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principles of finance
Questions and Answers of
Principles Of Finance
23. What is Argentina's current account balance? Argentina used a currency board to maintain its peso on a par with the U.S. dollar. However, in January 2002 the peso collapsed. Argentina's BOP could
24. What seems to have been the primary driver of Argentina's current account between 1998 and 2000? Argentina used a currency board to maintain its peso on a par with the U.S. dollar. However, in
25. What is Argentina's financial account balance? Argentina used a currency board to maintain its peso on a par with the U.S. dollar. However, in January 2002 the peso collapsed. Argentina's BOP
26. What is Argentina's Total for Groups A through C? Argentina used a currency board to maintain its peso on a par with the U.S. dollar. However, in January 2002 the peso collapsed. Argentina's BOP
27. What is Argentina's Total for Groups A through D? Argentina used a currency board to maintain its peso on a par with the U.S. dollar. However, in January 2002 the peso collapsed. Argentina's BOP
28. Argentina's balance of payments was clearly deteri- orating during this period. What would it forecast to happen to the country's currency board regime? Argentina used a currency board to
29. Trade Deficits and J-curve Adjustment Paths. Assume the United States has the following import/export volumes and prices. It undertakes a major "devaluation" of the dollar, say 18% on aver- age
4. World Trade Organization and Intellectual Property. The World Trade Organization (WTO) is currently in a multiple-year round of negotiations on international trade. The current round is taking
3. U.S. Bureau of Economic Analysis. Use the follow- ing Bureau of Economic Analysis (U.S. government) and the Ministry of Finance (Japanese government) Web sites to find the most recent balance of
2. St. Louis Federal Reserve. The Federal Reserve Bank of St. Louis provides a large amount of recent open-economy macroeconomic data online. Use thefollowing addresses to track down recent BOP and
1. World Organizations and the Economic Outlook. The IMF, World Bank, and United Nations are only a few of the major world organizations that track, report, and aid international economic and
15. BOP Transactions. Identify the correct BOP account for each of the following transactions:a. A German-based pension fund buys U.S. govern- ment 30-year bonds for its investment portfolio.b.
14. Capital Mobility-Brazil. Brazil has experienced periodic depreciation of its currency over the past 20 years despite occasionally running a current account surplus. Why has this phenomenon
12. Drags and Terrorists. Where in the balance of pay- ments accounts do the flows of "laundered" money by drug dealers and international terrorist organiza- tions flow?
11. The Balance. What are the main summary state- ments of the balance of payments accounts and what do they measure?
10. Classifying Transactions. Classify the following as a transaction reported in a sub-component of the cur- rent account or the capital and financial accounts of the two countries involved:a. A
9. Capital and Financial Accounts. What are the main components of the financial accounts? Give one debit and one credit example for each component account for the United States.
6. Current Account. What are the main component accounts of the current account? Give one debit and one credit example for each component account for the United States.
4. Balance. Why does the BOP always "balance"?
3. Economic Activity. What are the two main types of economic activity measured by a country's BOP?
1. Balance of Payments Defined. The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP). What
24.13. 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
24.11. 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
24.10. 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
24.9. Suppose that you have 50 years of temperature data at your disposal. Explain the analysis you would carry out to calculate the forward cumulative CDD for next July.
24.8. “HDD and CDD can be regarded as payoffs from options on temperature.” Explain this statement.
24.7. Explain how CAT bonds work.
24.6. How can an energy producer use derivative markets to hedge risks?
24.5. Why can the pricing of a weather derivatives contract and a CAT bond be based on probabilities calculated from historical data?
24.4. Why is the price of electricity more volatile than that of other energy sources?
24.3. How is a typical natural gas forward contract structured?
24.1. What is meant by HDD and CDD?
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
10.1. List the six factors affecting stock option prices.
10.5. “The early exercise of an American put is a trade-off between the time value of money and the insurance value of a put.” Explain this statement.
10.6. Explain why an American call option on a dividend-paying stock is always worth at least as much as its intrinsic value. Is the same true of a European call option? Explain your answer.
10.7. The price of a non-dividend paying stock is $19 and the price of a three-month European call option on the stock with a strike price of $20 is $1. The risk-free rate is 4% per annum.What is the
10.8. Explain why the arguments leading to put–call parity for European options cannot be used to give a similar result for American options.
10.10. What is a lower bound for the price of a two-month European put option on a nondividend-paying stock when the stock price is $58, the strike price is $65, and the risk-free interest rate is 5%
10.12. 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.
10.13. 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.
10.14. 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
10.15. Explain carefully the arbitrage opportunities in Problem 10.14 if the European put price is $3.
10.17. Explain carefully the arbitrage opportunities in Problem 10.16 if the American put price is greater than the calculated upper bound.
