthestockpricehasincreasedto$106.00,thenetcashflowfortheswapis:
A) againof$900,000.
B) zero.
C) alossof$900,000.
Explanation
TheequityswaprequiresGiertopayavariablerateoftotalreturnonQJXandreceiveafixedrate.Ifthestockappreciates,theswap
resultsinapositivecashflowof6.0%/4$20,000,000=$300,000andanegativecashflowof$20,000,000($106/$1001)=
$1,200,000,summingtoanetofoutflowof$900,000.Theswapplustheequitypositionresultinanoverallgain,asthegainonthestock
morethanoffsetsthelossontheequityswap.(LOS54.e)

Question#61of172
Basedonthefuturesinformation,anarbitrageopportunitycanbeexploitedby:
A) SellingthestockQJXandbuyingthefutures.

QuestionID:464147

 B) BuyingthefuturesandbuyingthestockQJX.
C) BuyingthestockQJX,andsellingthefutures.
Explanation
Thecalculatedfairvalueofthefuturescontractis$100(1+0.05)0.75=$103.73.Theassetisrelativelyunderpricedandthefutures
contractisoverpriced.Bybuyingthestockandsellingthefutureswecanlockinaprofitgreaterthantheriskfreeratewithnorisk.(LOS
51.b)

Question#62of172

QuestionID:464193

Regardingdeepinthemoneyoptionsonfutures,itis:
A) sometimesworthwhiletoexercisecallsearlybutnotputs.
B) sometimesworthwhiletoexercisebothcallsandputsearly.
C) neverworthwhiletoexerciseputsorcallsearly.
Explanation
Ifputsorcallsonfuturesaresignificantlyinthemoneyitmaybeworthwhiletoexercisethemearlytogeneratethecashfromthe
immediatemarktomarketofthefuturescontractwhentheoptionisexercised.

Question#63of172

QuestionID:464231

Whichofthefollowingstatementsregardingswaptionsisleastaccurate?Aswaptionisoftenusedto:
A) providetherighttoterminateaswap.
B) hedgetherateonananticipatedswaptransaction.
C) createasyntheticbondposition.
Explanation
Aswaptionislikeanoptiononabondwithpaymentsequaltothefixedpaymentsontheswap.Theothersarecommonusesofswaps.

Questions#6469of172
JacobBowerisabondstrategistwhowouldliketobeginusingfixedincomederivativesinhisstrategies.Bowerhasafirmunderstanding
ofthepropertiesfixedincomesecurities.However,hisunderstandingofinterestratederivativesisnotnearlyasstrong.Hedecidesto
trainhimselfonthevaluationandsensitivityofinterestratederivativesusingvariousinterestratescenarios.Heconsiderstheforward
LondonInterbankOfferedRate(LIBOR)interestrateenvironmentshowninTable1.Usingaroundeddaycount(i.e.,0.25yearsforeach
quarter)hehasalsocomputedthecorrespondingimpliedspotratesresultingfromtheseLIBORforwardrates.TheseareincludedinTable
1.

Table1
90DayLIBORForwardRatesandImpliedSpotRates

Period(inmonths) LIBORForwardRates ImpliedSpotRates

03

5.500%

5.5000%

36

5.750%

5.6250%

69

6.000%

5.7499%

912

6.250%

5.8749%

1215

7.000%

6.0997%

1518

7.000%

6.2496%

BowerhasalsoestimatedtheLIBORforwardratevolatilitiestobe20%.TheparticularfixedinstrumentsthatBowerwouldliketoexamine
areshowninTable2.HealsowantstoanalyzethestrategyshowninTable3.

Table2
InterestRateInstruments
DollarAmountofFloatingRateBond $42,000,000
FloatingRateBondpayingLIBOR+

0.25%

TimetoMaturity(years)

CapStrikeRate

7.00%

FloorStrikeRate

6.00%

InterestPayments

quarterly

Table3
InitialPositionin90dayLIBOREurodollarContracts
ContractMonth(fromnow) StrategyA(contracts) StrategyB(contracts)
3months

300

100

6months

100

9months

100

Question#64of172

QuestionID:464276

Bowerisabitpuzzledabouthowtousecapsandfloors.Hewondershowhecouldbenefitbothfromincreasinganddecreasinginterest
rates.Whichofthefollowingtradeswouldmostlikelyprofitfromthisinterestratescenario?
A) Sellatthemoneycapandatthemoneyfloor.
B) Buyatthemoneycapandsellatthemoneyfloor.
C) Buyatthemoneycapandatthemoneyfloor.
Explanation
Thisisastraddleoninterestrates.Thecapprovidesapositivepayoffwheninterestratesriseandthefloorprovidesapositivepayoff
wheninterestratesfall.(StudySession17,LOS55.a)

Question#65of172

QuestionID:464277

BowershortsthefloatingratebondgiveninTable2.WhichofthefollowingwillbestreduceBower'sinterestraterisk?

A) Buyinganinterestratefloor.
B) ShortingEurodollarfutures.
C) Shortinganinterestratefloor.
Explanation
IfheaddsashortpositioninEurodollarfuturestotheexistingliabilityinthecorrectamount,heisabletolockinaspecificinterestrate.A
shortEurodollarpositionwillincreaseinvalueifinterestratesrisebecausethecontractisquotedasadiscountinstrumentsoincreases
inratesreducethefuturesprice.(StudySession16,LOS52.g)

Question#66of172

QuestionID:464278

Bowerhasstudiedswapsextensively.However,heisnotsurewhichofthefollowingistheswapfixedrateforaoneyearinterestrate
swapbasedon90dayLIBORwithquarterlypayments.UsingtheinformationinTable1andtheformulabelow,whatisthemost
appropriateswapfixedrateforthisswap?

A) 6.01%.
B) 5.65%.
C) 5.75%.
Explanation
Theswapfixedrateiscomputedasfollows:
1
Z90day=

1+(0.05590/360)

= 0.98644
1
Z180day=

1+(0.05625180/360)

= 0.97264
1
Z270day=

1+(0.057499270/360)

= 0.95866
1
Z360day=

1+(0.058749360/360)

= 0.94451
10.94451
Thequarterlyfixedrateontheswap=

0.98644+0.97264+0.95866+0.94451

=0.05549/3.86225=0.01437=1.437%
Thefixedrateontheswapinannualtermsis:

1.437%360/90=5.75%
(StudySession17,LOS54.c)

Question#67of172

QuestionID:464279

BowerwouldliketoperformsomesensitivityanalysisonaoneyearcollartochangesinLIBOR.Specifically,hewondershowthepriceof
acollar(buyingacapandsellingafloor)isaffectedbyanincreaseintheLIBORforwardratevolatility.UsingtheinformationinTables1
and2whichofthefollowingismostaccurate?Thepriceofthecollarwill:
A) decrease.
B) increase.
C) staythesame.
Explanation
Thepriceofthefloorwillincreasemorethanthepriceofthecapsincethefloorisclosertobeingatthemoneythanthecap.Therefore,
thefloorpriceismoresensitivetovolatilitychangesintheLIBORforwardrate.Sincethepriceofthecollarisequaltothepriceofthecap
minusthepriceofthefloor,theneteffectisapricedecreaseforthecollar.(StudySession17,LOS55.a)

Question#68of172

QuestionID:464280

Bowercomputestheimpliedvolatilityofaoneyearcapletonthe90dayLIBORforwardratestobe18.5%.Usingthegiveninformation
whatdoesthismeanforthecaplet'smarketpricerelativetoitstheoreticalprice?Thecaplet'smarketpriceis:
A) overvalued.
B) undervaluedorovervalued.
C) undervalued.
Explanation
Volatilityandoptionpricesarealwayspositivelyrelated.Therefore,sincetheoptionimpliedvolatilityislowerthantheestimatedvolatility,
thisimpliesthatthecapletisundervaluedrelativetoitstheoreticalvalue.(StudySession17,LOS55.a)

Question#69of172

QuestionID:464281

Forthisquestiononly,assumeBowerexpectsthecurrentlypositivelyslopedLIBORcurvetoshiftupwardinaparallelmanner.Usinga
plainvanillainterestrateswap,whichofthefollowingwillallowBowertobesttakeadvantageofhisexpectations?Purchasea:
A) floatingratebondandenterintoareceivefixedswap.
B) receivefixedinterestrateswap.

 C) payfixedinterestrateswap.
Explanation
Sincetheinterestratesareexpectedtoriseforallmaturities,onecanbenefitfromthisrisebyreceivingafloatingrate(LIBOR)and
borrowingatafixedrate(i.e.apayfixedswap).(StudySession16,LOS54.c)

Question#70of172

QuestionID:464226

Considerafixedforfixed1year$100,000semiannualcurrencyswapwithratesof5.2%inUSDand4.8%inCHF,originatedwhenthe
exchangerateis$0.34.90dayslater,theexchangerateis$0.35andthetermstructureis:
90days

270days

LIBOR

5.2%

5.6%

Swiss

4.8%

5.4%

WhatisthevalueoftheswaptotheUSDpayer?
A) $2,719.
B) $2,814.
C) $2,719.
Explanation

ThepresentvalueofthefixedpaymentsononeCHFis

0.02372+0.98414=1.00786.
Atthecurrentexchangeratethevalueis1.007860.35=USD0.35275.
Thenotionalamountis100,000/0.34=294,118CHFsothedollarvalueoftheCHFpaymentsis0.35275294,118=$103,750.

ThepresentvalueoftheUSDpaymentsis

0.02567+0.98464=1.01031
1.01031100,000=$101,031.
Thevalueoftheswaptothedollarpayeris103,750101,031=$2,719.

Question#71of172

QuestionID:464228

Considerafixedratesemiannualpayequityswapwheretheequitypaymentsarethetotalreturnona$1millionportfolioandthefollowing
information:

180dayLIBORis5.2%
360dayLIBORis5.5%
Dividendyieldontheportfolio=1.2%
Whatisthefixedrateontheswap?

A) 5.4197%.
B) 5.1387%.
C) 5.4234%.
Explanation

Question#72of172

QuestionID:464179

Whichofthefollowingstatementsconcerningvegaismostaccurate?Vegaisgreatestwhenanoptionis:
A) atthemoney.
B) faroutofthemoney.
C) farinthemoney.
Explanation
Whentheoptionisatthemoney,changesinvolatilitywillhavethegreatestaffectontheoptionvalue.

Question#73of172

QuestionID:464114

WhichofthefollowingisNOToneoftheassumptionsoftheBlackScholesMerton(BSM)optionpricingmodel?
A) Anydividendsarepaidatacontinuouslycompoundedrate.
B) Therearenotaxes.
C) OptionsvaluedareEuropeanstyle.
Explanation
TheBSMmodelassumestherearenocashflowsontheunderlyingasset.

