CFA Level 1 (2009) - 5

Self-1cst: Derivatives and Ahernative Investments

1. C Since the FRA pays ,u the expiration of the forward contract, it pays the presellt value of the inlerest savings that would be realized at the end of the (hypothetical) loan term. The interest rale 0lnion will pay rhe interesl savings on the (hypothetical) loan aher expiration at the end of the loan term and its paymem will be greater (since it's not discounted back to the expiration date).

2.C The initial margin is 4 x $4,000 = $16,000 and the maimenance margin is 4 x $3,200 = $12,800. The loss on the position is (672 - 685) x 4 x 100 = -$5,200, leaving a balance of $16,000·- $5,200 = $10,800. Since the account has fallen below the maintenance margin, a deposit of $5,200 is required (0 bring the balance back up [() the inilial

margill.

3.H A decrease in the risk-free rate of illtaesl will decrease call values. The olher changes will

tend to increase lhe value of a call oplion.

1\. B The ncr COSl of the covered call posilion is 38 - 2 = 36, so the maximum loss (if the stock price goes to zero) is $36. The maximum gain (if the stock price goes to 40 or more) is $4. The sum is 36 + 4 = 40.

5.B If the index has risen to 2,805 (+2%), the index payer's liability (2% x $10 million) just offsets the fixed rale payer's liabiliry (8% I 4 x $10 million). The payment at the second settlemem date cannot be determined without knowing the change in the index level between the first and second setdement datcs. Thc index level at the first settlemcnt date does not determine the payment at the second settlement date.

6.C Forward contracts typically do not require a margin deposit. They are CUSlOffi instruments that may require settlement in cash or delivery of the underlying asset, and have counterparry risk.

7.B The no-load fund has transactions cOSts that are essentially zero while an ETF buyer must pay a srock commission and is subject to the effects of the bid-ask spread. Closedend fund shares often trade at significant premiums or discounts to NAV while ETF shares trade close to their NAVs because of their in-kind redemption and creation feature.

8.C After-tax cash Aow = (net operating income - depreciation - interest expense)(l - tax

rate) + depreciation - principal portion of the annual loan payment.

Net operating income = gross potential rent x (1 - % vacancy and collection losses) - mall1tenance expense

=[(30,000 x $40 x (l - 0.06)] -$150,000

=$978,000

Interest expense = 0.09($8,000,000) = $720,000

Principal reduction = $876,372 - $720,000 = $156,372

. Page 284

©2008 Kaplan Schweser

~~S~Lf~ZrhisT':'DE'RIVATI~ES~ND ALTERNATIVE			.
~-i~~§WM~\N't;S.: ..; "." " ,.,	:	." . :.. ' .	" ... ' ~i

1.Which of the following is Least Likely a similarity between a forward rate agreemenr based on L1BOR + 1.5% and an inrerest rate option on L1BOR?

A.A long position in either one will result in a positive paymem if inrerest rates increase above the contract rate.

B.The paymems to either are based on the difference between a conrracr rate and a market (reference) rate.

C.If both have the same conrract rate, notional principal, expiration date, and reference rate, they will make equal paymems to their (long) owners.

2.Adam Vernon took a long position in four 100 oz. July gold futures comracts at 685 when spot gold was 670. Initial margin is $4,000 per contract and maintenance margin is $3,200 per contract. If the accounr is marked to market when spot gold is 660 and the futures price is 672, the additional margin the investor must deposit to keep the position open is closest to:

A.$2,000.

	B.	$4,000.
	e.	$5,000.
3.	The value of a call option on a stock is Least Likely to increase as a result of:
	A. an increase in asset price volatility.
	B. a decrease in the risk-free rate of inrerest.
	e.	a decrease in the strike price of the option.
4.	Kurt Crawford purchased shares of Acme Inc. for $38 and sold call options at
	$40 covering all his shares for $2 each. The sum of the maximum per-share gain
	and maximum per-share loss (as an absolute value) on the covered call position

IS:

A.$36.

B.$40.

e. unlimited.

5.Craig Gram has emered inro a $10 million quarterly-pay equity swap based on the NASDAQ stock index as the 8% fixed rate payer when the index is at 2,750. Which of the following is most accurate?

A.He will make a payment of $200,000 on the second paymenr date if the

index is 2,750.

B.He will neither make nor receive a payment on the first settlement date if

the index is 2,805.

e. If the index at the first settlement date is 2,782, he must make a paymenr at the second settlement date.

