FMP QB 1

1. Inverted futures market- more distant delivery contracts are trading at lower prices than
nearer-term ones.

2. Futures price is typically lower than the expected spot price (normal backwardation).

3. The forward price is computed as follows: F0= 100× (F0-K) e- rT, F0 =990 K = 950.

4. In a backwardation market, the discount in forward prices relative to the spot price represents
a positive yield for the commodity consumer.

5. Forward price is higher than the futures price when: The asset is strongly negatively
correlated with interest rates.

6. One should choose the futures contracts with the highest correlation to price changes, and the
one with closest maturity, preferably expiring after the duration of the hedge. This minimizes
basis risk.

7. For arbitrage, always short the one that is overpriced. Sell the overpriced futures contract at,
borrow at the risk-free rate, buy the under-priced spot asset (under-priced relative to what it
will be in future).

8. h =ρ(𝜎𝑓𝑢𝑛𝑑/𝜎ℎ𝑒𝑑𝑔𝑒), N = h (Portfolio value) / (Futures contract size). Futures contracts size

= Price * notional value.

9. Ft = St * e (rf-q) *(T-t) …………. Ft: Theoretical future price of the contract St: spot price of
the underline asset rf: risk free rate q: Dividend yield T-t: Time until maturity of the contract.

10. Theoretical value of our futures contract is: = 2020 × e^ ((.0075-.025) × .5) = $2002.40 Since
the contract is trading at 2000, so 2002.40-2000 = 2.40 = Payoff for arbitrageur.

11. Vt (0, T) = St – F (0,T)/(l + r)T,t

…………………………………………………………………………..V3/12 (0, 6/12) =
145.45 – 154.38/ (1.05925)(6/12-3/12) = -$6.72. Value of short call option.

12. The futures contract trading at $1.5418/£ is overpriced. An arbitrageur would go short on the
GBP futures and buy GBP in the spot market.  To meet the delivery terms of her short
position on the futures contract, she must have £1.  The amount of GBP required today is
calculated as £1/ (1.045)88/365 = £0.9894.  The cost of buying £0.9894 units of GBP in
dollar terms equals £0.9894×$1.52/£ = $1.5039. The amount of interest that an arbitrageur
would incur in order to borrow $1.5039 equals $1.5039×0.014148 = $0.0213 Note:
(1+0.06)88/365 -1= 0.014148 At contract expiration:  An arbitrageur would deliver £1 and
receive $1.5418 under the terms of the futures contract.  She would return $1.5252 [=
amount originally borrowed ($1.5039) + Interest on USD loan for 88 days ($ 0.0213)]  Her
arbitrage profit per GBP would equal $1.5418-$1.5252 = $0.0166.

Assuming risk-free interest rates for USD as 6% and Pounds as 4.5%, find the arbitrage profit
per GBP on this transaction would be closest to.
Swaps:

1. Most common use of a commodity swap: To manage the cost of purchasing energy resources.

2. Proper discount rate to use when valuing an interest rate swap using a sequence of forward
rate agreement/ rate for discounting swap cash flow: Corresponding spot rate from a
LIBOR spot curve.

3. A currency swap can actually transform the currency backing any asset, or liability, into a
different currency entirely.

A currency swap can reduce a firm’s borrowing costs & produce enhanced investment returns.

Currency swaps, when combined with existing positions, can totally alter the risk of an asset
or a liability.

4. Equity swaps allow swap payments to be floating on both sides, with payments not known
until the end of each period.

5. The value of a plain vanilla swap at inception is zero as the swap fixed rate (SFR) is set to
make the PV of both the fixed and expected floating rate payments equal.

(A firm has entered into a $22.5 MM plain vanilla interest rate swap in which it pays fixed at
4.2 percent and receives LIBOR. At inception, what is the firm's credit exposure on this swap
if LIBOR is 3.2 percent?)

6. To compute the first floating rate cash ow, the last payment date's LIBOR rate of 3.3% is
needed, then the floating rate cash ow in 3 months is: 12,000,000 × 0.033 / 2 = $198,000.

7. If interest rates change markedly during the period of time of a plain vanilla interest rate
swap, then Interest rate risk exposure for the parties will completely change for each party.

8. The initial value of a swap is always zero. As interest rates move and payments take place, the
value of the swap will change for both parties.

9. The value of the fixed-rate component of the swap is ($50 × 1.065)e (−0.0575) = $50.27M.

The value of the floating-rate component of the swap is its par value of $50M since we
are currently at an annual settlement date. Hence, the value of the swap to this
counterparty is approximately $50M − $50.27M = −$270,000.

10. Swaps are largely customized, dominated by institutions, and financial intermediaries,
typically banks, earn a spread of 3-4 basis points for putting two parties together in a swap
agreement.
 Swaps are not traded in any organized secondary market, and financial intermediaries
earn a spread by bring two non-financial firms together in a swap agreement.

11. Confirmation is the term for standardized contract, or Master Agreement, which outlines
details of a particular swap, and ISDA created it.

12. An FRA settles in cash.

FRA carries both default risk and interest rate risk, even when based on an essentially
risk-free rate( e.g. Treasury bill rate).

It can be used to hedge the risk/uncertainty about a future payment on a floating rate
loan.

13. What is the total of the net cash flows to Company J in year 3 only: This is how we calculate
it. See question # 14 from this chapter for more information.

