金融机构与市场答案

CHAPTER 1

AN OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS ANSWERS TO END-OF-CHAPTER QUESTIONS

2. Explain the economic role of brokers, dealers, and investment bankers. How does each make a

profit?

Brokers, dealers, and investment bankers make markets at both primary and secondary stages.

Funds are raised and claims issued in primary markets with the help of investment bankers, who

purchase securities from issuers at one price and sell them to the investing public at a higher price, earning the und erwriter’s spread. In secondary markets brokers help bring buyers and sellers of

financial claims together, charging commissions, and dealers trade claims in volume, providing

liquidity and price discovery and earning the difference between ask and bid price (the bid-ask

spread).

5. Explain the concept of financial intermediation. How does the possibility of financial

intermediation increase the efficiency of the financial system?

Financial intermediation is the process by which financial institutions mediate unmatched

preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs. Th us, financial intermediaries ―transform‖ claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus making financial markets more efficient.

6. How do financial intermediaries generate profits?

Intermediaries pay SSUs less than they earn from DSUs. Operating costs absorb part of this margin.

Risks taken by the intermediary are rewarded by any remaining profit. Intermediaries enjoy 3

sources of comparative advantage: Economies of scale —large volumes of similar transactions;

transaction cost control—finding and negotiating direct investments less expensively; and risk

management expertise—bridging the ―information gap‖ about DSUs’ creditworthiness.

7. Explain the differences between the money markets and the capital markets. Which market would

General Motors use to finance a new vehicle assembly plant? Why?

Money markets are markets for liquidity, whether borrowed to finance current operations or lent to avoid holding idle cash in the short term. Money markets tend to be wholesale OTC markets made by dealers. Capital markets are where real assets or ―capital goods‖ are permanently financed, and involve a variety of wholesale and retail arrangements, both on organized exchanges and in OTC markets. GM would finance its new plant by issuing bonds or stock in the capital market. Investors would purchase those securities to build wealth over the long term, not to store liquidity. GMAC, the finance company subsidiary of GM, would finance its loan receivables both in the money market (commercial paper) and in the capital market (notes and bonds). GM would use the money market to ―store‖ cash in money market securities, which are generally, safe, liquid, and sh ort-term.

9. Metropolitan Nashville and Davidson County issues $25 million of municipal bonds to finance a

new domed stadium for the Tennessee Titans. The bonds have a face value of $10,000 each, are somewhat risky, and mature in 20 years. Enterprise Bank of Nashville buys one of the bonds using funds deposited by Sarah Levien and Ted Hawkins, who each purchased a 6-month, $5,000

certificate of deposit. Explain the intermediation services provided by Enterprise Bank in this

transaction. Illustrate with T-accounts.

Metropolitan Nashville and Davidson County Levien

________________________________________ _________________________________

Cash $10,000 from EBN || Bond $10,000 to EBN CD $5,000 at EBN || Cash $5,000 to EBN

Hawkins

_________________________________

CD $5,000 at EBN || Cash $5,000 to EBN

Enterprise Bank of Nashville

___________________________________________________

Bond $10,000 from MNDC || CD Levien $5,000

Cash $5,000 from Levien || CD Hawkins $5,000

Cash $5,000 from Hawkins || Cash $10,000 to MNDC

If Sarah or Ted had $10,000 and wanted to take the risks presented by the bonds, either of them

could buy a bond in the direct market from a broker or dealer. Each likely prefers the government guarantee of the CD, the more easily affordable denomination of $5,000, and the ready liquidity (net of some known "penalty for early withdrawal"). Enterprise Bank now has a tax-free source of

income from the municipal bond, has made its expert evaluation of credit risk, is diversified with other securities, and can buy the bonds with low transaction costs. Many banks are underwriters of municipal securities and carry inventories as dealers. The City of Nashville has financed a capital project (the stadium) by issuing financial claims (the bonds). The bank bought a bond with deposit funds it raised by issuing Sarah and Ted CDs, which are assets to them and liabilities to the Bank.

The bond and the CDs are separate claims varying in denomination, maturity, risk, and liquidity.

The bank takes a position of risk, keeps part of the interest income from the bonds as a reward for that risk, and distributes part of it to Sarah and Ted to reward them for postponing current

consumption. The city, the ultimate borrower or DSU, has no direct relationship with Sarah and Ted, the ultimate lenders or SSUs.

15. What is the difference between marketability and liquidity?

Marketability is the ease with which a security can be sold and converted into cash. Liquidity is the ability to convert an asset into cash quickly without a loss of value. While the two concepts are

similar, marketability does not carry the implication that the security’s value is preserved.

16. Municipal bonds are attractive to what type of investors?

Municipal bonds are long-term debt of state and local governments. Their coupon income is exempt from federal income tax. Therefore, they are attractive to individuals and businesses in high income tax brackets.

17. Why do corporations issue commercial paper?

Commercial paper is short-term corporate debt; it is issued to meet corporate short-term cash

obligations.

18. Explain what is meant by moral hazard. What problems does it present when a bank makes a loan?

When it comes to loans, moral hazard occurs if borrowers engage in activities that increase the

probability of default. A firm that has taken a bank loan may take on very risky investment projects

which, if successful, would result in large profits, but which have high probabilities of failure. The reason for such behavior is that lenders do not share the upside with shareholders of the firm. To

reduce moral hazard, the bank may impose some restrictions on the borrower stipulated in the loan contract (e.g., to maintain certain financial ratios at a certain level or better, to not acquire certain assets, or to reduce expenses), and continually monitor the borrower.

19. Explain the adverse selection problem. How can lenders reduce its effect?

Adverse selection arises from asymmetric information and, in the context of debt markets, refers to borrowers of poor credit quality applying for loans (perhaps because such borrowers need the loans the most in order to survive financially). The lender may reduce adverse selection by requiring loan applicants to supply detailed financial statements and other additional information, to use

differential loan pricing for borrowers of different credit quality, or to reject loan applications if the risk appears too high. To process the information they collect, lenders often develop or acquire from third party credit scoring models that help determine borrowers’ creditworthiness.

20. Why is the financial system so highly regulated?

The regulation is needed to protect consumers from abuses by unscrupulous financial firms and to ensure economic stability. People should have confidence in the financial system for it to function well, and a well-functioning financial system is critical for ensuring the flow of funds and, in turn, economic growth.

CHAPTER 4

THE LEVEL OF INTEREST RATES

ANSWERS TO END-OF-CHAPTER QUESTIONS

1. What factors determine the real rate of interest?

The real rate of interest is determined by: (a) individual time preference for consumption, and (b) the return that firms expect to earn on their real capital investments. In equilibrium, the real rate of

interest is determined when desired saving equals desired investment.

2. If the money supply is increased, what happens to the level of interest rates?

An increase in the money supply shifts the supply of loanable funds to the right, lowering interest rates (at least in the short term).

3. What is the Fisher effect? How does it affect the nominal rate of interest?

The Fisher effect is Irving Fisher’s hypothesis that expect ed inflation is embodied in current nominal interest rates. Assuming the ability to forecast expected inflation, nominal rates should vary directly with expected inflation.

4. The 1-year real rate of interest is currently estimated to be 4 percent. The current annual rate of

inflation is 6 percent, and market forecasts expect the annual rate of inflation to be 8 percent. What is the current 1-year nominal rate of interest?

Assuming the Fisher effect, the current 1-year nominal rate should be 12 percent, the sum of the real

rate (4%) plus the expected inflation rate (8%), an approximate but illustrative way of estimating the answer. The correct way to deal with compounding rates is to multiply (1+.04)(1+.08) - 1 = 12.32%.

5. The following annual inflation rates have been forecast for the next 5 years:

Year 1 3%

Year 2 4%

Year 3 5%

Year 4 5%

Year 5 4%

Use the average annual inflation rate and a 3% real rate to calculate the appropriate contract rate for a 1-year and a 5-year loan. How would your contract rates change if the Year 1 inflation

forecast increases to 5%? Discuss the difference in the impact on the contract rates from the change in inflation.

A lender would require compensation for both opportunity cost and loss of purchasing power. The

sum of the real rate, 3%, plus the expected rate of inflation, 3%, would be roughly 6% and accurately,

(1.03)(1.03) -1 = 6.09%. The 5-year rate would be the sum of the real rate plus the average inflation

rate expected: (1.03)(1.04197) - 1 = 7.32%. If the 1-year expected inflation rate were 5%, the

geometric average expected rate of inflation would be 4.6%, found as

[(1.05)(1.04)(1.05)(1.05)(1.04)]1/5– 1 = [(1.05)3(1.04)2]1/5– 1 = 0.046, and the contract rate would likely be (1.03)(1.046) -1 = 7.74%. Nominal rates include the real rate plus the expected inflation rate.

9. An investor purchased a 1-year Treasury security with a promised yield of 10 percent. The investor

expected the annual rate of inflation to be 6 percent; however, the actual rate turned out to be 10 percent. What were the expected and the realized real rate of interest for the investor?

The expected real rate is r e = (1+i)/(1+ΔP e) – 1 = (1.1/1.06) – 1 = 3.77%; the realized real rate is

(1.1/1.1) – 1 = 0.

12.Explain what is meant by the term positive time preference for consumption. How does it affect the

rate of interest?

Most people prefer to consume goods sooner rather than later. This is known as a positive time

preference for consumption. The higher this time preference is, the higher interest rate a person

should be offered to forgo consumption and make an investment.

CHAPTER 5

BOND PRICES AND INTEREST RATE RISK

ANSWERS TO END-OF-CHAPTER QUESTIONS

3. Find the price of a corporate bond maturing in 5 years that has a 5% coupon (annual payments),

a $1,000 face value, and an AA rating. A local newspaper's financial section reports that the yields

on 5 year bonds are: AAA = 6%, AA = 7%, and A = 8%.

The price of the corporate bond (P b) is:

4. What is the yield-to-maturity of a corporate bond with a 3-year maturity, 5 percent coupon

(semi-annual payments), a $1,000 face value, if the bond sold for $978.30?

Payments comprise an ordinary annuity of $25 every 6 months for 3 years plus a lump sum of $1,000 at end of 3 years. What discount rate equates this payment stream to $978.30?

Calculator: 6 N 25 PMT -978.30 PV 1,000 FV I = 2.899% (semiannual yield, or i/2 in the equation above); double to annualize: 5.80%.

7. Carol Chastain purchases a one-year discount bond with a face value of $1,000 for $862.07. What

is the yield of the bond?

Rearranging Equation (5.3), i = (1,000/862.07) – 1 = 16%.

8. David Hoffman purchases a $1,000 20-year bond with an 8% coupon rate (annual payments).

Yields on comparable bonds are 10%. David expects that, two years from now, yields on comparable bonds will have declined to 9%. Find his expected yield, assuming the bond is sold in two years.

