FRM 2009 Practice Questions

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Options, Futures & Derivatives, Hull Chapter 1-5
Author: David Harper August 2009

Compiled by: Suzanne Evans Published: Source: www.bionicturtle.com

.EliteBook.net

Hull Chapters 1-5 (Options, Futures and other Derivatives)

FRM 2009

These questions are for paid members only! You know who you are. Anyone else is using an illegal copy and also violates GARP's ethical standards. This includes piracy and will not be tolerated.

These questions are (i) selected from the John Hull text and (ii) in many cases, expanded and annotated with follow-up questions specifically designed to give FRM-specific practice - Thank you, David Harper

Some ofthe questions may have a follow-up explanation. This would be located on the forum: http://www.bionicturtle.com/forum/viewforum/39/

HuII.02.01: Distinguish between the terms open interest and trading volume. Answer: The open interest of a futures contract at a particular time is the total number oflong positions outstanding. (Equivalently, it is the total number of short positions outstanding.) The trading volume during a certain period of time is the number of contracts traded during this period. Hull.02.03: Suppose that you enter into a short futures contract to sell July silver for $5.20 per ounce on the New York Commodity Exchange. The size of the contract is 5,000 ounces. The initial margin is $4,000, and the maintenance margin is $3,000. What change in the futures price will lead to a margin call? What happens if you do not meet the margin call? 02.03b [my adds] What is the size of the margin call if the futures price immediately 02.03c. Explain how margin calls can contribute contract.

(in the first day) jumped to $5.50?

to a divergence in price between a forward and a futures

02.03d More specifically, if the underlying asset is positively correlated with interest rates, what is the implication for a commodity futures price vis-a-vis a forward price? 02.03e [harder] How does this rule (Le., correlation with interest rates) apply to the divergence in price between a Eurodollar futures contract and a forward rate agreement (FRA)?

.Elite Boo k. n

page2\t4

000/5. the loss = $0. providing it can be done at a price more favorable than $2 .000 = $0. • . Margin calls consume current investor cash. If the futures price jumps to $5. c..e. Expected (average) impact is positive 02. rather the margin call is for $1.000. 02. the future rate is always greater than the forward rate Futures rate = forward rate + convexity adjustment Hull. The price of silver must therefore rise to $5.03 There will be a margin call when $1. your broker closes out your position.implied forward rate).50. When the price of the underling asset is positively (negatively) correlated with interest rates. These cash flows must be funded (margin call) or they get to be invested (excess margin) at the prevailing interest rate. interest rate future price = 100 . 02. So the correlation is always positive (please note: the interest rate futures price the inverse of the rate. The margin balance drops to $2.30 * 5.500. It could be used to limit the losses from an existing long position. Futures and other Derivatives) FRM 2009 Answer: 02.20. If the margin call is not met.500 to restore the balance to the initial margin.$1. 02. the margin call is not for $500. b.000 . although it is less material for shorter maturities.05: What does a stop order to sell at $2 mean? When might it be used? What does a limit order to sell at $2 mean? When might it be used? Answers: a.000 has been lost from the margin account. i.02. converse.000 = $1.40 per ounce for there to be a margin call.03. It applies the same way the only difference is that the underlying here is the interest rate. It could be used to instruct a broker that a short position should be taken. losing forward requires funding margin calls at lower rate. So. A limit order to sell at $2 is an order to sell at a price of $2 or more. Why? The correlation implies asymmetry.03c. Although the maintenance margin is $3.500). d. A stop order to sell at $2 is an order to sell at the best available price once a price of $2 or less is reached. Positive correlation: profitable forward produces excess cash which is invested at higher rate. in this case. which is interim cash flow to the investor.500 ($4.03b. excess margin might be withdrawn.e.Hull Chapters 1-5 (Options. This cash flow volatility creates a pricing divergence between the forward and the futures price. Daily settlement is the difference between the future and the forward: daily settlement implies margin cash flows (positive or negative) to the investor. futures prices tend to be higher than (lower than) forward prices.03d. This will occur when the price of silver increases by 1.

the theory that basis must converge to zero)? .Hull Chapters 1-5 (Options. dollars per unit of foreign currency.0Sc [my add] If so.0Sd [my add] How might flexibility in short delivery impact theory of basis convergence in Hull [i. For other major currencies. how does the flexibility afforded the short impact the pricing of a Treasury Bond futures contract? 02. Futures and other Derivatives) FRM 2009 Hull.e. It has to be brought up to the initial margin level when the balance in the account falls below maintenance margin level. when delivery will take place. and the clearinghouse member is required to bring the account back up to the prescribed level daily.02. and New Zealand dollar. euro. the account does not have to be brought up to the initial margin level on a daily basis. dollar. However. where delivery will take place. n page4\t4 . The maintenance margin is usually about 75% of the initial margin. and the foreign exchange forward market? Answers: In futures markets prices are quoted as the number of U. Spot and forward rates are quoted in this way for the British pound. and so on. The party with a short position in a futures contract sometimes has options as to the precise asset that will be delivered. the foreign exchange spot market.08: 02.02.S. Do these options increase or decrease the futures price? Explain your reasoning.0Sb [my add] In the case of a Treasury bond futures contract.Elite Boo k.07: What differences exist in the way prices are quoted in the foreign exchange futures market. does the short have delivery flexi bili ty? 02. Australian dollar. spot and forward rates are quoted as the number of units of foreign currency per U.S. The margin account administered by the broker is also marked to market daily.02.06: What is the difference between the operation and those administered by a broker? Answers: of the margin accounts administered by a clearinghouse The margin account administered by the clearinghouse is marked to market daily. Hull.. Hull.0S. 02.

