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This study guide and solution manual is not quite complete and has not been verified for accuracy, so it is offered in an ``as is'' condition. It was written nearly 20 years ago during a self-study program in finance in anticipation of a career shift. This career shift never happened and was the primary reason this study guide and solution manual was not completed.

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R.E. Salvino∗ 4329 Thistlewood Terrace Burtonsville MD 20866 1994-1995, reformatted: 6 Apr 2013

Abstract This study guide and solution manual is not quite complete and has not been veriﬁed for accuracy, so it is oﬀered in an “as is” condition. It was written nearly 20 years ago during a self-study program in ﬁnance in anticipation of a career shift. This career shift never happened and was the primary reason this study guide and solution manual was not completed. Keywords: ﬁnance, economics, banking

Table of Contents Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter Chapter

∗

2: Determinants of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3: Neo-Keynesian Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 4: The Federal Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 5: Issuers of Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 6: Financial Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 7: Bank Regulation and Management . . . . . . . . . . . . . . . . . . . . . . . . 27 8: Eﬃcient Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 9: Spot and Forward Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . 37 10: Coupon-Bearing Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44 11: Money Market Instruments and Rates . . . . . . . . . . . . . . . . . . . . 52 12: Mortgages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 13: Bond Investment Risks and Portfolio Strategies . . . . . . . . . . 61 14: The Term Structure of Interest Rates . . . . . . . . . . . . . . . . . . . . 65

Current address: 9 Thomson Lane, 15-06 Sky@Eleven, Singapore 297726.

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Chapter 15: International Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Chapter 16: Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 Chapter 17: Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 Chapter 18: Financial Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 Chapter 19: Put and Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 Chapter 20: Call Features on Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Chapter 21: Default Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Chapter 22: Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Chapter 23: Financial Engineering: Specialized Financial Instruments 109 Appendix 1: Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Appendix 2: The Long and Short of It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Appendix 3: Notes on Put and Call Options . . . . . . . . . . . . . . . . . . . . . . . . . 121

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Chapter 2: Determinants of Interest Rates 1. Describe the diﬀerences between the classical and loanable funds approaches to the interest rate. In the classical theory, the money supply does not aﬀect interest rates, the interest rates are determined solely by business investment and savings by individuals. The MEI or marginal eﬃciency of investment (of capital) curve shows the cumulative amount invested as a function of the rate of return (usually stated as showing the rate of return as a function of the cumulative amount invested); classically, the cost of funds for business is simply the interest rate, that is, debt is ﬁnanced with no equity ﬁnancing. The savings curve shows the amount of savings by individuals as a function of the rate of return. Classically, the demands for funds comes only from business investment and savings from individuals. Consequently, the interest rate is determined by the intersection of the two curves, in other words by the −1 (F (i)). equation Fmei (i) = Fsave (i) or i = Fsave me In the loanable funds approach, the interest rate is determined by the supply and demand of loanable funds, that is, of the money supply. The consumer and government demands for funds is added to the business demand, and savings from business and increases in the money supply are added to savings by individuals. The interest rate is determined by the intersection of the demand for money as a function of the interest rate D(i) and the supply of money S (i), that is, by the equation D(i) = S (i) or i = S −1 (D(i)). 2. What are the major tenets of classical quantity theory and modern quantity theory of money? Is velocity a constant in each theory? In practice, what are the determinants of velocity? In the classical theory, the increase in the money supply for a ﬁxed supply of goods results in an increase in the prices of goods. If M is the money supply, V is the velocity of money (the number of times an average dollar changes hands during a year), P is the price level, and Q is the level of real (physical) output, then M V = P Q (this is basically a deﬁnition). The time derivative of this equation is m + v = p + q where m = d ln M/dt is the fractional rate of growth in the money supply, v = d ln V /dt is the fractional rate of growth in the velocity, p = d ln P/dt is the fractional rate of growth in the price level, that is, the inﬂation rate, and q = d ln Q/dt is the fractional rate of growth in real output. These equations are valid in the modern theory also. 3

In the classical theory, the velocity V is a constant so that v = 0 and as a result, m = p + q or p = m − q . This means there is inﬂation whenever the money supply fractional growth rate is larger than that for real output, that inﬂation can be eliminated by adjusting the money supply fractional growth rate to be that for real physical output, and deﬂation occurs whenever the real output fractional growth rate is larger than that for the money supply. In the modern theory, (1) the money supply is the most important determinant of FGN P = P Q and the velocity V is a relatively stable and predictable function of economic variables but is not a constant (v = 0); (2) there should be strict rules for government economic policy rather than wide discretion: active tinkering with the money supply is counter-productive since the government has a tendency to do the wrong thing; (3) changes in the money supply have wide ranging impacts upon the economy; (4) ﬁscal policy (government decisions on taxes and spending) has little impact upon the economy, it should focus exclusively on monetary policy (the money supply); (5) an increase in the money supply has 3 impacts which are possibly oﬀsetting: (a) it tends to increase bond prices and lower interest rates, (b) it tends to stimulate output which puts upward pressure on interest rates, (c) it aﬀects inﬂationary expectations requiring an ”inﬂationary premium” to be added to interest rates for bonds. 3. Assume that the real interest rate r = 3% and that the inﬂation rate p = 10% with complete certainty and no taxes (t = 0%). Determine the nominal interest rate. The nominal rate is given by i = (r + p + rp)/(1 − t) = 13.3%. 4. Make the same assumptions as the preceding problem except that the tax rate is t = 28%. Determine the before tax nominal interest rate and the before tax real interest rate. The before tax nominal rate is i = (r + p + rp)/(1 − t) = 18.47%, and the before tax real rate is r/(1 − t) = 4.167%. The remaining term in the before tax nominal rate is the before tax inﬂation premium, (p + rp)/(1 − t) = 14.306%. 5. The nominal rate is i = 15%, the inﬂation rate is p = 5% and there are no taxes (t = 0%). Assuming complete certainty, the real rate is given by r = (i(1 − t) − p)/(1 + p) = 9.524%.

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In the following problems, we will assume the risk premium for inﬂation, h, is simply given by h = rE (p) where r is the real interest rate and E (p) is the expected rate of inﬂation. Consequently, the nominal interest rate is given by i = (r + E (p) + h)/(1 − t) = (r + E (p) + rE (p))/(1 − t). For the case of complete certainty, E (p) = p. 6. Assume no taxes (t = 0%). The market anticipates an inﬂation rate E (pm ) = 8%. The real interest rate, r, is 4%. You anticipate an inﬂation rate E (p0 ) = 15%. Explain how you might proﬁt from this information. What is the gain if you are correct? At time t = 0, borrow $1 at the t = 0 market rate and buy real assets with the borrowed funds. At t = 1, repay the loan at the locked in t = 0 market rate (1 + r + E (pm ) + rE (pm )) and sell the assets at the t = 1 market rate (1 + r + E (p0 ) + rE (p0 )). The cash ﬂow at t = 0 is 0, and the cash ﬂow at t = 1 is (E (p0 ) − E (pm ))(1 + r). If the anticipated inﬂation rate is the correct one, then the gain is 7.28%. 7. Assume no taxes (t = 0%) and complete certainty (E (p) = p). The nominal interest rate i = 10% and the real rate is r = 5%. What is the inﬂation rate? Solving the equation for the nominal interest rate for the inﬂation rate p gives p = (i(1 − t) − r)/(1 + r). Substituting the given values yields the inﬂation rate p = 4.762%. 8. Assume no taxes (t = 0%). The real interest rate is 5% and the market anticipates an inﬂation rate of E (pm ) = 10%. You borrow money and repay it in one period. You used the borrowed funds to buy real assets at time t = 0 and sell the assets at the end of one period, when the loan is repaid. For what actual inﬂation rate will you make 15.75% ? The amount borrowed, B , is repaid in one period: R = B (1 + i) where the interest rate i is i = r + E (pm ) + rE (pm ). The borrowed funds, B , were used to get a return A = B (1 + i0 ) where i0 = r + E (p0 ) + rE (p0 ). The total net return is A − R and, consequently, the net percentage return is (A − R)/B = (E (p0 ) − E (pm ))(1 + r). Thus, E (p0 ) = E (pm ) + (A − R)/B (1 + r). For the values given, (A − R)/B = 0.1575, so E (p0 ) = 25%. 9. Assume no taxes (t = 0%). The nominal interest rate i = 10.25% and the real interest rate r = 5%. You forecast deﬂation at a rate E (p0 ) = −5% 5

over the next year. Explain how you could try to proﬁt from your forecast. What is your proﬁt, if your forecast is correct? At t = 0, borrow $1 worth of assets, sell them for $1, and lend it out at the market rate. At time t = 1, you will receive the repayment at the t = 0 market rate and you buy back the assets at the t = 1 rate. The cash ﬂow at t = 0 is 0, and the cash ﬂow at t = 1 is (1 + r + E (pm )(1 + r)) − (1 + r + E (p0 )(1 + r)) = (E (pm ) − E (p0 ))(1 + r) which is positive if the forecast for deﬂation, E (p0 ) ≤ 0, is correct. First, ﬁnd E (pm ) = (i − r)/(1 + r). For the values given, E (pm ) = 5% and so the proﬁt is 10.5%. 10. Assume complete certainty (E (p) = p) and no taxes (t = 0%). The nominal interest rate i = 20% and the real interest rate r = 8%. You forecast that inﬂation rate is going to be p0 = 18%. You decide to borrow $1 and buy real assets. After one period, you liquidate the real assets and pay oﬀ the loan. At what inﬂation rate would you earn a proﬁt of $0.12 ? At t = 0, borrow $1 and buy $1 worth of assets for zero net cash ﬂow at t = 0. At t = 1, repay the loan R = 1 + i and receive 1 + r + p0 (1 + r) from liquidating the assets. The net return is (1 + r + p0 (1 + r)) − (1 + i) = (r − i) + p0 (1 + r) = (p0 − pm )(1 + r) where pm = (i − r)/(1 + r) is the market inﬂation rate at t = 0. Since pm = 11.11111%, to get a net return of $0.12 on a dollar or 12%, the inﬂation rate must be p0 = 22.22222% = 2pm . 11. Assume no taxes. The market forecasts an inﬂation rate E (pm ) = 5%. You forecast an inﬂation rate of E (p0 ) = 15%. You decide to borrow $1 and invest in real assets for one period. Your forecast equals the actual inﬂation rate. When you sell the assets and repay the loan, you earn a proﬁt of $0.11. What is the real interest rate? The cash ﬂow at time t = 0 is zero; the cash ﬂow at time t = 1 consists of the return on the dollar investment (1 + r + E (p0 )(1 + r)) less the amount needed to repay the loan (1 + r + E (pm )(1 + r)) for a net cash ﬂow of (E (p0 ) − E (pm ))(1 + r). Since this net cash ﬂow is the net proﬁt for the transaction, this is equal to 11%, so the the real interest rate r is given by r =(net proﬁt)/(E (p0 ) − E (pm )) − 1 = 10%. 12. Assume no taxes. The nominal interest rate is observed to be 20%. What is the lowest possible value for the sum of the real interest rate r and the inﬂation rate p?

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Since i = (r + p) + rp, then (i − (r + p))2 = (rp)2 ≥ 0, so that the minimum value occurs for (i − (r + p)min )2 = 0, or (r + p)min = i. In this case, the minimum numerical value is 20%.

