Free PRMIA 8005 Practice Exam with Questions & Answers | Set: 5

Remember that:

- American options can be exercised at any time up to expiry

- European options can only be exercised at expiry

- Bermudan options can be exercised prior to expiry but only at certain dates or during certain specified periods, and not otherwise

- Since an American option can be exercised at any time prior to expiry while a European option can only be exercised at expiry, an American option will always be worth more than a European option

Therefore the first three statements are incorrect and Choice 'd' is the correct answer.

Under the contingent claims approach, a firm will default on its debt when the value of its assets fall to less than the face value of the debt. Debt holders can protect themselves against such an event by buying a put on the assets of the firm, where the strike price is equal to the value of the debt. In other words, Risky Debt + Put on the firm's assets = Risk free debt. This is because if the value of the assets is greater than the value of the debt, they will be paid in full. If the value of the assets is lower than the value of the debt, they will exercise the put and be paid in full.

Therefore the value of the put on the firm's assets with a strike equal to the value of the debt represents the cost of eliminating credit risk. Choice 'b' is the correct answer.

Note that it is improbable that a put on the firm's assets is available in real life to debt holders. However, the same effect can be synthetically achieved by using the shares of the firm as a proxy for its assets, and shorting an appropriate number of shares. Such a synthetic put will require frequent readjustments.

A computation of Altman's Z-score considers the following ratios:

- Working capital to total assets

- Retained earnings to total assets

- EBIT to total assets

- Market cap to debt

- Sales to total assets

Nearly all the numbers above are accounting measures derived straight from the balance sheet or the income statement. Market capitalization is a market driven number. Therefore Choice 'c' is the correct answer as the Altman credit risk score considers both accounting and market based measures.

Altman's score, though computationally straightforward and intuitively easy to understand, was introduced in the late sixties and has been very accurate in predicting corporate bankruptcies, which is why it continues to be used extensively.

Average rate options will be the most cost effective in this scenario as they are cheaper than vanilla options. Writer extendible options on commodities will be even more expensive, and correlation products are irrelevant to the manufacturing company's hedging needs.

Eurodollar deposits refer to US dollar denominated deposits outside the US, for example in a banking center such as London, and held by a non-US bank or a foreign branch of a US bank. Choice 'b' is the correct answer.