02. perhaps because it has been accumulated over time by buy-and-hold investors and institutions." OZ.The conversion factor (CF) is used to "standardize" variable available for delivery bonds. with value to the short. with the bounds of convergence determined by the cost of participating in the delivery process"). the size of the contract. location. For superior detail.OSd.com/archives /ZOOS/04 /commodity arbit. The when to deliver during the delivery month. then the futures contract would lose its liquidity as well. . This makes precise pricing of the contract difficult! As J. and timing delivery "options" that have a demonstrated value to sellers of contracts. They therefore tend to reduce the futures price. I recommend this great article from the brilliant Scott Irwin: http://www. delivery on grain futures contracts is not costless (who really wants corn on a barge at an Illinois River shipping station) and complicated by the existence of grade. The buyer of the futures delivery of the bonds chosen by the seller at the time Why can the short choose among bonds for delivery? "The design of bond futures contracts purposely avoids a single underlying security.Tuckman on Treasury bond futures: sell or deliver a particular quantity of a bond seller may choose which bond to deliver and options are called the quality option and the contract.OS. n pag es\t4 . Hull writes. but flexibility in delivery has similar impact. respectively. Futures and other Derivatives) FRM 2009 Answers: OZ.Elite Boo k. or the long." "The seller of a futures contract.. and the delivery months .It implies there is really a zone of convergence. OZ.econbrowser. commits to buy or take chosen by the seller. These timing option.These options make the contract less attractive to the party with the long position and more attractive to the party with the short position.OSb. commits to in that contract's basket during the delivery month. "An exact theoretical futures price for the Treasury bond contract is difficult to determine because of the short party's options .. One reason for this is that if the single underlying bond should lose liquidity. The short still choosed the cheapest to deliver (CTD) with flexibility. So it is better to think of a zone of convergence between cash and futures prices during delivery periods. Hull. the delivery arrangements.Hull Chapters 1-5 (Options.OSc. but it imposes the same 6% yield assumption on all bonds. This flexibility is essentially an embedded option. Another reason for avoiding a single underlying bond is the possibility of a squeeze.html His point is about the fact that delivery by the short has a cost (friction) which creates a zone of convergence ("in reality. or the short.09: What are the most important Answers: aspects of the design of a new futures contract? The most im portant aspects of the design of a new futures contract are the specification of th e underlying asset." OZ.

13: Explain the difference between a market-if-touched Answers: order and stop order. the investor is required to deposit a further margin. An arbitrageur can take a long futures position but cannot force immediate delivery of the asset. The balance in the margin account is adjusted daily to reflect gains and losses on the futures contract. Hull. Hull.Elite Boo k.OZ. n page6\t4 . A stop order is executed at the best available price after there is a bid or offer at the specified price or at a price less favorable than the specified price. Futures and other Derivatives) FRM 2009 Hull. Nevertheless.OZ. is made by the party with the short position. Answers: A margin is a sum of money deposited by an investor with his or her broker. If the futures price is less than the spot price during the delivery period.OZ.1Z: Show that if the futures price of a commodity is greater than the spot price during the delivery period than there is an arbitrage opportunity.Hull Chapters 1-5 (Options.10: Explain how margins protect investors against the possibility of default. there is no similar perfect arbitrage strategy. Answers: If the futures price is greater than the spot price during the delivery period. A market-if-touched order is executed at the best available price after a trade occurs at a specified price or at a price more favorable than the specified price. A similar system of margins make sit unlikely that the investor's broker will default on the contract it has with the clearinghouse member and unlikely that the clearinghouse member will default with the clearing house. an arbitrageur buys the asset. Iflosses are above a certain level. It acts as a guarantee that the investor can cover an losses on the futures contract. . Does an arbitrage opportunity exist if the futures price is less than the spot price? Explain your answer. companies interested in acquiring the asset will find it attractive to enter into a long futures contract and wait for delivery to be made. The decision on when delivery will be made. shorts a futures contract. This system makes it unlikely that the investor will default. and makes delivery for an immediate profit.