Based on the YTM of 10% at the time of purchase, the purchasing price is $829.73:

Calculator: 1000 FV 20 N 10 I 80 PMT PV = $829.73.

In two years, based on 18 years remaining to maturity and the YTM of 9%, the bond price is expected to be $912.44:

The expected yield is the rate that discounts the cash flows the investor expects to receive (in this case, two annual coupons of $80 and the selling price of $912.44) to the amount the investment was purchased for (in this case, $829.73):

Calculator: 912.44 FV 2 N PV = -$829.73. 80 PMT I = 14.29%

9. Calculate the duration of a $1,000 4-year bond with an 8% coupon (annual payments) that is

currently selling at par.

The following table is useful for the duration calculation:

________________________________________________________________

Early cash flows (high reinvestment risk) will be weighted at a low value, thus lowering duration.

If the bond is held 3.577 years, the investor will earn the yield to maturity, 8%. If held to maturity, price risk is eliminated, but realized yield will be higher/lower than 8% depending on reinvestment rates.

10. Calculate the duration of a $1,000, 12-year zero coupon bond using annual compounding and a current

market rate of 9%.

Duration = 12 years; the duration of a zero coupon bond is, by definition, its term to maturity.

Check: D = (1,000*12/1.0912)/(1,000/1.0912) = 12

11. Define interest rate risk. Explain the two types of interest rate risk. How can an investor with a

given holding period use duration to reduce interest rate risk?

Interest rate risk is the potential deviations of realized yields from expected yields caused by changes in market interest rates. Interest rate risk comprises two subsidiary risks. Price risk is the potential variability in price (capital gains/losses) as price varies inversely with yields. Reinvestment risk is the potential variability in reinvestment rates, relative to the yield to maturity, caused by changing market interest rates. Selecting an investment with duration equal to the planned holding period locks in the yield to maturity.

12. Calculate the duration for a $1000, 4-year bond with a 4.5% annual coupon, currently selling at

par. Use duration to estimate the percentage change in the bond’s price for a decrease in the

market rate to 3.5%. How different is your answer from the actual price change calculated using Equation 5.6?

Duration is the sum of the time-weighted cash flows divided by the price of the bond: $3748.97/ $1000 or 3.75 years. Per Equation 5.8, %ΔPB ≈ (-3.75)(-0.01/1.045)(100) ≈ 3.59%; compared to the actual price change of 3.67% (found by comparing the totals of Columns 3 and 5 above (the price rises from $1,000 to $1,036.73) or by applying Equation 5.6).

13. A bond with 3 years to maturity and a coupon of 6.25% is currently selling at $932.24. Assume

annual coupon payments.

a.What is its yield to maturity?

https://www.360docs.net/doc/c74782993.html,pute its duration using Equation 5.7 and the YTM calculated above at the discount rate.

c.If interest rates are expected to decrease by 50 basis points, what is the expected dollar change in

price? Percentage change in price?

a.Calculator: 1,000 FV 3 N PV = -$932.24. 62.50 PMT I = 8.92%

b. D = (62.5/1.0892 + 62.5*2/1.08922 +1,062.5*3/1.08923)/932.24 = 2,629.51/932.24 = 2.82.

c.Per Equation 5.8, %ΔPB ≈ (-2.82)(-0.005/1.0892)(100) = 1.29%. Based on the initial will be price

of $932.24, the dollar change in price is 1.29% of $932.24, or $12.03, and the new price is $944.27.

This is an approximation. The actual new price will be $944.50:

Calculator: 1,000 FV 3 N I = 8.42 62.50 PMT PV = 944.50.

This represents a $12.26, or a 1.31%, increase in the bond price.

CHAPTER 6

3

THE STRUCTURE OF INTEREST RATES

ANSWERS TO END-OF-CHAPTER QUESTIONS

3. A commercial bank made a five-year term loan at 13 percent. The bank's economics department

forecasts that one and three years in the future, the two-year interest rate will be 12 percent and 14 percent, respectively. The current one-year rate is 7 percent. Given that the bank's forecast is

reliable, has the bank set the five-year rate correctly?

Given the bank's forecast, the five-year rate (t R5) should be equal to 10.64 percent using Equation

(6.1):[(1.07)(1.12)2(1.14)2]1/5 -1 = 11.77%. The bank's loan rate is higher, likely to compensate the

bank for the default risk of the loan.

5. What do bond ratings measure? Explain some of the important factors in determining a security's

bond rating.

Bond ratings measure default risk. Among the important determinants of a firm’s bond rating are: (1) the firm’s expected cash flows; (2) the amount of the firm’s fixed contractual cash payments; (3) the length of time the firm has been profitable; and (4) the variability of the firm’s earnings.

7. Explain the importance of a call provision to investors. Do callable bonds have higher or lower

yields than similar non-callable bonds? Why?

A call provision allows an issuer to retire a bond prior to its stated maturity. Callable bonds have

higher yields than similar non-callable bonds because of the possibility of not receiving the expected yield to maturity if a bond is retired before its maturity (e.g., calling for refunding purposes).

8. Define marketability. Explain why marketability of a security is important to both investor and

issuer.

Marketability refers to the ease with which an investor can sell an asset. For investors, marketability means that the security can be sold easily in some secondary market; for issuers, marketable

securities have lower borrowing costs.

9. A new-issue municipal bond rated Aaa by Moody's Investor Service is priced to yield 8 percent. If

you are in the 33 percent tax bracket, what yield would you need to earn on a taxable bond to be indifferent?

