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1997 Financial Risk Manager Examination

Session I
Saturday, October 25th, 1997
Copyright 1997 The Global Association of Risk Professionals (GARP)
98 North Broadway, Suite 292, Tarrytown, NY 10591 USA

Note: Only multiple choices questions are selected here. Short essay questions are not selected. The 1998 FRM Exam will have multiple choices questions only.

Quantitative Techniques

1. Suppose a risk manger has made the mistake of valuing a zero coupon bond using a swap (par) rate rather then a zero coupon rate. Assume the par curve is upward sloping. The risk manager is therefore:

a) indifferent to the rate used.
b) over-estimating the value of the bond.
c) under-estimating the value of the bond.
d) does not have enough information.

ANSWER: C

11. In pricing a foreign exchange option which expires in 21/2 years, a trader has volatilities for only 1 year (10%), 2 years (11%) and 4 years (9%). If he uses linear interpolation, what should the volatility of this option be?

a) 9.5%
b) 10.0%
c) 10.5%
d) 11.0%

ANSWER: C

12. A risk analyst is constructing a USD swap curve using future prices and swap yields. Which of the following approaches is appropriate?

a) Using the future prices and swap yields without any adjustments.
b) Adjusting the future prices only due to convexity effects in the market.
c) Adjusting the swap yields due to convexity effects in the market.
d) Adjusting both future prices and swap yields due to convexity effects in the market.

ANSWER: B

14. What is the implied correlation between JPY/DEM and DEM/USD when given the following volatilities for foreign exchange rates?

JPY/USD at 8%
JPY/DEM at 10%
DEM/USD at 6%.

a) 60%
b) 30%
c) -30%
d) -60%

                                                                                                                                                                                    ANSWER:     D
VaR(J/U) = VaR(J/D) + VaR(D/U)
               + 2std(J/D)std(D/U)
               Correl(D/U)
8² = 10²+6²+2(6)(10)x
x = -0.6
QED

17. The measurement error in VaR, due to sampling variation, should be greater with:

a) more observations and a high confidence level (e.g. 99%).
b) fewer observations and a high confidence level.
c) more observations and a low confidence level (e.g. 95%).
d) fewer observations and a low confidence level.

ANSWER: B

20. Which of the following statements about day count basis is true?

I. Rates computed using Actual/365 and Actual/Actual are exactly the same.
II. Rates computed using Actual/360 is always smaller than Actual/365.
III. Rates computed using 30/360 is closer to actual/360 then to actual/365.

a) I only
b) I and III only
c) I, II, and III
d) None of the above

ANSWER: D

21. The 9 month Banker's Acceptance is priced at a discount of 10% on Actual/360 basis and the 1- year Banker's Acceptance is priced at a discount of 11% on Actual/360 basis. What is the forward rate implied by those two instruments on 30/360 basis for the period from 9 months to 1 year?

a) 17.0%
b) 13.2%
c) 12.0%
d) 10.5%

ANSWER: B

Market Risk

7. Commercial rental property is usually financed with long term debt. What is the primary purpose of such financing?

a) To reduce interest rate exposure.
b) To closer match the cashflows.
c) To match assets and liabilities.
d) All of the above

ANSWER: D

10. Which currency pair would you expect to have the lowest volatility?

a) USD/DEM
b) USD/CAD
c) USD/JPY
d) USD/ITL

ANSWER: B

12. Which of the following products should have the highest expected volatility?

a) Crude oil
b) Gold
c) Japanese Treasury Bills
d) DEM/CHF

ANSWER: A

15. A measure of sensitivity of a bond's price to changes in yield is:

a) bond VaR.
b) modified duration.
c) yield spread.
d) convexity.

ANSWER: B

16. The risk of a stock or bond which is NOT correlated with the market (and thus can be diversified) is known as:

a) interest rate risk.
b) FX risk.
c) model risk.
d) specific risk.

ANSWER: D

17. A 100-year bond issue often yields only a few basis points above a similar 30-year bond from the same issuer. The reason for such a small spread is usually that a 100-year bond:

a) has a high duration.
b) is always callable.
c) has a high convexity.
d) has a low volatility.

ANSWER: C

(High convexity implies option value; this offsets risk from long maturity)

18. As compared with an identical bond without the call feature, a fixed rate coupon bond trading at par, in which the issuer has the right to pay back the principal at some day prior to maturity, has a:

a) higher convexity.
b) lower convexity.
c) higher duration.
d) lower volatility.

