Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition Practice Questions
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Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition Questions and Answers
Profits and losses on futures contracts are:
Profits and losses on futures contracts are settled daily. (P&L on forward contracts is often settled upon the expiry of the contract, and may even be collateralized.) Therefore Choice 'd' is the correct answer.
Credit risk in the case of a CDO (Collateralized Debt Obligation) is borne by:
Investors in CDOs bear credit risk. The SPV is merely a conduit that owns the underlying assets on which the sponsoring institution has bought protection. The investors have sold them this protection, and are on the hook for defaults or other credit events. The reference entity is relevant only to CDSs, not CDOs. Choice 'b' is the correct answer.
An investor holds a portfolio of mortage backed securities valued at $100m. Using a Monte Carlo based pricing model, he determines that the value of the portfolio would rise to $102m if interest rates were to fall by 45 basis points, and fall to $97m if interest rates were to rise by 45 basis points. What is the estimated modified duration of the investor's portfolio?
For fixed income portfolios where standard cash flow discounting models are not available, duration calculations are based upon estimated price moves in response to a change in rates. Recall that we define duration as the percentage change in price expected for a 1% change in yield. In this case, we have three price points known to us:
Line | Price | Yield
a | $102 | r - 45bps
b | $100 | r
c | $ 97 | r + 45bps
(where r is the current yield)
The change in price from line a to line c is $102m - $97m = $5m. We use the middle point, ie $100m, to calculate the percentage change. Therefore the percentage change in price is $5m/$100m = 5%.
The change in yield between lines a and c is 90 basis points [=(r+45bps) - (r-45bps)]. In other words, the change in price is 5% for a 90 bps change in yield. So the duration can be calculated as 5/(90/100) = 5.56. The other answers are incorrect.
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