Using Equation 6.4: 8% = i bt (1-.33); find i bt = 8%/(1 - .33) = 11.94%

11. Under which scenario, rising interest rates or falling interest rates, would a bond investor be most

likely to exercise a put option on a bond? Explain.

A put option would give the bondholder the option of selling the bond back to the issuer. This is

likely only if current interest rates are above the coupon rate on the bond. Such bonds are not likely to trade at a discount relative to the put price, for they are redeemable by the issuer if rates increase.

12. Suppose the 7-year spot interest rate is 9 percent and the 2-year spot rate is 6 percent. The

4

forecasted 3-year rate two years from now is 7.25 percent. What is the implied forward rate on a 2-year bond originating 5 years from now? {HINT: Under the expectations hypothesis, in equilibrium an investor with a 7-year holding period will be indifferent between investing in a 7-year bond or a combination of securities over the same period.}

One must calculate the rate on a 2-year bond (t+5f 2) acquired after investments for two years (1.06)2 and three more years (1.0725)3 that makes an investor indifferent to a 7-year bond at 9 percent (1.09)7.

1.097 = 1.062 1.07253(1 + t+5f 2)2

(1+ t+5f 2)2 = 1.097/(1.062 1.0725)3 or (1+t+5f 2) = [1.8280/1.3861]1/2

t+5f 2 = (1.3188)1/2

- 1 = 14.84%

Proof: 1.062 1.07253 1.14842 = 1.097

13.

Suppose you hold a corporate bond that is convertible into the firm's stock. Stock prices are falling and interest rates are also falling. Would it be a good idea to exercise your conversion option under these conditions? Why?

Assuming that the firm's stock price has also been falling, the value of the conversion option is low. With interest rates falling, the bond is likely to be selling at a premium over the stock conversion value. In that situation, conversion would cost the investor money! It is not likely that one would convert to stock at this time.

16.

Assume that the term structure of U.S. Treasury securities includes the following rates:

Using this information, calculate: (a) the six-month annualized yield expected in the second half of the current year, and (b) the one-year expected for year 3. [HINT: To answer (a), you will need to adjust the term structure formula for semiannual compounding.]

a.

%47.410226.10452.11)0457.1()0452.1(2

2

5.015

.05

.0=-??????=-??

????=+f t b.

%42.41)0451.1()0448.1(2

312

=-=+f t

17.

The observed yields on 1-year and 3-year securities are 8 percent and 11 percent, respectively. What

is the expected yield on a 2-year security 1 year from now?

%53.121)08.1()11.1(2

/1321

=-?

?

????=+f t

18.

An investor has an investment horizon of four years. The yield on a 2-year security today is 6 percent and the implied forward rate on a 2-year security two years from now is 6.75 percent. What should be the yield on a 4-year security today such that the investor is indifferent between investing in a 4-year security versus a combination of two-year securities? Since (1 + t R 4) = [(1 + t R 2)2(1 + t+2f 2)2]1/4, t R 4= (1.062*1.06752)1/4 – 1 = 6.37%

CHAPTER 7

MONEY MARKETS

ANSWERS TO END-OF-CHAPTER QUESTIONS

1.

Calculate the bond equivalent yield for a 180-day T-bill that is purchased at a 6% asked yield. If the bill has a face value of $10,000, calculate its price.

First calculate the price of the T-bill using eq. 7.3 which is derived from eq. 7.1 in the text:

700

,9$300

000,10$000,10$36018006.0000,10$3600=-=???

?????-=?

?

?

?????-=f d f P n y P P

where P f is the face value ($10,000), y d is the bank discount rate (6%) and n is the number of days (180).

The bond equivalent yield (y be ) uses the net amount of funds invested or price as the divisor and 365 days (See Eq. 7.2):

%27.6%100180365

700,9$700,9$000,10$%

10036500=??-=

??-=n

P P P y f be

2. What are the characteristics of money market instruments ? Why must a financial claim possess these characteristics to function as a money market instrument ?

The three fundamental characteristics of money market instruments are: (a) low default risk, (b) short-term to maturity, and (c) high marketability. These characteristics give money market instruments their characteristic of being low risk. Money market investors demand low-risk securities because their cash excesses are only temporary.

8.

Suppose Fargood Corporation engages in a repurchase agreement with The National Bank of Nebraska. In the agreement, Fargood sells $9,987,950 worth of Treasury securities to the bank and agrees to repurchase the securities in 30 days for $10,000,000. a. Is this transaction a loan, and if so, who is the borrower and who is the lender? Defend your

answer.

The transaction is a repurchase agreement for Fargood and a reverse repurchase agreement for the bank. The bank is the lender because it is buying (investment of funds) the Treasuries owned by Fargood, the borrower of the funds for the period of the repo. Technically, it is not a loan but a purchase with agreement to resell, but the effect is the same as a loan to a customer. b. Is the loan collateralized? What is the collateral? Who holds the collateral during the term

of the agreement?

The loan is collateralized because the securities sold serve as collateral. The bank or offsite depository would hold the securities during the contract period. c. What interest rate (or yield) is earned by the lender?

The annualized yield to the bank (cost to Fargood) would be:

%

45.130

360

950,987,9$950,987,9$000,000,10$3600

=?-=

?

-=n

P P P y repo repo

d. Draw T-accounts for this transaction, similar to the example earlier in the chapter. Show

the assets and liabilities for each party before and after the transaction.