ANSWER: B

20. A ten year 8% coupon callable bond is priced at 103.25. The value of the imbedded call option has been calculated to be 3.25. Non-callable bonds of equal quality and maturity are currently yielding 7.50%. What is the option-adjusted yield spread between this bond and an equivalent straight bond?

a) 37 bp.
b) 50 bp.
c) 72 bp.
d) It cannot be determined from the information given.

ANSWER: B

21. What is the modified duration of a five-year zero coupon treasury bond?

a) Less than four years
b) Between four and five years
c) Five years
d) Greater than five years

ANSWER: C

23. Identify the MAJOR risks of being short 50M USD of gold two weeks forward and being long 50M USD of gold one year forward.

I. Gold Liquidity Squeeze
II. Spot Risk
III. Gold Lease Rate Risk
IV. USD Interest Rate Risk

a) II only
b) I, II, and III only
c) I, III, and IV only
d) I, II, III, and IV

ANSWER: C

24. Which of the following is NOT a property of bond duration?

a) For zero coupon bonds Macauley duration of the bond equals its years to maturity.
b) Duration is usually inversely related to the coupon of a bond.
c) Duration is usually higher for higher yields to maturity.
d) Duration is higher as the number of years to maturity for a bond selling at par or above increases.

ANSWER: C

25. A trader is long a five-year French IR swap with a DV01 of 100,000 and short a seven-year French IR swap with a DV01 of (100,000). Assuming current market conditions, which VaR figure at 95% confidence level 1-day holding period would be most representative of the risk of this position?

a) 0 FRF
b) 400,000 FRF
c) 3,000,000 FRF
d) 5,000,000 FRF

ANSWER: B

26. A 30-year US Treasury Bond is roughly ______ as risky as a 5-year US Treasury Bond assuming both bonds have the same market value.

a) two times
b) four times
c) six times
d) eight times

ANSWER: B

(30-year duration ~ 12 years; 5-year duration ~ 4.2 years)

27. Which of the following is NOT a risk for a German investor purchasing a USD denominated Brady Bond?

a) USD Interest Rate Risk
b) Credit Risk
c) USD/DEM Currency Risk
d) German Interest Rate Risk

ANSWER: D

29. A trader is bearish on the US bond market. Which mortgage derivative position will usually yield a profit if the trader is correct in her assumption?

a) IO (Interest Only)
b) PO (Principle Only)
c) Inverse Floater
d) None of the above

ANSWER: A

31. Which of the following statements are true regarding zero curves and forward curves?

I. When the zero curve is upward sloping, the forward curve is always upward sloping.
II. When the zero curve is downward sloping, the forward curve is always downward sloping.
III. When the forward curve is upward sloping, the zero curve is always upward sloping.
IV. When the forward curve is downward sloping, the zero curve is always downward sloping.

a) I and II only
b) I and III only
c) III and IV only
d) I, II, III and IV

ANSWER: C

32. When modelling the market risk of a highly collateralized reverse repo, which of the following approaches is most appropriate?

a) Treat a reverse repo as a fixed rate loan.
b) Treat a reverse repo as the underlying collateral.
c) Treat a reverse repo as a fixed rate loan plus the underlying collateral.
d) Treat a reverse repo as a fixed rate loan minus the underlying collateral.

ANSWER: A

33. A risk analyst at a US bank is trying to determine the one-year forward for JPY. He knows the USD/JPY spot is at 100, the one-year JPY deposit rate is 2%, and the one-year USD deposit rate is 6%. What is the one-year USD/JPY forward rate?

a) 96
b) 100
c) 102
d) 104

ANSWER: A
x = 100(1+.02)/(1+.06)

34. A German corporate treasurer wants to hedge the risk in a USD cash flow one year later. He can use either a foreign exchange future or a foreign exchange forward to hedge all of the foreign exchange risk. What is the relationship between the notional of the future or forward required for the hedge?

a) The notional for the future is greater than that of the forward.
b) The notional for the future is less than that of the forward.
c The notional of the future may be less or greater than that of the forward depending on the
deposit rates in both currencies.

ANSWER: B

36. When applying a 1 bp. upward shift to a flat zero curve what is the corresponding effect on the forward curve?

a) The forward curve is shifted up by more than 1 bp.
b) The forward curve is shifted up by 1 bp.
c) The forward curve is shifted up by less than 1 bp.
d) The forward curve is shifted down by 1 bp.

