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Questions and Answers of
Corporate Finance
The text derives a decomposition of a particular type of chooser option into a call maturing at time T2 and a put maturing at time T1. By using put–call parity to obtain an expression
Prove that an at-the-money forward start option on a non-dividend-paying stock that will start in three years and mature in five years is worth the same as a two-year at-the-money option starting
Suppose that the strike price of an American call option on a non-dividend-paying stock grows at rate g. Show that if g is less than the risk-free rate, r, it is never optimal to exercise the call
Answer the following questions about compound options: (a) What put–call parity relationship exists between the price of a European call on a call and a European put on a call? (b) What put–call
Does a down-and-out call become more valuable or less valuable as we increase the frequency with which we observe the asset price in determining whether the barrier has been crossed? What is the
Explain why a regular European call option is the sum of a down-and-out European call and a down-and-in European call.
What is the value of a derivative that pays off $100 in six months if the S&P 500 index is greater than 1,000 and zero otherwise. Assume that the current level of the index is 960, the risk-free rate
Outperformance certificates (also called “sprint certificates”, “accelerator certificates”, or “speeders”) are offered to investors by many European banks as a way of investing in a
Suppose that the LIBOR zero rate is flat at 5% with annual compounding. In a five-year swap, company X pays a fixed rate of 6% and receives LIBOR annually on a principal of $100 million. The
Consider an up-and-out barrier call option on a non-dividend-paying stock when the stock price is 50, the strike price is 50, the volatility is 30%, the risk-free rate is 5%, the time to maturity is
What is the value in dollars of a derivative that pays off $10,000 in one year provided that the dollar–sterling exchange rate is greater than 1.5000 at that time? The current exchange rate is
Use DerivaGem to calculate the value of: a. A regular European call option on a non-dividend-paying stock where the stock price is $50, the strike price is $50, the risk-free rate is 5% per annum,
Estimate the interest rate paid by P&G on the 5/30 swap in Business Snapshot 22.4 if a) the CP rate is 6.5% and the Treasury yield curve is flat at 6% and b) the CP rate is 7.5% and the Treasury
Describe the payoff from a portfolio consisting of a floating lookback call and a floating lookback put with the same maturity.
Consider a chooser option where the holder has the right to choose between a European call and a European put at any time during a two-year period. The maturity dates and strike prices for the calls
Table 23.7 shows the five-year iTraxx index was 77 basis points on January 31, 2008. Assume that the risk-free rate is 5% for all maturities, the recovery rate is 40%, and payments are quarterly.
What is the credit default swap spread in Problem 23.8 if it is a binary CDS?
How does a five-year n th-to-default credit default swap work. Consider a basket of 100 reference entities where each reference entity has a probability of defaulting in each year of 1%. As the
How is the recovery rate of a bond usually defined? What is the formula relating the payoff on a CDS to the notional principal and the recovery rate?
Show that the spread for a new plain vanilla CDS should be 1 – R times the spread for a similar new binary CDS where R is the recovery rate.
Verify that if the CDS spread for the example in Tables 23.2 to 23.5 is 100 basis points and the probability of default in a year (conditional on no earlier default) must be 1.61%. How does the
Explain how forward contracts and options on credit default swaps are structured.
“The position of a buyer of a credit default swap is similar to the position of someone who is long a risk-free bond and short a corporate bond.” Explain this statement.
The 1-, 2-, 3-, 4-, and 5-year CDS spreads are 100, 120, 135, 145, and 152 basis points, respectively. The risk-free rate is 3% for all maturities, the recovery rate is 35%, and payments are
Suppose that a. The yield on a five-year risk-free bond is 7% b. The yield on a five-year corporate bond issued by company X is 9.5% c. A five-year credit default swap providing insurance against
Explain how you would expect the returns offered on the various tranches in a synthetic CDO to change when the correlation between the bonds in the portfolio increases.
Assume that the default probability for a company in a year, conditional on no earlier defaults is and the recovery rate is . The risk-free interest rate is 5% per annum. Default always occur half
Suppose that the risk-free zero curve is flat at 6% per annum with continuous compounding and that defaults can occur at times 0.25 years, 0.75 years, 1.25 years, and 1.75 years in a two-year plain
Suppose that the risk-free zero curve is flat at 7% per annum with continuous compounding and that defaults can occur half way through each year in a new five-year credit default swap. Suppose that
What is the value of the swap in Problem 23.8 per dollar of notional principal to the protection buyer if the credit default swap spread is 150 basis points?
Consider two bonds that have the same coupon, time to maturity and price. One is a B-rated corporate bond. The other is a CAT bond. An analysis based on historical data shows that the expected losses
An insurance company’s losses of a particular type are to a reasonable approximation normally distributed with a mean of $150 million and a standard deviation of $50 million. (Assume no difference
“HDD and CDD can be regarded as payoffs from options on temperature.” Explain this statement.
Suppose that you have 50 years of temperature data at your disposal. Explain the analysis you would you carry out to calculate the forward cumulative CDD for next July.
Would you expect mean reversion to cause the volatility of the three-month forward price of an energy source to be greater than or less than the volatility of the spot price? Explain your answer.
