PRMIA 8006 Dumps

An increase in volatility increases the value of the option, and so do increases in the price of the underlying and the risk free rate. However, since a European option can only be exercised at expiry, an increase in the time to expiry may not necessarily increase the value of the option as it may increase the uncertainty around a more certain payout.

Consider the extreme case of a deep in the money European call option that has 1 day left to expiry, and a payout is certain. Now imagine the time to expiry is increased by say, 6 months. Now the payout is no longer certain as no one knows what the value of the underlying will end up at after 6 months. In such a case, the value of the option would decline. But this applies only to a European option. An American option, which can be exercised any time, will not be affected by this reasoning.

A rise in interest rates will cause fixed rate bond prices to fall. It will not affect the floating rate notes as their rates are going to float with the changes in interest rates. Inflation linked bonds will only be affected by changes in real interest rates, and even in a situation where the rise in interest rates is happening due to an increase in the real rates, a long position would hurt. As interest rates rise, the coupon payable on the inverse floater would fall, hurting a long position.

Of the given alternatives, the only position that would benefit from a rise in interest rates is the short position in fixed rate bonds. Hence Choice 'd' is the correct answer.

For a deep in the money option, the option value changes in line with the value of the underlying because at this point the option is effectively behaving like the underlying. Therefore its delta is the same as the delta of the underlying, ie 1. In the same way, its gamma will be the same as the gamma of the underlying, which is 0. Therefore Choice 'b' is the correct answer.