Question 1 (Bonds)



G350 Global Financial Management

FINAL EXAM 1997

Professor Harvey

NAME:

EMAIL:

TIME STARTED:

Question Maximum Student Score

1 (Bond Valuation) 25

2 (Options) 20

3 (Hedging) 25

4 (Portfolio Analysis and CAPM) 20

5 (Performance Evaluation) 20

TOTAL 110

You have 3 hours to complete the exam. Please include your answers in this word file and email it back to me. The exam is open book, web, .... - but to be completed individually. Since questions of clarification are not practical during your exam time, if there is any question, make an assumption which you think is reasonable and be sure to state the assumption. I do not anticipate this occuring.

Question 1 (Bond Valuation) [25 points]

(a) [10 points] You own a US Treasury bond with 5 years till maturity. It pays a coupon of 8% on a semiannual basis (i.e. $4 each six months for a $100 bond). The current (annual percentage rate) interest rate is 7% (3.5% semiannually). What is the price of this bond today? [Assume that the term structure is flat, i.e. interest rates of all maturities are 7%. Assume that the par or face value of the bond is $100] Be sure to show how you got the answer, i.e. do not just show the answer, go through the steps.

(b) [5 points] I own a 5 year zero coupon Treasury bond. Compared to the bond in (a) which is more sensitive to interest rate changes and why? (No calculations necessary.)

(c) [5 points] John Coleman owns a similar bond too. His bond is a 5-year 8% coupon bond issued by the Treasury. However, it has the following feature. If interest rates drop below 7%, the government has the right to call the bond back at $101.00. This right doesn’t take place until three years from now. That is, the government can recall the bond only in years 4 and 5. Discuss in words the impact of this feature on the bond. That is, discuss the nature of the option in John’s bond, (who writes and who buys it) and discuss which bond is more sensitive to interest rate shifts (part (a) bond or John’s bond).

(d) [5 points] You are concerned that interest rates might rise from the current levels (assume the data in part a). You are thinking about hedging. What are the possibilities. Outline in words how you would use the Treasury bond futures to hedge. No calculations necessary.

Question 2 (Options) [20 points]

(a) [10 points] Detail in words how changes in underlying asset prices, exercise prices, time to maturity and volatility impact both call and put option prices.

(b) [5 points ] Explain under what circumstances an investor would want to purchase both a call and a put on the same security?

(c) [10 points] Consider the following information. Intel July calls with an exercise price of $170 are trading for $7. The July put options with an exercise price of $170 are trading for $12. The current stock price is $163 49/64ths (May 29, 1997 closing price). In addition, a $1 million (par value) Treasury bill which has the exact same maturity as the option is trading for $992,738.97. [So this is the present value factor, or e-rT=.99273897). No dividends are paid on this stock. Are the calls and puts prices relatively correctly.

3. Hedging [25 points]

(a) [10 points] Your firm is based in the U.S. You have entered into a deal whereby you will purchase some equipment from a German supplier in the third week in September (that is when you will receive delivery of the equipment and pay for it). The price is fixed today at 169.65 million marks. The current exchange rate is 1.6965 DM per dollar. You are concerned about possible fluctuations in the exchange rate. How would you hedge this transaction with futures? [Note the futures are quoted in US dollars per DM, whereas the rate I quoted above is DM per dollars]. Answer in words, but feel free to give illustrative scenarios of exchange rate fluctuations. No calculations necessary.

(b) [5 points] You could also use options. What type of options would you use? Would you buy or sell the options?

(c) [5 points] Evaluate the following statement “The options protect my downside but I benefit in the upside, hence, I should always use options rather than futures”.

(d) [5 points] There have been many episodes of “derivative disasters,” where firms like P&G have lost millions on derivative transactions. Without going into the specifics of these cases, why should the firm hedge? What should the firm do to avoid getting into trouble?

4. Portfolio Analysis and the CAPM [20 points]

(a) [10 points] You are considering investing in one or both assets called A and B. Both A and B have identical expected returns and standard deviations. Evaluate the following two statements, i.e. are they true or false and why. (I) “No matter how I set up my portfolio between A and B I will have the same expected return. (assume no short sales).” (II) “It does not matter if I hold A, B, or a combination of A and B because A and B have the same expected returns and standard deviations.”

(b) [10 points] The CAPM says that the expected return on a security is determined by its covariance with the market portfolio. Hence, it is possible that security C has a lower expected return than security D, even though the standard deviation of C is double that of D. Does this make sense? Explain the intuition behind the CAPM. (No formulas required).

5. Performance evaluation [20 points]

(a) [10 points] The following is the idea of EVATM. The firm has, say, three divisions: aerospace, construction, and grocery stores. The overall weighted average “cost of capital” is 12%. However, the beta of firms that are exclusively focussed in aerospace is 1.5, in construction is 1.0 and in grocery stores is 0.5. EVA says that managers should be rewarded if they make returns on invested capital over and above the division cost of capital - not the overall cost of capital (which in this case is 12%).

If implemented, it might be the case that a project with a promised, say, 14% return is rejected by the Aerospace division. (Assume this project has identical risk to the Aerospace division). Do current shareholders want management at Aerospace to reject this project? Why? Use your insights from present value that we learned throughout the course. No numerical calculations necessary.

(b) [10 points] EVA is a short-term performance evaluation mechanism. That is, the firm is rewarding employees based on what happens this year - but stock price is determined by all future years. Hence, you can run into the problem of a manager squeezing the division for some extra short term cash flows at the expense of future competitive position in the market. One potential way to solve this problem is to set up a “phantom” stock for each division. The stock is “phantom” because its price is constructed and updated regularly (it does not trade on an exchange). Assume that the corporation (all three division) has stock that is traded on an indvidual exchange. Briefly describe why this idea has advantages over the EVA, how you would go about constructing the stock price (I am looking for a general answer), and how you would use this stock to provide incentives for management. [You could write a whole dissertation on this, just describe the basics and whether you think it is a good or a bad idea and why.]

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