Exam FM Practice Exam 3

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Exam FM Practice Exam 3

Attribution Non-Commercial (BY-NC)

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1. An n-year bond has a face amount of 1000 with annual coupons of 5%. The book value of the bond at the end of the 6th year is 857 and the adjustment to the bond in the 6th year is a write-up of 11. Calculate n. (A) 12 (B) 13 (C) 14 (D) 15 (E) 16

Correct answer: (D) Solution: Since the adjustment to the bond in the 6th year is +11, then BV5 = 846. Let j be the annual yield rate. We know that BV6 = BV5 (1 + j ) 50. Thus 857 = 846(1 + j ) 50. 907 1 = .0721. Therefore j = 846 We know that the book value immediately after the 6th payment is 857. At that time, there are n 6 payments remaining. Use a nancial calculator with I = 7.21, P V = 857, P M T = 50, and F V = 1000 to nd N = 9. This means that there are 9 payments remaining after the 6th payment, so there were 15 payments total.

2. An investor buys a 10-year bond for X . The bond pays semiannual coupons at a rate of 5% and is priced to yield 7.5% convertible semiannually. The investor reinvests all coupons into an account earning interest at an annual effective interest rate of 6%. After 10 years, he has 5445. Calculate X . (A) 2431 (B) 2579 (C) 2696 (D) 2703 (E) 2928

Correct answer: (C) Solution: Let F be the face amount of the bond. After 10 years, the investor has the face amount F plus the accumulated value of the coupons F .025. The nominal rate of interest convertible semiannually at which the investsed coupons accumulate is 1.061/2 1 = .02956. Therefore, the accumulated value of the coupons is F .025s20 .02956 . After 10 years, the investor has 5445, so we know that 5445 = F + F .025s20 .02956 . Solve to nd F = 3262.86. = .0375. Then the price of the bond is X = The semiannual yield rate of the bond is .075 2 20 3262.86( 1+.1 = 2696. ) + 3262 . 86 . 025 a 20 .0375 0375

3. Which of the following nancial instruments carries the highest credit risk? (I) A forward contract purchased over-the-counter (II) A futures contract (III) A put option purchased over-the-counter (A) (I) (B) (II) (C) (III) (D) (I) and (II) both have the highest credit risk (E) (I) and (III) both have the highest credit risk

Correct answer: (A) Solution: A forward contract purchased over-the-counter has a higher credit risk than a futures contract because a futures contract is traded on an exchange. A forward contract purchased over-the-counter has higher credit risk than a put option purchased over-the-counter because a put option may be worthless at maturity, which means that the exposure at default (the amount that could be lost if the other party defaults) may be 0. Therefore the answer is (A).

4. A 4-year annuity makes payments at the beginning of every month starting today. The rst 12 payments are 1000 each. The next 12 payments are 1100 each. The next 12 payments are 1210 each. The nal 12 payments are 1331 each. What is the value of the annuity at the end of 4 years valued at an interest rate of 12% convertible monthly? (A) 43438 (B) 43872 (C) 70032 (D) 70732 (E) 89073

Correct answer: (D) Solution: First nd the accumulated value of the rst 12 payments valued at the end of the rst year: 1000 s12 .01 = 12809.33. Now realize that this annuity is equivalent to a geometrically increasing annuity with an initial payment of 12809.33 where the payments increase 12 12 by 10% each year. The interest rate used to value this annuity is (1 + .12 ) 1 = .1268. Thus the accumulated value of the annuity is: 1.12684 12809.33(

1+.1 )4 1( 1+ .1268 ) .1268.1

= 70732

5. A company has a liability of 1000 due in 1.95 years. The company wants to provide Redington immunization for the liability by purchasing a combination of bond X and bond Y , which are available in any face amount. Bond X is a 2-year bond with annual coupons of 11%. Bond Y is a 2-year zero-coupon bond. The annual effective rate of interest is 5%. What amount of bond Y should be purchased to provide Redington immunization for this liability? (A) 385 (B) 434 (C) 471 (D) 518 (E) 575

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Correct answer: (C) Solution: The rst two conditions for Redington immunization are: .11Xv + 1.11Xv 2 + Y v 2 = 1000v 1.95 and .11Xv 2 2.22Xv 3 2Y v 3 = 1950v 2.95 Solve this system of two equations with two unknowns to nd Y = 471.

