FRM Book 3 Questions with Complete Solutions 100% Verified| Latest Update Graded A+
When the yield curve is upward sloping, CTD bonds tend to have longer maturities.
When the yield curve is downward sloping, CTD bonds tend to have shorter maturities.
What is a duration based hedge? A duration-based hedge is to create a combined position
that does not change in value when yields change by a small amount.
What is a limitation of duration based hedging? The effectiveness of duration-based hedging
strategies is limited when there are large changes in yield or nonparallel shifts in the yield
curve.
What is the competitive advantage argument for swaps? The comparative advantage
argument suggests that when one of two borrowers has a comparative advantage in either the
fixed- or floating-rate market, both borrowers will be better off by entering into a swap to
exploit the advantage. The comparative advantage argument is flawed in that it assumes rates
can be borrowed for the life of the swap. It also ignores the credit risk associated with the swap
that does not exist if funds were raised directly in the capital markets.
To calculate take the difference of the differences, for example difference between A and B of
Fixed and Difference of A and B floating.
What is a currency swap? A currency swap exchanges both principal and interest rate
payments with payments in different currencies. The exchange rate used in currency swaps is
the spot exchange rate.
How can a currency swap transform an asset or liability? Currency swaps can be combined
with existing positions to completely alter the risk of a liability or an asset. For example,
suppose that Company A has a dollar-based liability. By entering into a currency swap, the
liability has become a pound-based liability at the GBP fixed (or floating) rate.
,What is adverse selection? and what do insurance companies do to hedge this risk? Adverse
selection describes the situation where an insurer is unable to differentiate between a good risk
and a bad risk. Ongoing due diligence (as well as greater initial due diligence) is a method that
can be used against adverse selection.
Why type of funds are global macro managers? Global macro managers make large bets on
directional movements, typically in interest rates and exchange rates but also for commodities
and stock indices.
What are dedicated short funds focused on? Dedicated short funds focus exclusively on
finding a company that they think is overvalued and then short selling the stock.
What are emerging market funds focused on, and which investors would be interested in
looking at them? Emerging market funds focus on investments in developing countries and
not necessarily on foreign commodities.
What do managed futures funds used for and why would you invest in them? Managed
futures funds attempt to predict future movements in commodity prices based on either
technical analysis or fundamental analysis. Such funds are not necessarily focused on large price
movements or foreign commodities.
What is a PAC tranche? A PAC is a tranche that is amortized based on a sinking fund
schedule that is established within a range of prepayment speeds called the initial PAC collar or
initial PAC bond.
There is an inverse relationship between the prepayment risk of PAC tranches and the
prepayment risk associated with the support tranches. In other words, the certainty of PAC
bond cash flow comes at the expense of increased risk to the support tranches.
, Why are CCP's associated with the problem of a moral hazard Since CCPs are considered to
be "systemically important", there is a higher likely hood that they will bailed out by a
government entity, this cause a moral hazard problem, which would allow the CCP to accept a
higher risk than required.
What is a stop loss order? Stop-loss orders are used to prevent losses or to protect profits.
Suppose you own a stock currently selling for $40. You are afraid that it may drop in price, and
if it does, you want your broker to sell it, thereby limiting your losses.
What is a limit order? Limit orders are orders to buy or sell away from the current market
price. A limit buy order is placed below the current price. A limit sell order is placed above the
current price.
What is a stop limit order? Variations on these order types also exist. Stop-limit orders are a
combination of a stop and limit order. The stop price and limit price must be specified, so that
once the stop level is reached, or bettered, the order would turn into a limit order and
hopefully transact at the limit price.
Explain what a cross-hedge strategy is. Cross-hedging is using futures contracts for one
commodity to hedge the loss risk of a different underlying commodity. When cross-hedging, it
is important to hedge with the best futures contract available. This will be the one for which
price movements are expected to match the cash commodity most closely.
Explain what contraction risk is and what tranche does it affect It is the decrease in the
expected life of a mortgage pool due to falling interest rates and higher prepayment rates
Longer term maturing tranches protect against contraction risk
Explain what extension risk is and what tranche does it affect It is the increase in the
expected life of a mortgage pool due to rising interest rates and lower prepayment rates
Early maturing traches offer relatively greater protection against extension risk
When the yield curve is upward sloping, CTD bonds tend to have longer maturities.
