CFA Answers

Level I Derivative Markets and
Instruments
Test Code: L1 R56 DVMI Q-Bank
Number of questions: 56
Question Q-Code: L1-DV-DVMI-001 LOS a Section 2
1 Which of the following is not a derivative?
A) A contract to purchase shares of Infosys, a technology company, at a fixed price.

B) An asset backed security.
C) A global equity mutual fund.
Answer C) A global equity mutual fund.
Explanation C is correct. A derivative is a financial instrument which derives its value from the performance of an underlying
(asset). In simple terms, a derivative is a legal contract between a buyer and a seller entered into today, regarding a
transaction that will be fulfilled at a specified time in the future. For example, a contract to purchase the shares of
XYZ Company at $50 after six months is an example of a derivative contract.
An asset-backed security is a derivative contract in which a portfolio of debt instruments is assembled and claims
are issued on the portfolio in the form of tranches, such that the prepayments or credit losses are allocated to the
most-junior tranches first and the most-senior tranches last.
Another definition of a derivative is that it is a financial instrument that transforms the performance of the
underlying. Mutual funds do not transform the value of a payoff of an underlying asset; they merely pass those
payoffs through to their holders. Hence, they are not derivatives. Section 2. LO.a.
2 Which of the following statements is most likely to be correct about derivatives?
A) A derivative is a financial instrument that derives its value based on the performance of the underlying.
B) Derivatives are standardized financial instruments and cannot be customized.
C) The performance of a derivative is derived by replicating the performance of the underlying.
Answer A) A derivative is a financial instrument that derives its value based on the performance of the underlying.
Explanation A is correct. A derivative is a financial instrument that derives its value based on the performance of the underlying
(asset).
B is incorrect because unlike an exchange-traded derivative, over-the-counter contracts are customized as per
client’s needs.
C is incorrect because the performance of a derivative is derived by transforming, and not by replicating the
performance of the underlying. Section 2 and 3. LO.a.
3 Which of the following statements about derivatives is least accurate?
A) They derive their value from an underlying.

B) They have low degrees of leverage.
C) They involve two parties – a buyer and a seller.
Answer B) They have low degrees of leverage.
Explanation B is correct. Derivatives have high degrees of leverage. A and C are accurate statements. A derivative is a financial
instrument which derives its value from the performance of an underlying (asset). In simple terms, a derivative is a
legal contract between a buyer and a seller entered into today, regarding a transaction that will be fulfilled at a
specified time in the future. Section 2. LO.a.

4 Which of the following statements about derivatives is not true?
A) They are used for risk management.

B) They are created in the form of legal contracts.
C) They are created in the spot market.
Answer C) They are created in the spot market.
Explanation C is correct. Derivatives are not created in the spot market, which is where the underlying trades. Other two
statements are true. Derivatives are a cost-effective way of transferring risk from one party to another. For
example, if an investor has a substantial investment in a stock that he does not want to sell, but reduce the risk, he
can do so by taking a short position in a futures contract or buying a put option.
A derivative is a legal contract between a buyer and seller entered into today, regarding a transaction that will be
fulfilled at a specified time in the future. Section 2 and 5. LO.a.
5 Which of the following statements about exchange-traded derivatives is least accurate?
A) They are more transparent than over-the-counter derivatives.

B) All terms of the contract except the price are standardized.
C) They have more credit risk than over-the-counter derivatives.
Answer C) They have more credit risk than over-the-counter derivatives.
Explanation C is correct. Exchange-traded contracts have less credit risk than OTC derivatives because of the presence of a
clearinghouse, which guarantees that the winning party gets paid by requiring participants to post a margin (cash
deposit) called margin or performance bonds, and uses these deposits to make a payment in the event of default.
Statement A is correct as the presence of a clearinghouse also makes the whole process transparent. All the
information regarding prices, settlement, daily turnover is disclosed within exchanges and clearinghouse which
means there is a lack of privacy and flexibility.
Statement B is correct as the exchange-traded derivative clearly specifies when it can be traded, when it will expire,
what is the lot size, a minimum amount, and settlement price. There is no room for customization. The only aspect
not defined is the price. The price is determined by the buyers and sellers. For example, a gold contract on CME
defines its quality (995 fineness), contract size (100 troy ounces), how it will be settled (physical) and so on. Section
3.1 and 3.2. LO.a.
6 Which of the following best describes a characteristic of exchange-traded derivatives?
A) They are customized financial instruments.

B) A clearing house effectively guarantees against default risk.
C) They are characterized by a low degree of regulation.
Answer B) A clearing house effectively guarantees against default risk.
Explanation B is correct. Exchange-traded derivatives are guaranteed by a clearing house against default.
A is incorrect because the exchange traded derivatives are standardized. To standardize a derivative implies that
the contract is bound by terms and conditions, and there is little ability to alter those terms.
C is incorrect because they are characterized by a high degree of regulation. Section 3.1 and 3.2. LO.a.
7 Which of the following statements about over-the-counter derivatives is least accurate ?
A) They are less liquid than exchange-traded derivatives.

B) They are less regulated than exchange-traded derivatives.
C) They offer more flexibility than exchange-traded derivatives.
Answer A) They are less liquid than exchange-traded derivatives.
Explanation A is correct. Because of the customization and flexibility of OTC derivatives, there is a tendency to think that the
OTC market is less liquid than the exchange market. However, this is not necessarily true. Many OTC instruments
can easily be created and then essentially offset by doing the exact opposite transaction, often with the same
party.
Statement C is accurate. OTC contracts are negotiated directly between two parties without an exchange. Hence,
they are less regulated. Section 3.1 and 3.2. LO.a.
Question Q-Code: L1-DV-DVMI-037 LOS c Section 3
8 One way to describe the margin in a futures market is:
A) A good faith deposit that covers possible future losses.

B) A loan to the futures trader.
C) The difference between the futures price and the spot price.
Answer A) A good faith deposit that covers possible future losses.
Explanation A is correct. The initial margin can be thought of as a good faith deposit or performance bond. It covers possible
future losses. Section 3.1. LO.c.
9 Which of the following least likely describes over-the-counter (OTC) derivatives relative to exchange-traded
derivatives? OTC derivatives are:
A) more customized.
B) less liquid.
C) less transparent.
Answer B) less liquid.
Explanation B is correct. There is a tendency to think that OTC market is less liquid relative to the exchange market, but this is
not necessarily true. Other two statements are correct. Unlike an exchange-traded derivative, OTC contracts are
customized as per the client’s needs and are negotiated directly between two parties without an exchange, making
them less transparent. Section 3.1 and 3.2. LO.a.
10 Analyst 1: Market makers earn a profit in both exchange and over-the-counter derivatives markets by charging a
commission on each trade.
Analyst 2: Market makers earn a profit in both exchange and over-the-counter derivatives markets by buying at
one price, selling at a higher price, and hedging any risk.
Which analyst’s statement is most likely correct?
A) Analyst 1.
B) Analyst 2.
C) Neither of them.
Answer B) Analyst 2.
Explanation B is correct. Market makers can operate in both exchange-traded and OTC markets. The market makers make
money through the bid-ask spread. For instance, if party A wants to take a long position, the market maker will take
the opposite position, i.e. a short position. The market maker will then look for another party, suppose B, with
whom the market maker will take a long position. In other words, the market maker will sell to party A and buy from
party B. The overall effect is cancelled out, and no matter what happens to the underlying, the market maker is
covered. The bid amount will be lesser than the ask price, and the difference between both will generate a profit for
the market maker.
They do not charge a commission. Section 3.2. LO.a.
11 As compared to exchange-traded derivatives, over-the-counter derivatives are more likely to have:
A) lower credit risk.

B) customized contract terms.
C) lower risk management uses.
Answer B) customized contract terms.
Explanation B is correct. Customization of contract terms is a characteristic of over-the-counter derivatives.

Unlike an exchange-traded system where the clearinghouse guarantees settlement, OTC derivatives have credit
risk. Each party bears the risk that the other party will default. Both exchange-traded derivatives and over-the-
counter derivatives have same risk management uses. Section 3.2 and 5. LO.a.
12 As compared to over-the-counter options, futures contract:
A) are private, customized transactions.

B) represent a right rather than a commitment.
C) are not exposed to default risk.
Answer C) are not exposed to default risk.
Explanation C is correct. A futures contract is a standardized derivative contract created and traded on a futures exchange
such as Chicago Mercantile Exchange (CME). Hence, these contracts are standardized and are not exposed to
default risk.
A forward commitment is a contract that requires both parties to engage in a transaction at a later point in time
(the expiration) on terms agreed upon today. It includes forward contracts, futures contracts and swaps. Another
category of derivative instruments is called contingent claims. The holder of a contingent claim has the right, but
not the obligation to make a final payment contingent on the performance of the underlying.
In a contingent claim, two parties, A and B, sign a contract at time 0 to engage in a transaction at time T. Unlike a
forward or futures contract, A has the right, but not the obligation to make a payment and take delivery of the
asset at time T. Section 4.1 and 4.2. LO.a.
Question Q-Code: L1-DV-DVMI-015 LOS b Section 4
13 Which of the following is best classified as a forward commitment?
A) A convertible bond.
B) A swap agreement.
C) An asset-backed security.
Answer B) A swap agreement.
Explanation B is correct. A swap agreement is equivalent to a series of forward agreements, which are described as forward
commitments. Forward commitments are contracts entered into at one point in time that require both parties to
engage in a transaction at a later point in time (the expiration), on terms agreed upon at the start. Examples:
forward contracts, futures contracts and swaps.
On the other hand, convertible bonds and asset-backed securities are classified as contingent claims. The holder of
a contingent claim has the right, but not the obligation, to make a final payment, contingent on the performance of
the underlying.
A is incorrect because the convertible bond is an example of hybrid instrument which is created by combining
bonds and options. Section 4, 4.1 and 4.2. LO.b.
14 Which of the following statements about futures is least accurate?
A) They are standardized.

B) They are subject to daily price limits.
C) Their payoffs are received at settlement.
Answer C) Their payoffs are received at settlement.
Explanation C is correct. Any payoffs in the future contracts are settled on daily basis by the exchange through its
clearinghouse. This process is called mark to market.Other two statement are true. Futures contracts are
standardized derivative contracts and are subject to daily price limits. Section 4.1. LO.c.
15 Which of the following statements is most accurate?
A) Forwards are customized whereas swaps are standardized.

B) Forwards are subject to daily price limits whereas swaps are not.
C) Swaps have multiple payments, whereas forwards have only a single payment.
Answer C) Swaps have multiple payments, whereas forwards have only a single payment.
Explanation C is correct. A swap is a series of multiple payments at scheduled dates, whereas a forward has only one payment,
made at its expiration date.
A is incorrect because both forwards and swaps are standardized derivative contracts.
B is incorrect because neither forwards nor swaps are subject to daily price limits. Only futures contracts are
subject to daily price limits. Section 4.1. LO.c.
16 Analyst 1: During daily settlement of futures contract the initial margin deposits are refunded to the two parties.
Analyst 2: During daily settlement of futures contract losses are charged to one party and gains credited to the
other.
Which analyst’s statement is most likely correct ?
A) Analyst 1.
B) Analyst 2.
C) Neither of them.
Explanation B is correct. During daily settlement losses and gains are collected and distributed to the respective parties through
a process called mark to market. Option A is incorrect because during daily settlement of futures contract the initial
margin deposits are not refunded to any party. Section 4.1. LO.c.
17 While dealing with futures contracts, the maintenance margin requirement most likely refers to:
A) collateral to ensure fulfillment of obligation.

B) amount sufficient to bring ending account balance back to initial margin.
C) the minimum account balance a trader must maintain after the trade is initiated.
Answer C) the minimum account balance a trader must maintain after the trade is initiated.
Explanation C is correct. Futures position holders are required to maintain a minimum level of account balance which is called
the maintenance margin requirement. The amount sufficient to bring ending account balance back to initial margin
requirement is called the variation margin. Initial margin is the collateral or performance bond that ensures the
fulfillment of the obligation. Section 4.1. LO.c.
18 In which of the following contracts would the buyer face the least default risk?
A) Cotton futures.
B) Currency forwards.
C) Over-the-counter interest rate options.
Answer A) Cotton futures.
Explanation A is correct. While forward contracts and over-the-counter options are customized private contracts between
parties with a presence of default risk, futures contracts have the least risk of default because of the presence of a
clearinghouse as an intermediary guaranteeing the parties against default through the practice of daily settlement.
Section 3.2, 4.1 and 4.2. LO.c.
19 Microsoft issues 10-year fixed-rate bonds. Its treasurer expects interest rates to increase for all maturities for at
least the next 2 years. He enters into a 2-year agreement with SCB to receive semi-annual floating-rates payments
benchmarked on 6-month LIBOR and to make payments based on a fixed-rate. This agreement is best described
as a:
A) Swap.
B) Futures contract.
C) Forward contract.
Answer A) Swap.
Explanation A is correct. A swap is an agreement between two parties to exchange a series of future cash flows. Microsoft
receives floating interest rate payments and makes fixed interest rate payments. The given agreement is a swap.
Other two options are incorrect because in both forward and futures contracts, two parties agree to exchange a
specific quantity of the underlying asset at an agreed-upon price at a later date. The buyer agrees to purchase the
underlying asset from the other party, the seller. Section 4.1. LO.c.
20 Ali takes a long position in 50 futures contracts on Day 1. The futures have a daily price limit of €10 and closes with
a settlement price of €105. On Day 2, the futures trade at €115 and the bid and offer move to €116 and €118,
respectively. The futures price remains at these price levels until the market closes. The marked-to-market amount
the trader receives in his account at the end of Day 2 is closest to:
A) €500.
B) €550.
C) €650.
Answer A) €500.
Explanation A is correct. Because the future has a daily price limit of €10, the highest possible settlement price on Day 2 is
€115. Therefore, the marked to market value would be (€115 - €105) * 50 = €500. Section 4.1. LO.c.
21 Keene Smith, an investor, aims to invest in derivatives that can be classified as forward commitments. Which of the
following is she least likely to consider?
A) Credit default swaps.

B) Futures contracts.
C) Interest rate swaps.
Answer A) Credit default swaps.
Explanation A is correct. A credit default swap (CDS) is a derivative in which the seller provides credit protection to the buyer
against the credit risk of a separate party. It is hence classified as a contingent claim.
B and C are incorrect because futures contracts and interest rate swaps are classified as forward commitments.
Section 4.1 and 4.2. LO.c.
22 Which of the following is most likely to be correct regarding interest rate swaps?
A) Interest rate swaps provide the right to buy or sell the underlying asset in the future.
B) Interest rate swaps provide the promise to provide credit protection in the event of a default.
C) Interest rate swaps involve the obligation to lend or borrow at a given rate in the future at a fixed rate.
Answer C) Interest rate swaps involve the obligation to lend or borrow at a given rate in the future at a fixed rate.
Explanation C is correct. A swap is an over-the-counter contract between two parties to exchange a series of cash flows based
on some pre-determined formula. The simplest swap is a plain vanilla interest rate swap. Interest rate swaps are
forward commitments that require one party to pay a fixed rate and the other party to pay floating rate during the
life of the swap.
A and B are incorrect because they are characteristics of credit default swaps. A credit default swap is a derivative
contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes a
series of cash payments to the seller and receives a promise of compensation for credit losses resulting from the
default of a third party. Section 4.1. LO.c.
23 An attribute common to both forward and futures contracts is:
A) their mark to market feature.

B) their standardized nature.
C) their use in hedging and speculation.
Answer C) their use in hedging and speculation.
Explanation C is correct. Both forward and futures contracts are used for hedging and speculation purposes. Futures are
marked to market every day and are standardized, whereas forward contracts are customized and are settled at
expiry (there is no mark-to-market in between). Section 4.1 and 6.1. LO.c.
24 Which of the following statements is least likely correct about interest rate swaps ?
A) Interest rate swaps are derivatives where two parties agree to exchange a series of cash flows.
B) Interest rate swaps might require one party to make payments based on a fixed rate.
C) Interest rate swaps give the buyer the right to purchase the underlying from the seller.
Answer C) Interest rate swaps give the buyer the right to purchase the underlying from the seller.
Explanation C is correct. Interest rate swaps are derivatives where two parties agree to exchange a series of cash flows.
Typically, one set of cash flows is variable and the other set is fixed. Option C is a true statement with respect to
call options, not swaps. Section 4.1 and 4.2. LO.c
25 Joe is a futures trader. If on a given day his balance falls below the maintenance margin, he should add funds so as
to meet the:
A) Initial margin.
B) Maintenance margin.
C) Variation margin.
Answer A) Initial margin.
Explanation A is correct. In the futures markets the investor must top up to the initial margin. In the stock market an investor
only needs to top up to the maintenance margin.
Variation margin is the additional margin that must be deposited in an amount sufficient to bring the balance up to
the initial margin requirement. Maintenance margin is the minimum amount that is required by a futures
clearinghouse to maintain a margin account and to protect against default. Participants whose margin balances
drop below the required maintenance margin must replenish their accounts. Section 4.1. LO.c.
26 Which of the following statements is most accurate?
A) A forward contract is default free, whereas a futures contract is not.

B) A forward contact allows parties to enter into a customized transaction, whereas a futures contract does not.
C) A forward contract can easily be offset prior to expiration, whereas it is difficult to offset a futures contract prior
to expiration.
Answer B) A forward contact allows parties to enter into a customized transaction, whereas a futures contract does not.
Explanation B is correct. Unlike futures contracts, which have standardized features, forward contracts can be customized to
suit the needs of the parties involved.
Futures are exchange traded contracts with a credit guarantee and a protection against default. Forwards, on the
other hand, are over-the-counter contracts that are privately negotiated and are subject to default. Therefore, A is
incorrect.
Futures contracts can easily be offset prior to expiration as they are standardized in nature, making it easy to take
an opposite position. Whereas, it is difficult to offset forward contracts prior to expiration because they are
customized in nature, making it difficult to find a counterparty. Section 3.2 and 4.1. LO.c.
27 Which of the following is least likely to be subject to default?
A) Forwards.
B) Futures.
C) Interest rate swaps.
Answer B) Futures.
Explanation B is correct. Futures are exchange traded contracts with a credit guarantee and a protection against default.
Interest rate swaps and forwards are over-the-counter contracts that are privately negotiated and are subject to
default. Section 3.2 and 4.1. LO.c.
28 Klaus, Veronica, and Liam deal in derivatives. Liam and Veronica have a value of zero at the initiation of the contract,
while Klaus doesn’t. Which of the following correctly describes the derivative that each of these are dealing in?
Klaus Veronica Liam
A. Futures Options Forwards
B. Forwards Futures Options
C. Options Forwards Futures
A) Option A in the above table.

B) Option B in the above table.
C) Option C in the above table.
Answer C) Option C in the above table.
Explanation C is correct. Options require the payment of an option premium to the seller of the option at the initiation of the
contract. The premium can be thought of as the value of the option contract.
Futures and forwards have a value of zero at the initiation of the contract. Futures contracts do require an initial
deposit (initial margin) but this can be thought of as a down payment or a performance bond. The initial margin
does not represent the value of the futures contract. Section 4.1 and 4.2. LO.c.
29 Which of the following statements is least accurate?
A) An asset backed security is a contingent claim.

