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.

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.

The price of a treasury bill can be calculated as [Future value / (1 + yield x days-to-maturity/365)] = 100/(1+5%*90/365) = $98.78.