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6. A 10-year bond with annual coupons of 5% is priced to yield an effective annual interest rate of 8.3%. A 10-year bond with semiannual coupons at a rate of 5% has the same face amount and price and yields an annual effective interest rate of i%. Calculate i. (A) 8.25 (B) 8.30 (C) 8.42 (D) 8.51 (E) 8.57

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Correct answer: (C) Solution: We can choose to use any face amount to nd the answer. Suppose that the face amount for both bonds is 1000. Then the price of the rst bond can be calculated using a nancial calculator with N = 10, I = 8.3, P M T = 50, and F V = 1000; solve to nd P V = 781.53, so the bond price is 781.53. Then the semiannual yield rate of the second bond can be calculated using a nancial calculator with N = 20, P V = 781.53, P M T = 25, and F V = 1000; solve to nd I = 4.125. This represents the rate per coupon period, so the annual effective interest rate i is (1 + .04125)2 1 = .0842. Thus i = 8.42.

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7. Betty buys a 30-year bond with annual coupons of 4% priced to yield 7% for a purchase price of X . Coupon payments from the bond are reinvested into an account earning interest at an annual effective rate of 6%. After 30 years, Betty has 100,000. Calculate X . (A) 14977 (B) 15081 (C) 15119 (D) 15228 (E) 15414

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Correct answer: (B) Solution: Let F be the face amount of the bond that Betty buys. Then the coupon payments are .04F . The coupon payments accumulate at an annual effective rate of interest of 6% and Betty will also receive F at the end of 30 years. Therefore 100, 000 = .04F s30 .06 + F . Thus F = 24025 and so the coupon payments are 961. Find the purchase price X using a nancial calculator with N = 30, I = 7, P M T = 961, and F V = 24025 to nd X = 15081.

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8. A portfolio worth 500 produces cashows of 150 at time 3, X at time 4, and 200 at time 6. The cashow of X at time 4 makes up 45% of the value of the portfolio. Calculate the Macaulay duration of the portfolio. (A) 3.67 (B) 4.00 (C) 4.33 (D) 5.00 (E) 5.50

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Correct answer: (C) Solution: Since the cashow of X makes up 45% of the value of the portfolio, the remaining cashows of 300 makes up 55% of the value of the portfolio: 500 .55 = 150v 3 + 200v 6 . Use the substitution y = v 3 to transform this into a quadratic equation and solve to nd y = .856. Therefore v = .95. Then, since the cashow of X makes up 45% of the value of the portfolio, we have 500.45 = Xv 4 . Solve to nd X = 277. Then the Macaulay duration of the portfolio is

3150v 3 +4277v 4 +6200v 6 500

= 4.33.

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9. Which of the following are true regarding swaps? (I) A prepaid swap is a swap in which the present value of all payments, calculated using the current term structure, is paid immediately (II) A deferred swap is a swap in which the future value of all payments, calculated using the current term structure, is paid at the end of the swaps term (III) The swap spread is collected by an intermediary for the service of arranging a swap between two parties (A) (I) only (B) (II) only (C) (I) and (III) (D) (II) and (III) (E) The answer is not given by any of (A), (B), (C), or (D)

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Correct answer: (C) Solution: A prepaid swap is a swap in which the present value of all payments, calculated using the current term structure, is paid immediately. Therefore (I) is true. A deferred swap is a swap in which the conditions of the swap are agreed upon today, but the exchange of payments begins sometime in the future. Therefore (II) is false. The swap spread is collected by an intermediary for the service of arranging a swap between two parties. Therefore (III) is true. Therefore the answer is (C).

