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

Consider a long vanilla call at a strike of K1, and a short call with a strike price of K2 so that K2>K1. If you construct the payoff diagrams for these option positions, you will see that the combined payoff resembles very closely the payoff of a digital cash-or-nothing option. By bringing K2 and K1 closer together, we can make it very close to a digital cash-or-nothing option. Therefore Choice 'c' is the correct answer.

A zero coupon bond has a Macaulay duration equal to its maturity, ie in this case 5 years. We can calculate modified duration from Macaulay duration by using the following relationship:

Modified duration = Macaulay duration/(1 + y) where y is the yield.

Therefore the correct answer is 5 / (1.05) = 4.76.

Or intuitively, all the other answers appear clearly incorrect: 5 and 5.25 are too high, and 4 is too low. Therefore the only reasonable choice is 4.76.

As a bond approaches maturity, its value will be driven less by the time value of money or its coupons, and more by its redemption value, ie the par. Therefore as maturity approaches, its value converges to its par value and this phenomenon is called pull to par.