8006 Exam Dumps - Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

Explanation:

The correct answer is the index value times the contract size, in this case 1500 x 50.

One way to think about index futures is this: Consider equity index trading as trading in the shares of a company whose share price is equal to a number of dollars which is the same as the index. If the 'contract multiplier' for a index futures contract is 50, that means the futures contract is for 50 shares of such a fictitious company. Therefore the notional value of the contract will be 15000 x 50, and Choice 'a' is the correct answer.

Fixed income instruments go through the 'pull-to-par' phenomenon as they get closer to maturity. In this case, since interest rates stay constant, the bond will rise in price over the year to get closer to its redemption value. Of course, you can apply the standard discounting logic as well to say that while one year's coupon payment drops off, the remaining years' cash flows get discounted for a year less and the value would go up. However it is just easier to remember that at maturity the bond will be close to its notional or face value, and therefore if it is selling at a discount now, it will rise in value over its remaining life to get to the face value.

Exactly the reverse logic would apply to bonds sold at a premium, they would decline in value over time as to get to the par value at maturity.

The square root of time rule can be used to convert, say a 1-day volatility to a 10-day volatility, by multiplying the known volatility number by the square root of time to get the volatility over a different time horizon. However, there are key assumptions that underlie the application of this rule, and statements I to III correctly state those assumptions. If serial correlations (whether negative or positive) exist, then asset returns are not independent as they are affected by the prior day or prior period's returns, and we cannot use the square root of time rule. Therefore Choice 'd' is the correct answer.

In order to use the 'square root of time' rule, asset returns should be iid, volatility should stay constant (ie there should be no volatility clustering), and no serial correlations (ie the returns of one day should not be affected by the returns of the prior periods). Choice 'd' is the correct answer.

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.

When hedging one fixed income security with another, the question as to how much of the hedge to buy (or sell) (ie the hedge ratio) for a given primary position is determined by their respective basis point values, which in turn are determined by their duration. Therefore, when hedging a long maturity bond with a PV01 of $3 with a short maturity bond that has a PV of $1, we will need to buy 3 times the notional value of the short maturity bond to achieve the same sensitivity to interest rates as the longer maturity bond.

Additionally, we may also expect the interest rates on the hedge to move differently from the interest rates on the primary instrument being hedged, and this needs to be accounted for as well as part of the hedge ratio calculation. This is called the yield beta and is calculated as change in yield for primary position/change in yield for the hedge security.

The hedge ratio is determined both by the yield beta and the BPVs of the two securities. Choice 'd' is the correct answer.

The change in the price of the bond will be equal to $100* (-11*0.1% + 0.5* 80 *(0.1%)^2) = -1.096. Therefore the new price will be $100 - 1.096 = $98.904. Thus Choice 'd' is the correct answer, the rest are incorrect.

Note that the change in the price of a bond if you are given modified duration is convexity is given by the formula P * (-Duration*δi + 0.5*Convexity*(δi)^2); where δi is the change in interest rates. 10 basis points equal 0.1%, or 0.001.

Treasury bond futures do not specify which bond can be used to effect delivery, but allow the seller to pick from a number of available bonds. As a result, one of these eligible bonds emerges as being the 'cheapest' to deliver, and this CTD bond is determined by the basis between the cash price of the bond and the futures spot price as adjusted by the conversion factor for this specific bond. (ie, basis = Cash Price of the Bond - Futures Price x Conversion Factor)

The bond with the lowest basis is generally the CTD - therefore Choice 'c' is the correct answer.

From the put-call parity, we know that Call - Put = Stock - Bank deposit. Since the bank deposit has a zero delta, and the delta of the Stock itself is 1, we get the relationship Delta of Call - Delta of Put = 1. Therefore, if the delta of a call option is 0.3, the delta of the corresponding put option is 0.3 - 1 = -0.7