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< Answer
1. A reverse time spread option involves >
(a) Purchase and sell a call with the same time to maturity but different strike prices
(b) Sell a long period of time call and write another call with shorter time period to maturity, both
having same strike prices
(c) Purchase a long period of time call and write another call with shorter time period maturity, both
having same strike prices
(d) Purchase a call expiring in a short period of time and write another call with longer time period to
maturity, both having same strike prices
(e) Sell a short period of time call and write another call with longer time period to maturity, both
having same strike prices.
< Answer
2. An Indian exporter is exporting goods to his Japanese clients. The payment in Yen will be made on July >
01, 2006. The current spot rate is Rs.38.39/100¥. The exporter hedges the receivables by selling July
Yen futures. If Rupee appreciates in the spot market and basis remains unchanged till the payment is
received, which of the following condition must be true?
(a) Gain in the spot market is more than the gain in the futures market
(b) Gain in the futures market is more than the gain in the spot market
(c) Loss in the spot market is more than the gain in the futures market
(d) Loss in the futures market is equal to the gain in the spot market
(e) Loss in the spot market is equal to the gain in the futures market.
< Answer
3. If speculators believe interest rates will _______, they would consider ______ a T-bill futures contract >
today.
(a) Increase; selling (b) Increase; buying
(c) Decrease, selling (d) Decrease; selling a call option on
(e) Increase; purchasing a call option on.
< Answer
4. Costs involved in increased precautions and limits on the risky activities in order to reduce the chances >
of recurrence of risk is known as
(a) Loss financing costs (b) Risk handling costs
(c) Loss control costs (d) Social costs
(e) Residual uncertainty costs.
< Answer
5. XYZ Corporation sells for Rs.35 per share; the SEP option series has exactly six months until >
expiration. At the moment, the SEP 35 call sells for Rs.3, and the SEP 35 put sells for Rs.1.40. What
annual interest rate is implied in the option prices?
(a) 5.62% (b) 6.49% (c) 7.89% (d) 9.81% (e) 10.58%.
< Answer
6. Which of the following statements is not true regarding Swap markets? >
(a) The swap deal cannot be terminated without the agreement of parties involved in the transaction
(b) The swap market is an exchange controlled market
(c) Swaps are not easily tradable
(d) Comparative advantage theorem used in swap market is illusionary
(e) It is difficult to identify a Counterparty to take opposite side of the transaction once a party has
approached the swap dealer with his requirements.
< Answer
7. Which of the following kinds of swap is useful to those users of fund that need funds immediately but >
do not consider the current rates of interest very attractive and feel that the rates may fall in future?
(a) Extendible Swap (b) Roller-Coaster Swap
(c) Putable Swap (d) Forward Swap
(e) Deferred Rate Swap.
< Answer
8. The cash flow hedge between an interest-bearing financial instrument and an interest rate swap is said >
to be effective if,
I. The financial instrument is not pre-payable.
II. The fair value of swap is positive at origin.
III. The principal amount and the notional amount of the swap matches.
IV. All variable rates of interest payments or receipts on the instrument beyond the swap term are
designated as hedged.
(a) Both (I) and (II) above (b) Both (I) and (III) above
(c) Both (III) and (IV) above (d) (I), (II) and (III) above
(e) (II), (III) and (IV) above.
< Answer
9. Which of the following is not a derivative financial instrument according to FASB–133? >
(a) Interest only obligations (b) Letters of credit
(c) Note issuance facility (d) Forward rate agreements
(e) Interest rate indexes.
< Answer
10. Mr. Shyam has written APR 06 call option with strike price of Rs.45, priced at Rs.5 and purchased JUN >
06 call option with strike price of Rs.45, priced at Rs.6. Under which of the following situation the
investor will make profit on both the calls?
(a) Stock price remains below Rs.50 until April, 06 and then starts increasing
(b) Stock price remains above Rs.45 until April, 06 and then starts decreasing
(c) Stock price remains below Rs.45 until April, 06 and then starts increasing
(d) Stock prices remains above Rs.44 until June, 06 and then starts decreasing
(e) Stock prices remains below Rs.51 until June, 06 and then starts increasing.
< Answer
11. Which of the following statements is not true? >
(a) Delta of call will be most sensitive to change in the stock prices, when the underlying stock prices
approaches the exercise price
(b) For a put option that is near-the-money gamma decreases as expiration approaches
(c) Rho will be lower for deep-out-of-the-money call option
(d) Vega will be highest for a near-the-money put option
(e) Normally, theta is always less then zero.