6.It is least LikeLy that a forward contract on a zero-coupon bond:

A.has counterparty risk.

B.can be settled in cash.

e. requires a margin deposit.

©2008 Kaplan Schweser

Page 281

18%

10%

8CVo

Ifa.'!

c/O.H'.lt to:

Sclf-Test: Derivatives and Alternative Investments

7.Among a no-load mutllal fund, a closed-end fund, and an exchange-traded fund (ETF), which most likely has the lowest transactions costS and which most likely

will trade at a discount to NAY?

	Low trallSactions costs	Trade at a discoul1l
A.	No-load fund	ETF
B.	No-load fund	Closed-cnd fund
C.	ETF	Closed-end fund

8.Jodi Monroe has purchased all office building for $10 million and financed the purchase with a 20-year $8 million loan at 9%, which requires equal end-of.-year payments of $R76,372. The building has 30,000 square feet and will lease at an

annual rate of $40 per square foot with expected vacancy and bad debt expense of 6%. Mail1lenance cost is expected to be $150,000 per year. Depreciation

on the building is $250,000 per year and Monroe is in the 38% marginal tax bracket. The first-year annual after-lax cash Row on this investmenr is

A.-$100,000.

B.$0.

C. $100,000.

9.A consultanr has made a pn;sentation to a pension fund manager that shows that based on the last 10 years of available hedge fund data, the mean return after

fees was 14 0ft>, which exceeded the retllrl1 on a popular broad-based large-cap index by more than 3%. The standard deviation of net returns was estimated to be 12%, which is less than th:lt of the index. for [he hedge fund returns, it is

li/a'0' [hat:

A.standard deviation fails to describe risk well.

B.the estimate of risk is too low due to survivorship bias.

C.self-selection bias tends to smooth rhe reponed returns of each included fund.

10.The probabilities that a venture capital invest111elH will fail, given that it has

survived all prior periods, are: 1st year 15%

2nd year 3rd year 4th year

An investment of €1.5 million is expected to return €9 million if the venture survives until the end of the fourth year. The expected annual compound rate of return on this investment is closest to:

A.36%.

B.33%. C. 31%.

Page 282

©2008 Kaplan Sehweser

Self-Test: Derivatives and Alternative Investments

Mter-tax cash flow = ($978,000 - $250,000 - $720,000)(1 - 0.38) + $250,000-- $156,372

=$4,960 + $250,000 - $156,372

=$98,588

'). C Self-selcerion bias refers to the practice of reporring rerurns only for funds that do relatively well and tends to bias reponed returns upward. The faer that lIIany hedge funds conrain infrequently traded assets that must be valued with pricing models is what tends ro smooth reponed rerurns for each fund. Hedge fund rerurns arc often asymmetric and standard deviation as a risk measure does not account for the fact that many hedge fund strategies have limited upside potential (with relatively high probability) and almost unlimited downside risk (with low probability). Survivorship bias tends ro inflate rerum estimates and leads ro an underestimate of risk.

10.A The probability that the venture survives four years is:

(I - 15%)(1 - 18°;;,)(1 - 10%)(1 - 8%) = 57.7%.

The cxpected payoff is 0.577(9 million) = €5, 1')4,04t1.

The expected rcturn is 15,194,044/1,500,0001 1/4 = 36.4%.

Note that with a required return of 36.4% the NPV of this investment is zero, so at any discounr rate less thall .'36.4%, the NPV is positive and the venture inveSlmenr should be

\I nderraken hased on the NPV decision method.

II. C A long/shan fund takes both long and shorr positions but docs not necessarily take equal size positions to minimize market risk as a market neutral fund docs. Global macro funds make bets on the direction of currencies, interest rates, and other facrors.

12.C Since the 55% represents a controlling interest in the subject firm and neither firm's shares are traded in a liquid market, no adjustment is required for either characteristic.

©2008 Kaplan Schweser

Page 285

FORMULAS

-

Cull

pricc = clean pricc + accrued ilHerest

duration

pcrcclHage ch,ll1ge in bond price

yield changc in percelH

valuc of a callable bond = value of an option-free bond -

value of thc call

'I"'IPS

. fl'

d'

d

I

ue X

statcd coupon rate

coupon paymelH = In

anon-a

Juste

par va

---~'----

2

absolute yield spread = yield on the higher-yield bond -

yield on the lower-yield hand

.

