[According to the PRMIA study guide for Exam 1, Simple Exotics and Convertible Bonds have been excluded from the syllabus. You may choose to ignore this question. It appears here solely because the Handbook continues to have these chapters.]
Which of the following best describes a shout option
The objective function satisfying the mean-variance criterion for a gamble with an expected payoff of x, variance var(x) and coefficient of risk tolerance is is:
A)
B)
C)
D)
Choice 'd' represents the mean-variance function to be maximized for selecting between mutually exclusive gambles. The other choices are incorrect.
(The mean-variance criterion is a fairly complex subject, and this question is only intended to make sure that you know, and can identify the function that is being maximized. A complete explanation/derivation of the mean-variance criterion, that links together expected returns, volatility and the risk tolerance of the investor to arrive at the efficient frontier is beyond the scope of the PRM syllabus.)
Which of the following is true about the early exercise of an American call option:
Generally, it is not a good idea to exercise an option early as any more upside in the remaining period to expiry is being sacrificed. However, if an extraordinarily large dividend is coming due, and this dividend is larger than the interest foregone from holding the option, it may be a good idea to exercise the option early. In such cases, the exercise needs to happen before the ex-dividend date and not afterwards. Choice 'b' is therefore the correct answer.
Even if the option is deep in the money and delta is approaching 1, and exercise upon maturity is almost a certainty, it would still always be better to sell the option than exercise it . Therefore Choice 'a' is incorrect. Choice 'c' is correct in all cases except when a large dividend is coming in. Choice 'd' is not correct because an early exercise needs to happen prior to the ex-dividend date and not afterwards.
Which of the following statements is true:
1. On-the-run bonds are priced higher than off-the-run bonds from the same issuer even if they have the same duration.
II. The difference in pricing of on-the-run and off-the-run bonds reflects the differences in their liquidity
III. Strips carry a coupon generally equal to that of similar on-the-run bonds
IV. A low bid-ask spread indicates lower liquidity
On-the-run bonds yield less, and therefore are priced higher than similar off-the-run bonds. The difference in their pricing reflects the fact that on-the-run bonds are more liquid than off-the-run bonds. Therefore statements I and II are correct. Bonds are on-the-run when they are issued, and change hands frequently, and over time as they become 'seasoned', newer bonds take their place as on-the-run bonds making them off-the-run.
Strips are zero coupon instruments, and do not carry any coupon. Therefore statement III is not correct.
A lower bid-ask or bid-offer spread indicates lower transaction costs and is a result of greater liquidity. A higher bid-ask spread results for less liquid securities. Therefore statement IV is not correct.
If the CHF/USD spot and 3 month (91 days) forward rates are 1.1763 and 1.1652, what is the annualized forward premium or discount?
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.
