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Multiple Choice Test Bank: Questions with Answers

1. Prior to the credit crisis that started in 2007 which of the following was used

by derivatives traders for the discount rate when derivatives were valued

A. The Treasury rate

B. The LIBOR rate

C. The repo rate

D. The overnight indexed swap rate

Answer: B

Derivatives markets used LIBOR as the discount rate pre-crisis.

2. Since the credit crisis that started in 2007 which of the following have

derivatives traders used as the risk-free discount rate for collateralized

transactions

A. The Treasury rate

B. The LIBOR rate

C. The repo rate

D. The overnight indexed swap rate

Answer: D

Derivatives markets have used the OIS rate as the discount rate for

collateralized transactions since the crisis.

3. Which

A.

B.

C.

OIS rates are less than the corresponding LIBOR/swap rates

OIS rates are greater than corresponding LIBOR/swap rates

OIS rates are sometimes greater and sometimes less than LIBOR/swap

rates

D. OIS rates are equivalent to one-day LIBOR rates

Answer: A

OIS rates are less than LIBOR /swap rates when both have the same maturity.

A. A fixed rate is exchanged for the overnight rate every day for three

months

B. LIBOR is exchanged for the overnight rate every day for three months

C. The arithmetic average of overnight rates is exchanged for a fixed rate

at the end of three months

at the end of three months

Answer: D

The OIS rate is the rate exchanged for the geometric average of overnight rates.

In the U.S. the overnight rate is the fed funds rate

5. Suppose that OIS rates for all maturities are 2.5% and swap rates for all

maturities are 3%. Which of the following is true?

A. Forward LIBOR rates are greater when OIS discounting is used than

when LIBOR discounting is used

B. Forward LIBOR rates are less when OIS discounting is used than when

LIBOR discounting is used

C. Forward LIBOR rates are the same for both OIS discounting and LIBOR

discounting

D. Either A or B can be true

Answer: C

When the yield curves are flat, all forward LIBOR rates are 3% regardless of

whether OIS or LIBOR discounting is used. This is because, when all forward

LIBOR rates equal 3%, all exchanges on all swaps are worth zero regardless of

the discount rate used.

6. CVA stands for

A. Collateral value adjustment

B. Credit value adjustment

C. Credit value agreement

D. Collateral value agreement

Answer: B

CVA stands for credit value adjustment

7. In a fully collateralized transaction which of the following leads to a pricing

adjustment

A. The rate paid on cash collateral is the fed funds rate

B. The rate paid on cash collateral is greater than the fed funds rate

C. The rate paid on cash collateral is less than the fed funds rate

D. Both B and C

Answer: D

If the rate paid on cash collateral is different from the fed funds rate then an

adjustment is necessary. The OIS rate is linked to the fed funds rate and is the

rate used for discounting fully collateralized transactions.

8. When

A.

B.

C.

DVA increases so that the banks profit goes down

DVA increases so that the banks profit goes up

DVA declines so that the banks profit goes down

Answer: B

The bank is considered more likely to default. Its DVA therefore increases and

this increases its profit because it is then considered more likely that it will

default and not have to meet derivatives obligations.

9. In October 2008 the three-month LIBOR-OIS spread rose to

A. 231 basis points

B. 364 basis points

C. 450 basis points

D. 520 basis points

Answer: B

In October 2008 the three-month LIBOR-OIS spread rose to 364 basis point, a

record.

10.As a bank`s borrowing rate increases, which of the following is true if a bank

calculates FVA

A. FVA increases

B. FVA declines

C. FVA stays the same

D. FVA may increase or decline.

Answer: A

FVA is the funding value adjustment. As borrowing costs increase it costs the

bank more to fund its operations and FVA increases. (In theory, as explained in

the text, funding value adjustments should not be made but in practice they are

often made.)

A. CVA and DVA can be calculated deal by deal

B. CVA and DVA must both be calculated for the whole portfolio a bank

has with a counterparty

C. CVA can be calculated deal by deal but DVA must be calculated for a

portfolio

D. DVA can be calculated deal by deal but CVA must be calculated for a

portfolio

Answer: B

Because of netting, all derivatives in a portfolio are considered to be a single

derivative in the event of a default. CVA which measures the cost of a

counterparty default and DVA which measures the benefit of the bank defaulting

must therefore be calculated on a portfolio basis.