B) An interest rate swap is a forward commitment.
C) A credit default swap is a forward commitment.
Answer C) A credit default swap is a forward commitment.
Explanation C is correct. A credit default swap is a type of contingent claims. The holder of a contingent claim has the right, but
not the obligation to make a final payment contingent on the performance of the underlying.
An asset backed security is a type of a forward commitment. A forward commitment is a contract that requires
both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon today. The
parties establish the identity and quantity of the underlying, the manner in which the contract will be executed or
settled when it expires, and the fixed price at which the underlying will be exchanged. Both the parties – the buyer
and the seller - have an obligation to engage in the transaction at a future date in a forward commitment. An
interest rate swap is also a type of forward commitment.
30 Tim has a portfolio comprising of derivatives, which provide payoffs that are linearly related to the payoffs of the
underlying. Which of the following is least likely to be a part of Tim’s portfolio?
A) Forwards.
B) Interest-rate swaps.
C) Options.
Answer C) Options.
Explanation C is correct. Options are contingent claims that provide a one-sided payoff. The payoffs of contingent claims are
not linearly related to the underlying, and only one party, the short, can default. A and B are incorrect as they are
types of forward commitments with a linear payoff. Section 4.2. LO.c.
31 Which of the following is not a forward commitment?
A) Futures contracts.
B) Interest rates swaps.
C) Asset backed securities.
Answer C) Asset backed securities.
Explanation C is correct. Asset backed security is a type of Contingent claims.

Forward commitment includes forward contracts, futures contracts and swaps such as interest rate swaps.
Section 4, 4.1 and 4.2. LO.b.
32 Which of the following statements is least accurate about contingent claims?
A) The payoffs are not linearly related to the underlying.

B) The most the short can gain is the premium paid for the contingent claim.
C) Either party can default to the other.
Answer C) Either party can default to the other.
Explanation C is correct. In contingent claims, only one party, the short, can default.
Because the option buyer (the long) does not have to exercise the option, beyond the initial payment of the
premium, there is no obligation of the long to the short. Thus, only the short can default, which would occur if the
long exercises the option and the short fails to do what it is supposed to do.
Forwards provide payoffs that are linearly related to the payoffs of the underlying. Whereas, the payoffs of options
are non-linear, for example a call option will provide a payoff only if the underlying crosses the strike price,
otherwise it will expire worthless and have a zero payoff. Therefore, A is incorrect.
B is incorrect because the maximum a short party can gain is the premium paid for the contingent claim. Section
4.2. LO.b.
33 Which of the following statements about options is most accurate?
A) An option is the right to buy or the right to sell the underlying.

B) An option is the right to buy and sell, with the choice made at expiration.
C) An option is an obligation to buy or sell, which can be converted into the right to buy or sell.
Answer A) An option is the right to buy or the right to sell the underlying.
Explanation A is correct. An option is strictly the right to buy (a call) or the right to sell (a put). It does not provide both choices.
Similarly, the right to convert is an obligation, not a right. Therefore, statement C is incorrect.
Statement B is incorrect because American options can be exercised on or any time before the expiration date.
However, European options can only be exercised at expiration date. Section 4.2. LO.c.
34 Which of the following is a characteristic of a put option on the stock?
A) A guarantee that the stock price will decrease.

B) A specified date on which the right to sell expires.
C) A fixed price at which the put holder can buy the stock.
Answer B) A specified date on which the right to sell expires.
Explanation B is correct. A put option on a stock provides no guarantee of any change in the stock price. It has an expiration
date on which the right to sell expires, and it has a fixed price at which the holder can exercise the option, thereby
selling the stock. Section 4.2. LO.c.
35 Analyst 1: A credit derivative is a derivative contract in which the seller provides protection to the buyer against the
credit risk of a third party.
Analyst 2: A credit derivative is a derivative contract in which the exchange provides a credit guarantee to both the
buyer and the seller.
A) Analyst 1.
B) Analyst 2.
C) Neither of them.
Answer A) Analyst 1.
Explanation A is correct. A credit derivative is a class of derivative contracts between two parties, a credit protection buyer and
a credit protection seller, in which the latter provides protection to the former against a specific credit loss. B is
incorrect because in a credit derivative is a type of contingent claims where there is no involvement of an exchange.
Section 4.2. LO.c.
36 A corporation has issued 10-year, floating-rate bonds. The treasurer realizes that the interest rates are going to
rise and enters into an agreement to receive semi-annual payments based on the 6-month LIBOR and to make
semi-annual payments at a fixed rate. This agreement is best described as a(n):
A) option.
B) futures contract.
C) swap.
Answer C) swap.
Explanation C is correct. It is a swap because two parties agree to exchange a series of cash flows in the future.
In a futures contract, two parties agree to exchange a specific quantity of the underlying asset at an agreed-upon
price at a later date. The buyer agrees to purchase the underlying asset from the other party, the seller. The
agreed-upon price is called the futures price.
An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller
or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific
expiration date or at any time prior to the expiration date. Section 4.1 and 4.2. LO.c.
37 A market participant has a view regarding the potential movement of a stock. He sells a customized over-the-
counter put option on the stock when the stock is trading at USD46. The put has an exercise price of USD44 and
the put seller receives USD2.5 in premium. The price of the stock is USD43 at expiration. The profit or loss for the
put seller at expiration is:
A) USD(1.5).
B) USD1.5.
C) USD2.5.
Answer B) USD1.5.
Explanation B is correct. Profit = max (0, premium – value of put at expiration) = max (0, premium-(X-S)) = 2.5 – 1 = 1.5.
Section 4.2. LO.c.
38 Which of the following accurately describes a credit derivative?
A) In a credit derivative, the seller provides the buyer with protection against credit risk of a third party.
B) At the initiation of the contract of a credit derivative, the buyer and seller provide a performance bond.
C) The buyer and seller of a credit derivative are provided with a credit guarantee by the clearinghouse.
Answer A) In a credit derivative, the seller provides the buyer with protection against credit risk of a third party.
Explanation A is correct. A credit derivative is a derivative contract in which the seller provides credit protection to the buyer
against the credit risk of a third party.
B and C are incorrect because these are characteristics of futures, not credit derivatives. Section 4.1 and 4.2. LO.c.
39 Which of the following statements about the feature of an option is correct?
A) Only the long party can default.

B) Only the short party can default.
C) Both long and short party can default.
Answer B) Only the short party can default.
Explanation B is correct. There is always a possibility that short party may not fulfill its obligation if the long party decides to
exercise the option. Therefore, only the short party can default. Section 3.2 and 4.2. LO.c.
Question Q-Code: L1-DV-DVMI-045 LOS d Section 4
40 Analyst 1: Derivatives can be combined with other derivatives or underlying assets to form hybrids.
Analyst 2: Derivatives can be issued on weather, electricity, and disaster claims.
A) Analyst 1.
B) Analyst 2.
C) Both.
Answer C) Both.
Explanation C is correct. Derivatives can be combined with other derivatives or underlying assets to form hybrids. Derivatives
can be issued on a variety of such diverse underlying such as weather, electricity, and disaster claims. Section 4.3
and 4.4. LO.d.
41 Which of the following is an advantage of the derivatives market?
A) They are less volatile than spot markets.

B) They make it easier and less costly to transfer risk.
C) They incur higher transaction costs than spot markets.
Answer B) They make it easier and less costly to transfer risk.

Explanation B is correct. Derivatives facilitate risk allocation by making it easier and less costly to transfer risk.
A is incorrect because derivatives are not necessarily more or less volatile than spot markets.
C is incorrect because derivatives incur lower transaction costs than spot markets. Section 5.1, 5.3 and 6.2. LO.d.
42 Sebastian is planning to invest in derivatives. Which of the following is least likely to be an advantage that he should
consider?
A) Effective risk management.

B) Greater opportunities to go short compared to the spot market.
C) Similar payoffs to those of underlying.
Answer C) Similar payoffs to those of underlying.
Explanation C is correct. Derivative markets provide for effective risk management and thus result in payoffs different than
those of the underlying. Therefore similar payoffs are least likely to be an advantage to consider. An operational
advantage of derivative markets is the ease of going short in comparison to the underlying spot market. Section
5.1 and 5.3. LO.d.
43 When the implied volatility on equity market index options goes up, it is safe to assume that:
A) market interest rates have increased.

B) the market uncertainty has increased.
C) the market index value has increased.
Answer B) the market uncertainty has increased.
Explanation B is correct. The implied volatility measures the risk of the underlying or the uncertainty associated with options. So
an increase in the implied volatility on equity market index options indicates that the market uncertainty has gone
up. Section 5.2. LO.d.
44 Which of the following is most likely to be greater for derivative markets compared to underlying spot markets?
A) Capital requirements.
B) Liquidity.
C) Transaction costs.
Answer B) Liquidity.
Explanation B is correct. Derivative markets have greater liquidity than underlying spot markets with lower capital requirements
and lower transaction costs. Section 5.3. LO.d.
45 Compared to the underlying spot market, the derivatives market is least likely to have:
A) lower liquidity.
B) lower transaction costs.
C) lower capital requirements.
Answer A) lower liquidity.
Explanation A is correct. Compared to the underlying spot market, the derivatives market has higher liquidity, lower transaction
costs and lower capital requirements. Section 5.3. LO.d.
Question Q-Code: L1-DV-DVMI-052 LOS e Section 6
46 Which of the following is most likely to be a criticism of the derivatives market?
A) Derivatives provide price information but only at a cost of increasing transaction costs.
B) Derivatives are highly speculative instruments and effectively permit legalized gambling.
C) Default risk exists within all instruments of the derivative market.
Answer B) Derivatives are highly speculative instruments and effectively permit legalized gambling.
Explanation B is correct. The criticism to derivatives is that they are ‘too risky’ especially to investors with limited knowledge of
complicated instruments. Derivative markets do provide price information but also lower transaction costs.
Moreover, default risk is not existent in all instruments. With exchange traded instruments such as futures there is
virtually no default risk. Section 5.4 and 6.1. LO.e.
47 Which of the following statements about derivatives is least accurate?
A) Options convey the volatility of the underlying.

B) Swaps convey the price at which uncertainty in the underlying can be eliminated.
C) Futures convey the most widely used strategy of the underlying.
Answer C) Futures convey the most widely used strategy of the underlying.
Explanation C is correct. Derivatives do not convey any information about the use of the underlying in strategies.
Statement A is true. It is possible to determine the implied volatility of the options through models such as BSM.
Statement B is accurate. Swaps convey the price at which uncertainty in the underlying can be eliminated. Section
6.2. LO.d.
48 While responding to criticism that derivatives can be destabilizing to the market, an analyst makes the following
statements:
Statement 1: Market crashes and panics have occurred since long before derivatives existed.
Statement 2: Derivatives are sufficiently regulated that they cannot destabilize the spot market.
Which statement is most likely correct?
A) Statement 1.
B) Statement 2.
C) Both.
Answer A) Statement 1.
Explanation A is correct. Derivatives regulation is not more and is arguably less than spot market regulation. However, market
crashes and panics have a very long history, much longer than that of derivatives. Section 6.2. LO.d.
49 The benefits of derivatives can result in a destabilizing consequence. Which of the following is this most likely to be?
A) Arbitrage activities due to market price swings.

B) Asymmetric performance as a result of trading strategies created.
C) Defaults on the part of speculators and creditors.
Answer C) Defaults on the part of speculators and creditors.
Explanation C is correct. The benefits of derivatives can result in excessive speculative trading and hence cause defaults on the
part of creditors and speculators. A is incorrect because arbitrage tends to bring about convergence of prices to
the intrinsic value. B is incorrect because asymmetric information is not itself destabilizing. Section 6.2. LO.d.
50 Arbitrage is often referred to as the:
A) law of one price.

B) law of similar prices.
C) law of limited profitability.
Answer A) law of one price.
Explanation A is correct. Arbitrage is the condition that if two equivalent assets or derivatives or combinations of assets and
derivatives sell for different prices, then this leads to an opportunity to buy at a low price and sell at a high price,
thereby earning a risk-free profit without committing any capital. The combined actions of arbitrageurs bring about
a convergence of prices. Hence, arbitrage leads to the law of one price: transactions that produce equivalent
results must sell for equivalent prices.
There is nothing called the law of similar prices or the law of limited profitability. Section 7.2. LO.e.
51 When an arbitrage opportunity exists, the combined action of all arbitrageurs:
A) results in a locked-limit situation.

B) results in sustained profit to all.
C) forces the prices to converge.
Answer C) forces the prices to converge.
Explanation C is correct. Arbitrage is the condition that if two equivalent assets or derivatives or combinations of assets and
results must sell for equivalent prices. Prices converge because of the heavy demand for the cheaper asset and the
heavy supply of the more expensive asset. Section 7.2. LO.e.
52 Analyst 1: An arbitrage is an opportunity to make a profit at no risk and with the investment of no capital.
Analyst 2: An arbitrage is an opportunity to earn a return in excess of the return appropriate for the risk assumed.
A) Analyst 1.
B) Analyst 2.
C) Both.
Explanation A is correct. Arbitrage is risk free and requires no capital because selling the overpriced asset produces the funds
to buy the underpriced asset.
B is incorrect because arbitrage is the condition that if two equivalent assets or derivatives or combinations of
assets and derivatives sell for different prices, then this leads to an opportunity to buy at a low price and sell at a
high price, thereby earning a risk-free profit without committing any capital. Section 7.2. LO.e.
53 Which of the following statements about arbitrage is most accurate?
A) Arbitrage imposes penalty on rapid trading.

B) Arbitrage redistributes risk among market participants.
C) Arbitrage helps prices to converge to their relative fair values.
Answer C) Arbitrage helps prices to converge to their relative fair values.
Explanation C is correct. Arbitrage is the condition that if two equivalent assets or derivatives or combinations of assets and
results must sell for equivalent prices. Arbitrage results in an acceleration of price convergence to fair values
relative to instruments with equivalent payoffs.
A is incorrect because arbitrage does not impose penalty on rapid trading.
B is incorrect because arbitrage does not redistribute risk among market participants. Section 7.2. LO.e.
54 David is studying the law of one price. Which of the following statements is most likely to be correct?
A) The law of one price explains that two assets producing equal future cash flows would sell for equal prices.
B) The law of one price describes how a risk-free profit can be earned without capital commitments.
C) The true fundamental value of the asset can be described by the law of one price.
Answer A) The law of one price explains that two assets producing equal future cash flows would sell for equal prices.
Explanation A is correct. The law of one price occurs when participants in the market engage in arbitrage activities so that
identical assets sell for the same price in different markets. B refers to arbitrage and C does not account for
identical assets. Section 7.2. LO.e.
55 Which of the following most likely represents an arbitrage opportunity?
A) A risk free rate is earned by the combination of the underlying asset and a derivative.
B) Sale of the shares of a takeover target and purchase of shares of the potential acquirer.
C) Two identical assets or derivatives are sold for different prices in different markets.
Answer C) Two identical assets or derivatives are sold for different prices in different markets.
Explanation C is correct. Arbitrage opportunities exist when the same asset or two equivalent assets, producing the same
result, sell for different prices. A and B are incorrect because they do not define arbitrage opportunities. Section
7.2. LO.e.
56 Which of the following characteristics is least likely needed for the existence of riskless arbitrage? The underlying
security:
A) can be short sold.

B) is relatively liquid.
C) is a financial asset.
Answer C) is a financial asset.
Explanation C is correct. A riskless arbitrage can be done through both, financial asset and non-financial asset. A and B are
incorrect as derivatives are relatively liquid and can easily be short sold. Section 7.2. LO.e.
Level II R37 Pricing and Valuation
of Forward Commitments Q Bank
Test Code: L2 R37 PVFC Q-Bank Set 1
Question Q-Code: L2-DV-PVFC-001 LOS a Section 2
1 Which of the following statements is most likely accurate? In the carry arbitrage model:
A) an instrument is bought or sold along with a forward position in that instrument.

B) the law of one price does not hold.
C) the portfolio is created with no liabilities and a net positive cash flow today.
Answer A) an instrument is bought or sold along with a forward position in that instrument.
Explanation A is correct. In the carry arbitrage model, an instrument is bought or sold along with a forward position in that
instrument. Section 2. LO.a.
2 At the forward or futures contract initiation date the price negotiated is such that the value of the contract is:
A) less than zero.

B) equal to zero.
C) more than zero.
Answer B) equal to zero.
Explanation B is correct. The forward price or futures price is negotiated between parties such that market value of the
forward or futures contract at the initiation date is zero. Section 3.1. LO.a.
3 The no-arbitrage forward price of an underlying which has no storage cost and no convenience yield is:
A) the future value of the spot price compounded by the risk-free rate over time T.
B) the future value of the spot price using the discount rate which is relevant for the underlying instrument.
C) the same as the spot price.
Answer A) the future value of the spot price compounded by the risk-free rate over time T.
Explanation A is correct. F0(T) = Future value of underlying = FV(S0). Section 3.2.1. LO.a.
4 If F0(T) > FV(S0), an arbitrageur would:
A) conduct a reverse carry arbitrage strategy.

B) purchase the forward contract and sell the underlying short.
C) sell the forward contract and purchase the underlying.
Answer C) sell the forward contract and purchase the underlying.
Explanation C is correct. Unless F0(T) = FV(S0), there is an arbitrage opportunity. If F0(T) > FV(S0), then an arbitrage
opportunity exists, forward contract is sold and the underlying is purchased. A & B are incorrect. “If F0(T) <
FV(S0), then forward contract would be purchased and underlying is sold short.” This is known as reverse carry
arbitrage. Section 3.2.1. LO.a
5 The forward value at time t for a long forward contract initiated at time 0 is:
A) the future value of the difference in forward prices.
B) the present value of the difference in forward prices.
C) equal to the spot price at time t
Answer B) the present value of the difference in forward prices.
Explanation B is correct. Vt(T) = Present value of difference in forward prices = PVt,T[Ft(T) − F0(T)]. Equation 2 Section 3.2.1.
LO.a.
6 The one-year forward price of an underlying which pays a dividend in six months is given by:
A) the future value of the underlying less the future value of carry benefits.
B) the future value of the underlying plus the future value of carry benefits.
C) the future value of the underlying plus the future value of carry costs.
Answer A) the future value of the underlying less the future value of carry benefits.
Explanation A is correct. The forward price is the future value of the underlying plus the future value of the carry costs minus
the future value of the carry benefits. In this case no carry costs are given and the carry benefit is the dividend
payments in six months. Hence the no-arbitrage forward price is the future value of the underlying less the future
value of the carry benefits. Section 3.2.2. LO.a.
7 Suppose an investor buys a one-year equity futures contract and there are now three months to expiration.
Today’s futures price is 111.30. There are no other cash flows. The futures contract value after marking to market,
will be closest to:
A) 100.
B) 0.00.
C) 111.30.
Answer B) 0.00.
Explanation B is correct. Futures contracts are daily marked to market, such that the resulting profits and losses, are received
or paid at each daily settlement. Hence, the equity futures contract value is zero after settlement. Section 3.3.
LO.a.
8 The unique issues influencing the pricing of forward and futures fixed-income contracts based on the carry
arbitrage model are:
A) accrued interest, conversion factor adjustment, choosing cheapest-to-deliver bonds

