FRM Part I · FRM Exam Part I · Trading Strategies
A bank structures a 5-year principal-protected note (100% protection) from a zero-coupon bond and a call option on an equity index. If market interest rates fall while the call option's price and the note's issue price stay the same, what is the most likely effect on the note's participation rate?
The participation rate falls. A lower interest rate raises the present value of the zero-coupon bond needed to guarantee principal, leaving a smaller budget for the call option. With the option price unchanged, the investor can be given exposure to fewer index gains.
- AIt rises, because the call option becomes cheaper relative to the bond
- BIt falls, because the zero-coupon bond costs more and leaves less money to buy call optionsCorrect
- CIt is unchanged, because the protected principal is fixed at maturity
- DIt rises, because lower rates reduce the bank's funding cost for the note
Explanation
The zero-coupon bond must grow to the full principal at maturity. When rates fall, its present value rises, so less of the issue price remains for buying the call. With the call price unchanged, the participation rate declines. Option 0 reverses the effect.
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