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Chapter 3: Neo-Keynesian Model 1. Explain relationship between marginal propensity to consume (fmpc ) and the multiplier. The multiplier has a simple inverse relationship to the marginal propensity to save fmps , multiplier = 1/fmps . The marginal propensity to save has a simple linear relationship to the marginal propensity to consume, fmps = 1 − fmpc . Consequently, the multiplier has an inverse linear relationship to fmpc , multiplier = 1/(1 − fmpc ). As fmpc approaches 1 from below, the multiplier becomes arbitrarily large and positive; as fmpc approaches 0 from above, the multiplier approaches 1. 2. In the neo-Keynesian model, what determines the total demand for money? The total demand for money is the sum of transactions demand (the exact matching of cash inﬂows and cash outﬂows by business is usually not possible, resulting in transaction balances), speculative demand (cash balances held to buy securities in the future at lower, more attractive prices), and precautionary balances (cash balances kept as precautions against transaction balances running short, ”emergency funds”). Usually, precautionary balances are neglected in neo-Keynesian analyses. 3. If government spending increases in the neo-Keynesian approach, what is the impact upon interest rates? The IS curve generates the GNP as a function of interest rates from the income point of view, YIS (i). The LM curve generates the GNP as a function of interest rates from the demand for money point of view, YLM (i). The equilibrium interest rate is determined by the equation YIS (i) = YLM (i). An increase in government spending shifts the YIS (i) curve to the right, that is, for a given interest rate i, YIS (i) increases but leaves the LM curve unchanged. The intersection with the YLM (i) curve will change, depending on the shape of the LM curve. If the LM curve has a positive slope in the region of intersection with the IS curve, dYLM (i)/di > 0, then an increase of government spending increases interest rates (the intersection of the IS and LM curve occurs at a larger value of i) and some business investment is crowded out of the market. If the LM 8

curve is ﬂat in the region of intersection with the IS curve, dYLM (i)/di = 0, then an increase of government spending has no aﬀect on interest rates (the intersection of the IS and LM curves occurs at the same value of interest rate i) and no private business is crowded out of the market. Finally, if the LM curve has a vertical slope in the region of intersection with the IS curve, dYLM (i)/di → ∞, then an increase in government spending increases the interest rate (the intersection of the IS and LM curves occurs at a larger value of interest rate i) and crowds out enough business investment to oﬀset the change in government spending. 4. If the money supply is increased in the neo-Keynesian model, explain the impact upon interest rates. An increase in the money supply shifts the LM curve to the right, that is, for a given interest rate i, YLM (i) increases in regions where the LM curve is not ﬂat. The IS curve is unchanged and the intersection of the LM curve with the IS curve which determines the equilibrium interest rate changes depending on the shapes of the IS and LM curves. Since dYIS (i)/di ≤ 0, if dYLM (i)/di > 0 in the region of intersection with the IS curve, an increase in the money supply will lower the interest rate (the intersection of curves occurs at a lower interest rate) as long as the IS curve is not ﬂat; if the IS curve is ﬂat, then there is no change on the interest rate (intersection of curves occurs at same interest rate); if the IS curve is vertical in the region of intersection with the LM curve, dYIS (i)/di → −∞, then there is a decrease in the interest rates (the curves intersect at a lower value of interest rate i). If dYLM (i)/di = 0 in the region of intersection with the IS curve, there is no eﬀect on the interest rate (the intersection of curves occurs at the same interest rate): this is known as the “liquidity trap”, and has not yet been observed to occur in the U.S. 5. According to the Modern Monetarist approach, an increase in the money supply increases inﬂationary expectations. Show how an increase in inﬂationary expectations may be incorporated into the neo-Keynesian model. Probably the simplest way to do this is to assume the standard neo-Keynesian approach determines the real interest rate r, rather than the nominal interest rate i. We then determine the expected rate of inﬂation, E (p), by the money supply and construct the nominal rate from i = r + E (p)(1 + r).

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Appendix: IS and LM Curves The IS curve, YIS (i) or iIS (Y ), is generated geometrically from a sequence of four graphs. First, one uses the FM EI (i) + G(i) curve to obtain a value of J = I + G (investment plus government spending) that corresponds to a speciﬁed value of interest rate. Second, that value of J = I + G is used to obtain a corresponding value of R = S + T (savings plus taxes): in the simplest case, J = R because aggregate expenditures E = C + I + G and aggregate income Y = C + S + T , where C is consumer expenditures. The condition for equilibrium is aggregate expenditures equals aggregate income, E = Y , which simpliﬁes to J = R in this case. Third, that value of R = S + T is added to C to obtain Y which corresponds to the value of interest rate i, giving the fourth graph YIS (i) or iIS (Y ). The LM curve, YLM (i) or iLM (Y ), is generated geometrically from a sequence of four diﬀerent graphs. First, one uses the speculative demand for money curve, MS (i) or i(MS ), to obtain a value for MS that corresponds to a speciﬁed value of interest rate. Second, that value of MS is then used to obtain a corresponding value for transaction balances since MT = M − MS where M is the total money supply. Third, that transaction balance is used to obtain a corresponding FGN P = Y by means of the modiﬁed equation of exchange MT V = Y since Y = P Q = FGN P . This value of Y corresponds to the value of interest rate i, giving the fourth graph YLM (i) or iLM (Y ). It is the intersection of these curves which determines the equilibrium interest rate, YIS (i) = YLM (i) or the equilibrium GNP, iIS (Y ) = iLM (Y ). These 1 may be stated as i = Y1−1 (Y2 (i)) and Y = i− 1 (i2 (Y )) where the subscripts 1 and 2 could be either IS or LM.

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Chapter 4: Federal Reserve 1. Describe the composition and role of the Federal Open Market Committee (FOMC). The FOMC is composed of the 7 governors of the Board of Governors of the Federal Reserve, the president of the federal reserve district bank of NY, and four presidents of from the remaining 11 federal reserve district banks (who serve on a rotating basis). The primary task of the FOMC is to draft a monetary policy directive which sets guidelines for the growth rate of the money supply and the level of interest rates. This is kept secret for 6 weeks after a meeting of the FOMC. 2. Why are there several measures of the money supply? What are the major diﬀerences between M1, M2, and M3? What constitutes money is not completely clear, although money should have 3 main characteristics: (1) it should be a medium of exchange, (2) it should be a unit of account, and (3) it should have a store of value. But since there is no easy answer to the question of what is money, several measures have been adopted: M1, M2, and M3. M1 includes coins and currency in circulation, travelers checks, plus private bank deposits upon which checks can be written. M2 includes M1 and adds most types of personal savings accounts (including money market funds and money market deposit accounts at banks), CD’s of less than $100, 000, overnight repurchase agreements, overnight Eurodollars, and money market mutual funds held by individuals. M3 includes M2 and adds CD’s of more than $100, 000, repurchase agreements for longer than overnight, Eurodollars for longer than overnight, and institutional money market mutual funds. 3. Explain the impact of reduction in required reserves on the money supply. The reduction of required reserves in eﬀect produces excess reserves, freeing up the excess by making them available to the individual banks and thus increasing the money supply. This tends to decrease interest rates since there is more money available and stimulates economic activity. On the other hand, an increase in required reserves freezes the ”excess” reserves and makes less money available to banks for lending, thus decreasing

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the money supply. This tends to increase interest rates and depress or slow down economic activity. 4. What are the functions of the federal discount window? It allows the Federal Reserve to be a ”lender of last resort” to banks in need. In the commercial loan theory, the central federal district bank controls the economy by making loans to commercial banks backed by loans to businesses. This is an incorrect view since short-term business loans are not self-liquidating when economy-wide recessions or depressions occur and many ﬁrms are unable to sell their inventory and repay their short-term loans in full. It is still a tool, however, of a ”lender of last resort”, providing funds to individual banks or to the banking system as a whole at times when funds are short. It acts as an injector of funds, controlling the money supply by controlling the discount window interest rate. Changes in the discount rate follows the trend, it doesn’t set the trend: when the Fed eases monetary conditions by buying T-bills (increasing the money supply), short-term interest rates (including federal funds rate) decline, and then somewhat later the discount rate is lowered. When the Fed hardens the monetary conditions by selling or not buying T-bills (decreasing the money supply), short-term interest rates (including federal funds rate) increase, and somewhat later the discount rate is increased. 5. Describe the relationship between the discount rate and other money market rates. As stated in the answer to question 4, changes in the discount rate tend to lag behind other interest rates (such as federal funds rate, the rate at which banks lend to other banks) rather than to set the trend. However, there are times when discount rate changes are surprises and reveal new information about Federal Reserve policy decisions. As short-term interest rates decrease (due to an increase in the money supply), the discount rate decreases since fewer funds will need to be borrowed. As short-term interest rates increase (due to a decrease in the money supply) the discount rate increases since more funds will need to be borrowed. The increase is meant to discourage borrowing and thus to slow down the level of economic activity. 6. Why are open market operations the primary tool of monetary policy? 12

Open market operations involve the purchase and sale of US Treasury securities in the open market by the Federal Reserve. If the Fed buys securities from individuals, the money supply is increased (tending to decrease interest rates); if the Fed sells securities to individuals, the money supply is decreased (tending to increase interest rates); if the Fed buys securities from commercial banks, it creates excess reserves for the banks that can be withdrawn and thus increasing the money supply; if the Fed sells securities to commercial banks, it creates negative reserves for the banks that must be ﬁlled and thus decreases the money supply. In practice, the Fed has unlimited buying power since it can create money. It tends to maintain a large portfolio of US Treasury securities which earns interest: part of this interest is used to pay for operating expenses of the Fed, the remainder is put back into the US Treasury. 7. Explain the procedure for collecting a check drawn on a bank in on Federal Reserve district and deposited in another Federal Reserve district. The local bank in district A (where the check is deposited) accepts the check and sends the check to the Federal Reserve Bank for district A. The Federal Reserve Bank for district A transmits the check to the Federal Reserve Bank for district B, which sends the check to the local bank in district B (where the check was drawn) for payment. The Federal Reserve then transmits payment to the local bank in district A. The process typically takes several days. 8. What is the advantage of a local clearinghouse for check collection? The clearinghouse can settle all checks drawn on participating banks, cancelling out some of the interbank transfers of funds. This allows the net shifts of funds between participating banks to be made eﬃciently. 9. One of the functions of the Federal Reserve is to regulate security credit. What is the motivation behind this regulation? There is a concern that excessive use of security credit (buying on margin) might contribute to boom and bust cycles in security prices and in the overall economy. A buyer of common stock is required to put down a minimum of X % of the original purchase price in a margin account. The value of X depends on the type of security being purchased on margin.

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The use of borrowed funds to buy securities is a form of ﬁnancial leverage: fractional changes in a levered or margined position are greater than fractional changes in the underlying security. The fractional change in the leveraged position is equal to the fractional change in the underlying security divided by the fraction of the underlying security price put down (f ),

∆Plev ∆Psec = Plev Psec f

(0.1)

10. Reserve requirements on bank deposits are 5% and there are no leakages such as cash withdrawals. Banks receive an injection of $1, 000 in excess reserves. Determine the increase in the money supply if all excess reserves can be lent out. Deﬁne the following quantities for the nth deposit: excess reserves Rex (n), additional loans Ladd (n), additional required reserves Radd (n), and total deposits Dtot (n). Since all excess reserves are lent out, Ladd (n) = Rex (n). If x is the fractional reserve requirement on bank deposits, then the following equations hold: Rex (n + 1) = Rex (n) − Radd (n) Radd (n) = xRex (n) Rex (n + 1) = (1 − x)Rex (n) = (1 − x)n Rex (0)

n n

Dtot (n) =

j =1

Rex (j ) = Rex (0)

j =1

(1 − x)j −1

Dtot (n) is the increase in the money supply. The sum can be evaluated: since (1 − x) < 1 for 0 ≤ x < 1, this is a simple geometric series and yields Dtot (n) = Rex (0) (1 − (1 − x)n ) x

In the limit n → ∞, the increase in the money supply becomes Dtot (∞) = Rex (0)/x. In the particular case of x = 0.05 and Rex (0) = $1, 000, the increase in the money supply is $20, 000. 14

11. Assume single bank economy with very strong loan demand and all money held as checking deposits. The money supply, Mi , is initially $200, 000. The Fed buys $10, 000 worth of bonds from the bank. The money supply increases to Mf = $300, 000. What is the reserve requirement, x ? The increase in the money supply is Dtot (∞) = Mf − Mi = $100, 000. The injection into the supply is Rex (0) = $10, 000. Consequently, the reserve requirement is x = Rex (0)/Dtot (∞) = 0.10 = 10%. 12. Make the same assumptions as in problem 11. The initial money supply is Mi = $100, 000. The Fed increases the reserve requirement by 2% and the money supply drops to Mf = $50, 000. What percent is the new reserve requirement? The change in the money supply is Dtot (∞) = Mf − Mi = −$50, 000. The “injection” is Rex (0) = −0.02 × $100, 000 = −$2, 000. The new reserve requirement x is given by Rex (0)/Dtot (∞) = 0.04. So, the new requirement is 4%, and since the requirement increase was 2%, the initial reserve requirement was 2%. 13. You purchase $5, 000 worth of securities by putting down a margin of 25%. Compute the fractional gains and losses of the margined position if the underlying security (a) increases by 10% and (b) decreases by 20%. Assume the broker has a rule to give a margin call when the equity of the leveraged position is worth 10% of the underlying security. At what point would the margin call occur? In all cases, f = 0.25. In case (a), ∆Psec /Psec = 0.10 and in case (b) ∆Psec /Psec = −0.20. Since ∆Plev /Plev is given by the fractional change in the underlying security divided by f , ∆Psec /(Psec f ), so for case (a) ∆Plev /Plev = 0.40 = 40% and for case (b) ∆Plev /Plev = −0.8 = −80%. If the margin call occurs when the leveraged position has only 10% equity remaining in the underlying security, then the change in the leveraged position is −90%. So the margin call will come when the underlying security has changed by −0.9f = −0.225 = −22.5%. 14. Assume a margin requirement of 40% of the purchase price of a security. Neglecting any current interest or dividends, determine the fractional change in the underlying security if your equity changes by 25%.