14. The institution is paying USD and receiving JPY, so the value of this swap will equal the
current exchange rate times the value of the JPY portion minus the value of the USD portion.
The JPY portion of this swap is: =37.5e (−0.0075) + 37.5e (−0.0075 × 2) + 1,537.5e (−0.0075
× 3) = JPY1,577.45 million
The USD portion of the swap = 1e (−0.03) + 1e (−0.03 × 2) + 21e (−0.03 × 3) = USD21.10
million.

The value of the institution = [JPY1,577.45/ JPY120/USD ] − USD21.10 = −USD7.95

million.

They had asked us to find current value of this swap to the institution, that’s why we did all
this.

15. In a currency swap, both principal and interest rate payments are exchanged, and
periodic payments are not netted. The amounts exchanged are equal at the inception, and
the spot exchange rate is used.

16. When floating rates rise above the swap rate, the fixed rate side of the swap will have
positive value, and the credit risk borne by the fixed-rate payer will increase.

17. At the inception of the swap, the value to both sides is zero, and just prior to maturity, when
only one net payment remains, credit risk is relatively small.
 18. In currency swap, Company J is paying 3% in Euros to Company K, and receiving 2.5% in
USD from Company K.

Value of swap in USD to company J = PV of the USD payments − (Spot rate in USD per Euro
× PV of the Euro denominated payments).

19. Primary criticism with the comparative advantage argument as justification for the existence
of swaps is: Credit risk.

20. See question number 21 from the question bank.

MBS:
1. A mortgage passthrough security represents a claim against a pool of mortgages. Any number
of mortgages may be used to form the pool, and any mortgage included in the pool is referred
to as a securitized mortgage.

Mortgage passthrough security: A participation certificate in a pool of mortgages.

2. The passthrough coupon rates are less than the average coupon rate of the underlying
mortgages in the pool (due to servicing fees), not greater than the coupon rate.

Passthrough security investors receive the monthly cash flows generated by the underlying
pool of mortgages less any servicing and guarantee/insurance fees.

Passthrough securities convert illiquid mortgages into liquid securities.

3. Recent trends indicate that supplying documentation is becoming a less viable tool for
mortgage lenders. Borrowers may not be denied credit in the event of no or little
documentation, however, the mortgage rate assigned will reflect the riskiness of the loan.

4. Curtailments are prepayments of mortgages for less than the full amount.
5. The early maturing tranches offer relatively greater protection against extension risk.

Longer-term tranches offer relatively greater protection against contraction risk.

Principal pay down window refers to the number of months that it takes for a given tranche
to be fully amortized.

6. Prepayment amount = SMM × (beginning mortgage balance for a month − scheduled

principal payment for the month)
= 0.004 × ($100 million − $2.5 million) = $390,000.

7. A dollar roll transaction occurs when an MBS market maker buys positions for one
settlement month and, at the same time, sells those same positions for another month.

A dollar roll is trading special when there is a decrease in the back month price and/or an
increase in the front month price.

Funding costs in the repo market is a factor that impacts dollar roll valuations.

8. Characteristic of a fixed rate, level payment, fully amortized mortgage loan:

The payments are such that at the end of the mortgage, the loan has been fully amortized.

9. To use Monte Carlo simulation, you do not need to stipulate the number of paths you would
be willing to accept.

10. Monte Carlo simulation makes use of an interest rate model to generate a mortgage
refinancing rates for each month along each of a set of simulated interest rate paths.

These refinancing rates along with mortgage loan characteristics are then fed into a
prepayment model that estimates a prepayment rate for each month along each path.

With these prepayment rate projections, monthly cash flows can be estimated.

11. Used to avoid the problems associated with prepayment path dependency: Monte Carlo
simulation.

12. Zero-volatility spread (Z-spread): is not adjusted for prepayment risk.

It is the spread that must be added to Treasury spot rates that will cause the discounted value
of the cash flows for an MBS or asset-backed security (ABS) to equal its price, assuming that
the security is held until maturity.

13. Planned amortization class (PAC) bonds are protected against prepayment risk to create
products that provide better asset and liability matching for institutional investors.

PAC bonds protect against prepayment risk as they have a fixed principal repayment
schedule that must be satisfied as long as the support tranches exist.

14. Principal & Interest only strips:

 The IO price is positively related to mortgage rates at low current rates.
PO prices increase when interest rates fall.
The PO (not IO) exhibits some negative convexity at low rates.
PO strips are sold at a considerable (not moderate) discount to par.

To summarize IO strips rise and PO strips fall when interest rates rise. This in reversed when
interest rates fall.

15. MBSs can be created in two ways:

First, the loans that meet the government agency requirements are charged an insurance
premium (guarantee fee) by the agency and then securitized as a pool.

Alternatively, the loans that do not meet the requirements or where it is too costly to go
through an agency are securitized in non-agency or private label transactions.

Although there is no agency guarantee on those securities per se, there is insurance in the
form of a private guarantee or the creation of subordinate classes.

After a pool of mortgages is securitized, it is sold to investors as a pass-through investment.

16. Calculation of the OAS is not necessary to get the theoretical value or in Monte Carlo
simulation.
The OAS is the spread that makes the model (theoretical) value equal to the market
price and is used for relative valuation of securities.