F1) + 10(F2 . Hull. On September 1. 2007. the futures price for a contract that will be delivered in 45 days is 0. 2006.F1) million Hull.5479 futures quote is the number of dollars per Swiss franc.8204 = 0. Which is more favorable for an investor wanting to sell Swiss francs? Answers: The 1. When quoted in the same way as the futures price the forward price is 1/1. The Swiss franc is therefore more valuable in the forward market than in the futures market.30 the contract should be sold providing this can be done at 20.10 means.8204.n . 2007. the second contract 10(F2 .17: are the forward exchange rates for the contracts entered into July 1. Hull. Answers: Suppose F1 and F2 September 1.21: What do you think would happen if an exchange started trading a contract in which the quality of the underlying asset was incompletely specified? Answers: .S) = dollars.30 with a limit of 20. a US company enters into a forward contract to buy 10 million GBP on January 1. 2006.F1) million dollars and the payoff from is 10(F2 .02. The total payoff is therefore 10(S .02. it enters into a forward contract to sell 10 million GBP on January 1.8204 forward quote is the number of Swiss francs per dollar.02. Futures and other Derivatives) FRM 2009 Hull. 2007. The forward market is therefore more attractive for an investor wanting to sell Swiss francs.EliteBook.14: Explain what a stop-limit order to sell at 20.10 means that as soon as there is a bid at 20.16: On July 1. 2006.10 or higher price. 2006. The forward price on the Swiss franc for delivery in 45 days is quoted as 1. Answers: A stop-limit order to sell at 20.5493.5479. (All exchange rates are measured as The payoff from the first contract is 10(S . Explain these two quotes. dollars per pound). 2006 and September 1.30 with a limit of 20.Hull Chapters 1-5 (Options. 2006 and and S is the spot rate on January 1. Describe the profit or loss the company will make in dollars as a function of the forward exchange rates on July 1.02. The 0.S) million dollars.

03. the standard deviation of quarterly changes in a futures price on the commodity is $0.06: Suppose that the standard deviation of quarterly changes in the prices of a commodity is $0. cannot find jet fuel futures).Hull Chapters 1-5 (Options.000.000 gallons? 03.8. The airline whould short a number of contracts = MV Hedge Ratio * 1 MM gallons / 42.06d . in practice. This shows that futures contracts are feasible only when there are rigorous standards within an industry for defining the quality of the asset.642. ~DiC • rteBoo . What is the beta of the change in spot price with respect to the change in futures price? Answers: 03.642 This means that the size of the futures position should be 64. n . This might well be viewed by the party.8 A 2. as garbage! Once news of the quality problem became widely known.06b If an airline wants to hedge the anticipated purchase of jet fuel and uses oil futures contracts (see here: light sweet crude oil futures) to cross-hedge (Le. 03. HuI1.06b. line = beta of the dependent (explained var) with 64% = 0.2% of the size of the company's exposure in a three-month hedge. with the long position. Parties with short positions would hold their contracts until delivery and then deliver the cheapest form of the asset.. what is the optimal hedge ratio for a 3month contract? What does it mean? [my adds] 03. failed because of the problem of defining quality. how many contracts are optimal if the purchase will be for 1.06c.81.8 x 0. and the coefficient of correlation between the two changes is 0. what is the coefficient of determination (R A 2)? 03. If the above correlation represents the regression of changes in spot price against changes in futures price. it is just near. What is the covariance between the changes in futures and spot prices? What are the units of this covariance? 03. Many futures contracts have. 03.000 gallons. A single oil futures contract is for 42.. If the above correlation represents the regression of changes in spot price against changes in futures price.000 gallons per contract = 15.642. The MVhedge ratio = slope of the regression respect to the independen t (explanatory var) 03.06d. Note this is not exactly the same as the MV hedge ratio of 0.65/0.06e.65. what is the slope of the OLS regression line? 03.06c.81 = 0.06f. no one would be prepared to buy the contract.3 or about 15 contracts 0.06 The optimal hedge ratio is 0. Futures and other Derivatives) FRM 2009 The contract would not be a success.