B) quoted price, coupon frequency, choosing least expensive bonds
C) dirty price, bond maturity, price of eligible bonds
Answer A) accrued interest, conversion factor adjustment, choosing cheapest-to-deliver bonds
Explanation A is correct. Fixed-income forward and futures contracts have certain unique issues that are considered when
applying the carry arbitrage model. First, fixed-income securities are quoted without accrued interest. But full price
is paid when buying the bond so the accrued interest is included in forward/futures contracts’ pricing. Second a
conversion factor adjustment is used to make all deliverable bonds roughly equal in price. Third, when multiple
bonds can be delivered for a particular maturity of a futures contract, a cheapest-to-deliver bond is usually chosen
after the conversion factor adjustment. Section 3.5. LO.a.
9 The spot rate and forward rate for the US Dollar-Chinese Yuan pair is expressed as number of CNY per unit of
USD. The forward price for such a currency contract will be calculated as:
A) Future price of the spot exchange rate using the CNY interest rate adjusted for the USD interest rate.
B) Future price of the spot exchange rate using the USD interest rate adjusted for the CNY interest rate.
C) Future price of the spot exchange rate using the average of the USD and CNY interest rate.
Answer A) Future price of the spot exchange rate using the CNY interest rate adjusted for the USD interest rate.
Explanation A is correct. In this case the base currency is the USD and the price currency is the CNY. To calculate the forward
price, we determine the future value of the spot exchange rate using the price currency interest rate and adjust for
the base currency interest rate. Section 3.6. LO.a.
Question Q-Code: L2-DV-PVFC-010 LOS b Section 3
10 Assume an investor bought a one-year forward contract with price F0(T) = 110. Six months later, at Time t = 0.5,
the price of the stock is S0.5 = 115 and the interest rate is 4%. The value of the existing forward contract expiring
in six months will be closest to
A) -7.
B) 5.
C) 7.
Answer C) 7.
Explanation C is correct. F0(T) = 110, S0.5 = 115, r = 4%, and T – t = 0.5, the six-month forward price at Time t is equal to
Ft(T) = FVt,T(St) = 115(1 + 0.04)0.5 = 117.2775. Value of the existing forward entered at Time 0 valued at Time t
using the difference method is: Vt(T) = PVt,T[Ft(T) – F0(T)] = (117.2775 – 110)/(1 + 0.04)0.5 = 7.136. Section
3.2.1. LO.b.
11 The continuously compounded dividend yield on a broad based stock index is 4.88%, and the current stock index
level is 1,300. The continuously compounded annual interest rate is 5.8%. Based on the carry arbitrage model, the
nine-month futures price will be closest to:
A) 1,300
B) 1,408
C) 1,309
Answer C) 1,309
Explanation C is correct. Based on the carry arbitrage model forward price is F0(T) = S0e(rc-γ)T. Future value of the underlying
adjusted for the dividend payments = 1,300e(0.0580–0.0488)(9/12) = 1,309. Section 3.3. LO.b.
12 A stock trading at €50, pays a €1.00 dividend in three months. The price of the forward contract on this stock
expiring in six months will most likely decrease if there is a(n):
A) increase in dividend.
B) increase in expected future stock price.
C) increase in risk-free interest rate.
Answer A) increase in dividend.
Explanation A is correct. Being a carry benefit, the increase in dividend will decrease the forward price. The expected stock
price does not influence the forward price. An increase in the risk-free rate will increase the forward contract price.
Section 3.3. LO.b.
13 The three-month GBP Libor and the six-month GBP Libor based on the current market quotes is 0.39% and 0.52%
respectively. Assume a 30/360-day count convention. The 3 × 6 FRA fixed rate will be closest to:
A) 0.65%.
B) 0.52%.
C) 0.78%.
Answer A) 0.65%.
Explanation A is correct. FRA(0,90,90) = {[ 1+0.0052( 180 / 360 ) 1+0.0039( 90 / 360 ) ] − 1} × 4 = 0.0064937 ≅ 0.65%.
Section 3.4. LO.b.
14 Suppose an investor entered a receive-floating 6 × 9 FRA at a rate of 0.85%, with notional amount of
GBP1,000,000 at Time 0. The 6 × 9 FRA rate is quoted in the market at 0.85%. After 90 days the three-month GBP
Libor is 1.01% and the six-month GBP Libor is 1.11%, which is used as the discount rate to determine the value
after 90 days. The new 3 x 6 FRA rate is found as 1.21%. Assuming the appropriate discount rate is GBP Libor, the
value of the original receive-floating 6 × 9 FRA will be closest to:
A) GBP1,200.
B) GBP895.
C) GBP600.
Answer B) GBP895.
Explanation B is correct. V90(0,180,90) = 1,000,000 × [(0.0121−0.0085)(90 / 360)] / [1+0.0111( 180 360)] = GBP895.033.
Section 3.4. LO.b.
15 Suppose that a bond futures contract is based on an underlying French bond quoted at €106 that has accrued
interest of €0.063. The euro-bond futures contract matures in three months. At contract expiration, the bond will
have an accrued interest of €0.190. There are no coupon payments due until after the futures contract expires.
The current risk-free rate is 0.20%. The conversion factor is 0.75. The equilibrium euro-bond futures price based on
the carry arbitrage model will be closest to:
A) €150.
B) €130.
C) €140.
Answer C) €140.
Explanation C is correct. QF0(T) = [1/CF(T)]{FV0,T[B0(T + Y) + AI0] – AIT – FVCI0,T} = [1/ 0.75]{(1.002)3/12[106 + 0.063] −
0.19 − 0} = €141.2345. Section 3.5. LO.b.
16 AZ Corp. sold USD10,000,000 against GBP forward at a forward rate of £0.8200 for USD1 at Time 0. In the spot
market at Time t, USD1 is worth £0.7600, and the annually compounded risk-free rates are 1.00% for the British
pound and 3.00% for the USD. Assume at Time t the forward contract has one month to expiration. The forward
price Ft(£/$,T) at Time t will be closest to:
A) 0.82
B) 0.76.
C) 0.75.
Answer B) 0.76.
Explanation B is correct. The forward price at Time t is Ft(£/, T) = St(£/)FV₤,t,T(1)/FV$,t,T(1) = 0.76(1 + 0.01)1/12/(1 + 0.03)1/12
= 0.7588. Section 3.6. LO.b.
17 AZ Corp. sold USD10,000,000 against GBP forward at a forward rate of £0.8200 for USD1 at Time 0. The current
spot market at Time t is such that USD1 is worth £0.7600, and the annually compounded risk-free rates are 1.00%
for the British pound and 3.00% for the USD. Assume at Time t the forward contract has one month to expiration.
The value of the foreign exchange forward contract in ₤ at Time t will most likely be:
A) positive.
B) negative.
C) zero
Answer A) positive.
Explanation A is correct. The value per US dollar to the seller of the foreign exchange futures contract at Time t is simply the
present value of the difference between the initial forward price and the ₤/USD forward price at Time t or Vt(T) =
PV ,t,T[F0(₤/$,T) - Ft(₤/USD,T)] = (0.8200 - 0.7588)/(1 + 0.01)1/12 = ₤0.061149 per US dollar. AZ has an initial
short position, so the short position of a USD10,000,000 has a positive value of USD10,000,000(₤0.06115/$) =
₤611,500 because the forward rate fell between Time 0 and Time t. Section 3.6. LO.b.
Question Q-Code: L2-DV-PVFC-018 LOS c Section 4
18 Which of the following is least likely a feature of currency swaps? Currency swaps: A. involve an exchange of
notional amounts at the start and at the expiration of the swap.
A) involve an exchange of notional amounts at the start and at the expiration of the swap.
B) involve payments that are in different currency units on each leg of the swap
C) have payments which are netted at each leg.
Answer C) have payments which are netted at each leg.
Explanation C is correct. Options A and B represent features of currency swaps. Section 4.2. LO.c.
19 You enter into a one-year equity swap with quarterly settlement. You pay the S&P500 return and the counter party
pays fixed annualized rate of 4%. At the end of the first quarter the S&P500 index increases by 4%. Which of the
following statements is most likely true about cash flow at the end of first quarter?
A) You will need to make a payment to the counterparty.

B) You will receive a payment from the counterparty.
C) There will be no net cash flow.
Answer A) You will need to make a payment to the counterparty.
Explanation A is correct. The 4% is an annualized rate. The quarterly rate is 1%. At end of the first quarter you need to pay 4%
based on the S&P500 return and you should receive 1%. The net impact is that you need to pay 3%. Section 4.3.
LO.c
Question Q-Code: L2-DV-PVFC-020 LOS d Section 4
20 Suppose we are pricing a four-year Libor-based interest rate swap with annual resets (30/360 day count). The
estimated present value factors, are given in Table 1 below:
Table 1
Maturity ( Years ) Present value Factors
1 0.9901
2 0.97787
3 0.9654
4 0.9385
The Fixed rate of the swap is:
A) 1.5%.
B) 1.6%.
C) . 1.4%
Answer B) 1.6%.
Explanation B is correct. Sum of present value factors is 0.9901+0.97787+0.9654+0.9385 = 3.87187. Fixed swap rate = rFIX
= 1− 4 = (1 - 0.9385) / 3.87187 = 0.015884 = 1.588%. Section 4.1. LO.d
21 Suppose a year ago Company X entered a ₤10,000,000 five-year receive-fixed Libor-based interest rate swap with
annual resets (30/360 day count). The fixed rate in the swap contract entered one year ago was 2.30%. The
current discount factors are given in Table 1. The value (in thousands) for the party receiving the fixed rate will be
closest to:
A) ₤275.
B) ₤390.
C) -₤275.
Answer A) ₤275.
Explanation A is correct. The sum of present values = 3.87187. V = (FS0 − FSt)ΣPVt,ti = (0.0230.0159)(3.87187) = 0.02749
x ₤10 mil = ₤274,900. Section 4.1. LO.d
22 Suppose an investor entered into a receive-equity index and pay-fixed swap with a quarterly reset, 30/360 day
count. The notional amount is ₤10,000,000, pay-fixed (1.4% annualized, or 0.35% per quarter). Assuming an equity
index return of –5.0% for the quarter (not annualized), the equity swap cash flow in thousands will be:
A) ₤350.
B) -₤535.
C) ₤535
Answer B) -₤535.
Explanation B is correct. ₤10,000,000(-0.05-0.0035) = -₤535,000. Section 4.3. LO.d.
23 Six months ago a party entered a receive-fixed, pay-equity three-year annual reset swap in which the fixed leg is
based on a 30/360 day count. The fixed rate at the time of the swap was 2.2%, the equity was trading at 100, and
the notional amount was ₤5,000,000. Now all spot interest rates have fallen to 2.0% (a flat term structure), and the
equity is trading for 103. Calculate the fair value of this equity swap. The table below gives the present value factors
based on the new spot rates of 2.0% applied to the fixed cash flow of (2.2%x5 mil) ₤110,000.
Date (in PV Fixed Cash PV of Fixed Cash

years) Factors Flow Flow
0.5 0.9901 110,000 108,911
1.5 0.9707 110,000 106,777
2.5 0.9517 5,110,000 4,863,187
Total 5,078,87
A) -₤82,474.
B) -₤71,125.
C) -₤283,000.
Answer B) -₤71,125.
Explanation B is correct. The fair value of this equity swap is 5,078,875 less 5,150,000 [= (103/100) 5,000,000],or a loss of
₤71,125. Section 4.3. LO.d
Level II R38 Valuation of
Contingent Claims Q Bank
Test Code: L2 R38 VACC Q-Bank Set 1
Question Q-Code: L2-DV-VACC-001 LOS a Section 3
1 The multi-period binomial model can be used to value:
A) both path-dependent and path-independent options

B) path-independent options only.
C) path-dependent options only.
Answer A) both path-dependent and path-independent options
Explanation A is correct. The multi-period binomial model can be used to value both path-independent and path-dependent
options. Section 3. LO.a.
2 According to the no-arbitrage approach, an investor can synthetically replicate a long call option by:
A) short selling the underling and using a portion of the proceeds to buy put options.
B) short selling the underlying and lending a portion of the proceeds.
C) buying the underlying with partial financing.
Answer C) buying the underlying with partial financing.
Explanation C is correct. A long call option for a single-period is equal to owning ‘h’ units of partially financed stock. The
financed amount is: PV(–hS– + c–), or using the per period risk-free rate, (–hS– + c–)/(1+ r). Section 3.1. LO.a
3 According to the no-arbitrage approach, an investor can synthetically replicate a long put option by:
A) short selling the underling and using a portion of the proceeds to buy put options
B) short selling the underlying and lending a portion of the proceeds
C) buying the underlying with partial financing.
Answer B) short selling the underlying and lending a portion of the proceeds
Explanation B is correct. For a long put position, the underlying is sold short and a portion of the proceeds is lent. To hedge a
long put position h units of the underlying asset S are traded. Section 3.1. LO.a.
4 Consider a one-year put option with a strike price of USD100. The underlying stock is currently trading at USD100
and does not pay any dividends. At the end of one year the stock price will either be at USD125 or USD69. The
periodically compounded risk-free interest rate = 5.0%. Assuming a single-period binomial option valuation model,
the hedge ratio is closest to:
A) 0.55
B) -0.55.
C) 0.65
Answer B) -0.55.
Explanation B is correct. The hedge ratio = + − − / +− −. S+ = 125, S- = 69. p+ = (0,100 − 125) = 0. p - =

(0,100 − 69) = 31 Hence h = 0−31 / 125−69 = −0.554. Section 3.1. LO.a.
Question Q-Code: L2-DV-VACC-005 LOS b Section 3
5 A non-dividend paying stock is trading at €100. A European call option on this stock has two years to mature. The
periodically compounded risk-free interest rate is 3%, the exercise price of the option is €100. The up factor is 1.25,
and the down factor is 0.80. The riskneutral probability of an up move is 0.51. The call option value is closest to:
A) €13.80.
B) €14.20.
C) €14.50
Answer A) €13.80.
Explanation A is correct. At T=2, c++ = (0, 2 − )= [0,156.25 − 100] = 56.25 c -+ = c+- = (0, − )=
[0,100 − 100] = 0 c-- = (0, 2 − )= [0,64 − 100] = 0 c = PV[E(c 2 )] = PV[π2c++ + 2π(1 – π)c+– +
(1 – π)2c– –] = 1/(1.03)2 [0.51256.25 + 2 × 0.51 × 0.49 × 0 + 0.4920] = 13.7908. Section 3.2. LO.b.
6 A non-dividend paying stock is trading at €100. The risk-free rate is 3.00%. A two-year European call option with a
strike price of €100 is trading for €14.00. Using put-call parity, value of a two-year European put option with a
strike price of €100 is closest to:
A) €9.00.
B) €8.26.
C) €10.0.
Answer B) €8.26.
Explanation B is correct. The put option value can be computed simply by applying put–call parity: p = c + PV(X) – S = 14 +
100/(1 + 0.03)2 – 100 = 8.259. Thus, the current put price is €8.26. Section 3.2. LO.b.
7 Suppose you are given the following information: S0 = €100, X = €100, u = 1.25, d = 0.80, n = 2 (time steps), r =
3.00% (per period). The stock is not expected to pay dividends. The risk-neutral probability is 0.51. The tree below
shows that price of a two-period Europeanstyle option should be 8.15
The early exercise premium for a similar American style put option is closest to:
A) 2.30
B) 1.40.
C) 0.40.
Answer B) 1.40.
Explanation B is correct. At T = 1, when a down move occurs because of early exercise option (American-style) p = 100 – 80 =
20.00 instead of 17.1262. Hence the value of put at T = 0 = 9.51. The early exercise premium = 1 / (1.03) × [0.51
× 0 + 0.49 × 20] − 8.15 = 9.51 − 8.15 = 1.36. Section 3.2. LO.b.
Question Q-Code: L2-DV-VACC-008 LOS c Section 3
8 A non-dividend-paying stock is currently trading at USD50. A European call option has one year to mature, the
8 A non-dividend-paying stock is currently trading at USD50. A European call option has one year to mature, the
periodically compounded risk-free interest rate is 7%, and the exercise price is USD50. Assume this option can be
priced using a single-period binomial option valuation model, where u = 1.25 and d = 0.80. The market price of the
option is USD8. Determine whether there is an arbitrage opportunity and if so, how can this opportunity be
exploited?
A) There is no arbitrage opportunity.

B) An arbitrage profit can be made by selling options for $8 and buying underlying shares.
C) An arbitrage profit can be made by buying options for $8 and selling underlying shares.
Answer B) An arbitrage profit can be made by selling options for $8 and buying underlying shares.
Explanation B is correct. Using the binomial model, it can be shown that the arbitrage-free value of the call option is USD7. Since
the option is trading for USD8, it is overpriced. An arbitrage profit can be made by selling the overpriced options
and buying an appropriate number of underlying shares. Section 3.1. LO.c
Question Q-Code: L2-DV-VACC-009 LOS d Section 3
9 The underlying instrument for interest rate options is most likely the:
A) exercise rate.
B) spot rate.
C) futures rate
Answer B) spot rate.
Explanation B is correct. The underlying instrument for interest rate options is the spot rate. Section 3.3. LO.d
10 Which of the following statements is correct ?
A) Interest rate options’ valuation follows the expectations approach.

B) A put option on interest rates will be in the money when the spot rate is above the exercise rate.
C) A call option on interest rates will be in the money when the spot rate is below the exercise rate
Answer A) Interest rate options’ valuation follows the expectations approach.
Explanation A is correct. “Option valuation follows the expectations approach taken one period at a time.” B & C are incorrect.
A put option on interest rates will be in the money when the exercise rate is above the spot rate, and for in the
money call option the spot rate will be above the exercise rate. Section 3.3. LO.d.
11 The following information relates to next 2 questions.
Table 1: Two-Year Binomial Interest Rate Lattice by Year
T=0 T=1 T=2
Rate =
3.9670%
c++ =
0.00717
Value =
0.9626
Rate =
3.8900%
c+ = ?
Value = Rate =
0.9705 3.2450%
Rate = c+- = 0.0
3.0380%
c=?
Value =
0.9750
Rate =
2.5600% c-
=?
Rate =
2.2600%
c-- = 0.0
An analyst is valuing two-year European-style call options on the periodically compounded one-year spot interest
rate. Assume the notional amount of the options is €1, the call exercise rate is 3.25% of par, and the RN probability
is 50%. Using Table 1, the values of c+ and c- at T = 1 are closest to:
A) c+ = 0.0035, c- = 0.0000.
B) c+ = 0.0005,c- = 0.0040.
C) c+ = 0.0050, c- = 0.0006.
Answer A) c+ = 0.0035, c- = 0.0000.
Explanation A is correct. c+ = PV1,2[πc++ + (1 – π)c+–] = 0.9626 [0.5 × 0.00717 + (1 − 0.5)0.0] = 0.003451. c– = PV1,2[πc+–
+ (1 – π)c– –] = 0.9750 [0.5 × 0.0 + (1 − 0.5)0] = 0.0. Section 3.3. LO.d.
12 Table 1: Two-Year Binomial Interest Rate Lattice by Year
T=0 T=1 T=2
Rate =
3.9670%
c++ =
0.00717
Value =
0.9626
Rate =
3.8900%
c+ = ?
Value = Rate =
0.9705 3.2450%
Rate = c+- = 0.0
3.0380%
c=?
Value =
0.9750
Rate =
2.5600%
c- = ?
Rate =
2.2600%
c-- = 0.0
Using Table 1, the value of a call option at T = 0 with €1,000,000 notional principal is closest to:
A) €4,000.
B) €3,000.
C) €1,700.
Answer C) €1,700.
Explanation C is correct. At T = 0, c = PVrf,0,1[πc+ + (1 – π)c–] = 0.9705[0.5 × 0.003451 + (1 − 0.5)0.0] = 0.001675.

Multiplying by 1,000,000 gives 1,675 which is approximately €1,700. Section 3.3. LO.d
Question Q-Code: L2-DV-VACC-013 LOS e Section 3
13 Which of the following statements is most likely true? The value of a call option can be calculated as the present
value of the expected terminal option payoffs where the discount rate is:
A) the required return for the underlying stock and the expected payoff is based on the risk neutral probability.
B) the risk-free rate and the expectation is based on the risk neutral probability.
C) the required return for the underlying stock and the expected future cash flows are based on the actual
probability of the underlying stock going up or down in value.
Answer B) the risk-free rate and the expectation is based on the risk neutral probability.
Explanation B is correct. The value of a call option can be described as the present value of the expected terminal option
payoffs where the discount rate is the risk-free rate and the expectation is based on the risk neutral probability.
Section 3.2. LO.e.
Question Q-Code: L2-DV-VACC-014 LOS f Section 4
14 Which of the following is not an assumption of the BSM model?
A) The underlying follows geometric Brownian motion

B) The underlying has a constant volatility.
C) Short-selling of the underlying is not allowed.
Answer C) Short-selling of the underlying is not allowed.
Explanation C is correct. BSM assumes that short selling is allowed. Options A and B are assumptions of BSM. Section 4.2.
LO.f.
Question Q-Code: L2-DV-VACC-015 LOS g Section 4
15 Call option value based on the BSM model is given as:
A) the bond component minus the stock component.

