Lesson 1: Week 2 (Chapter 14)

1. A variable x starts at 10 and follows the generalized Wiener process

dx = a dt + b dz
where time is measured in years. If a = 2 and b =3 what is the expected value after 3 years?
A. 12
B. 14
C. 16
D. 18

Answer: C

The drift is 2 per year and so the expected increase over three years is 2×3 = 6 and the expected
value at the end of 3 years is 10+6 = 16.

2. A variable x starts at 10 and follows the generalized Wiener process

dx = a dt + b dz
If a = 3 and b =4 what is the standard deviation of the value in three months?
A. 1
B. 2
C. 3
D. 4

Answer: B

The variance per year is 42 or 16. The variance over three months is 16×0.25 = 4. The standard
deviation is .

3. The process followed by a variable X is

dX = mX dt+sX dz
What is the coefficient of dz in the process for the square of X.
A. sX
B. sX2
C. 2sX2
D. msX

Answer: C

From Ito’s lemma, the coefficient of dz is sX ∂f /∂ X where f = X2. Because ∂ f /∂ X=2 X , the
coefficient of dz is 2sX2.
4. Which of the following is true when the stock price follows geometric Brownian motion
A. The future stock price has a normal distribution
B. The future stock price has a lognormal distribution
C. The future stock price has geometric distribution
D. The future stock price has a truncated normal distribution
 Answer: B

Ito’s lemma show that the log of the stock price follows a generalized Wiener process. This means
that the log of the stock price is normally distributed so that the stock price is lognormally
distributed.

5. If a stock price follows a Markov process which of the following could be true
A. Whenever the stock price has gone up for four successive days it has a 70% chance of
going up on the fifth day.
B. Whenever the stock price has gone up for four successive days there is almost certain to
be a correction on the fifth day.
C. The way the stock price moves on a day is unaffected by how it moved on the previous
four days.
D. Bad years for stock price returns are usually followed by good years.

Answer: C

A Markov process is a particular type of stochastic process where only the current value of a variable
is relevant for predicting the future. Stock prices are usually assumed to follow Markov processes.
This corresponds to a weak form market efficiency assumption.
6. If a variable x follows the process dx = b dz where dz is a Wiener process, which of the
following is the process followed by y = exp(x).
A. dy = by dz
B. dy = 0.5b2y dt+by dz
C. dy = (y+0.5b2y) dt+by dz
D. dy = 0.5b2y dt+b dz

Answer: B

Ito’s lemma shows that the process followed by y is dy = 0.5b2exp(x) dt +bexp(x) dz. Substituting y
= exp(x) we get the answer in B.
7. Which of the following gives a random sample from a standard normal distribution in Excel?
A. =NORMSINV()
B. =NORMSINV(RAND())
C. =RND(NORMSINV())
D. =RAND()

Answer: B

The correct instruction in Excel is =NORMSINV(RAND())

8. Which of the following defines an Ito process?
A. A process where the drift is non-constant and can be stochastic
B. A process where the coefficient of dz is non-constant and can be stochastic
C. A process where either the drift or the coefficient of dz or both are non-constant and can
be stochastic
D. A process where proportional changes follow a generalized Wiener process
 Answer: C

In a generalized Wiener process the drift and coefficient of dz are both constant. In an Ito process
they are not both constant .
9. Which of the following is NOT a property of a Wiener process?
A. The change during a short period of time dt has a variance dt
B. The changes in two different short periods of time are independent
C. The mean change in any time period is zero
D. The standard deviation over two consecutive time periods is the sum of the standard
deviations over each of the periods

Answer D

Variances of Wiener processes are additive but standard deviations are not.

Lesson 2: Week 3 (Chapter 15)

1. Which of the following is assumed by the Black-Scholes-Merton model?
A. The return from the stock in a short period of time is lognormal
B. The stock price at a future time is lognormal
C. The stock price at a future time is normal
D. None of the above

Answer: B

Black-Scholes-Merton assumes that the return from a stock in a short period of time is
normally distributed. This means that the stock price at a future time is lognormally
distributed.
2. A stock price is $100. Volatility is estimated to be 20% per year. What is an estimate of the
standard deviation of the change in the stock price in one week?
A. $0.38
B. $2.77
C. $3.02
D. $0.76

