Best Quality PRMIA 8006 Exam Questions Exam4Free Realistic Practice Exams [2021]
Critical Information To Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition Pass the First Time
NEW QUESTION 62
Theta for a call option:
- A. approaches 1 as the expiration date draws closer
- B. approaches 0 as the expiration date draws closer
- C. approaches -1 as the expiration date draws closer
- D. approaches as the expiration date draws closer
Answer: B
Explanation:
Explanation
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.
NEW QUESTION 63
LIBOR is determined by the:
- A. LIFFE
- B. BBA
- C. EUREX
- D. FSA
Answer: B
Explanation:
Explanation
The London Interbank Offered Rate (LIBOR) is published by the British Bankers' Association (BBA). The BBA polls the rates offered by at least eight banks drops the top and bottom quartile, and averages the middle two quartiles of the rates to arrive at the LIBOR.
NEW QUESTION 64
Which of the following statements are true for a portfolio of two assets:
I. Given volatility, weights and correlation, combined standard deviation cannot be calculated without additional information on covariances.
II. When the two assets are perfectly negatively correlated, the standard deviation of the combined portfolio is just the weighted average of their standard deviations, weighted by their weights in the portfolio.
III. When the two assets are uncorrelated, the standard deviation of the combined portfolio is just the weighted average of their standard deviations, weighted by their weights in the portfolio.
IV. When the two assets are perfectly positively correlated, the standard deviation of the combined portfolio is just the weighted average of their standard deviations, weighted by their weights in the portfolio.
- A. II and IV
- B. IV
- C. All of the above
- D. I and III
Answer: B
Explanation:
Explanation
Given volatility, weights and correlation, we do not need any additional information on covariances - and therefore statement I is incorrect.
To evaluate the other statements, consider the formula for portfolio variance (recalling that standard deviation is just the square root of the variance) portfolio_var_diff_corr Statement II is incorrect because this statement describes what the standard deviation of the portfolio would be if the assets were to be perfectly positively correlated (here they are negatively correlated).
Statement III is incorrect. When the two assets are uncorrelated (ie correlation = 0), the combined standard deviation is the square root of the weighted sum of variances, where the squares of the asset weights are used as weights (see formula above).
Statement IV is correct. When the assets are perfectly positively correlated, they are effectively the same asset and the combined standard deviation of a portfolio of such assets is nothing but the sum of their weighted standard deviations.
Also refer to the tutorial (and the Excel model - you will find it under Exam 2) for portfolio variances to see how portfolio volatility behaves when correlations are -1, 0 or +1.
NEW QUESTION 65
Which of the following is one of the basic axioms on which the principle of maximum expected utility is based:
- A. Transportation of choice
- B. Cognitive bias
- C. Stochastic dominance
- D. Utility maximization
Answer: C
Explanation:
Explanation
Given a choice, decision makers will maximize expected utility. The four basic axioms on which the principle of maximizing expected utility is based are:
- Transitivity of choice,
- Continuity of choice,
- Independence of choice, and
- Stochastic dominance.
NEW QUESTION 66
Which of the following statements are true:
I. A credit default swap provides exposure to credit risk alone and none to credit spreads II. A CDS contract provides exposure to default risk and credit spreads III. A TRS can be used as a funding source by the party paying LIBOR or other floating rate IV. A CLN is an unfunded security for getting exposure to credit risk
- A. II and IV
- B. I, III and IV
- C. II and III
- D. II, III and IV
Answer: C
Explanation:
Explanation
A CDS contract provides exposure to default risk and the credit spread for a particular credit. It does not provide an exposure to the risk of interest rates going up or down. It is an instrument that allows institutions to take a view on the price of credit risk alone. Therefore statement I is false and statement II is true.
A total return swap (TRS) exchanges the return from an asset for a fixed or floating exchange rate. It is in essence a financing arrangement where one party pays the other interest to earn a return on an asset that it does not wish to hold itself, perhaps for liquidity reasons. The financed asset is held by the party paying the asset's returns, effectively creating a 'collateral'. Therefore statement III is correct.
A credit linked note is a funded instrument where the sellers of the protection have put up the money upfront in the form of a subscription to a note in case the credit losses are realized. Therefore statement IV is not correct.
NEW QUESTION 67
Which of the following statements are true:
I. Cash markets tend to be more liquid than derivative markets
II. A higher credit risk is associated with lower liquidity in times of crises III. A higher bid-ask spread indicates greater liquidity when compared to a lower bid-ask spread IV. A higher normal market size indicates greater liquidity than a lower market size
- A. I, III and IV
- B. I, II and III
- C. II, III and IV
- D. II and IV
Answer: D
Explanation:
Explanation
The existence of derivative markets actually drives liquidity out of cash markets into derivative markets.
Derivative markets are far more liquid than cash markets. Therefore statement I is not correct.
In times of crises, instruments or financial products bearing greater credit risk lose liquidity rapidly. Therefore statement II is correct.
A higher bid-ask spread indicates lower liquidity, not greater liquidity. Therefore statement III is false.
