FRM Part I

Question #1 of 15 Question ID: 1256562

An investor enters a short position in a gold futures contract at $318.60. Each futures contract controls 100 troy
ounces. The initial margin is $5,000 and the maintenance margin is $4,000. At the end of the first day the futures
price rises to $329.22. Which of the following is the amount of the variation margin at the end of the first day?

A) $0.

B) $62.
C) $1,000.

D) $1,062.

Explanation

The short position loses when the price rises.

($329.22 − $318.60) × 100 = 1,062 loss

Margin account will change as follows: $5,000 − $1,062 = $3,938

Variation margin of $1,062 is required because the balance has fallen below the maintenance margin level. This
variation margin payment is required in order to restore the account back to the initial level.

(Module 31.1, LO 31.c)

Question #2 of 15 Question ID: 1256563

A large-cap U.S. equity portfolio manager is concerned about near-term market conditions and wishes to reduce the
systematic risk of her portfolio from 1.2 to 0.90. Her portfolio value is $56 million, and the S&P 500 futures index is
currently trading at 1,050 and has a multiplier of 250. How can the portfolio manager's objective be achieved?

A) Sell 47 contracts.

B) Buy 47 contracts.
C) Sell 64 contracts.

D) Buy 64 contracts.
Explanation

The portfolio manager wants to reduce exposure to systematic risk so she will want to sell S&P index futures. This
will reduce the current beta to her target beta of 0.90.

number of contracts = (target beta − current beta) × (portfolio value / futures value)

number of contracts = (0.9 − 1.2) × [$56 million / (1,050 × 250)]

number of contracts = −64 (i.e., sell 64 contracts)

(Module 32.2, LO 32.f)

Question #3 of 15 Question ID: 1256564

Suppose the spot rate is 0.7102 USD/CHF. Swiss and U.S. interest rates are 7.6% and 5.2%, respectively. If the 1-
year forward rate is 0.7200 USD/CHF, an investor could:

A) not earn arbitrage profits.

B) earn arbitrage profits by investing in USD.

C) earn arbitrage profits by investing in CHF.

D) only earn arbitrage profits by investing in a third currency.

Explanation

Note that while the USD has the lower interest rate, it is also trading at a forward discount relative to the CHF. Since
the USD will earn less interest and depreciate in value, we definitely want to invest in CHF (not in USD), and no
calculation is necessary.

As an illustration of covered interest arbitrage, we have:

Today:

(1) Borrow USD1 at 5.2% and purchase CHF at $0.7102 to get $1 / 0.7102 = 1.408 CHF at
spot rate.

(2) Lend the purchased CHF at 7.6% and sell forward 1.5150 CHF at the forward rate of
0.7200 USD/CHF.

In one year:
(1) Use the proceeds of the savings account [(1.408)(1.076) = 1.5150 CHF] to purchase
USD1.0908 at the forward rate (1.515 CHF × 0.72 USD/CHF).

(2) Pay off the loan of USD1 × 1.052 = USD1.052 and earn a riskless profit = USD1.0908 −
USD1.052 = USD0.0388.

(Module 33.2, LO 33.k)

Question #4 of 15 Question ID: 1256566

A portfolio manager owns Macrogrow, Inc., which is currently trading at $35 per share. She plans to sell the stock in
120 days but is concerned about a possible price decline. She decides to take a short position in a 120-day forward
contract on the stock. The stock will pay a $0.50 per share dividend in 35 days and $0.50 again in 125 days. The
risk-free rate is 4%. The value of the trader's position in the forward contract in 45 days, assuming in 45 days the
stock price is $27.50 and the risk-free rate has not changed, is closest to:

A) $7.17.
B) $7.50.
C) $7.92.

D) $7.00.

Explanation

The dividend in 125 days is irrelevant because it occurs after the forward contract matures.

PVD = $0.50e−0.04×(35/365) = $0.4981

FP = ($35 − $0.4981) × e(0.04)(120/365) = $34.96

V45(short position) = −($27.50 − $34.96e−0.04×(75/365)) = $7.17

(Module 34.1, LO 34.f)

Questions #5-6 of 15

Use the following information to answer Questions 8 and 9.

Stock ABC trades for $60 and has 1-year call and put options written on it with an exercise price of $60. The annual
standard deviation estimate is 10%, and the continuously compounded risk-free rate is 5%. The value of the call is
$4.09.