line = beta of the dependent (explained var) * Using oil futures to hedge * The MVhedge ratio is the jet fuel is a cross-hedge (implication: basis risk) result of an OLSregression: change in futures against change in spot * The slope of the regression line = beta = Cov(f. or a short position in 44 contracts.Elite Boo k.s) * volatility (s) = correlation (f. covariance = 0.Hull Chapters 1-5 (Options. 0.9 Rounding to the nearest whole number. 89 contracts should be shorted.000.2. HuII. The index is currently standing at 1080..07: 1 volatility (f) A company has a $20 million portfolio with a beta of 1. What is the hedge that minimizes risk? What should the company do if it wants to reduce the beta of the portfolio to 0.06f. the units are dollar+z. Similarly it worsens as the basis decreases . half of this position. Covariance = Correlation*Volatility*Volatilty.4212 dollar" 2 = 0.8 correlation * $0.65 Since the correlation is unitless. It would like to use futures contracts on the S&P 500 to hedge its risk. To reduce the beta to 0. Futures and other Derivatives) FRM 2009 03.03.6.s) * "cross-volatility" = minimum variance hedge * Optimal number of contracts = MVhedge * Position 1 Size of 1 future contract HuII.s) IVar (f) = correlation(f. is required.642 again! The MVhedge ratio = slope of the regression with respect to the independen t (explanatory var) Key points to remember: 03.s)*volatility(f)*volatility(s) 1 Var(f) = correlation(f.000/(1080 x 250) = 88. and each contract is for delivery of $250 times the index.6? Answers: The formula for the number of contracts that should be shorted gives 1. n page9\t4 . In this case. A short hedger is long the asset and short futures contracts.2 x 20.10: Explain why a short hedger's position improves when the basis strengthens worsens when the basis weakens unexpectedly.06e .81 * $0. .03. Answers: unexpectedly and The basis is the amount by which the spot price exceeds the futures price. The value of his or her position therefore improves as the basis increases.

000 pounds of cattle. The producer wants to use the December live cattle futures contracts to hedge its risk.6 = 120. A beef producer is committed to purchasing 200. The market price is $30 per share. 03.Hull Chapters 1-5 (Options.000 Such that "tailing the hedge" implies Hull. replace size with values: Instead of: Optimal number of contracts = hedge ratio * Size of Position / Size of 1 futures contract Use: Optimal number of contracts = hedge ratio * Value of Position / Value of 1 futures contract In this case.000 = $40.16 .3 X (50.6 The beef producer requires a long position in 200000 x 0.6 * $140.18: On July investor use the delivery 1. It is now October 15.4.000 pounds of live cattle on November 15.03.70 * 200.3.The optimal hedge ratio is 0.500 and one contract is for of$50 times the index.000 = 2. The is interested in hedging against movements in the market over the next month and decides to September Mini S&P 500 futures contract. The beta of the stock is 1.000/$40. Each contract is for the delivery of 40.16b. To tail the hedge.7. .000 and value of 1 futures contract = $1 & 40. n~Oi24 . What strategy should the investor follow? = 0.500) = 26 contracts is required.16: The standard deviation of monthly changes in the spot price of live cattle is (in cents per pound) 1. The index is currently 1.1 or about 2 contracts Answers: A short position in 1. The standard deviation of monthly changes in the futures price of live cattle for the closest contract is 1.000 = $140.2. an investor holds 50. The correlation between the futures price changes and the spot price changes is 0.000 lbs of cattle.7 x 1.000 x 30)/(50 x 1. Futures and other Derivatives) FRM 2009 Hull.2/1.4 = 0. The beef producer should therefore take a long position in 3 December contracts closing out the position on November 15.000 shares of a certain stock. value of position = 0.Elite Boo k.03. What strategy should the beef producer follow? Answers: 03.

a 1% one day log return followed by a 2% one-day log return equals a 3% two-day log return. we can covert 14% quarterly to semi-annual [(1+14%/4)"(4/2) -1]*2 = 14. What advantage does discrete (period-to-period) compounding give us? 4. EXP[l %]*EXP[2%] = EXP [3%] 04.f. Solve for the formula that directly converts the 14% quarterly frequency to a semi-annual frequency.01. [my adds] What advantage does continuous compounding give us? 4.d. The rate with annual compounding (1 + (0.01.1376 or 13.01. n~~Oi24 . compounding is 04. Linda Allen refers to this property as time consistency: log returns (continuously compounded returns) for a single period can be added.14/4)4 . 14.01.01.01.01.75% per annum.a.75% is the effective annual yield. The rate with continuous 41n (1 + (0.b. such that = periods/year under another frequency. then: (l+Rm/m)"(mn) = (Ls-Rq/q):' (l+Rm/m)"m = (l+Rq/q)"q Rm = [(l+Rq/q)"(q/m)-l]*m In this case. Answers: 04.01. for example.01. discrete single-period returns can be added across the portfolio: the portfolio return is a weighted sum of component asset returns. 04.245% directly with: ..04.76% per annum.1475 or 14. If q = periods/year under one frequency and m (qn). Unlike log returns. e. $100 04.01: A bank quotes you an interest rate of 14% per annum with quarterly compounding.Hull Chapters 1-5 (Options. That is.f. Futures and other Derivatives) FRM 2009 Hull. equivalent rate with (a) continuous compounding and (b) annual compounding? What is the 4.g.e. is 04.d.75 after one year if compounded quarterly at 14%.14/4)) = 0.Elite Boo k.e.c [my adds] What is the effective annual yield (EAY)? 4. that is the effective return on the investment.1 = 0.01c. grows to $114.

