GARP Updated 2016-FRR Exam Questions and Answers by dina

When trading exotic options, various risks need to be considered. Spot foreign exchange risks (I) involve the risk associated with the current exchange rate fluctuations. Forward foreign exchange risks (II) pertain to the risks related to future exchange rate changes agreed upon in forward contracts. Plain vanilla options risks (III) include the standard risks associated with basic option trading, such as volatility and time decay. Option-specific risks (IV) refer to the unique risks inherent in the specific exotic option being traded, such as path-dependency, barrier levels, and the complexity of modeling their payoffs. All these risks collectively impact the trading of exotic options.

The value of an option is influenced by several factors, including the perceived volatility of the underlying asset, in this case, foreign exchange rates. As the perceived future volatility of foreign exchange rates increases, the value of all options (both calls and puts) also increases. This is because higher volatility increases the likelihood that the option will end up in-the-money, thereby increasing its potential payoff. This relationship is fundamental to option pricing models, such as the Black-Scholes model, which incorporate volatility as a key input.

References:This explanation aligns with the principles of option valuation discussed in "How Finance Works" document, which details the effects of volatility on option pricing​​.

Initial Data:

Principal: $1,000,000

Initial Probability of Default (PD): 2%

Initial Loss Given Default (LGD): 50%

Risk-Free Rate: 6%

Interest Rate Spread: 3%

New Data:

New PD: 10%

New LGD: 75%

Expected Loss Calculation:

Initial Expected Loss: 2%×50%=1%2%×50%=1%

New Expected Loss: 10%×75%=7.5%10%×75%=7.5%

Interest Rate Adjustment:

The initial interest rate was: 6%+3%=9%6%+3%=9%

To compensate for the increased expected loss, the new interest rate needs to reflect the higher risk.

New Interest Rate = Risk-Free Rate + Spread + Compensation for Additional Risk

New Spread: 7.5%−1%=6.5%7.5%−1%=6.5%

New Interest Rate = 6%+6.5%=12.5%6%+6.5%=12.5%

New Total Rate: 12.5%+3%(????????????????????????????????????????????????????)=15.5%12.5%+3%(initialspread)=15.5%

Thus, considering the new conditions, the bank must adjust the interest rate to 20.5% to cover the increased risk.

The value of the USD against other foreign currencies is influenced by various factors. An increase in the US current account surplus (D) would likely strengthen the value of the USD. This is because a current account surplus indicates that the US is exporting more goods and services than it is importing, leading to higher demand for the USD by foreign buyers who need it to pay for US exports. This increased demand for the USD relative to other currencies results in an appreciation of the USD.