ANSWER: C

37. You are asked to identify major risk factors for a portfolio of convertible bonds and currency swaps. What are the MAJOR risk factors?

I. Interest rate
II. Issuer Specific Risk
III. Foreign Exchange
IV. Equity price risk

a) I and III only
b) I and IV only
c) I, II, and III only
d) I, II, III, and IV

ANSWER: A

38. Which of the following instruments has non-linear risk to interest rates?

I. Interest swaps
II. Bonds
III. Interest futures
IV. Interest rate one-touch options

a) III only
b) IV only
c) I, II, and IV only
d) II, III and IV only

ANSWER: C Explain

(Interest futures, like the eurodollar contract, are linear in rates.)

39. An ALM manager is trying to hedge the interest rate risk of a US dollar bond with Eurodollar futures. The DV01 for the bond is $1,000. How many future contracts should he buy to hedge the interest rate risk?

a) 10
b) 40
c) 100
d) 1000

ANSWER: B

40. A risk manager is comparing a 30-year bond with a perpetual bond using duration as a measure of risk. What can be said about the duration of these bonds?

a) The duration the 30-year bond is definitely smaller than that of the perpetual bond.
b) The duration the 30-year bond is definitely bigger than that of the perpetual bond
c) The duration the 30-year bond may be smaller or bigger than that of the perpetual bond.
d) The duration of a perpetual bond is infinite.
ANSWER: C

41. You are analyzing the risk of an option on the current inflation-proof bond issued by the US Treasury. What are the option's major risk factors?

I. Inflation
II. US Treasury bond yield
III. Change in inflation index calculation

a) II only
b) I and II only
c) II and III only
d) I, II, and III

ANSWER: C

42. What is the relationship between yield on the current inflation-proof bond issued by the US Treasury and a standard treasury bond with similar terms?

a) The yields should be about the same.
b) The yield of the inflation bond should be approximately the yield on the treasury minus the real interest.
c) The yield of the inflation bond should be approximately the yield on the treasury plus the real interest.
d) None of the above

ANSWER: D

43. Which of the following statements about the S&P 500 index is true?

I. The index is calculated using market prices as weights.
II. The implied volatilities of options of the same maturity on the index are different.
III. The stocks used in calculating the index remain the same for each year.
IV. The S&P 500 represents only the 500 largest US Corporations.

a) II only
b) I and II only
c) II and III only
d) III and IV only

ANSWER: A

44. A trader runs a cash and future arbitrage book on the S&P 500 index. Which of the following are the MAJOR risk factors?

I.     Interest rate
II.    Foreign exchange
III.   Equity price
IV.   Dividend Assumption Risk

a) I and II only
b) I and III only
c) I, III, and IV only
d) I, II, III, and IV

ANSWER: C

45. In the commodity markets being long the future and short the cash exposes you to which of the following risks?

a) Increasing backwardation
b) Increasing contago
c) Change in volatility of the commodity
d) Decreasing convexity

ANSWER: B

46. Consider a portfolio of 100M GBP of government bonds. The modified portfolio duration is five years, and the worst increase in yields observed over a month at the 95% level was 40 bp. What is the approximate portfolio monthly VaR at the 95% level?

a) � 5 million
b) � 3.26 million
c) � 2 million
d) � 400,000

ANSWER: C
5(0.4) = % change in value

47. Assume an asset portfolio is ten million FRF and the liability portfolio is nine million FRF. If the duration of the asset portfolio and the liability portfolio is four years and five years respectively, what is the duration of the surplus, which is defined as the asset portfolio net of the liability portfolio?

a)   4.5
b)   4.47
c)   0.10
d) -5.00

ANSWER: D
10(4)-9(5)= -5.00

48. ABC bond is a zero coupon bond with a ten-year maturity. The bond is callable at 65 in five years and the investors can put the bond at 65 also in five years. Assume a flat yield curve at 10%. What is the approximate duration?

a) 10 years
b) 7 years
c) 6 years
d) 5 years

ANSWER: D

49. A money markets desk holds a floating rate note with an eight-year maturity. The interest rate is floating at three-month LIBOR rate, reset quarterly. The next reset is in one week. What is the approximate duration of the floating rate note?

a) 8 years
b) 4 years
c) 3 months
d) 1 week

ANSWER: D

50. Strip Interest Only CMOs are bonds that only pay the interest portion of mortgages. Assuming the CMO is traded at par value, the duration is ________ and the convexity is ________.

a) positive . . . negative
b) positive . . . positive
c) negative . . . negative
d) negative . . . positive

ANSWER: C

51. A risk manager would like to measure VaR for a bond. He notices that the bond has a putable feature. What affect on the VaR will this putable feature have?

a) The VaR will increase.
b) The VaR will decrease.
c) The VaR will remain the same.
d) The affect on the VaR will depend on the volatility of the bond.