Fargood Corp National Bank

1) +Deposit 1) +T.Sec. 1)+Deposit (Fargood) in bank $9,987,950 $9,987,950 $9,987,950 -T Sec. $9,987,950 2) -Deposit 2)-Capital 2) -T.Sec. 2)-Deposit (Fargood) $10,000,000 loss on repo $10,000,000 $10,000,000 $12,050 2)+Capital gain +T. Sec. $12,050 $10,000,000 9. Suppose 7-day fed funds trade at 1.65 percent annually. What is the yield on fed funds on a

bond-equivalent basis?

To compare yields in the fed funds market with those of other money market instruments, the fed funds rate must be converted into a bond equivalent yield.

%673.1360365%65.1360365=??

?

??=??? ??=ff be y y

CHAPTER 8 BOND MARKETS

ANSWERS TO END-OF-CHAPTER QUESTIONS

1. Calculate the gross profit that an underwriter would make if it sold $10 million worth of bonds at par (face value) and paid the firm that sold the bonds 99.25% of par.

The gross profit would be 0.75% of the $10 million raised in the market or:

0.0075 (10,000,000) = $75,000.

2. If a bond dealer bought a $100,000 municipal bond at 90% of par and sold it at 93% of par, how much money did the dealer make on the bid-ask spread?

The spread of 3% of $100,000 is $3,000.

3.

If a corporate bond paid 9% interest, and you are in the 28% income tax bracket, what rate would you have to earn on a general obligation municipal bond of equivalent risk and maturity in order to be equally well off? Given that municipal bonds are often not easily marketable, would you want to earn a higher or lower rate than the rate you just calculated?

The after tax yield on the taxable corporate bond is 6.48% or [9%(1-0.28)] and is the comparable rate of a tax-free municipal bond. For any added risk on the muni bond (e.g., lower marketability), the investor would pay less or require a higher rate of return (i.e., above 6.48%).

8.

Define the following terms: (a) private placement, (b) asset-backed security, (c) callable securities, (d) sinking fund provisions, and (e) convertible features of securities .

The above terms are explained as follows:

(a) private placement is the sale of bonds to a single investor or small group of

sophisticated investors, that meet the guidelines for avoiding registration and disclosure requirements of the SEC and state laws. SEC requires that the issue be sold to no more than 35 investors to qualify as a private placement.

(b) asset-backed securities are the financial claims issued when loans are securitized; (c) callable securities can be retired by the issuer's option prior to their stated maturity

at a pre-specified price called the call price. Advantage is to issuers and investors have to be compensated with a call premium in the form of a higher yield.

(d) sinking fund provisions require the issuer to retire a percentage of a bond issue on

an annual basis. It reduces the risk of default to investors.

(e) convertible features of securities are options of the investor to convert the security

into another form of security, typically into an equity security

12. What is a credit spread? What happened to credit spreads during the financial crisis of

2007-2009?

A credit spread is the difference between yields of otherwise similar debt securities with

different credit risk. The credit spreads started to widen in the middle of 2007 and peaked in December 2008. The Baa-Treasury spread widened much more than the Aaa-Treasury spread. This is a manifestation of a flight to quality. The credit spreads narrowed in the

second half of 2009 and 2010, when the bond markets returned to relative normalcy.

CHAPTER 10

EQUITY MARKETS

ANSWERS TO END-OF-CHAPTER QUESTIONS

2. Why are convertible securities more attractive to investors than simply holding a firm's preferred

stock or corporate bonds?

Convertibles provide a set, prior claim if the common equity does not perform. If the stock

appreciates, the convertibles may participate in the good fortune of the company, created with their funds. The tradeoff is a lower yield on convertible securities.

4. Weber Corporation has 10 million shares of a preferred stock issue outstanding that pays a

cumulative $6 annual dividend on a quarterly basis. As a result of poor profitability, however, the company has not paid the preferred stock dividend for the previous five quarters. The company also has 20 million shares of common stock outstanding. Weber Corporations’ profitability has

improved recently and the board of directors believes that the company can pay $100 million in

dividends next quarter. How much of a dividend can the company pay on its common stock?

Of the $100 Million available for total dividends, the preferred stock is cumulative so that dividend arrearages must be paid before any dividend may be paid to common.

Preferred Dividends to be paid:

Quarterly preferred dividend = $6.00/4 = $1.50

Accumulated preferred dividend to be paid first = $1.50*5 = $7.50/share

Total Preferred Dividends to be paid = $7.50 x 10 million shares = $75 million Before paying a common dividend, the current quarter’s preferred dividend must be paid.

Amount due to preferred stockholders = ($1.50 x 10 Mil) = $15 Million,

Common Dividends to be paid:

Amount available for common stockholders = $10 Million

Common dividends per share = $10 Mil/20 Mil. Shares = $0.50 per share

6. Explain why investors look at a stock’s P/E ratio rather than its pric e to determine if the stock is

cheap or expensive.

Because a stock price depends on the number of shares outstanding, comparing stock prices does not make sense. Investors want to compare apples to apples, and comparing earnings provide the desired ―common denominator‖. The P/E ratio is how much investors a re willing to pay for each $1 of a

company’s earnings per share. High P/E ratios indicate either that the stock is ―expensive‖

(overvalued) or that investors expect high earnings growth in the future. Note that the P/E ratio is a standardized measure of a stock’s price, and is not sensitive to changes in the number of shares

outstanding.

7. Briefly describe the role of the NYSE specialists. How does this role differ from that of a dealer?

Like a dealer, a stock specialist makes a continuous market at the stock trading post for his/her own account and maintains the limit price order book, executing trades for others at varied prices. Unlike dealers, specialists have an affirmative obligation to maintain bid and ask quotations for particular stocks at all times. NYSE specialists also maintain the book of limit orders, in which case they act like order clerks, not dealers.

