16. A bronze producer will sell 1,000 mt (metric tons) of bronze in three months at the prevailing market price at that time. The standard deviation of the change in the price of bronze over a 3-month period is 2.6%. The company decided to use 3-month futures on copper to hedge the exposure. The copper futures contract is for 25 mt of copper. The standard deviation of the futures price is 3.2%. The correlation between 3-month changes in the futures price and the price of bronze is 0.77. To hedge its price exposure, how many futures contracts should the company buy/sell?

A. Sell 38 futures

B. Buy 25 futures

C. Buy 63 futures

D. Sell 25 futures

17. Which of these transactions will NOT result in a credit loss for Bank A in the event of default before maturity by Bank A's counterparty?

I. Bank A buys an ATM (at-the-money) call option on the USD/CHF and the CHF subsequently depreciates against the USD.

II. Bank A buys an interest rate cap and interest rates are below the cap level.

III. Bank A goes long AUD through an OTC forward contract on the AUD/YEN and the AUD subsequently appreciates against the YEN.

IV. Bank A receives fixed in an interest rate swap and interest rates have risen.

A. II & III.

B. II & IV.

C. I, II & III.

D. I, III & IV.

18. A company has a constant 7% per year probability of default. What is the probability the company will be in default after three years?

A. 7%

B. 19.6%

C. 21%         

D. 22.5%

19. The KMV model measures the normalized "distance from default". How is this defined?

A. (Expected Assets - Weighted Debt) / (Volatility of assets)

B. Equity/ (Volatility of equity)

C. Probability of stock price falling below a threshold

D. Leverage x Stock Price Volatility

20. What is the lowest tier of an investment grade credit rating by Moody's?

A. Baa1

B. Ba1

C. Baa3

D. Ba3

16. A bronze producer will sell 1,000 mt (metric tons) of bronze in three months at the prevailing market price at that time. The standard deviation of the change in the price of bronze over a 3-month period is 2.6%. The company decided to use 3-month futures on copper to hedge the exposure. The copper futures contract is for 25 mt of copper. The standard deviation of the futures price is 3.2%. The correlation between 3-month changes in the futures price and the price of bronze is 0.77. To hedge its price exposure, how many futures contracts should the company buy/sell?

A. Sell 38 futures

B. Buy 25 futures

C. Buy 63 futures

D. Sell 25 futures

Correct answer is D

To hedge the exposure, the company should sell futures and not buy.  Their profits will be adversely affected by declines in the price.  The number of contracts to sell, N, equals (Beta x Size of the position)/Size of one futures contract. fficeffice" />

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Reference: Options, Futures, and Other Derivatives by C. Hull, 2006.

17. Which of these transactions will NOT result in a credit loss for Bank A in the event of default before maturity by Bank A's counterparty?

I. Bank A buys an ATM (at-the-money) call option on the USD/CHF and the CHF subsequently depreciates against the USD.

II. Bank A buys an interest rate cap and interest rates are below the cap level.

III. Bank A goes long AUD through an OTC forward contract on the AUD/YEN and the AUD subsequently appreciates against the YEN.

IV. Bank A receives fixed in an interest rate swap and interest rates have risen.

A. II & III.

B. II & IV.

C. I, II & III.

D. I, III & IV.

Correct answer is B

'I' is incorrect. It would result in a credit exposure as the option has moved in-the-money and has a positive value to Bank A.

'II' is correct. It would not result in any losses, as the option is out-of-the-money.

'III' is incorrect. It would result in a loss as the contract has a positive value to Bank A.

'IV' is correct. It would not result in any losses, as the replacement cost of finding a new fixed-rate payer is lower.

18. A company has a constant 7% per year probability of default. What is the probability the company will be in default after three years?

A. 7%

B. 19.6%

C. 21%         

D. 22.5%

Correct answer is B

The probability that the firm will be in default in three years = 1- (1-0.07)3 = 19.6%

A is incorrect.  7% is the probability of default in one year.

C is incorrect.  21% = 0.07x3

D is incorrect.  22.5% = 1.073 ?1

Reference: Measuring and Managing Credit Risk, De Servigny and Renault, 2004.

19. The KMV model measures the normalized "distance from default". How is this defined?

A. (Expected Assets - Weighted Debt) / (Volatility of assets)

B. Equity/ (Volatility of equity)

C. Probability of stock price falling below a threshold

D. Leverage x Stock Price Volatility

Correct answer is A

The distance to default is defined as (Expected Assets ? weighted debt) / (Volatility of assets), where weighted debt =short-term debt + 1/2 Long term debt.  It is a normalized measure of default and therefore may be used for comparing one company to another. It is an ordinal measures akin to a bond rating.  It does not tell you the probability of default.  In order to extend this measure to a probability of default, KMV uses historical default rates to determine an expected default frequency as a function the distance to default.

Reference:  Measuring and Managing Credit Risk, De Servigny and Renault, 2004.

20. What is the lowest tier of an investment grade credit rating by Moody's?

A. Baa1

B. Ba1

C. Baa3

D. Ba3

Correct answer is C

Investment grade debt is debt rated BBB-rated or better by Standard's and Poor and Baa3 or better by Moody's.

Reference: Measuring and Managing Credit Risk, De Servigny and Renault, 2004.