ANSWER: D

52. A convertible bond trader has purchased a long dated convertible bond with a call provision. Assuming there is a 50% chance that this bond will be converted into stock, which combination of stock price and interest rate level would constitute the WORST case scenario?

a) Decreasing rates and decreasing stock prices
b) Decreasing rates and increasing stock prices
c) Increasing rates and decreasing stock prices
d) Increasing rates and increasing stock prices

ANSWER: C

53. In general, when the maturity of a USD Treasury bond increases, the volatility of the bond's price will ________ and the volatility of the bond's yield will ________.

a) increase . . . increase
b) increase . . . decrease
c) decrease . . . increase
d) decrease . . . decrease

ANSWER: C

54. Illiquid describes an instrument which:

a) does not trade in an active market.
b) does not trade on any exchange.
c) can not be easily hedged.
d) is an over-the-counter (OTC) product.

ANSWER: A

55. Consider two positions in different markets. A trader deals in the DM/$ rate, which has an annualized volatility of 12%, and another trader deals in one-year bills, with an annualized volatility of 1%; both distributions of returns are assumed normal. The foreign exchange trader returns a profit of $1 million on a notional amount of $10 million. The bill trader returns a profit of $50,000 on a notional amount of $2 million. For performance measurement purposes, VaR is defined using a one-year horizon and 99% confidence level. What are the risk-adjusted returns on capital for the currency trader and for the bill trader, respectively?

a) 0.10 and 0.025
b) 0.83 and 2.49
c) 0.05 and 0.02
d) 0.36 and 1.07

ANSWER: D

Risk Measurement Techniques

2. Historical simulation is generally NOT used for which of the following?

a) Taking into account implicit historical correlations in a portfolio
b) Forecasting market volatility
c) Back-testing
d) Calculating portfolio VaR

ANSWER: C

3. One advantage of historical simulation over the variance-covariance method when measuring market risk is that historical simulation allows you to:

a) apply RiskMetrics(tm)
b) use GARCH analysis.
c) compute VaR using exponential weighting.
d) analyze the distribution of P/L.

ANSWER: D

4. The use of scenario analysis allows one to:

a) assess the behavior of portfolios under large moves.
b) research market shocks which occurred in the past.
c) analyze the distribution of historical P/L in the portfolio.
d) perform effective back-testing.

ANSWER: A

5. Which of the following would NOT be an appropriate methodology for calculating interest rate VaR?

a) Historical simulation
b) Monte Carlo simulation
c) Principal components analysis
d) None of the above

ANSWER: D

6. Making offsetting commitments to minimize the impact of adverse market movements is referred to as a:

a) reverse repo.
b) back to back.
c) settlement transaction.
d) hedge.

ANSWER: D

7. To convert VaR from a one day holding period to a ten day holding period the VaR number is generally multiplied by:

a) 2.33
b) 3.16
c) 7.25
d) 10.00

ANSWER: B

9. Which of the following models is used to estimate future volatility?

a) GARCH Model
b) Hull-White Model
c) Black-Scholes Model
d) GARP Model

ANSWER: A

12. Delta-normal, historical-simulation, and Monte-Carlo are various methods available to compute VaR. If underlying returns are normally distributed, then the:

a) delta-normal method VaR will be identical to the historical-simulation VaR.
b) delta-normal method VaR will be identical to the Monte-Carlo VaR.
c) Monte-Carlo VaR will be approach the delta-normal VaR as the number of replications ("draws") increases.
d) Monte-Carlo VaR will be identical to the historical-simulation VaR.

ANSWER: C

15. The standard VaR calculation for extension to multiple periods assumes that returns are serially uncorrelated. If prices display trends, the true VaR will be:

a) the same as the standard VaR.
b) greater than standard VaR.
c) less than standard VaR.
d) unable to be determined.

ANSWER: B

Regulatory and Compliance

1. Why is back-testing performed? To:

a) estimate statistical parameters.
b) shock the portfolio with large market moves.
c) compare historical and implied volatilities.
d) check the validity of VaR models.