Chefron, Inc. common stock trades for $60 and has a 1-year call option written on it with an exercise price of $60.
The annual standard deviation estimate is 10%, the continuous dividend yield is 1.4%, and the continuously
compounded risk-free rate is 5%.
Question #5 of 15 Question ID: 1256569

The value of the put on ABC stock is closest to:

A) $1.16.
B) $3.28.

C) $4.09.
D) $1.00.

Explanation

According to put/call parity, the put's value is:

(Module 37.2, LO 37.c)

Question #6 of 15 Question ID: 1256570

The value of the call on Chefron stock is closest to:

A) $3.51.
B) $4.16.

C) $5.61.
D) $6.53.

Explanation

ABC and Chefron stock are identical in all respects except Chefron pays a dividend. Therefore, the call option on
Chefron stock must be worth less than the call on ABC (i.e., less than $4.09). $3.51 is the only possible answer.

(Module 37.2, LO 37.c)

Question #7 of 15 Question ID: 1256571

An investor buys a Dec 2010 call of ABC limited stock with a strike of USD 85 for USD 6, and sells a Dec 2010 call
of ABC limited with a strike of 95 for USD 3. What is the name of this strategy and what is the maximum profit?

A) Bull spread Max profit 10

B) Bear spread Max profit 10

 C) Bull spread Max profit 7

D) Bear spread Max profit 7

Explanation

Bull and bear spreads are both constructed with either two calls or two puts with a lower and higher strike price.

Bull spread—buy the lower strike, sell the higher strike

Bear spread—buy the higher strike, sell the lower strike

This investor is buying low and selling high, so it is a bull spread.

Maximum profit is found at a price of 95. The profit consists of the following:

Profit on the long 85 call is $10.

Loss on the net premium (i.e., paid –6, earned +3) = –3.
Overall profit = +$7.

(Module 38.2, LO 38.c)

Question #8 of 15 Question ID: 1256572

Consider a bearish option strategy of buying one $50 put for $7, selling two $42 puts for $4 each, and buying one
$37 put for $2. All the options have the same maturity. Calculate the final profit per share of the strategy if the
underlying is trading at $33 at expiration.

A) $1 per share.

B) $2 per share.
C) $3 per share.
D) $4 per share.

Explanation

Consider each option separately:

$50 long put: $50 − $33 = +$17

$42 short put: $42 − $33 = –$9 × 2 = −$18

$37 long put: $37 − $33 = +$4

Net cost of options: (−7 + 8 − 2) = −$1

Overall profit per share: $2 per share

(Module 38.3, LO 38.d)

Question #9 of 15 Question ID: 1256573

Suppose you observe a 1-year (zero-coupon) Treasury security trading at a yield to maturity of 5% (price of
95.2381% of par). You also observe a 2-year T-note with a 6% coupon trading at a yield to maturity of 5.5% (price of
100.9232). And, finally, you observe a 3-year T-note with a 7% coupon trading at a yield to maturity of 6.0% (price
of 102.6730). Assume annual coupon payments and discrete compounding. Use the bootstrapping method to
determine the 2-year and 3-year spot rates.

2-year spot rate 3-year spot rate

A) 5.51% 5.92%

B) 5.46% 5.92%

C) 5.51% 6.05%

D) 5.46% 6.05%

Explanation

Here are the cash flows associated with the three bonds:

To find Z2, the 2-year spot rate:

To find Z3, the 3-year spot rate:

(Module 40.2, LO 40.j)

Question #10 of 15 Question ID: 1256575

A level-payment, fixed-rate mortgage has the following characteristics:

 Term 30 years.
Mortgage rate 9.0%.
Servicing fee 0.5%.
Original mortgage loan balance $150,000.

The monthly mortgage payment is:

A) $416.67.
B) $1,125.00.
C) $1,206.93.
D) $1,216.70.

Explanation

N = 360; I = 9/12 = 0.75; PV = 150,000; CPT → PMT = $1,206.93

(Module 42.1, LO 42.b)

Question #11 of 15 Question ID: 1256576

You are a fixed-income portfolio manager planning a six-month hedge for your portfolio value of $150 million. The
six-month T-bond futures contract is priced at 104-02 with a face value of $100,000. The duration of your portfolio is
9.2 and the duration of the futures contract is 10.7. What hedging strategy would be appropriate to protect your
portfolio against small yield changes?

