It’s Time to Take Your FRM® Exam

Focusing at work.

The FRM® exam is this Saturday, November 19th and we know you have been hard at work preparing for this important career milestone. We want to wish all candidates the best of luck, focus, and composure on exam day. Becoming a certified Financial Risk Manager is a unique and special accomplishment and we appreciate the months of preparation it has taken to get to this point.

Please comment your exam day tips and stories as we’d love to hear from you.

Meanwhile, here are 3 questions and helpful explanations from Wiley’s FRM Test Bank to help you with that last minute practice for exam day.

1. You manage an equity portfolio and are concerned about possible large moves in the stock market as the Federal Reserve begins to hike rates through 2016.
You know that exotic options can be structured to pay out in very specific scenarios and are sometimes cheaper than plain vanilla options.
You gather the most current prices for common exotic options with a time to expiration of one year and want to compare their cost to a standard European option. For the sake of the analysis, you are going to ignore dividend cash flows.
Current pricing of plain vanilla S&P one‐year put options with a strike of 2020 and an index value of 2010 is $138.75 assuming 18% volatility and a 100‐basis‐point risk‐free rate. A European call with the same parameters is $148.88.

Are the exotic options mispriced?

Option Price
Up‐and‐in barrier call, with barrier at USD 2020 60.39
Up‐and‐out barrier call, with barrier at USD 2020 88.49
Down‐and‐in barrier put, with barrier at USD 2020 27.56
Down‐and‐out barrier put, with barrier at USD 2020 108.19

A. The European call is mispriced.
B. The Exotic calls are mispriced.
C. The European put is mispriced.
D. The Exotic puts are mispriced.

Answer: D

Note: These are not actual market‐based exotic option prices, for those who are paying close attention. Just take what you are given on the exam as correct.

This is the kind of question that seems very complicated but is really a put call parity question or just simple addition. You do need to know that the combination of the up and in and up and out barrier options should price just like a plain European call. There isn’t enough information to see if the up or down exotics are mispriced but the answer choices don’t give you that flexibility.

Since you are given the European call and puts price, the up and down options must add to those prices and the exotic puts don’t.

2) One problem with options is that there is an exposure to volatility both in the asset price and in the asset itself. A variance or volatility swap are two exotic option types that offer payoffs based on volatility or variance. Which of the following is true of variance or volatility swaps?

A. Variance swaps are easier to value than volatility swaps.
B. Volatility swaps are easier to value than variance swaps because the payoff uses the common square root of time rule.
C. The pay fixed side of a variance or volatility swap would owe the counterparty money if the actual variance or volatility exceeded the fixed (strike) amount of variance or volatility.
D. The pay fixed side of a variance swap will receive money from the counterparty if the realized variance was less than the stated or agreed‐to variance level.

Answer: A

There is an important difference here in the payoff of variance swaps relative to any other kind of swap. Usually I want you to think of “pay fixed” as the side that is short the asset value. So for example, a pay fixed swapholder would earn a payoff if interest rates went higher (bond prices go lower). In the variance case, you are paying a fixed volatility or a fixed variance—think of this as paying a fixed level of uncertainty. If the actual volatility is higher than the strike, the payoff goes to the pay fixed holder. As long as you think of rates going higher and volatility going higher (in percentage terms), you will always know which side of the trade gets the payoff. The third and fourth answer choices reverse this relationship, and the second answer choice is a distractor.

3) You are considering the possible implications of the yield curve shifting higher starting in 2016 and the impact to the duration and convexity of your trading desk’s fixed income portfolio. Currently the book has a notional of 1.8 billion and a duration of 7.8 years. In 6 months, due to higher rates and issues in the portfolio maturing, you think your portfolio is going to extend in duration to 8.2 years.

Current 6‐month Treasury futures are trading at $99.48 and the cheapest to deliver issue right now has a duration of 4 and, you think, a duration of 4.3 in 6 months. You assume there is no change in the CTD security during the next 6 months and the 6‐month forward 1‐year rate is 85 basis points.

If you wanted to completely hedge against interest rate risk over the next 6 months, what is the closest to the number of contracts that should be sold to hedge the duration risk?

A. 34,500 contracts
B. 33,000 contracts
C. 35,000 contracts
D. 32,000 contracts

Answer: A

This learning objective assumes you know that futures contracts are delivered into a notional of $100,000 face value. The notional value of Treasury contracts is the only one you need to know. If they give you some obscure euro futures contract, they will give you the delivery terms, but you still have to know what to do with them. As always, there is extra info here like the 6‐month forward rate. GARP will give you extraneous information on exam day. Don’t be confused by it!

Take the portfolio size, 1.8 billion, and that we then need to scale that by the duration of the portfolio and the duration of the hedging instrument—in 6 months—to arrive at the number of contracts.

1.8 billion × 8.2 / (.9948 × 100,000 × 4.3) = 34,505 contracts

Stay calm and do your best. You’ve got this!

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