Elite Boo k. With continuous compounding. The price is 4/1. b.052"3 = 96. Monthly compounding d. we must have 4/1. With annual compounding the return is (1100/1000) . semi-annual = 9.05"2 + 104/ (1 + R/2)"3 = 96.74 the cash flows at If the 18-month zero rate is R.1 or 10% per annum.052 + 4/1. R = 9.052"2 + 4/1. Futures and other Derivatives) FRM 2009 Hull. With monthly compounding. Hull. n~~Oi24 . R = 9.e.4% per annum.Hull Chapters 1-5 (Options. Continuous compounding Answers: of $1. R .74 which gives R = 10.04.04. The answers are also given in this spreadsheet . What is the bond's price? What is the 18-month zero rate? All rates are quoted with semiannual compounding..4%. Calculate the a.42%. Semiannual compounding c.53% per annum.03: The 6-month and I-year zero rates are both 10% per annum.57% per annum. Annual compounding b.000 now.100 in one year in return for an investment percentage return per annum with: a.1 = 0. i. For a bond that has a life of 18 months and pays a coupon of 8% per annum (with semiannual payments and one having just been made). Answer: Suppose the bond has a face value of $100. the yield is 10. d. With semi-annual compounding the return is R where 1000(1 + (R/2)"2 = 1100. Its price is obtained by discounting 10.04: An investor receives $1.05 + 4/1.7618% c.

8% Qtr 5: 9.0'%.2. and sixth quarters.S% 8.:2'% 8.04. . 8.4% 12: 15. 8.8% 8.4% 12.4% 8.0% Qtr 6: 9.5. 9.Hull Chapters 1-5 (Options.6% 8.2% Maturity (months) 3 Rate (% per annum) 8. Futures and other Derivatives) FRM 2009 Hull.S% 8.8% 9.OOO? he interest rate is T expressed with quarterly compounding . Answers: Implied Forward Ra1Jes 8.06: compounding are as follows: Assuming that zero rates are as in Problem 4.0% 8.5% for a 3-month period starting in 1 year on a principal of $1.7% 18 Calculate forward interest rates for the second.7% 15 18 The forward rates with continuous Qtr 2: 8. compounding are as follows: 8. what is the value of an FRA that enables the beholder to earn 9. fourth. n~30i24 .0% 8.4% Qtr 3: 8.OOO.2% Hull.% 8. fifth.8% Qtr 4: 8.04.Elite Boo k. third.6'%.05: Suppose that zero interest rates with continuous Maturity (months) Rate (% per annum) 8.

• The FRAis an off-balance-sheet agreement to pay/receive the difference upon rate and the prevailing rate (at the future time).07: The term structure of interest rates is upward -sloping.25 x (0. or 9. Like a interest rate pay/receive cash flow is a net settlement. The yield on a 5-year coupon-bearing bond c.2:% 9 8. between an agreedswap..Elite Boo k.40% 8.095 .56 = Ifm = 4 (quarterly).086 or $893.0% 8.102% with quarterly compounding.000 le'r'o Maturity (months) 3 Implied F. The forward rate corresponding to the period between 5 and 5.O:O% Implied Forward Q. Futures and other Derivatives) FRM 2009 Answer: $1.000.Hull Chapters 1-5 (Options.7% 12 15 18 '9'. The 5-year zero rate b.25 = 893.e N.5% 8. Put the following in order of magnitude: a.2.8n% 8.0.09102)]e"-0.e.56 Key points: • Did you remember to convert the continuous rate to discrete quarterly? the quarterly rate 4*([EXP[9% continuous/4]-1].80~ ~'.uiarterly FRA Ralt.25 years in the future What is the answer to this question when the term structure of interest rates is downward-sloping? .et lcas:h Flow R:alt. x 1.-0% JJVoil[Net'Cilsh Flow Here is the spreadsheet.000. • The valuation using the forward rate: i.orward Raltes~'Oq 8. n~40i24 .0% with continuous compounding From equation (4.6% 8.4% 8. The exercise above is merely "simulating" the net cash flow to present value.9) the value of the FRA is therefore [1.000 x 0. the best estimate of the future forward rate.e pef ~% annum) 8. the prevailing rate is the and then discounting Hull.04. The forward rate is 9.

Elite Boo k. Futures and other Derivatives) FRM 2009 Answer: When the term structure When the term structure Hull.0y + 4e -2.407%.12h.51 04. n~$Oi24 .0y + 4e"-2. D Harper: I think solutions manual is mistaken. =RATE(3 per.24 months.49 and has a cash price of 104. [source Hull] The bond pays $4 in 6. b > a> c. $8 coupon.0y = 104 Using the Goal Seek tool in excel y= 0. and $104 in 36 months. What is the is upward sloping.04. =RATE(6 per.Sy + 4e -2. 100 par) = 6.51 % bond-equivalent basis With calculator: 6n -104 PV 4PMT 100 FV Then CPT -> IjY = 3.49% With calculator: 3n -104 PV 8PMT 100 FV Then CPT -> IjY = 6.26% 3. -104 price.26 * 2 = 6.12a.0y + 4e -1.18. $4 coupon.12.12c.26% * 2 = 6. 100 par) = 3.12: 04.Sy + 104e -3.12a.5y + 4e -1.0y = 100 With yield = 7.5y + 104e"-3. c > a > b. is downward sloping. .Hull Chapters 1-5 (Options. -104 price. The bond yield is the value of y that solves 4e"-0.Sy + 4e"-1. Should be: 4e -O.0y + 4e"-1.Sy + 4e"-2. A 3-year bond provides a coupon of 8% semiannually bond's yield? Answer: 04.588% 04.06407 or 6.