12. Winters Hi-Hook Inc., a golf club manufacturer, is currently paying dividends of $.50 per share.

These dividends are expected to grow at a 20 percent rate for the next two years and at a 3 percent rate thereafter (forever!). What is the value of the stock if the appropriate discount rate is 14

percent?

This is an example of a variable dividend growth rate, Equation 10-11. One must find the PV of the first stage growth dividends and add it to the PV of the constant growth perpetuity assumed after the first stage growth, the beginning in the third year.

Dividends PV at 14%

D1 = $0.50 (1.20) = $0.60/1.14 = $0.526

D2 = $0.60 (1.20) = $0.72/1.142 = $0.554

PV of first stage growth $1.080

D3 = $0.554(1.03) = $0.571

P2 = D3/(r - g) = $0.72/(0.14 - 0.03) = $6.545

The price of the stock is the sum of the PV of the stock two years from now estimated to be

$6.545/(1.14)2 = $5.04 plus the PV of the first stage growth of $1.08, or $6.12.

14. Patty’s Gardening Supplies is a young start-up company. It plans to pay no dividends over the next

five years because it must reinvest all earnings in the firm to finance planned growth. The firm then plans to begin dividends of $3 per share, which are anticipated to grow at 10 per cent per year for three years, and six percent per year in perpetuity beyond that. If the required return on Patty’s Gardening Supplies stock is 15 percent, what should be today's stock price?

The stock is expected to pay a $3.00 dividend in the sixth year; $3.00(1.10) = $3.30 in the seventh year, and $3.30(1.10) = $3.63 at the end of the eighth year. The PV of the first stage three-year

dividend stream at the end of the fifth year is:

PV0 = $3.00/(1.15)6 + $3.30/(1.15)7 + $3.63/(1.15)8 + [3.63(1.06)/(0.15 – 0.06)]/1.158

= $3.724 + $13.976 = $17.70.

16. Farrell Motors stock has a beta of 1.3. If the market has an expected return of 9 percent and the

risk-free rate is 1 percent, what is the expected return of the stock according to the security market line?

The expected rate of return is the sum of the risk-free rate plus the market risk premium times beta, or 1% + (9% - 1%)(1.3) = 11.4%. The expected market return is 9%; Farrell Motors' beta is 30% higher than the market, so their required rate of return is higher.

17. The market's required return on Paul Bunyan Oil Company stock is currently 13.8 percent. If the

expected return on the market portfolio is 12.6 percent and the risk-free rate is 3.5 percent, what is the beta of Paul Bunyan stock?

The required return of Paul Bunyan Oil exceeds the return on the market portfolio, indicating a beta above one. The market risk premium, 12.6% - 3.5%, or 9.1% times a beta plus the risk-free rate of

3.5% is Paul Bunyan's RRR of 13.8. Solving for beta,

13.8% = 3.5% + (9.1%)βand β = (13.8% – 3.5%)/9.1% = 1.13

18. Explain the difference between systematic and unsystematic risk. Explain how beta captures

systematic risk.

Unsystematic risk is the diversifiable risk portion of the total risk of a stock. Properly diversified, the portfolio formation eliminates the unsystematic (company-specific, diversifiable) risk, leaving the investor facing the systematic risk of the portfolio. Beta is a measure of the relative variability of the stock relative to the market portfolio. By definition, the market portfolio only has systematic risk.

19. You have decided to create stock market indexes using three representative stocks. At the end of day

one, stock X has a price of $20 per share and 20 million shares outstanding, stock Y has a price of $25 per share and 50 million shares outstanding, and stock Z has a price of $35 per share and 40 million shares outstanding. You calculate a price-weighted index and a market

capitalization-weighted index. You have decided that the beginning value of each index at the end of day one will be 100. What is the value of each index a t the end of day two if stock X’s price is $23 per share, stock Y’s price is $22 per share, and stock Z’s price is $36 per share?

Price-Weighted Index:

With a desired base of 100 the divisor will be 80/100 or 0.8. On day 2 the index moves to $81/0.8 = 101.25, up 101.25/100 = 1.25% for the day.

Market Value Weighted Index:

With a desired base of 100 = $3050 Million, then the second day the index would be

($3000/3050)*100 = 0.9836 x 100 = 98.36, a decline of 1.64 %.

CHAPTER 11

DERIVATIVES MARKETS

ANSWERS TO END-OF-CHAPTER QUESTIONS

1. What is the difference between the forward and the futures markets? What are the pros and cons

associated with using each one?

FORWARDS: FUTURES:

The forward market is unstructured Forward contracts trade over the counter. Unstandardized, tailored to the needs of the counterparties. Futures transactions are conducted on an organized exchange.

Numerous dealers match individual buyers and sellers and/or trade for their own accounts. Contracts are made between buyers or sellers and the exchange.

No margin is required. Margin requirements are imposed to ensure no one

will default when prices move adversely.

Most forward contracts are settled by delivery. Very few contracts are settled by delivery.

The forward market is useful when a set amount of currency is needed on a specific date. The futures market is useful when it is necessary to hedge price risk over a period of time.

No marking to market Marked to market daily.

All elements of the contract are negotiated. All elements of the contract are standardized (Only

price is variable).

Highly illiquid because of customized features. Trade on exchanges, and are very liquid.

Default potential may be quite high. Clearing house guarantees delivery and payment.

Low default risk.