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10. Two bonds have the same yield rate. Both bonds have a face amount of 1000, a redemption amount of 1100, and a price of 800. The rst is a 15-year bond with annual coupons at a coupons rate of 5%. The second is a 20-year bond with coupons at a coupon rate of r% convertible semiannually. Calculate r. (A) 2.43 (B) 2.68 (C) 4.87 (D) 5.35 (E) 5.45

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Correct answer: (D) Solution: From the rst bond, use a nancial calculator with N = 15, P V = 800, P M T = 50, and F V = 1100 to nd that the annual effective yield rate for both bonds is .07667. Therefore the yield rate per six months is (1 + .07667)1/2 1 = .03763. Then for the second bond, use a nancial calculator with N = 40, I = 3.763, P V = 800, and F V = 1100 to .762 = nd that each semiannual coupon is 26.76. Therefore the coupon rate r is given by 26 1000 .0535.

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11. Which of the following are true concerning the cost of carry of a long position in a stock? (I) The cost of carry includes any dividends paid by the stock. (II) The cost of carry includes the full price at purchase of the stock. (III) The cost of carry is zero if the stock pays no dividends and if the increase in stock price exactly matches the annual effective rate of interest. (A) (I) only (B) (III) only (C) (II) and (III) (D) (I), (II), and (III) (E) The answer is not given by any of (A), (B), (C), or (D)

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Correct answer: (E) Solution: The cost of carry of a long position does not include dividends paid. (The cost of carry of a short position does include dividends paid.) Therefore (I) is false. The cost of carry includes the interest paid on a hypothetical loan for the stocks purchase price, but does not include the purchase price. Therefore (II) is false. The cost of carry includes the interest paid on a hypothetical loan for the stocks purchase price, regardless of whether the stock price increase matches the annual effective rate of interest. Unless the stock price is zero, the cost of carry will not be zero. Therefore (III) is false. Therefore the answer is (E).

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12. Which of the following are true about convertible bonds? (I) A convertible bond is always a zero-coupon bond. (II) A convertible bond does not have a xed maturity date. (III) If a companys stock value falls, the value of a convertible bond issued by the company also must fall. (A) (I) only (B) (III) only (C) (I) and (II) (D) (II) and (III) (E) The answer is not given by any of (A), (B), (C), or (D)

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Correct answer: (E) Solution: Convertible bonds can have coupons. Therefore (I) is false. Convertible bonds have maturity dates. Therefore (II) is false. If a companys stock value is low, the value of a convertible bond will come from its coupons and redemption value. If the stock value falls, the value of convertible bonds will not fall any lower. Therefore a drop in stock value does not necessarily mean a drop in convertible bond value. Therefore (III) is false. Therefore the answer is (E).

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13. Adam and Jane both invest the same amount of money into 10-year bonds that have annual coupons and are priced to yield 6%. Adams bond has coupons of 5%, and Adam reinvests coupons into an account earning interest at an effective annual rate of 12%. Janes bond has coupons of 15%, and Jane reinvests coupons into an account earning interest at an effective annual rate of i%. After 10 years, Adam and Jane have the same amount of money. Calculate i. (A) 6.4 (B) 7.7 (C) 8.2 (D) 9.0 (E) 9.8

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Correct answer: (E) Solution: Suppose that Adam and Jane each invest 1000 into their bonds. The face amount of Adams bond can be calculated using the formula P = F + (r j )F anj , or 1000 = F +(.05.06)F a10 .06 . Solve to nd F = 1079.45. Therefore Adams coupons are each 1079.45 .05 = 53.97. After 10 years, Adam receives the face amount of the bond plus the accumulated value of the coupons reinvested at 12%, or 1079.45+53.97s10 .12 = 2026.60. The face amount of Janes bond can be calculated in the same way using the formula 1000 = F + (.15 .06)F a10 .06 . This yields F = 601.54. Therefore Janes coupons are each 90.23. After 10 years, Jane has the face amount plus the accumulated value of the coupons reinvested at i%. We know that after 10 years, Jane has 2026.60. Therefore 2026.60 = 601.54 + 90.23s10 i . Solve using a nancial calculator to nd i = 9.8.

