6. The risk-neutral default probability and the real-world (or physical) default probability are used in the analysis of credit risk. Which one of the following statements on their uses is correct?

A. Real-world default probability should be used in scenario analyses of potential future losses from defaults, and real-world default probability should also be used in valuing credit derivatives.

B. Real-world default probability should be used in scenario analyses of potential future losses from defaults, but risk-neutral default probability should be used in valuing credit derivatives.

C. Risk-neutral default probability should be used in scenario analyses of potential future losses from defaults, and risk-neutral default probability should also be used in valuing credit derivatives.

D. Risk-neutral default probability should be used in scenario analyses of potential future losses from defaults, but real-world default probability should also be used in valuing credit derivatives.

7. You want to implement a portfolio insurance strategy using index futures designed to protect the value of a portfolio of stocks not paying any dividends. Assuming the value of your stock portfolio decreases, which strategy would you implement to protect your portfolio?

A. Buy an amount of index futures equivalent to the change in the call delta × original portfolio value.

B. Sell an amount of index futures equivalent to the change in the call delta × original portfolio value.

C. Buy an amount of index futures equivalent to the change in the put delta × original portfolio value.

D. Sell an amount of index futures equivalent to the change in the put delta × original portfolio value.

8. Which of the following mortgage backed securities has a negative duration?

A. Interest-Only strips (IO).

B. Inverse floater.

C. Mortgage pass-through.

D. Principal-Only strips (PO).  

9. A portfolio manager wants to hedge his bond portfolio against changes in interest rates. He intends to buy a put option with a strike price below the portfolio's current price in order to protect against rising interest rates. He also wants to sell a call option with a strike price above the portfolio's current price in order to reduce the cost of buying the put option. What strategy is the manager using?

A. Bear spread

B. Strangle

C. Collar

D. Straddle 

10. Sylvia, a portfolio manager, established a Yankee bond portfolio. However, she wants to hedge the credit and interest rate risk of her portfolio. Which of the following derivatives will best fit Sylvia's need?

A. A total return swap

B. A credit default swap

C. A credit-spread option

D. A currency swap

6. The risk-neutral default probability and the real-world (or physical) default probability are used in the analysis of credit risk. Which one of the following statements on their uses is correct?

A. Real-world default probability should be used in scenario analyses of potential future losses from defaults, and real-world default probability should also be used in valuing credit derivatives.

B. Real-world default probability should be used in scenario analyses of potential future losses from defaults, but risk-neutral default probability should be used in valuing credit derivatives.

C. Risk-neutral default probability should be used in scenario analyses of potential future losses from defaults, and risk-neutral default probability should also be used in valuing credit derivatives.

D. Risk-neutral default probability should be used in scenario analyses of potential future losses from defaults, but real-world default probability should also be used in valuing credit derivatives.

Correct answer is B

A is incorrect. Risk-neutral default probability should be used in valuing credit derivatives.fficeffice" />

B is correct. Real-world default probability should be used in scenario analyses of potential future losses from defaults, but risk-neutral default probability should be used in valuing credit derivatives.

C is incorrect. Real-world default probability should be used in scenario analyses of potential future losses from defaults

D is incorrect. Real-world default probability should be used in scenario analyses of potential future losses from defaults

Reference: John Hull, Options, Futures, and Other Derivatives, 6th ed. (ffice:smarttags" />New York: Prentice Hall, 2006), Chapter 21.

7. You want to implement a portfolio insurance strategy using index futures designed to protect the value of a portfolio of stocks not paying any dividends. Assuming the value of your stock portfolio decreases, which strategy would you implement to protect your portfolio?

A. Buy an amount of index futures equivalent to the change in the call delta × original portfolio value.

B. Sell an amount of index futures equivalent to the change in the call delta × original portfolio value.

C. Buy an amount of index futures equivalent to the change in the put delta × original portfolio value.

D. Sell an amount of index futures equivalent to the change in the put delta × original portfolio value.

Correct answer is D

A is incorrect. For portfolio insurance strategy to work, index futures should be sold in an amount corresponding to the change in the put delta × original portfolio value.

B is incorrect. For portfolio insurance strategy to work, index futures should be sold in an amount corresponding to the change in the put delta × original portfolio value.

C is incorrect. For portfolio insurance strategy to work, index futures should be sold in an amount corresponding to the change in the put delta × original portfolio value.

D is correct. Portfolio insurance strategy is accomplished by selling index futures contracts in an amount equivalent to the proportion of the portfolio dictated by the delta of the required put option. When a decrease in the value of the underlying portfolio occurs, the amount of additional index futures sold corresponds to the change in the put delta × original portfolio value.

Assigned Reading:  John Hull, Options, Futures, and Other Derivatives, 6th ed. (New York: Prentice

Hall, 2002), Chapter 15.

8. Which of the following mortgage backed securities has a negative duration?

A. Interest-Only strips (IO).

B. Inverse floater.

C. Mortgage pass-through.

D. Principal-Only strips (PO).  

Correct answer is A

A is correct.   If interest rates fall, IO strips will decrease in value, the other 3 securities will increase in value.

B is incorrect. If interest rates fall, IO strips will decrease in value, the other 3 securities will increase in value.

C is incorrect.   If interest rates fall, IO strips will decrease in value, the other 3 securities will increase in value.

D is incorrect.   If interest rates fall, IO strips will decrease in value, the other 3 securities will increase in value.

Reference:  Fixed Income Securities,  by Bruce Tuckman.

Chapter 21 Mortgage-Backed Securities  covers the mortgage derivatives IO and PO on page 475.

If interest rates fall, mortgage prepayments will accelerate.   PO investors will receive their payments earlier than anticipated.  Therefore PO strips will increase in value.

If interest rates fall, IO strips will decrease in value.  This is due to increased mortgage prepayments will cause the outstanding principal  to shrink, that means a decrease in the interest payments.

9. A portfolio manager wants to hedge his bond portfolio against changes in interest rates. He intends to buy a put option with a strike price below the portfolio's current price in order to protect against rising interest rates. He also wants to sell a call option with a strike price above the portfolio's current price in order to reduce the cost of buying the put option. What strategy is the manager using?

A. Bear spread

B. Strangle

C. Collar

D. Straddle 

Correct answer is C

A is incorrect. The description is not for bear spread. A bear spread is created by buying a nearby put and selling a more distant put. A bear spread can also be set up using calls.

B is incorrect. The description is not for box spread. If the options are correctly priced, then the risk free rate will be earned for a box spread.

C is correct. The description is for a collar strategy which limits changes in the portfolio value in either direction. In other words, a collar is defined around the current portfolio value.

D is incorrect. The description is not for straddle. A straddle is created by buying a put and a call at the same strike price and expiration to take advantage of significant portfolio moves in either direction.

10. Sylvia, a portfolio manager, established a Yankee bond portfolio. However, she wants to hedge the credit and interest rate risk of her portfolio. Which of the following derivatives will best fit Sylvia's need?

A. A total return swap

B. A credit default swap

C. A credit-spread option

D. A currency swap

Correct answer is A

A is correct as total return swap exchanges all the cash flows by referencing an underlying asset.

B is incorrect as credit default swap becomes in effect when and only when credit event occurs.

C is incorrect as its payoff is a contigency.

D is incorrect as currency swap is not a credit derivative.

Reference: John B. Caouette, Edward I. Altman & Paul Narayanan, Managing Credit Risk, (New York: Wiley, 1998), Chapter 20