The loss to the fund manager is $20*100 = $2,000. The initial margin placed was $5,000. After the loss is charged to his account, the margin balance is only $3,000 ($5,000 - $2,000). The margin to be maintained is $5,000. Therefore the margin call is $2,000.

Note that there would have been no margin call till the balance in the margin account had reduced to the ' maintenance ' level of $4,000. So if the price had fallen by $5, and the loss had been $500, there would have been no margin call. But when the margin call would be made, it would require the balance to be brought up to the initial margin of $5,000 (and not the maintenance margin of $4,000).

The vast majority of exchange traded futures contracts are closed out prior to expiry by the parties acquiring offsetting positions. Very few contracts are settled by delivery. Since P & L on futures contracts is settled daily, ' cash settlement ' really does not mean much as only the previous day ' s P & L is due or receivable on any given day.

The put-call parity can be expressed as:

Call – Put = Spot – PV of exercise price

Note that a negative sign above means a short position. The ' term PV of exercise price ' is the same as a bank deposit placed today equivalent to the PV of the exercise price so that we will have the cash flow on the exercise date to exercise the option.

Therefore only Choice ' d ' is the correct answer as rearranging the above gives us Buying a call + Bank Deposit = Buying the stock + Buying a put.

Choice ' d ' is therefore the correct answer.

The OTC market for foreign exchange is indeed much larger than the exchange traded futures market for FX. Therefore statement I is correct.

Delivery-versus-payment (DVP) arrangements make sure that title to a security passes only when payment has been made, and these arrangements, usually implemented through national clearing agencies such as the DTC in the US, help avoid the risk of counterparty defaults.

Electronic Clearing Networks (ECNs) offer cheaper trading costs than exchanges, in fact that is their primary attraction. Exchanges offer other advantages, but lower trading costs is not one of them.

ISDA master agreements provide templates that a large number of OTC market participants use to standardize their OTC trading activities. Therefore statement IV is correct.

Some parts of this question draw upon contingent claims framework to the value of a firm. According to this framework, the relationship between the debt and equity holders of a firm can be viewed as follows: The equity holders have a call option on the assets of the firm with a strike price equal to the value of the debt, and the debt holders have sold them this call. This is so because should the value of the assets of the firm fall below the value of the debt, the equity holders can walk away by handing over the assets to the debt holders in full extinguishment of their claims. If the value of the firm ' s assets is greater than the value of debt, the equity holders will exercise their call option. At the same time, it is also possible to view the debtholders as holding an asset and having sold a put on the assets of the firm with a strike price equal to the value of the debt. If the value of the assets of the firm were to fall below the value of the debt, they will end up buying the assets at a price equal to the value of the debt.

An increase in the volatility of returns on the assets of a firm increases the volatility of the asset value. This means the likelihood that the asset value will go below the value of the debt of the firm will increase. Callable debt can be considered to be a summation of two separate securities: a regular debt, for which the firm pays interest and receives a principal loan; and a call option that the debt holders have sold to the firm allowing the firm to buy back the debt. In return, the firm pays an implied ' premium ' to the debt holders who have agreed to buy the callable debt. Therefore the total payments by the company to callable debt holders is equal to the interest payments plus the premium payment for the option. An increase in asset volatility will increase the value of this option as it is likely that the assets will increase in value, and strengthen the company ' s credit, and lower its spread at which time it would like to repay the debt and refinance/roll over at the new lower rate. Therefore an increase in volatility will increase the ' premium ' demanded by the callable debt holders, thereby increasing the total yield and lowering the value of the callable debt. Therefore Choice ' b ' (An increase in the value of the callable debt of the firm) is incorrect.

An increase in asset volatility will decrease the value of the firm as it is now riskier than before (higher standard deviation, same expected returns). Therefore Choice ' a ' (An increase in the value of the equity of the firm) is false too.

The value of the implicit put in the debt of the firm will increase and not decrease as the volatility of the underlying assets increases. Therefore Choice ' c ' (A decrease in the value of the implicit put in in the debt of the firm) is incorrect too.

Choice ' d ' (A decrease in the value of the non-callable debt issued by the firm) is correct because higher asset volatility will increase the riskiness of the company ' s debt, making the required yield higher and decreasing its value.

The forward price for a commodity is nothing but the spot price plus carrying costs till the maturity date of the forward contract. Any increase in carrying costs therefore has the effect of increasing the forward price. Note that carrying costs include interest cost in respect of funding the position, costs of storage, less any convenience yield.

Increase in the carrying costs will not affect the spot prices.

This question relates to the Black Scholes PDE (partial differential equation). The Black Scholes PDE is derived by combining the results of a stock price following a Weiner process with a mathematical result known as Ito ' s lemma and holds true for all derivatives whose prices depend upon S, the price of the underlying and upon t, which indicates time.

The derivation of the Black Scholes PDE is beyond the scope of the PRM syllabus (and also of the author of this question), but we need to know what it is. The PDE can be written as:

202.21.q1

Substituting , this can also be written as

202.21.e

202.21.q2

Therefore the first and the second equations are correct, and the other two are wrong. Choice ' c ' is the correct answer.

You should know the PDE in case there is a numerical question about it. The two ways of writing it (as I and II above in the question) express the same relationship. The BSM formula itself for valuing a vanilla European option is based upon the PDE. Most other options are also valued using the fundamental relationship expressed in the PDE.

The stock has a beta of 1.2, therefore intuitively it can be expected to earn more than the broad market index. It will earn the risk free rate, ie 3%, and 1.2 times the equity risk premium of 5% (8% - 3%). The expected returns from the stock therefore are 3% + (8% - 3%)*1.2 = 9%

Interest rate caps are effectively call options on an underlying interest rate that protect the buyer of the cap against a rise in interest rates over the agreed exercise rate. As with options, the premium on the cap depends upon the volatility of the underlying rates as one of its variables. A floor is the exact opposite of a cap, ie it is effectively a put option on an underlying interest rate that protects the buyer of the floor against a fall in interest rates below the agreed exercise rate.

A cap protects a borrower against a rise in interest rates beyond a point, and a floor protects a lender against a fall in interest rates below a point.

A collar is a combination of a long cap and a short floor, the idea being that the premium due on the cap is offset partly by the premium earned on the short floor position. Therefore a collar is less expensive than a cap or a floor.

Caps, floors and collars provide a hedge against interest rate risks, but do not protect against changes in credit spreads unless the reference rate already includes the spread (eg, by reference to the corporate bond rate), and they certainly do not have anything to do with gamma risk. Therefore Choice ' c ' is the correct answer.

Since $100 is convertible into two shares, the price upon conversion per share is $50, which is the same as the current share price. Therefore there is no premium, and Choice ' c ' is the correct answer.