Answer: B

√
The estimate is 100×0.2× 1/52=$2.77
3. A stock provides an expected return of 10% per year and has a volatility of 20% per year.
What is the expected value of the continuously compounded return in one year?
A. 6%
B. 8%
C. 10%
D. 12%

Answer: B
 2
The expected value of the continuously compounded return per year is μ−σ /2 . In
this case it is 0.1 – 0.22/2 = 0.08 or 8%.
4. Which of the following is NOT true?
A. Risk-neutral valuation provides prices that are only correct in a world where
investors are risk-neutral
B. Options can be valued based on the assumption that investors are risk neutral
C. In risk-neutral valuation the expected return on all investment assets is set equal to
the risk-free rate
D. In risk-neutral valuation the risk-free rate is used to discount expected cash flows

Answer: A

Risk-neutral valuation produces a valuation that is correct in all situations not just those
where investors are risk-neutral. The expected return on all investments is assumed to
be the risk-free rate and the risk-free rate is used to discount expected payoffs.
5. When the Black-Scholes-Merton and binomial tree models are used to value an option on a
non-dividend-paying stock, which of the following is true?
A. The binomial tree price converges to a price slightly above the Black-Scholes-Merton
price as the number of time steps is increased
B. The binomial tree price converges to a price slightly below the Black-Scholes-Merton
price as the number of time steps is increased
C. Either A or B can be true
D. The binomial tree price converges to the Black-Scholes-Merton price as the number
of time steps is increased

Answer: D

The binomial tree valuation method and the Black-Scholes formula are based on the
same set of assumptions. As the number of time steps is increased the answer given by
the binomial tree approach converges to the answer given by the Black-Scholes-Merton
formula.
6. Which of the following is true of a volatility smile?
A. Implied volatility is on the horizontal axis and strike price is on the vertical axis
B. Historical volatility is on the horizontal axis and strike price is on the vertical axis
C. Implied volatility is on the vertical axis and strike price is on the horizontal axis
D. Historical volatility is on the vertical axis and strike price is on the horizontal axis

Answer: C

A volatility smile shows implied volatility (which is on the vertical axis) as a function of the
strike price (which is on the horizontal axis).
7. Why do traders use volatility smiles for pricing options?
A. To allow for non-lognormality of the probability distribution of future asset price
B. Because it is consistent with recent market moves
C. As a tool to reflect their views about extreme market moves
D. Because extreme market moves are always more likely than Black-Scholes-Merton
assumes

Answer: A
 8. What does the shape of the volatility smile reveal about put options on equity?
A. Options close-to-the-money have the lowest implied volatility
B. Options deep-in-the-money have a relatively high implied volatility
C. Options deep-out-of-the-money have a relatively high implied volatility
D. All of the above

Answer: C

The volatility smile shows that low-strike-price options have high implied volatilities relative
to at-the-money options. High-strike-price options have low implied volatilities relative to at-
the-money options. Out-of-the-money put options have a low strike price. Hence C is
correct.

Lesson 3: Week 4 (Chapter 18)

1. Which of the following is acquired (in addition to a cash payoff) when the holder of a put
futures exercises?
A. A long position in a futures contract
B. A short position in a futures contract
C. A long position in the underlying asset
D. A short position in the underlying asset

Answer: B

The holder of the put acquires a short futures position which can be immediately closed out
if desired.
2. The risk-free rate is 5% and the dividend yield on the S&P 500 index is 2%. Which of the
following is correct when a futures option on the index is being valued?
A. The futures price of the S&P 500 is treated like a stock paying a dividend yield of 5%.
B. The futures price of the S&P 500 is treated like a stock paying a dividend yield of 2%.
C. The futures price of the S&P 500 is treated like a stock paying a dividend yield of 3%.
D. The futures price of the S&P 500 is treated like a non-dividend-paying stock.