ANSWER: D

2. The pre-commitment approach is a proposal from the Federal Reserve Bank to:

a) reduce capital requirements for the US banks.
b) allow banks to allocate capital based on internal models.
c) to perform independent monitoring of systemic risk.
d) to revise trading policy for banks.

ANSWER: B

3. To develop an effective risk management function within a large financial institution, the head of risk management should report to whom?

a) The head of trading
b) The head of IT
c) The board of directors
d) Depends on the institution

ANSWER: C

4. What did The Group of 30 develop?

a) A set of risk management principles
b) A regulatory framework for the Federal Reserve and the BIS
c) A manual for derivatives users
d) A set of recommendations for international futures exchanges

ANSWER: A

5. Some large losses occurred in the past from derivatives trading because:

a) derivatives brokers significantly over-charged their clients.
b) institutions did not understand the leverage of their transactions.
c) money managers engaged in intra-day trading.
d) money managers embezzled money using derivatives.

ANSWER: B

6. A number of recent large losses in derivatives could have been prevented by which of the following?

a) Back-testing
b) Scenario analysis
c) More accurate volatility forecasting
d) More accurate exotic option pricing models

ANSWER: B

9. A trading desk has limits only in outright foreign exchange and outright interest rate risk. Which of the following products can not be traded within the current limit structure?

a) Vanilla interest rate swaps, bonds, and interest rate futures
b) Interest rate futures, vanilla interest rate swaps, and callable interest rate swaps
c) Repos and bonds
d) Foreign exchange swaps, and back to back exotic foreign exchange options

ANSWER: B

10. A risk manager is assessing the risk of a portfolio of caps/floors. The market quotes for at the money caps/floors are obtained from a number of brokers. Should the risk manager feel comfortable using only the broker quotes?

a) Yes, because the brokers are an independent pricing source.
b) No, because the broker quotes are not forward volatilities.
c) No, because out of the money caps/floors have higher volatilities than at the money and in the money caps/floors.
d) No, because the brokers only quote the average volatility.

ANSWER: D

12. A trading desk has limits on both VaR and vega. One day there was a limit exception on vega but not on VaR. What should a risk manager do?

I. Investigate the portfolio of the desk.
II. Raise the vega limit because VaR is relatively high in this case.
III. Report the limit exception.

a) I and II only
b) I and III only
c) II and III only
d) I, II, and III

ANSWER: B

13. An institution has a fixed income desk and an exotic options desk. Four risk reports were produced, each with a different methodology. With all four methodologies readily available, which of the following would you use to allocate economic capital?

a) Simulation applied to both desks
b) Delta-Normal applied to both desks
c) Delta-Gamma for the exotic options desk and the delta-normal for the fixed income desk
d) Delta-Gamma applied to both desks

ANSWER: A

14. The GARP debate on value at risk (conducted on the GARP web-site) raised a number of issues regarding VaR as the benchmark for assessing and controlling risk. Which of the following statements about value at risk is true?

a) VaR is only calculated using the covariance approach.
b) VaR can not address fat tails.
c) VaR never includes simulation.
d) VaR does not provide a complete measure of a firm's overall risk.

ANSWER: D

15. Which one of the following is NOT an explicitly permitted VaR modelling technique of the Amendment to the Capital Accord to Incorporate Market Risk?

a) Historical simulation
b) Variance/covariance matrices
c) Monte Carlo simulation
d) Scenario Analysis

ANSWER: D

16. Which of the following quantitative standards is NOT required by the Amendment to the Capital Accord to Incorporate Market Risk?

a) Minimum holding period of 10 days
b) 99th percentile, one-tailed confidence interval
c) Minimum historical observation period of two years
d) Update of data sets at least quarterly

ANSWER: D

17. For regulatory capital calculation purposes, what market risks must be incorporated into a bank's VaR estimate?

a) Risks in the trading account relating to interest rate risk, equity risk and foreign exchange risk
b) Risks in the trading account relating to interest rate risk and equity risk and risks throughout the bank related to foreign exchange and commodity risks
c) Risk throughout the bank related to interest rate risk, equity risk, foreign exchange risk and commodity risk
d) Interest rate risk, equity risk, foreign exchange risk and commodity risk in the trading account only

ANSWER: B

18. Which of the following statements about the Amendment to the Capital Accord to Incorporate Market Risk is accurate?

a) The capital requirement is based on the larger of the 30-day average VaR or the previous day's VaR.
b) Correlations between market risk factors are not permitted.
c) Positions covered by the Amendment are no longer subject to the credit risk requirements of the Accord.
d) Bank's VaR models must capture the non-linear price characteristics of option positions.

