A RISK MANAGER IS PRICING A 10-YEAR CALL OPTION ON 10-YEAR TREASUR...

16.

A risk manager is pricing a 10-year call option on 10-year Treasuries using a successfully tested pricing model.

Current interest rate volatility is high and the risk manager is concerned about the effect this may have on

short-term rates when pricing the option. Which of the following actions would best address the potential for

negative short-term interest rates to arise in the model?

a.

The risk manager uses a normal distribution of interest rates.

b.

When short-term rates are negative, the risk manager adjusts the risk-neutral probabilities.

c.

When short-term rates are negative, the risk manager increases the volatility.

d.

When short-term rates are negative, the risk manager sets the rate to zero.

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2015 Financial Risk Manager (FRM®) Practice Exam