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Solving for the fractional change in the underlying security, we ﬁnd that ∆Psec /Psec = f × ∆Plev /Plev . Substituting the numerical values, the fractional change in the underlying security is 0.10 or 10%. 15. The Fed regulates margin requirements for security purchases. Assume that the margin requirement (percent put down) is X % (or a fraction of f = X/100). A speculator buys a security for $300 and the security doubles in price. What is the rate of increase in the speculator’s equity? The fractional change in the underlying security is 1 (($600 − $300) divided by $300). The change in the leveraged or margined position is 1/f = 100/X where X is expressed as a percent. 16. Three banks in a city - Barnett Bank, Sun Bank, and First Union Bank - establish a clearinghouse to handle all interbank checks. Compute the net interbank transfers required to net out all these checks. Written on Barnett Sun First Union Total Deposits Total Written Net Deposits Barnett 0 100 500 600 800 −200 Sun 300 0 400 700 500 200 First Union 500 400 0 900 900 0 Total Written 800 500 900 2200 2200 0

17. Three banks in Chicago established a clearinghouse for their checks written against each other. Determine the net transfers of funds to settle all these checks? Written on First Second Third Total Deposits Total Written Net Deposits First 0 200 300 500 900 −400 Second 100 0 700 800 800 0 Third 800 600 0 1400 1000 400 Total Written 900 800 1000 2700 2700 0

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Chapter 5: Issuers of Securities 1. Since 1980, the market for Treasury debt has become increasingly important. Why? Since 1980, annual deﬁcits of over $100 billion have become the norm. The total marketable debt (ﬁnanceable by debt securities) has ballooned to about $3 trillion, while non-marketable debt adds about another $1 trillion. The enormous growth of federal debt increases the importance of Treasury debt securities in the debt market. 2. What types of entities are major holders of Treasury securities and why? There are 5 major classes of Treasury security holders: (1) the Federal Reserve, in order to control monetary conditions, must have sizable holdings of US Treasury securities, (2) commercial banks have holdings as secondary reserves, assets that can be readily turned into cash as the need arises, (3) individual investors (private, domestic, nonﬁnancial) have Treasuries since they are default-free, free of state and local income taxes, and highly marketable, (4) foreigners have Treasuries since they are default-free, are denominated in US dollars which is a relatively safe currency, and (5) nonbank ﬁnancial institutions (private, nonbank, ﬁnancial) They all hold Treasuries for the same reasons as commercial banks and individual investors. 3. Explain the procedure by which the Treasury auctions securities. What are the pros and cons for using this type of auction? Treasury securities are sold in weekly auctions. These auctions require sealed bids by a speciﬁed time, and are either of a competitive or noncompetitive nature. A noncompetitive bid does not specify a price, it merely speciﬁes the par value (face value) of the securities desired and implicitly agrees to accept the 17

weighted average price of all accepted competitive bids: all noncompetitive bids are accepted by the Treasury. The Treasury accepts competitive bids with the highest prices and lowest interest rates. Since the bidding is sealed and not open, diﬀerent prices will be paid by diﬀerent purchasers for equivalent securities. The main advantage of this type of auction for the Treasury is that it will receive higher total proceeds than for an open auction. The main disadvantage is for the investors: it is actually an unfair process since diﬀerent buyers of the same security will pay diﬀerent prices. In practice, the diﬀerence between the highest and lowest accepted bids tends to be small, that is, the demand curve tends to be ﬂat since new issues must be competitively priced relative to traded old issues. 4. Treasury announces an auction of $10 billion par value of 52 week T-bills. $2 billion of noncompetitive bids are received. The competitive bids are as follows: Price/$ of Par Par Value Fraction 0.9200 $3 billion 0.1667 0.9194 $3 billion 0.1667 0.9188 $4 billion 0.2222 0.9180 $2 billion 0.1111 0.9178 $6 billion 0.3333 $18 billion 1.00 Compute the price per dollar of par paid by noncompetitive bidders. The third column above, Fraction, is the par value divided by the total par value of the auction. The price paid by the noncompetitive bidders is the weighted price of the accepted bids, that is, Pnon =

i

Fi Pi

where Fi is the fraction listed in the third column above, and Pi is the price per dollar of par of the accepted bids given in the ﬁrst column above. Consequently, the price paid per dollar of par by the noncompetitive bidders is Pnon = 0.9187. 5. Treasury announces an auction of $12 billion par value of 52 week T-bills. $3 billion of noncompetitive bids are received. The competitive bids are as follows: 18

Amount of Bid ($ M) 5.0 4.0 3.0 2.0 14.0

Price/$ of Par 0.9200 0.9180 0.9170 0.9160

Bid Fraction 0.35714 0.28571 0.21428 0.14286 1.00

What is the price paid per $1 of par (to 4 decimal places) by noncompetitive bidders? Par Value ($ M) 5.43478 4.35730 3.27154 2.18341 15.24703 Par Value Fraction 0.35645 0.28578 0.21457 0.14320 1.00

The weighted average using the bid fraction as the weights for the price per dollar of par gives Pnon = 0.9182 per dollar of par; the weighted average using the par value fraction as the weights for the price per dollar of par gives Pnon = 0.9182 per dollar of par. Thus, to 4 decimal places, it does not matter which weights are used in calculating the weighted average price per dollar of par. 6. What are the advantages and disadvantages for a corporation to issue bonds as opposed to selling equity or retained earnings? If a corporation does extremely well, all incremental returns above payments to bondholders go to stockholders who earn high returns; if the corporation does poorly, ther may be little or nothing left for stockholders after paying ﬁxed obligations to bondholders. Returns to stockholders contain a magniﬁcation eﬀect: if ﬁrm does well, stockholders do very well; if ﬁrm does poorly, stockholders do very poorly. In other words, equity is more volatile than debt obligations (bonds) and bonds may have a larger market if there are more risk-averse investors willing to forgo large gains if the ﬁrm does very well; equity will be more attractive to risk-seeking investors. In addition, there may be tax advantages for debt obligations which are absent for equity considerations. If managers of a ﬁrm have better information about the ﬁrm’s prospects than the markets do (asymmetric information ), the stock price of the ﬁrm may not reﬂect proﬁts from new opportunities and may be relatively low

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compared to what it should be - sale of stock at such a low price would be a mistake, and issuing debt obligations (bonds) would be a better idea. Mention should be made of the agency problem : stockholders typically hire managers to act as agents on their behalf, but the gain to the agent from corporate strategy may be diﬀerent from the gain to the stockholders. ”Rational agents” may be expected to act in their own personal interest even though their professional obligations require them to act for the interest of the stockholders. 7. What does the term securitization mean? Securitization is the process of selling ﬁnancial quantities (e.g., mortgages) which eﬀectively changes the ﬁnancial quantity into a security that can be bought and sold in the resale market. Originators of the ﬁnancial quantity no longer bear the risk of default on repayment or risk that interest rates might change adversely in the future - risks are borne by the purchaser of the ﬁnancial quantity. This opens up the market for a ﬁnancial quantity to more originators, increasing the availability of funds to the market for the particular ﬁnancial quantity and reducing interest costs to borrowers.

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Chapter 6: Financial Intermediaries 1. Describe the reasons why ﬁnancial intermediaries exist. The basic reasons for the existence of ﬁnancial intermediaries are: (1) they expedite the ﬂow of funds from sectors with surpluses to sectors with deﬁcits (2) they expedite the ﬂow of savings from savers to investors in capital equipment (3) they expedite the ﬂow in cases where direct investment is ineﬃcient, undesirable, or impossible (4) they make eﬃcient use of transaction balances (the funds held because of diﬃculties for ﬁrms and individuals to exactly match inﬂows and outﬂows of funds) held as demand deposits in banks, pooled together (5) they make the process of issuing securities easier so that more issuers are able to raise funds (investment bankers) (6) they aid in making the resale or secondary market for securities more eﬃcient (brokers and dealers) (7) they distribute risk among a large population of insured individuals or ﬁrms (insurance companies) (8) they can pool small savings (9) they can diversify risk (10) they have economies of scale in monitoring information and evaluating investment risk (11) they can lower transaction costs

2. Explain the meaning of the term diversiﬁcation. Under what circumstances is there a beneﬁt in diversifying? Diversiﬁcation is a process by which risks are spread out among many different investments. For instance, a large investor can spread the risk of 21

default over many loans, so even if some loans are not repaid, the entire portfolio of investments still makes a proﬁt; a small investor can not spread risk as much and is at greater risk of suﬀering devastating losses in case of default. The only case where diversifying is not beneﬁcial is in the case of absolute certainty with regard to the desired behavior of the investment, a most unlikely case. 3. What role do investment bankers play in the ﬁnancial system? What are the economic beneﬁts of investment bankers? (1) Investment banking ﬁrms are engaged in the marketing of securities when they are originally sold (competitive bidding at auctions or negotiated oﬀerings) (2) they expedite the sale for original sale of securities in the primary or new issue market (the resale market is frequently called the secondary market (3) underwriting: the outright purchase of an entire security issue by the investment banker (or syndicate) which takes the risk of reselling the issue to the public, earning the diﬀerence in prices as an underwriting fee or spread (part of the underwriting fee is compensation for the risk of having to sell below the purchase price) (4) shelf registration: securities are eﬀectively preregistered with the SEC and once approved the issue can be brought to market on very short notice, permitting the issuer to “time the issue” as market conditions change (without preregistration, public registration may take several weeks) (5) underwriter prefers low bid on ﬁrst issue (below fair market value) so it can rapidly sell the issue in the open market (the incentives of the underwriter conﬂict with the incentives of the issuing ﬁrm) (6) best eﬀorts selling: try to sell as much as possible of an issue, with any unsold amount reverting back to issuing ﬁrm; this procedure is concentrated in the low and high risk oﬀerings - low risk issues do not needan underwriter to absorb a risk, and the underwriter is unwilling to assume the risk for high risk securities (best selling is a low risk process for an investment banking ﬁrm)