.

absolutc yield spread

-

relative yield spread =-, -

yield on the benchmark bond

. Id'

subject bond yield

YlC

ratio =

bcnchmark bond yield

after-tax yield = taxable yield x (I -

marginal

tax rate)

.

.

tax-free yield

taxable-eqlllvalem yIeld =

(I - marginal tax rate)

zero-coupon bond value =

maturity value

2

(J

b

f

+ itum cr 0

ycarsX

- Id

=

annual cash coupon payment

current Yle

bond price

bond equivalent yield::.:: [(1 + monthly CFy)6 -1] X 2 = [)1 + annual-pay YTM -1] X 2

effective annual yield __ (1 + semiannualpay YTM)2 -1

2

spot rate from forward rates:

forward rate from spot rates:

Page 286

©2008 Kaplan Schweser

			Book 5 --	Fixed Income, Derivative, and Altern:llive Investmell(s
					Formulas
,	"	(bond price when yields Edl - bond price when yields rise)			V -VI
effeclIve duration =		------------- .	----- . --------	.	----
		2 x (initial price) x (change in yield in decimal ('arm)			2V()(6.y)

percentage change in bond price " --effective duration x change in yield in percenr

pcrcc'ntage change in price = duration effect + convexivity elTeer

= ([-duration x (6)')] + lconvexity x (6y)2]) x 100

price value of a basis point = duration x 0.000 I x bond value

(1oalIng' -orwarl1- l)(days).. -

.

I

.

.

I)

360

value of a long FRA at setrlemenr: (not!olu

prtnClpa ..--- . --- .

I +- ~"1(oalIng'

)[days)- ...

360

inrrinsic value of a call: C = Max I0, S -

Xl

intrinsic value of a put: P = MaxfO, X -

5]

OfHi on value = intrinsic value + rime value

lower and upper bounds for options:

____ __O!'t~~~1

MinimuI'n Vi/lu/'

Afaximum Valu/'

ct -2:

,s(

European call

Max[O, St - X / (1

+ RHZ)J'-IJ

American call

CT -2: Max[O, 5t -

X / (J

+ RFR)T-l]]

5t

European pur

PI -2:

Max[O, X / (I + RFR)T-t - SJ

X / (I

+ RFR)fr

American put

Pt -2: Max[O, X - 5t ]

X

put-call parity: c + X

/ (1 + RFR)f = 5 + p

pllt-call parity with asset cash flows: C + X /

(I

,

T

= (50 - PVCF) + P

+ RI<R)

plain-vanilla interest rate swap:

C' . )

(

swap fLXed rate

_LIBOR_)[numberofdays)

(net fixed-rate payment t =

t

]

360

x (notional principal)

income method for real estate:

. J' net operating rncome appralsa prrce =

market cap rate

net operating income = gross potential income - collections and vacancy losses - total operating expenses

©2008 Kaplan S~hweser

Page 287

INDEX

A

absolurc yield spread 72

3.ccc!cr3.red sinking fund provision 1'i accrued imercsr 13, 14

ad hoc auerion 46 affirmarive covenams 1 l afrer-raJ( cash flow 250 a[rer-raJ( yield 74

3.gency bonds 48 aggregarion vehicles 246

American oprions 192 amortizing securiries 14

annual-pay yield ro maruriry 100 appropriarion-backed obligarions 52 arbirrage 159

arbirrage-free Treasury spor rares 71 asser-backed securirics 58

B

back-end load 241,242 backfilling bias 256 backwardarion 275 bankers acceprances 57

bank reserve requiremems 67 bankruprcy rem ore enrily 58 besr efforrs basis 55, 60

bid-ask spread 35

bond equivalenr yield 100, 107 bond forwards 168 bondholder righrs 55

bond indenrure 11 bond oprions 194 boorsuapping 107 bought deal 59 bridge hnancing 251

c

callable bonds 28, 114, 134 caJJ oprion 159, 191, 194

call oprion pfOhl's and losses 232 caU prorecrion 14

call provisions 14 call risk 24

cap 13,16,17, 196 capler 196

cap risk 29

cash flow yield 104

cash managemenr bill 46

cash scrr]cmcn l (forwards)			165
cash selrlemenr (furures)		183
ccnrral bank	67
ct'frihcalcs of deposir (CDs)			57
cheapesr-ro-deliver 185
clean price 13
clearinghouse	180
closed-end fund 241
closely held companies		256
closing rrade	184

collar 13, 196

collateralized commodiries furures posirion 259 collarcralized debr obligation (CDO) 59 collareraJizcd l110rrgagc obligarions 50 coUareral rrusr bonds 54