B) the stock component minus the bond component.
C) the stock component plus the bond component.
Answer B) the stock component minus the bond component.
Explanation B is correct. The BSM model has two components: the stock component and the bond component. The stock
component is given by SN(d1) and the bond component is e-rTXN(d2). The call value is given by the stock
component minus the bond component. The put value based on the BSM model is the bond component - e-rTXN(-
d2) minus the stock component - SN(-d1). Section 4.3. LO.g.
16 Which of the following statements is least accurate?
A) A put option can be interpreted as lending that is partially financed with a short position in shares.
B) A call option be interpreted as short-selling the underlying stock and using the proceeds to buy zero-coupon
bonds.
C) A call option can be interpreted as a leveraged position in the underlying stock.
Answer B) A call option be interpreted as short-selling the underlying stock and using the proceeds to buy zero-coupon
bonds.
Explanation B is correct. The BSM model put value is equal to the cost of a portfolio of bonds bought with proceeds from short
selling of the underlying. A & C are correct statements. Section 4.3. LO.g
Question Q-Code: L2-DV-VACC-017 LOS h Section 4
17 Suppose a stock is trading on the Singapore Stock Exchange at SUSD60. A portfolio manager believes that the
stock price will rise in the next three months and decides to buy threemonth call options with exercise price at 62.
The risk-free government securities are trading at 1.74%, and the stock is yielding SUSD 0.35%. The stock volatility
is 30%. Which of the following statements regarding the application of the BSM model to value calls is correct? The
BSM model inputs (underlying, exercise, expiration, risk-free rate, dividend yield, and volatility) are
A) 60, 0.35%, 1.74%, 0.25, 62, 0.30.

B) 60, 62, 0.25, 0.0174, 0.0035, 0.30.
C) 62, 0.25, 0.0035, 0.0174, 0.30, 60.
Answer B) 60, 62, 0.25, 0.0174, 0.0035, 0.30.
Explanation B is correct. The spot price of the underlying is S60.TheexercisepriceisS62. The expiration is 0.25 years (three
months). The risk-free rate is 0.0174. The dividend yield is 0.0035. The volatility is 0.30. Section 4.3. LO.h.
Question Q-Code: L2-DV-VACC-018 LOS h Section 4
18 A Pakistani importer has to pay fixed euro (€) amounts each quarter for goods. The spot price of the currency pair
is 117.60 PKR/€. If the exchange rate rises to 120 PKR/€ then euro would have strengthened because it would take
more rupees to buy one euro. The importer feels that the rupee will depreciate in the following months. Hence, he
considers buying an at-the-money spot euro call option to protect against this rise. The Pakistani riskfree rate is
6.00% and the European risk-free rate is 1.00%. What is the underlying price, the risk-free rate and the carry rate
to use in the BSM model to get the euro call option value?
A) 117.60, 6.00%, 1.00%.

B) 1/117.60, 1.00%, 0.00%.
C) 117.60, 1.00%, 6.00%.
Answer A) 117.60, 6.00%, 1.00%.
Explanation A is correct. The underlying is the spot FX price of 117.60 PKR/€. The risk-free rate is the Pakistani rate, 6.00%, and
the carry rate is the European rate of 1.00%. Section 4.3. LO.h.
Question Q-Code: L2-DV-VACC-019 LOS i Section 5
19 The FTSE 100 Index (a spot index) is presently at 6,690 and the 0.25 expiration futures contract is trading at
6,702. Suppose further that the exercise price is 6,690, the continuously compounded risk-free rate is 0.16%, time
to expiration is 0.25, and the dividend yield is 4.0%. Based on this information and volatility, N(d1) = 0.526, N(d2) =
0.488. The statement that is most accurate under the Black model to value a European call option on the futures
contract is:
A) The call value is the present value of the difference between the futures price of 6,702 times 0.526 and the
exercise price of 6,690 times 0.488.
B) The call value is the present value of the difference between the futures price of 6,702 times 0.526 and the
underlying price times 0.474.
C) The call value is the present value of the difference between the exercise price of 6,690 and the futures price of
6,702.
Answer A) The call value is the present value of the difference between the futures price of 6,702 times 0.526 and the
exercise price of 6,690 times 0.488.
Explanation A is correct. Black’s model for call options can be expressed as c = e–rT [F0(T)N(d1) – XN (d2)], where F0(T) = the
futures price at Time 0 that expires at Time T = 6,702, X = exercise price = 6,690. Section 5.1. LO.i.
Question Q-Code: L2-DV-VACC-020 LOS j Section 5
20 For an interest rate call option on three-month Libor with one year to expiration, the FRA that expires in one year is
1.20%, the current three-month Libor is 0.84% and the call exercise rate is 0.90%. In applying the Black model to
value this interest rate call option, the underlying rate is:
A) 0.84%.
B) 0.90%.
C) 1.20%.
Answer C) 1.20%.
Explanation C is correct. The underlying rate is the FRA rate that expires in one year = 1.20%. Section 5.2. LO.j.
21 A receiver swaption value can be interpreted as:
A) swap component minus the bond component

B) bond component minus the swap component.
C) bond component plus the swap component.
Answer B) bond component minus the swap component.
Explanation B is correct. For receiver swaptions, the swap component is (AP)PVA(RFIX)N(–d1) and the bond component is
(AP)PVA(RX)N(–d2). The receiver swaption model value is simply the bond component minus the swap component.
The payer swaption model value is the swap component (AP)PVA(RFIX)N(d1) minus the bond component
(AP)PVA(RX)N(d2). Section 5.3. LO.j.
Question Q-Code: L2-DV-VACC-022 LOS k Section 6
22 Which of the following statements is incorrect?
A) Delta of an option gives the change in the option value for a given small change in the value of stock, holding
everything else constant.
B) All else constant, option gamma is the change in a given option delta for a given small change in stock value.
C) Vega of an option is always negative since an increase in volatility reduces both put and call values.
Answer C) Vega of an option is always negative since an increase in volatility reduces both put and call values.
Explanation C is correct. The vega of an option is always positive as an increase in volatility, leads to an increase in the call and
put option values. A & B are correct statements. Sections 6.1, 6.2, 6.4. LO.k.
Question Q-Code: L2-DV-VACC-023 LOS l Section 6
23 Which of the following statements regarding delta hedging of an option is incorrect ?
A) A delta neutral portfolio means that portfolio delta is set to zero.

B) A portfolio of put options with a delta of -1,000, can be hedged by selling 1,000 shares of the underlying stock.
C) The optimal number of hedging units = - Portfolio delta divided by the delta of the hedging instrument.
Answer B) A portfolio of put options with a delta of -1,000, can be hedged by selling 1,000 shares of the underlying stock.
Explanation B is correct. If the portfolio consists of put options, hedging will involve buying shares, not shorting. Section 6.1.
LO.l.
Question Q-Code: L2-DV-VACC-024 LOS l Section 6
24 A portfolio delta is 2,500. This portfolio needs to be hedged with call options. The call options have a delta of 0.5. A
delta neutral portfolio is most likely attained by:
A) buying 10,000 call options.

B) selling 5,000 call options.
C) selling 2,500 call options.
Answer B) selling 5,000 call options.
Explanation B is correct. To arrive at a delta neutral portfolio NH = - Portfolio delta / DeltaH = -2,500/0.5 = -5,000 = selling
5,000 call options. Section 6.1. LO.l.
Question Q-Code: L2-DV-VACC-025 LOS m Section 6
25 Which of the following statements is most likely correct ?
A) If a portfolio is delta hedged there is no gamma risk.

B) Gamma has the smallest value when an option is at the money.
C) Gamma risk arises if there is an abrupt change in the price of the underlying.
Answer C) Gamma risk arises if there is an abrupt change in the price of the underlying.
Explanation C is correct. Gamma risk arises when there is large jump in the value of the underlying. Gamma measures “the risk
that remains once the portfolio is delta neutral” hence A is incorrect. Gamma has the largest value when the option
nears at the money, hence B is incorrect. Section 6.2. LO.m.
Question Q-Code: L2-DV-VACC-026 LOS n Section 6
26 Which of the following statements is least accurate ?
A) Implied volatility provides an understanding of the investors’ opinions on volatility of the underlying.
B) If an option’s implied volatility is higher than an investor’s volatility expectations, the investor will consider the
option to be overvalued.
C) Implied volatility is not comparable for options with different exercise prices and expirations.
Answer C) Implied volatility is not comparable for options with different exercise prices and expirations.
Explanation C is correct. Implied volatility can be used to compare the value of different options with different exercise prices
and expirations. A & B are correct statements. Section 6.6. LO.n.
Level II R38 Valuation of
Contingent Claims Q Bank
Test Code: L2 R38 VACC Q-Bank Set 2
Barry Todd is a valuations specialist at BCI Capital with a specific focus on derivatives. He is valuing an American call
option on Air Blitz Ltd. (ABL) with an exercise price of USD25 and expiry in two years. The stock is currently trading
at USD45. The stock is due to pay a dividend of USD2 in one year’s time. The stock’s up move factor is 1.264 and
the down move factor is 0.679. The annual risk free rate is 3%.
The risk neutral probability of an up move is closest to:
A) 0.60
B) 0.54
C) 0.44
Answer A) 0.60
Explanation A is correct. The risk neutral probability is calculated as 1.03−0.679 / 1.264−0.679 = 0.6. Section 3.1. LO.a
2 Barry Todd is a valuations specialist at BCI Capital with a specific focus on derivatives. He is valuing an American call
The call option’s value after an up move at year 1 is closest to:
A) USD30.15
B) USD31.43
C) USD29.43
Answer B) USD31.43
Explanation B is correct. As indicated in the figure below, the call option’s value after an up move at year 1 is USD31.4257.
Using the RN probability of 0.6 for an up move and discount rate of 3%, the binomial option valuation lattice is as
follows:
At year 1 after an up move, the option value as per the expectations approach is USD30.1539. Because this is an
American call option, its value is influenced by the early exercise option. The stock value at Time 1 is calculated by
subtracting the present value of dividends from the current, S0 = USD45 value of the stock. Present value of
dividends at Time 0 = 2/1.03 = USD1.94175. Therefore, stock value at Time 1 = S+ = [(45-1.94175) X1.264] =
54.43. The early exercise value assumes the option is exercised right before the stock goes ex-dividend and the
investor receives the dividend. If the call is not exercised the call buyer will not receive this dividend. Hence, the
early exercise value is 54.43 + 2 - 25 = USD31.43. Section 3.2. LO.b.
The hedge ratio at year 1 after a down move is closest to:
A) 0.6990
B) 0.7050
C) 0.6850
Answer A) 0.6990
Explanation A is correct. The hedge ratio is calculated as +− − / +− −=11.9550 − 0 / 36.9550 − 19.8516 = 0.6990.
Section 3.2. LO.b.
The call option’s current value is closest to:
A) USD20.27
B) USD21.01
C) USD20.00
Answer B) USD21.01
Explanation B is correct. The binomial lattice shows that the option’s current value is USD21.0107. Section 3.2. LO.b.
Assuming that the given option was a European option, its current value would have been:
A) higher
B) same
C) . lower
Answer C) . lower
Explanation C is correct. Because the European option would not have the choice of an early exercise, its value would be lower
than the American option. Section 3.2. LO.b.
6 The following information relates to next 2 questions
Julia Bond, CFA, an analyst at Premium Investments is valuing a two year European call option on the periodically
compounded one year spot rate. The exercise rate is 2.5% and the risk neutral probability is 50%. The binomial
interest rate lattice is given below:
The rate at the top most node at year 2 is:
A) The two year spot rate at the beginning of year

B) The one year spot rate at the beginning of year
C) The one year spot rate at the end of year 2.
Answer C) The one year spot rate at the end of year 2.
Explanation C is correct. The binomial interest rate tree shows the one-year spot rates in year 2. Section 3.3. LO.d.
Question Q-Code: L2-DV-VACC-033 LOS e Section 3
7 Julia Bond, CFA, an analyst at Premium Investments is valuing a two year European call option on the periodically
compounded one year spot rate. The exercise rate is 2.5% and the risk neutral probability is 50%. The binomial
interest rate lattice is given below:
The current option value is closest to:
A) $0.0031
B) $0.0027
C) $0.0024
Answer B) $0.0027
Explanation B is correct. At year 2, the possible option values are:
c++= Max(0, 0.0325-0.025) = 0.0075
c+-= Max(0, 0.027-0.025) = 0.002
c--= Max(0, 0.0226-0.025) = 0
At year 1, we have:
c+= 0.9713(0.5 x 0.0075 + 0.5 x 0.002) = 0.004614
c-= 0.9761(0.5 x 0.002 + 0.5 x 0) = 0.000976
At year 0 the call option value is:

c = 0.9742 (0.5 x 0.004614 + 0.5 x 0.000976) = $0.002723. Section 3.3. LO.d, e.
Tim John and Bill Adams are analysts at Primus Capital. The have recently been assigned the task of valuing options
on equities in the market by the Chief Investment Officer. As beginners, they valued options based on binomial
models assuming discrete price changes of the underlying. However, they are now evaluating using other option
valuation models.
Tim and Bill discuss the characteristics, valuation methodologies and assumptions of option valuation models before
presenting their conclusions to the investment committee. Specifically they discuss the Black –Scholes-Merton
(BSM) model and the Black model. They observe the following:
Tim: The BSM model assumes that the underlying follows the Brownian motion, implying that the return of the
underlying is normally distributed. Bill: I disagree. I believe the underlying’s return follows a lognormal distribution.
Tim: The BSM model assumes that all trades can be done free of any transaction costs.
Bill: In addition, it also assumes that short selling of the underlying instruments and full use of proceeds is
permitted.
Tim: The BSM model assumes that options are American-style.
Bill: I disagree. The BSM model assumes the options are European-style. In addition, it also assumes that the risk-
free rate is non-constant.
Tim: The BSM model can be described as having two components; a bond and a stock component. For call options,
the model can be seen as the stock component minus the bond component. Bill: I agree, and for put options the
model can be seen as the bond component minus the stock component.
Tim: I recently used the BSM model to value the options of J&I Corp. My calculations of the parameters showed d1
= 0.333, d2 = 0.033, N(d1) = 0.633, N(d2) = 0.515.
Bill: What was the trading strategy matching the payoff of an option suggested by you?
Tim: The modified Black model used for valuing swaptions uses the fixed rate on a forward interest rate swap as
the underlying.
Bill: I believe the swap rate and the exercise rate are both expressed as percentages and not decimals.
Regarding the return distribution of the underlying,:
A) Tim is incorrect and Bill is correct.

B) Time is correct and Bill is incorrect.
C) Both Tim and Bill are incorrect.
Answer A) Tim is incorrect and Bill is correct.
Explanation A is correct. The BSM model assumes that the underlying follows the geometric Brownian motion, implying that the
return of the underlying is lognormally distributed. Hence Tim is incorrect and Bill is correct. Section 4.2. LO.f.
9 Tim John and Bill Adams are analysts at Primus Capital. The have recently been assigned the task of valuing options
valuation models.
underlying is normally distributed.
Bill: I disagree. I believe the underlying’s return follows a lognormal distribution.
permitted.
Tim: The BSM model assumes that options are American-style. Bill: I disagree. The BSM model assumes the options
are European-style. In addition, it also assumes that the risk-free rate is non-constant.
= 0.333, d2 = 0.033, N(d1) = 0.633, N(d2) = 0.515.
the underlying.
Regarding transaction costs and short selling,:
A) Tim is incorrect and Bill is correct.

B) Both Tim and Bill are incorrect.
C) Both Tim and Bill are correct.
Answer C) Both Tim and Bill are correct.
Explanation C is correct. The BSM model assumes there are no transaction costs and that short selling with full use of proceeds
is permitted. Hence both Tim and Bill are correct. Section 4.2. LO.f.
valuation models.
permitted.
= 0.333, d2 = 0.033, N(d1) = 0.633, N(d2) = 0.515.
the underlying.
With regards to option style and risk free rate,:
A) Tim is correct about option style, Bill is incorrect about option style but correct about risk free rate.
B) Tim is incorrect about option style, Bill is correct about option style but incorrect about risk free rate.
C) Tim is incorrect about option style, Bill is correct about option style and risk free rate.
Answer B) Tim is incorrect about option style, Bill is correct about option style but incorrect about risk free rate.
Explanation B is correct. The BSM model assumes that options are European-style i.e. early exercise is not allowed. In addition,
it also assumes that the continuously compounded risk-free interest rate is known and constant. Hence, Tim is
incorrect about option style. Bill is correct about option style but incorrect about risk-free rate. Section 4.2. LO.f.
valuation models.
permitted.
= 0.333, d2 = 0.033, N(d1) = 0.633, N(d2) = 0.515.
the underlying.
With regards to the BSM model being interpreted as having two components:
A) Only Tim is correct.

B) Both are correct.
C) Both are incorrect.
Answer B) Both are correct.
Explanation B is correct. Under the BSM model, a call option can be seen as the stock component minus the bond component
and the put option can be seen as the bond component minus the stock component. Hence, both Tim and Bill are
correct. Section 4.3. LO.g.
valuation models.
permitted.
= 0.333, d2 = 0.033, N(d1) = 0.633, N(d2) = 0.515.
the underlying.
The trading strategy most likely suggested by Tim that replicates call option payoffs for a buyer is:
A) buy 0.633 shares of stock and short sell 0.515 shares of zero-coupon bonds.
B) buy 0.515 shares of stock and short sell 0.633 shares of zero-coupon bonds.
C) buy 0.633 shares of zero-coupon bonds and short sell 0.515 shares of stock.
Answer A) buy 0.633 shares of stock and short sell 0.515 shares of zero-coupon bonds.
Explanation A is correct. The BSM model for call options is N(d1)S –N(d2)e–rTX and for put options is – N(–d1)S +N(–d2)e–rTX.
For call options, the model can be seen as buying N(d1) shares of the stock and short selling N(d2) shares of the
bond. For put options, the model can be seen as short selling N(-d1) shares of the stock and buying N(-d2) shares
of the bond. Hence the call option is the same as buying 0.633 shares of the stock and short selling 0.515 shares
of the bond.. Section 4.3. LO.g
valuation models.
permitted.
= 0.333, d2 = 0.033, N(d1) = 0.633, N(d2) = 0.515.
the underlying.
With regards to the modified Black model for valuing swaptions,:
A) Tim is correct and Bill is also correct.

