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FRM 2007 PI q16 - Interest Rate Floor

fullofquestions

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QUESTION
The payoff to a swap where the investor receives fixed and pays floating can be
replicated by all of the following except:

a. A short position in a portfolio of FRAs.
b. A long position in a fixed rate bond and a short position in a floating rate bond.
c. A short position in an interest rate cap and a long position in an interest rate floor.
d. A long position in a floating rate note and a short position in an interest rate floor.

CORRECT: D

The payoff to a swap where the investor receives fixed and pays floating could not be
replicated by a long position in a floating rate note and a short position in an interest rate
floor, since an investor in a long position in a floating rate note would receive floating and
an investor in a short position in an interest rate floor would pay fixed.

Reference: John Hull, Options, Futures, and Other Derivatives, 6th ed. Chapter 7.

INCORRECT: A
The payoff to a swap where the investor receives fixed and pays floating could be replicated by a
short position in a portfolio of forward rate agreements.
INCORRECT: B
The payoff to a swap where the investor receives fixed and pays floating could be replicated by a
long position in a fixed rate bond and a short position in a floating rate bond.
INCORRECT: C
The payoff to a swap where the investor receives fixed and pays floating could be replicated by a
short position in an interest rate cap and a long position in an interest rate floor.


As a matter of fact, I get the answer because a long position on a floating rate note means receiving floating so that is all you need for the answer. The question regards a short position in an interest rate floor. If index rate >= floor rate then short pays 0. Otherwise, short pays the difference. How is this considered to be a fixed amount?
 
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