A) Long 1,140 contracts.

B) Short 1,140 contracts.

C) Long 1,240 contracts.
D) Short 1,240 contracts.

Explanation

Number of contracts =

Number of contracts =

Futures value = $100,000 par × 1.040625 =

[Futures price = 104-02 (i.e., $104 + 2/32, so $104.0625)]

Number of contracts = $1,380 million / $1,113,474

Number of contracts = 1,239.36 (i.e., round up to 1,240 contracts)

As we wish to hedge exposure, we need to take a short position in 1,240 T-bond futures contracts.

(Module 43.3, LO 43.k)

Question #12 of 15 Question ID: 1256577

Company J and Company K enter into a 2-year plain vanilla interest rate swap. Company J agrees to pay Company
K a periodic fixed rate on a notional principal over the swap's tenor. In exchange, Company K agrees to pay
Company J a periodic floating rate on the same notional principal. Assume currency is the same, so the net
payment will be exchanged. The exchanges will be made semi-annually. The reference rate is the 6-month LIBOR.
The fixed rate of the swap is 1.1%, and the notional principal is $100 million. 6-month LIBOR rates are as follows:

Beginning of Period LIBOR

1 0.5%

2 0.75%

3 1.00%

4 1.25%

5 1.50%

What is the net payment for the end of the first period?

A) Company J pays Company K $300,000.

B) Company J pays Company K $550,000.
C) Company K pays Company J $250,000.
D) Company K pays Company J $50,000.

Explanation

Floating = $100 million × 0.005 × 0.5 = $250,000

Fixed = $100 million × 0.011 × 0.5 = $550,000

(Module 44.1, LO 44.a)

Question #13 of 15 Question ID: 1256565

Consider a U.K.-based company that exports goods to the EU. The U.K. company expects to receive payment on a
shipment of goods in 60 days. Because the payment will be in euros, the U.K. company wants to hedge against a
decline in the value of the euro against the pound over the next 60 days. The U.K. risk-free rate is 3% and the EU
risk-free rate is 4%. No change is expected in these rates over the next 60 days. The current spot rate is 0.9230 £
per €. To hedge the currency risk, the U.K. company should take a short position in a Euro contract at a forward
price of:

A) 0.9205.

B) 0.9215.
C) 0.9244.
D) 0.9141.

Explanation

The U.K. company will be receiving euros in 60 days, so it should short the 60-day forward on the euro as a hedge.
The no-arbitrage forward price is:

FT = £0.923 ×

(Module 33.2, LO 33.k)

Question #14 of 15 Question ID: 1256567

A 6-month futures contract on an equity index is currently priced at 1,276. The underlying index stocks are valued at
1,250 and pay dividends at a continuously compounded rate of 1.70%. The current continuously compounded risk-
free rate is 5%. The potential arbitrage is closest to:

A) 5.20.
B) 8.32.
C) 16.58.
D) 26.00.

Explanation

F = S × e(risk-free rate − dividend yield) × t

F = 1,250 × e(0.05 − 0.017) × 0.5

F = 1,270.80

The actual futures price is 1,276, so selling the futures and buying the underlying index nets a profit of 1,276 −
1,270.80 = 5.20.

(Module 34.1, LO 34.f)

Question #15 of 15 Question ID: 1256574

Former Treasury Secretary Robert Rubin decided to stop issuing 30-year Treasury bonds in 2001 and to replace
them by borrowing more with shorter-maturity Treasury bills and notes (although the U.S. Treasury has since
resumed issuing 30-year bonds). Which of the following statements concerning this decision is most accurate?

A) If the expectations theory of the term structure is correct, this decision will
reduce the government’s borrowing cost.
B) If the liquidity theory of the term structure is correct, this decision will
reduce the government’s borrowing cost.
C) If the liquidity theory of the term structure is correct, this decision will not
change the government’s borrowing cost.
D) If the expectations theory of the term structure is correct, this decision will
increase the government’s borrowing cost.

Explanation

If the expectations theory of the term structure is correct, altering the maturity of the government's borrowing will not
affect the government's borrowing cost (i.e., borrowing once for 30 years is the same as borrowing 30 times for one
year at a time). If the liquidity theory is correct, the government's borrowing cost will go down, as it no longer has to
compensate lenders with the liquidity premium for borrowing long term.

(Module 40.2, LO 40.k)