B) Tim is correct and Bill is incorrect.
C) Both are incorrect.
Answer B) Tim is correct and Bill is incorrect.
Explanation B is correct. In the modified Black model for valuing swaptions, the underlying is the fixed rate on a forward interest
rate swap and both the swap rate and the exercise rate are expressed as decimals and not percentages. Hence,
Tim is correct and Bill is incorrect. Section 5.3. LO.j
Chapter 12
Real Options
ANSWERS TO END-OF-CHAPTER QUESTIONS
12-1 a. Real options occur when managers can influence the size and risk of a project’s cash
flows by taking different actions during the project’s life. They are referred to as real
options because they deal with real as opposed to financial assets. They are also
called managerial options because they give opportunities to managers to respond to
changing market conditions. Sometimes they are called strategic options because
they often deal with strategic issues. Finally, they are also called embedded options
because they are a part of another project.
b. Investment timing options give companies the option to delay a project rather than
implement it immediately. This option to wait allows a company to reduce the
uncertainty of market conditions before it decides to implement the project. Capacity
options allow a company to change the capacity of their output in response to
changing market conditions. This includes the option to contract or expand
production. Growth options allow a company to expand if market demand is higher
than expected. This includes the opportunity to expand into different geographic
markets and the opportunity to introduce complementary or second-generation
products. It also includes the option to abandon a project if market conditions
deteriorate too much.
c. Decision trees are a form of scenario analysis in which different actions are taken in
different scenarios.
12-2 Postponing the project means that cash flows come later rather than sooner; however,
waiting may allow you to take advantage of changing conditions. It might make sense,
however, to proceed today if there are important advantages to being the first competitor
to enter a market.
12-3 Timing options make it less likely that a project will be accepted today. Often, if a firm
can delay a decision, it can increase the expected NPV of a project.
12-4 Having the option to abandon a project makes it more likely that the project will be
accepted today.
Answers and Solutions: 12 - 1

SOLUTIONS TO END-OF-CHAPTER PROBLEMS
12-1 a. 0 1 2 20
├─────┼─────┼────── • • • ────┤
-20 3 3 3
NPV = $1.074 million.
b. Wait 1 year:
PV @
0 1 2 3 21 Yr. 1
Tax imposed |r= 13% | | | • • • |
50% Prob. 0 -20 2.2 2.2 2.2 15.45
Tax not imposed | | | | • • • |

50% Prob. 0 -20 3.8 3.8 3.8 26.69
Tax imposed: NPV @ Yr. 1 = (-20 + 15.45)/(1.13) = -4.027

Tax not imposed: NPV @ Yr 1 = (-20 + 26.69)/ (1.13) = 5.920
Expected NPV = .5(-4.027) + .5(5.920) = 0.947
Note though, that if the tax is imposed, the NPV of the project is negative and therefore
would not be undertaken. The value of this option of waiting one year is evaluated as
0.5($0) + (0.5)($ 5.920) = $2.96 million.
Since the NPV of waiting one year is greater than going ahead and proceeding with the
project today, it makes sense to wait.

12-2 a. 0 10%
1 2 3 4
├─────┼─────┼─────┼─────┤
-8 4 4 4 4
NPV = $4.6795 million.
b. Wait 2 years:
PV @
0 1 2 3 4 5 6 Yr. 2
| r = 10% | | | | | |
10% Prob. 0 0 -9 2.2 2.2 2.2 2.2 $6.974
| | | | | | |
90% Prob. 0 0 -9 4.2 4.2 4.2 4.2 $13.313
Low CF scenario: NPV = (-9 + 6.974)/(1.1)2 = -$1.674
High CF scenario: NPV = (-9 + 13.313)/(1.1)2 = $3.564
Expected NPV = .1(-1.674) + .9(3.564) = 3.040
If the cash flows are only $2.2 million, the NPV of the project is negative and, thus,
would not be undertaken. The value of the option of waiting two years is evaluated as
0.10($0) + 0.90($3.564) = $3.208 million.
Since the NPV of waiting two years is less than going ahead and proceeding with the
project today, it makes sense to drill today.

12-3 a. 0 1 2 20
13%
├─────┼─────┼────── • • • ────┤
-300 40 40 40
NPV = -$19.0099 million. Don’t purchase.
b. Wait 1 year:
NPV @
0 1 2 3 4 21 Yr. 0
|r = 13% | | | | • • • |
50% Prob. 0 -300 30 30 30 30 -$78.9889
| | | | | • • • |
50% Prob. 0 -300 50 50 50 50 45.3430
If the cash flows are only $30 million per year, the NPV of the project is negative.
However, we’ve not considered the fact that the company could then be sold for $280
million. The decision tree would then look like this:
NPV @
0 r = 13% 1 2 3 4 21 Yr. 0
| | | | | • • • |
50% Prob. 0 -300 30 30 + 280 0 0 -$27.1468
| | | | | • • • |
50% Prob. 0 -300 50 50 50 50 45.3430
The expected NPV of waiting 1 year is 0.5(-$27.1468) + 0.5($45.3430) = $9.0981

million.
Given the option to sell, it makes sense to wait 1 year before deciding whether to
make the acquisition.

12-4 a. 0 1 14 15
| 12% | • • • | |
-6,200,000 600,000 600,000 600,000
Using a financial calculator, input the following data: CF0 = -6,200,000;

CF1-15 = 600,000; I = 12; and then solve for NPV = -$2,113,481.31.
b. 0 1 14 15
12%
| | • • • | |
-6,200,000 1,200,000 1,200,000 1,200,000
Using a financial calculator, input the following data: CF0 = -6,200,000;

CF1-15 = 1,200,000; I = 12; and then solve for NPV = $1,973,037.39.
c. If they proceed with the project today, the project’s expected NPV = (0.5  -
$2,113,481.31) + (0.5  $1,973,037.39) = -$70,221.96. So, Hart Enterprises would not
do it.
d. Since the project’s NPV with the tax is negative, if the tax were imposed the firm
would abandon the project. Thus, the decision tree looks like this:
NPV @
0 1 2 15 Yr. 0
50% Prob. | r= 12% | | • • • |
Taxes -6,200,000 6,000,000 0 0 -$ 842,857.14
No Taxes | | | • • • |
50% Prob. -6,200,000 1,200,000 1,200,000 1,200,000 1,973,037.39
Expected NPV $ 565,090.13
Yes, the existence of the abandonment option changes the expected NPV of the project
from negative to positive. Given this option the firm would take on the project because
its expected NPV is $565,090.13.
e. NPV @
0 1 Yr. 0
50% Prob. | r = 12% |
Taxes NPV = ? -1,500,000 $ 0.00
+300,000 = NPV @ t = 1 wouldn’t do
No Taxes | |
50% Prob. NPV = ? -1,500,000 2,232,142.86
+4,000,000 = NPV @ t = 1 Expected NPV $1,116,071.43
If the firm pays $1,116,071.43 for the option to purchase the land, then the NPV of the
project is exactly equal to zero. So the firm would not pay any more than this for the
option.

12-5 P = PV of all expected future cash flows if project is delayed. From Problem 15-3 we
know that PV @ Year 1 of Tax Imposed scenario is $15.45 and PV @ Year 1 of Tax Not
Imposed Scenario is $26.69. So the PV is:
P = [0.5(15.45)+ 0.5(26.690] / 1.13 = $18.646.

X = $20.
t = 1.
rRF = 0.08.
2 = 0.0687.
d1 = ln[18.646/20] + [0.08 + .5(.0687)](1) = 0.1688

(.0687)0.5 (1)0.5
d2 = 0.1688 - (.0687)0.5 (1)0.5 = -0.0933
From Excel function NORMSDIST, or approximated from Table 13E-1 in Extension to

Chapter 13:
N(d1) = 0.5670
N(d2) = 0.4628
Using the Black-Scholes Option Pricing Model, you calculate the option’s value as:
V = P[N(d1)] - Xe− rRF t [N(d2)]

= $18.646(0.5670) - $20e(-0.08)(1)(0.4628)
= $10.572 - $8.544
= $2.028 million.

12-6 P = PV of all expected future cash flows if project is delayed. From Problem 13-4 we
know that PV @ Year 2 of Low CF Scenario is $6.974 and PV @ Year 2 of High CF
Scenario is $13.313. So the PV is:
P = [0.1(6.974)+ 0.9(13.313] / 1.102 = $10.479.

X = $9.
t = 2.
rRF = 0.06.
2 = 0.0111.
d1 = ln[10.479/9] + [0.06 + .5(.0111)](2) = 1.9010

(.0111)0.5 (2)0.5
d2 = 1.9010 - (.0111)0.5 (2)0.5 = 1.7520
From Excel function NORMSDIST, or approximated from Table 12E-1 in Extension to

Chapter 12:
N(d1) = 0.9713
N(d2) = 0.9601
Using the Black-Scholes Option Pricing Model, you calculate the option’s value as:
V = P[N(d1)] - Xe− rRF t [N(d2)]

= $10.479(0.9713) - $9e(-0.06)(2)(0.9601)
= $10.178 - $7.664
= $2.514 million.

SOLUTION TO SPREADSHEET PROBLEMS
12-7 The detailed solution for the problem is available both on the instructor’s resource CD-
ROM (in the file Solution for FM11 Ch 12 P7 Build a Model.xls) and on the instructor’s
side of the textbook’s web site, http://brigham.swcollege.com.

MINI CASE
Assume that you have just been hired as a financial analyst by Tropical Sweets Inc., a mid-
sized California company that specializes in creating exotic candies from tropical fruits
such as mangoes, papayas, and dates. The firm's CEO, George Yamaguchi, recently
returned from an industry corporate executive conference in San Francisco, and one of the
sessions he attended was on real options. Since no one at Tropical Sweets is familiar with
the basics of real options, Yamaguchi has asked you to prepare a brief report that the
firm's executives could use to gain at least a cursory understanding of the topics.
To begin, you gathered some outside materials the subject and used these materials to
draft a list of pertinent questions that need to be answered. In fact, one possible approach
to the paper is to use a question-and-answer format. Now that the questions have been
drafted, you have to develop the answers.
a. What are some types of real options?
Answer: 1. Investment timing options

2. Growth options
a. Expansion of existing product line
b. New products
c. New geographic markets
3. Abandonment options
a. Contraction
b. Temporary suspension
c. Complete abandonment
4. Flexibility options.
b. What are five possible procedures for analyzing a real option?
Answer: 1. DCF analysis of expected cash flows, ignoring option.

2. Qualitatively assess the value of the real option.
3. Decision tree analysis.
4. Use a model for a corresponding financial option, if possible.
5. Use financial engineering techniques if a corresponding financial option is not
available.
Mini Case: 12- 9

c. Tropical Sweets is considering a project that will cost $70 million and will
generate expected cash flows of $30 per year for three years. The cost of capital
for this type of project is 10 percent and the risk-free rate is 6 percent. After
discussions with the marketing department, you learn that there is a 30 percent
chance of high demand, with future cash flows of $45 million per year. There is
a 40 percent chance of average demand, with cash flows of $30 million per year.
If demand is low (a 30 percent chance), cash flows will be only $15 million per
year. What is the expected NPV?
Answer: Initial Cost = $70 Million

Expected Cash Flows = $30 Million Per Year For Three Years
Cost Of Capital = 10%
PV Of Expected CFs = $74.61 Million
Expected NPV = $74.61 - $70
= $4.61 Million
Alternatively, one could calculate the NPV of each scenario:

Demand Probability Annual Cash Flow
High 30% $45
Average 40% $30
Low 30% $15
Find NPV of each scenario:

PV High: N=3 I=10 PV=? PMT=-45 FV=0
PV= 111.91
NPV High = $111.91 - $70 = $41.91 Million.
PV Average: N=3 I=10 PV=? PMT=-30 FV=0
PV= 74.61
NPV Average = $74.61 - $70 = $4.71 Million.
PV Low: N=3 I=10 PV=? PMT=-15 FV=0
PV= 37.30
NPV Low = $37.30 - $70 = -$32.70 Million.
Find Expected NPV:

E(NPV)=.3($41.91)+.4($4.61)+.3(-$32.70)
E(PV)= $4.61.
Mini Case: 12 - 10
d. Now suppose this project has an investment timing option, since it can be
delayed for a year. The cost will still be $70 million at the end of the year, and
the cash flows for the scenarios will still last three years. However, Tropical
Sweets will know the level of demand, and will implement the project only if it
adds value to the company. Perform a qualitative assessment of the investment
timing option’s value.
Answer: If we immediately proceed with the project, its expected NPV is $4.61 million.
However, the project is very risky. If demand is high, NPV will be $41.91
million. If demand is average, NPV will be $4.61 million. If demand is low, NPV
will be -$32.70 million. However, if we wait one year, we will find out additional
information regarding demand. If demand is low, we won’t implement project. If
we wait, the up-front cost and cash flows will stay the same, except they will be
shifted ahead by a year.
The value of any real option increases if the underlying project is very risky or if
there is a long time before you must exercise the option.
This project is risky and has one year before we must decide, so the option to wait
is probably valuable.
e. Use decision tree analysis to calculate the NPV of the project with the investment
timing option.
Answer: The project will be implemented only if demand is average or high.

Here is the time line:
0 1 2 3 4
High $0 -$70 $45 $45 $45
Average $0 -$70 $30 $30 $30
Low $0 $0 $0 $0 $0
To find the NPVC, discount the cost at the risk-free rate of 6 percent since it is known
for certain, and discount the other risky cash flows at the 10 percent cost of capital.
High: NPV = -$70/1.06 + $45/1.102 + $45/1.103 +$45/1.104 = $35.70

Average: NPV = -$70/1.06 + $30/1.102 + $30/1.103 +$30/1.104 = $1.79
Low: NPV = $0.
Expected NPV = 0.3($35.70) + 0.4($1.79) + 0.3($0) = $11.42.
Since this is much greater than the NPV of immediate implementation (which is
$4.61 million) we should wait. In other words, implementing immediately gives an
expected NPV of $4.61 million, but implementing immediately means we give up the
option to wait, which is worth $11.42 million.
Mini Case: 12- 11

f. Use a financial option pricing model to estimate the value of the investment
timing option.
Answer: The option to wait resembles a financial call option-- we get to “buy” the project for
$70 million in one year if value of project in one year is greater than $70 million.
This is like a call option with an exercise price of $70 million and an expiration date
of one year.
X = Exercise Price = Cost Of Implement Project = $70 Million.
RRF = Risk-Free Rate = 6%.
T = Time To Maturity = 1 year.
P = Current Price Of Stock = Current Value Of The Project’s Future Cash Flows.
σ 2 = Variance Of Stock Return = Variance Of Project’s Rate Of Return.
We explain how to calculate P and σ2 below.

Just as the price of a stock is the present value of all the stock’s future cash flows, the
“price” of the real option is the present value of all the project’s cash flows that occur
beyond the exercise date. Notice that the exercise cost of an option does not affect
the stock price. Similarly, the cost to implement the real option does not affect the
current value of the underlying asset (which is the PV of the project’s cash flows). It
will be helpful in later steps if we break the calculation into two parts. First, we find
the value of all cash flows beyond the exercise date discounted back to the exercise
date. Then we find the expected present value of those values.
Step 1: Find the value of all cash flows beyond the exercise date discounted back to
the exercise date. Here is the time line. The exercise date is year 1, so we discount
all future cash flows back to year 1.
0 1 2 3 4
High $45 $45 $45
Average $30 $30 $30
Low $15 $15 $15
High: PV1 = $45/1.10 + $45/1.102 + $45/1.103 = $111.91

Average: PV1 = $30/1.10 + $30/1.102 + $30/1.103 = $74.61
Low: PV1 = $15/1.10 + $15/1.102 + $15/1.103 = $37.30
The current expected present value, P, is:

P = 0.3[$111.91/1.1] + 0.4[$74.61/1.1] + 0.3[$37.30/1.1] = $67.82.
For a stock option, σ2 is the variance of the stock return, not the variance of the stock
price. Therefore, for a real option we need the variance of the project’s rate of return.
There are three ways to estimate this variance. First, we can use subjective judgment.
Second, we can calculate the project’s return in each scenario and then calculate the
return’s variance. This is the direct approach. Third, we know the projects value at
each scenario at the expiration date, and we know the current value of the project.
Mini Case: 12 - 12
Thus, we can find a variance of project return that gives the range of project values
that can occur at expiration. This is the indirect approach.
Following is an explanation of each approach.
Subjective estimate:
The typical stock has σ2 of about 12%. Most projects will be somewhat riskier than
the firm, since the risk of the firm reflects the diversification that comes from having
many projects. Subjectively scale the variance of the company’s stock return up or
down to reflect the risk of the project. The company in our example has a stock with
a variance of 10%, so we might expect the project to have a variance in the range of
12% to 19%.
Direct approach:
From our previous analysis, we know the current value of the project and the value
for each scenario at the time the option expires (year 1). Here is the time line:
Current Value Value At Expiration

Year 0 Year 1
High $67.82 $111.91
Average $67.82 $74.61
Low $67.82 $37.30
The annual rate of return is:

High: Return = ($111.91/$67.82) – 1 = 65%.
High: Average = ($74.61/$67.82) – 1 = 10%.
High: Return = ($37.30/$67.82) – 1 = -45%.
Expected Return = 0.3(0.65) + 0.4(0.10) + 0.3(-0.45)

= 10%.
2 = 0.3(0.65-0.10)2 + 0.4(0.10-0.10)2 + 0.3(-0.45-0.10)2

= 0.182 = 18.2%.
The direct approach gives an estimate of 18.2% for the variance of the project’s
return.
Mini Case: 12- 13

The indirect approach:
Given a current stock price and an anticipated range of possible stock prices at some
point in the future, we can use our knowledge of the distribution of stock returns
(which is lognormal) to relate the variance of the stock’s rate of return to the range of
possible outcomes for stock price. To use this formula, we need the coefficient of
variation of stock price at the time the option expires. To calculate the coefficient of
variation, we need the expected stock price and the standard deviation of the stock
price (both of these are measured at the time the option expires). For the real option,
we need the expected value of the project’s cash flows at the date the real option
expires, and the standard deviation of the project’s value at the date the real option
expires.
We previously calculated the value of the project at the time the option expires, and
we can use this to calculate the expected value and the standard deviation.
Value At Expiration
Year 1
High $111.91
Average $74.61
Low $37.30
Expected Value =.3($111.91)+.4($74.61)+.3($37.3)

= $74.61.
value = [.3($111.91-$74.61)2 + .4($74.61-$74.61)2
+ .3($37.30-$74.61)2]1/2
= $28.90.
Coefficient Of Variation = CV = Expected Value / value

CV = $74.61 / $28.90 = 0.39.
Here is a formula for the variance of a stock’s return, if you know the coefficient of
variation of the expected stock price at some point in the future. The CV should be
for the entire project, including all scenarios:
σ2 = LN[CV2 + 1]/T = LN[0.392 + 1]/1 = 14.2%.
Mini Case: 12 - 14
Now, we proceed to use the OPM:
V = $67.83[N(d1)] - $70e-(0.06)(1)[N(d2)].
ln( $67.83/$70) + [(0.06 + 0.142/2)](15)

d1 =
0.5 0.5
(.142) (1)
= 0.2641.
d2 = d1 - (0.142)0.5(1)0.5 = 0.2641 - 0.3768

= -0.1127.
N(d1) = N(0.2641) = 0.6041.
N(d2) = N(-0.1127) = 0.4551.
therefore,
V = $67.83(0.6041) - $70e-0.06(0.4551)
= $10.98.
g. Now suppose the cost of the project is $75 million and the project cannot be
delayed. But if Tropical Sweets implements the project, then Tropical Sweets
will have a growth option. It will have the opportunity to replicate the original
project at the end of its life. What is the total expected NPV of the two projects
if both are implemented?
Answer: Suppose the cost of the project is $75 million instead of $70 million, and there is no
option to wait.
NPV = PV of future cash flows - cost
= $74.61 - $75 = -$0.39 million.
The project now looks like a loser. Using NPV analysis:
NPV = NPV Of Original Project + NPV Of Replication Project
= -$0.39 + -$0.39/(1+0.10)3
= -$0.39 + -$0.30 = -$0.69.
Still looks like a loser, but you will only implement project 2 if demand is high. We
might have chosen to discount the cost of the replication project at the risk-free rate,
and this would have made the NPV even lower.
Mini Case: 12- 15

h. Tropical Sweets will replicate the original project only if demand is high. Using
decision tree analysis, estimate the value of the project with the growth option.
Answer: The future cash flows of the optimal decisions are shown below. The cash flow in
year 3 for the high demand scenario is the cash flow from the original project and the
cost of the replication project.
0 1 2 3 4 5 6
High -$75 $45 $45 $45 -$70 $45 $45 $45
Average -$75 $30 $30 $30 $0 $0 $0
Low -$75 $15 $15 $15 $0 $0 $0
To find the NPV, we discount the risky cash flows at the 10 percent cost of capital,
and the non-risky cost to replicate (i.e., the $75 million) at the risk-free rate.
NPV high = -$75 + $45/1.10 + $45/1.102 + $45/1.103 + $45/1.104

+ $45/1.105 + $45/1.106 - $75/1.063
= $58.02
NPV average = -$75 + $30/1.10 + $30/1.102 + $30/1.103 = -$0.39
NPV average = -$75 + $15/1.10 + $15/1.102 + $15/1.103 = -$37.70
Expected NPV = 0.3($58.02) + 0.4(-$0.39) + 0.3(-$37.70) = $5.94.
Thus, the option to replicate adds enough value that the project now has a positive
NPV.
i. Use a financial option model to estimate the value of the growth option.
Answer: X = Exercise Price = Cost Of Implement Project = $75 million.