Answer: A

When a futures option is being valued the dividend yield is set equal to the domestic risk-
free rate. In this case the domestic risk-free rate is 5%. A is therefore correct.
3. Which of the following is NOT true?
A. Black’s model can be used to value an American-style option on futures
B. Black’s model can be used to value a European-style option on futures
C. Black’s model can be used to value a European-style option on spot
D. Black’s model is widely used by practitioners

Answer: A

Black’s model is used for valuing European options. A is therefore clearly false.
4. Which of the following is true when the futures price exceeds the spot price?
A. Calls on futures should never be exercised early
B. Put on futures should never be exercised early
C. A call on futures is always worth at least as much as the corresponding call on spot
 D. A call on spot is always worth at least as much as the corresponding call on futures

Answer: C

If the futures price is above the spot price a call on futures must be worth more than a call
on spot. Both calls and puts on futures are sometimes exercised early.
5. A futures price is currently 40 cents. It is expected to move up to 44 cents or down to 34
cents in the next six months. The risk-free interest rate is 6%. What is the probability of an up
movement in a risk-neutral world?
A. 0.4
B. 0.5
C. 0.72
D. 0.6

Answer: D

The probability of an up movement is (1-d)/(u-d). In this case u is 1.1 and d is 0.85. The
probability of an up movement is therefore 0.15/0.25=0.6.
6. A futures price is currently 40 cents. It is expected to move up to 44 cents or down to 34
cents in the next six months. The risk-free interest rate is 6%. What is the value of a six-
month put option with a strike price of 37 cents?
A. 3.00 cents
B. 2.91 cents
C. 1.16 cents
D. 1.20 cents

Answer: C

The probability of an up movement is (1-d)/(u-d). In this case u is 1.1 and d is 0.85. The
probability of an up movement is therefore 0.15/0.25=0.6. The option pays off zero if there
is an up movement and 3 cents if there is a down movement. The value of the option is
therefore 0.4×3×e-0.06×0.5= 1.16 cents.
7. Which of the following are true?
A. Futures options are usually European
B. Futures options are usually American
C. Both American and European futures options trade actively are exchanges
D. Both American and European futures options trade actively in the OTC market

Answer: B

Futures options trade on exchanges and are American.

8. What is the cash settlement if a put futures option on 50 units of the underlying asset is
exercised?
A. (Current Futures Price – Strike Price) times 50
B. (Strike Price – Current Futures Price) times 50
C. (Most Recent Futures Settlement Price – Strike Price) times 50
D. (Strike Price – Most Recent Futures Settlement Price) times 50

Answer: D
 The cash payoff is the strike price minus the most recent futures settlement price times the
size of the contract. The party exercising also gets a short futures position which brings the
value of what is received at the time of exercise equal to strike price minus the current
futures price times the size of the contract.
9. Which of the following is true about a futures option and a spot option on the same
underlying asset when they have the same strike price? The expiration dates of the two
options and the futures are all the same.
A. A European call spot option and an American call futures option are equivalent
B. An American call spot option and a European call futures option are equivalent
C. A European put spot option and European put futures option are equivalent
D. An American put spot option and American put futures option are equivalent

Answer: C

The two European options are equivalent. This result is often used to price options on spot.
10. What is the expected growth rate of an index futures price in the risk-neutral world?
A. The excess of the risk-free rate over the dividend yield
B. The risk-free rate
C. The dividend yield on the index
D. Zero

Answer: D

All futures prices grow at rate zero on average in a risk-neutral world.

11. Consider a European one-year call futures option and a European one-year put futures
options when the futures price equals the strike price. Which of the following is true?
A. The call futures option is worth more than the put futures option
B. The put futures option is worth more than the call futures option
C. The call futures option is sometimes worth more and sometimes worth less than the
put futures option
D. The call futures option is worth the same as the put futures option

Answer: D

Put call parity is

c+ Ke-rT =p+ F0e-rT
When F0=K it follows that c = p.
12. One-year European call and put options on an asset are worth $3 and $4 respectively when
the strike price is $20 and the one-year risk-free rate is 5%. What is the one-year futures price
of the asset if there are no arbitrage opportunities? (Use put-call parity.)
A. $19.55
B. $18.95
C. $20.95
D. $20.45

Answer: B

Put call parity is

c+ Ke-rT =p+ F0e-rT
Hence
 F0=K+(c-p)erT =20+(3-4)e0.05×1= $18.95

Lesson 4: Week 5,7 (Chapter 21)

1. Which of the following cannot be estimated from a single binomial tree?
A. delta
B. gamma
C. theta
D. vega

Answer: D

To calculate vega it is necessary to increase volatility slightly and construct a new tree. The
other three can be estimated from a single tree.
1. Which of the following is true for u in a Cox-Ross-Rubinstein binomial tree?
A. It depends on the interest rate and the volatility
B. It depends on the volatility but not the interest rate
C. It depends on the interest rate but not the volatility
D. It depends on neither the interest rate nor the volatility

