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Questions and Answers of
Corporate Finance
A trader owns a commodity as part of a long-term investment portfolio. The trader can buy the commodity for $950 per ounce and sell it for $949 per ounce. The trader can borrow funds at 6% per year
A company enters into a forward contract with a bank to sell a foreign currency for K1 at time T1. The exchange rate at time T1 proves to be S1 (> K1). The company asks the bank if it can roll the
The current USD/euro exchange rate is 1.4000 dollar per euro. The six month forward exchange rate is 1.3950. The six month USD interest rate is 1% per annum continuously compounded. Estimate the
Is the futures price of a stock index greater than or less than the expected future value of the index? Explain your answer.
A one-year long forward contract on a non-dividend-paying stock is entered into when the stock price is $40 and the risk-free rate of interest is 10% per annum with continuous compounding.a) What are
The December Eurodollar futures contract is quoted as 98.40 and a company plans to borrow $8 million for three months starting in December at LIBOR plus 0.5%. (a) What rate can then company lock in
Suppose that the Treasury bond futures price is 101-12. Which of the following four bonds is cheapest to deliver?
It is July 30, 2015. The cheapest-to-deliver bond in a September 2015 Treasury bond futures contract is a 13% coupon bond, and delivery is expected to be made on September 30, 2015. Coupon payments
An investor is looking for arbitrage opportunities in the Treasury bond futures market. What complications are created by the fact that the party with a short position can choose to deliver any bond
Suppose that the nine-month LIBOR interest rate is 8% per annum and the six-month LIBOR interest rate is 7.5% per annum (both with actual/365 and continuous compounding). Estimate the three-month
A five-year bond with a yield of 11% (continuously compounded) pays an 8% coupon at the end of each year. a) What is the bond’s price? b) What is the bond’s duration? c) Use the duration to
Suppose that a bond portfolio with a duration of 12 years is hedged using a futures contract in which the underlying asset has a duration of four years. What is likely to be the impact on the hedge
Suppose that it is February 20 and a treasurer realizes that on July 17 the company will have to issue $5 million of commercial paper with a maturity of 180 days. If the paper were issued today, the
On August 1 a portfolio manager has a bond portfolio worth $10 million. The duration of the portfolio in October will be 7.1 years. The December Treasury bond futures price is currently 91-12 and the
How can the portfolio manager change the duration of the portfolio to 3.0 years in Problem 6.17?
Between October 30, 2015, and November 1, 2015, you have a choice between owning a U.S. government bond paying a 12% coupon and a U.S. corporate bond paying a 12% coupon. Consider carefully the day
A Treasury bond futures price is 103-12. The prices of three deliverable bonds are 115-06, 135-12, and 155-28. Their conversion factors are 1.0679, 1.2264, and 1.4169, respectively. Which bond is
Suppose that a Eurodollar futures quote is 88 for a contract maturing in 60 days. What is the LIBOR forward rate for the 60- to 150-day period? Ignore the difference between futures and forwards for
The three-month Eurodollar futures price for a contract maturing in six years is quoted as 95.20. The standard deviation of the change in the short-term interest rate in one year is 1.1%. Estimate
Explain why the forward interest rate is less than the corresponding futures interest rate calculated from a Eurodollar futures contract.
It is April 7, 2014. The quoted price of a U.S. government bond with a 6% per annum coupon (paid semiannually) is 120-00. The bond matures on July 27, 2023. What is the cash price? How does your
It is March 10, 2014. The cheapest-to-deliver bond in a December 2014 Treasury bond futures contract is an 8% coupon bond, and delivery is expected to be made on December 31, 2014. Coupon payments
Assume that a bank can borrow or lend money at the same interest rate in the LIBOR market. The 90-day rate is 10% per annum, and the 180-day rate is 10.2% per annum, both expressed with continuous
It is June 25, 2013. The futures price for the June 2013 bond futures contract is 118-23. a. Calculate the conversion factor for a bond maturing on January 1, 2026, paying a coupon of 10%. b.
A portfolio manager plans to use a Treasury bond futures contract to hedge a bond portfolio over the next three months. The portfolio is worth $100 million and will have a duration of 4.0 years in
Portfolio A consists of a one-year zero-coupon bond with a face value of $2,000 and a 10-year zero-coupon bond with a face value of $6,000. Portfolio B consists of a 5.95-year zero-coupon bond with
The price of a 90-day Treasury bill is quoted as 10.00. What continuously compounded return (on an actual/365 basis) does an investor earn on the Treasury bill for the 90-day period?
It is May 5, 2013. The quoted price of a government bond with a 12% coupon that matures on July 27, 2024, is 110-17. What is the cash price?
