Free PRMIA 8005 Practice Exam with Questions & Answers | Set: 4

The existence of derivative markets actually drives liquidity out of cash markets into derivative markets. Derivative markets are far more liquid than cash markets. Therefore statement I is not correct.

In times of crises, instruments or financial products bearing greater credit risk lose liquidity rapidly. Therefore statement II is correct.

A higher bid-ask spread indicates lower liquidity, not greater liquidity. Therefore statement III is false.

Normal market size (NMS) refers the 'normal' transaction size for which a dealer's quote is valid. A higher NMS is associated with greater liquidity, therefore statement IV is correct.

According to the option pricing approach developed by Merton, the shareholders of a firm have a put on the assets of the firm where the strike price is equal to the face value of the firm's debt. This is just a more complicated way of saying that the debt holders are entitled to all the assets of the firm if these assets are insufficient to pay off the debts, and because of limited liability of the shareholders of a corporation this part payment will fully extinguish the debt.

A firm will default on its debt if the value of the assets falls below the face value of the debt. Therefore Choice 'a' is the correct answer. All other choices are incorrect.

(There are two ways to consider this sort of optionality, and I have mentioned only one for this question:

1. The equity holders can sell the assets of the firm to the debt holders at a price equal to the face value of the debt, ie a put. (ie they can extinguish their liability to the debt holders in full by handing them the assets of the firm, effectively selling them the assets at the value of the debt)

2. The equity holders have a long position in a call option where they can keep the assets of the firm by paying a price equal to the face value of the debt (ie, they can pay off the debt holders and keep the assets)

For this question, perspective 1 applies but you should be aware of the second one too as a question may reference that view point.)

One may use separate UoMs for frequency and severity modeling, for example, a combined UoM may be used for estimating the frequency of cyber attacks in a scenario, while the severity may be modeled using a more granular line-of-business UoM. Therefore statement I is false, while statement IV is true.Statement II is correct, UoMs can be grouped together into larger units based on the facts relating to the business, controls and the business environment. Similarly, UoMs can be grouped together based on statistical clustering techniques using the 'distance' between the units of measure and combining UoMs that are closer to each other. In addition, it is also possible to combine both business knowledge and statistical algorithms to combine UoMs.

Treasury bills are short-term government securities with maturities ranging from a few days to 52 weeks. Bills are sold at a discount from their face value, and do not carry a coupon.