FNCE 403v2 Assignment 3 Revised Nov. 7, 2012
Assignment 3 Details
Complete and submit Assignment 3, which is worth 15% of your final grade, after
you have finished Unit 6. If you have any questions about this assignment and how
to complete it, contact the Student Support Centre.
This assignment contains ten problems and is worth a total of 100 marks.
Read the requirements for each problem and plan your responses carefully. Ensure
that you answer each of the required questions as concisely and as completely as
possible and include supporting calculations where required.
1. (7 marks) You are a bright new analyst in the risk-management division at
RMS, a multinational technology company, and have recently been put in
charge of managing the Euro/CAD exchange-rate risk that RMS faces.
Consider RMS’s operations in Europe and Canada.
a. Suppose monthly revenues in Europe average 10 million Euros and
monthly production and distribution costs average 8 million Euro. If the
resulting profits are repatriated to the production unit in Canada monthly,
what risk does this production unit face? How might it hedge this risk?
(2 marks)
b. RMS’s worldwide retirement benefits unit is located in Canada and has the
obligation to pay its retired European employees 20 million Euros monthly.
What does this unit face and how could it hedge the risk? (2 marks)
c. Given the transactions of the production and retirement units as given
previously, what do you conclude are the exchange-rate risks faced by
RMS as a whole in Europe? Does RMS need to enter into forward
contracts? (3 marks)
2. (10 marks) Suppose the spot exchange rate between U.S. dollar and
Canadian dollar is US$1.03/C$. The U.S. dollar risk-free rate is 2% per
annum, compounded annually. The price of a two-year European call option
and put option with an exercise price of US$1.05/C$ is US$4.45 and
US$4.54, respectively. What is the Canadian dollar risk-free rate?
FNCE 403v2 Assignment 3 Revised Nov. 7, 2012
3. (10 marks) Two firms have the borrowing rates shown below.
Firm Fixed Rate Floating Rate
AAA 5 yr T-bond + 60 bp LIBOR
BBB 5 yr T-bond + 75 bp LIBOR + 30 bp
As the CFO of firm AAA, you always consider an interest rate swap before
borrowing money. Explain how, if at all, a swap with BBB would be
advantageous to you if
a. you wanted to borrow at a fixed rate. (7 marks)
b. you wanted to borrow at a floating rate. (3 marks)
4. (10 marks) A corporation enters into a $35 million notional principal plain
vanilla interest rate swap. The swap calls for the corporation to pay a fixed
rate and receive a floating rate of LIBOR. The payments will be made every
three months for one year. The term structure of LIBOR when the swap is
initiated is as follows:
Months Rate (%)
3 7.00
6 7.25
9 7.45
12 7.55
Assume all of rates are continuously compounded.
a. Determine the fixed rate on the s ...
1. FNCE 403v2 Assignment 3 Revised Nov. 7, 2012
Assignment 3 Details
Complete and submit Assignment 3, which is worth 15% of your
final grade, after
you have finished Unit 6. If you have any questions about this
assignment and how
to complete it, contact the Student Support Centre.
This assignment contains ten problems and is worth a total of
100 marks.
Read the requirements for each problem and plan your
responses carefully. Ensure
that you answer each of the required questions as concisely and
as completely as
possible and include supporting calculations where required.
1. (7 marks) You are a bright new analyst in the risk-
2. management division at
RMS, a multinational technology company, and have recently
been put in
charge of managing the Euro/CAD exchange-rate risk that RMS
faces.
Consider RMS’s operations in Europe and Canada.
a. Suppose monthly revenues in Europe average 10 million
Euros and
monthly production and distribution costs average 8 million
Euro. If the
resulting profits are repatriated to the production unit in Canada
monthly,
what risk does this production unit face? How might it hedge
this risk?
(2 marks)
b. RMS’s worldwide retirement benefits unit is located in
Canada and has the
obligation to pay its retired European employees 20 million
Euros monthly.
What does this unit face and how could it hedge the risk? (2
marks)
3. c. Given the transactions of the production and retirement units
as given
previously, what do you conclude are the exchange-rate risks
faced by
RMS as a whole in Europe? Does RMS need to enter into
forward
contracts? (3 marks)
2. (10 marks) Suppose the spot exchange rate between U.S.
dollar and
Canadian dollar is US$1.03/C$. The U.S. dollar risk-free rate is
2% per
annum, compounded annually. The price of a two-year
European call option
and put option with an exercise price of US$1.05/C$ is US$4.45
and
US$4.54, respectively. What is the Canadian dollar risk-free
rate?
FNCE 403v2 Assignment 3 Revised Nov. 7, 2012
3. (10 marks) Two firms have the borrowing rates shown below.