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14. At time t = 0, Roger deposits $100 into an account earning interest at a force of interest of 1 . At time t = 4, he transfers all of the money to a second account earning interest at a 1+3t rate of 12% compounded monthly. How much money does Roger have at time t = 8? (A) 200 (B) 379 (C) 422 (D) 429 (E) 560

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Correct answer: (B) Correct answer: 379 Solution: At time t = 4, Roger will have 100e

4 0 (1+3t)dt 1 4

.12 124 ) 12

= 379.

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15. A 30-year bond has a face amount of 10,000 and a redemption amount of 12,000. It has annual coupons of 5% and the purchase price is 10,000. Calculate the adjustment to book value in the 5th year. (A) Write-down of 103.87 (B) Write-down of 35.21 (C) No adjustment (D) Write-up of 35.21 (E) Write-up of 103.87

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Correct answer: (D) Solution: Use a nancial calculator to nd the yield rate using N = 30, P V = 10, 000, P M T = 500, and F V = 12, 000 to nd I = 5.287. The adjustment to book value in the 5th year is the price immediately after the 5th payment minus the price immediately after the 4th payment. The value immediately after the 5th payment can be computed using a nancial calculator with N = 25, I = 5.287, P M T = 500, and F V = 12, 000 to nd the value is 10,159.23. The value immediately after the 4th payment can be computed in the same way with N = 26 to nd the value is 10,124.02. Therefore the adjustment was 10, 159.23 10, 124.02 = 35.21. This is a write-up of 35.21.

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16. Which of the following positions could result in unlimited gain? (I) Short position in a call ratio (II) Long position in a put option (III) Short position in a strangle (A) (I) only (B) (III) only (C) (I) and (II) (D) (I), (II), and (III) (E) The answer is not given by any of (A), (B), (C), or (D)

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Correct answer: (A) Solution: As the price of the underlying asset increases, a long position in a call ratio could result in unlimited loss, and a short position in a call ratio could result in unlimited gain. Therefore (I) could provide unlimited gain. As the price of the underlying asset decreases, a long position in a put option will provide more gain. However, once the asset price reaches 0, the gain can no longer increase. Therefore (II) could not provide unlimited gain. As the price of the underlying asset increases or decreases, a long position in a strangle will provide increasing gain, but a short position in a strangle will provide increasing loss. Therefore (III) could not provide unlimited gain. Therefore the answer is (A).

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17. At an annual effective interest rate of 7%, the accumulated value of an annuity due with n annual payments of 10 is 110. At an annual effective rate of i%, the accumulated value of an annuity immediate with n annual payments of 13 is 140. Calculate i. (A) 5.1 (B) 5.8 (C) 6.5 (D) 7.3 (E) 8.3

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Correct answer: (E) Solution: Use the rst annuity to nd n using the formula 110 = 10 sn.07 . This shows that n = 8. The second annuity gives a formula for i: 140 = 13s8 i . Use a nancial calculator to nd i = .083.

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18. Daniel writes a covered call with maturity in six months, a premium of 4, and a strike price of 38. He also buys a put option for the same underlying asset with maturity in six months, a premium of 4, and a strike price of 38. After six months, the underlying assets price is 44. The annual effective interest rate is 11.8%. What is Daniels prot? (A) -10 (B) 0 (C) 10 (D) 12 (E) 18

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Correct answer: (B) Solution: By drawing prot diagrams for the covered written call and the purchased put, we can see that the prot is 0. We can also calculate this using prot formulas. Writing a covered call consists of writing a call option and purchasing the underlying asset. Daniels prot from writing the call option is max{44 38, 0} + F V (4). His prot from owning the underlying asset is 44 38. His prot from buying the put option is max{38 44, 0} F V (4). The prot from the entire portfolio is max{44 38, 0} + F V (4) + 44 38 + max{38 44, 0} F V (4) = 0. Notice that we did not need the annual effective interest rate because we did not have to calculate the future value of the premiums.