RRF = Risk-Free Rate = 6%.
T = Time To Maturity = 3 years.
P = Current Price Of Stock = Current Value Of The Project’s Future Cash Flows.
σ2 = Variance Of Stock Return = Variance Of Project’s Rate Of Return.
We explain how to calculate P and σ2 below.
Step 1: Find the value of all cash flows beyond the exercise date discounted back to
the exercise date. Here is the time line. The exercise date is year 1, so we discount
all future cash flows back to year 3.
0 1 2 3 4 5 6
High $45 $45 $45
Average $30 $30 $30
Low $15 $15 $15
Mini Case: 12 - 16
High: PV3 = $45/1.10 + $45/1.102 + $45/1.103 = $111.91
Average: PV3 = $30/1.10 + $30/1.102 + $30/1.103 = $74.61
Low: PV3 = $15/1.10 + $15/1.102 + $15/1.103 = $37.30
The current expected present value, P, is:

P = 0.3[$111.91/1.13] + 0.4[$74.61/1.13] + 0.3[$37.30/1.13] = $56.05.
Direct approach for estimating σ2:
From our previous analysis, we know the current value of the project and the value
for each scenario at the time the option expires (year 3). Here is the time line:
Current Value Value At Expiration

Year 0 Year 3
High $56.02 $111.91
Average $56.02 $74.61
Low $56.02 $37.30
The annual rate of return is:

High: Return = ($111.91/$56.02)(1/3) – 1 = 25.9%.
High: Average = ($74.61/$56.02)(1/3) – 1 = 10%.
High: Return = ($37.30/$56.02)(1/3) – 1 = -12.7%.
Expected Return = 0.3(0.259) + 0.4(0.10) + 0.3(-0.127)

= 8.0%.
2 = 0.3(0..259-0.08)2 + 0.4(0.10-0.08)2 + 0.3(-0.127-0.08)2

= 0.182 = 2.3%.
This is lower than the variance found for the previous option because the dispersion
of cash flows for the replication project is the same as for the original, even though
the replication occurs much later. Therefore, the rate of return for the replication is
less volatile. We do sensitivity analysis later.
The indirect approach:

First, find the coefficient of variation for the value of the project at the time the option
expires (year 3).
Mini Case: 12- 17

We previously calculated the value of the project at the time the option expires, and
we can use this to calculate the expected value and the standard deviation.
Value At Expiration
Year 3
High $111.91
Average $74.61
Low $37.30
Expected Value =.3($111.91)+.4($74.61)+.3($37.3)

= $74.61.
value = [.3($111.91-$74.61)2 + .4($74.61-$74.61)2
+ .3($37.30-$74.61)2]1/2
= $28.90.
Coefficient Of Variation = CV = Expected Value / value

CV = $74.61 / $28.90 = 0.39.
To find the variance of the project’s rate or return, we use the formula below:
σ2 = LN[CV2 + 1]/T = LN[0.392 + 1]/3 = 4.7%.
Now, we proceed to use the OPM:
V = $56.06[N(d1)] - $75e-(0.06)(3)[N(d2)].
ln( $56.06/$75) + [(0.06 + 0.047/2)](3)

d1 =
0.5 0.5
( 0.047) ( 3)
= -0.1085.
d2 = d1 - (0.047)0.5(3)0.5 = -.1085 - 0.3755

= -0.4840.
N(d1) = N(-0.1080) = 0.4568.
N(d2) = N(-0.4835) = 0.3142.

Therefore,
V = $56.06(0.4568) - $75e-(0.06)(3)(0.3142)
= $5.92.
Total Value = NPV Of Project 1 + Value Of Growth Option

=-$0.39 + $5.92
= $5.5 million
Mini Case: 12 - 18
j. What happens to the value of the growth option if the variance of the project’s
return is 14.2 percent? What if it is 50 percent? How might this explain the
high valuations of many dot.com companies?
Answer: If risk, defined by σ2, goes up, then value of growth option goes up (see the file ch 12
mini case.xls for calculations):
σ2 = 4.7%, option value = $5.92
σ2 = 14.2%, option value = $12.10
σ2 = 50%, option value = $24.09
If the future profitability of dot.com companies is very volatile (i.e., there is the
potential for very high profits), then a company with a real option on those profits
might have a very high value for its growth option.
Mini Case: 12- 19

Level I An Introduction to Asset-
Backed Securities
Test Code: L1 R53 IABS Q-Bank
Question Q-Code: L1-FI-IABS-001 LOS a Section 2
1 Which of the following statements is most likely correct?

Statement 1: Securitization is beneficial for banks because it allows banks to maintain ownership of their
securitized assets.
Statement 2: Securitization is beneficial for banks because it increases the funds available for banks to lend.
A) Statement 1.
B) Statement 2.
C) Neither of them.
Answer B) Statement 2.
Explanation B is correct. Securitization allows banks to remove assets from their balance sheet, therefore increasing the pool of
available capital that can be loaned out.
Following are the benefits of securitization to the bank or loan originator:
It enables banks to increase loan origination, monitoring, and collections.

It reduces the role of the intermediaries (known as disintermediation) like the bank. However, note that an
intermediary is still required to package and distribute securities.
Banks have the ability to lend more money if the demand for ABS and MBS is high relative to if the money was
self-financed (from deposits, debt, equity etc.).
There is greater efficiency and profitability for the banking sector: the mortgage-backed securities, at least in the
US market, trade actively in the secondary market which improves the efficiency and liquidity of the financial
market.
Section 2. LO.a.
2 Securitization is beneficial for investors because it:
A) provides direct access to mortgages and portfolios of receivables that would be otherwise unattainable.
B) repackages bank loans into simpler structure.
C) allows them to choose which borrowers to lend to.
Answer A) provides direct access to mortgages and portfolios of receivables that would be otherwise unattainable.
Explanation A is correct. Securitization is beneficial for investors because it provides direct access to mortgages and portfolios
of receivables that would be otherwise unattainable. B is incorrect because securitization does not repackage bank
loans into simpler structure. C is incorrect because securitization does not allow investors to choose which
borrowers to lend to but rather give them an opportunity to buy a small part of the home buyers’ mortgage in the
form of a security issued by the SPV.
Following are the benefits of securitization to investors:
Securitization converts an illiquid asset into a liquid security.

It gives investors direct access to the payment streams of the underlying mortgage loans that would otherwise
be unattainable.
There are higher risk-adjusted returns to investors: pooling loans results in diversification and lower risk for
investors.
It gives investors an opportunity to buy a small part of the home buyers’ mortgage in the form of a security
issued by the SPV.
It gives exposure to the market, real estate in this example, without directly investing in it.
Section 2. LO.a.

3 Which of the following is least likely a benefit of securitization for banks?
A) It transfers credit risk.

B) It increases market capital requirements.
C) It increases funding availability without increasing reserve requirements.
Answer B) It increases market capital requirements.
Explanation B is correct. The benefits of securitization include transfer of credit risk, increased funding availability without
increasing reserve requirements, and automatically decreased market capital requirements.
Following are the benefits of securitization to the bank or loan originator:
It enables banks to increase loan origination, monitoring, and collections.

It reduces the role of the intermediaries (known as disintermediation) like the bank. However, note that an
intermediary is still required to package and distribute securities.
Banks have the ability to lend more money if the demand for ABS and MBS is high relative to if the money was
self-financed (from deposits, debt, equity etc.).
There is greater efficiency and profitability for the banking sector: the mortgage-backed securities, at least in the
US market, trade actively in the secondary market which improves the efficiency and liquidity of the financial
market.
Section 2. LO.a.
4 Which of the following statements about securitization is least accurate? Due to securitization:
A) the risk adjusted returns to the ultimate investors can be enhanced.

B) the profitability of banks can be improved.
C) the costs paid by borrowers are effectively higher.
Answer C) the costs paid by borrowers are effectively higher.
Explanation C is correct. Because of securitization, the costs paid by borrowers can be effectively reduced. Options A and B are
the benefits of securitization. Section 2. LO.a.
Question Q-Code: L1-FI-IABS-005 LOS b Section 3
5 In a securitization, the loan servicer is least likely responsible for the:
A) issuance of the asset-backed securities.

B) collection of payments from the borrowers.
C) recovery of underlying assets for delinquent loans.
Answer A) issuance of the asset-backed securities.
Explanation A is correct. In a securitization, the special purpose vehicle (SPV) is responsible for the issuance of the asset
backed securities. Whereas, the loan servicer is responsible for collection of payments from the borrowers and
recovery of underlying assets for delinquent loans. Section 3.2. LO.b.
6 In a securitization, the seller of the collateral is called the:
A) special purpose vehicle (SPV).

B) originator.
C) guarantor.
Answer B) originator.
Explanation B is correct. In a securitization, the seller of the collateral is called the originator.
Party Role
Seller of pool of Originates the loans and sells to a special purpose entity
securities (SPE).
SPV or trust or Buys the loans from the seller and issues ABS.
issuer
Servicer Services loans such as collecting payments from

borrowers, notifying borrowers who may be delinquent,
and if necessary, seizing automobiles from borrowers
who do not make payments on time.
Section 3.2. LO.b.
7 A special purpose vehicle (SPV) most likely:
A) sells accounts receivable.

B) sells asset backed securities.
C) collects payments from borrowers.
Answer B) sells asset backed securities.
Explanation B is correct. Special purpose vehicles (SPV) sell asset backed securities. The originator sells assets (receivables) to
the SPV for cash. The servicer is responsible for the collection of payments from the borrowers. Section 3.2. LO.b.
Question Q-Code: L1-FI-IABS-009 LOS c Section 5
8 Analyst 1: Credit tranching allows investors to choose between extension risk and contraction risk.
Analyst 2: Time tranching allows investors to choose between extension risk and contraction risk.
A) Analyst 1.
B) Analyst 2.
C) Neither of them.
Explanation B is correct. Time tranching or prepayment tranching allows investors to choose between extension risk and
contraction risk. Credit tranching refers to creating a multi-layered capital structure that has senior and subordinate
tranches. Section 3.3 and 5.1. LO.c.
9 Credit tranching refers to creating a multi-layered capital structure that has:
A) fully amortizing and partially amortizing tranches.

B) recourse and non-recourse tranches.
C) senior and subordinate tranches.
Answer C) senior and subordinate tranches.
Explanation C is correct. Credit tranching refers to creating a multi-layered capital structure that has senior and subordinate
tranches.
Recourse loans: The lender can claim the shortfall (outstanding mortgage balance – proceeds from the sale of the
property) from the borrower. For instance, if the borrower has other properties or possessions such as an
expensive car, valuable art, then these could be sold to fulfill the shortfall.
Non-recourse loans: Most mortgage loans are non-recourse. The lender may sell the property in case of a default
and keep the proceeds. But, unlike a recourse loan, the bank/lender cannot claim other assets of the borrower to
fulfill the shortfall in outstanding mortgage balance.
There are two types of amortizing loans:
Fully amortizing loans: There is no outstanding balance at the end of the mortgage’s life. The loan is fully repaid
with the last mortgage payment.
Partially amortizing loans: The sum of all the scheduled mortgage repayments is less than borrowed amount. A
last payment, called the balloon payment, is made equal to the unpaid mortgage balance.
Section 3.3. LO.c.

10 Time tranching helps investors to choose between:
A) extension risk and credit risk.

B) contraction risk and credit risk.
C) extension risk and contraction risk.
Answer C) extension risk and contraction risk.
Explanation C is correct. Time tranching helps investors in choosing between extension risk and contraction risk. Credit
tranching refers to creating a multi-layered capital structure that has senior and subordinate tranches. It helps
investors in managing credit risk.
Section 3.3 and 5.1. LO.c.
11 Which of the following events will most likely violate the absolute priority rule?
A) Bankruptcy reorganization.
B) Bankruptcy liquidation.
C) Special purpose entity reorganization.
Answer A) Bankruptcy reorganization.
Explanation A is correct. The absolute priority rule is the principle that senior creditors are paid in full before subordinated
creditors are paid anything. The absolute priority rule also guarantees the seniority of creditors relative to equity
holders. Whereas the absolute priority rule generally holds in liquidations, it has not always been upheld by the
courts in reorganizations. Section 3.4. LO.b.
12 Analyst 1: An SPV makes it possible for the asset-backed securities to have a higher credit rating than the parent
company.
Analyst 2: If bankruptcy occurs, SPV can shield its assets from the parent company’s creditors.
A) Analyst 1.
B) Analyst 2.
C) Both.
Answer C) Both.
Explanation C is correct. Both statements are correct. Section 3.4. LO.b.
Question Q-Code: L1-FI-IABS-018 LOS d Section 4
13 A mortgage starts out with a fixed rate and then becomes an adjustable rate after a specified initial term. The
mortgage is most likely a:
A) rollover mortgage.
B) renegotiable mortgage.
C) hybrid mortgage.
Answer C) hybrid mortgage.
Explanation C is correct. When the mortgage starts out with a fixed rate and then becomes an adjustable rate after a specified
initial term, the mortgage is referred to as a hybrid mortgage. If the mortgage rate is fixed for some initial period
and is then adjusted to a new fixed rate, the mortgage is referred to as a rollover or renegotiable mortgage. Section
4.2. LO.d.

14 Which of the following statements about convertible mortgages is most accurate?
A) The mortgage rate is initially a fixed rate. At some point, the borrower has the option to convert into an
adjustable rate for the remainder of the mortgage’s life.
B) The mortgage rate is initially an adjustable rate. At some point, the borrower has the option to convert into a
fixed rate for the remainder of the mortgage’s life.
C) The mortgage rate is initially either a fixed rate or an adjustable rate. At some point, the borrower has the option
to convert into a fixed rate or an adjustable rate for the remainder of the mortgage’s life.
Answer C) The mortgage rate is initially either a fixed rate or an adjustable rate. At some point, the borrower has the option
to convert into a fixed rate or an adjustable rate for the remainder of the mortgage’s life.
Explanation C is correct. In a convertible mortgage, the mortgage rate is initially either a fixed rate or an adjustable rate. At
some point, the borrower has the option to convert into a fixed rate or an adjustable rate for the remainder of the
mortgage’s life. Section 4.2. LO.d.
15 Ali reviews the status of his home mortgage schedule for the month of December 2017:
Date Item Balance

(GBP)
01 Outstanding mortgage loan balance 700,000

December
31 Total monthly required payment 15,000

December
31 Interest component of total monthly required 3,000

December payment
On 31 December 2017, Ali makes a payment of GBP 20,000 rather than GBP 15,000. What will be outstanding
mortgage loan balance immediately after the payment is made?
A) GBP 680,000.
B) GBP 683,000.
C) GBP 688,000.
Answer B) GBP 683,000.
Explanation B is correct. The difference between the GBP 15,000 monthly mortgage payment and the GBP 3,000 portion of the
payment that represents interest equals GBP 12,000, which is the amount of the total required payment applied to
reduce the outstanding mortgage balance. In addition, a payment made in excess of the monthly mortgage
payment is called a prepayment. The prepayment of GBP 5,000 is a partial pay down of the mortgage balance. The
outstanding mortgage balance after the GBP 20,000 payment is the mortgage balance of GBP 700,000 – GBP
12,000 – GBP 5,000 = GBP 683,000. Section 4.3 and 5.1. LO.d.
16 A balloon payment is least likely a feature of:
A) partially amortizing mortgage.

B) fully amortizing mortgage.
C) interest-only mortgage.
Answer B) fully amortizing mortgage.
Explanation B is correct. A fully amortizing loan is structured in a way that when last mortgage payment is made the loan is paid
in full. Therefore, it is least likely to contain a balloon payment.
In Partially amortizing loans, the sum of all the scheduled mortgage repayments is less than borrowed amount. A
last payment, called the balloon payment, is made equal to the unpaid mortgage balance. In interest-only mortgage,
no scheduled principal repayment for a certain number of years. Section 4.3. LO.d.
17 Frank Smith obtains a recourse mortgage loan for USD 300,000. One year later, when the outstanding balance of
the mortgage is USD 290,000, Frank cannot make his mortgage payments and defaults on the loan. The lender
forecloses the loan and sells the house for USD 250,000. What amount is the lender entitled to claim from Frank?
A) $0.
B) $40,000.
C) $50,000.
Answer B) $40,000.
Explanation B is correct. In a recourse loan, the lender is entitled to claim the shortfall between the mortgage balance
outstanding and the proceeds received from the sale of the property. i.e. 290,000 – 250,000 = 40,000. Section 4.5.
LO.d.
18 Sean obtains a 10 million GBP mortgage loan from Barclays Bank. Two years later, the principal on the loan is 8
million GBP and Sean defaults on the loan. Barclays Bank forecloses the loan, sells the property for 6 million GBP,
and is entitled to collect the shortfall, 2 million GBP, from Sean. Sean most likely had a:
A) recourse loan.
B) unsecured loan.
C) non-recourse loan.
Answer A) recourse loan.
Explanation A is correct. Barclays Bank has a claim against Sean for the shortfall between the amount of the mortgage balance
outstanding and the proceeds received from the sale of the property. This indicates that the mortgage loan is a
recourse loan. If Sean had a non-recourse loan, the bank would have only been entitled to the proceeds from the
sale of the underlying property.
In Recourse loans, the lender can claim the shortfall (outstanding mortgage balance – proceeds from the sale of the
property) from the borrower. In Non-recourse loans, the lender may sell the property in case of a default and keep
the proceeds. But, unlike a recourse loan, the bank/lender cannot claim other assets of the borrower to fulfill the
shortfall in outstanding mortgage balance.
Section 4.5. LO.d.
19 Maria obtains a non-recourse mortgage loan for PKR 8,000,000. Three year later, when the outstanding balance of
the mortgage is PKR 5,000,000, Maria cannot make her mortgage payments and defaults on the loan. The lender
forecloses and sells the house for PKR 3,750,000. What amount is the lender entitled to claim from Maria?
A) PKR 0.
B) PKR 1,250,000.
C) PKR 5,000,000.
Answer A) PKR 0.
Explanation A is correct. For a non-recourse loan, the bank can only look to the underlying property to recover the outstanding
mortgage balance and has no further claim against the borrower. The bank is simply entitled to foreclose on the
home and sell it. Section 4.5. LO.d.
20 Charles Dent obtains a non-recourse loan for USD 200,000. A year later the principal on the loan is USD 180,000
and Charles defaults on the loan. The lender forecloses and sells the house for USD 150,000. What amount is the
lender entitled to claim from Charles?
A) $0.
B) $30,000.
C) $50,000.
Answer A) $0.
Explanation A is correct. In a non-recourse loan, the lender can only look to the underlying property to recover the outstanding
mortgage balance and has no further claim against the borrower. B is incorrect because in a recourse loan, the
lender is entitled to claim the shortfall between the mortgage balance outstanding and the proceeds received from
the sale of the property. i.e. 180,000 – 150,000 = 30,000. Section 4.5. LO.d.
21 Taha is an analyst for Adamjee Insurance that invests in residential mortgage pass-through securities. Taha reviews
the monthly cash flow of one underlying mortgage pool to determine the cash flow to be passed through to
investors:
Total principal paid including prepayment $2,445,000
Scheduled principal to be paid before $445,000

prepayment
Gross coupon interest paid $3,555,000
Servicing fees $145,000
Other fees for guaranteeing the issue $55,000
Based on Taha’s table, the total cash flow to be passed through to the investors is closest to:
A) $5,800,000.
B) $5,855,000.
C) $6,000,000.
Answer A) $5,800,000.
Explanation A is correct. The total cash flow to be received by the investors is as follows:
Total principal + gross coupon interest - less servicing and other fees = 2,445,000 + 3,555,000 – 145,000 –
55,000 = USD 5,800,000.
Section 5.1. LO.d.
Question Q-Code: L1-FI-IABS-030 LOS e Section 5
22 Which of the following is least likely a feature of a non-agency residential mortgage-backed security (RMBS)?
A) Overcollateralization.
B) A pool of conforming mortgages as collateral.
C) Senior/subordinated structure.
Answer B) A pool of conforming mortgages as collateral.
Explanation B is correct. Conforming mortgages are used as collateral for agency mortgage pass-through securities. If a loan
satisfies the underwriting standards for inclusion as collateral for an agency RMBS, it is called a “conforming
mortgage.” If a loan fails to satisfy the underwriting standards, it is called a “non- conforming mortgage.” Non-
agency RMBS are credit enhanced, either internally or externally, to attract investors. Internal credit enhancements
include senior/subordinated structures, cash reserve funds, overcollateralization, and excess spread accounts.
External credit enhancements include third party guarantee, such as monoline insurance company. Section 5.1 and
5.3. LO.e.
23 Suppose there are three mortgages with respective balances of USD 100,000, USD 200,000, and USD 300,000.
The mortgage rates are 6%, 7%, and 8% respectively. The WAC is closest to:
A) 6.33.
B) 7.33.
C) 8.
Answer B) 7.33.
Explanation B is correct. The Weighted average coupon or WAC is found by weighting the rate of each mortgage loan in the
pool by the percentage of the mortgage outstanding relative to the outstanding amount of all mortgages in the
pool.
Weighted average coupon = (100/600) * 6% + (200/600) * 7% + (300/600) * 8% = 7.33. Section 5.1. LO.e.
Question Q-Code: L1-FI-IABS-036 LOS f Section 5
24 A conditional prepayment rate (CPR) of 6% means that approximately 6% of the outstanding mortgage pool
balance at the beginning of this year will be prepaid:
A) in the current month.