12.Which of the following is true when a bank uses OIS discounting for valuing a

LIBOR-for-fixed swap

A. The LIBOR/swap zero curve is calculated before the OIS zero curve

B. The OIS zero curve is calculated before the LIBOR/swap zero curve

C. The swap is valued using OIS forward rates and OIS discounting

D. The forward rates are calculated from the banks borrowing costs

Answer: B

First the OIS zero curve is calculated. LIBOR forward rates are then calculated so

that all swaps when entered into at mid-market swap rates have zero value

13.It is assumed that a company can default after one year or after two years.

The probability of default at each time is 1.5%. The present value of the

expected loss to a bank on a derivatives portfolio if the company defaults

after one year is estimated to be $1 million. The present value of the

expected loss if it defaults after two years is estimated to be $2 million.

Which of the following is the banks CVA ?

A. $3,000,000

B. $300,000

C. $450,000

D. $150,000

Answer: C

The present value of the expected loss is 0.015$1,000,000 +

0.015$2,000,000 or $450,000. This is the CVA.

14.Accountants like to value a derivatives portfolio at

A. The bid price

B. The offer price

C. The exit price

D. Original cost less depreciation

Answer: C

Accountants like to value a derivatives position at the exit price. This is the price

at which the bank could trade out of the position or enter into an offsetting

transaction.

15.In the

A.

B.

C.

D.

Their income is not subject to tax at the state level

Their income is not subject to tax at the federal level

Both A and B are true

They are not subject to capital gains tax at the federal level

Answer: A

Income from Treasury instruments is not subject to tax at the state level. This is

one of the reasons why the yield on Treasuries is lower than the yield on other

instruments that have very little credit risk.

16.Suppose that OIS rates of all maturities are 6% per annum, continuously

compounded. The one-year LIBOR rate is 6.4%, annually compounded and

the two-year swap rate for a swap where payments are exchanged annually

is 6.8%, annually compounded. Which of the following is closest to the LIBOR

forward rate for the second year when LIBOR discounting is used and the rate

is expressed with annual compounding

A. 7.199%

B. 7.221%

C. 7.223%

D. 7.225%

Answer: C

When LIBOR discounting is used, the OIS rates are irrelevant. The two year

LIBOR/swap zero rate, R, is given by

6.8

106.8

100

1.064 (1 R ) 2

so that R=6.8137%. We can calculate the forward rate from the one- and twoyear zero rates as 1.0681372/1.0641 or 7.223%

17.Suppose that OIS rates of all maturities are 6% per annum, continuously

compounded. The one-year LIBOR rate is 6.4%, annually compounded and

the two-year swap rate for a swap where payments are exchanged annually

is 6.8%, annually compounded. Which of the following is closest to the LIBOR

forward rate for the second year when OIS discounting is used and the rate is

expressed with annual compounding?

A. 7.199%

B. 7.221%

C. 7.223%

D. 7.225%

Answer: D

In the two-year swap the forward rate corresponding to the first exchange is the

one-year zero rate or 6.4%. This means that, when a fixed rate is paid the value

of that exchange per $100 of principal is $100(0.064-0.068)e 0.061 =-$0.3767.

If F is the forward rate for the second year we must have

(F-0.068)e-0.062 =0.3767

so that F=0.07225.

18.Which of the following involves most credit risk

A. Exchange trading

B. OTC trading with a central clearing party being used

C. OTC trading with bilateral clearing and collateral being posted

D. OTC trading with bilateral clearing and no collateral being posted

Answer: D

In the case of both exchange trading and trading using a CCP initial margin and

variation margin have to be posted so that the risk of a loss because of a default

is low. Bilateral clearing usually involves more credit risk than exchange/CCP

trading and credit risk is greater when there is no collateral agreement.

19.A bank has three uncollateralized transactions with a counterparty worth +

$10 million, $20 million and +$25 million. A netting agreement is in place.

What is the maximum loss if the counterparty defaults today.

A. $15 million

B. $35 million

C. $20 million

D. Zero

Answer: A

The netting agreement means that the three transactions are considered to be a

single transaction. The net value of the transactions to the bank is 1020+25 or

$15 million. This is the maximum amount that could be lost if the counterparty

defaults today.

20.Since the 2008 credit crisis

A. LIBOR has replaced OIS

swaps

B. OIS has replaced LIBOR

swaps

C. LIBOR has replaced OIS

D. OIS has replaced LIBOR

as the discount rate for non-collateralized

as the discount rate for collateralized swaps

as the discount rate for collateralized swaps

Answer: D

OIS has replaced LIBOR as the discount rate for collateralized derivatives.

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