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19. A stock costs 54 and will pay a dividends of 6 this year. The annual effective rate of interest is 6%. Let X be the one-year cost of carry of a long position in the stock, Y be the one-year cost of carry of a short position in the stock, and Z be the one-year cost of carry of a long position in a futures contract in the stock. What is the relationship between X , Y , and Z ? (A) X > Y > Z (B) X > Z > Y (C) Y > X > Z (D) Y > Z > X (E) Z > X > Y

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Correct answer: (C) Solution: The one-year cost of carry of a long position in one share of the stock is 54 .06 = 3.24 because 3.24 is the amount of interest that could be earned at the risk-free rate if the stock were sold and the money used to buy bonds. Therefore X = 3.24. The cost of carry of a short position in one share of the stock is 6 because the stock will pay a dividend of 6 this year. Therefore Y = 6. The cost of carry of a long position in a futures contract is 0 because no investment is required and the position will not be short any dividends. Therefore Z = 0. Thus Y > X > Z , so the answer is (C).

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20. A loan with amount A makes n level annual payments, where n is even, beginning 1 year after the loan is taken out. The annual effective interest rate is i such that 0 < i < 1. Which of the following scenarios are possible? (I) The interest paid in year

n 2

(II) The principal paid in year 1 equals the interest paid in year n.

1 (III) Immediately after payment n , the oustanding balance on the loan is 2 A. 2

(A) (I) only (B) (II) only (C) (I) and (III) (D) (II) and (III) (E) The answer is not given by any of (A), (B), (C), or (D)

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2 1.

(II) is possible where n = 2 and i = .618 (the golden ratio minus one). (III) is not possible because the majority of principal on a loan is paid during the second half of the loan. Therefore the answer is (E).

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21. A 10-year zero-coupon bond has a face value of 1000. Let i be the annual effective interest rate such that i > 0, MacD be the bonds Macaulay duration, and ModD be the bonds modied duration. Which of the following relationships is true? (A) MacD < ModD < 10 (B) MacD < ModD = 10 (C) ModD < MacD < 10 (D) ModD < MacD = 10 (E) It cannot be shown that any of (A), (B), (C), or (D) is true.

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Correct answer: (D) Solution: The Macaulay duration of a single cashow is equal to the time at which the cashow is made. Therefore MacD = 10. The modied duration ModD is related to the Macaulay duration MacD according to the following formula: ModD = MacD v . Since i > 0, we know that v < 1, and therefore ModD < MacD. (Note that if the interest rate i were 0, then ModD = MacD.) Therefore ModD < MacD = 10.

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22. It is known that K1 < K2 . An investor has purchased a combination of options that result in a position equivalent to a K1 -K2 bear spread. What transaction will change his position to be equivalent to a long position in a ratio spread? (A) Buy a call option with strike price K1 (B) Buy a call option with strike price K2 (C) Write two call options with strike price K2 (D) Buy a put option with strike price K1 (E) The answer is not given by any of (A), (B), (C), or (D).

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Correct answer: (E) Solution: Since the investor already has a bear spread, he will change his position to a long position in a put ratio spread. He needs to change his payoff on the interval (0, K1 ). He can accomplish this by writing a put option with strike price K1 . (Buying a call option with strike price K2 creates a short position in a ratio spread.) The correct transaction is not given among (A), (B), (C), or (D), so the answer is (E).