4. Firm Fixed Rate Floating Rate
AAA 5 yr T-bond + 60 bp LIBOR
BBB 5 yr T-bond + 75 bp LIBOR + 30 bp
As the CFO of firm AAA, you always consider an interest rate
swap before
borrowing money. Explain how, if at all, a swap with BBB
would be
advantageous to you if
a. you wanted to borrow at a fixed rate. (7 marks)
b. you wanted to borrow at a floating rate. (3 marks)
4. (10 marks) A corporation enters into a $35 million notional
principal plain
vanilla interest rate swap. The swap calls for the corporation to
pay a fixed
rate and receive a floating rate of LIBOR. The payments will be
made every
three months for one year. The term structure of LIBOR when
the swap is
initiated is as follows:
5. Months Rate (%)
3 7.00
6 7.25
9 7.45
12 7.55
Assume all of rates are continuously compounded.
a. Determine the fixed rate on the swap. (7 marks)
b. Calculate the first net payment on the swap. (3 marks)
5. (10 marks) Suppose that the British pound interest rate is
0.65% per
annum and Canadian dollar interest rate is 1% per annum for all
maturities,
annually compounded. The current exchange rate is 1.6033
CAD/£. Under
the terms of a swap agreement, a bank receives 2% per annum
in Canadian
dollars and pays 3% per annum in British pounds. Payments are
exchanged
6. every year, with one exchange having just taken place. The
principal
amounts are $10 million Canadian dollars and $6 million British
pounds. The
swap will last two more years.
a. Determine the cash flows to the bank. (4 marks)
b. What is the value of the swap to the bank in terms of
Canadian
dollars? (6 marks)
6. (6 marks) PQR Company longs a FRA on 2-month LIBOR
with a fixed rate of
5.25 percent and a notional principal of $38 million. If the
market LIBOR rate
is 6.125 percent at expiration, what would be the payoff of this
FRA to PQR?
Assume that there are 30 days in a month.
7. FNCE 403v2 Assignment 3 Revised Nov. 7, 2012
7. (6 marks) A portfolio consists of 1,000 shares of stock and
500 short calls
on that stock. If the delta for the call is 0.5, what would be the
dollar change
in the value of the portfolio in response to a one dollar increase
in the stock
price?
8. (16 marks) A firm has a portfolio composed of stock A and B
with normally
distributed returns. Stock A has an annual expected return of
10% and
annual volatility of 25%. The firm has a position of $100
million in stock A.
Stock B has an annual expected return of 20% and an annual
volatility of
20% as well. The firm has a position of $50 million in stock B.
The correlation
coefficient between the returns of these tow stocks is 0.2.
a. Compute the 5% annual VAR for the portfolio. (8 marks)
8. b. If the firm sells $10 million of stock A and buys $10 million
of stock B,
by how much does the 5% annual VAR change? (8 marks)
9. (16 marks) A firm has total assets with a market value of
$1,500,000. It
has one issue of 1,000 zero coupon bonds outstanding, each
with a face
value of $1,000 and a maturity of 3 years. The volatility of the
assets is
20%, and the risk-free rate is 5%.
a. What is the market value of the firm’s equity? (7 marks)
b. What is the market value of the bonds? (2 marks)
c. What is the continuously compounded yield on the bonds? (2
marks)
d. Analyze the credit risk structure for this firm by varying the
maturity
on the bonds from 3 to 7 years. Discuss this credit risk
structure. (5
marks)
9. 10. (9 marks) Given interest rate options with notional
principals of $10 million
on an underlying 120-day LIBOR. The options have exercise
rates of 6% and
will expire in 30 days.
a. What is the payoff on the call option if the LIBOR in 30 days
is 7%, in
60 days is 8%, and in 90 days is 9%? (3 marks)
b. What is the payoff on the put option if the LIBOR in 30 days
is 3%, in
60 days is 4%, and in 90 days is 5%? (3 marks)
c. Discuss the difference between the payoff on an FRA and the
payoff
on an interest rate option. (3 marks)
Assignment 1
10. Assignment 1, which is worth 10 percent of your total grade for
the course, is
made up of three parts:
-answer and problem-solving
questions
worth a total of 40 marks.
(Assignment
4). Part C is worth a total of 10 marks.
Review the "Course Assignments" page in the Welcome and
Orientation
section of this course website for important information
regarding
requirements for submitting your answers to problem-solving
questions. Include your student ID number and contact
information on the top
page of your assignment. If you have questions about any
portion of
Assignment 1, contact the Student Support Centre.
