Final Exam Anwer of Finance Essay

The Financial System Special exam, spring semester, 2011 Time Allowed: 3 hours plus 10 minutes reading time. Exam day and date: 1. Exam Paper: • Please ensure that your name and student number are at the top of this page. • There are three parts to this exam: Part A, Part B and Part C. All questions are compulsory. This paper will be marked out of 50 marks. Part A: 15 (1-mark) multiple choice questions. Record your chosen answer to each question on the supplied computer card starting with Q1 Part B: Five (5-mark) questions. Write your answers in the spaces provided in this exam paper. Part C: 10-mark case study. Write your answer in the separate booklet. • Answers to calculation questions must be substantiated by showing your working. • This exam paper includes a formula sheet on the final page. 2. Exam Conditions: • Financial calculators and other non-programmable calculators are allowed. Pencils may be used, but write clearly if you want your answers to be graded. PART A:15 MULTIPLE CHOICE QUESTIONS (15 MARKS) 1. Our study of “business angels” revealed they a) are the main lenders to small business; b) are security analysts who provide financial advice; c) invest in non-government bonds; d) are investors in the venture capital market; e) are not described by all of the above. 2. Our study of Australia’s bond market revealed: a) Stocks and bonds are the main securities traded in the bond market; b) Treasury bonds pay coupons on the 8th of each coupon month; ) There are much more government bonds issued than non-government bonds; d) Bond prices rise when coupons are paid; e) Non-government bonds will always trade at a “discount” to their face value. 3. Our study of Australia’s bond market revealed that a) bond investors are exposed to credit risk but not price risk; b) bond dealers conduct trades by quoting bid and offer prices; c) the Government conducts monetary policy by setting the interest rate for bonds; d) mortgage brokers are the main issuers of mortgage-backed securities; e) none of the above are correct. 4.

It is clear from our study of exchange rates that a) in the AUD/USD rate the USD is the commodity currency; b) exchange rate movements quickly adjust for variations in inflation rates; c) increases in the current account surplus causes the exchange rate to depreciate; d) the RBA sells the AUD to increase its value; e) the AUD/EUR is an example of a cross rate. 5. The ASX option market a) requires margin payments from buyers and seller; a) specifies the expiry date and the exercise price of option contracts; a) specifies four expiry months a year; March, June, September and December; ) mandates that contracts be closed out on their expiry date; a) is an example of an over-the-counter market. Over 6. Suppose you paid $0. 50 each for call options on Telstra shares with a $3 exercise price a) you pay the 50 cents (per option) to the clearinghouse as your initial deposit; b) your option position is out-of-the-money if the share price is $3. 25; c) you would closeout your option position by buying Telstra put options; d) you are described as the holder of the long position in Telstra options; e) both (b) and (d) are correct. 7. Our study of IPOs revealed a) they always raise funds for the new company; ) institutional investors are the main buyers of shares in small IPOs; c) a prospectus is not required for institutional investors; d) they result in the shares being listed on the share market; e) the share price must be approved by ASIC. 8. Which of the following option values is determined by traders rather than the exchange? a) the contract’s size; b) the option’s premium; c) the option’s margin payments; d) the contract’s exercise price; e) the option’s expiry date. 9. From our study of plain vanilla swaps we learned that a) the floating rate payer will benefit if interest rates rise unexpectedly; ) the floating-rate payments are based on the cash rate; c) the fixed-rate payer will benefit if interest rates increase unexpectedly; d) settlement payments are made at the start of each quarter; e) none of the above answers are correct.