Answer: B

u=eσ √ Δt .It therefore depends on volatility but not the interest rate.
1. When the stock price is 20 and the present value of dividends is 2, which of the following is
the recommended way of constructing a tree?
A. Draw a tree for an initial stock price of 20 and subtract the present value of future
dividends at each node
B. Draw a tree for an initial stock price of 22 and subtract the present value of future
dividends at each node
C. Draw a tree with an initial stock price of 18 and add the present value of future
dividends at each node
D. Draw a tree with an initial stock price of 18 and add 2 at each node

Answer: C

We first subtract the present value of dividends from the initial stock price. We then draw
the tree and then add back the present value of future dividends at each node
2. Which of the following cannot be valued by Monte Carlo simulation
A. European options
B. American options
C. Asian options (i.e., options on the average stock price)
D. An option which provides a payoff of $100 if the stock price is greater than the strike
price at maturity

Answer: B

American options cannot be valued in a simple way using Monte Carlo simulation because
Monte Carlo simulation works forward from the beginning of the life of an option and we do
not know whether the option should be exercised when a particular time is reached.
3. The standard deviation of the values of an option calculated using 10,000 Monte Carlo trials
 is 4.5. The average of the values is 20. What is the standard error of this as an estimate of
the option price?
A. 4.5
B. 0.45
C. 0.045
D. 0.0045

Answer: A

The standard deviation of 20 as an estimate of the price is the standard deviation of the
calculated values divided by the square root of the number of trials. In this case the square
root of the number of trials is 100 and so the standard error of the price estimate is 4.5/100
or 0.045.
4. What is the difference between valuing an American and a European option using a tree?
A. The value of u is higher for American options
B. The value of u is lower for American options
C. The time steps for American options are not equal
D. It is necessary to do two calculations at nodes where the option is in the money

Answer: D

When valuing American options it is necessary to calculate at each in-the-money node how
much the option is worth if it is exercised (i.e., the intrinsic value at the node) and how much
it is worth if it is not exercised (i.e., the roll back value)
5. Which of the following can be valued without using a numerical procedure such as a
binomial tree?
A. American put options on a non-dividend paying stock
B. American call options on a non-dividend paying tock
C. American call options on a currency
D. American put options on futures

Answer: B

The answer is B because an American call on a non-dividend paying stock is worth the same
as the corresponding European call, which can be valued with BSM.

Lesson 5: Week 6(Chapter 26)

1. An Asian option is a term used to describe which of the following
A. An option where the payoff depends on whether a barrier is hit
B. An option where the payoff depends on the average value of a variable over a period
of time
C. An option that trades on an exchange in the Far East
D. Any option with a nonstandard payoff

Answer: B

An Asian option is an option whose payoff is calculated from the average value of a
variable over a period of time
2. As the barrier is observed more frequently, which of the following is true of a knock-out
option
 A. It becomes more valuable
B. It becomes less valuable
C. There is no effect on value
D. It may become more valuable or less valuable

Answer: B

As the barrier is observed more frequently it is more likely to be hit. A knock-out option
therefore becomes less valuable
3. There are two types of regular options (calls and puts). How many types of compound
options are there?
A. Two
B. Four
C. Six
D. Eight

Answer: B
There are four: call on call, call on put, put on call, and put on put
4. There are two types of regular options (calls and puts). How many types of barrier options
are there?
A. Two
B. Four
C. Six
D. Eight

Answer: D
There are eight: up and in call, up and in put, down and in call, down and in put, up and out
call, up and out put, down and out call, and down and out put.
5. Which of the following is equivalent to a long position in a European call option?
A. A short position in a cash-or-nothing put option plus a long position in an asset-or-
nothing put option
B. A long position in an asset-or-nothing put option plus a long position in a cash-or-
nothing put option
C. A long position in an asset-or-nothing call option plus a long position in a cash-or-
nothing call option
D. A long position in an asset-or-nothing call option plus a short position in a cash-or-
nothing call option