The option adjusted spread for the Monte Carlo model is the spread that must be added to all
of the spot rates along each interest rate path that will make the average present value of the
path cash flows equal to the market price (plus accrued interest) for the MBSs being
evaluated.

17. Both IOs and POs exhibit greater price volatility than the pass-throughs from which
they are derived.
This occurs because IO and PO returns are negatively correlated.

18. When interest rates fall many borrowers refinance (i.e., pay off their loans and take them to a
new lender). Once they do this, they get locked into a new deal and cannot refinance again
rates keep falling—called refinancing burnout.

19. CPR (month 20) = 20 × 0.2% = 4%

125 PSA = 1.25 × 4 = 0.05

SMM = 1 − (1 − 0.05) 1/12 = 0.004265319
CPR (month 30) = 6%
125 PSA = 1.25 × 6 = 0.075
SMM = 1 − (1 − 0.075) 1/12 = 0.006475737

20. Refinancing burnout refers to the fact that even though interest rates may be low relative
to the original mortgage rate, homeowners may have already refinanced due to a prior
rate drop.
 Most important determinant of refinancing burnout: Path that mortgage rates have followed
since origination.

21. The mortgage servicing rights associated with CMOs are assets that have cash flows that are
uncertain because of mortgage prepayment risk.

PAC bonds are CMO structures that are designed to minimize CMO prepayment risk. These
provide the best hedge against impairment of mortgage servicing rights.

22. The analyst must make specific assumptions about the rate at which prepayments of the
pooled mortgages occur when valuing the passthrough securities.

23. Monte-Carlo simulation model is not designed to be arbitrage-free.

The key difference between the various suppliers of the Monte-Carlo-based simulation
programs is the assumed level of interest rate volatility.

The critical refinancing rate spread (spread relationship between the refinancing rate and the
1-month interest rates along each of the simulated paths) is assumed to remain constant.

Monte Carlo models must be calibrated so that the average price generated by the paths in
the model is equal to the market price of the on-the-run benchmark issues.

24. IO strip cash flow starts out big and gets smaller over time.

25. The spread (k) that must be added to all of the spot rates along each interest rate path that will
force equality between the average present value of the path's cash flows and the market price
(plus accrued interest) for the MBS being evaluated is called the OAS.

26. A CMO is created by: redistributing the cash flows of mortgage-related products to different
bond classes.

27. For a principal mortgage strip the investor does not receive interest but only the principal.
Therefore, the sooner the investor receives the principal the higher the return.

Investment characteristics of a principal-only (PO) mortgage strip: The faster the

prepayments the higher the investor's return.

28. Lock-in effect refers to borrowers who may wish to avoid the costs of a new mortgage which
likely consists of a higher mortgage rate.

Burnout effect can be described as follows: consider a mortgage pool that was formed when
rates were 8%, then interest rates dropped to 5%, rose to 8%, and then dropped again to 5%.
Many homeowners will have refinanced when interest rates dipped the first time. On the
second occurrence of 5% interest rates, most owners in the pool who were able to refinance
would have already done so.

29. Prepayments or curtailments will reduce the amount of interest the lender receives over
the life of the loan.
30. A trader who is bearish on the U.S. bond market believes that interest rates will rise. Of the
three securities listed, only the IO would increase in value in such a scenario.

31. Cash flows of a fixed rate, level payment, fully amortized mortgage loan : The borrower pays
equal installments over the term of the mortgage.

32. Generally speaking, an analyst would like the OAS to be big.

33. The purchaser of a mortgage passthrough security: has a claim to equal percentage shares of
the interest and principal payments from a pool of mortgages.

34. A large OAS indicates a wider risk-adjusted spread and lower relative price. Option cost
measures prepayment risk.

In general, the highest OAS and lowest option cost is most attractive. Tranche C has the
highest OAS and the lowest option cost at the same time.

35. A mortgage is a loan that is collateralized with a specific piece of real property, either
residential or commercial.

36. With a mortgage loan, the borrower must make a series of mortgage payments over the life of
the loan, and the lender has the right to "foreclose" or lay claim against the real estate in the
event of loan default.

37. OAS is the: average spread over the Treasury spot rate curve. OAS measures the average
spread over Treasury spot rates, not the Treasury yield.

38. With a passthrough security, interest and principal payments generated by the underlying
mortgage pool are allocated to the bondholders on a pro rata basis.

Stripped mortgage-backed securities differ in that principal and interest are not allocated
on a pro rata basis, but unequally.

39. FICO Scores above 660 are considered prime (lower risk) scores below are considered
subprime (higher risk).

40. Securitizing a mortgage: Including a mortgage in a pool of mortgages that is used as

collateral for a mortgage passthrough security.

41. When mortgage rates decline, prepayments are expected to increase. Therefore, the
principal-only strip investor gets payments sooner increasing the value of the PO.
Interest Rate futures:
1. The conversion factor denes the price received by the short position of the contract.

2. Number of futures contracts to hedge:

P is portfolio size; Fc is current futures prize. D specifies duration/time to maturity.

3. When yields are fairly low (below 6%), ) High-coupon, short maturity bonds tend to be the
cheapest-to- deliver.

4. Selling T-bond futures will shorten the portfolio duration and, in turn, decrease the
portfolio's interest rate sensitivity. Conversely, the portfolio manager can increase the
duration of the portfolio by buying T-bond futures, which will increase the portfolio's interest
rate sensitivity.