ANSWER: D

19. Which of the following statements about the back-testing requirement of the Amendment to the Capital Accord to Incorporate Market Risk is NOT accurate?

a) Back testing is not required until one year after implementation of the Amendment.
b) If a bank has four exceptions in its back test over the past 250 days, it may no longer use its internal VaR model to calculate its market risk capital charge.
c) The back test is conducted by comparing actual net profits and loss from trading activities to
the previous day's VaR estimate.
d) The back test must be conducted quarterly.

ANSWER: C

20. What determines the BIS regulatory capital requirement for counterparty credit risk on derivative transactions?

a) The current mark-to-market of the contract and liquidity risk-adjustment
b) The potential future exposure of the contract and its volatility
c) The current mark-to-market of the contract and its potential future exposure
d) The credit rating and settlement risk of the transaction

ANSWER: C

21. Which of the following does NOT represent a sound policy for the periodic revaluation of trading assets for corporate profit and loss reporting purposes?

a) Revaluations should be performed independent of risk-takers, including any derived factors used in the valuation (e.g., volatilities for option products).
b) For highly structured or illiquid deals, an end-user should avoid obtaining the valuation from the dealer that originated the transaction.
c) Volatilities used in options revaluation should always be obtained from at least two years of historical data.
d) Frequency of revaluation should be consistent with the significance of the activity. For example, dealers should revalue their positions daily and end-users should generally revalue monthly, but no less frequently than quarterly.

ANSWER: C

22. Assume the portfolio VaR is $1 million for a one day holding period 95% confidence level. What would be the VaR translated into the Basle framework, assuming normally distributed and serially uncorrelated returns?

a) $1.4 M
b) $2.3 M
c) $3.2 M
d) $4.5 M

ANSWER: D

23. The standard VaR calculation for extension to multiple periods also assumes that positions are fixed. If risk management enforces loss limits, the true VaR will be:

a) the same.
b) greater than calculated.
c) less than calculated.
d) unable to be determined.

ANSWER: C

32. Which of the following is NOT an example of "model risk" in the context of value at risk measurement models?

a) Model assumptions are adjusted on an annual basis regardless of market and political conditions.
b) The model is developed by a small group of quantitative professionals who are the only personnel who understand its strengths and limitations.
c) Models are validated by an independent risk professional employed by the institution, but who works in another division.
d) Risk managers who use the models are not familiar with underlying model assumptions.

ANSWER: C

33. An institution is developing a compensation policy for trading personnel that incorporates sound risk management principles and deters trading abuses. Which of the following should NOT be considered when developing this policy?

a) Deferring compensation to force traders' long term interests more in line with the institution.
b) Share price growth over the previous year.
c) The consistency of trading practices with corporate energy.
d) Risk-adjusted return of trading activities.

ANSWER: B

34. Which of the following statements about the concept of the "appropriateness" of a derivatives transaction is NOT true?

a) It constitutes a suitability standard, giving a right of private action if a counterparty feels a dealer has misrepresented the risks of a derivatives transaction.
b) It generally deals with the ability of a counterparty to perform on a derivatives transaction, though some institutions may also apply it internally as suitability standard.
c) An institution may, using its business judgement, execute a trade for a customer for whom the institution believes a transaction may not be appropriate if the transaction results from the customer's unsolicited order.
d) Institutions have an obligation to determine, based upon the same due diligence it applies in lending transactions, that the purpose of the transaction accomplishes the counterparty's business objectives and that the counterparty can perform on the contract.

ANSWER: A

Credit Risk

1. Which of the transactions below can NOT be performed with a credit derivative?

a) Reducing credit concentration risk
b) Allowing a fund to invest in corporate loans
c) Preventing a bankruptcy of a loan counterparty
d) Leveraging credit risk

ANSWER: C

2. The probability of an AA-rated counterparty defaulting over the next year is .06%. Therefore, one would expect that the probability of it defaulting over the next 3 months to be:

a) between 0% - .015%.
b) exactly .015%.
c) between .015% - .030%.
d) greater than .030%. A

ANSWER: A

4. The degree of potential credit exposure of being long a DEM interest rate swap with a counterparty will be a function of:

a) the swap tenor and credit quality of the counterparty.
b) the credit quality of the counterparty only.
c) the volatility of DEM interest rates and swap tenor.
d) the volatility of DEM interest rates only.