Answer: D

A long position in a European call is equivalent to a long position in an asset-or-nothing

call option (this is worth S0N(d1)) and a short position in a cash-or-nothing call option
(this is worth –Ke-rTN(d2))
6. Which of the following is equivalent to a short position in a European put option?
A. A short position in a cash-or-nothing put option plus a long position in an asset-or-
nothing put option
B. A long position in an asset-or-nothing put option plus a long position in a cash-or-
nothing put option
C. A long position in an asset-or-nothing call option plus a long position in a cash-or-
nothing call option
 D. A long position in an asset-or-nothing call option plus a short position in a cash-or-
nothing call option

Answer: A

A short position in a European put is equivalent to a short cash-or-nothing put option

(−KN(−d2)e-rT) and a long position in an asset-or-nothing put (S 0N(−d1))
7. Which of the following is the payoff from an average strike call option?
A. The excess of the strike price over the average stock price, if positive
B. The excess of the final stock price over the average stock price, if positive
C. The excess of the average stock price over the strike price, if positive
D. The excess of the average stock price over the final stock price, if positive

Answer: B

An average strike call pays off the excess of the final stock price over the average stock
price if this is positive
8. A binary option pays of $100 if a non-dividend-paying stock price is greater than its current
value in three months. The risk-free rate is 3% and the volatility is 40%. Which of the
following is its value?
A. 99.25N(-0.1375)
B. 99.25N(0.1375)
C. 99.25N(-0.0625)
D. 99.25N(0.0625)

Answer: C

The binary call option is worth 100N(d2)e-0.03×0.25. In this case S0 = K so than ln(S0/K) = 1 and
2
(0 .03−0 . 4 /2)×0 .25
d 2= =−0 .0625
0 . 4×√ 0. 25

9. Exotic options
A. Can always be hedged just as easily as regular options
B. Are easier to hedge than regular options
C. Are more difficult to hedge than regular options
D. Are sometimes easier and sometimes more difficult to hedge than regular options.

Answer: D

Average price options are usually easier to hedge than regular options because as time
passes there is progressively less uncertainty about what the final average will be.
Barrier options are more difficult to hedge because of discontinuities.

Lesson 6: Weeks 7-8 (Chapter 22)

1. The gain from a project is equally likely to have any value between -$0.15 million and +$0.85
million. What is the 99% value at risk?
A. $0.145 million
B. $0.14 million
 C. $0.13 million
D. $0.10 million

Answer: B

The gain is uniformly distributed between −0.15 and +0.85 million dollars. The
probability that it will be between −0.15 and −0.14 million dollars is therefore 1%. This
means that there is a 99% chance that the loss will not be greater than $0.14 million.
This is the 99% VaR.
6. Which of the following is true of the historical simulation method for calculating VaR?
A. It fits historical data on the behavior of variables to a normal distribution
B. It fits historical data on the behavior of variables to a lognormal distribution
C. It assumes that what will happen in the future is a random sample from what has
happened in the past
D. It uses Monte Carlo simulation to create random future scenarios

Answer: C

The historical simulation method assumes that the percentage changes in all market
variables during the next day is a random sample from the percentage changes in a
certain number of past days.
7. An investor has $2,000 invested in stock A and $5,000 in stock B. The daily volatilities of A
and B are 1.5% and 1% respectively and the coefficient of correlation is 0.8. What is the one
day 99% VaR? Assume that returns are multivariate normal (Note that N(-2.326)=0.01)
A. $177
B. $135
C. $215
D. $331

Answer: A

The standard deviation of the change in the stock A position in one day is 2,000×0.015=
$30. The standard deviation of the change in the value of the stock B position in one day
is 5,000×0.01 = $50. The variance of the combined position is 30 2+502+2×0.8×30×50 =
5,800. The standard deviation is the square root of this or 76.16 and the 99% VaR is
therefore 2.33 times 76.17 this or about $177.
8. Which of the following describes stressed VaR?
A. It is based on movements in market variables in stressed market conditions
B. It is VaR with a very high confidence level
C. It is VaR multiplied by a factor of 3
D. None of the above

Answer: A

Stressed VaR was introduced in Basel II.5. It calculates VaR based on movements in
market variables in stressed market conditions.

