FM FM Derivatives and Options 2 â Questions and Answers
Question 1: An interest rate swap in which Party A pays a fixed rate and receives a floating rate results in Party A having:
- Fixed-to-floating exposure, benefiting if floating rates rise (Correct answer)
- Floating-to-fixed exposure, benefiting if floating rates fall
- Zero net interest cost regardless of rate movements
- A long bond position with no interest rate risk
Correct answer: Fixed-to-floating exposure, benefiting if floating rates rise
Paying fixed and receiving floating means Party A benefits when floating rates rise above the fixed rate.
Question 2: The swap rate in a plain vanilla interest rate swap is the fixed rate that makes the swap's initial value:
- Equal to zero (fair swap) (Correct answer)
- Equal to the notional principal
- Positive for the fixed-rate payer
- Equal to the floating rate at inception
Correct answer: Equal to zero (fair swap)
The fixed swap rate is set so that the present value of fixed payments equals the present value of expected floating payments, making initial value zero.
Question 3: A futures contract differs from a forward contract primarily because futures are:
- Exchange-traded and marked to market daily (Correct answer)
- Always settled by physical delivery of the asset
- Customized agreements between two private parties
- Immune to counterparty default risk
Correct answer: Exchange-traded and marked to market daily
Futures are standardized, exchange-traded, and subject to daily mark-to-market settlement, which virtually eliminates counterparty risk.
Question 4: The intrinsic value of a put option with strike K and current asset price S is:
- max(K â S, 0) (Correct answer)
- max(S â K, 0)
- K â S regardless of sign
- S â K regardless of sign
Correct answer: max(K â S, 0)
Put intrinsic value is max(K â S, 0): positive when the asset is below the strike, zero otherwise.
Question 5: On the FM exam, a 'cap' is a series of interest rate call options (caplets) used by borrowers to:
- Limit the maximum interest rate paid on a floating-rate loan (Correct answer)
- Guarantee a minimum interest rate received on a deposit
- Lock in a fixed interest rate on a bond
- Exchange fixed payments for floating payments
Correct answer: Limit the maximum interest rate paid on a floating-rate loan
An interest rate cap protects a floating-rate borrower from rising rates by providing payoffs whenever the reference rate exceeds the cap rate.
Question 6: Under the FM exam syllabus, the payoff of a short forward position at maturity with forward price Fâ and spot price S_T is:
- Fâ â S_T (Correct answer)
- S_T â Fâ
- max(Fâ â S_T, 0)
- max(S_T â Fâ, 0)
Correct answer: Fâ â S_T
The short forward holder delivers the asset and receives Fâ, so payoff = Fâ â S_T.
FM FM Derivatives and Options 2
An interest rate swap in which Party A pays a fixed rate and receives a floating rate results in Party A having: