8006 Exam Dumps : Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

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%

The effect of higher convexity is that when yields rise, the price decrease is lower than the increase in yields, and when yields fall, the increase in price is greater than the fall in yield. In either case, it benefits the holder of the fixed income instrument that carries such positive convexity. The converse is true for someone short a bond - such an investor would prefer lower convexity to higher convexity. Therefore statement I is not true for an investor who is short a bond.

An increase in yields makes bond prices decrease, something that would benefit the short. Therefore statement II is true for an investor short a bond.

Negative convexity has exactly the opposite effect as the one described for positive convexity for statement I above. An investor short a bond would prefer negative convexity (which by the way is exhibited by very few fixed income instruments such as mortgages) to positive convexity, therefore statement III is true for such an investor.

Choice 'b' is the correct answer.

Explanation:

If the spot rate is 1.1010 and the forward is 1.1040, the swap rate is 30 "points" (= 1.1040 - 1.1010). The annualized swap premium is the swap premium divided by the spot rate, and therefore =0.0030/1.1010 =0.27%, or 27 basis points.