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10. The liquidity premium hypothesis a) is that longer-term securities have more price risk than shorter-term securities; a) is based on the assumption that forward rates reflect expected future spot rates; b) implies that 2-period securities will trade at a higher price than one-period securities; a) assumes that financial markets are not liquid; ) is not correctly described by any of the above answers. Over/… 11. Our study of spot and forward interest rates allows us to conclude that a) forward short-term rates are traded in the money market; b) the two-period future value of $1 is given by (1 + 0r2)2; c) the one-period future value of $1 is given by (1 + 1r2)2; d) forward rates are established by trading in debt security markets; e) forward rates are uncertain unlike future spot rate. 12. Our study of the futures and FRA markets revealed that a) FRAs establish forward rates whereas futures establish future spot rates; ) futures contracts can be closed out only on their contract date; c) the settlement date in a 1:4 FRA is in four months; d) a 2:5 FRA in April provides the same hedge as a 90-day BAB futures contract; e) FRAs are a standardised contract with a face value of $1 million. 13. Our study of Australia’s foreign exchange market revealed a) the AUD must be purchased in Australia; b) the RBA does not conduct trades in the AUD because the currency has been floated; c) purchases of EUR in Australia can be paid for with USD; d) the RBA trades in the market to keep the exchange rate in line with its target rate; ) both (a) and (c) are correct. 14. Identify the most correct statement concerning share valuation a) fundamental analysts assume the share market is semi-strong efficient; b) technical analysts assume markets are weak form efficient; c) a high price-earnings ratio indicates investors expect the firm’s earnings will increase; d) the estimation of the price of preference shares requires a dividend growth model; e) both (a) and (b) are correct. 15. It is clear from our study of the Australian share market that a) The order book records at-market orders that have not resulted in a trade; ) trading is conducted by dealers providing traders with bid and offer quotes; c) a company’s market capitalisation in the number of shares it has issued; d) the ASX uses an automatic trading system; e) both (a) and (b) are correct. Over/… Part B (25 marks):five question each is worth five marks 1. This question provides you with the opportunity to demonstrate your achievement of some of the learning objectives from your study of bond investments and the bond market. a) Concisely explain the Fisher effect and its implication for movements in bond yields. (1 mark) Answer

Answers should present the Fisher equation and explain that movements in the expected long-term inflation rate are reflected in bond yields. b) What causes Treasury bonds to trade at a premium? (1 mark) Answer The term premium refers to the price of the bond at the current market yield exceeding the bond’s face value. This results when the market yield is less than the bond’s coupon rate. c) A bond portfolio manager invested in a parcel of the 6. 0% February 2017 Treasury bond on 15 February 2007 at 5. 60% and sold the parcel on 15 August 2011 one month after the interest rate in the bond market fell to 5. 40%. i.

What was the term (in coupon periods) of the investment’s holding period? (0. 5 marks) ii. Explain the impact on the investment’s holding-period yield of the bonds being sold at 5. 4% rather than the 5. 6% at which the bonds were purchased? (0. 5 marks) iii. Calculate the investment’s yield. (2 marks) Answer i9 coupon periods iiThe lower selling yield (5. 4% < 5. 6%) results in a higher bond price (i. e. , a capital gain) and so contributes to an investment yield above 5. 6% iii Pbuy = [pic] Psell = [pic] FV(C) = [pic] RHP = [pic] 2. This question allows you to demonstrate your achievement of learning objectives for bond prices and shares ) Calculate the price (per $100 of face value) of the 6. 0% February 2017 bond on the 1st of January 2011 given it was purchased at 5. 4%; given that f = 45 and d = 181. (2 marks) Answer Step 1: Pbuy = $103. 040393 Step 2: P = $103. 040393 + 3. 00 Step 3: [pic] b) Explain the relationship between a share price and two of the factors in Gordon’s dividend growth model. (1 mark) Answer The Gordon dividend growth model proposes that a share price depends on the dividend payment (D), its expected average growth rate (g) and the required return on funds invested in the shares (r).

The size of the dividend and its growth rate each has a positive relationship with the share price and the required return has an inverse relationship. c) Explain the impact of a rights issue on a company’s share price. (1 mark) Demonstrate the impact of a one-for-two rights issue with a $5. 00 subscription price on its cum-rights share price of $6. 50. (1 mark) Answer Since the subscription price would be set below the cum-rights price it adds less value per share to the company than is represented by the current share price and so would reduce the share price on the ex-rights date. [pic] 3.

This question allows you to demonstrate your achievement of learning objectives in our study of foreign exchange (FX) markets. a) Describe the circumstances that result in the three-month forward AUD/USD rate being higher than the spot AUD/USD rate. (1 mark) Answer Forward rates are set to offset the difference between the two interest rates. Thus the forward rate for the AUD/USD would be at a premium when the three-month interest rate in the Australia is lower than the rate in the USA. b) How are the terms of trade measured and how do they influence the value of the AUD/USD rate. (1 mark) Answer

