A stock has a spot price of $46 and a strike price of $48. The risk-free interest rate is 6% pa continuously compounding. Additionally, assume that over the next two four-month periods, the share price is expected to go up by 11% or down by 10%.

• a. Use a two-step binomial tree to calculate the value of an eight-month European call option using the no-arbitrage approach.
• b. Use a two-step binomial tree to calculate the value of an eight-month European put option using the no-arbitrage approach.
• c. Show whether the put-call-parity holds for the European call and the European put prices you calculated in a. and b
• d. Use a two-step binomial tree to calculate the value of an eight-month European call option using risk-neutral valuation.

Question 2

In the Mundell-Flemming model with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when taxes are reduced. Contrast what would happen if exchange rates were fixed rather than floating?

Question 3

Should we proceed with this project?

*Initial investment = $5,000,000; taxes = 35%; Beta = 1.27; T-note = 2.4%

*Dividends paid = $1,000,000, with a payout rate of 33%

*Estimated sales are: $2,500,000 for year 1; $4,000,000 for year 2; $7,500,000 for year 3; $6,000,000 for years 4 & 5; $4,500,000 for year 6; and $1,500,000 in year 7, with a sale of an asset in year 7 for $250,000

*VC = 52%; FC = $400,000 per year

*The company's benchmark is the Wilshire 5000, which is expected to return 11% this year, with 250,000 shares of common stock quoted today at $25, paying a dividend of $1.20 per share, and 100,000 shares of preferred stock quoted today at $45, paying a dividend of $2.50 per share.

*The company is paying on a 20-year, 4.75% loan issued 5 years ago with today's principal = $2,750,000.

*There are two bonds outstanding: 1) 2,000 20-year bonds issued 5 years ago with a coupon rate of 4.25% with today's market rate = 3.75%, and 2) 2,500 15-year bonds issued 3 years ago with a coupon rate of 3.88% with today's market rate = 3.6%.

*The company estimates its return on equity is 12%.

Question 4

In the Mundell-Flemming model with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when the money supply is increased. Contrast what would happen if exchange rates were fixed rather than floating?

Question 5

Assume that capital markets are perfect: there are no transactions costs or taxes, no bankruptcy costs, individuals can borrow and lend at the same rate as corporations can, and all agents in the economy have the same information. Let us compare two corporations that are identical except that one is all equity financed and the other is part equity and part debt financed. Denote the value of the unlevered (all equity) firm by VU and the value of the levered firm by VL. Assume that VU = $20,000. Interest rate on the firm's debt is 0.10. The firms generate identical net revenues of $2000 in good times, $500 in bad times. Levered firm has $5,000 of debt. A. Compute the cash flows accruing to an investor who borrows on her personal account an amount equal to one percent of the debt of the levered firm and purchases one percent of the unlevered firm. B. Compute the cash flows of an investor who purchases one percent of the equity of the levered firm. C. Using your results in parts (A) and (B) and the no-arbitrage condition, construct an argument to prove that VL = $20,000.