Explain how a 5 × 8 option contract for May 2011 on electricity with daily exercise works. Explain how a 5 × 8 option contract for May 2011 on electricity with monthly exercise works. Which is
Use the Keynes’s conception of the tension among the goals of efficiency, justice, and liberty that must be resolved by a political system in each of the following public finance issues:a.
Discuss the issues of public and private interests in the following cases:a. Parking on your campusb. Sharing the bathroom with your suite matesc. Tax evasiond. Speeding on the highwaye. A
Describe which economic role of government (allocation, distribution, or stabilization) is addressed in each of the following cases of government agencies or programs: a. Environmental Protection
In each of the following cases explain the potential causes of market failure (public goods, externalities, lack of competition, or imperfect information) that may be involved with each good or
Using the information provided in the Policy Study on the European Union, compare the role of the central government in the United States and in the European Union.a. Would you call the EU a
Use the figures in Table 2.1 to answer the following questions.a. For which decade did federal government current expenditures rise more, the 1980s or the 1990s?b. During the period 1995 to 2005
Use the figures in Table 2.3 to answer the following questions.a. For which five-year period listed in the table was the rate of growth of federal government expenditures greatest?b. For which
Use the figures in Table 2.4 to answer the following questions.a. For the period 1970-2005 compute the rate of growth in federal receipts (as a percent of GDP) for each five year period. Identify the
Use the figures in Table 2.5 to answer the following questions.a. For which five-year period listed in the table was the rate of growth of federal government expenditures per capita greatest?b. For
Use the GDP deflator reported in table below to convert the nominal expenditure per capita figures in Table 2.5 into real terms, answering the following questions. YearGDP Deflator (2005 =
Use the population figures reported in table below to convert the real government receipts and expenditures in Table 2.3 into real per capita terms, answering the following questions. YearPopulation
Use the information in the following table on receipts by the federal and state/local governments to support your evaluation of the following proposition: During the period 2000 to 20010 federal
Trash collection is a typical service provided by most local governments. But is it really a public good?a. Analyze this service according to the characteristics of a public good.b. Explain the
In many transition economies it is still the case that the price of electricity provided by the state utility is well below the marginal cost of production. Describe what is wrong in such a
Consider each of the following goods and services and explain whether it is purely private, purely public, or a public good subject to congestion: a. Security guard services b. Police services c.
Suppose that the community of Twainville consists of three people with the following marginal benefits (MB) for street lights provided in quantity q:Tom:MB = 1,500 - 5q for 0 # q # 300, MB = 0
Suppose that the (inverse) demand for a good is given by the equation p =100 - 4q. a. Compute the consumer surplus corresponding to a price of 80. b. Compute the change in consumer surplus
True, False, Uncertain? Explain. a. As a fiscal conservative, I maintain that it is always good to reduce government expenditure by providing smaller quantities of public goods. b. As a fiscal
Suppose that we have a simple two-person exchange economy with two goods: sunglasses and capes. At the present allocation of goods in the economy Clark is willing to exchange three pair of sunglasses
Suppose that we have a simple two-firm production economy with two goods: software and movie videos. At the present allocation of resources in the economy Bill is producing software at a marginal
Suppose that we have two inputs that are used in the production of sports entertainment: Mac’s hitting and Tommy’s managing. At the present allocation of resources in the economy the value of
In which of the following situations is the Coase Theorem likely to apply? Explain. a. The neighbor who lives below you in the apartment building loves to play old John Denver records at loud volume
One of the most striking aspects of cities in the Former Soviet Union is the poor condition of public places. Streets, parks, libraries, museums, concert halls, and public gathering places of every
Suppose that the marginal benefit associated with corn production is MB = 2.5. Marginal private cost of production is MPC = 2 + 0.1 Q, where Q measures bushels of corn produced in thousands. The
Policy analysts in the Department of Natural Resources have estimated that the marginal benefits from water pollution abatement are given by the function MB = 0.90 - 0.03A where A is a measure of the
Write a one-page memo to President Obama outlining a Pigouvian tax solution to the BP oil leak problem described in the Policy Study, "BP's Deepwater Horizon Gulf Oil Leak."
Consider the issue of emissions trading introduced in the policy study “The Kyoto Protocol.”a. What is the economic rationale for permitting emissions trading?b. If the objective is to minimize
Consider a hypothetical economy with ten people, eight of whom have income of $30,000, one of whom has income of $100,000 and one of whom has income of $500,000. Sketch the Lorenz curve for this
Consider a hypothetical economy consisting of you and Bill Gates (the CEO of Microsoft, a billionaire). Draw the Lorenz curve. What is the approximate value of the Gini coefficient?
Suppose we broaden our definition of the middle class to include the middle three quintiles combined. Using this definition and the data in Table 2, explain what has happened to the middle class
The following table provides information on the distribution of money income among families in the U.S.a. Explain the concept of a quintile in the distribution of income.b. Suppose that we define to
Suppose that an economy consists of two people: Ted and Jane. Their marginal utility functions are given by: MUT = 600 - 3IT and MUJ = 600 - 2IJ, where IT is Ted’s income and IJ is Jane’s income.