Normal market size (NMS) refers the 'normal' transaction size for which a dealer's quote is valid. A higher NMS is associated with greater liquidity, therefore statement IV is correct.
NEW QUESTION 68
The rule that optimal portfolios will maximize the Sharpe ratio only applies when which of the following conditions is satisfied:
I. It is possible to borrow or lend any amounts at the risk free rate
II. Investors' risk preferences are fully described by expected returns and standard deviation III. Investors are risk neutral
- A. I and II
- B. I, II and III
- C. II
- D. I and III
Answer: A
Explanation:
Explanation
The Sharpe ratio does not require investors to be risk neutral, only that for a given level of returns they prefer less risk to more risk. (Risk neutral means that investors are indifferent to the level of risk, and are only driven by a desire to maximizing expected value, regardless of risk levels.) The ability to borrow and lend any amounts of money at the risk free rate is a fundamental assumption for the rule that optimal portfolios will maximize the Sharpe ratio.
This rule also assumes that risk preferences are completely described by return and standard deviation of returns.
Therefore Choice 'd' is the correct answer as statements I and II are correct.
NEW QUESTION 69
Credit risk in the case of a CDO (Collateralized Debt Obligation) is borne by:
- A. The reference entity
- B. The Special Purpose Vehicle (SPV)
- C. Investors
- D. The sponsoring institution
Answer: C
Explanation:
Explanation
Investors in CDOs bear credit risk. The SPV is merely a conduit that owns the underlying assets on which the sponsoring institution has bought protection. The investors have sold them this protection, and are on the hook for defaults or other credit events. The reference entity is relevant only to CDSs, not CDOs. Choice 'b' is the correct answer.
NEW QUESTION 70
Determine the enterprise value of a firm whose expected operating free cash flows are $100 each year and are growing with GDP at 2.5%. Assume its weighted average cost of capital is 7.5% annually.
- A. $2,000
- B. $4,000
- C. $1,000
- D. $1,333
Answer: A
Explanation:
Explanation
The operating free cash flows can be considered a perpetual annuity with a given growth rate.
The value of a perpetuity of a periodic cash flow of 'c', with a discount rate 'r' and growth rate 'g' is given by c/(r - g). In the given case, the company can be considered as providing a perpetual annuity which provides an annual cash flow of $100 which are growing at 2.5% (equal to the GDP's growth rate, as given), and whose cost of capital, or the discount rate to use, is 7.5% Therefore the value of the firm in this case is given by $100/(7.5% - 2.5%) = $2,000. Recall that the value of the firm is equal to the Operating Free Cash Flow/Weighted Average Cost of Capital (OFCF/WACC).
Therefore Choice 'd' is the correct answer.
NEW QUESTION 71
Continuously compounded returns for an asset that increases in price from S1 to S2 over time period t (assuming no dividends or other distributions) are given by:
- A. ln(S2/S1 - 1)
- B. (S2 - S1) / S1
- C. exp(S2/S1 - 1)*t
- D. ln(S2/S1)
Answer: D
Explanation:
Explanation
Choice 'd' is the correct answer. Continuously compounded returns are given by the log of S2/S1. The expression (S2 - S1)/S1 gives discrete returns, not continuously compounded returns.
Note that the question is only asking for the return over the given time period, not annualized returns. So t is not relevant here. If we had to find annualized returns, and t were expressed in years, then the annualized return would have been (1/t)*ln(S2/S1).
Also refer to the tutorial on interest rates and compounding for more information on continuously compounded rates.
NEW QUESTION 72
The risk of a portfolio that cannot be diversified away is called
- A. Portfolio risk
- B. Diversifiable risk
- C. Systematic risk
- D. Specific risk
Answer: C
Explanation:
Explanation
Systematic risk refers to market risk that cannot be diversified away. Specific risk relates to the unique risk from the securities selected in the portfolio, and these can be diversified away by adding other securities to the portfolio. Diversifiable risk is risk that can be diversified away, ie the same as specific risk. Portfolio risk is the total risk of the portfolio that includes both specific and systematic risk.
NEW QUESTION 73
Which of the following best describes a 'when-issued' market?
- A. The when-issued market is one where dealers trade in a security after its price has been set but before the bonds are available for delivery
- B. The when-issued market is one where securities are traded on the OTC forward markets prior to their issue
- C. where members of the syndicate bringing a bond issue to the market are obliged to not undercut the issue price till the first settlement date
- D. The when-issues market is one where the lead manager agreed to buy an entire bond issue at an agreed price, and having done so may sell them onwards to institutional or other investors
Answer: B
Explanation:
Explanation
Each of the choices describes various scenarios related to the issue of bonds. A when-issued market is a market in government securities where securities are traded as forward contracts prior to their issue. Choice 'c' is the correct answer.
Choice 'd' refers to a 'bought deal'. Choice 'b' refers to the 'grey market', usually in corporate bonds. Choice 'a' refers to a fixed price re-offer mechanism.
NEW QUESTION 74
A 'consol' is a perpetual bond issued by the UK government. Its running yield is 5%. What is its duration?