9. Consider a position in options on a particular stock. The position has a delta of 12 and the
stock price is 10. Which of the following is the approximate relation between the change in
the portfolio value in one day, dP, and the return on the stock during the day, dx
A. dP=12dx
 B. dP=1.2dx
C. dP=120dx
D. dP=22dx

Answer: C

If S is the stock price and the change in the stock price is dS, from the definition of delta we
know that dP=12dS. This means that dP=12S(dS/S). dS/S is dx. In this case S=10 so that C is
correct.

10. A position in options on a particular stock has a delta of zero and a gamma of 4. The stock
price is 10. Which of the following is the approximate relation between the change in the
portfolio value in one day, dP, and the return on the stock, dx
A. dP = 4 times the square of dx
B. dP = 2 times the square of dx
C. dP = 20 times the square of dx
D. dP = 200 times the square of dx

Answer: D

If S is the stock price and the change in the stock price is dS, the change in the portfolio
value is 0.5×4×(dS)2. This is 2S2(dS/S)2. dS/S is dx. In this case S=10 so that D is correct.

11. Which of the following is true

A. Expected shortfall is always less than VaR
B. Expected shortfall is always greater than VaR
C. Expected shortfall is sometimes greater than VaR and sometimes less than VaR
D. Expected shortfall is a measure of liquidity risk wheras VaR is a measure of market
risk

Answer: B

Expected shortfall and VaR can both measure market risk. Expected shortfall is the expected
loss level conditional on the loss level being greater than VaR. By definition expected
shortfall must be greater than VaR.

Lesson 7: Week 9 (Chapter 22)

13. A company can invest funds for five years at LIBOR minus 30 basis points. The five-year swap
rate is 3%. What fixed rate of interest can the company earn by using the swap?
E. 2.4%
F. 2.7%
G. 3.0%
H. 3.3%

Answer: B
 When the company invests at LIBOR minus 0.3% and then enters into a swap where it pays
LIBOR and receives 3% it earns 2.7% per annum. Note that it is the bid rate that will apply to
the swap.

14. Company X and Company Y have been offered the following rates

Fixed Rate Floating Rate

Company X 3.5% 3-month LIBOR plus 10bp
Company Y 4.5% 3-month LIBOR plus 30 bp

Suppose that Company X borrows fixed and company Y borrows floating. If they enter into a
swap with each other where the apparent benefits are shared equally, what is company X’s
effective borrowing rate?
A. 3-month LIBOR−30bp
B. 3.1%
C. 3-month LIBOR−10bp
D. 3.3%

Answer: A
The interest rate differential between the fixed rates is 100 basis points. The interest rate
differential between the floating rates is 20 basis points. The difference between the interest
rates differentials is 100 – 20 = 80 basis points. This is the total apparent gain from the swap
to the two sides. Since the benefits are shared equally company X should be able to borrow
at 40 bp less than it is currently offered in the floating rate market, i.e., at LIBOR minus 30
bp.

15. Which of the following describes an interest rate swap?

A. The exchange of a fixed rate bond for a floating rate bond
B. A portfolio of forward rate agreements
C. An agreement to exchange interest at a fixed rate for interest at a floating rate
D. All of the above

Answer: D

The answer is D because all of A, B, and C are true for an interest rate swap.
16. Which of the following is true for an interest rate swap?
A. A swap is usually worth close to zero when it is first negotiated
B. Each forward rate agreement underlying a swap is worth close to zero when the
swap is first entered into
C. Comparative advantage is a valid reason for entering into the swap
D. None of the above

Answer: A

A swap is worth close to zero at the beginning of its life. (It may not be worth exactly zero
because of the impact of the market maker’s bid-offer spread.) It is not true that each of the
forward contracts underlying the swap are worth zero. (The sum of the value of the forward
contracts is zero, but this does not mean that each one is worth zero.) The remaining
 floating payments on a swap are worth the notional principal immediately after a swap
payment date, but this is not necessarily true for the remaining fixed payments.
17. A bank enters into a 3-year swap with company X where it pays LIBOR and receives 3.00%. It
enters into an offsetting swap with company Y where is receives LIBOR and pays 2.95%.
Which of the following is true:
A. If company X defaults, the swap with company Y is null and void
B. If company X defaults, the bank will be able to replace company X at no cost
C. If company X defaults, the swap with company Y continues
D. The bank’s bid-offer spread is 0.5 basis points
Answer: C

