Name : ______

FNCE 4070 – Final Exam

  1. (4 points) What is the present value of a 364-day piece of commercial paper with an investment rate of 2% and a face value of $1,000?
  1. (4 points) What is the present value of a 182-day T-bill with a discount yield of 2.5% and a face value of $100?
  1. In the following question we are going to discuss a bond with semi-annual coupons of 10% (pays 5% of face amount every 6 months), a 2 year maturity and a face amount of $1,000. The following table gives interest rates for various maturities. All interest rates are of the form 1+rt where t is measured in years.

Maturity in years / Interest Rate
0.5 / 2%
1 / 2.5%
1.5 / 3%
2 / 3.5%
  1. (4 points) Fill out the following table to three decimal places:

Maturity in years / Discount Factor
0.5
1
1.5
2
  1. (4 points) What is the present value of the bond?
  1. (4 points) What is the duration of the bond?
  1. (4 points) If I buy this bond today for $1,120 and sell it in 1 year for $1,047 what is my return in dollar terms? Assume that all cash-flows are reinvested at a 2% interest rate.

In the final parts of this question we are considering the same bond but with a changed interest rate environment. The changed interest rates are:

Maturity in years / Interest Rate
0.5 / 2.1%
1 / 2.6%
1.5 / 3.1%
2 / 2.5%
  1. (2 points) Given the change in interest rates would you expect that the value of the bond to increase or decrease? Explain why?
  1. (4 points) The ECB recently announced a bond-buying program for three-year government bonds if the country requests and accepts the conditions for a bailout. If immediately prior to this announcement the Spanish government had sold a 3-year annual coupon bond for 100 EUR with a face amount of 100 EUR and a coupon of 7.5% and the 3-year yield to maturity changed to 7% after the announcement, how much would a holder of one of these bonds make in EUR.
  1. The following questions are to do with securities lending:
  2. (2 points) Describe two investment strategies that require the borrowing of securities?
  1. (2 points) Why might a company that has a portfolio of securities be interested in lending them out?

At its peak AIG Securities Lending Corporation had lent $76bn of securities and invested 60% of the resulting cash in residential mortgage backed securities.

  1. (2 points) Why might AIG have set up a separate company to handle securities lending for all subsidiary companies?
  1. (2 points) As borrowers of AIG securities became concerned about AIG what actions might they have taken to protect themselves from problems with AIG?
  1. (2 points) In bailing out AIG why did the Federal Reserve set up Maiden Lane II to buy the RMBS AIG had bought with the cash from its securities lending program?
  1. (1 point) The Fed announced in February 2012 that they sold the last securities from Maiden Lane II. Overall did they make or lose money on these investments?
  1. The following question has to do with the following foreign exchange rates.

Market Participant / CCY1/CCY2 / Market Buys CCY1 and sells CCY2 / Market Buys CCY2 and sells CCY1
Trader 1 / EUR/CHF / 0.85 / 0.83
Trader 1 / EUR/USD / 0.77 / 0.74
Trader 2 / EUR/CHF / 0.86 / 0.84
Trader 2 / EUR/USD / 0.77 / 0.76
  1. (4 points) Given this market if you currently hold $1,000 dollars how should you turn these into CHF so as to maximize the number of CHF you will end up with?
  1. (4 points) Fill in the following table. Round to 3 decimal places.

Market Participant / CCY1/CCY2 / Market Buys CCY1 and sells CCY2 / Market Buys CCY2 and sells CCY1
Trader 1 / USD/CHF
Trader 2 / USD/CHF
  1. The following problem has to do with the following foreign exchange rates

Market Participant / CCY1/CCY2 / Market Buys CCY1 and sells CCY2 / Market Buys CCY2 and sells CCY1
Trader 1 / EUR/CHF / 0.85 / 0.83
Trader 2 / EUR/CHF / 0.88 / 0.86
  1. (4 points) If I start with 1,000,000 EUR what arbitrage can I take advantage of in this market? Describe the transactions precisely and how much money will I make?
  1. The following has to do with exchange rates and interest rates between Europe and Switzerland.
  2. (2 points) The current exchange rate between Euros (EUR) and Swiss francs (CHF) is 0.8500 EUR/CHF. 1-year interest rates in Europe are 2% and the 1-year forward exchange rate between EUR and CHF is 0.8600. What is the 1-year interest rate in Switzerland?
  1. (2 points) If the forward exchange rate stays fixed at 0.8600, interest rates in Switzerland stay fixed (from part (a) and European interest rates increase to 3% do you expect the Swiss franc to strengthen or weaken relative to the Euro? Would you expect the exchange rate to be more or less than 0.8500 EUR/CHF?
  1. The following has to do with the following order book for a stock:

Bid Quantity / Bid Price / Offer Price / Offer Quantity
5,000 / 50 / 52 / 6,000
4,000 / 49 / 53 / 10,000
6,000 / 48 / 60 / 15,000

The following traders enter orders into the order book

Trader / Order
A / A stop limit order to sell 2000 shares at 52
B / A limit order for 8,000 shares to buy at 52
C / A market if touched sell order for 5,000 shares at 53
D / A market sell order for 5,000 shares
  1. (8 points) How many shares does each trader buy/sell and at what average price?

Trader / Shares bought/sold / Average Price
A
B
C
D
  1. (4 points) Given these trades what is the resulting order book?