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(7) private oﬀering: the direct selling of securities by corporations to buyers (e.g., corporate bond issue to an insurance company) - (a) no registration cost for public oﬀering, (b) can be tailor made to ﬁt needs of issuer and buyer, (c) can not be widely traded, the resale market for private oﬀerings is limited (illiquid), and (d) the interest rate for private oﬀerings is higher than an identical public oﬀering (disadvantage to issuer, advantage to buyer) 4. Why has investment banking been separated from banking? Are there any disadvantages of separating the two? Investment bankers are marketers of securities and are not banks: the GlassSteagall Act of 1933 prohibited banks from investment banking. (1) banks might be able to use bank funds to manipulate security prices (2) it is possible that the ups and downs of the stock market prices might adversely aﬀect the stability of the banking system (3) banks are regulated and so might have an unfair advantage over nonregulated, nonprotected investment bankers, brokers, and dealers (could separate regulated from nonregulated parts of the bank, but would probably be unlikely in practice) There has been a trend to whittle away at the Glass-Steagall prohibition. (1) nonbanks have increasingly been allowed to engage in banking activities without the burden of regulation imposed on banks - why not permit banks some investment banking activities? (2) other industrialized nations have less separation of banking from other ﬁnancial intermediaries 5. Describe various types of orders for securities, including market order, limit order, stop order, and a shortsale. The resale or secondary market is “run” by brokers and dealers. It is usually double auction where buyers and sellers submit bids simultaneously and all participants are aware of everyone else’s bids, submitted “continuously.” For an English auction, the price is raised in an open and oral auction until 23

only a single bidder remains. Trading takes place on organized exchanges (NYSE, AMEX: the ﬁrst and second largest by volume of trading), members of exchanges are said to “have a seat” on the exchange. Exchange seats themselves are traded and their market value ﬂuctuates as market conditions change. The types of exchange members are: (a) commission brokers, the largest group, (b) odd-lot brokers for transactions involving an amount of less than 100 shares, (c) a registered trader who trades for his/her own account, and (d) specialist ﬁrms, market makers for individual securities listed on the exchange. There are listing requirements a ﬁrm must meet in order for its stock to be traded on an exchange: a minimum size, a minimum number of shareholders, and a minimum period of existence. The Third Market is the Over The Counter (OTC) market, a network of dealers who make markets in individual securities. A sizable volume of stock trading occurs in the OTC market, as well as virtually all bond volume. Dealers are highly levered, their equity is a small percentage of the market value of their inventory of securities (they have some debt ﬁnancing in the form of bank loans, most is in the form of repos). A repurchase agreement (repo) is the sale of a US Treasury security with an agreement to repurchase the same security the next day at the sale price plus overnight interest. If the agreement is for longer than overnight, it is called a “term repo.” Positioning refers to gambling on the direction of price movements: for example, a bond dealer buys bonds in expectation of lower interest rates and consequent higher prices for the purchase bonds (if wrong, the dealer closes the position at unfavorable prices and takes a loss). Options and futures are traded on organized exchanges, but a clearinghouse is required to guarantee performance since participants may have ﬁnancial liabilities exceeding their original cash committments. market order - commission broker executes order at most favorable price at time order hits the exchange ﬂoor (the order will deﬁnitely be carried out, but price may change adversely by time order is carried out) limit order - an order with constraints, the order will be executed only if constraints are met (it can be left outstanding indeﬁnitely until constraints are met or it can be canceled if not executed immediately as a “ﬁll or kill” order)

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stop order - an order to close out an existing position if certain conditions are met (e.g., “buy at $40 but sell at $37”) shortsale - a security is borrowed and sold with the expectation of buying back the security at a later time for a lower price to return to the lender (borrowing to sell high and buy low); the proceeds from a shortsale must be left on deposit with the broker, and the shortseller must pay any cash dividends from the security to the lender of the security

6. What are the pros and cons of having a specialist system of market making? pro : the purpose is to reduce the variability of security prices: when too many sellers exist, the specialist buys to keep prices from falling too low; when too many buyers exist, the specialist sells to prevent prices from rising too high (the price protection is meant over the short term) pro : it is a monopoly position, since every listed security has one and only one specialist for that security, which is supposedly the most eﬃcient method of stabilizing prices over the short term con : SEC evidence indicates very high proﬁts for specialist ﬁrms con : specialists have the right to request suspension of trading when buy and sell orders are allegedly imbalanced: but proﬁt incentives of specialist ﬁrms conﬂict with its role as stabilizer of prices (why buy at dropping prices, postpone until prices have completed their drop); comparison with OTC shows that trades continued on securities that were stopped by specialists on NYSE

7. Explain economic reasons for the existence of bid-asked spreads. The bid-price is the price at which dealers are willing to buy; the asked-price is the price at which dealers are willing to sell. The bid-asked spread is the diﬀerence between bid and asked prices and represents the price of dealer services and are related to risks borne by dealers.

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(1) they are inversely related to the volume of trading (a large spread for a “thin market” or low volume market), an inactive resale market implies longer holding periods for the dealer and a consequent greater chance of a price change (the likelihood of an unfavorable event increases with increasing holding periods). (2) they are positively related to the inherent price risk of individual securities: the bid-asked spread is smaller on less risky investments than on higher risk investments (3) the spread should be a function of dealer ﬁnancing costs: high spreads for high interest rates, low spreads for low rates, reﬂecting the cost of ﬁnancing the inventory of securities (4) the spread may depend on the possibility that the dealer is trading against an informed investor who knows more than the dealer, which is an incentive to widen the spread

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Chapter 7: Bank Regulation and Management 1. What is the diﬀerence between a commercial bank and a savings and loan? A commercial bank in an institution which oﬀers checking deposits and makes commercial loans; a savings and loan, or ”thrift”, have no checking accounts and are primarily restricted to real estate loans. Thrifts have recently been permitted to oﬀ checking accounts and to make more non-real estate loans, blurring the distinction between commercial banks and savings and loans. 2. What are the motivations for regulating banks? There has been a trend toward deregulation in recent years. Why? The three main motivations behind bank regulation are: (1) bank safety is considered essential, that bank depositors should not be regarded as creditors who bear the risk of default: insured deposits requires bank regulation (2) the fear that bank failures will seriously damage local economies and even the overall economy (3) it is essential to maintaining competition, reﬂecting a concern about the extremes of too few or too many banks: a monopoly or oligopoly which controls the market in the ﬁrst case, cut-throat competition resulting in many failures in the second case. The recent trend toward deregulation: . . . For the most part, it seems that deregulation is just a form of “disguised regulation.” It’s not a conﬂict of “regulation versus deregulation” but “my regulations versus your regulations.” This, of course, is not the standard view of deregulation. 3. What are the practical diﬀerences if a bank has a national charter as opposed to a state charter? A national charter is granted by the Comptroller of Currency; a state charter is granted by the state regulatory authorities. The diﬀerence has blurred in recent years as restrictions have been eased: interstate banking has been permitted for states agreeing to interstate reciprocal branching. 27

4. Explain intrastate and interstate bank branching restrictions. Intrastate bank branching limits the banks ability to create branches within a state: (1) unit banking allows only one bank oﬃce, (2) limited branching allows branches in areas approved by the state banking authorities, and (3) unrestricted branching permits oﬃces anywhere in the state. Interstate bank branching enables banks to have oﬃces in more than one state. This is permitted by a national charter or, in a more restricted sense, by state chartered banks with reciprocal agreements allowing branching across speciﬁed state lines. 5. FDIC insurance fees are a ﬁxed percentage. How might this aﬀect risk taking attitudes of bank management? A poorly managed, high-risk bank with low quality loans pays the same insurance rate as a well managed low-risk bank with high quality loans. This ﬂat rate insurance fee gives incentives to take on high risk loans which carry high interest rates since the rewards for success are high and the penalty for failure is small. 6. What is the purpose of bank examinations? If a problem bank does not improve its performance, what courses of action are available to regulators? The purpose of bank examinations is to maintain good loan quality and to prevent fraud and embezzlement. Banks with problems are put on a “problem list” and monitored more closely. If performance does not improve, regulators have 6 courses of action they can take: (1) issue cease and desist orders prohibiting the bank from a speciﬁc activity, (2) levy ﬁnes of up to $10, 000 per day, (3) remove the managers of the bank, (4) revoke the bank’s charter, forcing the bank to cease operations, (5) stop insurance coverage by FDIC, and (6) deny access to the Fed’s discount window, wire transfer system, and check collection facilities. 7. If a bank fails, how can FDIC handle the situation? FDIC can handle the situation in one of three basic ways: (1) try to arrange a merger with a more sound ﬁnancial institution, compensating the acquiring bank to make the merger feasible, (2) pay oﬀ insured depositors and liquidate assets, using the residual proceeds to pay oﬀ uninsured depositors, and (3) take over the failed institution and operate it.

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8. Why do banks hold cash and marketable securities? Banks must hold cash to meet the needs of its customers, to expedite a number of transactions such as check clearing, and to meet reserve requirements set by the Fed. Banks hold marketable securities, such as short term ﬁxed income securities (large US Treasury securities), as secondary reserves: highly liquid assets available to sell rapidly if the need for cash arises. The bank may also hold municipal bonds of municipalities served by the bank, typically a customer of the bank, partly because such bonds are exempt from income taxes. 9. Explain why default risk raises the interest rate on a loan. Loans are major earning assets of banks, a major share of bank revenues come from interest on loans. A premium to compensate the bank for default risk is a higher interest rate, set high enough to allow for expected losses from default on some loans. If the bank portfolio of loans reﬂects the default risks of its customers, on average, it should make a proﬁt on its loans. 10. Why is diversiﬁcation of a loan portfolio important to a bank? If a bank makes loans to a single sector or industry and that sector or industry does poorly as a whole, many bank loans may default resulting in excessive losses to the bank. Diversiﬁcation lessens the impact of widespread default in a given sector or industry. 11. What risk reduction alternatives are available to a bank faced with variable interest rates on its sources of funds? The ﬁve main risk reduction alternatives are: (1) make relatively short term business and nonmortgage consumer loans (2) match maturities of loans (bank assets) and ﬁnancing (bank liabilities): e.g., a 6 month loan to a construction company at 12% ﬁnanced with 6 month certiﬁcates of deposit at 9%, locking in the borrowing and lending rates for the same time period and eliminating the risk of ﬂuctuating rates (3) make variable rate loans with an interest rate tied to some market rate (e.g., 30 day T-bill rate plus a margin ), the rate ﬂuctuating with the market rate but the margin remains ﬁxed. This eﬀectively transforms 29

a long term loan into a short term loan in its dependence on interest rates (as far as the bank is concerned), transferring interest rate risk to the borrower (4) sell loans in the secondary market (e.g., securitization of mortgages), reducing the bank to the role of a middleman who originates the loan and then funnels the loan payments to the buyer of the loan. It passes on the risk to the buyer of the loan, but also passes on any higher expected proﬁts to the buyer of the loan as well. (5) GAP management: classify assets and liabilities by maturity, comparing diﬀerences or gaps in maturity; decide what mismatch, if any, for a given maturity range is desirable by comparing the proﬁt potential from the mismatch with the loss potential if rates rise.