Question#74of172

QuestionID:464274

Whichofthefollowingbestdescribesaninterestratecap?Aninterestratecapisapackageorportfolioofinterestrateoptionsthat
provideapositivepayofftothebuyerifthe:

 A) TBondfuturesexceedsthestrikeprice.
B) referencerateisbelowthestrikerate.
C) referencerateexceedsthestrikerate.
Explanation
AninterestratecapisapackageofEuropeantypecalloptions(calledcaplets)onareferenceinterestrate.

Question#75of172

QuestionID:464240

Thepayoffonareceiverswaptionismostlikethatofa:
A) putoptiononadiscountbond.
B) calloptiononacouponbond.
C) putoptiononacouponbond.
Explanation
Thepayoffonareceiverswaptionislikethatofacalloptiononabondissuedattheexercisedateoftheswaption,withacouponequal
tothefixedrateoftheswap,andatermequaltothatoftheswap.

Question#76of172

QuestionID:464247

Comparedtoanequityswap,acurrencyswaphascreditriskthatis:
A) approximatelythesameduringthelifeoftheswap.
B) greater,laterintheswap.
C) greater,earlierintheswap.
Explanation
Acurrencyswaphasafinalexchangeofprincipal,movingthemaximumcreditrisklaterinthelifeoftheswap.

Question#77of172
Whichofthefollowingbestrepresentsaninterestfloor?
A) Aportfolioofputoptionsonaninterestrate.
B) Aputoptiononaninterestrate.
C) Aportfolioofcalloptionsonaninterestrate.
Explanation
Alongfloor(floorbuyer)hasthesamegeneralexpirationdatepayoffdiagramasthatforlonginterestrateputposition.

QuestionID:464291

Question#78of172

QuestionID:464186

Attime=0,foraputoptionatexerciseprice(X)onanewlyissuedforwardcontactatFT(theforwardpriceattime=0),aportfoliowith
equalvaluecouldbeconstructedfrombeinglongin:
A) theunderlyingasset,longaputatX,andshortinapurediscountriskfreebondthat
paysXFTatoptionexpiration.
B) acallatXandlonginapurediscountriskfreebondthatpaysXFTatoptionexpiration.
C) ariskfreepurediscountbondthatpaysFTXatoptionexpirationandlonginaputatX.
Explanation
Utilizingthebasicput/callparityequation,we'relookingforaportfoliothatisequaltotheportfoliomentionedinthestem(aputoption).
Theputcallparityequationisc 0+(XFT)/(1+R)T=p0.Since(XFT)/(1+R)isactuallyjustthepresentvalueofthebondatexpiration,
therelationshipcanbesimplifiedtolongcall+longbond=put.

Question#79of172

QuestionID:464096

Referringtoputcallparity,whichoneofthefollowingalternativeswouldallowyoutocreateasyntheticrisklesspurediscountbond?
A) SellaEuropeanputoptionsellthesamestockbuyaEuropeancalloption.
B) BuyaEuropeanputoptionbuythesamestocksellaEuropeancalloption.
C) BuyaEuropeanputoptionsellthesamestocksellaEuropeancalloption.
Explanation
Accordingtoputcallparitywecanwritearisklesspurediscountbondpositionas:
X/(1+Rf)T=P0+S0C0.
Wecanthenreadofftherighthandsideoftheequationtocreateasyntheticpositionintherisklesspurediscountbond.Wewouldneed
tobuytheEuropeanput,buythesameunderlyingstock,andselltheEuropeancall.

Question#80of172

QuestionID:464233

Apayerswaptiongivesitsholder:
A) therighttoenteraswapinthefutureasthefloatingratepayer.
B) therighttoenteraswapinthefutureasthefixedratepayer.
C) anobligationtoenteraswapinthefutureasthefixedratepayer.
Explanation
Apayerswaptiongiveitsholdertherighttoenteraswapinthefutureasthefixedratepayer.

Question#81of172

QuestionID:464217

A$10million1yearsemiannualpayLIBORbasedinterestrateswapwasinitiated90daysagowhenLIBORwas4.8%.Thefixedrateon
theswapis5%,current90dayLIBORis5%and270dayLIBORis5.4%.Thevalueoftheswaptothefixedratepayerisclosestto:
A) $19,229.
B) $15,633.
C) $12,465.
Explanation
Thefixedratepaymentsare0.05(180/360)10,000,000=250,000.Thepresentvalueoftheremainingpaymentsare250,000/(1+
0.05(90/360))+10,250,000/(1+0.054(270/360))=$10,097,947.
Thefloatingpaymentin90daysis0.048(180/360)=240,000andthepresentvalueis240,000/(1+0.05/4)=$237,037.Thesecond
floatingratepaymentcombinedwith1attheendoftheswaphasapresentvalueof1onthefirstpaymentdate.Thepresentvalueof1is
1/(1+0.05(90/360))=0.987654321sothepresentvalueofthesecondfloatingratepaymentcombinedwiththeprincipalamountis
$9,876,543.Thetotalvalueis9,876,543+237,037=$10,113,580.
Thevalueoftheswaptothefixedratepayeris10,113,58010,097,947=$15,633.

Question#82of172

QuestionID:464242

TheLIBORyieldcurveis:
180days 5.2%
360days 5.4%

Whatisthevalueofa1yearsemiannualpayLIBORbasedreceiverswaption(expiringtoday)ona$10million1year4.8%swap?

A) $50,712.
B) $0.
C) $50,712.
Explanation
First,findthediscountfactors.1/(1+(0.052(180/360)))=0.97465887and1/(1+(0.054(360/360)))=0.94876660Calculatethemarket
fixedratepayments:(10.94876660)/(0.97465887+0.94876660)=0.026637andcomparetotheexerciseratepayments0.024.The
valueofthereceiverswaptioniszerosincetheexerciserateisbelowthemarketrate.

Question#83of172

QuestionID:464236

MarkRobertsanticipatesutilizingafloatingratelineofcreditin90daystopurchase$10millionofrawmaterials.Togetprotection
againstanyincreaseintheexpectedLondonInterbankOfferedRate(LIBOR)yieldcurve,Robertsshould:
A) buyapayerswaption.
B) buyareceiverswaption.
C) writeareceiverswaption.

Explanation
ApayerswaptionwillgiveRobertstherighttopayafixedratebelowmarketifratesrise.

Question#84of172

QuestionID:464167

Thevalueofaputoptionwillbehigherif,allelseequal,the:
A) exercisepriceislower.
B) underlyingassethaslessvolatility.
C) underlyingassethaspositivecashflows.
Explanation
Positivecashflowsintheformofdividendswilllowerthepriceofthestockmakingitclosertobeing"inthemoney"whichincreasesthe
valueoftheoptionasthestockpricegetsclosertothestrikeprice.

Question#85of172

QuestionID:464098

Referringtoputcallparity,whichoneofthefollowingalternativeswouldallowyoutocreateasyntheticstockposition?
A) BuyaEuropeancalloptionbuyaEuropeanputoptioninvestthepresentvalueofthe
exercisepriceinarisklesspurediscountbond.
B) SellaEuropeancalloptionbuyaEuropeanputoptionshortthepresentvalueoftheexercise
priceworthofarisklesspurediscountbond.
C) BuyaEuropeancalloptionshortaEuropeanputoptioninvestthepresentvalueofthe
exercisepriceinarisklesspurediscountbond.
Explanation
Accordingtoputcallparitywecanwriteastockpositionas:S0=C0P0+X/(1+Rf)T
Wecanthenreadofftherighthandsideoftheequationtocreateasyntheticpositioninthestock.WewouldneedtobuytheEuropean
call,selltheEuropeanput,andinvestthepresentvalueoftheexercisepriceinarisklesspurediscountbond.

Question#86of172

QuestionID:464195

Thepriceandvalueofaplainvanillainterestrateswapare:
A) equalinequilibrium.
B) neverequal.
C) onlyequalattheinceptionofaswapcontract.
Explanation
Thepriceofaswapisthefixedratespecifiedintheswapandisthesameforthepayerandthereceiver.Thevalueisthedollarvalueof
thecontracttothefixedratepayerandistheoppositeofthevaluetothefloatingratepayer.

Question#87of172

QuestionID:464189

Putcallparityforoptionsonforwardcontractsattheinitiationoftheoptionwheretheforwardpriceatthattime(time=0)isFT,canbest
beexpressedas:
A) c0(XFT)/(1+R)T=p0.
B) c 0+(XFT)/(1+R)T=p0.
C) c 0+X/(1+R)TFT=p0.
Explanation
Putcallparityforstocks(withdiscretetimediscounting)isc 0+X/(1+R)TS0=p0.Notingthatfortheforwardcontractonanasset
withnounderlyingcashflows,S0=FT/(1+R)T,andsubstituting,wegetc 0+(XFT)/(1+R)T=p0.

Question#88of172

QuestionID:464203

Whichofthefollowingisequivalenttoapayfixedswapwithatenoroftwoyearswithsemiannualswappaymentsandafixedrateof6%
(exchangedforLIBOR)?Thenotionalprincipalis$100,000,000.
A) Astripofthreeforwardrateagreements,whichobligatesthepartytopayafixedrateof
6%andreceivesixmonthLIBORonanotionalprincipalof$100,000,000.
B) Aforwardrateagreement,whichobligatesthepartytopayafixedrateof6%andreceivesix
monthLIBORonanotionalprincipalof$100,000,000.
C) Astripoftwoforwardrateagreements,whichobligatesthepartytopayafixedrateof6%and
receivesixmonthLIBORonanotionalprincipalof$100,000,000.
Explanation
Inaninterestrateswap,thefirstpaymentisknownwithcertaintyandwillbemadeatmonth6.Thedeterminationdatesforthefloating
ratewillbeatmonths6,12,and18andthecorrespondingpaymentdateswillbeatmonths12,18,and24.Thesecorrespondtothethree
forwardrateagreements.

Question#89of172

QuestionID:464178

Whichofthefollowingbestexplainsthesensitivityofacalloption'svaluetovolatility?Calloptionvalues:
A) increaseasthevolatilityoftheunderlyingassetincreasesbecausecalloptionshave
limitedriskbutunlimitedupsidepotential.
B) arenotaffectedbychangesinthevolatilityoftheunderlyingasset.
C) increaseasthevolatilityoftheunderlyingassetincreasesbecauseinvestorsarerisk
seekers.
Explanation
Ahighervolatilitymakesitmorelikelythatoptionsendupinthemoneyandcanbeexercisedprofitably,whilethedownsideriskis
strictlylimitedtotheoptionpremium.

