1. Suppose that Gene owns a perpetuity, issued by an insurance company that pays $1,250 at the end of each year. The insurance company now wishes to replace it with a decreasing perpetuity of $1,500 decreasing at 1% p.a. without any change in the payment dates. At what rate of interest (assuming a flat yield curve) would Gene be indifferent between the choices?
2. Which of the following is considered to be the responsibility of the legal risk manager?
I. Inadequate documentation of OTC derivatives transactions.
II. The enforceability of netting agreements in bankruptcy.
III. Default on interest and principal payments.
A. I only
B. II only
C. I and II only
D. I, II, and III
3. An analyst has constructed the following t-test for a portfolio of financial securities whose returns are normally distributed: Number of securities = 40.
H0: Mean return >= 18 percent.
Significance level = 0.1
What is the rejection point for this test?
4. Consider an A-rated institution that funds itself in the wholesale market at LIBOR + 90bps. Which of the following is the most attractive instrument for this firm to take exposure to an AAA-corporate issuer?
A. Credit swap.
B. Floating rate note.
C. Credit-linked note.
D. Fixed coupon bond.
5. Which of the following statements about the Treynor ratio is correct?
A. The Treynor ratio considers both systematic and unsystematic risk of a portfolio.
B. The Treynor ratio is equal to the excess return of a portfolio over the risk-free rate divided by the total risk of the portfolio.
C. The Treynor ratio can be used to appraise the performance of well-diversified portfolios.
D. The Treynor ratio is derived from portfolio theory since it assesses a portfolio's excess return relative to its risk.
1. Correct answer: B
1,250 / r = 1,500 / (r + 1%) or, 1,250 x (r + 1%) = 1,500 x r or, r = 12.5 / (1,500 - 1,250) = 5%.
2. Correct answer : D
Legal risk management is concerned with adequate documentation, public filings, compliance with regulatory entities, and some borrower impositions. The legal manager is also involved in deciding if default has occurred and, if so, assisting with the enforcement of netting agreements.
3. Correct answer: A
This is a one-tailed test with 39 degrees of freedom and significance level of 0.1. Looking up the Student's t-distribution for df = 39 and p = 0.1, we get the critical value of 1.304.
4. Correct answer: A
This firm has a fairly high funding cost. Funding itself at 90 bps over LIBOR and lending to AAA names at around LIBOR is a loss making strategy, which rules out the notes and the bond. The only way this firm can make money is by selling credit protection via a credit swap that does not require it to make a physical investment.
5. Correct answer: C
A is incorrect - Treynor ratio considers only systematic risk of a well-diversified portfolio
B is incorrect - Treynor ratio denominator is beta of the portfolio
C is correct - this statement is correct
D is correct - Treynor ratio is derived from CAPM and not portfolio theory.