B) by the end of the year.
C) over the life of the mortgages.
Answer B) by the end of the year.
Explanation B is correct. CPR is an annualized rate, which indicates the percentage of the outstanding mortgage pool balance at
the beginning of the year that is expected to be prepaid by the end of the year. Section 5.1. LO.f.
25 In the context of mortgage-backed securities, a conditional prepayment rate of 10% means that approximately
10% of an outstanding mortgage pool balance at the beginning of the year will be prepaid:
A) by the end of the year.

B) by the end of the month.
C) over the life of the mortgage.
Answer A) by the end of the year.
Explanation A is correct. A conditional prepayment rate (CPR) is an annualized rate which indicates the percentage of the
mortgage balance at the beginning of the year which is expected to be prepaid by the end of the year. Section 5.1.
LO.f.
26 Which of the following statements best describes the relationship between CPR and SMM?
A) SMM deals with the expected prepayment rate while CPR is a measure for the actual prepayment rate.
B) SMM is a measure of prepayment risk while CPR is a measure of credit risk.
C) CPR is an annualized version of SMM.
Answer C) CPR is an annualized version of SMM.
Explanation C is correct. Single month mortality (SMM) measures prepayments in a month. An SMM of x % means that x % of the
outstanding mortgage balance at the start of the month minus the scheduled principal repayment, will be repaid
that month.
SMM = (Prepayment for a month) / (Beginning mortgage balance for month - Scheduled principle repayment for
month)
Conditional repayment rate (CPR) is an annualized version of SMM. CPR indicates the percentage of the outstanding
mortgage pool balance at the beginning of the year that is expected to be prepaid by the end of the year.
The other statements are incorrect. Section 5.1. LO.f.

27 Which of the following statements is/are correct?
Statement 1: A pass through rate in a mortgage pass-through security is equal to the weighted average
mortgage rate on the underlying pool of mortgages.
mortgage rate on the underlying pool of mortgages after the servicing and other fees have been deducted.
mortgage rate on the underlying pool of mortgages after the servicing and other fees have been added.
A) Only Statement 2 is correct.

B) Statements 1 and 3 are correct.
C) Only statement 1 is correct.
Answer A) Only Statement 2 is correct.
Explanation A is correct. A pass through rate in a mortgage pass-through security is equal to the mortgage rate on the
underlying pool of mortgages after the servicing and other fees have been deducted. Section 5.1. LO.d.
28 Which of the following statements is correct?

Statement 1: A contraction risk is a risk that when interest rates fall, the security will have shorter maturity than
was expected at the time of purchase.
Statement 2: A contraction risk is a risk that when interest rates rise, the security will have shorter maturity than
was expected at the time of purchase.
A) Statement 1 only.
B) Statement 2 only.
C) None of them.
Answer A) Statement 1 only.
Explanation A is correct. A contraction risk is a risk that when interest rates fall, the security will have shorter maturity than was
expected at the time of purchase because now the refinancing can be done at new and lower rates. The extension
risk is the risk that when interest rates rise, fewer prepayments will occur because homeowners are reluctant to
give up the benefits of a contractual interest rate that now looks low. Section 5.1. LO.d.
29 Which of the following statements about contraction and extension risks is most accurate?
A) Contraction risk increases when interest rates fall and extension risk increases when interest rates rise.
B) Contraction risk increases when interest rates rise and extension risk increases when interest rates fall.
C) Contraction risk decreases when interest rate fall and extension risk decreases when interest rates rise.
Answer A) Contraction risk increases when interest rates fall and extension risk increases when interest rates rise.
Explanation A is correct. Prepayment risk includes two components: contraction risk and extension risk. The former is the risk
that when interest rates decline, the security will have a shorter maturity than was anticipated at the time of
purchase because homeowners refinance at now-available lower interest rates. The latter is the risk that when
interest rates rise, fewer prepayments will occur because homeowners are reluctant to give up the benefits of a
contractual interest rate that now looks low. Section 5.1. LO.f.
30 The principal balance of a pool is USD 10 million and USD 100,000 is scheduled to be repaid in a given month. The
SMM is 0.93%. The forecasted prepayment amount for the month is closest to:
A) $930.
B) $92,070.
C) $93,000.
Answer B) $92,070.
Explanation B is correct.
Explanation B is correct.
Single month mortality (SMM) measures prepayments in a month. An SMM of x % means that x % of the outstanding
mortgage balance at the start of the month minus the scheduled principal repayment will be repaid that month.
SMM = (Prepayment for a month) / (Beginning mortgage balance for month - Scheduled principal repayment for
month)
Prepayment = SMM * (Beginning balance – Scheduled principal repayment) = 0.93% * (10,000,000 – 100,000) =
92,070.
Section 5.1. LO.f.
31 The average life of a MBS is more relevant than the security’s final maturity because it represents the average time
to receipt of:
A) scheduled principal payments.

B) expected prepayments.
C) both expected prepayments and scheduled principal payments.
Answer C) both expected prepayments and scheduled principal payments.
Explanation C is correct. The average life of an MBS is more relevant than the security’s final maturity because it represents the
average time to receipt of both expected prepayments and scheduled principal payments. The weighted average life
(average life) gives investors an indicator of how long investors can expect to hold the MBS before it is paid off.
Section 5.1. LO.f.
Question Q-Code: L1-FI-IABS-045 LOS g Section 5
32 In a mortgage pass-through security, which of the following has a direct relation with interest rates?
A) Credit risk.
B) Extension risk.
C) Liquidity risk.
Answer B) Extension risk.
Explanation B is correct. When interest rate increases, extension risk increases because there will be fewer prepayments. This
shows that interest rate has a direct relation with extension risk. On the other hand, both credit risk and liquidity
risk have an indirect relationship with the interest rate. Section 5.1. LO.g.
33 An investor who is willing to accept significant prepayment risk if compensated with a relatively high expected
return will most likely invest in:
A) a PAC tranche.
B) A latter-paying tranche in sequential structure.
C) Support tranche.
Answer C) Support tranche.
Explanation C is correct. The prepayment risk is first absorbed by the support tranche before affecting the PAC tranche. For
this reason, a support tranche has high prepayment risk and therefore a higher expected rate of return. The
support tranches defer principal payments to the PAC tranches if the collateral prepayments are slow; support
tranches do not receive any principal until the PAC tranches receive their scheduled principal repayment.
Support tranches absorb any principal prepayments in excess of the scheduled principal repayments that are
made. This rule reduces the contraction risk of the PAC tranches. If the support tranches are paid off quickly
because of faster-than-expected prepayments, they no longer provide any protection for the PAC tranches.
Section 5.2. LO.e.

34 Consider a CMO structure with one planned amortization class and one support tranche. The initial PAC collar was
100-250 PSA. If the actual prepayment speed is 50 PSA, the average life of the PAC tranche will:
A) contract.
B) extend.
C) remain the same.
Answer B) extend.
Explanation B is correct. If the actual PSA rate is slower than the lower collar of the PAC, the average life of the PAC tranche will
extend. Section 5.2. LO.e.
35 Which of the following statements about the planned amortization class (PAC) structure is least accurate?
A) Support tranches are exposed to high levels of credit risk.

B) Support tranches provide prepayment protection to the PAC tranches.
C) If prepayments are too low to maintain the PAC schedule, the shortfall is provided by the support tranche.
Answer A) Support tranches are exposed to high levels of credit risk.
Explanation A is correct. Support tranches are exposed to high levels of prepayment risk not credit risk. The support tranches
provide protection against both contraction and extension risk by absorbing excess principal paid or forgoing
principal payment if the collateral payments are slow. Options B and C are true statements. Section 5.2. LO.e.
36 Consider a CMO with three sequential pay tranches A, B, and C. The average lives for the tranches are 4.6, 10.3,
and 15.0 years respectively under a 150 PSA assumption. An investor concerned about extension risk is most likely
to invest in:
A) tranche A.
B) tranche B.
C) tranche C.
Answer A) tranche A.
Explanation A is correct. Extension risk is the risk that when interest rates rise, prepayments will be lower than forecasted
because homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low. As a
result, a security backed by mortgages will typically have a longer maturity than was anticipated at the time of
purchase. In this structure, tranches B and C provide protection against extension risk to Tranche A. Section 5.2.
LO.e.
37 Consider a CMO structure with one planned amortization class and one support tranche. The initial PAC collar was
150-250 PSA. If the actual prepayment speed is 100 PSA, the average life of the PAC tranche will:
A) contract.
B) extend.
C) remain the same.
Answer B) extend.
Explanation B is correct. If the actual PSA rate is lower than the lower collar of the PAC, the average life of the PAC tranche will
extend. Section 5.2. LO.e.
38 Analyst 1: Although the collateral pays a fixed rate, it is possible to create a CMO with a floating rate tranche.
Analyst 2: We can create a CMO with a floating rate tranche, only with collateral that pays floating rate.
A) Analyst 1.
B) Analyst 2.
C) Neither of them.
Explanation A is correct. Although the collateral pays a fixed rate, it is possible to create a CMO with a floating rate tranche. This
is done by constructing a floater and an inverse floater combination. Section 5.2. LO.e.
39 Consider a CMO with three sequential pay tranches A, B and C. The average lives for the tranches are 4.6, 10.3,
and 15.0 years respectively under a 150 PSA assumption. An investor concerned about contraction risk is most
likely to invest in:
A) tranche A.
B) tranche B.
C) tranche C.
Answer C) tranche C.
Explanation C is correct. In this structure tranches A and B provide protection against contraction risk to Tranche C. Section
5.2. LO.e.
40 Analyst 1: Non-agency residential mortgage backed securities consists of a pool of conforming mortgages as
collateral.
Analyst 2: Non-agency residential mortgage backed securities are guaranteed by the appropriate government
sponsored enterprise.
A) Analyst 1.
B) Analyst 2.
C) Neither of them.
Answer C) Neither of them.
Explanation C is correct. Agency residential mortgage backed securities consists of a pool of conforming mortgages as
collateral. Agency residential mortgage backed securities are guaranteed by the appropriate government sponsored
enterprise. Section 5 and 5.3. LO.e.
41 Which of the following is an important consideration of non-agency residential mortgage-backed security (RMBS) as
compared to an agency RMBS?
A) Credit risk.
B) Extension risk.
C) Contraction risk.
Answer A) Credit risk.
Explanation A is correct. Credit risk is an important consideration of non-agency residential mortgage-backed security (RMBS)
as compared to an agency RMBS because unlike agency residential mortgage backed securities (RMBS), non-
agency RMBS is not backed by the government or a by a GSE. Section 5.3. LO.e.
42 Which of the following is least likely an external credit enhancement for an asset backed security?
A) Bond insurance.
B) Letter of credit.
C) Reserve account.
Answer C) Reserve account.
Explanation C is correct. A reserve account is an internal credit enhancement. Whereas, A and B are the examples of external
credit enhancement.
In order to obtain a favorable credit rating and to ensure some protection against losses in the pool, non-agency
RMBS and non-mortgage ABS often require one or more credit enhancements.
Internal credit enhancements include senior/subordinated structures, cash reserve funds, overcollateralization,
and excess spread accounts.
External credit enhancements include third party guarantee, such as monoline insurance company.
Section 5.3 and 7.1. LO.e.
43 Which of the following is least likely an internal credit enhancement for an asset backed security?
A) Excess spread.
B) Corporate guarantee.
C) Overcollateralization.
Answer B) Corporate guarantee.
Explanation B is correct. Corporate guarantee is an external credit enhancement. Whereas, excess spread and
overcollateralization are the examples of internal credit enhancement.
In order to obtain a favorable credit rating and to ensure some protection against losses in the pool, non-agency
RMBS and non-mortgage ABS often require one or more credit enhancements.
Internal credit enhancements include senior/subordinated structures, cash reserve funds, overcollateralization,
and excess spread accounts.
External credit enhancements include third party guarantee, such as monoline insurance company.
Section 5.3. LO.e.
44 Which of the following statements about LTV is least accurate?
A) LTV is the ratio of the mortgage loan amount to the property’s purchase price.
B) Lower the LTV, the more likely the borrower is to default.
C) Lower the LTV, the more protection the lender has for recovering the amount loaned if the borrower defaults.
Answer B) Lower the LTV, the more likely the borrower is to default.
Explanation B is correct. Lower the LTV, the less likely the borrower is to default. Options A and C are true statements. Section
4 and 6. LO.d.
45 In the United States a commercial loan is usually a:
A) recourse loan.
B) non-recourse loan.
C) credit risk-free loan.
Answer B) non-recourse loan.
Explanation B is correct. In the United States and other countries, commercial mortgage loans are usually non-recourse loans,
which implies that the lenders can only stake a claim to the income-producing property backing the loan in case of a
default and not on any other asset of the borrower. Section 4.5 and 6. LO.g.
46 Which of the following is least likely a key indicator of potential credit performance of a commercial mortgage-
backed security (CMBS)?
A) Loan-to-value ratio.
B) Debt-to-service-coverage.
C) Value-to-service-coverage.
Answer C) Value-to-service-coverage.
Explanation C is correct. There are two key indicators to assess the potential credit performance of a commercial mortgage
loan: 1) debt-to-service coverage ratio and 2) the loan-to-value ratio.
Debt-to-service coverage ratio = (Annual net operating income)/(Debt service)
where:
Debt service = annual interest payment and principal repayment

Net operating income = rental income – cash operating expenses – a non-cash replacement reserve
If DSC > 1.0, then cash flows from property are sufficient to service debt.
The higher the DSC ratio, the lower the credit risk and better is the borrower’s ability to service debt.
A low loan-to-value ratio implies lower credit risk.
Section 6 and 6.2. LO.g.
47 Analyst 1: Commercial mortgage-backed security (CMBS) loans typically have greater call protection than
residential MBS loans because they are usually smaller-dollar sized loans and hence are not refinanced when
interest rates fall.
Analyst 2: Commercial mortgage-backed security (CMBS) loans typically have greater call protection than
residential MBS loans because commercial mortgages may have yield maintenance charges.
A) Analyst 1.
B) Analyst 2.
C) Both.
Explanation B is correct. CMBS has considerable call protection, which is protection against early prepayment of mortgage
principal. The call protection comes in two forms: at the structure level and at the loan level.
Call protection at the structural level comes by structuring CMBS into sequential-pay tranches, by credit rating. A
lower-rated tranche cannot be paid off until the higher-rated tranches are retired. But, in the case of a default, the
losses must be charged to the lowest-rated tranche first and last to the highest-rated tranche.
There are four mechanisms that offer investors call protection at the loan level:
1. Prepayment lockouts : The borrower is prohibited from any prepayments during a specific period of time.
2. Prepayment penalty points : The borrower must pay a fixed percentage of the outstanding loan balance as
prepayment penalty if he wishes to refinance.
3. Yield maintenance charges : Also known as “make-whole charge”. The borrower must pay a penalty to the lender
that makes refinancing uneconomical if the sole objective was to get a lower mortgage rate.
4. Defeasance: Defeasance is a protection at the loan level that requires the borrower to provide sufficient funds
that can be invested in a portfolio of government securities to replicate the cash flows in the absence of
prepayments.
Analyst 1 is incorrect because CMBS are not typically smaller sized loans. Section 6.2. LO.g.
48 The balloon risk in a CMBS can be best described as a type of:
A) extension risk.
B) contraction risk.
C) interest rate risk.
Answer A) extension risk.
Explanation A is correct. Balloon risk refers to the risk that a borrower will not be able to make the balloon payment when due.
Since the term of the loan will be extended by the lender during the workout period, balloon risk is a type of
extension risk. Section 6.2. LO.g.
49 Under the defeasance mechanism of a commercial mortgage, a borrower:
A) is prohibited from making prepayments during a specified period of time.

B) is required to pay a ‘make-whole charge’ penalty if he refinances the loan to get a lower mortgage rate.
C) provides sufficient funds for the servicer to invest in a portfolio of government securities that replicates the cash
flows that would exist in the absence of prepayments.
Answer C) provides sufficient funds for the servicer to invest in a portfolio of government securities that replicates the
cash flows that would exist in the absence of prepayments.
Explanation C is correct. Under the defeasance mechanism of a commercial mortgage, a borrower provides sufficient funds for
the servicer to invest in a portfolio of government securities that replicates the cash flows that would exist in the
absence of prepayments. A is incorrect because it defines prepayment lockout mechanism. B is incorrect because
it defines yield maintenance charge mechanism. Section 6.2. LO.g.
50 Which of the following is not a form of credit enhancement of auto loan-backed securities?
A) Reserve account.
B) Overcollateralization.
C) Under-collateralization.
Answer C) Under-collateralization.
Explanation C is correct. Under-collateralization is not a form of credit enhancement of auto loan-backed securities.
All auto-loan backed securities have some form of credit enhancement such as:
A senior/subordinated structure so the senior tranches have credit enhancement.