Question#90of172

QuestionID:464169

Dividendsonastockcanbeincorporatedintothevaluationmodelofanoptiononthestockby:
A) subtractingthepresentvalueofthedividendfromthecurrentstockprice.
B) subtractingthefuturevalueofthedividendfromthecurrentstockprice.
C) addingthepresentvalueofthedividendtothecurrentstockprice.
Explanation
Theoptionpricingformulascanbeadjustedfordividendsbysubtractingthepresentvalueoftheexpecteddividend(s)fromthecurrent
assetprice.

Question#91of172

QuestionID:464183

IfweusefouroftheinputsintotheBlackScholesMertonoptionpricingmodelandsolvefortheassetpricevolatilitythatwillmakethe
modelpriceequaltothemarketpriceoftheoption,wehavefoundthe:
A) historicalvolatility.
B) optionvolatility.
C) impliedvolatility.
Explanation
Thequestiondescribestheprocessforfindingtheexpectedvolatilityimpliedbythemarketpriceoftheoption.

Question#92of172

QuestionID:464116

ThevalueofaputoptionispositivelyrelatedtoallofthefollowingEXCEPT:
A) timetomaturity.
B) riskfreerate.
C) exerciseprice.
Explanation
Thevalueofaputoptionisnegativelyrelatedtoincreasesintheriskfreerate.

Question#93of172

QuestionID:464140

ThepriceofaJunecalloptionwithanexercisepriceof$50fallsby$0.50whentheunderlyingstockpricefallsby$2.00.Thedeltaofa
Juneputoptionwithanexercisepriceof$50isclosestto:
A) 0.25.
B) 0.25.

 C) 0.75.
Explanation
Thecalloptiondeltais:

Theputoptiondeltais0.251=0.75.

Question#94of172

QuestionID:464177

Whichofthefollowingisleastlikelyacommonformofexternalcreditenhancement?
A) Acorporateguarantee.
B) Bondinsurance.
C) Portfolioinsurance.
Explanation
Externalcreditenhancementsarefinancialguaranteesfromthirdpartiesthatgenerallysupporttheperformanceofthebond.Portfolio
insuranceisnotathirdpartyguarantee.

Question#95of172

QuestionID:464224

AU.S.firm(U.S.)andaforeignfirm(F)engageinafixedforfloatingcurrencyswap.Thefixedrateatinitiationandattheendoftheswap
was5%.Thevariablerateattheendofyear1was4%,attheendofyear2was6%,andattheendofyear3was7%.Atthebeginning
oftheswap,$2millionwasexchangedatanexchangerateof2foreignunitsper$1.Attheendoftheswapperiodtheexchangeratewas
1.75foreignunitsper$1.
Attheterminationoftheswap,onaccountofexchangeofprincipal,firmFgivesfirmU.S.:

A) $1,750,000.
B) $2million.
C) 4millionforeignunits.
Explanation
Attermination,thenotionalprincipalwillbeexchanged.FirmFgivesbackwhatitborrowed,$2million,andtheterminalexchangerateis
notused.

Question#96of172

QuestionID:464222

Consideraoneyearcurrencyswapwithsemiannualpayments.ThepaymentsareinU.S.dollarsandeuros.Thecurrentexchangerateof
theeurois$1.30andinterestratesare

180

360

days
USD

days

5.6%

6.0%

Euribor 4.8%

5.4%

LIBOR

Whatisthefixedrateineuros?
A) 5.318%.
B) 2.659%.
C) 5.245%.
Explanation
Thepresentvaluesof1euroreceivedin180daysand1euroreceivedin360daysare:
1/(1+0.048(180/360))=0.9766and1/1.054=0.9488
Thefixedrateineurosis(10.9488)/(0.9766+0.9488)=0.026592(360/180)=5.318%.Thenotionalprincipalis100,000/1.30=
76,923euros.

Question#97of172

QuestionID:464204

Thefixedratereceiverinaplainvanillainterestrateswaphasapositionequivalenttoaseriesof:
A) longinterestrateputs.
B) shortinterestputsandlonginterestratecalls.
C) longinterestrateputsandshortinterestratecalls.
Explanation
Thefixedratereceiverhasprofitswhenshortratesfallandlosseswhenshortratesrise,equivalenttobuyingputsandwritingcalls.

Question#98of172

QuestionID:464243

CalSmartwrotea90dayreceiverswaptionona1yearLIBORbasedsemiannualpay$10millionswapwithanexerciserateof3.8%.At
expiration,themarketrateandLIBORyieldcurveare:

Fixedrate3.763%
180days3.6%
360days3.8%
Thepayofftothewriterofthereceiverswaptionatexpirationisclosestto:
A) $3,600.
B) $0.
C) $3,600.

Explanation
Atexpiration,thefixedrateis3.763%whichisbelowtheexerciserateof3.8%.Thepurchaserofthereceiverswaptionwillexercisethe
optionwhichallowsthemtoreceiveafixedrateof3.8%fromthewriteroftheoptionandpaythecurrentrateof3.763%.
Theequivalentoftwopaymentsof(0.0380.03763)(180/360)(10,000,000)willbemadetothereceiverswaption.Onepayment
wouldhavebeenreceivedin6monthsandwillbediscountedbacktothepresentatthe6monthrate.Onepaymentwouldhavebeen
receivedin12monthsandwillbediscountedbacktothepresentatthe12monthrate
Thefirstpayment,discountedtothepresentis(0.0380.03763)(180/360)(10,000,000)(1/1.018)=$1,817.28.
Thesecondpayment,discountedtothepresentis(0.0380.03763)(180/360)(10,000,000)(1/1.038)=$1,782.27
Thetotalpayoffforthewriteris$3,599.55.

Question#99of172

QuestionID:464296

Inanticipationofanannouncementofleveragedbuyoutofapubliclytradedcompany,whichofthefollowingactionswouldbemost
appropriate?
A) BuythestockofthecompanyandbuyCDSprotectiononcompany'sdebt.
B) Buyboththestockandthebondsofthecompany.
C) Sellprotectionofthecompany'sbondandbuyputoptionsonthecompany'sstock.
Explanation
Inthecaseofaleveragedbuyout(LBO),thefirmwillissueagreatamountofdebtinordertorepurchaseallofthecompany'spublicly
tradedequity.ThisadditionaldebtwillincreasetheCDSspreadbecausedefaultisnowmorelikely.AninvestorwhoanticipatesanLBO
mightpurchaseboththestockandCDSprotection,bothofwhichwillincreaseinvaluewhentheLBOhappens.

Question#100of172

QuestionID:464246

Whichofthefollowingstatementsrelatedtocreditriskduringthelifeofaswapismostaccurate:
A) Creditriskisgreatestattheendoftheswaptermbecausecreditworthinessofthe
counterpartyislikelytohavedeterioratedsinceswapinitiation.
B) Creditriskisgreatestatthebeginningoftheswaptermbecausetherearesignificant
paymentsyettobemadeovertheremainingtermoftheswap.
C) Creditriskisgreatestinthemiddleoftheswaptermwhenboththecreditworthinessofthe
counterpartymayhavedeterioratedsinceswapinitiationandtherearesignificantpayments
yettobemadeovertheremainingtermoftheswap.
Explanation
Creditriskisgreatestinthemiddleoftheswaptermwhenboththecreditworthinessofthecounterpartymayhavedeterioratedsince
swapinitiationandtherearesignificantpaymentsyettobemadeovertheremainingtermoftheswap.

Question#101of172

QuestionID:464190

Regardingdeepinthemoneyoptionsonforwards,itis:
A) sometimesworthwhiletoexercisecallsearlybutnotputs.
B) sometimesworthwhiletoexercisebothcallsandputsearly.
C) neverworthwhiletoexerciseputsorcallsearly.
Explanation
Unlikefutures,forwardsdonotgenerateanycashatexerciseevenwhentheyaredeepinthemoneysothereisnoadvantagetoearly
exercise.

Question#102of172

QuestionID:464188

Whichofthefollowingwouldhavethesamevalueatt=0asanatthemoneycalloptiononaforwardcontractpricedatFT(theforward
priceattime=0)?
A) Aputoptionontheforwardatexerciseprice(X).
B) Aputoption,longtheunderlyingasset,andshortariskfreebondthatmaturesatXatoption
expiration.
C) Aputoption,longtheunderlyingasset,andshortariskfreebondthatpaysXFTatoption
expiration.
Explanation
Putcallparityforoptionsonforwardcontractsisc 0+(XFT)/(1+R)T=p0.SinceX=FTforanatthemoneyoption,theputandthecall
havethesamevalueforanatthemoneyoption.

Questions#103108of172
JohnFairfaxisarecentlyretiredexecutivefromRestonIndustries.Overtheyearshehasaccumulated$10millionworthofRestonstock
andanother$2millioninacashsavingsaccount.HehiresRichardPotter,CFA,afinancialadviserfromStanMorgan,LLC,tohelphim
developinvestmentstrategies.PottersuggestsanumberofinterestinginvestmentstrategiesforFairfax'sportfolio.Manyofthestrategies
includetheuseofvariousequityderivatives.Potter'sfirstrecommendationincludestheuseofatotalreturnequityswap.Potteroutlines
thecharacteristicsoftheswapinTable1.Inadditiontotheequityswap,PotterexplainstoFairfaxthattherearenumerousoptions
availableforhimtoobtainalmostanyriskreturnprofilehemightneed.PottersuggeststhatFairfaxconsideroptionsonbothReston
stockandtheS&P500.Pottercollectstheinformationneededtoevaluateoptionsforeachsecurity.TheseresultsarepresentedinTable
2.
Table1:SpecificationofEquitySwap
Term

3years

Notionalprincipal

$10million

Settlementfrequency

Annual,commencingatendofyear1

Fairfaxpaystobroker

TotalreturnonRestonIndustriesstock

BrokerpaystoFairfax

TotalreturnonS&P500StockIndex

Table2:OptionCharacteristics
Reston

S&P500

Stockprice

$50.00

$1,400.00

Strikeprice

$50.00

$1,400.00

Interestrate

6.00%

6.00%

Dividendyield

0.00%

0.00%

0.5

0.5

40.00%

17.00%

BetaCoefficient

1.23

Correlation

0.4

Timetoexpiration(years)
Volatility

PotterpresentsFairfaxwiththepricesofvariousoptionsasshowninTable3.Table3detailsstandardEuropeancallsandputoptions.
PotterpresentstheoptionsensitivitiesinTables4and5.
Table3:RegularandOptions(OptionValues)
Reston

S&P500

Europeancall

$6.31

$6.31

Europeanput

$4.83

$4.83

Americancall

$6.28

$6.28

Americanput

$4.96

$4.96

Table4:RestonStockOptionSensitivities
Delta
Europeancall

0.5977

Europeanput

0.4023

Americancall

0.5973

Americanput

0.4258

Table5:S&P500OptionSensitivities
Delta
Europeancall

0.622

Europeanput

0.378

Americancall

0.621

Americanput

0.441

Question#103of172

QuestionID:464123

GiventheinformationregardingthevariousRestonstockoptions,whichoptionwillincreasethemostrelativetoanincreaseinthe
underlyingRestonstockprice?
A) Americancall.
B) Europeancall.