When the yield curve is downward sloping, CTD bonds tend to have shorter maturities.
What is a duration based hedge? A duration-based hedge is to create a combined position
that does not change in value when yields change by a small amount.
What is a limitation of duration based hedging? The effectiveness of duration-based hedging
strategies is limited when there are large changes in yield or nonparallel shifts in the yield
curve.
What is the competitive advantage argument for swaps? The comparative advantage
argument suggests that when one of two borrowers has a comparative advantage in either the
fixed- or floating-rate market, both borrowers will be better off by entering into a swap to
exploit the advantage. The comparative advantage argument is flawed in that it assumes rates
can be borrowed for the life of the swap. It also ignores the credit risk associated with the swap
that does not exist if funds were raised directly in the capital markets.
To calculate take the difference of the differences, for example difference between A and B of
Fixed and Difference of A and B floating.
What is a currency swap? A currency swap exchanges both principal and interest rate
payments with payments in different currencies. The exchange rate used in currency swaps is
the spot exchange rate.
How can a currency swap transform an asset or liability? Currency swaps can be combined
with existing positions to completely alter the risk of a liability or an asset. For example,
suppose that Company A has a dollar-based liability. By entering into a currency swap, the
liability has become a pound-based liability at the GBP fixed (or floating) rate.
,What is adverse selection? and what do insurance companies do to hedge this risk? Adverse
selection describes the situation where an insurer is unable to differentiate between a good risk
and a bad risk. Ongoing due diligence (as well as greater initial due diligence) is a method that
can be used against adverse selection.
Why type of funds are global macro managers? Global macro managers make large bets on
directional movements, typically in interest rates and exchange rates but also for commodities
and stock indices.
What are dedicated short funds focused on? Dedicated short funds focus exclusively on
finding a company that they think is overvalued and then short selling the stock.
What are emerging market funds focused on, and which investors would be interested in
looking at them? Emerging market funds focus on investments in developing countries and
not necessarily on foreign commodities.
What do managed futures funds used for and why would you invest in them? Managed
futures funds attempt to predict future movements in commodity prices based on either
technical analysis or fundamental analysis. Such funds are not necessarily focused on large price
movements or foreign commodities.
What is a PAC tranche? A PAC is a tranche that is amortized based on a sinking fund
schedule that is established within a range of prepayment speeds called the initial PAC collar or
initial PAC bond.
There is an inverse relationship between the prepayment risk of PAC tranches and the
prepayment risk associated with the support tranches. In other words, the certainty of PAC
bond cash flow comes at the expense of increased risk to the support tranches.
, Why are CCP's associated with the problem of a moral hazard Since CCPs are considered to
be "systemically important", there is a higher likely hood that they will bailed out by a
government entity, this cause a moral hazard problem, which would allow the CCP to accept a
higher risk than required.
What is a stop loss order? Stop-loss orders are used to prevent losses or to protect profits.
Suppose you own a stock currently selling for $40. You are afraid that it may drop in price, and
if it does, you want your broker to sell it, thereby limiting your losses.
What is a limit order? Limit orders are orders to buy or sell away from the current market
price. A limit buy order is placed below the current price. A limit sell order is placed above the
current price.
What is a stop limit order? Variations on these order types also exist. Stop-limit orders are a
combination of a stop and limit order. The stop price and limit price must be specified, so that
once the stop level is reached, or bettered, the order would turn into a limit order and
hopefully transact at the limit price.
Explain what a cross-hedge strategy is. Cross-hedging is using futures contracts for one
commodity to hedge the loss risk of a different underlying commodity. When cross-hedging, it
is important to hedge with the best futures contract available. This will be the one for which
price movements are expected to match the cash commodity most closely.
Explain what contraction risk is and what tranche does it affect It is the decrease in the
expected life of a mortgage pool due to falling interest rates and higher prepayment rates
Longer term maturing tranches protect against contraction risk
Explain what extension risk is and what tranche does it affect It is the increase in the
expected life of a mortgage pool due to rising interest rates and lower prepayment rates
Early maturing traches offer relatively greater protection against extension risk
