PRMIA Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition 8006 Exam Dumps: Updated Questions & Answers (October 2025)

The price of an interest rate cap is affected by all of the listed choices except the risk free rate. The risk free rate does not come into play in the pricing of caps, and therefore Choice 'b' is the correct answer.

An m x n FRA is an agreement to borrow money for a period starting at time m and ending at time n at the contracted rate. Therefore, the buyer of the 3 x 6 FRA has committed to borrow $1m at the beginning of 3 months and return it at the end of 6 months, ie a total borrowing period of 3 months at a rate of 5%. Of course, the $1m is never actually exchanged, and at the beginning of the 3 month period when the next three months' interest rate is known (6%), the parties merely exchange the difference in the interest. SInce this interest was only due at the end of the 6 months and is being exchanged at the 3 month time point, it will have to be discounted to its present value.

The correct answer to this question is =(1,000,000 * (6% - 5%) * 3/12)/(1 + (6%*3/12))=$2463.05. Since interest rates rose, the borrower gained as he has the right to borrow at a lower rate, and therefore the seller will pay the borrower.

(Here:

- $1m is the notional

- 6% - 5% represents the difference between the contracted and the realized interest rates

- 3/12 is the 3 month period from month 3 to 6

- Finally, we divide by the current interest rate for 3 months to present value the payment from month 6 to month 3)

The objective of decisions relations to capital structure is to maximize the value to shareholders. The management of the company is entrusted with the job of maximizing shareholder value, and this objective is generally achieved by attempting to maximize enterprise value. Enterprise value includes the value of both debt and equity, and since debt has a fixed claim on the assets of the business, maximizing enterprise value also maximizes the value of equity.

The investor would benefit from the risk reversal and the bull spread as both these strategies have a payoff profile that benefit from rising prices of the underlying. The collar is the opposite of risk reversal, and benefits during a bear market, and the butterfly spread benefits when prices remain range bound. Therefore Choice 'c' is the correct answer.

Implied volatility is the volatility that is priced in the current market prices. In other words, we know the formula for pricing an option, and we find the value of the volatility for which we get the current market price. It is the volatility that the market is ascribing to that security. Therefore statement I is not correct.

Implied volatility in the market tends to vary across strikes, even with the same underlying. There is a certain level of demand for out of the money puts, for example, from investors trying to set a floor for their losses. At the same time, there is a natural supply of out of the money calls from investors trying to earn some relatively risk free premiums. These factors cause options with different strikes to be priced in a way as to give different estimates of market volatility at each strike *& resulting in the 'volatility smile'). Therefore statement II is not correct.

The shape of the implied volatility curve is called the 'volatility smile', because of the shape it sometimes takes. Statement III is correct.

Theta is the rate of change of an option's price with the passage of time. It causes the value of the option to decrease over time, such that if it is out of the money and close to expiry, the price of the option approaches zero. Theta is therefore negative by definition. Statement IV is not correct. Remember that theta will be positive for short positions.

Theta measures time decay, ie the change in value of the option with the passage of time. When the option is close to expiry, theta is very low as the value of the option is driven by intrinsic value rather than the time value. Therefore theta approaches zero as the option comes closer to expiry.

The arbitrage pricing theory is a multifactor model for explaining asset returns as it can be used to incorporate multiple factors, for example inflation, GDP growth rate, employment, interest rates etc to explain asset returns. Choice 'a' is the correct answer.

The single index model, as the name implies, uses only a single factor, and so does the CAPM which uses excess returns to explain an individual security's returns. Neither of these are multi-factor models.

This question highlights the difference between zero rates, yield-to-maturity and forward rates. Forward rates are from one point in time to another, for example say from year 4 to 5 in the future. A zero rate is from time 0, or now, to a point in time in the future. The zero rate is dependent on the forward rates for all the different periods from now to the future. The yield curve represents the various zero rates at different points in time, and if it is upward sloping it means forward rates for years further out are greater than the years prior. That is what causes the zero rate yields to increase over time and the curve to slope upwards. So the forward rate from year 9 to 10 will certainly be higher than the 10 year zero rate.

The yield-to-maturity for a bond is the rate at which the payments on the bond discount to be equal to the current bond price. It is therefore the average rate that applies to the bond. This average is based upon the different zero rates for the years in which bond holders receive payments. Since coupons are smaller than the payment at maturity, the zero rate that applies to the payment at maturity will have the most impact on the numerical value of the bond's yield-to-maturity. Also affecting the yield-to-maturity will be the values of the coupon payments, which will be discounted at lower rates when the yield curve is upward sloping. So the yield-to-maturity will be an average lower than the 10 year zero. Since the 10 year zero will be lower than the forward rate from t=9-10, the yield-to-maturity will be the lowest rate of the three.

A residential mortgage carries a prepayment option for the borrower, where in the event of a decrease in interest rates they are likely to repay the mortgage and refinance at the new lower rate. If rates go up, the bank does not have a similar option. If the volatility of the underlying interest rates increases, mortgage holders are more likely to be faced with new rates that are sufficiently lower to persuade them to refinance. This reduces the ability of the bank to continue to earn the higher interest rate it was earning before.

Therefore an increase in volatility of the mortgage interest rates decreases the value of the mortgage portfolio.

The same rationale applies to callable bonds, where the borrower has the option to call the bond.

The futures price of the contract will be the future value of the spot price, calculated at a net rate equal to the cost of funding the futures position, less any dividends or other distributions. Also note that when rates are continuously compounded, Future Value = Present Value x (exp(rate x time)).

Therefore in this case the futures price for the S&P = 1000 * exp((5%-2%)*3/12) = 1007.53