06xl. and 7%.536e"-0.04. third. 12-month. 6. Also A = e"-0.O + 3.065x1. 6%.072 % per year (that is 3.04.5365e"-0.0 =100 verifying that 7.6935 = 7.07x2 = 0. Answer: Spreadsheet is here: http://sheet. and fifth years.14: Suppose that zero interest rates with continuous compounding are as follows: Z!ero M.8694.6935 The formula in the text gives the par yield as (100 .072% is the par yield.5%.05xO.annuml] 2.5°/0 Calculate forward interest rates for that second.13: Suppose that the 6-month.Hull Chapters 1-5 (Options.5 + 3. respectively.07x2.07x2. m = 2.zoho.zoho.V.065x1.0 = 3. Futures and other Derivatives) FRM 2009 Hull. 18-month. d = e"-0.e1arsl Rale (% pelli . The value is 3.536e"-0.5 + e"-0. Hull.05365 every six months). fourth.5 + e"-O.com/public/btzoho/hull-04-13 Using the notation in the text. What is the 2-year par yield? Answer: Spreadsheet Here: http://sheet.(100 x 0.5 +103. and 24-month zero rates are 5%.072 To verify tha t this is correct we calculate the value of a bond that pays a coupon of 7.7% 4.0% 3.0% 3.8694) x 2)j3.com/public/btzoho/04-14-15 .atLuritty (.05x0.536e"-0.2% 4.

From equation (4.078.7% .037x3 or $2.7% $1.85 .000 Ziero Imlpliedi Irorward '. the value of the FRA is there fore [1.05232 .078.mnum) 2:.Vearsl ~' 2 33.3.741% IN of Net Cash Flow 'S .0% 5.2%.15: Use the rates in Problem "HuI1.ua rlterly FRA. Answer: Spreadsheet is here: http://sheet.000.000.7% with continuous compounding.14" to value an FRA where you will pay 5% for the third year on $1 million.Elite Boo k.!):% 5.0% 3. Rate N'e1t Q!iSh MalJurity R:aitte~ per ~% (.051xl1 = 5.04.1 % with continuous compounding or e"-0.com/public/btzoho/04-14-15 The forward rate is 5.1% 5.2.. IFlow 5. The 3-year interest rate is 3.FRM 2009 Year Year Year Year 2: 3: 4: 5: 4.078.232% with annual compounding.8 Hull.0% 4. n~0f24 .2:% 5}()01o/0 4.10).zoho.85. = 2.0.05) x 1]e"-0.7% 5.000 x (0.04.2.

ardi q.7'% 4. This is because the coupons are discounted at a lower rate than the N-year rate and drag the yield down below this rate.erly Net Raite' (% per annum) 2_i()1% FRA Ra.70'% 5.000 Zero Ma.turity ~VearsJ Imlplied F.232% Implied Forw.te! Q1.uar1:.04.Hull Chapters 1-5 (Options.19: Why are US treasury Answer: There are three reasons (see Business Snapshot 4.5Pk.000. Similarly. the yield on a N-year coupon-bearing bond is less than the yield on an N-year zero-coupon bond.0% 3.04.741% 5. Hull. the zero rate for a particular maturity is greater than the par yield for that maturity.Elite Boo k.2% 4. Treasury bills and Treasury rates significantly lower than that of other rates that are close to risk-free? regulatory requirements.18: "When the zero curve is upward-sloping..sh Flow 3. Answer: The par yield is the yield on a coupon-bearing bond.018. n~0f24 . When the yield curve is upward sloping.8 Hull. S.70%. The amount of capital a bank is required to hold to support an investment in Treasury bills and bonds is substantially smaller than the capital required to support a similar investment in other verylow-risk instruments.2.1). i. ." Explain why this is so.orwardl R:ail. S . Futures and other Derivatives) FRM 2009 $1.00'% S. when the yield curve is downward sloping. bonds must be purchased by financial institutions to fulfill a variety of This increases demand for these Treasury instruments driving the price up ii.et Cash Flow . When the zero curve is downward-sloping the reverse is true. The zero rate is the yield on a zero-coupon bond. 5.e's 'cq ( 4.. the yield on an N-year coupon bearing bond is higher than the yield on an N-year zero-coupon bond. ~V oif N.lO%. and the yield down.