Bid Quantity / Bid Price / Offer Price / Offer Quantity
  1. Consider the three theories of the term structure of interest rates – expectations, premium liquidity and market segmentation. Probably should have three parts – do the students understand the difference between the different theories

a.  (6 points) Should be a problem on how to differentiate between different theories of interest rates

  1. (3 points) Which of these criteria does the liquidity premium theory of interest rates explain which the expectations theory does not? Explain your answer.
  1. Assume that the reserve requirements by the Federal Reserve are 10% of all checkable deposits. In the following problems there are two people with currency: Fred has $10,000 in his pocket and Sue has $10,000 dollars in her pocket. Further assume that two banks, Bank 1 and Bank 2 have just opened for business and have no assets or liabilities. Assume that the Fed has issued only the cash held by Fred and Sue and has the following balance sheet. Finally assume that there are no treasury monetary liabilities.

Federal Reserve

Assets / Liabilities
T-Bills / $20,000 / Cash in Circulation / $20,000
  1. (4 points) Fred opens a bank account at bank 1 and deposits $5,000. Sue opens a bank account at bank 2 and deposits $10,000. Fred and Sue borrow $8,000 each from Bank 2. The money is deposited into their respective banks. If Bank 2 does not have enough reserves to complete this transaction then it will borrow directly from the Federal Reserve. Correctly fill out the following T-accounts for the bank balance sheets after these transactions – distinguish between reserves and excess reserves.

Bank 1

Assets / Liabilities

Bank 2

Assets / Liabilities
  1. (4 points) Complete the following table describing the Federal Reserve’s balance sheet.

Assets / Liabilities
  1. (4 points) What is the Monetary Base after these transactions? What is M1 after these transactions?
  1. A hedge fund is going to set up a pairs trading strategy for 182 days between Pepsi (PEP) and Coca-Cola.(KO). They are going to go long PEP and short KO. In order to compute the cost of borrowing a share use the following formula:

InitialStockValue×BorrowRate×days365

The current market in these share are:

Stock / Today’s Share Price / Commission per share / Borrow Rate
PEP / $75.00 / $0.25 / 0.75%
KO / $37.50 / $0.25 / 0.25%
  1. (2 points) If your strategy is to have $750,000 long of PEP and $750,000 short of KO how many shares are you going to buy of PEP and how many shares of KO are you going to sell?
  1. (4 points) What percentage outperformance must PEP have over KO in order for the strategy to break even?
  1. (4 points) Upon further analysis both PEP and KO are expected to pay dividends during the 182 days that the strategy is to be held. Both are expected to pay $0.5 dividends. Would you expect that your strategy has a higher or lower probability of making money? Why?
  1. (NOT A GREAT PROBLEM – TOO DETAIL ORIENTATED)A money market mutual fund is a common type of financial intermediary.
  2. (2 points) What advantages does a money market mutual fund provide over individual investments in the money markets?
  1. (2 points) In late 2007 several money market funds found themselves in difficulties and had to be bailed out by their parent companies over what type of commercial paper?
  1. (4 points) In September 2008 a money market mutual fund - the Reserve Fund - broke the buck? What does this mean and why was it important to investors?
  1. (4 points) Assume I have two portfolios of bonds, one with a present value of $20m and a duration of 2 years and the other with a present value of $40m and a duration of 5 years. What is the duration of the combined portfolio?
  1. Assume the liquidity premium theory of interest rates. The interest rates in the following table are of the form 1+rt where t is measured in years.

Maturity in years / Interest Rate / Liqudity Premuim
1 / 3.00% / 0%
2 / 3.5% / 0.5%
3 / 4.0% / 0.75%
  1. (2 points) Given this information would you expect that the present value of $1,000 dollars paid in three years time would be higher, lower or stay the same under the expectations theory of interest rates? Explain your answer.
  1. (4 points) Find the 1 year forward interest rate starting in 2 years time.
  1. The following question has to do with supply and demand for non-borrowed reserves at the Federal Reserve.
  2. (4 points) Draw supply and demand curves for non-borrowed reserve at the Federal Reserve compared to the Federal Funds Rate. Clearly mark:

·  The Fed Funds rate

·  The primary credit rate (discount rate)

·  The rate the Fed pays on reserves.

·  Units on both axes

·  Your supply and demand curves

  1. (4 points) What effect on the Fed Funds rate would you expect there to be from an open market operation where the Fed buys T-bills? Will the resultant monetary base increase or decrease? Demonstrate this effect using your supply and demand curves.
  1. (4 points) What effect on the US dollar (strengthen/weaken or stay the same) would you expect there to be from an open market operation where the Fed sells T-bills. Explain your answer.
  1. 10 year Hewlett Packard (HPQ) debt is trading at $900 for a face amount of $1000. A trader spends $900,000 buying this debt. He is concerned about the company and buys a $1m 5 year credit default swap (CDS) against HPQ defaulting. The quarterly CDS spread is 2%.
  2. (2 points) Describe the cash flows on this credit default swap prior to default.
  1. (4 points) Name 4 events that will trigger a default event for a credit default swap.
  1. (4 points) IF HPQ were to trigger a default event on this credit default swap describe how the settlement of the credit default swap works.
  1. (4 points) If immediately after the second payment (3 months from the inception of the trade) Hewlett Packard defaults on its bond. What is the total return in dollars to the trader?

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