5. For Eurodollar futures:

Contract price = 10,000 [100 − (0.25)(100.0 − 97.1)] = 992,750.

6. The full price or dirty price of the bond is the price of the bond plus accrued interest.

7. The dirty price is equal to the agreed upon, or quoted price, plus interest accrued from
the last coupon date.

Here, the quoted price is 1,000 × 104.75%, or 1,000 × 1.0475 = 1,047.50. Thus, the dirty price
= 1,047.50 + 33.50 = 1,081.00.

8. For cheapest to deliver:

Bond A: 101 − (97.85 × 1.03) = $0.21

Bond B: 116 − (97.85 × 1.12) = $6.41
Bond C: 105 − (97.85 × 1.07) = $0.30
Bond D: 124 − (97.85 × 1.23) = $3.64

101, 116… these are quoted price of the bond.

97.85 is the quoted futures price of the bond.
1.03, 1.12…these are the CFs.
9. Generally long-dated Eurodollar futures contracts result in implied forward rates which tend
to be larger than actual forward rates.

Effect of use of the convexity adjustment on difference between actual forward rates, and
those rates implied by the futures contracts: The difference is reduced by using the convexity
adjustment.

10. The discount rate, or quoted price, is calculated as: (360 / n) × (100 − cash price)

Given a 180-day T-bill and a cash price of 98, the annual discount rate is: (360 / 180) × (100 −
98) = 4%.

11. When a security trades ex-coupon, the buyer pays the clean price, which is the quoted price
without accrued interest.

12. Accrued interest is not discounted when calculating the dirty price of a bond.

13. When a bond trades between two consecutive coupon dates, the seller is entitled to
receive interest earned from the previous coupon date until the date of the sale. The price
paid includes accrued interest and is referred to as the "dirty price.

14. The clean price is the bond price without the accrued interest, so it is equal to the quoted price

15. The accrued interest is paid by the new owner of the bond to the seller of the bond. If the
buyer must pay the seller accrued interest, the bond is said to be trading cum-coupon.
Otherwise, it is trading ex-coupon.

16. The bond is trading at flat if the bond issuer is in default and the bond is trading without
accrued interest.

17. Accrued interest covers the part of the next coupon payment not earned by buyer.

18. The dirty, or full, price of a bond: equals the present value of all cash flows, plus accrued
interest.

19. If a T-bill is quoted at two, that means that the annualized interest rate is 2% of face
value.

Interest rate computation: (100 × 0.02 × 90 / 360) = 0.50

True rate of interest computation: 0.50 / (100 − 0.5) = 0.5025%

20. Day count convention used to calculate accrued interest on U.S. Treasury bonds is: actual /
actual.

21. The flat price is the bond price without the accrued interest, so it is equal to the quoted
price of bond.

22. The dirty price is equal to the agreed upon, or quoted price, plus interest accrued from the last
coupon date. Here, the quoted price is 1,000 × 104.75%, or 1,000 × 1.0475 = 1,047.50. Thus,
the dirty price = 1,047.50 + 33.50 = 1,081.00.
 23. Using the actual/actual convention there are 184 days between coupon payments and 104
days from March 1 and June 13.

Accrued interest: 104 / 184 × $8 / 2 = $2.26.

24. Since the bond is trading ex-coupon, the buyer will pay the seller the clean price, or the
price without accrued interest.

25. The formula to produce the theoretical price for this specific Treasury bond is

Quoted Futures Price (QFP) divided by the conversion factor: 96.99 / 1.15 = 84.34.

Corporate Bonds:
1. Callable bonds are called when interest rates have declined.

2. Callable bonds may be called at par. The indenture species the call premium and the rate at
which the call premium declines over time.

3. Callable bonds typically require that the issuer pay a premium above par to call the issue, and
the amount of this premium usually declines as the bond approaches maturity.

4. A corporation calling a large bond issue is an example of call risk.

Types of event risk : disaster/accident, corporate, regulatory, and political risks.

Event risk refers to the possibility that there may be a single event or circumstance that could
have a major effect on the ability of an issuer to repay a bond obligation.
The South American government's actions are an example of political event risk. The
FDA's actions represent regulatory event risk. The LBO-related rating downgrade is an
example of corporate event risk. Other e.g.: A local government regulatory agency
introduces more stringent clean-water requirements that will significantly reduce the cash
flow of an area paper mill.

5. Customarily, when a bond is called on the first permissible call date, the call price represents
a premium above the par value.

6. Call provisions give the issuer the right (but not the obligation) to retire all or a part of an
issue prior to maturity. Call features give the issuer the opportunity to get rid of expensive
(high coupon) bonds and replace them with lower coupon issues in the event that market
interest rates decline during the life of the issue.

7. Duration of the spread is the approximate percentage change in the bond's price per 100
basis point movement: 6 × 0.75 = 4.5%. (If a corporate bond has a spread duration of 6, how
will the value of the bond change if there is a 75 basis point change)

8. Deferred-coupon-structures bonds include deferred-interest bonds, step-up bonds, and

payment-in-kind bonds. They sell at a deep discount initially and do not pay interest for
several early years.

9. The dollar default rate is the par value of all bonds that defaulted during the year divided
by the total par value of all.

10. Measuring recovery rates can be complicated because the analyst must compute the present
value of the remaining cash flows at the time of the default & also some of the recovered
amounts can be in the form of securities.

