The efficient markets hypothesis states that all known information is captured in the prices of a security. It does not explain the shape of the yield curve.

The expectations hypothesis, the LPT and the market segmentation theory are all attempts to explain the shape of the term structure of interest rates.

Therefore Choice ' c ' is the correct answer as it does not explain the shape of the yield curve.

An out of the money convertible security behaves just like a regular debt security as the option is near worthless. Therefore it is affected by changes in interest rates and the credit risk of the issuer, and unaffected by changes in the prices or volatility of the issuer ' s shares (the underlying).

The dates on which the interest rates applicable to the floating rate leg of an IRS are determined are called ' reset dates ' . Choice ' c ' is the correct answer, the other choices are incorrect. Settlement date is the date a transaction settles, normally a few days after the trade is done depending upon the market. Trade date is the date the terms of the transaction are agreed. (Settlement normally happens on T+n, where T is the trade date, and n the number of days to settlement as decided by agreement or market convention.)

There are two ways to think about this question: First, because the asset manager thinks that interest rates are going to decline, his profit will be maximized if he buys the bond with the greatest duration. The zero coupon bond has the greatest duration among the alternatives listed. Therefore Choice ' c ' is the correct answer.

The second way to look at this question is to consider what is called ' reinvestment risk ' . Yields to maturity calculations have an implicit assumption that any cash flows received prior to maturity are investible at the ytm rate. Thus, an yield to maturity calculation for a coupon bearing bond assumes that coupon payments get invested at the same rate as the calculated ytm from the time they are received till the time the bond matures. In an environment where interest rates fall, this assumption will not hold true. Reinvestment risk is the risk that coupons will not be able to earn the ytm that the bond was brought at - and the investor will be at a loss to the extent the money does not earn the ytm rate till the end of the investment. One way to reduce reinvestment risk is to minimize coupon receipts so the money stays invested as part of the bond, and the zero coupon bond helps to do exactly that.

All the statements are correct, and represent the relationships between the values of the Greek variables for calls and puts for the same option. It is important to know why as the PRM exam often asks tough questions about the Greeks.

Statement I is correct because of the put-call parity. According to the put-call parity,

Value of call - Value of put = Spot price - Exercise price discounted to the present

Now the delta of the spot is 1, and that of the discounted price is zero. Therefore

Delta of Call - Delta of Put = 1 - 0, or by rearranging we get the equation in statement I.

Statements II and III are correct as the gamma and vega of both the spot price and the discounted price are zero. Therefore using the put-call parity, we can say

Gamma of Call - Gamma of Put = 0 - 0, and

Vega of Call - Vega of Put = 0 - 0

Rearranging, we get statements II and III.

Statement IV is correct because of the following relationship between theta of call and theta of put:

Theta of Put = Theta of Call + rKe^(-rt).

Since rKe^(-rt) can only be a positive number, theta of put can only exceed the theta of a call. However, since theta is generally negative, it often implies that the theta of a call is the larger absolute number.

Additional explanation for the last point: Assume rKe^(-rt) =+1 and theta of a put is -5 (completely hypothetical)

Now Theta of Put = Theta of Call + rKe^(-rt)

Ie -5 = -6 + 1

Now -5 is the larger number than -6. In other words, theta of put exceeds that of the call in a pure mathematical sense, which is what I mean when I say “theta of put can only exceed the theta of call”. But if you ignore the sign, then theta of call is larger at 6 when compared to 5. Therefore the theta of the put is greater than the theta of the call – which is what the answer says.

A short squeeze results when short sellers are trying to cover their short positions by buying in the spot markets, which do not have adequate supply. This results in sharp spikes in spot prices, which further forces any other shorts to try cut their losses. The result is a sharp rise in spot prices.

Choice ' a ' is the correct answer, the other choices do not describe a short squeeze.

The dividend payment has a present value of $2.20*e^( -6%*6/12) = $2.14. Therefore the forward price for delivery 9 months hence should be ($102 - $2.14)*e^(7%*9/12) = $105.25

This question is based upon a weather derivative contract traded on the CME in the US. For each day, ' Heating-Degree-Days ' (HDD) is calculated as equal to 65 degrees Fahrenheit minus the daily average temperature. The daily average temperature is based upon the temperature reported by the Earth Satellite Corporation using a specified automated weather station. Based upon daily values of HDD, an aggregated number called the ' CME degree days index ' is calculated for each contract month. In other words, the index for a particular month is just the aggregation of the ' HDD ' value for each of the days of that month. Each contract settles at the end of the month at a value equal to $20 x Degree Days Index. (In a similar way, ' Cooling Degree Days ' are also calculated and a futures contract offered, except that CDD is equal to the average daily temperature minus 65 degrees). (Source: CME ' s website at CMEGroup.com)

In the given question, we are interested in hedging against the possibility of the temperature being too low. This means we should buy the HDD futures contract (the lower the temperature, the higher the difference of the average temperature from 65 degrees, and the higher the settlement). Therefore Choice ' b ' is the correct answer. The lower the actual temperature turns out to be, the higher the payout to the grower. It would not be wise to wait till January to buy the contract as by then the prices of the contract would have already risen if the grower ' s fears of a colder January appear to be coming true. He can hedge his exposure by immediately locking in the January prices.

The duration matched hedge is the best hedge for the bond manager. Matched durations in the bond portfolio and the hedge positions will ensure that any decline in the bond portfolio due to interest rate changes is matched by a rise in the futures position. Hedging dollar-to-dollar will not work unless the bonds and the futures contracts are identical in duration terms. For example, if the duration of the portfolio is 7 years, and each futures contract has a duration of 3.5 years, then selling $1m in value will only cover half the risk. Choice ' b ' is the right answer.

The forward rate from year 2 to year 3 in this case can be derived as =(1.05^3/1.04^2) - 1, or 7.03%. All other answers are incorrect.