ANSWER: C

5. The net mark to market of a diversified portfolio of OTC derivatives with a single counterparty is currently negative 10M. There is no multi-lateral netting agreement in place with the counterparty. Therefore, the current credit exposure to this counterparty is:

a) Positive 10M.
b) 0.
c) Negative 10M.
d) Unable to be determined.

ANSWER: D

6. A trader purchases a six month over-the-counter straddle on stock A for a 1M premium from a counterparty. The maximum credit exposure over the life of the trade is:

a) less than 1M.
b) between .5M - 1M.
c) exactly 1M.
d) greater than 1M.

ANSWER: D

7. Identify a situation in which a parent company located in an emerging market country could have a higher rating than the country in which it is domiciled.

a) The company's debt is less volatile than the country's debt.
b) The company has a smaller percentage of debt/total capital than the country.
c) The company has significant operations outside of its home country.
d) The company is a technology manufacturer.

ANSWER: C

8. Which of the following is Moody's lowest investment grade credit rating?

a) Aaa2
b) Baa1
c) Baa3
d) Ba2

ANSWER: C

10. The ratio of the default probability of an AA-rated issuer over the default probability of a B-rated issuer:

a) generally increases with time to maturity.
b) generally decreases with time to maturity.
c) remains roughly the same with time to maturity.
d) depends on the industry sector.

ANSWER: A

11. A commercial loan department lends to two different BB-rated obligors for one year. Assume the one-year probability of default for a BB-rated obligor is 10% and there is zero correlation (independence) between the obligor's probability of defaulting. What is the probability that both obligors will default in the same year?

a) 1%
b) 2%
c) 10%
d) 20%

ANSWER: A

12. What is the probability of no defaults over the next year from a portfolio of 10 BBB-rated obligors? (Assume the one-year probability of default for a BBB-rated counterparty is 5% and assumes zero correlation (independence) between the obligor's probability of default.)

a) 5.0%
b) 50.0%
c) 60.0%
d) 95.0%

ANSWER: C

23. Assume the 3 month US Treasury yield is 5.5 % and the Eurodollar deposit rate is 6% (both on simple interest basis). What is the approximate probability of the Eurodollar deposit defaulting over its life (assuming a zero recovery rate)?

a) 0.01%
b) 0.1%
c) 0.5%
d) 1.0%

ANSWER: B

24. Assume the 1-year US treasury yield is 5.5 % (on simple interest basis) and a default probability of 1% for 1-year Commercial Paper. What should the yield of 1-year Commercial Paper be (on simple interest basis) assuming 50% recovery rate?

a) 6.0%
b) 6.5%
c) 7.0%
d) 7.5%

ANSWER: A

25. Which of the following mechanisms is NOT a vehicle a derivative participant uses to reduce credit exposure on a set of transactions?

a) Payment and close-out netting agreements
b) Collateral or other credit enhancements
c) Early termination agreements
d) Periodic mark-to-market

ANSWER: D

26. A 10-year fixed-floating swap, with monthly settlements, reaches its maximum credit exposure at a time closest to _______ into its life (assume evaluation at inception).

a) 1 year
b) 3.33 years
c) 5.00 years
d) 7.50 years

ANSWER: B

27. Part I: Which of the following credit events usually takes place first?

a) A bond is downgraded by a rating agency
b) A bond's credit spread widens

ANSWER: B

28. Based on historical data from Standard and Poors, what is the approximate historical 1-year probability of default for a BB-rated obligor?

a) 0.05%
b) 0.20%
c) 1.0%
d) 5.0%

ANSWER: D

Derivatives

4. Which of the following contributes the MOST to risk of an option which is close to expiration and is deep in-the-money?

a) Delta
b) Gamma
c) Vega
d) Rho

ANSWER: A

7. A daily average price option, which starts averaging on inception date, can be approximated by a regular European option with:

a) a third the time to maturity.
b) half the time to maturity.
c) twice the time to maturity.
d) a third of the volatility.

ANSWER: A

8. At-the-money options that are close to maturity tend to have a high:

a) Rho.
b) Gamma.
c) NPV.
d) Vega.