11. Sinking fund provision requires that the issuer retire a portion of the principal through a series
of principal payments over the life of the bond.

12. The refunding provision found in nonrefundable bonds allows bonds to be retired unless: the
funds come from a lower cost bond issue.
 13. Indenture contains the overall rights of the bondholders. An indenture is the contract between
the issuer and bondholder that species the issuer's legal requirements. Covenants are part of
the indenture.

Properties of Interest Rates:

1. RForward = 2-year rate + (2-year rate − 1-year rate) × 1 / (2 − 1)

RForward = 3.77 + (3.77 − 2.92) × 1 / (2 − 1) = 4.62%

This is the calculation of forward rate from spot rates.

 2. Percentage price of bond change = [(−) (effective duration)(Δy)] + [(1/2)(convexity)
( Δy)^2 ]

3. For large changes in yield, duration underestimates the increase in price that occurs with
a decrease in yield, and overestimates the decrease in price that occurs with an increase in
yield. For small changes in yield, the estimated price change and actual price change are very
close to the same.

4. Traders consider Treasury rates too low, and use LIBOR since it better reflects their
opportunity cost of capital.

5. Convexity accounts for the amount of error in the estimated price change based on duration.
The relationship between bond price and yield is not really linear, and convexity converts the
straight line into a curved line, which more closely resembles the actual price relationship.

6. Bond price is always PRESENT VALUE, Face value is the future value.

7. See question number 7 from the QB.

8. The following Treasury zero rates are exhibited in the marketplace:

6 months = 1.25% 1 year = 2.35% 1.5 years = 2.58% 2 years = 2.95%

Price of a 2-year Treasury bond that pays a 6 percent semi-annual coupon is

3e (−0.0125 × 0.5) + 3e (−0.0235 × 1) + 3e (−0.0258 × 1.5) + 103e (−0.0295 × 2) = 105.90.

9. Since the bank has entered into the forward rate agreement to receive payment, and interest
rates have increased, it will have to pay on the contract. The amount it will have to pay is
(0.0335 − 0.0362)($12 million)(0.25) = −$8,100.

10. The change in assets would be an increase of ($100)(8.5)(0.005) = $4.25 million, whereas the
change in liabilities would be an increase of ($90)(6.5)(0.005) = $2.925 million. The net
effect would be an increase in equity of $1.325 million.

NEW GARP QUESTION BANK:

Futures Market:

1. Decreasing settlement prices over time are most indicative of an inverted market.

2. Approximately one percent of futures transactions are closed through actual delivery or cash
settlement.
3. For futures, Marking-to-market means that, at the end of the day, all gains or losses are tallied
to the trader's account.

4. In commodity trading, the exchange removes any daily losses from a trader's account and
adds any gains to the trader's account. This process is known as:

marking to market.

5. An offsetting trade such as described is how most futures positions are settled. This
effectively closes out the position, and the difference is deducted from Chavez's margin
account.

(Dan Chavez, FRM is long one contract at $1,610 per ounce of gold in the futures market.
Gold has dropped to $1,575 per ounce. Chavez is trying to decide how to settle the position.)

6. When the margin in a futures account falls below the maintenance margin, the additional
margin required is called the variation margin.

7. Initial margin deposits for futures accounts are: based on price volatility.

Initial Margin deposits for futures trades are based on the price volatility of the underlying
asset, are set by the clearinghouse, are equal for long and short positions, and are typically
a small percentage of the contract value.

8. Futures accounts are marked to market daily based on the new settlement price, which
can result in either an addition to or subtraction from the previous margin balance.

Under extraordinary circumstances (volatility) the mark to market can be required more
frequently. Once the margin is marked to market, the contract is effectively a futures contract
at the new settlement price.

9. Futures trades are done through open outcry on the futures exchange and require a buyer
(long) and a seller (short) for a trade to take place.

10. Providing a location for price discovery is a key role that the futures exchange plays. 98% of
futures contracts are actually offset so there is not physical delivery required.

11. An exchange-for-physicals involves an agreement between long and short contract

holders to settle their respective obligations by delivery and purchase of an asset. It is
executed of the floor of the exchange and reported to exchange officials who then cancel
both positions.

12. If the margin balance in a futures account with a long position goes below the maintenance
margin amount: a deposit is required to return the account margin to the initial margin level.

13. An exchange for physicals differs from a delivery in that:

The traders actually exchange the goods. The contract is not closed on the floor of the
exchange. The two traders privately negotiate the terms of the transaction.

14. An offsetting, or reversing trade occurs through the clearinghouse.

15. The futures contract ended at 995 on the first day. This represents a decrease in value in the
position of 5 × 250 × 60 = $75,000. The initial margin placed by the manager was $12,500 ×
60 = $750,000. The maintenance margin for this position requires $10,000 × 60 or $600,000.
Since the value of the position declined $75,000 on the first day, the margin account is now
worth $675,000, and will not require a variation margin to bring the position to the proper
margin level.

16. Prior to expiration, a futures position (long or short) is closed out by an

offsetting/reversing trade.

The other methods are used to settle positions at contract expiration such as: using an
exchange-for-physicals, delivering the asset at the current spot price, paying a cash settlement
amount.

17. With futures margin, there is no loan of funds.

18. A covered call strategy does indeed lower the risk by somewhat cushioning losses through
receipt of the premium received on the short call option. However the upside is lost, since
the strategy eliminates large upside gains. Expected return is thus reduced by this
strategy.