 C) Americanput.
Explanation
UsingitsdeltainTable4,iftheRestonstockincreasesbyadollartheEuropeancallonthestockwillincreaseby0.5977.(StudySession
17,LOS53.a)

Question#104of172

QuestionID:464124

FairfaxisveryinterestedinthetotalreturnswapandasksPotterhowmuchitwouldcosttoenterintothistransaction.Whichofthe
followingisthecostoftheswapatinception?
A) $45,007.
B) $340,885.
C) $0.
Explanation
Swapsarealwayspricedsothattheirvalueatinceptioniszero.(StudySession17,LOS54.a)

Question#105of172

QuestionID:464126

FairfaxwouldliketoconsiderneutralizinghisRestonequitypositionfromchangesinthestockpriceofReston.Usingtheinformationin
Table4howmanystandardRestonEuropeanoptionswouldhavetobeeitherboughtorsoldinordertocreateadeltaneutralportfolio?
A) Sell334,616putoptions.
B) Buy300,703putoptions.
C) Sell334,616calloptions.
Explanation
Numberofcalloptions=(RestonPortfolioValue/StockPriceReston)(1/Deltacall).
Numberofcalloptions=($10,000,000/$50.00/sh)(1/0.5977)=334,616.(StudySession17,LOS53.e)

Question#106of172

QuestionID:464127

FairfaxremembersPotterexplainingsomethingabouthowoptionsarenotlikefuturesandswapsbecausetheirriskreturnprofilesare
nonlinear.WhichofthefollowingoptionsensitivitymeasuresdoesFairfaxneedtoconsidertocompletelyhedgehisequitypositionin
RestonfromchangesinthepriceofRestonstock?
A) DeltaandVega.
B) DeltaandGamma.
C) GammaandTheta.
Explanation
Vegameasuresthesensitivityrelativetochangesinvolatility.Thetameasuressensitivityrelativetochangesintimetoexpiration.(Study
Session17,LOS53.d)

Question#107of172

QuestionID:464128

Fairfaxhasheardpeopletalkingabout"makingaportfoliodeltaneutral."Whatdoesitmeantomakeaportfoliodeltaneutral?The
portfolio:
A) isinsensitivetovolatilitychangesinthereturnsontheunderlyingequity.
B) isinsensitivetointerestratechanges.
C) isinsensitivetostockpricechanges.
Explanation
Thedeltaoftheoptionportfolioisthechangeinvalueoftheportfolioifthestockpricechanges.Adeltaneutraloptionportfoliohasa
deltaofzero.(StudySession17,LOS53.e)

Question#108of172

QuestionID:464129

AfterdiscussingthevariousequityswapoptionswithFairfax,PottercheckshisemailandreadsamessagefromClarkAli,aclientof
PotterandthetreasurerofafirmthatissuedfloatingratedebtdenominatedineurosatLondonInterbankOfferedRate(LIBOR)+125
basispoints.NowAliisconcernedthatLIBORwillriseinthefutureandwantstoconvertthisintosyntheticfixedratedebt.Potter
recommendsthatAli:
A) enterintoareceivefixedswap.
B) enterintoapayfixedswap.
C) takeashortpositioninEurodollarfutures.
Explanation
Thefloatingratedebtwillbeeffectivelyconvertedintofixedratedebtifheenteredintoapayfixedswap.AshortpositioninEurodollar
futureswouldcreateahedge,butinthewrongcurrency.(StudySession17,LOS54.d,e)

Question#109of172

QuestionID:464237

WandaBrunner,CFA,iscontemplatingaddingaswaptiontoherportfolio.Whichofthefollowingisleastlikelyhergoal?
A) interestratespeculation.
B) lockinafixedrate.
C) provideshorttermliquidity.
Explanation
Thethreeprimaryusesofswaptionsaretolockinafixedrate,interestratespeculation,andswaptermination.

Questions#110115of172
AlBingly,CFA,isaderivativesspecialistwhoattemptstoidentifyandmakeshorttermgainsfromtradingmispricedoptions.Oneofthe
strategiesthatBinglyusesistolookforarbitrageopportunitiesinthemarketforEuropeanoptions.Thisstrategyinvolvescreatinga
syntheticcallfromotherinstrumentsatacostlessthanthemarketvalueofthecallitself,andthensellingthecall.Duringthecourseof
hisresearch,heobservesthatHillandCorporation'sstockiscurrentlypricedat$56,whileaEuropeanstyleputoptionwithastrikeprice
of$55istradingat$0.40andaEuropeanstylecalloptionwiththesamestrikepriceistradingat$2.50.Bothoptionshave6months
remaininguntilexpiration.Theriskfreerateiscurrently4percent.

Binglyoftenusesthebinomialmodeltoestimatethefairpriceofanoption.Hethencompareshisestimatedpricetothemarketprice.He
observesthatDaleCorporation'sstockhasacurrentmarketpriceof$200,andhepredictsthatitspricewilleitherbe$166.67or$240in
oneyear.Theriskfreerateiscurrently4percent.Healsoobservesthatthepriceofaoneyearcallwitha$220strikepriceis$11.11.
BinglyalsousestheBlackScholesMertonmodeltopriceoptions.Hisstatedrationaleforusingthismodelisthathebelievestheprices
ofthestocksheanalyzesfollowalognormaldistribution,andbecausethemodelallowsforavaryingriskfreerateoverthelifeofthe
option.Hisplanistouseastatisticaltechniquetoestimatethevolatilityofastock,enteritintotheBlackScholesMertonmodel,andsee
iftheassociatedpriceishigherorlowerthantheobservedmarketpriceoftheoptionsonthestock.
BinglywishestoapplytheBlackScholesMertonmodeltobothnondividendpayinganddividendpayingstocks.Heinvestigateshowthe
presenceofdividendswillaffecttheestimatedcallandputprice.

Question#110of172

QuestionID:464104

InthecaseoftheoptionsonHillandCorporation'sstock,ifBinglyweretoestablishalongprotectiveputposition,hecould:
A) earnanarbitrageprofitof$0.03persharebysellingthecallandborrowingthe
remainingfundsneededforthepositionattheriskfreerate.
B) notearnanarbitrageprofitbecauseheshouldshorttheprotectiveputposition.
C) earnanarbitrageprofitof$0.30persharebysellingthecallandlending$57.20attheriskfree
rate.
Explanation
Underputcallparity,thevalueofthecall=put+stockPV(exerciseprice).Therefore,theequilibriumvalueofthecall=$0.40+$56
$55/(1.040.5)=$2.47.Thus,thecallisoverpriced,andarbitrageisavailable.IfBinglysellsthecallfor$2.50andborrows$53.93=
$55/(1.040.5),hewillhave$56.43>$56.40(=$56+$0.40),whichisthepricehewouldpayfortheprotectiveputposition.Thearbitrage
profitisthedifference($0.03=$56.43$56.40).

Question#111of172

QuestionID:464105

TheoneyearcalloptiononDaleCorporation:
A) isoverpriced.
B) maybeoverorunderpriced.Thegiveninformationisnotsufficienttogiveananswer.
C) isunderpriced.
Explanation
TheupmovementparameterU=1.20,andthedownmovementparameterD=0.833.WecalculatetheprobabilityofanupmoveU=(1+
0.040.833)/(1.20.833)=0.564.Thecallisoutofthemoneyintheeventofadownmovement,andhasanintrinsicvalueof$20inthe
eventofanupmovement.Therefore,theestimatedvalueofthecallisC=(0.564)$20/(1.04)=$10.85.Thus,thepriceof$11.11is
toohighandthecallisoverpriced.

Question#112of172

QuestionID:464106

Bingly'ssentimentstowardstheBlackScholesMerton(BSM)modelregardingalognormaldistributionofpricesandavariableriskfree
rateare:
A) correctforbothreasons.
B) correctconcerningthedistributionofstocksbutincorrectconcerningtheriskfreerate.

 C) incorrectforbothreasons.
Explanation
Themodelrequiresmanyassumptions,e.g.,thedistributionofstockpricesislognormalandtheriskfreerateisknownandconstant.
Otherassumptionsarefrictionlessmarkets,theoptionsareEuropean,andthevolatilityisknownandconstant.

Question#113of172

QuestionID:464107

WhichofthefollowingisleastaccurateregardingthelimitationsoftheBSMmodel?
A) TheBSMisnotusefulinpricingoptionsonbondsandinterestrates.
B) TheBSMisdesignedtopriceAmericanoptionsbutnotEuropeanoptions.
C) TheBSMisnotusefulinsituationswherethevolatilityoftheunderlyingassetchangesover
time.
Explanation
ThefollowingarelimitationsoftheBSM:
1. TheassumptionofaknownandconstantriskfreeratemeanstheBSMisnotusefulforpricingoptionsonbondpricesandinterest
rates.
2. TheassumptionofaknownandconstantassetreturnvolatilitymakestheBSMnotusefulinsituationswherethevolatilityisnot
constantwhichoccursmuchofthetime.
3. TheassumptionofnotaxesandtransactioncostsmakestheBSMlessuseful.
4. TheBSMisdesignedtopriceEuropeanoptionsandnotAmericanoptions.

Question#114of172

QuestionID:464108

IfBinglyforecaststhevolatilityforastockandfindthatitissignificantlygreaterthanthatimpliedbythepricesoftheputsandcallsof
thestock,hewouldconcludethat:
A) theputsareoverpricedandthecallsareunderpriced.
B) putsandcallsareunderpriced.
C) putsandcallsareoverpriced.
Explanation
Thereisapositiverelationshipbetweenthevolatilityofthestockandthepriceofbothputsandcalls.Ahigherestimateofvolatility
impliesthatthepricesofbothputsandcallsshouldbehigher.

