Pass the PRMIA PRM Certification 8006 Questions and answers with ExamsMirror

Credit derivatives can indeed be used for reducing credit exposures, earning credit risk premiums and getting market exposure without taking cash market positions. They cannot be used for reducing interest rate risks, as they pay out only when agreed 'credit events' take place. Changes in interest rates are not a credit event. Therefore Choice 'b' is the correct answer.

The investor would benefit from the risk reversal and the bull spread as both these strategies have a payoff profile that benefit from rising prices of the underlying. The collar is the opposite of risk reversal, and benefits during a bear market, and the butterfly spread benefits when prices remain range bound. Therefore Choice 'c' is the correct answer.

Explanation:

The weighted average cost of capital (WACC) is given by the average cost of debt and equity, weighted by their proportions in the capital structure. The cost of debt should be considered after taxes, as interest is a tax deductible expense. Therefore the WACC in this case can be calculated as = [10% x (1-25%) x 0.5] + [14% x 0.5] = 10.75%

The operating free cash flows can be considered a perpetual annuity with a given growth rate.

The value of a perpetuity of a periodic cash flow of 'c', with a discount rate 'r' and growth rate 'g' is given by c/(r - g). In the given case, the company can be considered as providing a perpetual annuity which provides an annual cash flow of $100 which are growing at 2.5% (equal to the GDP's growth rate, as given), and whose cost of capital, or the discount rate to use, is 7.5%

Therefore the value of the firm in this case is given by $100/(7.5% - 2.5%) = $2,000. Recall that the value of the firm is equal to the Operating Free Cash Flow/Weighted Average Cost of Capital (OFCF/WACC). Therefore Choice 'd' is the correct answer.

Imagine a bond that provides just two cash flows: $100 in one year and $10 in 10 years. Imagine another bond that pays nothing now but $100 in 10 years. Assume that both have identical yields to maturity. Yet despite the identical YTM, the bonds are quite dissimilar. For the first bond, we face the risk that we would receive the bulk of the present value of the bond in an year's time, and while there is a small amount due in 10 years, the first payment may not find an equally attractive investment opportunity. Reinvestment risk refers to the risk that cash flows from a bond may not be investible at the yield to maturity for the bond. In such cases, bonds that have longer durations are preferable.

A coupon bearing bond with a coupon rate lower than our benchmark bond will carry a lower reinvestment risk as its cash flows are weighted more towards the end. An amortizing bond returns a part of the principle periodically, increasing reinvestment risk. A higher coupon bearing bond will have a higher reinvestment risk, and a zero coupon bond will have the least reinvestment risk.

A money market security is one that is initially issued with a maturity of less than one year. Treasury bills are short-term government securities with maturities ranging from a few days to 52 weeks. Bills are sold at a discount from their face value, and do not carry a coupon. Treasury notes and treasury bonds are not money market instruments as they are issued for a maturity greater than a year. Treasury notes are issued with maturities of 2, 3, 5, 7, and 10 years and pay interest every six months. Treasury bonds pay interest every six months and mature in 30 years.

Commercial paper is issued by corporations to meet their short term funding needs and is a money market instrument. Bankers' acceptances are short term loans to corporations that are guaranteed by a bank.

Of the given list, since treasury notes are the only instrument that are not money market securities, Choice 'a' is the correct answer.

When hedging an equity portfolio with index futures, the number of futures contracts to hold is given by the [beta x value of portfolio/value of one futures contract]. Therefore Choice 'a' is the correct answer.

The volatility, risk free rate have nothing to do with determining the number of futures contracts to hold. Systematic risk is expressed in the form of beta. Therefore the other choices are incorrect.

A portfolio is considered dominated when it is not on the efficient frontier, which is another way of saying that there exists another portfolio with a better risk reward payoff. Therefore Choice 'a' is the correct answer.If the portfolio has a higher mean and the same or lower standard deviation than any other portfolio, this means it is already on the efficient frontier and is not dominated. The other choices do not make any sense in the context of the question.

Theta measures time decay, ie the change in value of the option with the passage of time. When the option is close to expiry, theta is very low as the value of the option is driven by intrinsic value rather than the time value. Therefore theta approaches zero as the option comes closer to expiry.

Over the counter and electronic communication networks match buyers and sellers. However, there is no market making function, ie, in periods of stress liquidity may completely disappear from these markets. Exchanges normally have market makers that are required to present two way quotes on the securities they are making the market for. Therefore Choice 'a' is the correct answer.