Part A: (40 marks in total)
1. An executive makes so much money per year that the last
$50,000 of his income goes almost entirely into his income
11. tax. Under this circumstance, should the executive ask for a
stock option of an equivalent amount? What tax benefits
could a stock option bring to this executive?
(4
marks)
2. Discuss the role of financial engineering in response to
taxation and regulation.
(4
marks)
3.
T-Bill
Price
Time to
Maturity
Principle
$984.98 91 days
$1000
$970.87 182 days
$1000
12. $943.40 1 year
$1000
Given the information on the three treasury bills in the table
above, calculate their bond equivalent yields and their
effective annual yields. Are their bond equivalent yields
different from their effective annual yields? Why or why not?
Do treasury bills with the same bond equivalent yields also
(8
marks)
http://sb.lms.athabascau.ca/mod/assignment/view.php?id=2751
have the same effective annual yield? Why or why not?
4.
Stock No.
of
Shares
Initial
Price
Market
Value
Final
13. Price
Market
Value
ABC 1000 $20 $20,000
$15 $15,000
XYZ 2000 $50 $100,000
$55 $110,000
Suppose that ABC and XYZ are the only companies in this
market. Based on the information in the table above,
calculate the following:
1. the value-weighted average and price-weighted average
at the beginning and at the end.
2. the historical rate of return for ABC and XYZ.
3. the historical rate of return for a portfolio that consists
of 500 shares of ABC and 200 shares of XYZ.
(6
marks)
5. Suppose that the current market price of Oxen stock is $50
per share. You expect that the Oxen stock is under downward
14. pressure, and you ask your broker to sell 100 shares short.
With a 60% margin requirement, how much short term
securities do you need to possess before the short sale
transaction can take place? After the short sale transaction,
what does your account with your broker look like? What is
the margin ratio immediately after the short sale took place?
Given a minimum margin requirement of 40%, how far can
the Oxen price rise before you get a margin call? At the point
of margin call, what does your account with your broker look
like? If Oxen did not pay any dividends, what would your rate
of return be if you can sell the stock at $30 per share (ignore
interest on margin)?
(10
marks)
6. An investor’s portfolio is currently worth $1 million. During
the year, the investor sells 2000 shares of Talisman Energy at
a price of $50 per share and 1000 shares of Research in
Motion at a price of $75 per share. If the Talisman Energy and
Research in Motion shares were originally purchased for $45
and $69 per share, respectively, and the investor’s tax rate
on capital gains income is 30%, how much additional tax will
(5
15. marks)
the investor have to pay as a result of these transactions?
7. Given the following information about a mutual fund,
calculate
the NAVPS.
Current market value of the fund’s
portfolio of assets
$728,525,000
Number of shares outstanding 200,000,000
Unpaid bill for management fees $1,250,000
Unpaid bill for fund auditor’s fees $60,000
(3
marks)
Part B: (20 marks in total)
Write an analysis on the prevailing economic conditions in
Canada and globally.
16. Your report must include discussion on common economic
indicators, and the
analysis should be current to the date of assignment submission.
The report
should not exceed three typewritten pages and must include a
list of the
references you consulted. Grammar and spelling account for
four of the 20
possible marks, so take time to write and proofread your report
carefully.
Part C: (10 marks in total)
This part of Assignment 1 is very important because it is the
foundation of your
term project (Assignment 4). You must decide right now
between two options,
and you are not allowed to switch options part way through the
course. Think
carefully about your interests and strengths and decide between
Option 1 and
Option 2.
Assignment 4 Option 1:
Term Paper
The topic of the term paper must
fall in the field of investment. The
17. paper should have a theme,
discuss the chosen topic
thoroughly, express your original
view clearly, and make
Assignment 4 Option 2:
Investment Project
Imagine you have inherited a
large amount of money. You are
expected to carry out an
investment project detailing your
strategy for investing this money
and at the end of the project write
contributions to the field of
investments.
Review the term paper
requirements carefully.
an investment report.
Review the investment project
18. requirements carefully.
Part C of Assignment 1 requires you to indicate whether you
have decided to do
Option 1 or Option 2 in Assignment 4 and submit either a
written outline for
your term paper or a written outline discussing your strategy for
investing in a
windfall. This part of Assignment 1 is worth a total of 10
marks, with two marks
allotted to grammar and spelling.
http://sb.lms.athabascau.ca/mod/assignment/view.php?id=2758#
1
http://sb.lms.athabascau.ca/mod/assignment/view.php?id=2758#
1
http://sb.lms.athabascau.ca/mod/assignment/view.php?id=2758#
2
http://sb.lms.athabascau.ca/mod/assignment/view.php?id=2758#
2