12. Why has the failure rate of thrift institutions been high in recent years? Thrifts have traditionally made long term ﬁxed rate mortgage loans. If a loan is made at a given rate and interest rates subsequently rise, the thrift’s cost of funds can rise above the rate that it is earning on its loans. If such a situation occurs for a sustained period, the thrift will inevitably fail. In addition, poor economic conditions in some regions have caused failures since smaller banks typically do not diversify loans on a geographic basis. If hard times fall on a region, there will be widespread default and consequent bank failures. 13. What steps have been taken to reduce the likelihood of bank and thrift failures in the future? Five main steps have been taken to reduce the risk of bank failures: (1) capital requirements have been raised, providing a larger cash buﬀer to the FDIC, (2) FDIC policy will close institutions sooner, (3) FDIC raised insurance premiums to put more funds into the insurance fund, (4) Congress contributed extra funds (tax payer funds) into the insurance fund, and (5) bank examinations are more stringent. In addition, there has been discussion but not implementation of (a) risk adjusted insurance premiums on bank deposits requiring high risk banks to pay more than low risk banks, (b) a greater geographical diversiﬁcation of banks, and (c) a greater use of market-based valuation of bank assets. 30

Chapter 8: Eﬃcient Markets 1. What is an informationally eﬃcient market? An eﬃcient market is a security market in which all currently available public information is very rapidly reﬂected in security prices. A market is eﬃcient if a number of investors try to utilize information for their own beneﬁt, since other investors will monitor the ﬂow of information and any beneﬁcial information will soon spread throughout the marketplace. The driving force behind informational eﬃciency is simply competition for proﬁts. 2. Describe the economic forces that tend to make ﬁnancial markets informationally eﬃcient. As mentioned in the reponse to problem 1, competition for proﬁts is the driving force behind informational eﬃciency. If a security is underpriced given the current public information, investors buying the security in anticipation of price increases will drive the price up to its equilibrium value (But who are they buying from? Who wants to sell if the security is undervalued? The fact that the security is underpriced can not be available to everyone, otherwise no one would sell); if a security is overvalued given current public information, investors selling the security in anticipation of price decreases drive the price down to its equilibrium value (But who are they selling to? Who wants to buy if the security is overvalued? The fact that the security is overvalued can not be available to everyone, otherwise no one would buy). Tests of market eﬃciency require the deﬁnition of relevant information and a model showing the impact of this information upon prices. These tests of eﬃciency are actually joint tests of eﬃciency and a particular pricing model. 3. Eﬃciency has sometimes been broken down into weak form, semistrong form, and strong form eﬃciency. What are the diﬀerences between these forms of eﬃciency? The weak form is the basic form of the statement of market eﬃciency, the others include additional, stronger requirements. In the weak form statement, past price and volume of trading information are instantaneously incorporated into current prices: knowledge of past price and volume information adds nothing new and does not allow prediction of future price changes. This means that the expected value for tomorrow’s price is today’s price, 31

E (Pt+1 ) = Pt . An alternative interpretation is in terms of price changes, that is, E (Pt+1 ) − Pt = 0: the expected price change is zero, price changes can not be predicted in an eﬃcient market. The semistrong form, in addition to the statements contained in the weak form, states that the impact of nonprice information upon security prices is practically instantaneous. This means that information about earnings and dividends is rapidly reﬂected in security prices (stocks), and information about determinants of interest rates is instantaneously incorporated into security prices (bonds). The strong form, in addition to the statements contained in the semistrong form, states that information available to special groups of investors is already incorporated into security prices and is thus of no real value to these investors. 4. Describe the empirical evidence concerning the three forms of the eﬃcient market hypothesis. The weak form is a short run or short term hypothesis covering periods such as days or perhaps weeks (over long intervals such as years, price changes can and do have up trends and down trends). • The overall evidence is consistent with price changes for common stocks, bonds, and futures contracts being random. • The evidence is consistent with interest rates following a random walk. • Statistically signiﬁcant patterns in security price changes have not been found. • Proﬁtable short term trading rules, after subtracting out commission costs, have been found to be unproﬁtable. These, however, are not compelling pieces of evidence in favor of the eﬃcient market hypothesis. The semistrong form requires a model for the determinants of security prices. Tests of the model must distinguish between anticipated information (which should already be incorporated in prices) and unanticipated information (which should have the predicted impact on prices). • The existing evidence is consistent with the market’s ability to rapidly readjust to surprises. 32

• The accuracy of tests is aﬀected by the procedure for separating announcements into anticipated components and unanticipated or surprise components. These, too, are not compelling pieces of evidence in favor of the eﬃcient market hypothesis. These tests would appear to be far too model dependent to make any far reaching claims based on them. The strong form addresses three types of special groups of investors: (1) professional money managers, (2) investment advisory services (“market letters”), and (3) corporate insiders (e.g., director, oﬃcer, large stockholder, involved in management and having access to information not available to the public). (1) professional money managers: the average mutual fund earns fair rates of returns given the risk levels, which is consistent with eﬃciency; in addition, the current interest rate is a better forecast of the next period’s interest rate than the expert’s forecast. (2) investment advisory services: following their advice produces no more than a fair return, consistent with eﬃciency. (3) corporate insiders: proﬁts from insider information is illegal for short term gains, but for long term investment purposes it is permitted (such insider trading must be reported to the SEC which releases the information to the public); corporate insiders have done quite well, and since SEC insider reports have become a source of investor information available to the public, this is not consistent with the strong form. Concerning corporate insiders, insider proﬁts from mergers and takeovers are illegal, but the price of the acquired ﬁrm’s stock tends to rise signiﬁcantly prior to public announcement of a tender oﬀer. In addition, the precise meaning of “insider” is subject to judicial interpretation, that is, it is not clear how it should be deﬁned. There are also a number of “eﬃcient market anomalies” (5 documented) which are inconsistent with the eﬃcient market hypothesis: (1) Weekend Eﬀect: a small, but statistically signiﬁcant unexplained tendency for stock prices to decline over the weekend and on Monday mornings. 33

(2) January Eﬀect: stock returns are relatively high for the month of January, the explanation is not clear but may be due to investors taking tax losses by selling in December (depressing December prices) and permitting high returns in January (but this would seem to indicate a December Eﬀect as well, that is, relatively low stock returns for the month of December). (3) Small Firm Eﬀect: small ﬁrms have been found to have relatively high returns after adjusting for risk; this “seems” to be related to the January Eﬀect since most excess January returns are for small ﬁrms; small ﬁrms are not carefully monitored by security analysts, resulting in a tendency for good news about small ﬁrms to be hidden from the market; skewness of returns may be an additional factor in this eﬀect. (4) Individual Investor’s Performance: some investors have been found to have abnormally good performance over time (e.g., Value Line Investment Advisory Service which uses a secret mathematical formula to determine ratings of stocks (from a top rating of 1 to a low rating of 5), inputting current and past ﬁnancial data of the corresponding ﬁrms), but evidence is mixed. (5) Overshooting: security prices for stocks and bonds have been shown to ﬂuctuate more than probable underlying determinants of prices, which may be an indicator of ineﬃciency or it may be an indicator of a psychological tendency to put too much weight upon relatively recent news: (a) the “bigger fool theory” states that security prices are determined by whatever people will pay for them, and (b) security prices are often aﬀected by speculative bubbles, during which bubbles the price levels are not justiﬁed by the objective determinants of security prices.

5. How should investors behave in a market that is informationally eﬃcient? How does this diﬀer from behavior in a market that is not informationally eﬃcient? An investor should decide upon preferences about levels of expected returns and risk, and select a portfolio accordingly. The investor should minimize transaction costs and limit the amount of trading since trading costs are not oﬀset by trading gains in an eﬃcient market. In addition, the investor should minimize the amount of taxes paid. On the other hand, the investor should 34

not abandon a search for ineﬃciency in the form of mispriced securities (if all investors assumed a perfectly eﬃcient market, then the market would actually become ineﬃcient - a “driving force” is required), some investors must believe the market to be ineﬃcient in order to drive the market toward eﬃciency. As for issuers of securities, they should not try to time new issues: long term success in timing is very unlikely since accurate prediction of price and interest rate changes in the future is not possible in an eﬃcient market. For an informationally ineﬃcient market, there would be no reason to limit trading since trading gains could become “unlimited” for a good trader. Taxes would not be a major concern since they could be oﬀset by suﬃciently large gains. Market timing would become a “science” for good investors and issuers. 6. What is technical analysis? Why is there a conﬂict between technical analysis and eﬃcient markets? Technical analysis is the development of predictors of security price changes. A conﬂict with the eﬃcient market hypothesis arises because any predictive rule using past information should not give an advantage in an eﬃcient market: any successful rule attracts the attention of proﬁt seeking investors and market watchers act as soon as the predictor gives a signal, prices adjusting almost instantaneously. A technical analyst must ﬁnd a predictor that predicts a predictor, and keep that information secret in order to get a jump on market watchers (perhaps, such as Value Line?). Alternatively, an analyst must ﬁnd a consistently incorrect predictor and do the opposite to that incorrect predictor (contrarian approach ). For example, the “odd lot theory” states that odd lot investors are poorly informed and are consistently incorrect in stock picks: if odd lotters are heavily buying, that is a signal to sell; if odd lotters are heavily selling, that is a signal to buy. However, the evidence indicates that odd lotters are sometimes correct and sometimes give no signal when one would be expected. There has been a claim that trading volume statistics can give price change information: high volume on days when prices rise, low volume when prices drop (bullish signal, sign of rising prices); low volume on days when prices rise, high volume when prices decline (bearish signal, sign of falling prices). There is, however, no evidence to support a relationship between prices and trading volume. There does seem to be some evidence relating the absolute size of price changes and trading volume (heavy trading, large price changes; 35

light trading, small price changes), but they may go in opposite directions, that is, there is no strong correlation in sign.

36

Chapter 9: Spot And Forward Interest Rates 1. Assume the following information for spot rates of interest for zero coupon bonds and determine the spot prices, forward rates, and forward prices. Graph the yield curve for spot and forward rates. The spot rates are given in the table below. The spot price, forward rate, and forward price are given by Dn = fn = 1 (1 + Rn )n

(1 + Rn )n −1 (1 + Rn−1 )n−1 Fn = 1 (1 + fn )

Consequently, the completed table is: Maturity (Period) 1 2 3 4 Spot Rate 0.03 0.04 0.05 0.06 Spot Price 0.9709 0.9246 0.8638 0.7921 Forward Rate 0.03 0.05 0.07 0.09 Forward Price 0.9709 0.9524 0.9174 0.9174

The yield curve for spot and forward rates is simply a plot of the spot rate versus maturity, and a plot of the forward rate versus maturity. The yield curve for both spot and forward rates are straight lines, the spot rate yield curve has a slope of one with intercept at 0.02; the forward rate yield curve has a slope of two with intercept at 0.01. The two curves intersect at period 1 with a rate of 0.03 (see Figure 9.1). 2. Given the following forward rates, compute the forward prices, spot rates, and spot prices. Graph the spot and forward yield curves. The forward rates are given in the table below. The forward price, spot price, and spot rates are given by Fn = 1 (1 + fn ) 37

Dn = Dn−1 Fn

1/n Rn = Dn −1

where D1 = F1 and R1 = f1 . Thus, the completed table is: Maturity (Period) 1 2 3 4 Forward Rate 0.08 0.01 0.12 0.03 Forward Price 0.9259 0.9901 0.8919 0.9709 Spot Price 0.9259 0.9167 0.8185 0.7947 Spot Rate 0.08 0.04 0.07 0.06

The yield curve for both the forward and spot rates are oscillatory or ﬂuctuating. The curves intersect three times, once for period 1 at 0.08, once just beyond period 2 at approximately 0.05, and once just before period 3 at approximately 0.065 (see Figure 9.2). 3. Assume the following information about the prices of STRIPS with $100 par values. Compute the spot interest rates, forward interest rates, and forward prices. Graph the spot and forward rates. Assume no taxes. The spot prices are given in the table below. The spot price, the spot rate, the forward rate, and the forward price are given by Dn = 100 (1 + Rn )n Dn 100

1/n

Rn = fn =

−1

(1 + Rn )n −1 (1 + Rn−1 )n−1 Fn = 1 (1 + fn )

where f1 = R1 and F1 = D1 . The completed table is thus:

38

Maturity (Period) 1 2 3 4

Spot Price 94.34 88.17 81.64 74.22

Spot Rate 0.060 0.065 0.070 0.077

Forward Rate 0.060 0.070 0.080 0.098

Forward Price 94.34 93.46 92.59 91.07

The graph of the spot and forward yield curves show that the forward rate always lies above the spot rate (intersecting at period 1 for a rate of 0.060). Both curves begin to lose their linear appearance as period 4 is approached, the rates being higher than linear extrapolation would give (see Figure 9.3). 4. Given choice of $100 one year from now or $115 two years from now. Which is better? What does the choice depend upon? The present value of $100 is D1 (100) = 100/(1+ R1 ) and the present value of $115 is D1 (115) = 115/(1 + R2 )2 = 115/(1 + R1 )(1 + f1 ) = 1.15D1 (100)/(1 + f1 ). The choice depends upon the value of the forward rate f1 : if 1.15/(1 + f1 ) > 1 then $115 two years from now is better; on the other hand, if 1.15/(1 + f1 ) < 1 the $100 one year from now is better. 5. Suppose R1 = 0.10, R2 = 0.12, R3 = 0.14, and R4 = 0.16. You are given a choice of $100 at time 1, $110 at time 2, $130 at time 3 and $140 at time 4. Compute the time 1 value of each of these cash ﬂows; which is the best? Compute the time 2 cash ﬂows; which is the best? Are the answers to these questions the same? Why or why not? The present value (time 0) of each of these cash ﬂows is given by Dn (k ) = D(k )/(1+ Rn )n where the time n values are D(1) = 100, D(2) = 110, D(3) = 130, and D(4) = 140. The results are D1 (1) = 90.91, D1 (2) = 87.69, D1 (3) = 87.75, D1 (4) = 77.32. The time 1 values are given by the time 0 values times the forward rate factor (1 + f1 ) = 1/F1 where forward rate is fn = (1 + Rn )n /(1 + Rn−1 )n−1 − 1 = R1 for n = 1. Consequently, the time 1 values are 100, 96.46, 96.525, 85.05. The best is the $100 at time 1. The time 2 values are given by the time 1 values times the forward rate factor (1 + f2 ) = 1/F2 where the forward rate is f2 = 0.140363636. Consequently the time 2 values are 100, 110, 110.07, 96.99. The best is the $130 at time 3 by a few cents. The time 1 and time 2 best values are diﬀerent is that the time 1 best value was its maturity value, it does not change from time 1 to time 2 whereas the time 2 best value increases from its time 1 value in order to reach its time 3 maturity value of $130. 39

6. Assume zero coupon bonds with $1 par values. A two period bond has a price of D2 = 0.70 and a three period bond has a price of D3 = 0.80. Show the arbitrage opportunities. Since Dn = 1/(1 + Rn )n , the spot rates corresponding to these prices are R2 = 0.1952 and R3 = 0.0772 which implies the forward rate from period 2 to period 3 is f3 = −0.125: the negative forward rate is an indication that arbitrage opportunities exist (a diﬀerent way of stating that D3 > D2 is and indication that arbitrage opportunities exist). Actions (t=0) Buy 2 period bond Shortsell 3 period bond Net ﬂow = 0.10 0 −0.70 +0.80 +0.10 1 2 +1.00 +1.00 3 −1.00 −1.00

7. Assume a one period spot rate R1 = 0.10 and a two period spot rate R2 = 0.08. Show how a long forward contract can be created from these two spot bonds and determine the price and yield of the forward contract. Show how a short forward position can be created. The present values corresponding to the spot rates are D1 = 0.9091 and D2 = 0.8573 and the forward price is F2 = D2 /D1 = 0.9431. An investor can create a long forward contracts (zero cash ﬂow at time 0, cash outﬂow at time 1, cash inﬂow at time 2) by buying 2 period bonds and short selling 1 period bonds: Actions (t = 0) Short sell y 1 period bonds Buy x 2 period bonds Net = x − y 0 yD1 −xD2 0 1 −y −y 2 +x +x

where the net position is a long forward. For a forward contract, the net ﬂow at t = 0 must be zero, which imposed the condition that yD1 = xD2 or y = xD2 /D1 = xF2 or x = y/F2 and a net forward position of (1 − F2 )x = (1 − F2 )y/F2 . For a unit outﬂow at time 1, y = 1, the inﬂow at time 2 is x = 1.06033 and a net of 0.06033; for a unit inﬂow at time 2, x = 1, the outﬂow at time 1 is y = F2 = 0.9431 and a net of 0.0549. To create a short forward position (zero cash ﬂow at time 0, cash inﬂow at time 1, cash outﬂow at time 2) by buying 1 period bonds and short selling 2 period bonds:

40

Actions (t = 0) Short sell y 2 period bonds Buy x 1 period bonds Net = x − y

0 yD2 −xD1 0

1 +x +x

2 −y −y

where the net position is a short forward. The zero cash ﬂow condition at time t = 0 imposed the condition that yD2 = xD1 or x = yF2 or y = x/F2 and a net short position of (F2 − 1)y or (F2 − 1)x/F2 . In either case, this is a sure loss: for a unit outﬂow at time 2, y = 1, the net is −0.0569; for a unit outﬂow at time 1, the net is −0.0603. The only way a short forward position would prove proﬁtable on its own, is for x > y or F2 > 1 which implies a negative value for the forward interest rate f2 , indicating that there would be arbitrage opportunities (the forward rate implicit in R1 and R2 is diﬀerent than the market forward rate). 8. Assume D1 = 0.90 and D2 = 0.80. You decide to short a one period zero coupon bond and go long one two period zero coupon bond. Is the resulting position a forward position? Actions (t = 0) Short sell a 1 period bond Buy a 2 period bond Net = +0.1 0 0.9 −0.8 +0.1 1 −1 −1 2 +1 +1

This is not a forward position since it involves a non-zero cash ﬂow at time 0. This is simply short selling and going long in the spot market for a guaranteed proﬁt of 0.1. 9. Assume the one period spot rate is R1 = 0.10, the two period spot rate is R2 = 0.08, and the forward rate f2 = 0.0. Is this information consistent with equilibrium? What arbitrage opportunities are available to investors? The forward rate implicit in the two spot rates is fim = (1 + R2 )2 /(1 + R1 ) − 1 = 0.06036, so the market rate for the forward rate is not consistent with equilibrium. An arbitrage opporunity is to borrow at the market forward rate of 0% and to lend at the 6.036% rate implicit in the spot rates (deﬁne the implicit forward price Fim = 1/(1+ fim )): create a short forward position at the market rate and a long forward position at the rate implicit in the spot rates. Action (t = 0) Short forward at market f2 rate Go long forward at implicit f2 rate Net = fim Fim 41 0 0 0 0 1 +1 −Fim 1 − Fim 2 −1 +1 0

where the net position is an arbitrage position. For the numerical values supplied, this is a riskless proﬁt of 0.059797. 10. Assume R1 = 0.12, R2 = 0.10, and R3 = 0.03. Are these interest rates consistent with equilibrium? Explain why or why not. The spot rates corresponding to these spot rates are D1 = 0.89286, D2 = 0.82645, and D3 = 0.91514. Equilibrium requires Dj > Dj +1 for all j , and since D3 > D1 > D2 , these rates are not consistent with equilibrium. The equilibrium inequality constraint on the spot prices tranlates into spot rate inequality Rn > (1 + Rn−1 )(n−1)/n − 1. For the stated value of R1 , R3 > 0.03895; for the stated value of R2 , R3 > 0.0656. 11. Assume D2 = 0.85 and D4 = 0.75. What statements can be made about f3 and f4 ? What are the largest possible values for these forward rates? Since the forward rate is given by 1+ fm = 1/Fm = Dm−1 /Dm , using m = n and m = n − 1 and multiplying together gives (1 + fn )(1 + fn−1 ) = Dn−1 Dn Dn−2 Dn−1 = Dn−2 Dn

**Thus, the forward rates are given by
**

Dn−2 Dn

fn =

− 1 − fn−1

(1 + fn−1 )

Dn−2 Dn

fn−1 =

− 1 − fn

(1 + fn )

Since the forward rates are required to be positive, these equations show that fn ≤ Dn−2 /Dn − 1 and fn−1 ≤ Dn−2 /Dn − 1. The maximum value for f3 occurs for f4 = 0 (D3 = D4 ) or (f3 )max = Dn−2 /Dn − 1 = 1.13333; the maximum value for f4 occurs for f3 = 0 (D2 = D3 ) or (f4 )max = 1.133333. 12. Obtain prices and yields of U.S. Treasury STRIPS from The Wall Street Journal. Plot the yields to maturity versus maturity at yearly intervals. 13. Given the following information about forward interest rates, what is the smallest possible value of the four period spot interest rate and what will 42

the forward interest rate be? What is the largest possible value for the four period spot interest rate and what will the forward rate be? See Appendix B. Maturity (n) 1 2 3 Forward Rate (fn ) 0.12 0.10 0.08 Time Interval from t = 0 to t = 1 from t = 1 to t = 2 from t = 2 to t = 3

Since the relation between the spot rates and the forward rate is (1+ Rn )n = n−1 (1+Rn −1 )(1+fn ), and since the forward rates are positive, fn ≥ 0, Rn ≥ (1+ ( Rn−1 ) n−1)/n . Using the forward rates to generate the spot rates (R1 = f1 ), we obtain the following table: Maturity (n) 1 2 3 Forward Rate (fn ) 0.12 0.10 0.08 Spot Rate (Rn ) 0.12 0.11 0.10

Consequently, R4 ≥ (1+ R3 )0.75 . The minimum value occurs for the equality (R4 )min = (1 + R3 )0.75 = 0.074 and corresponds to a zero forward rate, f4 = 0.0: these are the smallest possible values for the four period rates, those rates which make D4 = D3 . As far as maximum values are concerned, there doesn’t seem to be any way to determined these values with the information given. The upper bounds are determined by the ﬁve period rates: given a minimum four period spot rate, we can calculate a minimum ﬁve period spot rate corresponding to a zero ﬁve period forward rate, but this is not the maximum four period spot rate. The lower period rates can determine minimum values for the next period rates, but they can not determine the maximum values.

43

Chapter 10: Coupon Bearing Bonds 1. Compute the present value of a two period annuity of $1 per period if the discount rate is 10%. The present value of an annuity paying $1 per period for n periods is

n

An =

k=1

1 1 1 = 1+ k R (1 + R)n (1 + R)

where R is the discount rate. For n = 2 and R = 0.10, the two period annuity has a present value of A2 = 1.7355. 2. A 2 period annuity has a present value of $1.808. Find the discount rate from the present value table. Looking up the present value in the annuity tables, one ﬁnds that the discount rate is 7%. An iterative procedure can be set up to solve this numerically by writing R(k + 1) = 1 1 1− A2 (1 + R(k ))2

where k is the iteration index and an initial value R(0) must be assumed. The rapidity of convergence of the iteration will depend on this initial choice. For instance, choosing R(0) = 1/A2 = 0.5531 leads to convergence relatively slowly, but lucky guesses close to the correct value will convergence fairly rapidly. An alternative interative procedure is R(k + 1) = 1 −1 (1 − A2 R(k ))1/2

but this has no obvious advantages over the ﬁrst method and it has a potential disadvantage in that it may lead to unphysical complex values during the iterative procedure if R(0) is chosen to be too large. 3. The one period spot rate is R1 = 0.04, the two period spot rate interest rate is R2 = 0.10. Compute the present value of a two period annuity. Approximate the yield to maturity on this annuity. How does this yield to maturity compare to the one period spot rate and the two period spot rate? 44

**The present value of a general n period annuity that pays $1 per period is
**

n

An =

k=1

1 (1 + Rk )k

For the two period case this is simply A2 = (1 + R1 )−1 + (1 + R2 )−2 . Substituting the values for the spot rate, we obtain A2 = 1.78798. The yield to maturity is the ﬂat rate that solves the equation A2 = 1 1 1+ y (1 + y )2

Using the approximate formula given in the text for maturities of less than 15 years, y = 2(1 − A2 /2)/A2 = 0.1186 which is not a good approximation (it corresponds to a present value of 1.69317, an error of 5%). An iterative procedure solution deﬁned by y (k + 1) = 1 1 1+ A2 (1 + y (k ))2

with y (0) = 0.1186 a convenient starting point. A value of y = 0.08128 leads to an error in the present value of 0.4%. Consequently, the approximate formula in the text overestimated the yield to maturity by at least 3.5%. The yield to maturity should lie between the one period and two period spot rates, R1 ≤ y ≤ R2 . 4. Bonds K and M are each two period bonds with $100 par values. Bond K has a coupon of $9 and bond M has a coupon of $11. Bond K sells for $98 and bond M sells for $98. Explain the arbitrage available to investors. Is there an arbitrage opportunity if the price of bond M is $99? Explain. The arbitrage opportunity is to short sell bond K and buy bond M, and is summarized in the table below: Action (t = 0) Short sell K Buy M Net = 4 0 98 −98 0 1 −9 +11 +2 2 −109 +111 +2

where the net position is an arbitrage position. The net ﬂows at t = 1 and t = 2 are risk free since there is no cash ﬂow at time t = 0. If the price of 45

bond M is $99, a straight short sell of bond K and buying of bond M results in the following cash ﬂows: Action (t = 0) Short sell K Buy M Net = 3 0 98 −99 −1 1 −9 +11 +2 2 −109 +111 +2