The protective put strategy requires the actual purchase of a put option. The maximum loss
is equal to the cost of the initial position, the stock price at the outset of the strategy plus
the put premium, less the exercise price of the put option.

19. Both futures accounts and equity margin accounts have minimum margin requirements
that, if violated, require the deposit of additional funds. There is no loan in a futures
account; the margin deposit is a performance guarantee. The seller does not receive the
margin deposit in futures trades. The seller must also deposit margin in order to open a
position.

20. A limit order to buy is placed below the current market price.

A limit order to sell is placed above the current market price.

A stop (loss) order to buy is placed above the current market price.
A stop (loss) order to sell is placed below the current market price.

21. Most futures positions are closed out by an offsetting trade at some point during life of the
contract.

22. A forward contract is a private customized contract, so specifying quality is no problem.

The futures exchange also species quality of a good that would be acceptable for settling the
contract.

23. Closing a futures contract through offset: The clearinghouse nets the position to zero.

24. An offset trade must be conducted on the floor of the exchange through the
clearinghouse. Reverse, or offsetting, trades are the most common way to close a futures
position. Exchange for physicals (EFP) involves private parties and takes place ex pit, or
off the exchange floor.
 25. A stop buy order at 31 is an order to buy if/when the price rises to 31; a limit sell is an
order to sell a stock as soon as possible at the limit price or higher.

26. A stop buy order can be combined with a short sale to limit losses.

27. Each trade is made at the then current equilibrium price, determined by open outcry on
the floor of the exchange, and is reported as it is executed. The long is obligated to buy,
and the short is obligated to sell, the specified quantity of the underlying asset.

28. A futures contract cannot expire without any action being taken. If the contract has not
been closed out through an offsetting trade, then one party must deliver the underlying
commodity and the other party must purchase the commodity.

29. A deliverable contract does not permit equivalent cash settlement.

30. The settlement price for a futures contract is: an average of the trade prices during the
‘closing period’.

The length of the closing period is set by the exchange.

31. Basis = spot price − futures price. As maturity approaches, the basis converges to zero.

Using futures for hedging:

1. The portfolio manager's target beta measure is 1.05, while its current beta is 0.92.

The number of futures contracts can be determined as [(1.05 − 0.92) $15 million] / ($250 ×
1205)] ≈ 6 contracts.
The portfolio manager wants to buy six S&P 500 contracts to increase his exposure.

2. Because the manager is considering hedging his S&P 400 exposure with S&P 500 contracts,
his primary concern should be basis risk between the two.

3. "Tailing the hedge": Multiply the hedge ratio by the daily spot price to futures price ratio.

4. basis = spot price of asset being hedged − futures price of contract used in hedge: $15.0 −
$18.0 = −$3.0.

5. Basis risk is the uncertainty about the difference between the: spot and futures price over the
hedging horizon.

6. Weakening of the basis occurs when the futures price increases relatively faster than the spot
price.
7. The source of basis risk for this farmer arises from the fact that his contract and harvest dates
do not perfectly match. As a result, he will be exposed to basis risk due to a necessary rollover
in his position.

8. In a hedge using futures contracts, the price risk of the hedged security is replaced with
basis risk.

9. How will the value of a portfolio of non-callable corporate bonds hedged with Treasury
futures change if the yield curve shifts up in a parallel manner by an anticipated amount? The
value of the newly hedged portfolio: stays the same.

The portfolio is hedged against parallel movements in the yield curve so its value will not
change.

10. A long hedge is the purchase of a futures contract to protect against the price increase of a
short position.

11. The purpose of computing a minimum variance hedge ratio is to minimize the variance of
the combined portfolio.

12. problem with hedged positions:

 Uncertainty with roll-over of the hedging instrument.

 Imperfect correlation between the hedged asset and the hedging instrument.

13. Imperfect correlations between the futures price and the underlying spot price decrease the
effectiveness of a hedged position.

14. Rolling the hedge forward exposes the hedger to the basis risk of the new position each time
the hedge is rolled.

15. The minimum variance hedge ratio is defined as the product of the correlation coefficient
times the ratio of the standard deviation of the spot price and the standard deviation of the
future price.

16. Cross hedge: investor takes a position in two different markets with essentially equal
positions in each, in an attempt to effectively counterbalance risk and to manage volatility.

Examples of cross-hedging: (1) Hedging jet fuel with crude oil, (2) Utility rms using weather
derivatives to hedge cost of energy purchases.
Forex Markets:

1. Because the EURUSD quote represents the amount of USD per 1 euro, we can say that the
euro now buys fewer USD and, therefore, it has depreciated relative to the dollar.

2. Interest rate parity is a situation in which the differential between spot and forward exchange
rates is equal to the differential between interest rates for the two different currencies.