Question#115of172

QuestionID:464110

Allelsebeingequal,thegreaterthedividendpaidbyastockthe:
A) lowerthecallpriceandthehighertheputprice.
B) higherthecallpriceandthelowertheputprice.
C) lowerthecallpriceandthelowertheputprice.
Explanation
Whendividendpaymentsoccurduringthelifeoftheoption,thepriceoftheunderlyingstockisreduced(ontheexdividenddate).Allelse

beingequal,thelowerpricereducesthevalueofcalloptionsandincreasesthevalueofputoptions.

Question#116of172

QuestionID:464295

WhichofthefollowingstrategieswouldbemostappropriateuseofCDSgivenanexpectationofcreditcurvesteepening?
A) Acurveflatteningtrade.
B) EngageinanakedCDS.
C) Acurvesteepeningtrade.
Explanation
Acreditcurvesteepeningexpectationwouldentailthecreditspreadforlongermaturitiesincreasingrelativetothechangeincreditspread
forshortermaturities.Insuchascenario,onewouldbuyprotectionforlongermaturitiesandsellprotectionforshortermaturity(i.e.,a
curvesteepeningtrade).

Question#117of172

QuestionID:464232

Thewriterofareceiverswaptionhas:
A) therighttoenteraswapinthefutureasthefloatingratepayer.
B) anobligationtoenteraswapinthefutureasthefloatingratepayer.
C) anobligationtoenteraswapinthefutureasthefixedratepayer.
Explanation
Areceiverswaptiongivesitsownertherighttoreceivefixed,thewriterhasanobligationtopayfixed.

Question#118of172

QuestionID:464248

Thecreditriskofaninterestrateswapisgreatest:
A) atthemiddleoftheterm.
B) justbeforethefinalpaymentmustbemade.
C) lateintheterm.
Explanation
Thecreditriskinaninterestrateswapisgreatestatthemiddleoftheswap.

Question#119of172

QuestionID:464130

Inordertoformadynamichedgeusingstockandcallswithadeltaof0.2,aninvestorcouldbuy10,000sharesofstockand:
A) buy50,000calls.

 B) write50,000calls.
C) write2,000calls.
Explanation
Eachcallwillincreaseinpriceby$0.20foreach$1increaseinthestockprice.Thehedgeratiois1/deltaor5.Ashortpositionof
50,000callswilloffsettheriskof10,000sharesofstockoverthenextinstant.

Question#120of172

QuestionID:464263

Totheissuerofafloatingratenote,acapisequivalentto:
A) writingaseriesofinterestratecalls.
B) owningaseriesofcallsonafixedincomesecurity.
C) owningaseriesofinterestratecalls.
Explanation
Theissuerofthenoteisborrowingatafloatingrate,andwillhavehigherinterestexpensesifratesincrease.Acapisequivalentto
owningaseriesofinterestratecallsatthecapratethatwillpaythedifferencebetweenthemarketrateandthecaprate.Ifinterestrates
increase,thepayofffromthecallswillcompensatetheborrowerforthehigherinterestexpenses.

Question#121of172

QuestionID:464197

Overthelifeofaswap,thepriceoftheswap:
A) isapproximatelyequaltothemarketvalueoftheswap.
B) fluctuateswithchangesintheyieldcurve.
C) doesnotchange.
Explanation
Thepriceofaswap,quotedasthefixedrateintheswap,isdeterminedatcontractinitiationandremainsfixedforthelifeoftheswap.

Question#122of172

QuestionID:464113

WhichofthefollowingisleastlikelyoneoftheassumptionsoftheBlackScholesMertonoptionpricingmodel?
A) Therearenocashflowsontheunderlyingasset.
B) Theriskfreerateofinterestisknownanddoesnotchangeoverthetermoftheoption.
C) Changesinvolatilityareknownandpredictable.
Explanation
TheBSMmodelassumesthatvolatilityisknownandconstant.Thetermpredictablewouldallowfornonconstantchangesinvolatility.

Question#123of172

QuestionID:464239

WandaBrunner,CFA,iscontemplatingaddingaswaptiontoherportfolio.Shemakesthefollowingtwostatementsaboutthepossible
payoffsandcashflowsofaninterestrateswaption:
Statement1: Exercisinganinthemoneyswaptioneffectivelygeneratesanannuityoverthetermoftheunderlyingswap.
Statement2: Apositivepayofftoareceiverswaptioneachquarteristheinterestsavedbyreceivingthehigherfixedrate.

WhichofthefollowingstatementsareCORRECT?

A) Onlystatement1iscorrect.
B) Onlystatement2iscorrect.
C) Bothstatementsarecorrect.
Explanation
Exercisinganinthemoneyswaptioneffectivelygeneratesanannuityoverthetermoftheunderlyingswap.Theamountofeachannuity
paymentistheinterestsavingsthatresultfrompayingaratelowerthanthemarketrateunderapayerswaptionortheextrainterestthat
resultsfromreceivingahigherrateunderareceiverswaption.

Question#124of172

QuestionID:464229

Considera$5millionsemiannualpayfloatingrateequityswapinitiatedwhentheequityindexis760and180dayLIBORis3.7%.After90
daystheindexisat767,90dayLIBORis3.4and270dayLIBORis3.7.Whatisthevalueoftheswaptothefloatingratepayer?
A) $3,526.
B) $2,726.
C) $3,526.
Explanation
1.0185=1+0.037(180/360)
1.0085=1+0.034(90/360)
767/7601.0185/1.0085=0.000705795,000,000=$3,526
Note:The1.0185/1.0085isthepresentvalueofthefloatingratesideafter90days.

Question#125of172
Anoffmarketforwardrateagreement(FRA):
A) cannotbepricedwithmarketrates.
B) providesaseriesofpayments.
C) hasapositivevalueatcontractinitiation.

QuestionID:464213

Explanation
AnoffmarketFRAhasacontractratethatdiffersfromthezerovaluerateattheinceptionofthecontractbydefinition,ithasapositive
valuetooneofthepartiestotheFRA.

Question#126of172

QuestionID:464112

AbondanalystdecidestousetheBSMmodeltopriceoptionsonbondprices.Thismodelwillmostlikelybeinadequatebecause:
A) theriskfreeratemustbeconstantandknown.
B) thepriceoftheunderlyingassetfollowsalognormaldistribution.
C) BSMcannotbemodifiedtodealwithcashflowslikecouponpayments.
Explanation
TheBSMmodelisnotusefulforpricingoptionsonbondpricesandinterestrates.Inthosecases,interestratevolatilityisakeyfactorin
determiningthevalueoftheoption.BSMcanbemodifiedtodealwithcashflowslikecouponpayments.Theassumptionthat"theprice
oftheunderlyingassetfollowsalognormaldistribution"isnotapplicable.

Question#127of172

QuestionID:464164

Howisthegammaofanoptiondefined?Gammaisthechangeinthe:
A) vegaastheoptionpricechanges.
B) optionpriceastheunderlyingsecuritychanges.
C) deltaasthepriceoftheunderlyingsecuritychanges.
Explanation
Gammaistherateofchangeindelta.Itmeasureshowfastthepricesensitivitychangesastheunderlyingassetpricechanges.

Question#128of172

QuestionID:464293

WhichofthefollowingstatementsregardingsettlementprotocolswithrespecttoCDSisleastaccurate?
A) Whenthereisacreditevent,theswapwillbesettledincashorbyphysicaldelivery.
B) Whenacrediteventhasoccurred,withphysicalsettlement,theprotectionsellerreceivesthe
referenceobligationandtheprotectionbuyerreceivesthemarketvalueofthereference
obligationimmediatelypriortothecreditevent.
C) AsupermajorityvoteofthedeclarationscommitteeofISDAisneededforacrediteventtobe
declared.
Explanation
Incaseofphysicalsettlement,theprotectionbuyerreceivesthenotionalprincipalandnotthemarketvalueofthebondpriortothecredit
event.

Question#129of172

QuestionID:464166

Whenanoption'sgammaishigher:
A) adeltahedgewillperformmorepoorlyovertime.
B) adeltahedgewillbemoreeffective.
C) deltawillbehigher.
Explanation
Gammameasurestherateofchangeofdelta(ahighgammacouldmeanthatdeltawillbehigherorlower)astheassetpricechanges
and,graphically,isthecurvatureoftheoptionpriceasafunctionofthestockprice.Deltameasurestheslopeofthefunctionatapoint.
Thegreatergammais(themoredeltachangesastheassetpricechanges),theworseadeltahedgewillperformovertime.

Question#130of172

QuestionID:464180

WhichofthefollowingmethodsisNOTusedforestimatingvolatilityinputsfortheBlackScholesmodel?
A) Usingexponentiallyweightedhistoricaldata.
B) Modelsofchangingvolatility.
C) Usinglongtermhistoricaldata.
Explanation
ThevolatilityisconstantintheBlackScholesmodel.

Questions#131136of172
RonaldFranklin,CFA,hasrecentlybeenpromotedtojuniorportfoliomanagerforalargeequityportfolioatDavidsonSherman(DS),a
largemultinationalinvestmentbankingfirm.HeisspecificallyresponsibleforthedevelopmentofanewinvestmentstrategythatDS
wantsallequityportfoliomanagerstoimplement.UppermanagementatDShasinstructeditsportfoliomanagerstobeginoverlaying
optionstrategiesonallequityportfolios.Therelativelypoorperformanceofmanyoftheirequityportfolioshasbeenthemainfactorbehind
thisdecision.Priortothisnewmandate,DSportfoliomanagershadbeenallowedtouseoptionsattheirowndiscretion,andtheresults
weresomewhatinconsistent.Someportfoliomanagerswerenotcomfortablewiththemostbasicconceptsofoptionvaluationandtheir
expectedreturnprofiles,andsimplydidnotutilizeoptionsatall.UppermanagementofDSwantsFranklintodevelopanoptionstrategy
thatwouldbeapplicabletoallDSportfoliosregardlessoftheirunderlyinginvestmentcomposition.Managementviewsthisnew
implementationofoptionstrategiesasanopportunitytoeitheraddvalueorreducetheriskoftheportfolio.
Franklingainedexperiencewithbasicoptionsstrategiesathispreviousjob.Asanexercise,hedecidestoreviewthefundamentalsof
optionvaluationusingasimpleexample.Franklinrecognizesthatthebehaviorofanoption'svalueisdependentonmanyvariablesand
decidestospendsometimecloselyanalyzingthisbehavior.HisanalysishasresultedintheinformationshowninExhibits1and2for
Europeanstyleoptions.