< Answer
12. If a risk less portfolio can be constructed by combining 500 long call options on TTK Ltd. with a short >
position of 100 shares of TTK Ltd. Which of the following statements is true?
(a) The option’s hedge ratio is 0.20
(b) The option’s lambda is 0.5213
(c) The option’s delta is 5.00
(d) The option’s theta is 5.00
(e) The option’s gamma is 0.25.
< Answer
13. If a day’s temperature is 720 F, then Heating Degree Days (HDD) index is >
(a) – 7 (b) –5 (c) 0 (d) 5 (e) 7.
< Answer
14. The contract size for futures contracts on weather derivatives in CME is >
(a) $1 million
(b) $100 times the CME Degree Day Index
(c) $ 200 times the CME Degree Day Index
(d) 100 future contracts
(e) 20 future contracts.
< Answer
15. In a single period binomial option-pricing model, the underlying stock is currently selling for Rs.80 and >
will rise or fall by 15% over the next period. A call option with an exercise price of Rs.95 would have a
premium of
(a) Zero (b) Rs.3 (c) Rs.5 (d) Rs.8 (e) Rs.15.
< Answer
16. Which of the following statements is not true with respect to Value At Risk (VAR)? >
(a) Prices may not respond in a linear fashion to change in the market variables, resulting in erroneous
measurement by VAR
(b) Intra-day positions are considered in VAR
(c) It is based on the past data
(d) It focuses on single arbitrary point
(e) Firms with market risk measurement systems which apply portfolio diversification theory can
lower their risk with the use of VAR.
< Answer
17. Which of the following is an implied warranty in Marine Insurance? >
(a) The ship will sail on a particular day
(b) The ship is neutral and will remain so during the voyage
(c) The ship is seaworthy on a particular day
(d) The ship is not overloaded or badly loaded
(e) The ship will proceed to the destination without any deviation.
< Answer
18. The road transit insurance policy ceases _____ days after arrival of lorry at the destination named in the >
policy.
(a) 3 (b) 7 (c) 10 (d) 14 (e) 30.
< Answer
19. Options in inter-bank market are quoted in terms of >
(a) Explicit volatility (b) Historical volatility
(c) Future volatility (d) Implied volatility
(e) Market volatility.
< Answer
20. Which of the following statements does not explain the fact that mispricing or arbitrage opportunities in >
stock index persist for a short period of time?
(a) Large orders are not guaranteed and any price or prices can change quickly
(b) There can be a potential tracking error
(c) There is a dividend risk
(d) There is transaction costs involved in the trading
(e) It is easy to duplicate the underlying stocks comprising the index.
< Answer
21. The discount yield on a 90-day T-bill futures of remaining maturity 60 days and size $1,000,000, traded >
on IMM at $992,417 is
(a) 4.45% (b) 4.50% (c) 4.55% (d) 4.60% (e) 4.65%.
< Answer
22. An investor has taken long position in Microsys stock for Rs.6,00,000. The beta of the stock is 1.5. To >
hedge its position against the market movement, what would be the appropriate action?
(a) Short on index futures for Rs.4,00,000
(b) Short on index futures for Rs.6,00,000
(c) Long on index futures for Rs.6,00,000
(d) Short on index futures for Rs.9,00,000
(e) Long on index futures for Rs.4,00,000.
< Answer
23. If the previous fixed day payment date and forthcoming fixed day payment date are 01-08-2005 and 01- >
03-2006, then fixed day count fraction as per 30/360 convention will be
(a) 208/360 (b) 209/360 (c) 210/360 (d) 212/360 (e) 214/360.
< Answer
24. Which of the following statements is/are not true regarding portfolio insurance? >
I. It is a dynamic hedging strategy which uses stock index future.
II. It implies buying and selling securities periodically in order to maintain limit of the portfolio
value.
III. The working of portfolio insurance is similar to buying an index call option.
IV. Portfolio insurance can be done by using listed index options.
(a) Only (II) above (b) Only (III) above
(c) Both (I) and (IV) above (d) Both (II) and (III) above
(e) (I), (II) and (IV) above.
< Answer
25. An order to execute a transaction at the best available price, when the market reaches a price specified >
by the customer is called
(a) Market Order (b) Market-if-touched Order
(c) Market on close Order (d) Stop-loss Order (e) Not held Order.