True, False, or Uncertain? Explain. a. Using a majority voting method, a public good will only be provided in the quantity desired by the majority of the voters. b. An increase in the transactions
Suppose that there are three groups of voters in Scholarville where there is a budget vote coming up soon to determine the level of public school expenditures per pupil. The choices are a high level
Suppose that there are three groups of voters in North town where there is a vote coming up soon to determine the number of old-growth trees to protect from logging in order to save habitat for the
Suppose that we know the demand for schooling in Scholarville is given by the equation p = 7,500 - 75q, where p is price per pupil and q is the quantity of schooling measured in hours per day per
Consider the following set of voter preferences:a. Compute the plurality winner of the election. b. Compute the Borda winner of the election. c. Compute the Condorcet winner of the election. d.
Consider the following utility changes that will result from the passage of two legislative bills on issues X and Y:a. Identify the logrolling opportunity present in this situation. b. Identify the
Suppose that the annual marginal benefit of crime prevention program that puts police walking the beat on the streets of Crimeville has been estimated as MB = 500,000-1,200q, where q is the number of
The total benefits of the COMMIT program which is designed to encourage school children to commit themselves to a life free of drug addiction has been estimated to be B = 800q - 4q2, where q is the
Use the perpetuity formula to estimate the value of the following projects generating net benefits in perpetuity. a. Bi = 5,000, r = 0.06. b. Bi = 10,000, r = 0.06. c. Bi = 10,000, r = 0.05. d. Bi =
Sketch the conceptual outline of how you would conduct a cost-benefit analysis of the 55 mph speed limit law implemented in the U.S. during the 1970s and 80s. a. Identify benefits, both direct and
Analyze the Phillip Morris study of the public finance consequences of smoking discussed in the Policy Study: The Benefits of Smoking. Do so by answering the following questions. a. Identify the
A cost-benefit analysis of a new irrigation project indicates that the net benefits of the project in each of the first four years will be -$2 million. That is, Bi - Ci = -2 million for i = 1, 2, 3,
Calculate the present value of each of the following income streams using a 5% discount rate: a. An income stream of $1,000 per year for 20 years. b. An income stream of $1,000 per year for years
Suppose that a proposed government irrigation project lowers the marginal cost of producing food and thereby lowers the market price of food. If the market demand for food is given by the estimated
You work for the State Department of Labor and have been given the task of evaluating a state job-training program. In order to conduct the analysis, suppose that the typical client for the program
Set up a diagram like Figure 8.6 and analyze the potential effects of the following:a. A reduction in the price of capital used to produce schooling.b. An increase in the price of labor used to
Suppose that you serve on the city council of Larcenyland, a suburban community adjacent to the central city Burglarytown. Individual efforts to fight crime in both cities have been very expensive in
Use the information in Table 8.4 to construct a graph of the long-run average cost function for health insurance administration. Assume that a particular benefit costs $1,000 to provide. Use the
The following table provides data on elementary and secondary school enrollment and the number of classroom teachers for each of five years in the U.S.a. Plot the five points on the total product
Does the university where you study charge the same tuition rate for students in all majors, or does it differentiate tuition according to major? Is there evidence of marginal cost pricing? Even if
Suppose that the Department of Transportation has advanced a proposal to install scanners along roadsides and I.D.s on the sides of cars and trucks, much like universal product codes used in grocery
For each of the following education production functions determine the returns to scale:a. q = (40) l.8 k.2b. q = (40) l.9 k.15c. q = (40) l.7 k.25
Suppose that the marginal cost of producing a public service is MC = 100 - 2q while the average total cost is ATC = 100 - (3/2)q. a. If the optimal quantity of the public service is q = 20, compute
The Policy Study on the Central London Congestion Tolls includes a list of the discounts and exemptions that are provided for certain types of drivers and vehicles. Analyze whether each of those
Compute the tax owed in each of the following cases:a. Social Security tax (employer and employee portions) for a pre-retirement worker with income of $50,000b. Social Security tax (employer and
Compute the Social Security primary insurance amount (PIA) for a retiree in each of the following cases:a. Average indexed monthly earnings (AIME) of $1,000b. AIME of 3,000c. AIME of $6,000d. Compare
For the tax year 2011the Social Security tax rate applied to pre-retirement employees is reduced from 6.2% to 4.2%. Compute and explain the tax savings for workers in each of the following
Using a figure such as Figure 9.1, illustrate and explain the effect of a reduction in the degree of risk aversion (which makes the utility function less concave).
Feldstein (2005) points out that a large volume of research over the years confirms the conclusion that the Social Security system depresses private savings. Explain the economic and policy
The U.S. Social Security program is funded on a PAYGO basis along with a trust fund. Explain what rationales might account for this hybrid method of financing.
Using the information in the Appendix on PAYGO systems, explain the politics of the initial adoption of a social security system funding using a PAYGO financing mechanism.
In 2009 the State Farm Insurance Company withdrew from writing homeowners insurance policies in Florida, claiming that state regulations prevented it from charging premiums sufficient to cover
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