Exhibit1:InputforEuropeanOptions
StockPrice(S)

100

StrikePrice(X)

100

InterestRate(r)

0.07

DividendYield(q)

0.00

TimetoMaturity(years)(t)

1.00

Volatility(Std.Dev.)(Sigma)

0.20

BlackScholesPutOptionValue $4.7809
Exhibit2:EuropeanOptionSensitivities
Sensitivity

Call

Put

Delta

0.6736

0.3264

Gamma

0.0180

0.0180

Theta

3.9797

2.5470

Vega

36.0527

36.0527

Rho

55.8230

37.4164

Question#131of172

QuestionID:464132

UsingtheinformationinExhibit1,FranklinwantstocomputethevalueofthecorrespondingEuropeancalloption.Whichofthefollowing
istheclosesttoFranklin'sanswer?
A) $5.55.
B) $11.54.
C) $4.78.
Explanation
Thisresultcanbeobtainedusingputcallparityinthefollowingway:
CallValue=PutValueXert +S=$4.78$100.00e(0.071.0)+100=$11.54

Theincorrectvalueof$4.78doesnotdiscountthestrikepriceintheputcallparityformula.(StudySession17,LOS53.i)

Question#132of172

QuestionID:464133

FranklinisinterestedinthesensitivityoftheEuropeancalloptiontochangesinthevolatilityoftheunderlyingequity'sreturns.What
happenstothevalueofthecalloptionifthevolatilityoftheunderlyingequity'sreturnsdecreases?Thecalloptionvalue:
A) decreases.
B) increasesordecreases.
C) increases.
Explanation
Duetothelimitedpotentialdownsideloss,changesinvolatilitydirectlyeffectoptionvalue.Vegameasurestheoption'ssensitivityrelative
tovolatilitychanges.(StudySession17,LOS53.d)

Question#133of172

QuestionID:464134

FranklinisinterestedinthesensitivityoftheEuropeanputoptiontochangesinthevolatilityoftheunderlyingequity'sreturns.What
happenstothevalueoftheputoptionifthevolatilityoftheunderlyingequity'sreturnsincreases?Theputoptionvalue:
A) increasesordecreases.
B) decreases.
C) increases.
Explanation
Duetothelimitedpotentialdownsideloss,changesinvolatilitydirectlyeffectoptionvalue.Vegameasurestheoptionpricesensitivity
relativetothevolatilityoftheunderlyingstock.(StudySession17,LOS53.d)

Question#134of172

QuestionID:464135

FranklinwantstoknowhowtheputoptioninExhibit1behaveswhenalltheparametersareheldconstantexceptthedelta.Whichofthe
followingisthebestestimateofthechangeintheputoption'spricewhentheunderlyingequityincreasesby$1?
A) $3.61.
B) $0.33.
C) $0.37.
Explanation
ThecorrectvalueissimplythedeltaoftheputoptioninExhibit2.
Theincorrectvalue$3.61representsthechangeduetothevolatilitydividedby10multipliedby1.
Theincorrectvalue$0.37calculatesthechangebydividingtheshortterminterestratedividedby100.(StudySession17,LOS53.e)

Question#135of172

QuestionID:464136

FranklincomputestherateofchangeintheEuropeanputoptiondeltavalue,givena$1increaseintheunderlyingequity.Usingthe
informationinExhibits1and2,whichofthefollowingistheclosesttoFranklin'sanswer?
A) 0.0180.
B) 0.3264.
C) 0.6736.
Explanation
Thecorrectvalue0.0180isreferredtoastheputoption'sGamma.
Theincorrectvalue0.3264isthedeltaoftheputoption.
Theincorrectvalue0.6736isthecalloption'sdelta.(StudySession17,LOS53.e)

Question#136of172

QuestionID:464137

FranklinwantstoknowiftheoptionsensitivitiesshowninExhibit2haveminimumormaximumbounds.Whichofthefollowingarethe
minimumandmaximumbounds,respectively,fortheputoptiondelta?
A) 1and0.

 B) Therearenominimumormaximumbounds.
C) 1and1.
Explanation
Thelowerboundisachievedwhentheputoptionisfarinthemoneysothatitmovesexactlyintheoppositedirectionasthestockprice.
Whentheputoptionisfaroutofthemoney,theoptiondeltaiszero.Thus,theoptionpricedoesnotmoveevenifthestockpricemoves
sincethereisalmostnochancethattheoptionisgoingtobeworthsomethingatexpiration.(StudySession17,LOS53.e)

Question#137of172

QuestionID:464115

WhichofthefollowingisNOToneoftheassumptionsoftheBlackScholesMertonoptionpricingmodel?
A) Therearenocashflowsoverthetermoftheoptions.
B) Therearenotaxesandtransactionscostsarezeroforoptionsandarbitrageportfolios.
C) Theyieldcurveforriskfreeassetsisfixedoverthetermoftheoption.
Explanation
Theyieldcurveisassumedtobeflatsothattheriskfreerateofinterestisknownandconstantoverthetermoftheoption.Havinga
fixedyieldcurvedoesnotnecessarilyimplythattheyieldcurveisflat.

Question#138of172

QuestionID:464102

Astockispricedat40andtheperiodicriskfreerateofinterestis8%.ThevalueofatwoperiodEuropeancalloptionwithastrikepriceof
37onashareofstockusingabinomialmodelwithanupfactorof1.20isclosestto:
A) $9.25.
B) $3.57.
C) $9.13.
Explanation
First,calculatetheprobabilityofanupmoveoradownmove:
U=1.20soD=0.833
Pu=(1+0.080.833)/(1.200.833)=0.673
Pd=10.673=0.327
Twoupmovesproduceastockpriceof401.44=57.60andacallvalueattheendoftwoperiodsof20.60.Anupandadownmove
leavethestockpriceunchangedat40andproduceacallvalueof3.Twodownmovesresultintheoptionbeingoutofthemoney.The
valueofthecalloptionisdiscountedbackoneyearandthendiscountedbackagaintotoday.Thecalculationsareasfollows:
C+=[20.6(0.673)+3(0.327)]/1.08=13.745
C=[3(0.673)+0(0.327)]/1.08=1.869
Callvaluetoday=[13.745(0.673)+1.869(0.327)]/1.08=9.13

Question#139of172

QuestionID:464210

Whichofthefollowingisequivalenttoaplainvanillareceivefixedinterestrateswap?
A) Alongpositioninabondcoupledwiththeissuanceofafloatingratenote.
B) Ashortpositioninabondcoupledwithalongpositioninafloatingratenote.
C) Ashortpositioninabondcoupledwiththeissuanceofafloatingratenote.
Explanation
Alongpositioninafixedratebondpaysfixedcoupons.Theshortfloatingratenoterequiresfloatingratepayments.Together,theseare
thesamecashflowasareceivefixedswap.

Question#140of172

QuestionID:464211

Aplainvanillainterestrateswaptothefixedratepayerisequivalenttoissuingafixedratebondand:
A) buyingafloatingratebond.
B) sellingaseriesofinterestrateputs.
C) sellingaseriesofinterestratecalls.
Explanation
Payingfixedandreceivingfloatinginaswapisequivalenttoissuingafixedratebondandinvestingtheproceedsinafloatingratebond.

Question#141of172

QuestionID:464252

Aswapspreaddependsprimarilyonthe:
A) shapeofthereferencerateyieldcurve.
B) generallevelofcreditriskintheoveralleconomy.
C) creditofthepartiesinvolvedintheswap.
Explanation
Theswapspreaddependsprimarilyonthegenerallevelofcreditriskintheoveralleconomy.

Questions#142147of172
MaxPerrot,CFA,worksforWWF,amortgagebankingcompanywhichoriginatesresidentialmortgageloans.Onamonthlybasis,WWF
issuesagencymortgagebackedsecurities(MBS)backedbytheirloans.WWFsellstheMBSintheopenmarketsoonafter
securitization,butretainstheservicingrightstotheloans.WWFcurrentlyownsthethirdlargestmortgageservicingportfoliointheU.S.
PerrothasrecentlybeenpromotedtoSeniorVicePresidentofAssetandLiabilityManagementforWWF.Perrot'snewresponsibilities
encompasshedgingWWF'snewlycreatedMBSpriortotheirsale,aswellasmanagingtheinterestrateexposureontheservicing
portfolio.Bothtypesofassetsareextremelysensitivetochangesininterestrates,thoughnotnecessarilyinthesamemanner.

AlthoughWWFhasretainedalloftheservicingrightsofitsloansinthepast,theyarenotopposedtothesellingofportionsofthe
portfolioifmarketconditionsareright.WWF'smanagementwantsPerrotinhisnewpositiontofocusprimarilyonpreservingthevalueof
theservicingportfoliothroughhedgingstrategiesthatarecosteffectivetoexecute.Also,anyhedgestrategyusedbyPerrotmustbe
extremelyliquidintheeventthataportionoftheservicingportfolioissoldandthehedgeneedstobeunwound.Theuppermanagement
ofWWFanticipatesaperiodofvolatilityininterestrates,andtheyhaveaskedPerrottoprojectexpectedreturnsofahedgedposition
underavarietyofinterestratesscenarios.
Perrot'spredecessorlackedexperienceinhedgingwithswapsandfuturescontracts,buthehadusedthemperiodicallywithlackluster
results.Throughhisinaction,hehadexposedthefirmtosignificantassetandliabilitymismatch,whichhadincreaseddramaticallyover
thepasttwoyearsasbothproductionandtheservicingportfoliohadgrown.Perrot,ontheotherhand,hadextensiveexperiencewith
hedgingwithderivativesinhispriorjob.Heisfamiliarwithexecutinghedgingstrategiesutilizingnotonlyswapandfutures,butalsowith
optionssuchascapsandfloors.HedecidesthatbeforehepresentsanypotentialhedgingstrategytoWWF'smanagement,hewouldfirst
liketobringthemuptospeedonthebasichedgingconcepts.Hepreparesabriefpresentationontherelationshipsbetweeninterestrates
andoptions,andoutlinessomebasichedgingstrategies.Heanticipatesmanyquestionsthatmayarisefromhispresentation,and
preparesahandoutinaquestionandanswerformat.

