8006 PRMIA Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition Free Practice Exam Questions (2025 Updated)

Open interest refers to the number of outstanding contracts, which is the same as the number of long positions or short positions held by market participants. Note that since for every long futures contract position held there is a seller who holds the short side, the open interest that is long is identical to the open interest that is short. (This is unlike the spot market where one could have long positions without anyone else needing to be symmetrically short).

The total number of contracts traded refers to traded volumes, and not open interest. Other choices are irrelevant in the context.

A short squeeze results when short sellers are trying to cover their short positions by buying in the spot markets, which do not have adequate supply. This results in sharp spikes in spot prices, which further forces any other shorts to try cut their losses. The result is a sharp rise in spot prices.

Choice 'a' is the correct answer, the other choices do not describe a short squeeze.

Overcollateralization is when the notes issued by the special purpose vehicle are less in value compared to the underlying pool of assets, thereby providing a buffer to absorb losses. Excess spread implies that the notes issued carry a lower interest rate than the interest rate received on the underlying assets. Cash reserves are reserves intended to take first hits when losses happen. All of these are valid credit enhancements for structured products. Additionally, 'insurance wraps' are also used as a credit enhancement. Choice 'c' is the correct answer.

'Margin requirements' do not mean anything in this context and are not a valid credit enhancement used for credit derivatives.

Investors have differing view of the market, which means differing view of expected returns, correlations and volatilities. Not only do they have differing views, these views change frequently as new information reveals itself. Accordingly, each investor has their own version of the efficient frontier. Once investors have determined their efficient frontiers, they will determine the extent of risk they wish to hold. If they had identical views, they would have held the same portfolio. But they do not, and if they did, there would be very little trading in the markets.

All the above statements are true except statement I which is false due to differing investor expectations.

(Re statement IV: If investors have different risk appetites, their portfolio will vary in the split between the risky and the riskfree assets. But inside the 'risky' assets bundle the proportion of the assets will be identical. Ie, they would express their varying risk appetites by varying how much of the risky bundle and the riskfree asset they hold, but inside the risky bundle the proportion of the different risky assets will be the same.)

Standard deviation of this portfolio can be calculated as SQRT(4000^2*20%^2 + 6000^2*25%^2 + 2*0.6*4000*6000*20%*25%), which is equal to $2,081. Choice 'a' is the correct answer. The other answers are incorrect.

The duration of a perpetuity is 1/running yield. Therefore the correct answer is 1/.05 = 20 years

All the statements given are true, except that standard deviations cannot be averaged to get the portfolio standard deviation unless the assets are perfectly positively correlated. Therefore Choice 'd' is the false statement, and the correct answer.

For a portfolio of uncorrelated assets, ie correlations being equal to zero, variances can be added together to get portfolio variance. Also, regardless of correlations, portfolio returns are always the weighted average of asset returns, and just averages will do in this case as the portfolio is said to be equally weighted across the assets. A correlation of zero produces a risk level less than that possible with positive correlations.

All the choices listed are valid assumptions underlying the BSM option valuation formula except that the BSM formula is based upon the option being exercisable only at expiry. The assumption is that early exercise is not permitted. In other words, BSM applies to European options and not American options. Therefore Choice 'd' represents the correct answer as it is not an assumption underlying Black Scholes.

A swaption is an option to enter into a fixed for floating interest rate swap at a point in the future, with the fixed rate decided upfront. These options can be European, Bermudan or American, in terms of what dates the option can be exercised. A receiver option on a swap is an option that gives the buyer the right to enter into a swap and receive the fixed rate and pay the variable rate. In the case of a payer option, the buyer pays the fixed rate and receives the variable rate. One way to remember this is that receiving and paying are terms used with reference to the fixed rates.

A covered call is an attempt to earn premium income by selling calls while protecting against the downside by holding long the underlying. In case prices rise, the holder of the covered call can give away the held underlying. In case prices fall or stay below the strike price of the sold call, the holder of the covered call gets to keep the premium.

The holder of the covered call will suffer a loss if the price of the underlying declines due to the long position held in the underlying. However, these losses will be partly offset by the premiums earned on the calls sold.

Choice 'd' does not represent a correct statement as in the event of a rise in the price of the underlying the holder of the covered call will lose any upside, but will not have unlimited losses. In the event of a decline in stock prices, his losses will be equal to the loss on the underlying, minus the premium earned.

There was no event such as the CDO squeeze in 2008. (Quite on the contrary, securitized products were selling at distressed prices.).

The silver squeeze of 1979-80 (Hunt brothers), the Chicago fire of 1872 (leading to a short squeeze on wheat), and the wheat squeeze (Hutchingson) of 1866 are real historical events that led to short squeezes in commodity markets. Choice 'b' is therefore the correct answer.

For the PRM exam, you should try to remember the event broadly, and the commodity involved.

The put-call parity applies to European options and does not hold for American options because the latter can be exercised at any time up to expiry. Therefore statement I is false.