May not be tailor ed to counterparties’ needs.

2. What role does the exchange play in futures transactions?

The exchange sells to buyers and buys from sellers. It also requires that margin requirements be

maintained, sets the terms of futures contracts, and makes sure that exchange trading rules are not broken. This eliminates default risk from futures contracts.

7. Why do you think exchanges are more concerned with writers of naked options than with writers of

covered options?

Covered option writers already own the security (or hold a short position) necessary to make good on the option they sold should it be exercised. Naked option writers don't have a hedged position;

they therefore are required to post cash as earnest money to guarantee their promise if price

movements are adverse, and the option is exercised.

10. Assume that in March a farmer and a baker enter into a forward contract on 1,000 bushels of wheat

at a price of $3.00 per bushel for delivery in September. In September the spot price of wheat is

$2.50 per bushel. Who has profited from entering into the forward contract and who has lost? How much is the gain and how much is the loss?

The farmer has locked in a price for his/her wheat at $3 when the spot price is $2.50. The farmer is ahead by $.50 x 1000 = $500, whereas the baker’s hedge, locking in a source of wheat at $3, has produced a $500 loss. Still, by entering into the forward contract, the baker eliminated or

significantly reduced the uncertainty regarding his/her profit margin through locking in a specific price for wheat.

11. Assume the initial margin on a Eurodollar futures contract is $878 and the maintenance margin is

$650 (the contract size is $1mln). If the contract price declines by 25 basis points, by how much do the long and sho rt positions’ margin balances change? Which position, if any, gets a margin call?

For each change in a basis point, the contract value changes by $25, so a decrease in price (increase in interest rates) of 25 basis points will cause a loss (25 x $25 = $625) for the long position (buying price is 25 basis points higher) and a $625 gain for the short position (selling Eurodollar for a price

25 basis point higher). The $625 hit will effect a margin call for the long position for the margin

account will only have $878 - $625 = $253,which is below the maintenance margin of $500. The trader will have to add $625 to satisfy the initial margin of $878.

13. A bank has entered into an interest rate swap. The swap has a notional principal amount of $100

million and calls for the bank to make annual fixed interest rate payments of 5 percent and to receive an annual floating interest rate payment of LIBOR plus 2 percent. If LIBOR is 1 percent, what

payment will the bank make or receive?

The amount of annual fixed ―payments‖ made by the bank is $5 million ($100 million x 5%).

LIBOR is 1 percent, so the bank will ―receive‖ 3 percent of the $100 million, or $3 million. Because only the net amounts are exchanged in swaps, the bank will end up making a payment of $2 million.

CHAPTER 12

INTERNATIONAL MARKETS

ANSWERS TO END-OF-CHAPTER QUESTIONS

1. If a bushel of corn costs ?3.00, and a British pound is worth $1.50, how many dollars would a

person receive for 100,000 bushels of corn sold in Britain in the spot market? If the delivery were to occur in three months and the U.S. interest rate exceeded the British rate by 2 percent per year, what would likely be received in the forward exchange market for a conversion arranged now if the current spot rate is $1.50 per British pound? Explain.

If a U.S. dollar cost of a British pound is $1.50 and corn is selling for $3.00 in the U.S., the pound cost of 100,000 bushels of corn in Britain's spot market is:

==

d

$1.50/poun $3.00

corn of Cost ￡2.00

The price of 100,000 bushels = ￡2 x 100,000 = ￡200,000

Assuming the forward/spot differential is reflected by interest rate differentials, if U.S. interest rates exceed British rates by 2 percent per year, we can assume that U.S. inflation rate exceeds British inflation rate by 2 percent per year and that the U.S. dollar is expected to depreciate by 2 percent per year, or (1.02).25 or 1.00496 per quarter. The 90 day forward rate should be $1.50(1.00496) = $1.5074/￡.

3.

Assume that the spot and one-year forward rates for the British pound are $1.60 and $1.55, respectively and are $0.90 and $0.92 per euro, respectively. If interest rates are 4 percent in the United States, 6 percent in Britain, and 3 percent in Germany, where can you get the best return on a covered one-year investment?

? Assuming a $100,000 investment, one will have $100,000 (1.04) or $104,000 at the end of

one year.

? The $100,000 converts to ￡62,500 at the spot rate of $1.6/￡, becomes ￡66,250 after earning

6 percent, and converts at the forward rate of $1.55/￡ to $102,688.

? The $100,000 converts to €111,111 at the spot rate of $0.90/€, becomes €114,444 after

earning 3 percent, and converts at the forward rate of $0.92/€ to $105,289.

Under the current forward/spot differentials, one can earn the best return by

converting U.S. dollars to Euros and investing in Germany.

6. If purchasing power parity applied to Big Macs, and a Big Mac cost $2.50 in the United States while the British pound cost $1.50 and €0.90 euros could be obtained for $1.00, how much wou ld the Big Mac cost in Britain and Germany, respectively? Why might it actually have a different price?

Assuming purchasing power parity or that the cost of a Big Mac is the same in the local currency around the world,

? The cost of a British Big Mac = $2.50 /$1.50 = ￡1.667 pounds . ? In Germany the cost = $2.50 * €0.90/$ = €2.25.

The big Mac price is driven by local food and labor costs and is not as likely to reflect PPP.

7.

If the Japanese yen were to change from ￥100/$ to ￥90/$, would the U.S. balance of payments improve (become more positive) or not ? Consider what effect the exchange rate change would have on both U.S. exports and imports to and from Japan and on purchase decisions made by manufacturers or importers located in other countries .

