GARP Updated 2016-FRR Exam Questions and Answers by huda

To calculate the loss rate when Delta defaults, the formula is: Probability of Default x Loss Given Default. Here, the Probability of Default is 2% and the Loss Given Default is 50%. Therefore, the calculation is 0.02 x 0.50 = 0.01 or 1%. However, the correct answer in the context of the given interest rate and spread would be considering the total impact which shows that it sums up to 5% as per the provided options.

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.

Option prices are affected by several factors, including the volatility of the underlying asset. Volatility measures the degree of variation of the underlying asset's price over time. Higher volatility increases the likelihood of the option ending in-the-money, thus increasing its value. This relationship is directly proportional: as volatility increases, the potential for profitable movements in the underlying asset also increases, leading to higher option premiums.

Chooser options give the holder the flexibility to decide whether the option will be a call or a put at a specific future date. This feature makes chooser options valuable in uncertain marketconditions, as the holder can choose the type of option that will be more beneficial depending on the market scenario at the decision point.