22: instruments are given a favorable tax treatment because they are not taxed at the state level. [my adds] What is the difference between this bond's Macaulay and modified duration? 6. 1. What is the bond's price? compounded) pays an 8% coupon at the end of each 2. n~BOi24 . At 11 % yield.04. is the convexity positive or negative? . Use the duration to calculate the effect on the bond's price of a 0. In the United States. compared with most A s-year bond with a yield of 11 % (continuously year. what is the first derivative of the bond's price change with respect to an (instantaneous) yield change? 7. Treasury other fixed-income investments Hull. 4.Hull Chapters 1-5 (Options.Elite Boo k.2% decrease in it's yield. At 11 %. Recalculate the bond's price on the basis of a 10.8% per annum yield and verify that the result is in agreement with your answer to "c". What is bond's duration? 3. Futures and other Derivatives) FRM 2009 iii. 5.

oo 5.e'ff Flow $7_17 $1!i42 $5_75.11x2 + Se"-0. % Viield $100.11x4 + 10Se"-0.256 years 3.ci'pal 4_0 ss.002 = 0.11x2 + 3 x Se"-0.54.00 8.riCle' :. $8:_00 O_SH3: ~~MtOO 0_119 $8:_00 0.S0 [Se"-O.1. The bond's price is S"-O.80 (Mia:caJUilay) Durati'.10Sx3 + Se"-0.3 0_148 0_01591 :$140.74 The bond's price should increase from S6.n Yj'eld ch.11x4 + 5 x 10Se"-0.ll + Se"-0. $5_15 $62.'& Presentt SemiAnnual P.]1 $1m3:_00 Dis- Vallue .rin.'0% HUlIl Taible 4.S% yield the bond's price is Se"-O.8:_00 0_896.11 Durati'on IContti'nUIOUS $16.e.11x3 + Se"-0.com/public/btzoho/hull-04-22 Par value 'Coupon.31 0_083: 0_074- o.on Modlifi'ed Ou rati'.zoho.S0 2.540 1.1)00% 4.ll + 2 x Se"-0.Hull Chapters 1-5 (Options. Futures and other Derivatives) FRM 2009 Answer: Spreadsheet is here: http://sheet.of lCash Tim. Since.54 iteBook. 4. With a 10..440_5.11x5] = 4.mgle (billS) 11.S0 x 4.'1:.B*D*delta_y the effect on the bond's price of a 0. The bond's duration is 1/S6. . with the notation in the chapter delta_B = .11x3 + 4 x Se"-0.S0 to S7.10Sx2 + Se"-0.dl Pri'Cie Estti'mattedi Nlew Bond iJ.25'60 Chalngle in Bion.0% 11.10Sx4 + 10Se"-0.10Sx5 = S7.lOS + Se"-0._0 $10l100' Ca'sh ()ountt 'Caish IIHow Fador $.2% decrease in its yield is S6.ess W.256 x 0.11x5 = S6.ei'glhrt 0_08.

Under Hull's cost of carry.256 * $86. but under continuous compounding k -> infinity and so.Hull Chapters 1-5 (Options. the two durations are the same! 6. without embedded Hull. PV of income = $1 *EXP[-12%*3 months/12 months] $0. What should the futures price for a 4 month contract be? 05.97)*EXP[12%*0.03c..03c.03: options) bond. Futures and other Derivatives) FRM 2009 5 [my adds] What is the difference between this bond's Macaulay and modified duration? Modified duration = Macaulay Duration / (1 +y/k).Elite Boo k.5] = $31.54 05.03b [my adds]. what is the 4-month futures price? 05.86 05.82 Hull. If the dividend instead pays an $8 lump sum in 3 months (flat interest rate term structure). n~~Oi24 .5 = $31.5] = $30.At 11% yield.12x0. Forward price = ($30 - A stock index currently stands at 350. what is the first derivative of the bond's price change with respect to an (instantaneous) yield change? The first derivative is the dollar duration. is the convexity positive or negative? Always positive for plain vanilla (Le. The risk-free interest rate is 8% per annum (with continuous compounding) and dividend yield on the index is 4% per annum.97.04c. What is the forward price? 05. At 11%. What is the 6 month forward price if the stock pays a dividend of 2% (as constant % of stock price) per year? 05.OS. Suppose that you enter into a 6 month forward contract on a non-dividend-paying stock when the stock price is $30 and the risk-free interest rate (with continuous compounding) is 12% per annum. What is the 6 month forward price if the stock pays a lump sum dividend of $1 dollar in 3 months (assume flat term structure of interest rates)? Answer: 05.04: = $0. dollar duration (@ 11%.04b.OS.03b. only under continuous compounding.42 = Duration 4. what is required for the stock index forward curve to exhibit backwardation? . because the slope varies based on the yield) = $369.2%)*. Forward = $30*EXP[(12% .03 The forward price is 30eAO.80 price 7. In this case.