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23. On January 1, a fund has a balance of 1000. At the end of each month for 12 months, interest is credited to the account at a rate of 12% convertible monthly, and a deposit of 100 is made into the account. Calculate the time-weighted rate of return of the fund. (A) 12.0% (B) 12.7% (C) 17.3% (D) 29.5% (E) 39.5%

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Correct answer: (B) Solution: Using the denition of time-weighted rate of return, we can calculate the answer:

1010 1000

1121.1 1110

...

2295.08 2272.35

1 = 12.7%

However, it is much simpler to recognize that at the end of each month, the account accrues to 101% of its previous value. Therefore the time-weighted rate of return is 1.0112 1 = 12.7%. Note that this is equal to the annual effective rate of interest.

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24. A zero-coupon bond has a modied duration of 8. Calculate the convexity of the zero-coupon bond assuming an annual effective rate of interest of 12.5%. (A) 56.9 (B) 64.0 (C) 71.1 (D) 85.3 (E) 91.1

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Correct answer: (C) Solution: We know that MacD = ModD(1 + i). Therefore the Macaulay duration of the zero-coupon bond is 8(1 + .125) = 9. Remember that the Macaulay duration of a single cashow is equal to the time at which that cashow occurs. Therefore the redemption date is t = 9.

(i) , where P (i) is the price as a function of Remember that convexity is dened as C = P P (i) the interest rate i. Let F be the face amount of the bond. Then P (i) = F (1 + i)9 . Also, P (i) = 9F (1 + i)10 and P (i) = 90F (1 + i)11 . Then the convexity of the bond is (i) F (1+i)11 C=P = 90 = 71.1. P (i) F (1+i)9

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25. A loan is to be repaid in n years, where n is divisible by 3, with level annual payments at n is one-half the principal paid during the end of each year. The principal paid during year 1 3 2 year 3 n. The annual effective interest rate is 8%. Calculate n. (A) 15 (B) 18 (C) 21 (D) 24 (E) 27

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Correct answer: (E) Solution: Since i = .08, then v = .9259. Let P be the annual payment. Then the prinn is P (.9259nn/3+1 ) and the principal paid during year 2 n is cipal paid during year 1 3 3 1 n2n/3+1 P (.9259 ). Since the principal paid during year 3 n is one-half the principal paid 2 during year 3 n, we know that: P (.9259n2n/3+1 ) P (.9259nn/3+1 ) = 1 2

.92592n/3+1 .9259n/3+1 n/3

= =

1 2 1 2

.9259

n = 27

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26. The following chart shows prices for zero-coupon bonds with face amount 1000. It is known that the one-year forward rate two years from now is 6.1%. Time to maturity (years) 1 2 3 Calculate X . (A) 756.57 (B) 791.05 (C) 840.05 (D) 874.19 (E) 892.42 Zero-coupon bond price 930.00 X X 50.26

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Correct answer: (D) Solution: Let v (t, u) be the forward discount factor from time t to time u. (In this way, .) Since the one-year forward rate two years from now is 6.1%, we know v (t, u) = 1+i1 (t,u) 1 that v (2, 3) = 1+.061 = .9425. The price of a zero-coupon bond is its face amount multiplied by the forward discount factors from now until its maturity date. Therefore: 930 = 1000 v (0, 1) X = 1000 v (0, 1) v (1, 2) X 50.26 = 1000 v (0, 1) v (1, 2) v (2, 3) The value of v (2, 3) is already known, so this is a system of three equations with three unknowns. Solve to nd X = 874.19.

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27. A company has a liability of 800 in 6 years. The company wants to provide Redington immunization for the liability by purchasing two zero-coupon bonds are available for purchase at any face amount. Bond X matures in 4 years and bond Y matures in 8 years. The annual effective rate of interest is 6%. What amount of bond X should be purchased to provide Redington immunization for this liability? (A) 255 (B) 276 (C) 309 (D) 327 (E) 356

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Correct answer: (E) Solution: Let X be the face amount of bond X purchased and let Y be the face amount of bond Y purchased. The rst two conditions for Redington immunization are: Xv 4 + Y v 8 = 800v 6 and 4Xv 5 8Y v 9 = 4800v 7 . Solve this system of two equations with two unknowns to nd X = 356.