Question#142of172

QuestionID:464284

Whichofthefollowingbestexplainstherelationshipbetweeninterestrateswapsandforwardcontracts?Interestrateswaps:
A) areequivalenttoforwardcontracts.
B) areequivalenttoaseriesofforwardcontracts.
C) havethesamepayoffasapackageofforwardcontractsbutnotthesamevalue.
Explanation
Aswapagreementisequivalenttoaseriesofforwardcontracts.Aslongastheunderlyingdetailsarethesame,aninterestrateswapwill
havethesamepayoffandthesamevalueasaseriesofforwardcontracts.(StudySession17,LOS54.b)

Question#143of172

QuestionID:464285

Whichofthefollowingmostaccuratelydescribestherelationshipbetweenaninterestratefloorandabondoption?Buyinganinterestrate
floorisequivalentto:
A) buyingaportfolioofputoptionsonabond.
B) buyingaportfolioofcalloptionsonabond.
C) sellingaportfolioofputoptionsonabond.
Explanation
Foracalloptiononafixedincomeinstrument,ifinterestratesdecrease,thefixedincomeinstrument'spriceincreases.Sothecalloption
valueincreases.Thisisthesamepayoffstructureasaninterestratefloor,whichprovidesapositivepayoffiftheinterestrateisbelow
thestrikerate.(StudySession17,LOS55.a)

Question#144of172

QuestionID:464286

Assumethatathreeyearsemiannuallysettledfloorwithastrikerateof8%andanotionalamountof$100millionisbeinganalyzed.The
referencerateissixmonthLondonInterbankOfferedRate(LIBOR).SupposethatLIBORforthenextfoursemiannualperiodsisas
follows:
Period

LIBOR

7.5%

8.2%

8.1%

8.7%

Whatisthepayoffforthefloorforperiod1?

A) $500,000.
B) $250,000.
C) $0.
Explanation
Thepayoffforeachsemiannualperiodiscomputedasfollows:
Payoff=notionalamount(floorratesixmonthLIBOR)/2

soforperiod1:
=$100million(8.0%7.5%)/2=$250,000

(StudySession17,LOS55.b)

Question#145of172

QuestionID:464287

Whichofthefollowingbestexplainsthedifferencebetweenaninterestrateputoptionandaputoptiononafixedincomesecurity?The
interestrateputoptionvalue:
A) increasesifinterestratesincreasejustasthevalueofaputoptiononafixedincome
securityincreases.
B) decreasesifinterestratesincreasejustasthevalueofaputoptiononafixedincome
securitydecreases.
C) decreasesifinterestratesincreasewhilethevalueofaputoptiononafixedincomesecurity
increasesifinterestratesincrease.
Explanation
Aninterestrateputoptionpaysoffthedifferencebetweenthestrikerateandthecurrentinterestrateifthatdifferenceispositive.Sothe
valueoftheinterestrateoptionwillbehighifinterestratesdecreasebelowthestrikerate.Incontrast,aputoptiononafixedincome
securityhasahighvalueifinterestratesincreasebecausethenthefixedincomesecurity'spricedecreasesbelowthevaluebasedstrike
price.(StudySession17,LOS55.a)

Question#146of172

QuestionID:464288

ALIBORbasedfloatingratebondcombinedwithaLIBORbasedcollar(ashortpositioninaninterestratecapandalongpositioninan
interestratefloorbothatthesamestrikerate)isequivalenttoa:
A) fixedratebond.
B) payfixedswapposition.

 C) calloptiononabond.
Explanation
Theeffectiverateabovethecapstrikeandbelowthefloorstrike,whencombinedwiththefloatingrateonabond,isconstant.(Study
Session17,LOS55.b)

Question#147of172

QuestionID:464289

Whichofthefollowingismostlikelyareasonwhydynamicrisklessarbitrageisdifficultinrealmarkets?
A) Continuousrebalancing.
B) Securitiesaresubjecttoinsidertrading.
C) Shortsaleconstraintsexist.
Explanation
Thecontinuousrebalancingrequiredwithdynamicrisklessarbitrageisnotpractical.Foronething,itleadstosignificanttransaction
costs.(StudySession17,LOS54.e)

Question#148of172

QuestionID:464245

Currentandpotentialcreditriskinaswapare:
A) greatestbetweenpaymentdates.
B) equalatalltimesoverthetermofaswap.
C) notequalattheinceptionoftheswap.
Explanation
Currentcreditriskistheriskofnotreceivingapaymentcurrentlydue,sincethereisnoneattheinceptionoftheswap,currentcreditrisk
iszero.Potentialcreditriskistheriskthatpaymentspossiblydueinthefuturewillnotbemade.

Question#149of172

QuestionID:464196

Thepriceofaninterestrateswapisthe:
A) fixedrateofinterest.
B) marketvalueoftheswap.
C) costtopurchaseaswap.
Explanation
Thepriceofaninterestrateswapisquotedastherateonthefixedratepayments.Thefloatingrateisaknownreferencerate,suchas
LondonInterbankOfferedRate(LIBOR),butdoesnotneedtobequoted.

Question#150of172

QuestionID:464244

TheLondonInterbankOfferedRate(LIBOR)yieldcurveis:
180days:5.2%.
360days:5.4%.
WhatisthevalueofaLIBORbasedpayerswaption(expiringtoday)ona$10million1yearsemiannual4.8%swap?

A) $50,712.
B) $0.
C) $50,712.
Explanation
1. Determinethediscountfactors.

180day:1/[1+(0.052(180/360))]=0.974659
360day:1/[1+(0.054(360/360))]=0.948767

2. Then,plugasfollows:

(10.9487666)/(0.974659+0.9487667)=0.026637

3. Thevalueofthepayerswaptionisthesavingsbetweentheexerciserateandthemarketrate:

(0.0266370.024)(0.97465887+0.9487666)10,000,000=$50,712.

Question#151of172

QuestionID:464216

AU.S.firm(U.S.)andaforeignfirm(F)engageinafouryearplainvanillaannualpaycurrencyswap.TheU.S.firmpaysfixedintheFC
andreceivesfloatingindollars.Thefixedrateatinitiationandattheendoftheswapwas5%.Thevariablerateattheendofyear1was
4%,attheendofyear2was6%,andattheendofyear3was7%.Atthebeginningoftheswap,$2millionwasexchangedatan
exchangerateof2foreignunitsper$1.Attheendoftheswapperiodtheexchangeratewas1.75foreignunitsper$1.
Attheendofyear3,firmFwillpayfirmU.S.:

A) 280,000foreignunits.
B) $140,000.
C) $120,000.
Explanation
Aplainvanillacurrencyswappaysfloatingondollarsandfixedonforeign.Thefloatingratecashflowsonthesettlementdatearebased
onthepreviousperiod'sendingfloatinginterestrate0.06x$2,000,000=$120,000.

Question#152of172

QuestionID:464199

Fora1yearquarterlypayswap,anequivalentpositionwithshortputsandlongcallswouldinvolve:
A) threeputcallcombinationsonthelastthreesettlementdatesoftheswap.
B) putcallcombinationsexpiringoneachofthefoursettlementdates.
C) threeputcallcombinationsexpiringonthefirstthreesettlementdatesoftheswap.
Explanation
Interestrateoptionspayoneperiodafterexercise.Optionsexpiringonsettlementsatt=1,2,3,willmimictheuncertainswappayments
att=2,3,4.

Question#153of172

QuestionID:464198

Thefixedrateonasemiannual2yearinterestrateswapisclosesttothe:
A) couponrateona2yearparbondwiththesamecreditriskasthefixedratepayer.
B) couponrateona2yearparbondwiththesamecreditriskasthereferencerate.
C) current180dayTbillrate.
Explanation
Thefixedrateonaswapiscalculatedusingtheyieldcurveforthefloatingratereference,usuallyLondonInterbankOfferedRate
(LIBOR).Therefore,thefixedratereflectsthecreditspreadofthatrateovertherisklessrateofreturn.

Question#154of172

QuestionID:464192

EarlyexerciseofinthemoneyAmericanoptionson:
A) bothfuturesandforwardsissometimesworthwhile.
B) forwardsissometimesworthwhilebutneverisforoptionsonfutures.
C) futuresissometimesworthwhilebutneverisforoptionsonforwards.
Explanation
EarlyexerciseofinthemoneyAmericanoptionsonfuturesissometimesworthwhilebecausetheimmediatemarktomarketupon
exercisewillgeneratefundsthatcanearninterest.Itisneverworthwhileforoptionsonforwardsbecausenofundsaregenerateduntilthe
settlementdateoftheforwardcontract.

Question#155of172
Aflooronafloatingratenote,fromthebondholder'sperspective,isequivalentto:
A) writingaseriesofinterestrateputs.
B) owningaseriesofcallsonfixedincomesecurities.
C) owningaseriesofputsonfixedincomesecurities.

QuestionID:464272

Explanation
Afloor,whichputsaminimumonfloatingrateinterestpaymentsisequivalenttoowningcallsonfixedincomesecuritieswhichwillpay
wheninterestratesfall.Owninginterestrateputs,ratherthanwritingthem,wouldbeequivalenttothefloor.Putsonfixedincome
securitiespaywheninterestratesincrease.

Question#156of172

QuestionID:464250

Theswapspreadwillincreasewith:
A) thevariabilityofinterestrates.
B) adeteriorationinoneparty'scredit.
C) anincreaseinthecreditspreadembeddedinthereference.
Explanation
TheswapspreadisthespreadbetweenthefixedrateonamarketrateswapandtheTreasuryrateonasimilarmaturitynote/bond.Since
thefixedrateiscalculatedfromthereferencerateyieldcurve,itisincreasedasthecreditspreadembeddedinthereferencerateyield
curveincreases.

Question#157of172

QuestionID:464207

Supposeaforwardrateagreement(FRA)callsfortheexchangeofsixmonthLIBORoneyearfromnowforapaymentofafixedrateof
interestof8%.Inotherwords,payfloatingandreceivefixed.WhichofthefollowingstructuresisequivalenttothisFRA?Along:
A) callandashortputonLIBORwithastrikerateof8%andsixmonthstoexpiration.
B) putandashortcallonLIBORwithastrikerateof8%andtwelvemonthstoexpiration.
C) callandashortputonLIBORwithastrikerateof8%andtwelvemonthstoexpiration.
Explanation
ThestrikerateoftheoptionscorrespondstothefixedrateoftheFRA.TheexpirationoftheoptioncoincideswiththeLIBOR
determinationdate.

Question#158of172

QuestionID:464191

Whichofthefollowingstatementsismostaccurate?
A) AmericanoptionsonforwardsaremorevaluablethancomparableEuropeanoptionson
forwards.
B) AmericanoptionsonfuturesaremorevaluablethancomparableEuropeanoptionsonfutures.
C) EuropeanoptionsonfuturesaremorevaluablethancomparableAmericanoptionsonfutures.
Explanation
Becauseofthemarktomarketfeatureoffuturescontracts,AmericanoptionsonfuturesaremorevaluablethancomparableEuropean

options.ThevalueofAmericanandEuropeanoptionsonforwardsarethesame.

