FRM·P1 · FRM Part I·UnitP1 · Unit 03Access: Premium
Financial Markets and Products
Prepare for Financial Markets and Products with FRM practice questions covering 12 topics. Part of FRM Part I — build your knowledge and track your progress with Pass FRM.
What’s in it.
12 topics- Topic 01
Bond Markets and Fixed Income
54 questions - Topic 02
Equity Markets and Products
28 questions - Topic 03
Foreign Exchange Markets
30 questions - Topic 04
Commodity Markets
28 questions - Topic 05
Futures Contracts
33 questions - Topic 06
Forward Contracts
33 questions - Topic 07
Swaps
59 questions - Topic 08
Options Fundamentals
51 questions - Topic 09
Options Pricing Models
48 questions - Topic 10
Exotic Options and Structured Products
33 questions - Topic 11
Mortgage-Backed Securities
35 questions - Topic 12
Central Counterparties and Clearing
57 questions
Sample questions
3 of manyA few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.
What is a Forward Rate Agreement (FRA) and what interest rate risk does it hedge?
- An FRA is a futures contract on a government bond yield, traded on an exchange.
- An FRA is a bond forward contract that locks in the price of a fixed-rate bond at a future date.
- An FRA fixes the yield to maturity on a bond issued at a future date, hedging bond market risk.
- An FRA is an OTC contract that fixes an interest rate for a future borrowing or lending period, hedging the risk that floating rates will rise (for borrowers) or fall (for lenders) before the period begins.Correct answer
ExplanationA Forward Rate Agreement (FRA) is an OTC interest rate derivative that fixes a borrowing/lending rate for a specified reference period starting at a future settlement date. The buyer (pay-fixed party) is protected against rising rates: if the reference rate exceeds the FRA rate at settlement, the seller pays the buyer the discounted difference. The seller (receive-fixed party) is protected against falling rates. FRAs are commonly used by corporates to lock in future borrowing costs on floating-rate debt, or by banks to hedge their interest rate exposure on forthcoming floating-rate assets.
A bond is callable in 2 years at 101, callable in 4 years at 100.5, and matures in 6 years at par. The bond's current price is 103 and its coupon is 6% (annual). The YTM is 5.3%, YTC (2-year call) is 4.1%, and YTC (4-year call) is 4.7%. A portfolio manager wants to compare this bond with a non-callable bond. What is the YTW, and what does the option cost embedded in this bond approximately equal in spread terms?
- YTW is 5.3% (YTM) because the investor should always use maturity-based yield for comparisons.
- YTW cannot be determined without running an interest rate model.
- YTW is 4.1% and the option cost equals YTM minus YTW (1.2%) in yield terms.
- YTW is 4.1% (minimum yield); the option cost ≈ the Z-spread minus the OAS, reflecting the value of the embedded call option the investor has implicitly sold.Correct answer
ExplanationYTW = min(YTM, all YTCs) = min(5.3%, 4.1%, 4.7%) = 4.1%. The investor holds a bond with an embedded short call option (the issuer can call). The value of this embedded call is captured by the option cost = Z-spread − OAS. A positive option cost (Z-spread > OAS) means the callable bond's extra spread over the benchmark partly compensates for the call risk. Using YTW (4.1%) rather than YTM (5.3%) gives a realistic conservative estimate. The 1.2% gap between YTM and YTW is not the option cost per se, but it illustrates the magnitude of call risk for this bond.
What is 'skin in the game' in the CCP default waterfall and why is it important for incentive alignment?
- Skin in the game is the minimum equity a clearing member must maintain to remain eligible for CCP membership.
- Skin in the game means the CCP must retain a portion of each member's default fund contribution as its own risk capital.
- Skin in the game is the tranche of the CCP's own equity capital placed in the default waterfall ahead of surviving members' default fund contributions, ensuring the CCP shares losses before passing them to members, aligning the CCP's risk appetite with those of its members.Correct answer
- Skin in the game refers to the requirement that all clearing members post collateral equal to at least 10% of their cleared volume.
Explanation'Skin in the game' is the CCP's own equity capital tranche in the default waterfall, placed between the defaulting member's resources (IM + default fund) and the surviving members' default fund. It is typically small — around 5–10% of the total waterfall.
Why it matters for incentive alignment: without skin in the game, a CCP might set margins and risk controls too loosely (since losses fall on members, not itself). By placing the CCP's own capital in the loss-sharing sequence before surviving members' funds, regulators ensure the CCP has a direct financial stake in effective risk management. If the CCP sets margins too low, its own capital is at risk. This is a key element of the CPMI-IOSCO Principles for Financial Market Infrastructures (PFMI).