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28. The price of a 10-year bond, which is 100 less than its face amount, is equal to the present value of the face amount. It is known that j = r + .03, where j is the annual yield rate and r is the annual coupon rate. Calculate the face amount. (A) 291 (B) 301 (C) 332 (D) 391 (E) 440

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Correct answer: (D) Solution: Since the price of the bond is equal to the present value of its face amount, this must be a zero-coupon bond. (This is because none of the interest is paid during the life of the bond, so the coupons must be 0. This can also be proved by using the identity P = K + r (F K ), where K is the present value of the face amount. This gives us P = P + r (F P ) j j r or equivalently 0 = j (100). Therefore r = 0.) Since r = 0, we know that j = .03. Therefore (F 100)(1 + .03)10 = F , where F is the face amount. This gives F = 391.

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29. A company has a liability of 1000 due in 2.6 years. The company purchases a 3-year bond with face amount F and annual coupons of r% to provide Redington immunization for the liability. The annual effective rate of interest is 6%. Calculate r. (A) 12.6 (B) 14.7 (C) 16.4 (D) 18.1 (E) 19.7

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Correct answer: (E) Solution: The rst two conditions for Redington immunization are: (F r)v + (F r)v 2 + (F + F r)v 3 = 1000v 2.6 and (F r)v 2 2(F r)v 3 3(F + F r)v 4 = 2600v 3.6 . Solve this system of two equations with two unknowns to nd r = 19.7.

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30. It is known that K1 < K2 . Which of the following positions create a bear spread? (I) Buying a call with strike K1 and selling a call with strike K2 (II) Buying a call with strike K2 and selling a call with strike K1 (III) Selling a covered written call with strike K1 and selling a put with strike K2 (IV) Buying a put with strike K1 and selling a put with strike K2 (A) (I) only (B) (I) and (IV) (C) (II) only (D) (II) and (III) (E) The answer is not given by any of (A), (B), (C), or (D)

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Correct answer: (C) Solution: Combinations (I), (III), and (IV) create bull spreads. Combination (II) creates a bear. (Remember that a covered written call has the same prot as a purchased put.) The answer is (C).

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31. ABC Co. takes out a loan for 10,000. For the rst 19 years, ABC Co. makes payments at the end of each year of 120% of the interest due. At the end of the 20th year, ABC Co. makes a nal balloon payment of X . The annual effective interest rate is 8%. Calculate X . (A) 7243 (B) 7360 (C) 7497 (D) 7822 (E) 7949

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Correct answer: (E) Solution: At the end of each year, ABC Co. pays 120% of the interest due, so the outstanding balance is reduced by 20% of the interest due. The interest due is 8% of the outstanding balance. Therefore, at the end of each year, the outstanding balance is reduced by 20% of 8% of the outstanding balance. Thus OBt = (1 .2 .08) OBt1 = .984 OBt1 . Equivalently, OBt = 10, 000 .984t . The outstanding balance at time 19 is 10, 000 .98419 = 7360. At time 20, this has accumulated to 7360(1 + .08) = 7949. Then ABC Co. pays off the entire remaining balance of 7949.

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32. A 12-year loan makes 11 annual payments of 100 at the end of each year followed by a balloon payment of 400 at the end of year 12. The annual effective interest rate is i. Which of the following represents the interest paid in the 4th payment?