This is a sure proﬁt but it is not risk free since there is a net cash ﬂow at t = 0. This could, however, be converted into an arbitrage opportunity by buying 98/99 amount of bond M: Action (t = 0) Short sell K Buy (98/99) of M Net = 3.78 0 98 −98 0 1 −9 +10.89 +1.89 2 −109 +110.89 +1.89

The net position is an arbitrage opportunity since it is a risk free proﬁt, involving zero cash ﬂow at time t = 0. 5. The one period spot interest rate R1 = 0.04 and the two period spot interest rate is R2 = 0.10. Compute the price of a two period bond with $100 par value and a coupon of $7. The price or present value of a bond with coupon c and par value Ppar of maturity n is given by

n

P =

j =1

Ppar c + j (1 + Rj ) (1 + Rn )n

For the two period case, this is simply P = c/(1 + R1 ) + (c + Ppar )/(1 + R2 )2 . Using the values given, this works out to be P = 95.16. 6. In Problem 5, estimate the yield to maturity, the current yield, and the stated yield. Compare these three yields. Compare these yields to the approximation in equation 10.12. The current yield is simply the coupon divided by the price, yc = c/P which in this case is yc = 7.356%. The stated yield is the coupon divided by the par valued, ys = c/Ppar which in this case is ys = 7.0%. The yield to maturity is found by replacing the spot rates R1 and R2 by a ﬂat rate yytm : given

46

the price, coupon, and par value, this equation can be solved for the yield to maturity: P = c + Ppar c + (1 + yytm ) (1 + yytm )2

1 1 1 + 1/ys = + yc (1 + yytm ) (1 + yytm )2 (1 + yytm )2 − yc (1 + yytm ) + yc 1 + 1 ys =0

This quadratic equation in (1 + yytm ) has the simple solution (the negative square root must be discarded as “unphysical” since the interest rate must be positive) yc + 1 + yytm =

2 + 4y (1 + yc c 1 ys )

2

Substituting the values for the current and stated yields gives the result yytm = 9.7805. These yields satisfy the inequalities ys < yc < yytm . The approximate formula equation 10.12 gives c+

Ppar +P n Ppar +P 2

yapp =

which, upon substitution of the numerical values, gives yapp = 9.654%. This is low by 0.126% which is not too bad an approximation. 7. Re-do Problems 5 and 6 with a bond having a coupon of $4. Compare your answers. Substituting c = 4 in the equation for the two period bond with $100 par value gives a price of P = 89.80. The current yield is then yc = c/P = 4.454%, the stated yield is ys = c/Ppar = 4%, and the yield to maturity is yytm = 9.86%. The yields satisfy the same inequalities as in Problems 5 and 6, ys < yc < yytm . The approximate formula for the yield to maturity, equation 10.12, gives yapp = 9.589% which is low by 0.271%, which is nearly twice as large as the error generated in Problems 5 and 6, but is still not too bad an approximation. 47

8. Using the information in Problem 5, compute the yield to maturity for a par bond. What is its annual coupon, current yield, and stated yield? For a par bond, the price is equal to the par value, P = Ppar = c + Ppar c + (1 + R1 ) (1 + R2 )2

Solving this equation for the coupon gives, c= Ppar (1 − D2 ) D1 + D2

where Dn = 1/(1 + Rn )n . Substituting the values from Problem 5 gives a coupon for the par bond of c = 9.71. The current yield is yc = 9.71%, the stated yield is ys = 9.71%, and the yield to maturity is yytm = 9.71%. For a par bond, all three yields are expected to be the same. In addition, the approximate expression for the yield, equation 10.12, reduces to the current yield (or stated yield, since they are the same for a par bond), and so gives the exact yield to maturity, yapp = 9.71%. 9. A perpetual bond has a coupon of $8, par value of $100, and price of $80. Compute its yield to maturity, current yield, and stated yield. For a perpetual bond, n → ∞, and so the equation for the yield to maturity becomes simply P = c/yytm . Consequently, the current yield and the yield to maturity are the same, yc = yytm = c/P = 10%, while the stated yield is ys = c/Ppar = 8%. These yields satisfy the inequalities ys < yc = yytm . 10. Assume a bond paying a coupon of $4 semiannually and having a $100 par value and price. Determine the semiannual and annual yields to maturity. Compare the two. The price for a bond paying a coupon semiannually is P = c/2 1 1− i/2 (1 + i/2)2n + Ppar (1 + i/2)2n

For a par bond, P = Ppar , and consequently

48

P = Ppar =

c/2 c = i/2 i

The interest is paid out semiannually at a rate of i/2, where i is called the semiannual yield to maturity. Thus, since c/2 = 4, c = 8, and so the semiannual yield to maturity is i = c/P = 8% although the interest is being paid out semiannually at a rate of i/2 = 4%. For the annual yield to maturity, the equation for the price of the bond is written as Ppar c/2 + k/2 (1 + y )n (1 + y ) k=1 c/2 + (1 + y )k

n k=1 2n

P = 1 (1 + y )1/2

n−1 k=0

P =

Ppar c/2 + k (1 + y )n (1 + y )

The sums can be done in closed form since each is a geometric series. The result is √

c P = 2

1+y 1 1− y (1 + y )n

+

c/2 1 1− y (1 + y )n

+

Ppar (1 + y )n

Since this is a par bond, P = Ppar = $100, the resulting equation for the yield to maturity is √ 2P 1+ 1+y = c y This equation may be solved iteratively for y in the following fashion: y (k + 1) = c 1+ 2P 1 + y (k )

given a suitably chosen initial value for y (0). Starting with y (0) = 0, the iterative solution gives an annual yield to maturity of y = 8.16%. The annual yield to maturity is larger than the semiannual yield to maturity since the annual yield takes into account the fact that payments are made semiannually at a rate of 4%: this simply reﬂects the fact that (1 + i/2)2 = (1 + y ) or y = i + i2 /4. 49

11. The yield to maturity on a one period par bond is y1 = 0.06. The yield to maturity on a two period par bond is y2 = 0.08. Compute the forward interest rate for period 2. The coupon for the one period bond is found from Ppar = (c1 + Ppar )/(1+ y1 ) or c1 = y1 Ppar ; the coupon for the two period bond is found from Ppar = c2 /(1+ y2 )+(c2 + Ppar )/(1+ y2 )2 or c2 = Ppar [(1+ y2 )2 − 1]/(2+ y2 ) = Ppar y2 . Since the yield to maturity for a one period bond is the one period spot rate, P = (c1 + Ppar )/(1 + R1 ) = (c + Ppar )/(1 + y1 ) → R1 = y1 , the problem is reduced to ﬁrst ﬁnding the two period spot rate R2 . The general expression for a two period par bond is Ppar = c2 /(1 + R1 ) + (c2 + Ppar )/(1 + R2 )2 which can be solved for R2 , D2 = Ppar − c2 /(1 + R1 ) (c2 + Ppar ) 1 − y2 /(1 + R1 ) (y2 + 1)

−1/2

D2 =

R 2 = D2

−1

Now that we have obtained the one and two period spot rates, we can calculate the forward rate by f2 = (1 + R2 )2 /(1 + R1 ) − 1. Substituting the values for y1 and y2 , we ﬁnd that R1 = y1 = 0.06, y2 = 0.0808, and so the forward rate is f2 = 0.1020. 12. A 10 year bond ha a coupon of c = $5, a par value of Ppar = $100, and a price of P = $100. A 5 year bond ha an annual coupon of c = $16, a par value of Ppar = $100, and a price of P = $100. Which bond is a better buy? Does your answer depend upon individual investor preferences? Are there any arbitrage opportunities? The general expression for the price of an n period par bond reduces to the simple expression Ppar = c/y where y is the yield to maturity. Thus, the ten year bond has a yield to maturity of y10 = 5% and the ﬁve year bond has a yield to maturity of y5 = 16%. The cash ﬂows for buying 5 year and 10 year bonds at time t = 0 are given in the table: Action 5 yr 10 yr 0 -100 -100 1 16 5 2 16 5 3 16 5 4 16 5 50 5 116 5 6 5 7 5 8 5 9 5 10 105

The overall amount accumulated by the ﬁve year bond is $180, while the overall amount accumulated by the ten year bond is $150. Thus, from both the yield and total amount accumulated points of view, the ﬁve year bond looks to be the better buy. An arbitrage opportunity is available: buy the ﬁve year bond and short sell the ten year bond. The cash ﬂows for buying a 5 year bond and shorting a 10 year bond at time t = 0 are as follows: Action 5 yr 10 yr Net = 30 0 −100 +100 0 1 16 −5 11 2 16 −5 11 3 16 −5 11 4 16 −5 11 5 116 −5 111 6 −5 −5 7 −5 −5 8 −5 −5 9 −5 −5 10 −105 −105

This gives a risk free net proﬁt of $30 after the ten year period with zero cash ﬂow at time t = 0, that is, a zero investment guarantees a $30 proﬁt. 13. In The Wall Street Journal, ﬁnd the prices and yields of Treasury Notes, Bonds, and Bills. For the longest maturity bill, longest maturity note, and longest maturity bond, compute the yield to maturity. Compare your answer with the yield in the newspaper. 14. In The Wall Street Journal, ﬁnd three or more securities with the same maturity, but diﬀerent coupons. Plot price (bid and asked) versus coupon (horizontal axis). Also plot yield to maturity versus coupon.

51

Chapter 11: Money Market Instruments And Rates 1. Explain why each of the following money market instruments exists: commercial paper, bankers’ acceptances, repurchase agreements, certiﬁcates of deposit, and federal funds. Why does each of these have an advantage over competing methods of ﬁnancing? 1 Commercial paper is a promissory note issued by large ﬁrms with high credit ratings as a source of short term funds. It can be a cheaper source of funds for ﬁnancially sound ﬁrms than commercial bank loans. 2 Bankers’ acceptances are short term debt obligations guaranteed by large commercial banks. They are highly liquid, low risk, low return investments. They typically involve international trade. 3 Repurchase agreements (repos) are generally overnight sales of U.S. government securities with an agreement to repurchase the security on the next business day with overnight interest. There is a huge volume of transactions for repos. They are a cheap source of ﬁnancing since the interest is charged for overnight only at a rate slightly below the federal funds rate (the rate at which a bank loans to another bank). 4 Certiﬁcates of deposit of large denomination (CD’s larger than $100, 000) are a signiﬁcant source of funds for money centers and large regional commercial banks. 5 Federal funds are loans from one bank to another. Banks with reserves in excess of the required Fed reserves can lend the excess to other banks. These are usually overnight loans at the federal funds rate (the most volatile interest rate in the entire market). 2. Why did the market for Eurodeposits develop? What is the advantage of a Eurodeposit over a domestic deposit from a bank’s viewpoint as well as a depositor’s? A Eurocurrency deposit is a deposit denominated in terms of a foreign currency. For example, a deposit in U.S. dollar terms made in London is considered a Eurodollar deposit. The interest rate is typically higher than rates on domestic U.S. deposits and are typically free of regulation beneﬁtting both bank and depositor. 52

