Part 1 Place yourself in the role of the owner of a bank that is making loans to businesses. Suppose you always loan money in increments of $1000 (i.e. 1000,2000,. 12,000 1,200,000 etc..) and you charge interest every six months. Finally your client will pay all principal at the end of the loan (a date you will agree to). Make up one fictitious loan given the conditions above. When will your client want to prepay the loan? When will your client not want to prepay the loan? What is the impact on the value of the loan when market interest rates increase or decrease? What is the impact of the value of the loan if the firm becomes more or less risky? How might you design the loan so that it is less risky to you (i.e. more risky to the borrower).

Part 2 A call option gives the owner of the option the right to buy a specific asset at a specific price on or before a specific date. Can you related a call option to the answer you gave in Part 1? Suppose you see an advertisement for a computer selling for $499 that you would like to purchase. You race to the store, but when you arrive you are unsure you want to buy the computer because it isnt quite what you expected. The sale ends today, but the owner of the store decides that if you are willing to pay a fee of $10 he will sell you the computer for the sale price any time in the week. What is the call option in this example? What is the call price? What is the price of the call option? When does the option mature? Have you ever purchased or exercised a call option?