(A European bank exchanges euros for USD, lends them at the U.S. risk-free rate, and
simultaneously enters into a forward contract to sell the loan proceeds for euros at loan
maturity. If the net effect of these transactions is to earn the risk-free euro rate)

3. Interest rate parity situation:

4. Assume that the current spot exchange rate between the U.S. dollar and the euro is $1.2500
per €. In the U.S., the 3-year nominal continuously compounded risk-free interest rate is 5%.
 In Europe, the 3-year nominal continuously compounded risk-free interest rate is 6.5%. The
3-year forward exchange rate is closest to:

Pricing Forwards & futures:

1. 1015e (0.041 − 0.02)(0.25) = 1020.34

(The S&P 500 index is trading at 1015. The S&P 500 pays an expected dividend yield of 2
percent and the current risk-free rate is 4.1 percent. The value of a 3-month futures contract
on the S&P 500 is closest to)

2. Assuming forward and futures prices are the same is an approximation. Forward and futures
prices are the same only when interest rates are known over a contract's life. There are
circumstances in which forward and futures prices will diverge.

3. On what does the interest rate parity relationship depend?

Spot and forward exchange rates between the two currencies.

4. A "short squeeze" is when the broker runs out of securities to borrow, forcing the short seller
to immediately close out his position.

5. At the inception of a six-month forward contract on a stock index, the value of the index was
$1,150, the interest rate was 4.4 percent, and the continuous dividend was 1.8 percent. Three
months later, the value of the index is $1,075. Which of the following statements is true? The
value of the:
6. The cost of carry must be reduced by the dividends that are expected to be received while
holding the underlying stock.

7. A synthetic commodity forward price can be derived by combining a long position on a

commodity forward, F0,T , and a long zero-coupon bond that pays F0,T at time T.

8. The total cost at time 0 is equivalent to the cost of the bond, or e −rTF0,T.

9. The payoff at time T is ST − F0,T + F0,T = ST.

10. Normal backwardation exists when futures prices are generally less than spot prices,
with the difference being larger for longer-term contracts. Contango exists when futures
prices are greater than spot prices.

11. As a market shifts from normal backwardation to contango, futures prices rise above the
spot price, and rolling a long hedge involves selling relatively cheap short-term contracts
and buying relatively expensive long-term contracts, thereby increasing the cost of rolling
the hedge.

12. If the lease rate is less than the risk-free rate, the forward market is said to be in contango.

13. Calculating the future cost of storage for 3 months: 0.50 + 0.50(1.0075) + 0.50(1.0075) 2 =
1.51 This means that it costs $1.51 to store the oil for 3 months, including interest. The next
step is to add the cost of storage to the spot price, plus interest: 92(1.0075 3 ) + 1.51 = 94.09 +
1.51 = 95.60 = 3-month forward price.

(Calculate the 3-month forward price for a barrel of crude oil if the current spot price is
$92/barrel, the effective monthly interest rate is 0.75%, and the monthly storage costs in a
floating tanker are $0.50/barrel.)

14. Normal backwardation means that expected futures spot prices are greater than futures prices.
It suggests that when hedgers are net short futures contracts, they must sell them at a
discount to the expected future spot prices to get speculators to assume the risk of holding a
net long position. The futures price rises over the life of the contract, which compensates
speculators for the exposure of their long positions.

15. The futures price is too low, so a reverse cash-and-carry arbitrage should be initiated. The
commodity should be sold short, the short sale proceeds should be loaned at the 6.25%
rate, and the futures contract should be bought. At expiration, the proceeds of the loan
 are collected, and the arbitrageur will take delivery of the commodity for the futures price
and cover the short sale commitment.

16. In contango there is no benefit to holding the asset.

17. The owner of a commodity is able to create a range of no-arbitrage prices as follows:

S0e (r + λ − c)T ≤ F0,T ≤ S0e (r + λ)T

The lower bound adjusts for the convenience yield and therefore explains why forward prices
may appear lower at times when the convenience yield is accounted for. The upper bound
depends on storage costs but not on the convenience yield.

18. Consumption assets’ actual storage costs may be expressed as either a known cash flow or as
a yield.
19. If inventory is low, this would increase convenience yield, since it is more valuable to hold
the physical asset in times of a shortage. Convenience yield is the cost-of-carry adjustment in
the non-arbitrage pricing formula, in determining forward prices.

Convenience yield is the benefit of holding the physical asset, and is inversely related to
levels of inventory.

20. Burton Riviera, FRM does not know the forward price of a commodity and wants to derive it
by establishing a synthetic commodity forward price. How would this strategy be
implemented?

Combine a long position on the commodity forward, and a long zero-coupon bond.
The payoff at the end will come from the forward contract plus the bond payoff.
Options:

1. A n-for-m reverse stock split adjusts the number of options by multiplying them by the split
and dividing the strike price by the same amount.

Since this is a reverse split, 500,000 shares (500 option contracts) now become 5,000 shares
(50 contracts), and the $15 strike price now becomes $150.

2. The value of an option is its time value plus its intrinsic value.

3. While out-of-the-money options have no intrinsic value, they still have time value prior to
maturity.

4. LEAPs are exchange-traded options. They are simply long-dated options with expirations
greater than one year. All LEAPS have January expirations.

5. FLEX options are exchange-traded options on equity indices and equities that allow
some alteration of the options contract specifications. The nonstandard terms include
alteration of the strike price, different expiration dates, or European-style (rather than the
standard American-style).

6. Call − Put = Stock – Xe^-rT.

7. American put options on non-dividend paying stocks may be exercised early if the
underlying stock price is sufficiently low.

The owner of the option would essentially receive the strike price, which is the maximum
value of the option, and could reinvest the proceeds at the risk-free rate, which would
generate a payoff received today as opposed to in the future.