(a) Company X has been offered the rates shown in Table 7.3. It can invest for four years at 5.5%. What floating rate can it swap this fixed rate into? (b) Company Y has been offered the rates shown
A financial institution has entered into an interest rate swap with company X. Under the terms of the swap, it receives 10% per annum and pays six-month LIBOR on a principal of $10 million for five
A financial institution has entered into a 10-year currency swap with company Y. Under the terms of the swap, the financial institution receives interest at 3% per annum in Swiss francs and pays
Companies A and B face the following interest rates (adjusted for the differential impact of taxes):Assume that A wants to borrow U.S. dollars at a floating rate of interest and B wants to borrow
After it hedges its foreign exchange risk using forward contracts, is the financial institution’s average spread in Figure 7.11 likely to be greater than or less than 20 basis points? Explain your
“Companies with high credit risks are the ones that cannot access fixed-rate markets directly. They are the companies that are most likely to be paying fixed and receiving floating in an interest
Why is the expected loss from a default on a swap less than the expected loss from the default on a loan with the same principal?
A bank finds that its assets are not matched with its liabilities. It is taking floating-rate deposits and making fixed-rate loans. How can swaps be used to offset the risk?
Explain how you would value a swap that is the exchange of a floating rate in one currency for a fixed rate in another currency.
The LIBOR zero curve is flat at 5% (continuously compounded) out to 1.5 years. Swap rates for 2- and 3-year semiannual pay swaps are 5.4% and 5.6%, respectively. Estimate the LIBOR zero rates for
OIS rates have been estimated as 3.4% for all maturities. The three-month LIBOR rate is 3.5%. For a six-month swap where payments are exchanged every three months the swap rate is 3.6%. All rates are
The one-year LIBOR rate is 10% with annual compounding. A bank trades swaps where a fixed rate of interest is exchanged for 12-month LIBOR with payments being exchanged annually. Two- and three-year
(a) Company A has been offered the rates shown in Table 7.3. It can borrow for three years at 6.45%. What floating rate can it swap this fixed rate into? (b) Company B has been offered the rates
In an interest rate swap, a financial institution pays 10% per annum and receives three-month LIBOR in return on a notional principal of $100 million with payments being exchanged every three months.
Company A wishes to borrow U.S. dollars at a fixed rate of interest. Company B wishes to borrow sterling at a fixed rate of interest. They have been quoted the following rates per annum (adjusted for
For all maturities the US dollar (USD) interest rate is 7% per annum and the Australian dollar (AUD) rate is 9% per annum. The current value of the AUD is 0.62 USD. In a swap agreement, a financial
Company X is based in the United Kingdom and would like to borrow $50 million at a fixed rate of interest for five years in U.S. funds. Because the company is not well known in the United States,
The one-year LIBOR rate is 3% and the forward rate for the one- to two-year period is 3.2%. The three-year swap rate for a swap with annual payments is 3.2%. What is the LIBOR forward rate for the 2
Explain why a bank is subject to credit risk when it enters into two offsetting swap contracts.
Companies X and Y have been offered the following rates per annum on a $5 million 10-year investment:Company X requires a fixed-rate investment; company Y requires a floating-rate investment. Design
Explain why the end-of-year bonus is sometimes referred to as “short-term compensation.”
What is meant by the term “agency costs”? How did agency costs play a role in the credit crisis?
How is an ABS CDO created? What was the motivation to create ABS CDOs?
Explain the impact of an increase in default correlation on the risks of the senior tranche of an ABS. What is its impact on the risks of the equity tranche?
Explain why the AAA-rated tranche of an ABS CDO is more risky than the AAA-rated tranche of an ABS.
Add rows in Table 8.1 corresponding to losses on the underlying assets of (a) 2%, (b) 6%,(c) 12%, (d) 18%.
Suppose that the principal assigned to the senior, mezzanine, and equity tranches is 70%, 20%, and 10% for both the ABS and the ABS CDO in Figure 8.3. What difference does this make to Table 8.1?
Suppose that mezzanine tranches of the ABS CDOs, similar to those in Figure 8.3, are resecuritized to form what is referred to as a “CDO squared.” As in the case of tranches created from ABSs in
Investigate what happens as the width of the mezzanine tranche of the ABS in Figure 8.3 is decreased with the reduction of mezzanine tranche principal being divided equally between the equity and
Suppose that the structure in Figure 8.1 is created in 2000 and lasts 10 years. There are no defaults on the underlying assets until the end of the eighth year when 17% of the principal is lost
Resecuritization was a badly flawed idea. AAA tranches created from the mezzanine tranches of ABSs are bound to have a higher probability of default than the AAA-rated tranches of ABSs. Discuss this
How were the risks in ABS CDOs misjudged by the market?
Calculate the intrinsic value and time value from the mid-market (average of bid and offer) prices the July 2012 call options in Table 1.2. Do the same for the July 2012 put options in Table 1.3.
Suppose that a European put option to sell a share for $60 costs $8 and is held until maturity. Under what circumstances will the seller of the option (the party with the short position) make a
Describe the terminal value of the following portfolio: a newly entered-into long forward contract on an asset and a long position in a European put option on the asset with the same maturity as the
A trader buys a call option with a strike price of $45 and a put option with a strike price of $40. Both options have the same maturity. The call costs $3 and the put costs $4. Draw a diagram
Explain why an American option is always worth at least as much as a European option on the same asset with the same strike price and exercise date.
