Question 4 (Capital Structure-Theory)

Part A

How do taxes affect choices of debt versus equity?

Part B

What is meant by diversification and how does it relate to systematic versus unsystematic

risk?

Part C

Which of the following risks of stock are likely to be unsystematic, diversifiable risks and

which are likely to be systematic risks? Which risks will affect the risk premium that investors will demand?

1. The risk that inflation will rise by 0.5%

2. The risk that oil price rises, increasing the production cost

3. The risks that the drug produced by a pharmaceutical company causes serious side

effect

4. The risk that a mining company pollute the environment the company is operate in.

Question 5 (Derivatives Securities-Calculation and theory)

Part A

You happened to check the newspaper and noticed an arbitrage opportunity. The current stock

price of Zahari Ltd is $20 and the one-year risk free rate is 8%. A one year put option on Zahari

Ltd with a strike price of $18 sell for $3.33, while the identical call sell for $7. What is your

arbitrage profit if you take advantage of the opportunity available to you?

Part B

You own a put option on Ford stock with a strike price of $30. You paid $3 for the call option

which will expire in exactly six months' time.

a. If the stock is trading at $38 in six months' time, what will be the pay out of the put?

b. If the stock is trading at $38 in six months' time, what will be the profit or loss of the put?

c. If the stock is trading at $29 in six months' time, what will be the pay out of the put?

d. If the stock is trading at $29 in six months' time, what will be the profit or loss of the put?

e. Illustrate using a payoff diagram showing the value of the call at expiration for (a) as a

function of the stock price at expiration.