8. To create riskless synthetic bond:

According to put-call parity we can write a riskless pure-discount bond position as:

Xe -rT = P0 + S0 − C0
 We can then read off the right-hand side of the equation to create a synthetic position in the
riskless pure-discount bond. We would need to buy the European put, buy the same
underlying stock, and sell the European call.

9. Using put-call parity, the value of a put is: p = c + Xe −rT − S0

Thus a put is equivalent to being long a call, long a zero-coupon bond, and short the stock.

10. Increased volatility positively influences put and call option values, while a decrease in time
to expiration will negatively influence call and put prices.

11. An increase in the stock price and an increase in the risk-free rate will cause the price of an
American call to increase but will cause the price of an American put to decrease.

12. Put call parity:

A portfolio of the three instruments will have the identical profit and loss pattern as the fourth
instrument and therefore the same value by no arbitrage. So the fourth security can be
synthetically replicated using the remaining three.

13. The upper bound on a European call option is the stock price, so it can't be worth $55.

(Consider a call option on a stock currently priced at $50 with a strike price of $55. Which of
the following cannot be the price of the call option?)

14. Due to the limited potential downside loss, changes in volatility directly affect option value.
Vega measures the option's sensitivity relative to volatility changes.

15. The following relationship must hold for American options: S0 − X ≤ C − P ≤ S0 − Xe −rt.

16. American put option values increase as a result of increases in :

I. Volatility. II. Dividends. III. Time to expiration.

American put option values decrease as stock prices increase.

Trading strategies:

1. The buyer of a bull spread buys the call with an exercise price below the current stock
price and sells the call option with an exercise price above the stock price.

2. A covered call strategy is used to generate cash on a stock position that is not expected to
increase in value over the life of the option.

(An investor owns a stock and believes that the stock's price will remain relatively
unchanged for the short term but is bullish in the long term.)

3. A covered call combines a long position in a stock with a written call. The payoff is similar
to cash plus a short put option because the upside is capped at the strike price plus the
premium, but still both have the downside of the strike price less the stock price.

The call writer is trading the stock's upside potential for the call premium. The desirability of
writing a covered call to enhance income depends upon the chance that the stock price will
exceed the exercise price at which the trader writes the call.

4. A short stock plus long call will profit as the stock price declines, but if the stock price rises,
losses are limited by the long call.

5. Why would you write a covered call? You feel the stock's price will not go up any time soon,
and you want to increase your income by collecting some call option premiums.

6. The buyer of a bull spread buys the call with an exercise price below the current stock price
and sells the call option with an exercise price above the stock price. Therefore, for a stock
price of $110 at expiration of the options, he gets a payoff $13 from his long position and a
payoff of −$7 from his short position for a net payoff of $6. The cost of the strategy is $4.
Hence the profit is equal to $2.

7. A bear spread is an option strategy in which the option trader: Short call at lower strike price
+ long call at higher strike price.

8. Long buttery is the choice as this combination produces gains should stock prices do not
move either up or down, while not producing much in loss if prices are volatile.

9. The protective put guards against falling prices, the bull call limits losses and gains should
prices move, and the 2:1 ratio spread gains should prices move up.

10. Long straddle produces gains if prices move up or down, and limited losses if prices do
not move.
 Short straddle produces significant losses if prices move significantly up or down. Long
Butterfly also produces losses should prices move either up or down.

11. Condor is similar to the long buttery, although the gains for no movement are not as great.

12. Situation: Good chance of large losses between now and end of year.

Strategy: Long put positions gain when stock prices fall and produce very limited losses if
prices instead rise.

13. A long straddle consists of a long call and put with the same exercise price and the same
expiration, at a stock price of $125 the put will expire worthless and the call value will be
$25.

14. The buyer of the straddle purchases both a call and a put. This position will benefit from
large swings of the price of the underlying stock in either direction. If the position expires
worthless, which occurs when the stock price stays at, the investor will lose 100% of the
investment.

15. The trader of a bear call spread sells the call with an exercise price below the current stock
price and buys the call option with an exercise price above the stock price. Therefore, for a
stock price of $110 at expiration of the options, the buyer realizes a payoff of −$13 from his
short position and a positive payoff of $7 from his long position for a net payoff of −$6. The
revenue of the strategy is $4. Hence the profit is equal to −$2.

16. A short straddle comprises a trading combination of options that: sells a put and call option at
the same strike price.
Exotic options:

1. "A six month call option may only be exercised early on the first day of each month":

Bermudan option.

2. Binary options generate discontinuous payoff profiles because they pay only one price at
expiration if the asset value is above the strike price.

3. An up-and-out put is a standard put option that only ceases to exist if the underlying asset
price hits a barrier level, which is set above the current stock value.

4. A shout option allows the owner to: receive the greater of the intrinsic value at shout time or
the intrinsic value at expiration.

5. Vega may be negative for a barrier option but is always positive for a standard option.

6. Compound options are options on other options. Buying a call option on another call option
allows the owner to determine whether he wishes to exercise the first option to own the
second.

7. There is lower transaction costs in exchange market as compared to OTC.

8. An option wherein the payoff is based on the highest or lowest price experienced over some
period of time, whichever is most advantageous to the option holder, is called a lookback
option.

9. Owing to their inherent discontinuities, both knock-in and knock-out barrier options are
relatively difficult to hedge (and value) when the spot price is close to the barrier price
and the contract is near maturity.