The bank`s bid-offer spread is 5 basis points not 0.5 basis points. The bank has quite
separate transactions with X and Y. If one defaults, it still has to honor the swap with the
other.
18. When LIBOR is used as the discount rate:
A. The value of a swap is worth zero immediately after a payment date
B. The value of a swap is worth zero immediately before a payment date
C. The value of the floating rate bond underlying a swap is worth par immediately after
a payment date
D. The value of the floating rate bond underlying a swap is worth par immediately
before a payment date

Answer: C

The value of the floating rate bond underlying an interest rate swap is worth par
immediately after a swap payment date. This result is used when the swap is valued as the
difference between two bonds.
19. A company enters into an interest rate swap where it is paying fixed and receiving LIBOR.
When interest rates increase, which of the following is true?
A. The value of the swap to the company increases
B. The value of the swap to the company decreases
C. The value of the swap can either increase or decrease
D. The value of the swap does not change providing the swap rate remains the same

Answer: A

It is receiving the floating rate. When interest rates increase the floating rate can be
expected to be higher and so the swap becomes more valuable. The answer is therefore A.
20. An interest rate swap has three years of remaining life. Payments are exchanged annually.
Interest at 3% is paid and 12-month LIBOR is received. A exchange of payments has just taken
place. The one-year, two-year and three-year LIBOR/swap zero rates are 2%, 3% and 4%. All
rates an annually compounded. What is the value of the swap as a percentage of the
principal when LIBOR discounting is used.
A. 0.00
B. 2.66
C. 2.06
D. 1.06

Answer: B
 Suppose the principal 100. The value of the floating rate bond underlying the swap is 100.
The value of the fixed rate bond is 3/1.02+3/(1.03) 2+103/(1.04)3=97.34. The value of the
swap is therefore 100−97.34 = 2.66 or 2.66% of the principal
21. A semi-annual pay interest rate swap where the fixed rate is 5.00% (with semi-annual
compounding) has a remaining life of nine months. The six-month LIBOR rate observed three
months ago was 4.85% with semi-annual compounding. Today’s three and nine month LIBOR
rates are 5.3% and 5.8% (continuously compounded) respectively. From this it can be
calculated that the forward LIBOR rate for the period between three- and nine-months is
6.14% with semi-annual compounding. If the swap has a principal value of $15,000,000, what
is the value of the swap to the party receiving a fixed rate of interest?
A. $74,250
B. −$70,760
C. −$11,250
D. $103,790

Answer: B

The forward rates for the floating payment at time 9 months is 6.14%. The swap can be
valued assuming that the fixed payments are 2.5% of principal at 3 months and 9 months
and that the floating payments are 2.425% and 3.07% of the principal at 3 months and 9
months. The value of the swap to the party receiving fixed is therefore
1,000,000(0.025-0.02425)e-0.053×0.25+1,000,000(0.025-0.0307)e-0.058×0.75 = –$70,760

Lesson 8: Week 10 (Chapter 25)

12. In a CDS with a notional principal of $100 million the reference entity defaults. What is the
payoff to the buyer of protection when the recovery rate is 30%?
A. $100 million
B. $30 million
C. $130 million
D. $70 million

Answer: D

The payoff is the notional principal times one minus the recovery. In this case this is
100×(1−0.3) or $70 million.
13. Which of the following is the most popular life for a credit default swap?
A. 1 year
B. 3 years
C. 5 years
D. 10 years

Answer: C

5 years is the most popular life for a CDS

14. If the CDS spread for a regular 5-year CDS is 120 basis points, what is the CDS spread for a 5-
year binary CDS on the same underlying reference entity? Assume a recovery rate of 40%.
A. 48 basis points
B. 72 basis points
C. 200 basis points
D. 300 basis points
 Answer: C

The payoff from a regular CDS is (1-R) times the payoff from a binary CDS where R is the recovery
rate. It follows that the CDS for a binary CDS is 120/(1-0.4) or 200 basis points

1. Which of the following is true about a CDS?

A. Restructuring is never a credit event
B. Restructuring is always a credit event
C. Certain types of restructuring qualify as credit events but others do not
D. Sometimes a CDS is defined so that restructuring is a credit event and sometimes it
is not

Answer: D

Sometimes restructuring is included as a credit event and sometimes it is not.