- A. 5 years
- B. Infinity
- C. 25 years
- D. 20 years
Answer: D
Explanation:
Explanation
The duration of a perpetuity is 1/running yield. Therefore the correct answer is 1/.05 = 20 years
NEW QUESTION 75
When graphing the efficient frontier, the two axes are:
- A. Portfolio return and market standard deviation
- B. Asset beta and standard deviation of the market portfolio
- C. Portfolio return and portfolio standard deviation
- D. Expected return and asset's beta
Answer: C
Explanation:
Explanation
The efficient frontier is plotted on a graph with portfolio return (mean) as the y-axis and portfolio volatility, or standard deviation, on the x-axis. Asset beta and standard deviation of the market portfolio have nothing to do with the determination of the efficient portfolio.Therefore Choice 'd' is the correct answer, and the rest of the choices are incorrect.
NEW QUESTION 76
The gamma in a commodity futures contract is:
- A. dependent upon the convexity
- B. zero
- C. always negative
- D. parabolic
Answer: B
Explanation:
Explanation
Futures contracts carry no gamma. Only options have gamma. Choice 'a' is the correct answer. Any instrument whose price varies in a linear fashion with respect to the underlying will have gamma equal to zero.
NEW QUESTION 77
A borrower who fears a rise in interest rates and wishes to hedge against that risk should:
- A. Go short an FRA
- B. Buy fed futures
- C. Go long an FRA
- D. Sell T-bill futures
Answer: C
Explanation:
Explanation
T-bill futures and fed futures are very short term futures contracts, and unlikely to provide much of a hedge against a rise in interest rates. FRAs however are customized and would be the right instrument for the borrower to hedge his interest rate risk. A long FRA position gives him the right to borrow at an agreed rate in the future. This rate will not change regardless of the changes in interest rates, and therefore Choice 'b' is the correct answer.
NEW QUESTION 78
Which of the following is NOT an assumption underlying the Black Scholes Merton option valuation formula:
- A. There are no transaction costs
- B. There is no credit risk
- C. The option can be exercised at any time up to expiry
- D. Volatility of the underlying and the risk free interest rate is constant
Answer: C
Explanation:
Explanation
All the choices listed are valid assumptions underlying the BSM option valuation formula except that the BSM formula is based upon the option being exercisable only at expiry. The assumption is that early exercise is not permitted. In other words, BSM applies to European options and not American options. Therefore Choice 'd' represents the correct answer as it is not an assumption underlying Black Scholes.
NEW QUESTION 79
The transformation line has a y-intercept equal to
- A. the risk-free rate
- B. the expected rate of return
- C. zero
- D. the expected portfolio standard deviation
Answer: A
Explanation:
Explanation
The transformation line represents the combination of a 'risky bundle' and the risk free asset. Investors can choose different combinations of these assets depending upon their risk appetite. The transformation line meets the y-axis (portfolio returns) at the point equal to the risk free rate. Choice 'b' is the correct answer and the rest are incorrect.The highest possible transformation line, ie the transformation line with the maximum slope, is the transformation line joining the risk free rate on the y-axis and the portfolio with the maximum Sharpe ratio on the efficient frontier. This line is called the 'capital markets line'. Investors can pick any point on this line according to their risk appetite, and doing so would maximize the return they can obtain for their desired level of risk. The capital markets line is tangential to the efficient frontier. The Sharpe ratio stays constant throughout the CML.
NEW QUESTION 80
A portfolio is considered 'dominated' if
- A. it has a standard deviation higher than the minimum achievable standard deviation
- B. it has a higher mean and the same or lower standard deviation than any other portfolio
- C. its returns are uncorrelated to market returns
- D. there is at least one other portfolio with a higher mean and the same or lower standard deviation
Answer: D
Explanation:
Explanation
A portfolio is considered dominated when it is not on the efficient frontier, which is another way of saying that there exists another portfolio with a better risk reward payoff. Therefore Choice 'a' is the correct answer.If the portfolio has a higher mean and the same or lower standard deviation than any other portfolio, this means it is already on the efficient frontier and is not dominated. The other choices do not make any sense in the context of the question.
NEW QUESTION 81
Backwardation can happen in markets where
- A. convenience yields are positive
- B. convenience yield is less than the total interest and carrying costs
- C. convenience yields are greater than the total interest, storage and other carrying costs
- D. convenience yields are zero
Answer: C
Explanation:
Explanation
Convenience yield is the benefit from having access to the commodity - and if the convenience yield is very high, for example in a market where manufacturers must never run out of a particular raw material, then these can switch the total cost of carry (which include interest and storage costs, less convenience yields) to being negative. This causes forward prices to become lower than spot prices, a phenomenon known as backwardation.
Therefore Choice 'b' is the correct answer. If convenience yields are less than other carrying costs, then backwardation will not happen. The sign of convenience yields does not matter, what matters is their relative magnitude when compared to the other costs of carry.
To understand this in an intuitive way, consider that forward prices are nothing but spot prices, plus interest, plus storage costs, less convenience yields. If interest and storage costs are less than the convenience yield, the market will be backwarded.
NEW QUESTION 82
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