marks Alex is excited to realize how various concepts in finance can be applied to solve multiple problems. I mean who could have thought that Black-Scholes model for computing the value of a call option could help me figure out the value of a firm's equity, he muses aloud. Henry overhears him and is annoyed by the over-imaginativeness of his friend. "Hey, hey, hey, hold your horses man. What are you talking about? The professor already had a lengthy discussion or how to establish a firm's equity value. I mean we have so many models for computing a firm's stock price and y extension, the value of equity. Using a call option model to find out a firm's equity value is something that he never spoke about and it seems like a far cry." Alex then goes on to share his idea with Henry as follows: "The value of a call option is based on an underlying asset, the standard deviation of returns of the underlying asset, a proxy for the risk-free rate and exercise price. Now imagine a situation where the lenders held a firm hostage by saying - Either repay the loan or we seize and sell the assets of your company to recover our dues. In that case, the owners or the equityholders would have an option to pay the loan amount and reclaim the firm's assets. Or they could let the option expire (default) and let the firm's assets be seized. If they wanted to acquire their assets, it would be just like paying the exercise price (loan) and acquring the underlying (asset)." Alex pats himself on the back at his new-found understanding and runs off, leaving Henry to ponder if the equityholders have an option, what type of option would that be? Call or Put? And how would this translate into a firm's equity value. SECTION 3 - 35 marks There are five (5) questions in this section. For Question 3.1, two questions are provided and you can choose to attempt either Question 3.la or 3.1b. Other questions are compulsory Question 3.1a - 10 marks You are a financial manager and you have bonds worth $3,000,000 in your portfolio which have a 7 percent coupon ate and will be maturing in 10 years from now. The market rate is also 7 percent. Suppose a futures contract on these bonds is available with a standard contract size of $300,000 per contract. i) What type of risk are you exposed to and how will you hedge your exposure? ii) If the market interest rates change to 9 percent, show through relevant calculations, how hedge will protect you from loss. What if the interest rate in the market went down to 5%? your iii) Do you think you would have hedged better if you had used an options contract on these bonds with an exercise price of $3,140,000? The options contracts are available in the size of 10% options per contract at a price of $5 per contract. Show detailed workings. (1 + 4+ 5 = 10 marks) OR CIT , equityholders have an option, what type of option would that be? Call or Put? And how would this translate into a firm's equity value. Since Alex has run off to celebrate somewhere, you are required to do some research on this and clarify Henry's doubts by answering the following questions: a) If equity holders have an option to reclaim the firm's assets, what type of an option would this be, given that options can be exercised to either acquire something or give something away. Justify your response. b) In terms of options terminology, which term could be used to indicate a firm's equity value? The University of the West Indies Course Code: MGMT 3048 13/......... page 9 I c) Do a demonstration for Henry by computing the value of equity from the following information about Nectar Inc. Nectar Inc. has a 10-year, zero coupon bond with a face value of $30 million. The firm's assets have a market value of $100 million. The volatility of asset returns is 0.2, and the continuously compounded risk- free rate is 2%. D040 GTina has a junior colle X + C:/Users/donal/Downloads/MGMT%203048%20QUESTION%20PAPER%20(1)%20(1).pdf Tyvury zu market value of $100 million. The volatility of asset returns is 0.2, and the continuously compounded risk- free rate is 2%. up UWIE TUEEL VEVOU EEEEEEEEEE TE TEXTE DVE KEY (2 + 1 + 7 = 10 marks) Question 3.2 - 10 marks In a recent e-news, you observe that the 6-month forward rate is $1.5031 / Euro. Further, if you invest the dollar, it fetches you interest at the rate of 2% p.a. In comparison, the interest rate in Eurozone is 1% p.a. You also see that CAD 1.5513 are needed to purchase a Euro and CAD 1.332 are needed to buy a US$. Is it possible for you to make an arbitrage profit? If so, which of the arbitrage strategies will you employ and what will be the profit? Assume that interest rate parity holds and you have one million dollars available to conduct arbitrage. (10 marks) Question 3.3 - 5 marks ABC can borrow at either a fixed rate of 11% or a floating rate of LIBOR + 1% XYZ can borrow at either a fixed rate of 10% or a floating rate of LIBOR + 3% I The swap dealer can help them meet and negotiate for a fee of 2% of the deal Construct a mutually beneficial swapping arrangement if ABC and XYZ decide to share the available QSD equally and show that the dealer is satisfied with the deal as