An American put can not be cheaper than a European put is correct. This is because the American put will always be valued at at least its intrinsic value whereas a European value may be valued at less than intrinsic value if the exercise date is too far away in the future. This is because a long time interval will increase the chance that the intrinsic value may not be realized at expiry. Because the American put can be exercised anytime, it will always be at least equal to its intrinsic value because if it were to be cheaper than that, investors would immediately buy and exercise it, creating a riskless profit. Therefore statement II is correct, and statement IV is correct as well.

It may be optimal to exercise an American put (unlike an American call - note the difference!) before its expiry on a non dividend paying stock. This would be the case only when the put is deep in the money. If the option is really deep in the money (say, when the underlying's price is down to zero), then it may be worthwhile to cash the option out prior to expiry as the upside might be lost if time were to be allowed to pass. Additionally, any further upside in the case of a deep in the money option may be zero or very little, and the time value of money would also make immediate exercise prefereable. Therefore statement III is not correct.

Delta hedges need to be rebalanced periodically because with changes in prices, delta changes, and the amount of hedge required changes as well, requiring a readjustment. The more frequent the rebalancing, the better the performance of the hedge. However, the greater the rebalancing frequency, the greater are the number of trades required, increasing the costs from trading. The trader has to balance transaction costs against the adverse effects from poorer hedge performance. Therefore rebalancing frequency is a consideration for a trader and statement I is true.

Statement II is not true. When options are granted, their future impact on the price gets priced in into the current price, and no change occurs when these are actually exercised.

Statement III is true. Consider the Black Scholes PDE

202.23.e1

and substitute delta = 0 (as this is a delta neutral portfolio), and we get the result 202.23.e. Since r is generally small, a large negative theta means a large positive gamma and vice-versa. Therefore theta can be used as a proxy for gamma and this statement is correct.

Statement IV is correct. Vega is highest closest to the strike price - look at the graph for vega to see how vega behaves with changes to spot. (Do it yourself or there is a graph in the tutorial too.)

The zero coupon spot rate for 4 years can be calculated as = (1.02*1.03*1.04*1.05)^(1/4) - 1 = 3.49%, which is the correct answer. (3.50% is just the mathematical average of the rates for the four years and is not correct, even though close.)

A 'hard call protection' means the bond cannot be called until a certain date, regardless of what the share price is. Therefore statement I is false. Also note that a 'soft call protection' means that a bond can be called only if the share price reaches a certain threshold.

It is advantageous for the issuer to call its convertible securities when the share price exceeds the conversion price - because these shares can instead be sold in the market at the higher share price than the lower conversion price. Statement II is true.

When the issuer's share price is very high, the convertible bond trades at a discount to the share price because it is almost certain to be called by the issuer and be redeemed at par. Therefore statement III is right. Statement IV is incorrect because convertible bonds need to pay less coupon than equivalent non-convertible bonds because of the value of the option embedded in them.

Commodity futures prices can be expressed as the summation of their spot prices and the carrying costs. Therefore any changes in either of these two would be a risk to the futures prices, and Choice 'b' is the correct answer. It is common to decompose complex commodity portfolios into underlying equivalent spot positions and the carrying costs, which includes interest, convenience yield and storage costs. For liquid commodities such as gold where changes of a short squeeze are low, interest costs dominate the carryings costs. Choice 'b' is the correct answer as it is most complete and covers the elements in the other choices. The 'lease rate' for a commodity is equivalent to (Fwd Price - Spot Price)/Spot Price, and comprises the interest and storage costs and the convenience yield. The other choices do not represent complete answers.

The price of an interest rate cap is affected by all of the listed choices except the risk free rate. The risk free rate does not come into play in the pricing of caps, and therefore Choice 'b' is the correct answer.

Since AUD 1 = USD 0.6831, and USD 1 = SEK 8.1329, AUD 1 = SEK 8.1329*0.6831 = 5.5556.

It is important to remember how exchange rates are generally quoted. Most exchange rates are quoted in terms of how many foreign currencies does USD 1 buy. Therefore, a rate of 99 for the JPY means that USD 1 is equal to JPY 99. However, there are four major world currencies where the rate quote convention is the other way round - these are EUR, GBP, AUD and NZD. For these currencies, the FX quote implies how many US dollars can one unit of these currencies buy. So a quote of "1.1023" for the Euro means EUR 1 is equal to USD 1.1023 and not the other way round.

When calculating cross rates, it is important to pay attention to how the rates are quoted. This particular question is quoted in a very straightforward way because it specifies exactly what the rate means, eg by saying USD/AUD it clarifies that the rate is the number of USDs per AUD. If the question is not clear, remember how exchange rates are quoted - all are against 1 USD, except for EUR, GBP, AUD and NZD where it is the other way round.

The efficient frontier is a two dimensional plot with volatility and returns on its axes. For a given level of return, it helps identify the portfolio with the lowest volatility. From the other axis, it helps identify the portfolio with the highest return for a given level of volatility.

Therefore Choice 'b' is the correct answer. Note that in the exam you may be asked the question slightly differently.