Pass the PRMIA PRM Certification 8006 Questions and answers with CertsForce

An out of the money convertible security behaves just like a regular debt security as the option is near worthless. Therefore it is affected by changes in interest rates and the credit risk of the issuer, and unaffected by changes in the prices or volatility of the issuer's shares (the underlying).

The LIBOR square is a (rare) derivative contract which pays, as mentioned in the question, the square of the interest rate move between two dates. If LIBOR at inception is y, and upon settlement is x, the contract pays (x - y)^2 for x > y; and -(x - y)^2 for x < y.

For any question that involves calculating delta or gamma, and the payoff is described in terms of variables as is the case here, remember that delta is always the first derivative and gamma is the second derivative. For this question, let us calculate the second derivative and see what the gamma is:

If x > y, then the payoff is (x - y)^2

The first derivative wrt x is 2(x - y)

The second derivative wrt x is 2.

ie, the gamma is 2

If x < y, then the payoff is -(x - y)^2

The first derivative wrt x is -2(x - y)

The second derivative wrt x is -2.

ie, the gamma is -2

If x = y, then the payoff is 0. Both the first and the second derivatives are zero. ie the gamma is 0.

Based on the above, we see that the contract can have a gamma of either 0, +2 or -2. 1 is not a possible value for gamma, and therefore Choice 'b' is the correct answer.

Forward premium or discount can be easily calculated as {(Forward rate - Spot rate) / Spot rate x 365/number of days]. In this case, it can be calculated as =((1.1652 - 1.1763) / 1.1763 ) * 365/91 = 3.785%, which is a discount as it is a negative number. It can also be interpreted as a discount as the forward price is lower than the spot price.

A money market security is one that is initially issued with a maturity of less than one year. Treasury bills are short-term government securities with maturities ranging from a few days to 52 weeks. Bills are sold at a discount from their face value, and do not carry a coupon. Treasury notes and treasury bonds are not money market instruments as they are issued for a maturity greater than a year. Treasury notes are issued with maturities of 2, 3, 5, 7, and 10 years and pay interest every six months. Treasury bonds pay interest every six months and mature in 30 years.

Commercial paper is issued by corporations to meet their short term funding needs and is a money market instrument. Bankers' acceptances are short term loans to corporations that are guaranteed by a bank.

Of the given list, since treasury notes are the only instrument that are not money market securities, Choice 'a' is the correct answer.

Explanation:

The BSM formula assumes that prices are lognormally distributed. Therefore Choice 'b' does not represent a valid assumption underlying Black Scholes. All other choices represent valid assumptions.

Explanation:

Notional principals are not exchanged at the start and the end of an FRA. In fact, if the notional principals were to be exchanged, it would increase credit risk and not decrease it by introducing settlement risk. Therefore Choice 'd' is incorrect.

All other choices correctly describe various aspects of an FRA.

The loss to the fund manager is $20*100 = $2,000. The initial margin placed was $5,000. After the loss is charged to his account, the margin balance is only $3,000 ($5,000 - $2,000). The margin to be maintained is $5,000. Therefore the margin call is $2,000.

Note that there would have been no margin call till the balance in the margin account had reduced to the 'maintenance' level of $4,000. So if the price had fallen by $5, and the loss had been $500, there would have been no margin call. But when the margin call would be made, it would require the balance to be brought up to the initial margin of $5,000 (and not the maintenance margin of $4,000).

The duration of a perpetuity is 1/running yield. Therefore the correct answer is 1/.05 = 20 years

Choice 'b' lists all the factors that affect the forward price of a physical asset and is the most complete answer. Forward prices for physical assets are not affected by volatility (only options are), nor are they arbitrarily decided by any prevailing 'views'.

The investor would benefit from the risk reversal and the bull spread as both these strategies have a payoff profile that benefit from rising prices of the underlying. The collar is the opposite of risk reversal, and benefits during a bear market, and the butterfly spread benefits when prices remain range bound. Therefore Choice 'c' is the correct answer.