collareral yield 276 commercial paper 56 commodiries 258, 275

commodiry-linked securiries 258 comparables approach 257 condirional failure probabiliries 252 comango 275

comingent claim 159

conringem deferred sales charges 242 connan multiplier 194

conversion oprion 16 convexiry 134,141

cost approach (closely held companies) 257 cost method (real estate) 247

coumerparry risk 165,255 coupon 11

coupon rate 27 coupon srrips 48 covenams 11 covered call 235

credir enhancements 54 credit rating 53

credit risk 25, 166 credit spread 34, 73 credit spread risk 34

currency denomination of a bond 12 currency forward contracl 172 currency futures 185

currency options 194 currency risk 35 currency swap 220 current yield 98

Page 288

©2008 Kaplan Schweser

o

(kakr-placed paper 56 debentures 49

default risk 34, 165 deferred-coupon bonds 12

deliverable forward contract 165 delivery 183

delivery oprions 18" derivatives 158

criticism of 159 difficulty in valuation 252 directly-placed paper 56 dirty price 13

discouIHed after-tax cash flow model 2,,8 discount rate 67

discoulH to par value 26 disrressed securities 258 dollar duration 30 double-barreled bonds 52 downgrade risk 34 duration 27, 29

of a portfolio 140 duration/convexity approach 131

E

early exercise, possibility of 209

early stage of venture capital investing 251 effective convexity 143

effective duration 136 embedded options 16, 27, 73

entrepreneurial/management mismatches 252 equity forward contracts 167

equity swap 225

equivalent annual yield 107

Euribor 169

Eurodollar deposit 169

Eurodollar futures 185

European options 192 evem-driven funds 254 evem risk 25, 36,37 exchange for physicals 184 exchange rate risk 25, 35

exchange-traded derivatives 158 exchange traded fund 244 exchange-traded options 193 exercise price 192

external credit enhancemem 59

F

[ace value 12

Federal Farm Credit System 49

Federal Home Loan Bank Corporation (Freddie

Mac) 49

Book 5 - Fixed Income, Derivative, and Alternative Investmems

Index

Federal Home Loan Bank (FHLB) 48

federally related institutions 49

Federal National Mortgage Association (Fannie Mac) 49

fcc simple 246

fee structures and gaming 256 tlduciary call 208

Ii nancial options 194 l1rm cOlllmitment 59

floating-rate securities 12, 28 floor 13,17,196

Roorlet 196

foreign currency options 194

formative stage of venture capiral investing 251 ftHward commitment 158

forw:udconrract 158,164 forward discoun t facror 114 forward rate 114

forward rate agreement 169 free and clear equity 246 froIH-cnd load 241

full price 13

full valuation approach 131 funded invesror 75

fund manager incentive misrakes 252 fund of funds 254

fu tures contracts 159, 179

G

general obligation bonds 52 global fund strategy 244 global macro funds 254

GovernmelH National Mortgage Association 49 government sponsored emerprises 49

H

hedge funds 253

high watermark provision 253

I

illiquidity in hedge fund investing 255 illiquidity in venture capital investing 252 income approach, closely held companies 257 income approach, real estate 250

income method 248 indemure 11

index fund 244 index options 194

inflation-indexed bonds 13 inflation risk 25, 36

initial margin 181

"in-kind" creation and redemption of shares

244

©2008 Kaplan Schweser

Page 28')

Book 5 - Fixed Income, Derivative, and Alternative InvesnnelHs

I nuex

insured bonds 53 interest rale cap 196 interest rate collar 196 il1lereSI rate nOll!' 196

interest rale options 191, 195, 1')8 ilHerest rate policy 100is 67 interesl rate risk 21. 27

inleresl rate swaps 222

in-the-money call option 193 inlrinsic value of an option 198, 199 inverse Hoater 13

Issuer 12

L

later stage of velHure capital investing 251 law of one price 160

lellers of credit 55, 59 leveraged equilY position 246 limit move (lip, down) 182 liquidity of a bond issue 74 liquidity preference theory 69 liquidity risk 25,35

listed options 193 locked limit 182

London IIHerhank Offered Rate (UBOR) 75.