< Answer
26. Which of the following is/are not true with respect to US T-bill futures and Eurodollar futures quoted in >
US exchanges?
I. Unlike Eurodollar futures, T-bill futures are cash settled.
II. Eurodollar future contract is a future contract on an interest rate whereas T-bill future contract is a
future contract on price of a T-bill.
III. Minimum tick size for both the contracts is 10 basis points each.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (II) and (III) above
(e) Both (I) and (III) above.
< Answer
27. An investor buys a strap using July call of 140 with a premium of Rs.5 and July put of 140 with a >
premium of Rs.6. What will be the break-even points for the strategy?
(a) Rs.124 and Rs.148 (b) Rs.136 and Rs.145
(c) Rs.134 and Rs.150 (d) Rs.131.5 and Rs.157
(e) Rs.123 and Rs.147.5.
< Answer
28. A US exporter is exporting goods to his Australian client. On September 14, 2005, the exporter got >
confirmation from the Australian importer that the payment of AUS$6,00,000 will be made on
November 1, 2005. The exporter uses futures market to cover the exchange risk. On September 14,
2005, the spot exchange rate is 0.7462$/AUS$ and December futures contract rate is 0.7497$/AUS$. If,
on November 1, 2005 the spot exchange rate is 0.7446$/AUS$ and December futures rate is
0.7481$/AUS$, what will be US$ cash flow to the exporter?
(a) $4,45,800 (b) $4,46,760 (c) $4,47,720 (d) $4,47,960 (e) $4,48,860.
< Answer
29. A savings and loan association has long-term fixed-rate mortgages financed by short-term funds. It >
hedges by selling Treasury bond futures. If interest rates decline, and many mortgages are prepaid,
(a) The gain on the futures contracts offsets the loss on the mortgages
(b) The gain on the mortgages offsets the loss on the futures contracts
(c) The gain on the futures contracts more than offsets any unfavorable effects on mortgages
(d) A loss on the futures contracts more than offsets the favorable effect on the mortgage portfolio
(e) The loss on the mortgages offset by the gain on the futures contracts.
< Answer
30. Assume that a futures contract on Treasury bonds with a face value of $100,000 is purchased at 93-00. >
If the same contract is later sold at 94-18, what is the gain, ignoring transactions costs?
(a) $1,180,000 (b) $118 (c) $11,800 (d) $15,625 (e) $1,562.50.
END OF SECTION A
Section B : Problems (50 Marks)
• • This section consists of questions with serial number 1 – 5.
• • Answer all questions.
• • Marks are indicated against each question.
• • Detailed workings should form part of your answer.
• • Do not spend more than 110 - 120 minutes on Section B.
1. On September 16, a London bank needs to issue $10 million for 180-day Eurodollar time deposits. The current
rate on such deposits is 8.75%. The bank is considering the alternative of selling a Eurodollar futures contract and
issuing a 90-day time deposit and rollover it.
The following data is available for 90-day time deposit and Eurodollar future contract:
4. A European company has decided to take a 5-year floating rate loan of $250 million to finance its acquisition. The
loan is indexed to 6 months LIBOR with a spread of 50 basis points.
The company has identified the following caps and floors quoted by a European bank:
Term Cap Floor
5-years 5-years 5-years 5-years
Underlying interest rate 6-m LIBOR 6-m LIBOR 6-m LIBOR 6-m LIBOR
Strike rate 3.0% 3.5% 3.0% 3.5%
Premium 2.0% 1.5% 1.2% 2.0%
Face value $250million $250 million $250million $250 million You are
required to state how the company can hedge its interest rate exposure by using an interest rate Collar strategy.
Also calculate the effective cost of the loan showing all the relevant cash flows if the 6 months LIBOR at the 10
reset dates turn out to be: 3.60%, 4.00%, 3.55%, 3.40%, 2.90%, 2.80%, 2.65%, 2.75%, 3.00% and 3.25%.
(Use a discount rate of 4% to amortize the premium)
(10 marks) < Answer >
5. Excel Export Inc. (EEI) of US has a one-month forward currency contract to sell AUS$ 310 million at the forward
rate of AUS$1.58/US$. The spot rate is AUS$1.55/US$. The 1-month interest rate for US$ is 5% p.a. and the 1-
month interest rates in AUS$ is 7.30% p.a. The annual volatility of the AUS$/US $ exchange rate is 6.04%. The
yield volatility of 1-month remaining maturity zero coupon AUS$ bond is 1.32% p.a. and the yield volatility of 1-
month remaining maturity zero coupon dollar bond is 1.88% p.a. The correlation of returns between two bonds is
0.55.