Question#159of172

QuestionID:464201

Aswapisequivalenttoaseriesof:
A) interestratecalls.
B) FRAspricedatmarketrates.
C) offmarketFRAs.
Explanation
Sincethefixedrateontheswapisthesameateverysettlementdate,aseriesofFRAsatthosefixedrateswillhavevaluesthatdiffer
fromzerototheextentthefixedrateandthezerovalueratediffer.ThismakesthemoffmarketFRAs.

Question#160of172

QuestionID:464117

ThevalueofaEuropeancalloptiononanassetwithnocashflowsispositivelyrelatedtoallofthefollowingEXCEPT:
A) timetoexercise.
B) riskfreerate.
C) exerciseprice.
Explanation
Thevalueofacalloptiondecreasesastheexercisepriceincreases.

Question#161of172

QuestionID:464187

Whichofthefollowingisacorrectspecificationofputcallparityforoptionsonfutures?
A)
B)
C)

Explanation
Beginwithputcallparityforastock,

Question#162of172

andsubstitute

QuestionID:464230

Considera1yearsemiannualequityswapbasedonanindexat985andafixedrateof4.4%.90daysaftertheinitiationoftheswap,the

indexisat982andLondonInterbankOfferedRate(LIBOR)is4.6%for90daysand4.8%for270days.Thevalueoftheswaptothe
equitypayer,basedona$2millionnotionalvalueisclosestto:
A) $22,564.
B) $22,314.
C) $22,564.
Explanation

$22,564isthevaluetothefixedratepayer,thus$22,564isthevaluetotheequityreturnpayer.

Question#163of172

QuestionID:464181

WhichofthefollowingbestdescribestheimpliedvolatilitymethodforestimatedvolatilityinputsfortheBlackScholesmodel?Implied
volatilityisfound:
A) usingthemostcurrentstockpricedata.
B) usinghistoricalstockpricedata.
C) bysolvingtheBlackScholesmodelforthevolatilityusingmarketvaluesforthestockprice,
exerciseprice,interestrate,timeuntilexpiration,andoptionprice.
Explanation
Impliedvolatilityisfoundby"backingout"thevolatilityestimateusingthecurrentoptionpriceandallothervaluesintheBlackScholes
model.

Questions#164169of172
JoelFranklin,CFA,hasrecentlybeenpromotedtojuniorportfoliomanagerforalargeequityportfolioatDavidsonSherman(DS),alarge
multinationalinvestmentbankingfirm.Theportfolioissubdividedintoseveralsmallerportfolios.Ingeneral,theportfoliosarecomposedof
U.S.basedequities,rangingfrommediumtolargecapstocks.Currently,DSisnotinvolvedinanyforeignmarkets.Inhisnewposition,
hewillnowberesponsibleforthedevelopmentofanewinvestmentstrategythatDSwantsallofitsequityportfoliostoimplement.The
strategyinvolvesoverlayingoptionstrategiesonitsequityportfolios.Recentperformanceofmanyoftheirequityportfolioshasbeenpoor
relativetotheirpeergroup.TheuppermanagementatDSviewsthenewoptionstrategiesasanopportunitytoeitheraddvalueorreduce
risk.
Franklinrecognizesthatthebehaviorofanoption'svalueisdependentuponmanyvariablesanddecidestospendsometimeclosely
analyzingthisbehavior.Hetookanoptionsstrategiesclassingraduateschoolafewyearsago,andfeelsthatheisfairlyknowledgeable
aboutthevaluationofoptionsusingtheBlackScholesmodel.Franklinunderstandsthatthevolatilityoftheunderlyingassetreturnsis
oneofthemostimportantcontributorstooptionvalue.Therefore,hewouldliketoknowwhenthevolatilityhasthelargesteffectonoption

value.UppermanagementatDShasalsorequestedthathefurtherexploretheconceptofadeltaneutralportfolio.Hemustdetermine
howtocreateadeltaneutralportfolio,andhowitwouldbeexpectedtoperformunderavarietyofscenarios.Franklinisalsoexamining
thechangeinthecalloption'sdeltaastheunderlyingequityvaluechanges.Healsowantstodeterminetheminimumandmaximum
boundsonthecalloptiondelta.Franklinhasbeenauthorizedtopurchasecallsorputsontheequitiesintheportfolio.Hemaynot,
however,establishanyuncoveredor"naked"optionpositions.HisanalysishasresultedintheinformationshowninExhibits1and2for
Europeanstyleoptions.
Exhibit1
InputforEuropeanOptions
StockPrice(S)

100

StrikePrice(X)

100

InterestRate(r)

0.07

DividendYield(q)

TimetoMaturity(years)(t)

Volatility(Std.Dev.)(sigma)

0.2

BlackScholesPutOptionValue

$4.7809

Exhibit2
EuropeanOptionSensitivities
Sensitivity

Call

Put

Delta

0.6736

0.3264

Gamma

0.0180

0.0180

Theta

3.9797

2.5470

Vega

36.0527

36.0527

Rho

55.8230

37.4164

Question#164of172

QuestionID:464156

Whatdoesitmeantomakeanoptionsportfoliodeltaneutral?Theoptionportfolio:
A) isinsensitivetopricechangesintheunderlyingsecurity.
B) movesexactlyinlinewiththestockprice.
C) movesexactlyintheoppositedirectionwiththestockprice.
Explanation
Thedeltaoftheoptionportfolioisthechangeinvalueoftheportfolioiftheunderlyingstockpricechanges.Adeltaneutraloptionportfolio
hasadeltaofzero.(StudySession17,LOS53.e)

Question#165of172

QuestionID:464157

Whichofthefollowingmostaccuratelydescribesthesensitivityofthecalloption'sdeltatochangesintheunderlyingasset'sprice?The
sensitivitytochangesinthepriceoftheunderlyingisthegreatestwhenthecalloptionis:
A) atthemoney.
B) inthemoney.
C) itdependsontheotherinputs.

Explanation
Whentheoptionisatthemoney,deltaismostsensitivetochangesintheunderlyingasset'sprice.(StudySession17,LOS53.f)

Question#166of172

QuestionID:464158

Whichofthefollowingmostaccuratelydescribeswhenthecalloptiondeltareachesitsminimumbound?Thecalloptionreachesits
minimumboundwhencalloptionis:
A) faroutofthemoney.
B) atthemoney.
C) theoption'sdeltahasnominimumbound.
Explanation
Whenacalloptionisfaroutofthemoneyitsvalueisinsensitivetochangesinvalueoftheunderlying.Thisisbecausethechancesthat
itisgoingtoendupinthemoneyatexpirationareverysmall.(StudySession17,LOS53.e)

Question#167of172

QuestionID:464159

Iftheportfoliohas10,000sharesoftheunderlyingstockandhewantstocompletelyhedgethepriceriskusingoptions,whatkindof
optionsshouldFranklinbuy?
A) Calloptions.
B) Callandputoptions.
C) Putoptions.
Explanation
BuyingputoptionswillallowFranklintocompletelyhedgethestockpricerisk.(StudySession17,LOS53.e)

Question#168of172

QuestionID:464160

Computethenumberofsharesofstocknecessarytocreateadeltaneutralportfolioconsistingof100longputoptionsinExhibit2andthe
stock.
A) 67.36.
B) 32.64.
C) 32.64.
Explanation
Thisissimply100timestheputoptiondelta.Sinceeachsharehasadeltaof1,weonlyneed32.64shares(long)tocreateadelta
neutralportfolio.(StudySession17,LOS53.e)

Question#169of172

QuestionID:464161

Computethenumberofsharesofstocknecessarytocreateadeltaneutralportfolioconsistingof100longcalloptionsinExhibit2and
thestock.
A) 67.36.
B) 32.64.

 C) 67.36.
Explanation
Thisissimply100timesthecalloptiondelta.Sinceeachsharehasadeltaof1,weonlyneed67.36(short)sharestocreateadelta
neutralportfolio.(StudySession17,LOS53.e)

Question#170of172

QuestionID:464223

ThecurrentU.S.dollar($)toCanadiandollar(C$)exchangerateis0.7.Ina$1millioncurrencyswap,thepartythatisenteringtheswap
tohedgeexistingexposuretoC$denominatedfixedrateliabilitywill:
A) payfloatinginC$.
B) receivefloatinginC$.
C) payC$1,428,571atthebeginningoftheswap.
Explanation
ThepartythatisenteringtheswaptohedgeexistingexposuretoC$denominatedfixedrateliabilitywillwanttoreceivefixedC$.They
willpay1,000,000/0.7=C$1,428,571(principal)atswapinception(inexchangeforUSD1million)andgetthesameamount
(C$1,428,571)backattermination(inexchangeforpayingbacktheUSD1million).

Question#171of172

QuestionID:464206

Supposeaforwardrateagreement(FRA)callsfortheexchangeofsixmonthLondonInterbankOfferedRate(LIBOR)twoyearsfromnow
forapaymentofafixedrateofinterestof6%.WhichofthefollowingstructuresisequivalenttothislongFRA?Along:
A) putandashortcallonLIBORwithastrikerateof6%andtwoyearstoexpiration.
B) callonLIBORwithastrikerateof6%andeighteenmonthstoexpiration.
C) callandashortputonLIBORwithastrikerateof6%andtwoyearstoexpiration.
Explanation
ThestrikerateoftheoptionscorrespondstothefixedrateoftheFRA.Theexpirationoftheoptioncoincideswiththedeterminationdate
oftheLIBORbasedpaymentwhichispaidtwoyearsfromnow.

Question#172of172

QuestionID:464241

Considera3yearquarterlypaybondtobeissuedin180dayswitha7%coupon.A180dayputoptiononthisbond,withanexercise
pricerateof7%,hasapayoffequaltothatofa:
A) receiverswap.
B) payerswaption.
C) receiverswaption.
Explanation

Thepayoffonapayerswaptionisequivalenttothatofaputoptiononabondasdescribedinthequestion.Apayerswaptionistheright
toenterintoaspecificswapatsomedateinthefutureasthefixedratepayerataratespecifiedintheswaption.Ifswapfixedrates
increase(asinterestratesincrease),therighttoenterthepayfixedsideofaswap(apayerswaption)becomesmorevaluable.Similarly,
whenratesincrease,bondpricesfallandaputoptiononthebondbecomesmorevaluable.Considerthataputoptiononabondgives
onearighttosellthebondatafixedprice.Onewouldexercisetheputoptiononlyifthemarketpriceofthebondislowerthanthe
exercisepriceoftheputoption.