are related by FO = SO*EXP[(c-y)*T] where c is the cost of carry. What is the relationship between futures price. the price of the stock is $45 and the risk-free interest rate is still 10%.09: A 1 year long forward contract on a non-dividend-paying stock is entered into when the stock price is $40 and the risk-free rate of interest is 10% per annum with continuous compounding. Futures and other Derivatives) FRM 2009 Answer: 05. Six months later. Hull. In return for bearing risk. Hull.7 05. So. IfE(St) = FO.14 and the fact that the index has positive systematic risk. y is the convenience contract. convenience yield.08: yield. What are the forward price and the initial price of the forward contract? b.Hull Chapters 1-5 (Options.F > O. The dividend yield (constant as %) would need to exceed the riskless rate.OB-0.05.7.05. PVof$Blump sum = $7.B4. The future price is 350e"(0. This is the theory of normal backwardation.41 05. Fo. What are the forward price and the value of the forward contract? .05.04c. a. Future price = (350 . The futures price. Answer: The futures price of a stock index is always less than the expected future value of the index. This follows from Section 5.06: Question: Explain carefully the meaning of the terms convenience yield and cost of carry.Elite Boo k. The cost of carry is the interest cost plus cost less the income earned.B4) * EXP[B%*4j12] = $351. the long forward position expects compensation for bearing that risk. and cost of carry? Answer: Convenience yield measure the extent to which there are benefits obtained from ownership of the physical asset that are not obtained by owners oflong futures contracts.04b.04. spot price. Hull. and T is the time to maturity of the futures Is the futures price of a stock index greater than or less than the expected future value of the index? Explain your answer.04)x0. n~~Oi24 . if the underlying has systematic risk.then the expected profit = 0 and the long forward bears risk without any expected profit. the long forward expects profit: E(St) . and spot price.3333 = $354.

The forward price is 45e"0. Futures and other Derivatives) FRM 2009 Answer: a. it is $2. 2006 is 300. The current value of the index is 150.12: Suppose that the risk-free interest rate is 10% per annum with continuous compounding and that the dividend yield on a stock index is 4% per annum.11: Assume that the risk-free rate is 9% per annum with continuous compounding and that the dividend yield on a stock index varies throughout the year. The value of the contract. The initial value of the forward contract is zero. dividends are paid at a rate of 2% per annum. What is the futures for a contract deliverable on December 31. The index is standing at 400. What is the 6 month futures price? Answer: Using equation (5. b.34.032) = 152.07 -0.lx1 = 44. and the dividend yield on a stock index is 3.032)x0.5 = 47.21 or $44.5 = 2. n~30i24 .88. What arbitrage opportunities does this create? 300e"(0.95.95 i.88 or $152. The average dividend yield is therefore 1/5(3 x 2 + 2 x 5) = 3.31 or $47. .Elite Boo k. Hull.10: The risk-free rate of interest is 7% per annum with continuous compounding.OS.lx0.31.3) the 6 month future price is 150e" (0. August.21.Hull Chapters 1-5 (Options.21e"-0. The forward price.lxO.OS.21. Fo.4167 = 307. Suppose that the value of the index on July 31. The delivery price K in the contract is $44. f..09-0. and November.OS. Hull.34 or $307. after six months is given by equation as: F = 45 . is given by equation as: Fo = 40e"-0. The dividend yield is 2% for three of the months and 5% for two of the months.2% The futures price is therefore Hull. 2006? Answer: The futures contract lasts for five months. and the futures price for a contract deliverable in four months is 405. In February.2% per annum. May.44.e.

Futures and other Derivatives) FRM 2009 Answer: The theoretical futures price is 400e"(0. What arbitrage opportunities does this create? Answer: The theoretical futures price is 0. Hull. This suggests that an arbitrageur short Swiss francs futures.6600.Hull Chapters 1-5 (Options. The spot price of the Swiss franc is $0. This shows that the index futures price is too low relative to the index.6500. respectively 3% and B% per annum with continuous compounding.6500e"(0.15: should buy Swiss francs and The 2 month interest rates in Switzerland and the United States are. respectively 3% and B% per annum with continuous compounding. Short the shares underlying the index.OB-0.OB-0.03)x2j12 = 0. 2.03)x2j12 = 0.10-0. Hull. The futures price for a contract deliverable in 2 months is $0.6554 The actual figures price is too high.6500.6500e"(0.05.05.OB The actual futures price is only 405. What arbitrage opportunities does this create? Answer: The theoretical futures price is 0.14: The 2 month interest rates in Switzerland and the United States are. The correct arbitrage strategy is 1. .6600.04)x4j12 = 40B. Hull. This suggests that an arbitrageur short Swiss francs futures.18: It is sometimes argued that a forward exchange rate is an unbiased predictor Under what circumstances is this so? Answer: of future exchange rates. Buy futures contracts.6554 should buy Swiss francs and The actual figures price is too high. The spot price of the Swiss franc is $0.05. The futures price for a contract deliverable in 2 months is $0.

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