1 9 ) (A) 100 100( 1+ i 1 9 (B) 100 + 400( 1+ ) i 1 9 1 8 ) 400( 1+ ) (C) 100( 1+ i i 1 8 1 9 (D) 300( 1+ ) 200( 1+ ) i i 1 9 1 8 ) 400( 1+ ) (E) 100 + 300( 1+ i i

64

Correct answer: (E) Solution: Treat this as a 12-year loan with level payments of 100 plus a lump sum with a future value of 300. The interest paid in the 4th year on the loan with level payments is 1 9 1 124+1 ) ) or equivalently 100 100( 1+ ) . The interest paid on the lump sum in 100(1 ( 1+ i i 1 8 1 9 1 8 1 9 th the 4 year is 300( 1+i ) 300( 1+i ) . Thus the answer is 100 + 300( 1+ ) 400( 1+ ). i i

65

33. A geometric annuity immediate with 24 monthly payments is worth 3000. A geometric annuity immediate with 12 monthly payments is worth 1000. The rst payment of both annuities is the same, and the payments of the annuities increase at the same rate. The annual effective rate of interest is 10%. What is the amount of the nal payment of the 24-month annuity? (A) 253.20 (B) 271.65 (C) 290.10 (D) 308.55 (E) 327.00

66

Correct answer: (B) Solution: The monthly interest rate is 1.11/12 1 = .00797. Let X be the rst payment of each annuity. The 24-month annuity is worth 3000 = X The 12-month annuity is worth 1000 = X Then:

2 r )12 1( 1.1+ 00797 . .00797r r )24 1( 1.1+ 00797 . .00797r r ( 1.1+ )12 . 00797

1 y 2 = 3(1 y ) y 2 3y + 2 = 0 y = 1 or y = 2

r )12 to nd r = .0679. (If y = 1 is used, there is no possible value Use y = 2 = ( 1.1+ 00797

1.00797 of X that satises the problem description.) Then use the equation 3000 = X .00797 .0679 to nd X = 59.94. Therefore the rst payment is 59.94 1.06790 , the second payment is 59.94 1.06791 , and the 24th payment is 59.94 1.067923 = 271.65.

1(

1.0679

)24

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34. Order the following quantities from smallest to greatest valued at the same annual effective interest rate. I. The present value of an annuity immediate with 12 annual payments of P . II. The present value of an annuity due with 12 annual payments of P . III. The present value of an annuity immediate with 12 monthly payments of P . IV. The present value of an annuity due with 12 monthly payments of P . V. The present value of an 12-month continuously payable annuity paying a total of 12P during the annuity. (A) I, II, III, IV, V (B) I, II, III, V, IV (C) I, III, II, V, IV (D) I, III, V, II, IV (E) The answer is not given by any of (A), (B), (C), or (D).

68

Correct answer: (B) Solution: One solution is to calculate the present value of each annuity. Another approach is to recognize that the present value of sooner payments is greater. This means that payments far into the future are worth less. The 12-year annuities have smaller present values than the 12-month annuities. Furthermore, the 12-year annuity immediate has a smaller present value than the 12-year annuity due because the payments are delayed by 1 year. Therefore, the smallest quantity is (I) followed by (II). The 12-month continuously payable annuity is payed evenly over 12-months, while the payments of the 12-month annuity immediate are skewed toward the end of the year and the payments of the 12-month annuity due are skewed toward the beginning of the year. Therefore, the 12-month annuities are ordered as follows: (III), (V), (IV). The answer is (B).

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35. An investor creates a 2:1 ratio spread by buying one call with strike price 105 and selling two calls with strike price X . If the spot price at maturity were 130, the investors payoff would be 5. What is the investors maximum possible payoff? (A) 10 (B) 15 (C) 20 (D) 25 (E) 30

70

Correct answer: (A) Solution: The payoff for the ratio spread is max{S 105, 0} 2 max{S X, 0}. If the investors payoff is negative, we know that all three options were exercised, so 5 = (130 105) 2(130 X ). Therefore X = 115. The investors maximum payoff occurs when the spot price is as large as possible (to maximize payoff from the bought call) but when the sold calls are not exercised. This occurs when S = 115. The payoff for this price is max{115 105, 0} 2 max{115 115, 0} = 115 105 = 10.

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