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FRM exam 2008 Practice

Shradha

New Member
Hi David,

Just would like to tell you that your FRM material has been excellent, and all the Q's are answered in such a simple way. It is commendable.

Could you pls also help me out with a practice exam 2008 Q.

Your firm is holding a short position in Argentian bond with a notional value of ARS 5000000 & a coupon yield of 5.5%, Your model predicts the bonds yield to decrease over the coming yr. U r asked to hedge the position. Ur recommendation is

a) Buy a credit default swap
b) Sell a credit-spread put option
c) Short a credit spread forward
d) Buy a total rate of return swap.

Mini
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
Hi Mini,

I think it's a flawed question, but (D) appears to be the best choice among bad options.
IMO, the best here (i.e., to hedge a yield decrease and price increase) might be to go LONG (to buy) a CREDIT-SPREAD CALL; i.e., for a yield decrease, the long here would profit. But (D) is okay but overkill on the hedge.

(a) doesn't work, CDS doesn't protect against market risk (yield change)
(b) is not really a hedge. To sell the CS put is to receive the up-front put premium. Then, if yield do decline (I am being a bit imprecise myself here. When i say yields decline, I mean, the spread narrows), the CS put buyer will be unable to exercise. So, this doesn't hurt the hedger but it's not a hedge
(c) is on the wrong side. If yields decrease, then short loses to the long, who profits.
(d) "To Buy" a swap makes the reader do too much work. Should say payer/receiver. Assuming the question has the correctly (a leap of faith!), to buy = TROR Payer. Okay, this is the best answer. It is overkill (it hedges everything) but it protects against price increases.

Note, too, when says "the bond's yield will decrease," this could refer to either a narrowing of the spread (i.e., credit improvement in the bond) or just a yield curve shift down (market risk), so that's not really addressed.

Hope that helps!

*** Thank you for your kind support! Especially ahead of the exam, when i imagine stress is high, it is very nice of you to offer such feedback. After the exam, please come back and tell me your impressions!!

David
 
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