Explain why an American option is always worth at least as much as its intrinsic value.
Explain carefully the difference between writing a put option and buying a call option.
The treasurer of a corporation is trying to choose between options and forward contracts to hedge the corporation’s foreign exchange risk. Discuss the advantages and disadvantages of each.
Consider an exchange-traded call option contract to buy 500 shares with a strike price of $40 and maturity in four months. Explain how the terms of the option contract change when there is a) A 10%
“If most of the call options on a stock are in the money, it is likely that the stock price has risen rapidly in the last few months.” Discuss this statement.
What is the effect of an unexpected cash dividend on (a) a call option price and (b) a put option price?
A trader has a put option contract to sell 100 shares of a stock for a strike price of $60. What is the effect on the terms of the contract of? (a) A $5 dividend being declared (b) A $5 dividend
Explain why the market maker’s bid-offer spread represents a real cost to options investors.
A United States investor writes five naked call option contracts. The option price is $3.50, the strike price is $60.00, and the stock price is $57.00. What is the initial margin requirement?
A trader writes five naked put option contracts, with each contract being on 100 shares. The option price is $10, the time to maturity is six months, and the strike price is $64. (a) What is the
The price of a stock is $40. The price of a one-year European put option on the stock with a strike price of $30 is quoted as $7 and the price of a one-year European call option on the stock with a
“If a company does not do better than its competitors but the stock market goes up, executives do very well from their stock options. This makes no sense” Discuss this viewpoint. Can you think of
Use DerivaGem to calculate the value of an American put option on a nondividend paying stock when the stock price is $30, the strike price is $32, the risk-free rate is 5%, the volatility is 30%,
On July 20, 2004 Microsoft surprised the market by announcing a $3 dividend. The ex-dividend date was November 17, 2004 and the payment date was December 2, 2004. Its stock price at the time was
A corporate treasurer is designing a hedging program involving foreign currency options. What are the pros and cons of using (a) The NASDAQ OMX (b) The over-the-counter market for trading?
Suppose that a European call option to buy a share for $100.00 costs $5.00 and is held until maturity. Under what circumstances will the holder of the option make a profit? Under what circumstances
A European call option and put option on a stock both have a strike price of $20 and an expiration date in three months. Both sell for $3. The risk-free interest rate is 10% per annum, the current
What is a lower bound for the price of a two-month European put option on a non-dividend-paying stock when the stock price is $58, the strike price is $65, and the risk-free interest rate is 5% per
A four-month European call option on a dividend-paying stock is currently selling for $5. The stock price is $64, the strike price is $60, and a dividend of $0.80 is expected in one month. The
A one-month European put option on a non-dividend-paying stock is currently selling for $2.50. The stock price is $47, the strike price is $50, and the risk-free interest rate is 6% per annum. What
Give an intuitive explanation of why the early exercise of an American put becomes more attractive as the risk-free rate increases and volatility decreases.
The price of a European call that expires in six months and has a strike price of $30 is $2. The underlying stock price is $29, and a dividend of $0.50 is expected in two months and again in five
Explain carefully the arbitrage opportunities in Problem 10.14 if the European put price is $3.
The price of an American call on a non-dividend-paying stock is $4. The stock price is $31, the strike price is $30, and the expiration date is in three months. The risk-free interest rate is 8%.
Explain carefully the arbitrage opportunities in Problem 10.16 if the American put price is greater than the calculated upper bound.
Prove the result in equation (10.7). For the first part of the relationship consider (a) a portfolio consisting of a European call plus an amount of cash equal to K and (b) a portfolio consisting of
Prove the result in equation (10.11). For the first part of the relationship consider (a) a portfolio consisting of a European call plus an amount of cash equal to D + K and (b) a portfolio
Suppose that c1, c2, and c3 are the prices of European call options with strike prices K1, K2, and K3, respectively, where K3 > K2 > K1 and K3 – K2 = K2 – K1. All options have the same
Consider a five-year call option on a non-dividend-paying stock granted to employees. The option can be exercised at any time after the end of the first year. Unlike a regular exchange-traded call
Use the software DerivaGem to verify that Figures 10.1 and 10.2 are correct.
Calls were traded on exchanges before puts. During the period of time when calls were traded but puts were not traded, how would you create a European put option on a nondividend-paying stock
The prices of European call and put options on a non-dividend-paying stock with 12 months to maturity, a strike price of $120, and an expiration date in 12 months are $20 and $5, respectively. The
What is the result corresponding to that in Problem 10.23 for European put options?
Suppose that you are the manager and sole owner of a highly leveraged company. All the debt will mature in one year. If at that time the value of the company is greater than the face value of the
Consider an option on a stock when the stock price is $41, the strike price is $40, the risk-free rate is 6%, the volatility is 35%, and the time to maturity is 1 year. Assume that a dividend of
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