Reserve account, overcollateralization, and excess interest on the receivables.
The purpose of a reserve account is to provide credit enhancement. More specifically, the reserve account is
a form of internal credit enhancement that will protect the bondholders against losses up to x % of the par
value of the entire issue.
Overcollateralization means that the aggregate principal balance of the automobile loan contracts exceeds
the principal balance of the notes. It represents another form of internal credit enhancement.
Overcollateralization can be used to absorb losses from the collateral.
Section 7.1. LO.e.
Question Q-Code: L1-FI-IABS-051 LOS h Section 7
51 Jane Smith is seeking to purchase an ABS backed by automobile loans. However, Jane is extremely concerned
about prepayment risk. Which of the following factors should least concern Jane?
A) Insurance payoffs.
B) Loan refinancing.
C) Trade-ins.
Answer B) Loan refinancing.
Explanation B is correct. Refinancing of automobile loans is a low probability event due to the short maturity of the loans.
Section 7.1. LO.h.
52 If a credit card receivables asset backed security (ABS) has a lock-out feature:
A) no investors may sell the ABS for a certain period of time.

B) no payments are made to the ABS investor for a certain period of time.
C) no principal payments are made to the ABS investor for a certain period of time.
Answer C) no principal payments are made to the ABS investor for a certain period of time.
Explanation C is correct. If a credit card receivables asset backed security (ABS) has a lock-out feature no principal payments
are made to the investor, instead the principal repayments are reinvested in new receivables. Section 7.2. LO.h.
53 A principal repayment of €1 billion on the collateral of a €10 billion face value non-amortizing asset backed security,
during the lockout period will result in the security having a total face value of:
A) €9 billion.
B) €10 billion.
C) €11 billion.
Answer B) €10 billion.
Explanation B is correct. Any principal payment received during the lockout period of a non-amortizing bond is reinvested in
acquiring the additional loans of the same amount, keeping the total face value constant. Section 7.2. LO.g.
54 Which of the following statements is correct?
A) Collateral for auto loan-backed securities are non-amortizing loans.

B) Collateral for credit card receivable-backed securities are amortizing loans.
C) Auto loan-backed securities’ principal is typically distributed across different bond classes each month.
Answer C) Auto loan-backed securities’ principal is typically distributed across different bond classes each month.
Explanation C is correct. The collateral for credit card receivable-backed securities are non-amortizing loans, whereas the
collateral for auto loan-backed securities are amortizing loans. Auto loan-backed securities’ principal is typically
distributed across different bond classes each month. Section 7 and 7.2. LO.e.
55 In a credit card receivable asset backed securities (ABS) cash flows paid to security holders is based on:
A) finance charges collected and fees.

B) finance charges collected only.
C) fees only.
Answer A) finance charges collected and fees.
Explanation A is correct. Cash flow, on a pool of credit card receivables consists of:
Finance charges: These represent the periodic interest the credit card borrower is charged on the unpaid
balance after the grace period.
Fees and principal repayments. Fees include any late payment fees and any annual membership fees.
Section 7.2. LO.h.
Question Q-Code: L1-FI-IABS-054 LOS i Section 8
56 A CDO can be best described as:
A) a security backed by a specific type of debt obligation.

B) a security backed by debt and equity instruments.
C) a security backed by a pool of one or more debt obligations.
Answer C) a security backed by a pool of one or more debt obligations.
Explanation C is correct. A collateralized debt obligation is a generic term used to describe a security backed by a diversified
pool of one or more debt obligations (e.g. corporate and emerging market bonds, leveraged bank loans, ABS,
RMBS, CMBS, or CDO). Section 8. LO.i.
57 Which of the following statements is/are correct?

Statement 1: A synthetic collateralized debt obligation is a CDO backed by a portfolio of leveraged bank loans.
Statement 2: A synthetic collateralized debt obligation is a CDO backed by a portfolio of residential mortgage
backed securities.
Statement 3: A synthetic collateralized debt obligation is a CDO backed by a portfolio of credit default swaps.
A) Statements 1 and 2 are correct.

B) Statements 2 and 3 are correct.
C) Only statement 3 is correct.
Answer C) Only statement 3 is correct.
Explanation C is correct. A synthetic collateralized debt obligation is a CDO backed by a portfolio of credit default swaps. Section
8. LO.h.
58 In an arbitrage CDO structure, is the collateral manager required to actively manage the debt obligations?
A) Yes.
B) No.
C) It depends on what type of CDO structure we are creating.
Answer A) Yes.
Explanation A is correct. In an arbitrage CDO, a CDO manager buys and sells debt obligations in order to pay off the holders of
the bond classes and to generate an attractive return for the equity tranche and for the manager. Section 8 and
8.1. LO.i.
59 Interest rate swaps are required in CDOs because:
A) cash flows are mismatched.

B) the subordinated tranche investors have credit risk.
C) the equity tranche investors have credit risk.
Answer A) cash flows are mismatched.
Explanation A is correct. Interest rate swaps are required because the cash inflows from floating or fixed rate assets are
mismatched with the cash outflows to floating rate tranches. Section 8.2. LO.i.
60 Which of the following is most likely a risk faced by senior tranche investors in a collateralized Debt Obligation
(CDO)?
A) Manager will not earn sufficient return to payoff investors in an event of default.
B) Leverage inherent in the CDO transaction results in higher risk.
C) There are no triggers that require the payoff of the principal to investors.
Answer A) Manager will not earn sufficient return to payoff investors in an event of default.
Explanation A is correct. In an event of default, there is a risk that CDO manager will not earn sufficient return to pay to the
senior tranche investors. Section 8.2. LO.h.
Level II R37 Pricing and Valuation
of Forward Commitments Q Bank
Test Code: L2 R37 PVFC Q-Bank Set 2
James Miller, a fund manager at a bank’s treasury department, considers long forward contracts on Parma Inc’s
(PIC) shares. The stock is currently trading at USD102 and the annual compounded risk free rate is 4%. The
company recently declared a dividend of USD2 a share and the payment is to be received in two months. James
decides to go long 3-month forward contracts on 1,000 shares.
After one month, the share price is USD110 a share whereas the risk free rate remains the same. James is
concerned about the value of the forward position. He is also concerned about how the value of the position could
be impacted due to changes in the stock’s price, the risk free rate and the dividend payments.
The forward price at the inception of the contract is closest to:
A) $100.9850
B) $100.9985
C) $100.9880
Answer B) $100.9985
Explanation B is correct. The forward price is calculated as 102 × 1.043/12 − 2 × 1.041/12 = 100.9985. Section 3.2.2. LO.b.
2 James Miller, a fund manager at a bank’s treasury department, considers long forward contracts on Parma Inc’s
After one month, the value of the forward position is closest to:
A) $7,641
B) $7,650
C) $7,666
Answer C) $7,666
Explanation C is correct. After one month, the new forward price is calculated as 110 × 1.042/12 − 2 × 1.041/12 = 108.7149.
The forward position’s value is 1000 × (108.7149 −100.9985) / 1.042/12 = USD7,666.08. Section 3.2.2. LO.b.
If James had entered into a futures contract instead of the forward contract, the value of his position after one
month would have most likely been:
A) Higher
B) Lower
C) Same
Answer B) Lower
Explanation B is correct. Futures contracts are marked to market daily and after marking to market the value of the contract
becomes zero. Hence compared to the value of the forward contract, James’s position after one month would have
been lower under a futures contract. Section 3.7. LO.b.
Which of the following will most likely result in an increase in the value of a short forward position?
A) Increase in spot price

B) Increase in interest rates
C) Increase in dividend paid
Answer C) Increase in dividend paid
Explanation C is correct. An increase in dividend paid will cause the forward price to decline which will increase the value of a
short forward position. A and B will result in an increase in forward price hence a decrease in the value of a short
forward position. Section 3.2-3.3. LO.a.

Magna Corp. plans to take out a three-month loan of USD1,000,000 in three months’ time to meet its working
capital needs. The company’s CFO, Adam Sand CFA, was concerned about an increase in interest rates during that
time. Therefore, he had entered into a pay-fixed forward rate agreement three months ago with a notional principal
of USD1,000,000. The LIBOR rate summary is presented below:
Rate three months Current

ago rate
1 month 1.00% 1.20%

LIBOR
3 month 1.05% 1.30%

LIBOR
6 month 1.10% 1.35%

LIBOR
9 month 1.15% 1.35%

LIBOR
Adam would like to evaluate the company’s current position on the FRA
The forward rate at which the company had initiated its FRA is closest to:
A) 1.19%
B) 1.24%
C) 1.31%
Answer B) 1.24%
Explanation B is correct. Three months ago the company must have entered into a 6 x 9 FRA. The relevant rates are therefore
the 6 month LIBOR and 9 month LIBOR three months ago. The forward rate is calculated as ( [1+(0.0115 9 / 12
)][1+(0.0110 6 / 12)]− 1) × 4 =1.243%. Section 3.4. LO.b.
6 Magna Corp. plans to take out a three-month loan of USD1,000,000 in three months’ time to meet its working
Rate three Current rate

months ago
1 month 1.00% 1.20%

LIBOR
3 month 1.05% 1.30%

LIBOR
6 month 1.10% 1.35%

LIBOR
9 month 1.15% 1.35%

LIBOR
The interest amount actually paid at the maturity of the loan will be based on:
A) the 3 month LIBOR 3 months from now

B) the 3 month LIBOR 6 months from now
C) the forward rate
Answer A) the 3 month LIBOR 3 months from now
Explanation A is correct. The interest actually paid would be based on the 3 month LIBOR in three months i.e. when the loan is
taken out. Section 3.4. LO.a.

months ago
1 month 1.00% 1.20%

LIBOR
3 month 1.05% 1.30%

LIBOR
6 month 1.10% 1.35%

LIBOR
9 month 1.15% 1.35%

LIBOR
The current forward rate for a notional loan beginning in three months with three months to maturity is closest to:
A) 1.40%
B) 1.15%
C) 1.35%
Answer A) 1.40%
Explanation A is correct. The relevant rates are the current 3 month LIBOR and the current 6 month LIBOR. The forward rate is
calculated as ([1+(0.0135 6 / 12)] / [1+(0.0130 3 / 12)]− 1) × 4 =1.395%. Section 3.4.LO.b.

months ago
1 month 1.00% 1.20%

LIBOR
3 month 1.05% 1.30%

LIBOR
6 month 1.10% 1.35%

LIBOR
9 month 1.15% 1.35%

LIBOR
The current value of the company’s position on the FRA is closest to:
A) $400
B) $405
C) $397
Answer C) $397
Explanation C is correct. The increase in the forward rate over the three month period would result in a gain on the position.
The profit would be due at loan maturity and therefore its current value would be calculated by discounting it to the
present using the 6 month LIBOR. The value on the FRA is calculated as:
[(0.0140 × 3 /12 ) − (0.0124 × 3 / 12 )] × 1,000,000/[1 + (0.0135 × 6 / 12 )] = 397.3. Section 3.4. LO.b
Crocon footwear is a European company engaged in the business of importing shoes and selling them in the local
market. The company imports shoes regularly from the United States and makes its payments in the US dollar. The
payment for the latest consignment is USD10,000,000 and is due in 3 months. The spot exchange rate is €1 =
USD1.2000. The company decides to hedge its exposure to the foreign currency payment by entering into a
currency forward contract on USD10,000,000. The annual compounded risk free rate at the inception of the
contract is 2.0% in Europe and 2.5% in the United States.
One month later, the risk free rate in Europe is 2.1% and that in the United States is 2.7%. The spot exchange rate
is €1 = $1.2300.
At the contract inception, in order to hedge the currency risk, Crocon footwear most likely:
A) sold dollars in the spot market and purchased dollars in the forward market.
B) sold euros in the spot market and purchased dollars in the forward market.
C) purchased dollars and sell euros in the forward market.
Answer C) purchased dollars and sell euros in the forward market.
Explanation C is correct. The company will purchase dollars and sell euros in the forward market at time T (T = 3 months) in
order to hedge against a rise in the dollar’s value. Section 3.6. LO.b.
10 Crocon footwear is a European company engaged in the business of importing shoes and selling them in the local
is €1 = $1.2300.
The forward rate at the contract’s inception is closest to:
A) €1 = $1.2059
B) €1 = $1.2015
C) €1 = $1.1985
Answer B) €1 = $1.2015
3 / 12
Explanation B is correct. The forward rate is calculated as 1.23 1.025 / 1.023 /12 = USD1.2015. Section 3.6. LO.b
is €1 = $1.2300.
The forward rate after one month from the contract’s inception is closest to:
A) €1 = $1.2372
B) €1 = $1.2312
C) €1 = $1.2012
Answer B) €1 = $1.2312
Explanation B is correct. The forward rate after one month is calculated as 1.23 1.027 2 /12 / 1.0212 / 12 = USD1.2312.
Section 3.6. LO.b.
is €1 = $1.2300.
The value of the forward position after one month is closest to:
A) -€200,078
B) -€200,772
C) €200,078
Answer A) -€200,078
Explanation A is correct. At the time of the payment, the value of the forward would be 10,000,000 / 1.2312 − 10,000,000
/ 1.2015 = −€200,772. The present value of the forward’s value is therefore −200,772 / 1.0212/12 = −€200,078.
Section 3.6. LO.b.
Alan Joe, an avid fixed income investor has a large portfolio of corporate and government bonds. Joe’s portfolio
consists of floating as well as fixed rate bonds. Anticipating an increase in interest rates, Alan had entered into a
three year interest rate swap. He had consequently entered into an interest rate swap on a notional principal of
$100,000 for three years with semi-annual payments. The LIBOR term structure at that time produced the
following discount factors:
Time Discount factor
0.5 0.9759
1 0.9506
1.5 0.9248
2 0.8985
2.5 0.8737
3 0.8480
One year later, the discount factors are:
TIme Discount factor
0.5 0.9731
1 0.9461
1.5 0.9192
2 0.8917
Alan would like to evaluate his current position on the swap.
In order to hedge against an increase in interest rates, Alan had most likely entered into a:
A) receive-fixed, pay-floating swap

B) receive-floating, pay-fixed swap
C) receive-fixed, pay-fixed swap
Answer B) receive-floating, pay-fixed swap
Explanation B is correct. Alan had entered into a receive-floating, pay-fixed swap to hedge against an increase in interest rates.
Section 4.1. LO.c.
14 Alan Joe, an avid fixed income investor has a large portfolio of corporate and government bonds. Joe’s portfolio
0.5 0.9759
1 0.9506
1.5 0.9248
2 0.8985
2.5 0.8737
3 0.8480
0.5 0.9731
1 0.9461
1.5 0.9192
2 0.8917
The swap rate at the initiation of the contract was closest to:
A) 5.56%
B) 2.78%
C) 5.85%
Answer A) 5.56%
Explanation A is correct. The swap would consist of a long floating rate bond and a short fixed rate bond. The value of the fixed
rate bond for each dollar should be equal to that of the floating rate bond i.e. $1 per each dollar. Hence the fixed
swap rate is calculated as: Fixed rate x (0.9759+0.9506+0.9248+0.8985+0.8737+0.8480) +1(0.8480) = 1 Fixed
rate = (1 - 0.8480)/5.4715 Fixed rate = 2.78%, or 5.56% on an annual basis. Section 4.1. LO.d.
0.5 0.9759
1 0.9506
1.5 0.9248
2 0.8985
2.5 0.8737
3 0.8480
0.5 0.9731
1 0.9461
1.5 0.9192
2 0.8917
The current swap rate is closest to:
A) 5.96%
B) 5.81%
C) 2.90%
Answer B) 5.81%
Explanation B is correct. The fixed swap rate is calculated as: Fixed rate x (0.9731+0.9461+0.9192+0.8917) + 1(0.8917) = 1
Fixed rate = (1-0.8917) / 3.73 Fixed rate = 2.904%, or 5.81% on an annual basis. Section 4.1. LO.d.
0.5 0.9759
1 0.9506
1.5 0.9248
2 0.8985
2.5 0.8737
3 0.8480
0.5 0.9731
1 0.9461
1.5 0.9192
2 0.8917
The current value of the swap to Alan is closest to:
A) $490
B) -$466
C) $466
Answer C) $466
Explanation C is correct. the value of the swap is calculated as 100,000 (0.0581−0.0556) / 2 × 3.73 = $466.25. Section 4.1.
LO.d.

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Level I Derivative Markets and

Question Q-Code: L1-DV-DVMI-001 LOS a Section 2

1 Which of the following is not a derivative?

A) A contract to purchase shares of Infosys, a technology company, at a fixed price.

Answer C) A global equity mutual fund.

Question Q-Code: L1-DV-DVMI-002 LOS a Section 2

2 Which of the following statements is most likely to be correct about derivatives?

Question Q-Code: L1-DV-DVMI-003 LOS a Section 2

3 Which of the following statements about derivatives is least accurate?

A) They derive their value from an underlying.

Answer B) They have low degrees of leverage.

Question Q-Code: L1-DV-DVMI-004 LOS a Section 2

A) They are used for risk management.

Answer C) They are created in the spot market.

Question Q-Code: L1-DV-DVMI-005 LOS a Section 3

5 Which of the following statements about exchange-traded derivatives is least accurate?

A) They are more transparent than over-the-counter derivatives.

Answer C) They have more credit risk than over-the-counter derivatives.

Question Q-Code: L1-DV-DVMI-007 LOS a Section 3

6 Which of the following best describes a characteristic of exchange-traded derivatives?

A) They are customized financial instruments.

Answer B) A clearing house effectively guarantees against default risk.

Question Q-Code: L1-DV-DVMI-008 LOS a Section 3

7 Which of the following statements about over-the-counter derivatives is least accurate ?

A) They are less liquid than exchange-traded derivatives.

Answer A) They are less liquid than exchange-traded derivatives.

Question Q-Code: L1-DV-DVMI-037 LOS c Section 3

8 One way to describe the margin in a futures market is:

A) A good faith deposit that covers possible future losses.

Answer A) A good faith deposit that covers possible future losses.

Question Q-Code: L1-DV-DVMI-006 LOS a Section 3

Answer B) less liquid.

Question Q-Code: L1-DV-DVMI-009 LOS a Section 3

Question Q-Code: L1-DV-DVMI-010 LOS a Section 3

11 As compared to exchange-traded derivatives, over-the-counter derivatives are more likely to have:

A) lower credit risk.

Answer B) customized contract terms.

Explanation B is correct. Customization of contract terms is a characteristic of over-the-counter derivatives.

Question Q-Code: L1-DV-DVMI-011 LOS a Section 4

12 As compared to over-the-counter options, futures contract:

A) are private, customized transactions.

Answer C) are not exposed to default risk.

Question Q-Code: L1-DV-DVMI-015 LOS b Section 4

13 Which of the following is best classified as a forward commitment?

Answer B) A swap agreement.

Question Q-Code: L1-DV-DVMI-016 LOS c Section 4

14 Which of the following statements about futures is least accurate?

A) They are standardized.

Answer C) Their payoffs are received at settlement.

Question Q-Code: L1-DV-DVMI-017 LOS c Section 4

15 Which of the following statements is most accurate?

A) Forwards are customized whereas swaps are standardized.

Question Q-Code: L1-DV-DVMI-018 LOS c Section 4

Question Q-Code: L1-DV-DVMI-023 LOS c Section 4

A) collateral to ensure fulfillment of obligation.

Question Q-Code: L1-DV-DVMI-024 LOS c Section 4

Answer A) Cotton futures.

Question Q-Code: L1-DV-DVMI-026 LOS c Section 4

Question Q-Code: L1-DV-DVMI-028 LOS c Section 4

A) Credit default swaps.

Answer A) Credit default swaps.

Question Q-Code: L1-DV-DVMI-029 LOS c Section 4

Question Q-Code: L1-DV-DVMI-055 LOS c Section 6

23 An attribute common to both forward and futures contracts is:

39 Which of the following statements about the feature of an option is correct?