You are required to compute 1-day VAR for the forward contract at 99% confidence level using
variance/covariance approach. (Assume 250 days in a year).
(10 marks) < Answer >
END OF SECTION B
Suggested Answers
Financial Risk Management - I (231) : April 2006
Section A : Basic Concepts
1. Answer : (d) <
TOP
Reason: The reverse time spread options >
On December 16: - The 90-day time deposit issued on Sep. 16 will mature and thus, bank will
have to pay
90
10, 000, 000 1 0.0825
360 = $10,206,250
Thus, the effective annual borrowing rate for the company will be
365
10426438 180
1 100
10000000
= 8.84% p.a.
Thus, bank should raise the funds by selling Eurodollar future contract and issuing 90-day time
deposit and rollover it as the effective cost of fund for this alternative less by 23 basis point
than alternative-I.
< TOP >
4. The company should go for interest rate collar i.e. it should buy the cap at a higher strike rate
and sell the floor at the lower strike rate. Therefore, the company should buy cap at the strike
rate of 3.5% and sell floor at the strike rate of 3.0%.
Net premium outflow = (1.5% – 1.2%) of $ 250 million
= $ 750,000
$750, 000 750, 000
=
PVIFA(2.00%,10) 8.9826
Amortization of premium =
= $ 83,495
Cash
Time LIBOR Cash flow Amortization Cash flow flow Net
semester (%) on loan of premium from Cap from cash flow
floor
0 250,000,000 250,000,000
1 3.60 – – 83,495 +125,000 – 5,083,495
5,125,000
2 4.00 – 5,625,000 – 83,495 +625,000 _ 5,083,495
3 3.55 – 5,062,500 –83,495 +62,500 _ 5,083,495
4 3.40 – 4,875,000 –83,495 – _ 4,958,495
5 2.90 – 4,250,000 –83,495 – -125,000 4,458,495
6 2.80 – 4,125,000 –83,495 _ –250,000 4,458,495
7 2.65 – 3,937,500 –83,495 _ –437,500 4,458,495
8 2.75 – 4,062,500 –83,495 _ –312,500 4,458,495
9 3.00 – 4,375,000 –83,495 _ – 4,458,495
10 3.25 – 4,687,500 –83,495 _ – 254,770,995
–
250,000,000
Effective cost ‘r’ is given by the following equation:
250,000,000 = 5,083,495 PVIF (r, 1) + 5,083,495 PVIF (r, 2)
+ 5,083,495 PVIF (r, 3) + 4,958,495 PVIF (r, 4)
+ 4,458,495 PVIF (r, 5) + 4,458,495 PVIF (r, 6)
+ 4,458,495 PVIF (r, 7) + 4,458,495 PVIF (r, 8)
+ 4,458,495 PVIF (r, 9) + 254,770,995 PVIF (r, 10)
Therefore, r = 1.90%
∴ Annualized rate = 3.80%
< TOP >
5. EFI will sell AUS$310 million at a 1-month forward rate of AUS$1.58/$ to buy US$.
At forward rate, AUS$310 million = $310/1.58 million = $196.20 million
The forward position can be broken down into the following two positions:
310
=
1 + 0.073
i. Going short on 1-month zero-coupon AUS$ bond at AUS$308.13 million 12 ,
where maturity value is AUS$310 million.
196.20
=
1 + 0.05
ii. Going long on 1-month zero-coupon US$ bond at $ 195.39 million 12 , where
maturity value is US$ 196.20 million. The value of this bond in AUS$ is AUS$302.85
million at spot market.
For AUS$, yield volatility = 1.32%
Duration = 0.083 year
Yield = 7.30%
0.083
Modified duration = 1.073 =
0.0774
Delta yield = Yield × Yield volatility
= 7.30 × 1.32
= 9.636%
= $0.0941
The standard deviation of portfolio value for 1-day
1
0.09412 + 0.09222 − 2 × 0.55 × 0.0941× 0.0922 2
=
= $0.0884 million
1-day VAR at 99% confidence level
= 0.0884 × 2.33
= $ 0.2060 million.
< TOP
>