well. marks Alex is excited to realize how various concepts in finance can be applied to solve multiple problems. I mean who could have thought that Black-Scholes model for computing the value of a call option could help me figure out the value of a firm's equity, he muses aloud. Henry overhears him and is annoyed by the over-imaginativeness of his friend. "Hey, hey, hey, hold your horses man. What are you talking about? The professor already had a lengthy discussion or how to establish a firm's equity value. I mean we have so many models for computing a firm's stock price and y extension, the value of equity. Using a call option model to find out a firm's equity value is something that he never spoke about and it seems like a far cry." Alex then goes on to share his idea with Henry as follows: "The value of a call option is based on an underlying asset, the standard deviation of returns of the underlying asset, a proxy for the risk-free rate and exercise price. Now imagine a situation where the lenders held a firm hostage by saying - Either repay the loan or we seize and sell the assets of your company to recover our dues. In that case, the owners or the equityholders would have an option to pay the loan amount and reclaim the firm's assets. Or they could let the option expire (default) and let the firm's assets be seized. If they wanted to acquire their assets, it would be just like paying the exercise price (loan) and acquring the underlying (asset)." Alex pats himself on the back at his new-found understanding and runs off, leaving Henry to ponder if the equityholders have an option, what type of option would that be? Call or Put? And how would this translate into a firm's equity value. SECTION 3 - 35 marks There are five (5) questions in this section. For Question 3.1, two questions are provided and you can choose to attempt either Question 3.la or 3.1b. Other questions are compulsory Question 3.1a - 10 marks You are a financial manager and you have bonds worth $3,000,000 in your portfolio which have a 7 percent coupon ate and will be maturing in 10 years from now. The market rate is also 7 percent. Suppose a futures contract on these bonds is available with a standard contract size of $300,000 per contract. i) What type of risk are you exposed to and how will you hedge your exposure? ii) If the market interest rates change to 9 percent, show through relevant calculations, how hedge will protect you from loss. What if the interest rate in the market went down to 5%? your iii) Do you think you would have hedged better if you had used an options contract on these bonds with an exercise price of $3,140,000? The options contracts are available in the size of 10% options per contract at a price of $5 per contract. Show detailed workings. (1 + 4+ 5 = 10 marks) OR CIT , equityholders have an option, what type of option would that be? Call or Put? And how would this translate into a firm's equity value. Since Alex has run off to celebrate somewhere, you are required to do some research on this and clarify Henry's doubts by answering the following questions: a) If equity holders have an option to reclaim the firm's assets, what type of an option would this be, given that options can be exercised to either acquire something or give something away. Justify your response. b) In terms of options terminology, which term could be used to indicate a firm's equity value? The University of the West Indies Course Code: MGMT 3048 13/......... page 9 I c) Do a demonstration for Henry by computing the value of equity from the following information about Nectar Inc. Nectar Inc. has a 10-year, zero coupon bond with a face value of $30 million. The firm's assets have a market value of $100 million. The volatility of asset returns is 0.2, and the continuously compounded risk- free rate is 2%. D040 GTina has a junior colle X + C:/Users/donal/Downloads/MGMT%203048%20QUESTION%20PAPER%20(1)%20(1).pdf Tyvury zu market value of $100 million. The volatility of asset returns is 0.2, and the continuously compounded risk- free rate is 2%. up UWIE TUEEL VEVOU EEEEEEEEEE TE TEXTE DVE KEY (2 + 1 + 7 = 10 marks) Question 3.2 - 10 marks In a recent e-news, you observe that the 6-month forward rate is $1.5031 / Euro. Further, if you invest the dollar, it fetches you interest at the rate of 2% p.a. In comparison, the interest rate in Eurozone is 1% p.a. You also see that CAD 1.5513 are needed to purchase a Euro and CAD 1.332 are needed to buy a US$. Is it possible for you to make an arbitrage profit? If so, which of the arbitrage strategies will you employ and what will be the profit? Assume that interest rate parity holds and you have one million dollars available to conduct arbitrage. (10 marks) Question 3.3 - 5 marks ABC can borrow at either a fixed rate of 11% or a floating rate of LIBOR + 1% XYZ can borrow at either a fixed rate of 10% or a floating rate of LIBOR + 3% I The swap dealer can help them meet and negotiate for a fee of 2% of the deal Construct a mutually beneficial swapping arrangement if ABC and XYZ decide to share the available QSD equally and show that the dealer is satisfied with the deal as well