The terms of trade is measured by the ratio of a country’s export prices over its import prices. Since Australia’s exports differ from its imports changes in its terms of trade have a positive impact on the value of the AUD because higher export prices (relative to import prices) generate greater demand for AUD as exporters convert their USD into AUD. c) Explain the main purpose of the inter-dealer segment of Australia’s FX market. (1 mark) Answer The main purpose of the inter-dealer segment of the FX market is to enable dealers to manage their inventories so as to be able to respond to the FX requirements of their clients. ) If the one-year interest rate is 5% in Australia and 3% in the US and the spot exchange rate is 1AUD=1USD explain how an Australian bank could hedge its FX risk exposure when borrowing USD100m for one year (1 mark) and estimate the bank’s cost (as a percentage) of these funds. (2 marks) Answer The Australian bank could enter a sell/buy FX swap since this converts its USD into AUD at the spot rate and arranges the purchase of the USD at the forward rate when the loan is to be repaid. The swap points would add approximately 2% points to the cost of funds (and so the funds will cost the bank approximately 5%). . Answer the following questions to demonstrate your achievement of important learning objectives. a) Calculate the implicit forward rate when 0r2 = 5% and 0r1 = 4. 8%. (1 mark) Answer 5. 2%, since 0. 5(4. 8+5. 2) = 5% b) Explain how the S&P/ASX300 index classifies “large-cap” and “small-cap” companies (1 mark) and explain how a 1% increase in the price of a large-cap firm and a 1% fall in the price of a small-cap firm (assume all other share prices did not change) would influence the level of the S&P/ASX300 index. 1 mark) Answer Large-cap firms are those in the S&P/ASX100 index and small-cap firms comprise the extra 200 firms in the S&P/ASX300 index.

Because the index is a weighted-average price level (i. e. it is the sum of price times the number of issued shares for each company divided by its divisor) a much greater weight is attached to a 1% price increase in the share prices of large-cap firms than to a 1% decrease in the share prices of small-cap firms and so the index would increase sa a result of these price changes. ) Clearly explain the asymmetric intrinsic value of a $40 BHP put option (1 mark) and explain whether the put (that was purchased for $1. 80 each) would be exercised if BHP was trading at $39 just prior to the put’s expiry date. (1 mark) Answer The intrinsic value of a put is zero for prices from $40 and upwards and increases $ for $ at prices below $40. Should the share price be $39 just prior to expiry the holder of a $40 put would exercise the contract to earn 80 cents each (and so avoid the loss of $1. 80 each). 5. This question allows you to further demonstrate your achievement of the learning objectives for your study of options. ) Clearly show and explain the effect of using $40 BHP put options purchased at $1. 80 each to hedge the future sale of a parcel of BHP when at expiry the price of BHP shares is (i) $35; (ii) $45. (2 marks) Answer In (i) the put would be exercised because this would be at a selling price of $40, which when deducting the cost of the put achieves a net selling price of $38. 20. In (ii) the put will be allowed to lapse and the shares are sold at $45 netting $43. 20 (allowing for the cost of the puts). b) Given that ANZ shares are trading at $24. 0 calculate (i) the intrinsic values of the following ANZ call options (1 mark) and (ii) their time values (1 mark) and finally explain the higher premium for July $23. 75 call option. (1 mark) PremiumIntrinsic valueTime value June ANZ $23. 75 call$0. 75 July ANZ $23. 75 call$1. 35 Answer (i) The intrinsic values are 25 cents (S-X) and (ii) the time values are 50 cents and $1. 05, respectively. (iii) The July call has the same intrinsic but a greater time value because it has a further month to expiry and this increases the option’s exposure to volatility in ANZ’s share price.

PART C: HEDGING CASE STUDY (10 MARKS) Write your answer to the case study in a separate book to that used for Part B “Describe a two-year bill facility that uses 90-day bills and explain how it poses interest rate risk for the borrower. Describe FRAs, BAB futures and interest rate swaps and explain how they can be used to hedge the interest rate risk involved in the planned issue of BABs. Demonstrate how each hedge instrument establishes the company’s cost of funds. ” For the purposes of your demonstration, assume: the two-year bill facility uses 90-day BABs with a face value of $110 million; • the facility is being organised in November for commencement in mid December 2011; • when the bill facility was being arranged the December 2011 BAB futures price was 95. 45 and the March 2012 BAB futures price was 95. 55; • the two-year swap rate commencing in December 2011 is 5. 15%pa • the mid December 90-day spot rate was 4. 95%pa • the FRA rate match the relevant BAB futures rate Answer (demonstrations): FRA: [pic] [pic] BAB futures [pic] [pic] Swap: [pic] [pic] [pic] [pic] FORMULA SHEET [pic] |[pic] | |[pic] |[pic] | |[pic] |[pic] | |[pic] |[pic] | |[pic] |[pic] | |[pic] |[pic] | |[pic] |[pic] | |[pic] |[pic] | |[pic] |[pic] | | |[pic] | ———————– Q1…………. Q2………….. Q3…………. Q4…………. Q5…………. Total……….