Pass the PRMIA PRM Certification 8006 Questions and answers with CertsForce

The buyer of a cap who is primarily interested in protecting against a rise in interest rates and does not mind losing some of the gains if interest rates were to fall can reduce her costs by selling a floor with a lower strike rate. Selling a cap would further expose her to the risk of rising rates, exactly what she is trying to protect herself against, and reducing the strike rate for the cap will actually increase the cost of the cap. Similarly, increasing the time period to which the cap applies will also increase the cost of the cap.

The minimum variance hedge ratio is effectively the beta between the asset to be hedged and the asset used as a hedge, calculated as [correlation between the hedge and the asset to be hedged x volatility of the asset to be hedged/volatility of the hedge].The effectiveness of the hedge depends upon the correlation between the two, ie the asset to be hedged and the hedge. The minimum variance hedge ratio can be 1.0 even in situations where the correlation between the asset and the hedge is low, and as such does not mean much unless we know the hedge effectiveness (ie, the correlation).

It is therefore not possible to draw any certain conclusions based on the minimum variance hedge ratio alone. IV therefore is the only correct answer.

The delta of an at-the-money call option is close to 0.5. It is close to 1 when it is deep in the money. It is close to 0 when it is deep out of the money. It is never negative. Therefore Choice 'b' is the correct answer.

When hedging an equity portfolio with index futures, the number of futures contracts to hold is given by the [beta x value of portfolio/value of one futures contract]. Therefore Choice 'a' is the correct answer.

The volatility, risk free rate have nothing to do with determining the number of futures contracts to hold. Systematic risk is expressed in the form of beta. Therefore the other choices are incorrect.

A swaption is an option to enter into a fixed for floating interest rate swap at a point in the future, with the fixed rate decided upfront. These options can be European, Bermudan or American, in terms of what dates the option can be exercised. A receiver option on a swap is an option that gives the buyer the right to enter into a swap and receive the fixed rate and pay the variable rate. In the case of a payer option, the buyer pays the fixed rate and receives the variable rate. One way to remember this is that receiving and paying are terms used with reference to the fixed rates.

Explanation:

Remember how exchange rates are generally quoted. Most exchange rates are quoted in terms of how many foreign currencies does USD 1 buy. Therefore, a rate of 99 for the JPY means that USD 1 is equal to JPY 99. These are called 'direct rates'. However, there are four major world currencies where the rate quote convention is the other way round - these are EUR, GBP, AUD and NZD. For these currencies, the FX quote implies how many US dollars can one unit of these currencies buy. So a quote of "1.1023" for the Euro means EUR 1 is equal to USD 1.1023 and not the other way round.

Statement I correctly describes an IRS.

Statement II is correct - in an IRS the parties do not exchange the principal or the notional amounts as they are in the same currency and can be netted off, but in a currency swap the amounts are in different currencies that cannot be netted (not at least without doing a spot transaction simultaneously), and principals are exchanged.

Statement III is incorrect as the floating rate leg actually is subject to no risk as it resets itself to the current interest rate. The true risk is in the fixed leg which is sensitive to changes in interest rates.

Swaps carry counterparty risks just like any other OTC contract, therefore statement IV is false.

The objective of decisions relations to capital structure is to maximize the value to shareholders. The management of the company is entrusted with the job of maximizing shareholder value, and this objective is generally achieved by attempting to maximize enterprise value. Enterprise value includes the value of both debt and equity, and since debt has a fixed claim on the assets of the business, maximizing enterprise value also maximizes the value of equity.

The value of a business derives itself from the value of its cash flows, and not its capital structure. However, the availability of tax deductions on debt allow increasing the value of the business to equity holders by using the tax shield.

In the absence of taxes, there is no such advantage. Even if debt is nominally priced lower than the cost of equity, substituting debt for equity makes the remaining equity more risky and increasing the cost of equity to offset any advantage gained from the lower cost of debt. Changing the capital structure does not change the value of the firm, and this in essence is the conclusion of the Modigliani-Miller theorem.

Theta measures time decay, ie the change in value of the option with the passage of time. When the option is close to expiry, theta is very low as the value of the option is driven by intrinsic value rather than the time value. Therefore theta approaches zero as the option comes closer to expiry.