169, 195, 223

long forward position 164

long/shon funds 254

long-term equity anticipatory securities (LEAPS)

195

M

Macaulay duration	139
main tenance margin	181
margin buying by institutional investors t 7
margin in futures markets 180
market-neutral funds 254
market segmentation theory 69
marking to market 35, 182
maturity, relation to interest rate risk 27
maturityvaJue 12
medium-term notes (MTNs) 55
mezzanine financing 251
minimum and maximum values of options		201
minimum value of a European pllt option		204
minimum value of an American call option		205
modified duration 139
moneyness 193

moral obligation bonds 52 mortgage-backed securities 49 mortgage passthrough security 50 mortgages 246

municipal honds 52 mutual funds 241

mumal termination of a swap 219

N

negative conveXIlY			131
negative covenams			I I
negotiable CD.~ 57
negotiated offering			GO
net asset value 35, 242
net operating income (NO!)						218
no-load fund	241
nominal spread 72,			II I
nonrefundahle bonds				15
normal backwardation				275
notional princi p:ll		22 t
o
offsetting COlllraC[ (to terminate a swap)								21')
offsening trade (10 l'xit a futures position)								184
off-the-run issues		47
on-the-run issues		47
open-cnd fund 24 I
open-end investmellt company							241
open market operations					67
option-adjusteu spleau (OA5)							113
oplion contraCl 191
option-like strategies 256
option payoffs 197
option premium		191
option prof-il diagrams				252
options 158
options on futures			194
option writer	191
our-of-the-money call option							193
overnight repo 17
over-the-counrer derivatives						158
over-the-coullter options					j 93
p
parallel shift	32
par value 12, 26
plain vanilla illterest rate swap							222
portfolio duration			140
positive convexity			134
preferred habitat theory					70
premium of an option				192
premium to par value				26
prepayahle debt		134
prepayment option			14, 16, 32
prepayment risk		24, 50
pterefunded bonds			53
price limits	182
price return	276
price value of a basis poin t						144

Page 290

©2008 Kaplan Schweser

IJrice-yield profile 87 primary market for debt 59 principal strips 48

Private Export runding Corporation 49 private placement 60

protective put 208, 236 public credit ('nhancemcnt 53

pure expectations theory 69,70 plilablebond 114,135

put-call parity 207,208,210 [HII option 159, 191, 195

put option profits and losses 233 put provisions 16

Q

quality spread 73

R

rating agencies 53

real estate investments 246

real estate investment trusts (REITs) 246 real estate valuation 247, 249

realized yield 105 real options 195 redemption 15

reference rate (for a Aoating-rate sec'lrity) 12 regular cycle auction 46

regular redemption 15 reinvestment income 105 reinvestment risk 24, 33, 98, 106 relative yield spread 72 repurchase agreement (repo) 17 resale of a swap 220

reset date 29

revenue bonds 52, 53

reverse trade (to exit a futures position) 184 roll yield 276

Rule 144A offering 60

s

sales comparison approach 248, 249, 250 scenario analysis approach (to measuring interest

rate risk) 131 secondary market for debt 60 SEC Rule 415 55

sector strategy 244 secured debt 54

Securities and Exchange Commission (SEC) 49 sced stage of venture capital investing 25 J self-selection bias 256

serial bonds 52

senlement date 165, 219, 221 settlcment errors 255

		Book 5 -				fixed Income, Derivative, and Alternative Investments
										Index
settlement price				181
shelf registration				55
short forward			position				161
sinking fund			15, 16
smoothed pricing					256
sources of return from debt securities									98
sovereign bonds				15
sovereign risk			25
special [Hill Jose vehicle							58
special redcmption					15
spot rate 71,114,116
stable value fund				244
static spread			112
step-u p notes			12
stock ind ex fut ures					185
stress testing			131
strike price		1'J2
stripped Treasury securi tics (STRIPS)									48
structured note 56
structured security					55
Student Loan Marketing Association (Sallie
	Mae)		49
style of an equity fund							244
subordinated debentures 54
survivorship bias				256, 257
swap	159
swaps	158, 219
swaption 220
swap, ways to terminate 219
T
tap system		46
taxable-equivalent yield							74
tax-backed bonds					52
tax-free bonds 52
Tennessee Valley Authority 49
tenOl	219
terminating a forward contract								165
terminating a futures contract								183
terminating a swap 219
tcrm repo		17
theoretical Treasury spot rate curve 71,										107
third-parry guarantee						55
time value		200
tracking error risk					246
tranches 50
Treasury bill futures						184
Treasury bond futures							185
Treasury InAation-Protected Securities										47
Treasuty securities (bills, notes, bonds)										46
12b-l	fees	242

©2008 Kaplan Schweser

Page 29 I