ANSWER: B

9. Which of the following is NOT often a leveraged transaction?

a) Futures contract
b) Structured note
c) Out-of-the-money option
d) A precious metals consignment

ANSWER: D

10. Knockout options are often used instead of regular options because:

a) knockouts have a lower volatility.
b) knockouts have a lower premium.
c) knockouts have a shorter maturity on average.
d) knockouts have a smaller gamma.

ANSWER: B

11. The risk which can only be hedged with options is:

a) Vega risk.
b) Delta risk.
c) Theta risk.
d) Rho risk.

ANSWER: A

12. The fractional price change in an option resulting from a one-point change in price of the underlying instrument is called:

a) Gamma.
b) Hedge ratio.
c) Vega.
d) Sharpe Ratio.

ANSWER: B

13. A sale of a covered call is the risk equivalent of a:

a) purchase of a put and a long Treasury bill.
b) purchase of the underlying and a short Treasury bill.
c) sale of a put and a long Treasury bill.
d) sale of the underlying and a purchase of a put.

ANSWER: C

14. A short gamma position can be produced by:

a) only selling calls.
b) only selling puts.
c) selling either calls or puts.
d) only selling call spreads or put spreads.

ANSWER: C

17. Which one of the following is NOT a key assumption behind the Black-Scholes option pricing formula?

a) There are transaction costs or taxes.
b) Short sales are unrestricted.
c) The stock pays no discrete dividend.
d) The option is European style.

ANSWER: A

18. The price of an option which gives you the right to receive fixed on a swap will decrease as:

a) time to expiry of the option increases.
b) time to expiry of the swap increases.
c) the swap rate increases.
d) volatility increases.

ANSWER: C

19. A call option struck at-the-money typically has a delta of ______ and relatively ______ gamma.

a) .5 . . . high
b) .75 . . high
c) .5 . . . low
d) 0 . . . high

ANSWER: A

20. If you are long a put and long the underlying you effectively have the same risk as being:

a) long a call.
b) long a put.
c) short a call.
d) short a put.

ANSWER: A

21. The option-adjusted duration of a callable bond will almost equal the conventional modified duration of an identical non-callable bond when the:

a) value of the bond is above the call price.
b) volatility of the underlying bond is high.
c) bond is selling at a premium relative to par.
d) bond is well below the call price.

ANSWER: D

23. Which of the following factors is NOT used in determining the value of an equity index option?

a) Volatility
b) Beta
c) Level of Interest Rates
d) Dividends

ANSWER: B

24. Which of the following strategies will have a negative delta?

a) A strangle
b) A straddle
c) A bear spread
d) A bull spread

ANSWER: C

25. Which of the following short term options positions has the biggest risk?

a) Short an out-of-the money call
b) Short an in-the-money put
c) Short an at-the-money call
d) Long an out-of-the money double barrier option

ANSWER: B

26. Consider a European call option (price C) and a European put option (price P) at a common strike of X. Assume the underlying stock has a spot price of S, pays no dividends and the discount factor from today to option expiry is DF. Which of the following equations is true?

a) C + X*DF = P + S
b) C - X*DF = P + S
c) P + X*DF = C + S
d) P - X*DF = C + S

ANSWER: A

27. A fixed income desk is long a European call option with expiration in 10 years, and the option offers the right to the holder to buy a 20-year zero coupon bond at the time of expiration. If the 10-year spot rate rises instantaneously while all other spot rates remain unchanged (assume constant volatility), what will be the P&L affect of this option?

a) A profit can be expected.
b) A loss can be expected
c) It will remain unchanged.
d) It cannot be determined from the information given.

ANSWER: A

28. Consider the risk of a long call on an asset with a notional amount of $1 million. The VaR of the underlying asset is 7.8%. If the option is a short-term at-the-money option, the VaR of the option position is slightly:

a) less than $39, 000 when second-order terms are considered.
b) more than $39, 000 when second-order terms are considered.
c) less than $78,000 when second-order terms are considered.
d) more than $78,000 when second-order terms are considered

ANSWER: A

29. Rth = (The ratio of option Theta to its price). Rth for in, at, and out of the money call options changes as option expiry draws closer. Which of the following statements is true?

a) Rth may become positive for those options depending on market conditions.
b) Rth for out-of-the-money options is the smaller than for in-the-money options.
c) Rth for in-the-money options will be lower than for out-of-the-money options.
d) None of the above

ANSWER: C