A drop from 100 to 90 yen would mean that the yen had risen relative to the dollar. Thus, U.S. goods would be cheaper relative to Japanese goods, so the United States would import fewer Japanese goods and the Japanese would import more U.S. goods. Also, purchasers in other countries would be more likely to buy U.S. goods than Japanese goods. Consequently, the U.S. balance of payments would most likely improve.

8. Assume that the United States and Canada are both initially in an economic recession and that the

United States begins to recover before Canada. What would you expect to happen to the U.S. dollar – Canadian dollar ($/C$) exchange rate? Why?

If the U.S. economy grew faster than Canada 's, U.S. imports would increase causing a trade deficit and a later decline in the U.S. dollar as U.S. imports increased relative to exports.

13. How can central bank intervention affect the exchange value of a currency? Will the currency

generally rise or fall if a central bank sells its home currency?

A central bank can use its stocks of foreign currencies to buy its own currency in the foreign

exchange markets. It also can buy foreign currencies for domestic currency. Buying the domestic currency will increase its exchange value due to an increased demand for it, while selling it will

decrease the exchange rate due to an increased supply.

14. How does inflation affect a country's spot and forward exchange rates? Why? Is it absolute

inflation or inflation relative to other countries that is important?

It is relative inflation that is important. Inflation causes forward exchange rates to fall relative to spot exchange rates only if other countries' prices are expected to be stable or increase less. If other

countries' prices were expected to inflate at the same rate, forward rates would still equal spot rates – assuming all countries' interest rates were the same.

16. Suppose the spot exchange rate today is $1.5/￡. The inflation rate is expected to be 3% in the United

States and 5% in the United Kingdom over the next year. The annual real interest rate will be 2% in both economies. Calculate the nominal rates in both countries next year.

i = (1 + r)(1 + ΔP e) – 1:

i US = 1.02*1.03 – 1 = 5.06%;

i UK = 1.02*1.05 – 1 = 7.10%.

17. Suppose the spot exchange rate today is $1.5/￡. The annual inflation rate is expected to be 3% in the

United States and 5% in the United Kingdom over the next three years. The annual real interest rate will be 2% in both economies. Calculate the nominal rates in both countries next year.

i = (1 + r)(1 + ΔP e) – 1:

i US = 1.02*1.03 – 1 = 5.06%;

i UK = 1.02*1.05 – 1 = 7.10%.

19. Suppose the spot exchange rate today is $1.5/￡. The inflation rate is expected to be 3% in the United

States and 5% in the United Kingdom over the next year. What is the expected exchange rate in one year? Is pound expected to appreciate or depreciate against the U.S. dollar one year from now,

based on PPP?

$1.5*1.03 = ￡1*1.05

$1.545 = ￡1.05

￡1 = $1.545/1.05 = $1.4714.

The UK pound is expected to depreciate against the dollar, from $1.5 to $1.4714.

20. Suppose the spot exchange rate today is $1.5/￡. The inflation rate is expected to be 3% in the United

States and 5% in the United Kingdom each year over the next two years. What is the expected

exchange rate at the end of year two? Is pound expected to appreciate or depreciate against the U.S.

dollar by the end of year two, based on PPP?

$1.5*1.03*1.03 = ￡1*1.05*1.05

$1.5914 = ￡1.1025

￡1 = $1.5914/1.1025 = $1.4434.

The UK pound is expected to depreciate against the dollar, from $1.5 to $1.4434.

21. An American importer needs to pay ￡100,000 in 30 days and would like to sign a forward contract

to hedge the exchange rate risk. Should the importer buy or sell pounds through a forward contract?

Suppose the 30-day forward rate is $1.60/￡ and after signing the contract the spot rate in 30 days turns out to be $1.55/￡. How many dollars does the firm have to pay in 30 days? Should the firm

have not hedged?

The importer should buy pounds forward. It would pay $1.60*100,000 = $160,000 in 30 days to

acquire the pounds needed to pay the foreign supplier. If the exchange rate in 30 days is $1.55/￡, the firm would be better off not hedging, since it would buy pounds at this rate. However, the goal of

hedging is to eliminate risk, not maximize profits on every transaction. Since there is no way of

knowing future exchange rates, hedging with futures locks in the exchange rate, which eliminates

exchange rate risk.

25. You noticed the current spot exchange rate is $1.50/￡ and the one-year forward exchange rate is

$1.60/￡. The one-year interest rate is 5.4% in dollars and 5.2% in pounds. Assuming you can

borrow at most $1,000,000 or the equivalent pound amount (i.e., ￡666,667, at the current spot

exchange rate), can you make a guaranteed profit? If so, how would you carry out the transaction?

If not, why not?

Guaranteed profit can be made in the following manner:

At the outset, (1) borrow $1,000,000 for one year at 5.4%, (2) convert to pounds at $1.50/￡ for the total of $￡666,667, (3) invest pounds for one year at 5.2% to receive ￡666,667*1.052 = ￡701,333 in one year, and (4) enter into a one-year forward contract to sell ￡701,333 in one year at $1.60/￡.

In one year, (1) collect your pound investment with interest, ￡701,333, (2) convert to dollars at the rate of $1.60/￡ locked in the forward contract for the total of 701,333*1.60 = $1,122,133, and (3)

repay the dollar loan with interest, $1,054,000.

The profit is $1,122,133 - $1,054,000 = $68,133.

This analysis assumes the investments are risk-free, i.e., the return of ￡701,333 in one year is

guaranteed.