10.18. Prove the result in equation (10.7). (Hint: 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
10.19. Prove the result in equation (10.11). (Hint: 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
10.20. 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
10.21. Use the DerivaGem software to verify that Figures 10.1 and 10.2 are correct.
10.23. 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 non-dividend-paying stock
10.24. The prices of European call and put options on a non-dividend-paying stock with a strike price of $120 and an expiration date in 12 months are $20 and $5, respectively. The current stock price
10.26. 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
10.27. What is the result corresponding to that in Problem 10.26 for European put options?
10.28. 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 debt, you
10.29. Consider an option on a stock when the stock price is $41, the strike price is $40, the riskfree rate is 6%, the volatility is 35%, and the time to maturity is one year. Assume that a dividend
10.30. Consider a put option on a non-dividend-paying stock when the stock price is $40, the strike price is $42, the risk-free interest rate is 2%, the volatility is 25% per annum, and the time to
10.31. Section 10.1 gives an example of a situation where the value of a European call option decreases with the time to maturity. Give an example of a situation where the value of a European put
What difference does it make to your calculations in the previous question if a dividend of $1.50 is expected in two months?
Show that the Black–Scholes–Merton formula for a call option gives a price that tends to max(S0 - K, 0) as T → 0.
If the volatility of a stock is 18% per annum, estimate the standard deviation of the percentage price change in (a) one day, (b) one week, and (c) one month.
A financial institution plans to offer a derivative that pays off a dollar amount equal to 2ST at time T, where ST is the stock price at time T. Assume no dividends. Defining other variables as
14.1. Why was it attractive for companies to grant at-the-money stock options prior to 2005?What changed in 2005?
14.2. What are the main differences between a typical employee stock option and an American call option traded on an exchange or in the over-the-counter market?
14.4. “Stock option grants are good because they motivate executives to act in the best interests of shareholders.” Discuss this viewpoint.
14.5. “Granting stock options to executives is like allowing a professional footballer to bet on the outcome of games.” Discuss this viewpoint.
14.6. Why did some companies backdate stock option grants in the US prior to 2002? What changed in 2002?
14.7. In what way would the benefits of backdating be reduced if a stock option grant had to be revalued at the end of each quarter?
14.8. Explain how you would do an analysis similar to that of Yermack and Lie to determine whether the backdating of stock option grants was happening.
14.10. The notes accompanying a company’s financial statements say: “Our executive stock options last 10 years and vest after 4 years. We valued the options granted this year using the
14.11. A company has granted 500,000 options to its executives. The stock price and strike price are both $40. The options last for 12 years and vest after 4 years. The company decides to value the
14.13. A company has granted 2,000,000 options to its employees. The stock price and strike price are both $60. The options last for 8 years and vest after 2 years. The company decides to value the
14.14. (a) Hedge funds earn a management fee plus an incentive fee that is a percentage of the profits, if any, that they generate (see Business Snapshot 1.3). How is a fund manager motivated to
16.19. Show that, if C is the price of an American call option on a futures contract when the strike price is K and the maturity is T, and P is the price of an American put on the same futures
16.24. Calculate the implied volatility of soybean futures prices from the following information concerning a European put on soybean futures: Current futures price 525 Exercise price 525 Risk-free
17.24. A financial institution has the following portfolio of over-the-counter options on sterling:A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.(a) What
23.25. Table 23.7 shows the five-year iTraxx index was 77 basis points on January 31, 2008.Assume the risk-free rate is 5% for all maturities, the recovery rate is 40%, and payments are quarterly.
23.24. 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
23.23. 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%, and (c) a five-year credit default swap providing
23.22. 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.
23.21. Assume that the hazard rate for a company in a year is λ and the recovery rate is R. The risk-free interest rate is 5% per annum. Default always occur halfway through a year. The spread for a
23.20. 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, 0.75, 1.25, and 1.75 years in a twoyear plain vanilla
23.19. Does valuing a CDS using real-world default probabilities rather than risk-neutral default probabilities overstate or understate its value? Explain your answer.
23.18. Why is there a potential asymmetric information problem in credit default swaps?
23.17. “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.
23.16. Explain how forward contracts and options on credit default swaps are structured.
23.15. A company enters into a total return swap where it receives the return on a corporate bond paying a coupon of 5% and pays LIBOR. Explain the difference between this and a regular swap where 5%
23.14. Verify that, if the CDS spread for the example in Tables 23.2 to 23.5 is 100 basis points, the hazard rate is 1.63% per year. How does the hazard rate change when the recovery rate is 20%
23.13. 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.
23.12. 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 recovery rate?
23.11. How does a five-year nth-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
23.10. What is the credit default swap spread in Problem 23.8 if it is a binary CDS.
23.9. 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?
23.8. Suppose that the risk-free zero curve is flat at 7% per annum with continuous compounding and that defaults can occur halfway through each year in a new five-year credit default swap. Suppose,
23.7. Explain why a total return swap can be useful as a financing tool.
23.6. Explain the difference between risk-neutral and real-world default probabilities.
23.5. Explain what a first-to-default credit default swap is. Does its value increase or decrease as the default correlation between the companies in the basket increases? Explain why.
23.4. Explain how a cash CDO and a synthetic CDO are created.
23.3. Explain how a credit default swap is settled.
23.1. How does a binary credit default swap differ from a regular credit default swap?
22.26. What is the relationship between a regular call option, a binary call option, and a gap call option?
22.25. 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
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