3. Find the prices of the following Treasury bills per dollar of par: (a) 40 days, discount rate of 6%, (b) 90 days, discount rate of 12%, (c) 80 days, discount rate of 8%, and (d), 92 days, discount rate of 7%. The price per dollar of par is P/Ppar = 1 − dt/360 = 1 − interest, where d is the discount rate and t is in days. Consequently, the following prices are obtained: (a) 0.9933, (b) 0.9700, (c) 0.9822, and (d) 0.9821. 4. In Problem 3, ﬁnd the add on interest rates, bond equivalent yields, semiannual, and annual yields to maturity. The add on interest rate is obtained from the discount rate by a = d/(1 − dt/360) = d/(P/Ppar ) where P is the price of the security. The bond equivalent yield is then simply obtained from the add on rate by r = (365/360)a. The semiannual yield to maturity is deﬁned by i = 2((Ppar /P )365/2t − 1), and the annual yield to maturity is deﬁned by y = (Ppar /P )365/t − 1. For the values in Problem 3, we obtain the following table: Rates a r i y (a) 6.04 6.12 6.20 6.30 (b) 12.08 12.22 12.74 13.15 (c) 8.14 8.26 8.35 8.53 (d) 7.13 7.23 7.29 7.42

where all rates are expressed as a percent. 5. Determine Treasury bill discount rates, assuming the following information. Assume $1 par values. (a) P = 0.96, t = 91 days, (b) P = 0.94, t = 91 days, (c) P = 0.98, t = 91 days, (d) P = 0.98, t = 90 days. The equation relating the price and discount rate can be solve for the discount rate, giving a function of t and price per dollar of par: d = (360/t)(1 − P/Ppar ). Upon substitution of the numerical values, we obtain (a) 15.82%, (b) 23.74%, (c) 7.91%, and (d) 8.0%. 6. Assume a discount rate of 6%. Compute the add on interest rate, the bond equivalent yield, the semiannual, and annual yield to maturity for 30, 60, 90, and 180 days. Graph these results. Using the equations for these quantities deﬁned in Problem 4, we generate the following table (all rates expressed as a per cent):

53

Rates a r i y

30 6.03 6.11 6.19 6.29

60 6.06 6.14 6.21 6.30

90 6.09 6.18 6.22 6.32

180 6.19 6.27 6.27 6.37

Each rate is an increasing function of maturity, all of which look nearly linear over the range covered. The slope of the bond equivalent yield looks to be the largest, followed by the add on rate, the semiannual, and the annual yield to maturity. 7. Look in The Wall Street Journal for the column entitled “Money Rates.” Compare the prime rate, the federal funds rate, the discount rate, the commercial paper rate, the bankers’ acceptance rate, and the Treasury bill rate. For the federal funds rate, note the diﬀerence between the high and the low.

54

Chapter 12: Mortgages 1. For a standard ﬁxed rate mortgage, compute the annual mortgage payment for a 5 year annual mortgage loan with principal of $50, 000 and interest rate of 10%. The principal or present value of a loan assuming annual compounding is P = (M/y )(1 − (1 + y )−n ). Solving for the annual payment, M , gives M = P y/(1 − (1 + y )−n ). Substituting for the values quoted in the problem gives M = $13, 189.87 per year. 2. For the preceding problem, break each mortgage payment into interest on remaining principal and amortization. Also compute the remaining balance on the mortgage at each point in time. What is the total amount of interest paid over the mortgage’s life? Does this seem high or low, fair or unfair? For the period indexed by the integer j , the principal payment is given by Pj = M/(1 + y )n+j −1 , the interest payment is given by Ij = M − Pj , and the balance remaining is given by Bj = Bj −1 − Pj where B0 is the initial balance or principal of the loan, $50, 000. Period j 1 2 3 4 5 Totals Pj 8,189.87 9,008.86 9,909.74 10,900.72 11,990.79 49,999.98 Ij 5,000.00 4,181.01 3,280.13 2,289.15 1,199.08 15,949.37 Bj 41,810.13 32,801.27 22,891.53 11,990.81 0.02 50,000

The total interest payment of $15, 949.37 amounts to 31.89874% over the 5 year life of the loan giving an annual percentage rate (not compounded) of 6.3797%. This actually seems a little low from the bank’s point of view, but quite good from the borrower’s point of view (given today’s rates). 3. Assume you take out a 25 year mortgage at a 10% interest rate. After 5 years, the interest rate on new loans is 7%. If you reﬁnance, there is a loan origination fee of 3%. Compute the immediate gain from reﬁnancing. The original principal or present value of the loan, in units of the yearly payment M , is P/M = (1/y )(1 + (1 + y )−n ), the principal repayment is Pj /M = 1/(1 + y )n+j −1 , the interest payment is Ij /M = 1 − Pj /M and the 55

remaining balance is Bj /M = Bj −1 /M − Pj /M where j is the period index and B0 /M = P/M . The table of values, in units of the yearly payment M is: Period j 1 2 3 4 5 Pj /M 0.0923 0.1015 0.1117 0.1228 0.1351 Ij /M 0.9077 0.8985 0.8883 0.8772 0.8649 Bj /M 8.9847 8.8832 8.7715 8.6487 8.5136

After the ﬁfth year, will need to reﬁnance Pnew /M = 8.5136. The loan origination of fee of 3% is then 0.2554M . A new 25 year loan at a new rate of 7%, with principal or present value of Pnew , gives a new yearly payment of Mnew = Pnew ynew /(1 − (1 + ynew )−n ) = 0.73056M . So, in the ﬁrst year you will immediately save M − 0.2554M − 0.73056M = 0.014M . 4. Explain what it means to originate a mortgage loan. Who are the originators? An institution originates a loan with a borrower and then sells the loan in the secondary market to a “ﬁnal lender.” The originator usually processes the monthly payments and collects a fee for this processing. Originators include thrifts, banks, mortgage companies: ﬁrms that match borrowers with ultimate lenders (investors) and consequently sell most of their mortgages in the secondary market - they originate and administer mortgage loans but sell them rather than hold them as investments. 5. A bank has a choice of making a 2 year loan at 10% or a variable rate loan at the 1 year Treasury bill rate plus 2%. Currently, the Treasury bill rate is 7%. Under what circumstances is the 2 year loan better than the variable rate loan and vice versa? The ﬁxed rate loan with principal P , yearly payment Mf , and ﬁxed interest rate yf is determined by P = Mf /yf (1 − (1 + y )−2 ) since this is a two year loan. The ﬁxed rate is yf = 0.10, so the principal is P/Mf = 1.73554. The table of values for this is loan is: Period j 1 2 Total Pj /Mf 0.82645 0.90909 1.73554 Ij /Mf 0.17355 0.09091 0.26446 Bj /Mf 0.90909 0.0

56

The variable rate loan with principal P , yearly payment Mv , and variable interest rate yi (for i = 1, 2) is determined by P = Mv /y1 (1 − (1 + y1 )−2 ) since this is a two year loan and it is assumed that the interest rate remains the same for the two years. The initial variable rate is y1 = 0.09%, so the principal is P/Mv = 1.75911. The table of values for this loan is: Period j 1 2 Total Pj /Mv 0.84168 0.91743 1.75911 Ij /Mv 0.15832 0.08257 0.24089 Bj /Mv 0.91743 0.0

Since the principal value of the loan is the same in the two cases, this determines the ratio of the ﬁxed rate yearly payments to the variable rate yearly payments, P = 1.75355Mf = 1.75911Mv , or Mf = 1.00317Mv . Thus, converting the ﬁxed rate table of values to be in units of the variable rate yearly payments gives: Period j 1 2 Total Pj /Mv 0.82907 0.93004 1.75911 Ij /Mv 0.17410 0.08370 0.25780 Bj /Mv 0.93004 0.0

In units of the variable rate yearly payment, the ﬁxed rate pays out 1.75911 in principal and 0.25780 in interest for a total of 2.01691; the variable rate also pays out 1.75911 in principal but 0.24089 in interest, giving an edge to the variable rate loan. In units of the ﬁxed rate yearly payment, the ﬁxed rate pays out 1.73554 in principal and 0.26446 in interest for a total of 2.0000; the variable rate also pays out 1.75354 in principal but pays out only 0.24013 in interest for a total of 1.97567. However, if the second year variable rate changes, the variable rate loan may no longer have an advantage: as the interest rate increases, not only is more interest being paid, but less of the second payment is applied to the principal requiring an additional payment of principal only. The more general variable rate relation is P/Mv = 1/(1 + y1 ) + 1/(1 + y2 )2 where y1 = 0.09 and y2 is only known to be 2% above the future T-bill rate. Consequently, P/Mv = 0.91743 + 1/(1 + y2 )2 or P/Mf = 0.91435 + 0.99684/(1 + y2 )2 . The ﬁxed rate loan makes two payments of Mf in any case. If the second year rate is y2 , the second year interest payment for the variable rate loan is 0.91743y2 Mv = 0.91453y2 Mf and the second year principal payment for the variable rate loan is (1 − 0.91743y2 )Mv = (0.99684 − 0.91453y2 )Mf for a total second year payment of Mv = 0.99684Mf . The principal remaining is (0.91743 − (1 − 57

0.91743y2 ))Mv = (0.91743y2 −0.08257)Mv = (0.91453y2 −0.08231)Mf . Consequently, the total payments for the variable rate loan would be (1.91743 + 0.91743y2 )Mv = (1.91137 + 0.91453y2 )Mf . For the variable rate loan to be better than the ﬁxed rate loan, this total payment must be less than 2Mf which puts a constraint on the second year interest rate: y2 < 0.0969. If the second year interest rate is greater than 9.69%, then the ﬁxed rate is a better deal. Since the 2% margin is ﬁxed, this is actually a constraint on the future T-bill rate: as long as the T-bill rate is below 7.69%, then the variable rate is better; if the T-bill rate is above 7.69%, then the ﬁxed rate loan is better. 6. An investor buys a claim on a pool of 25 year mortgages at 10%. Compute the interest and principal payments of the ﬁrst ﬁve years assuming no prepayments. Next, assume that 5% of the original principal is prepaid every year. Compute the interest and principal payments for the ﬁrst ﬁve years. For a 25 year mortgage at 10% interest, the principal or present value of the loan is P = 9.077M where M is the yearly payment. The table of values for principal repayment, interest payment, and remaining balance, in units of the yearly payment M , for the ﬁrst ﬁve years is: Period j 1 2 3 4 5 Total Pj /M 0.0923 0.1015 0.1117 0.1228 0.1351 0.5634 Ij /M 0.9077 0.8985 0.8883 0.8772 0.8649 4.4366 Bj /M 8.9847 8.8832 8.7715 8.6487 8.5136

If we now include 5% of the original principal as prepaid each year, then in addition to the scheduled principal repayment we add the prepaid amount of 0.45385M . The new repayment table is: Period j 1 2 3 4 5 Total Pj /M 0.54615 0.60075 0.66084 0.72692 0.79961 3.33427 Ij /M 0.90770 0.85309 0.79301 0.72693 0.65423 3.93496 Bj /M 8.53085 7.93010 7.26926 6.54234 5.74273

58

As a result of the 5% prepayment schedule, after 5 years the investor has lost 11.3% in interest payments, while the principal during the ﬁrst 5 years has been repaid nearly 6 times faster. 7. In the preceding problem assume that the mortgage pool is broken down into four trenches. The ﬁrst 25% of principal repayments go to repay the principal on the ﬁrst tranche. Compute the cash ﬂows for the ﬁrst tranche. The prepaid repayment of principal for the ﬁrst tranche is 0.1135M for each year. Consequently, the repayment table is: Period j 1 2 3 4 5 Total Pj /M 0.20576 0.22634 0.24897 0.27387 0.30126 1.25620 Ij /M 0.90770 0.88712 0.86449 0.83959 0.81221 4.31111 Bj /M 8.87124 8.64490 8.39593 8.12206 7.82080

Thus, by splitting the mortgate pool into four trenches, the investor in the ﬁrst tranche loses only 2.83% due to the 5% per year accelerated principal repayment, while the principal is repaid at a little over 2 times as fast for the ﬁrst 5 years (compared to owning all four trenches). 8. A thrift institution decides to sell all its mortgages and use the proceeds to purchase pass-through securities. What is the gain to the thrift institution? Whatever the thrift gains, someone else loses. Who takes the other side of this transaction and what are the consequences for this party? Is there any net gain to the system from shifting risks in this way? By selling the mortgages and purchasing pass-through securities, the thrift will share in prepayments with the other holders of the pass-through securities and reduction of interest payments will be minimized in this way. If the thrift held on to all the mortgages, the thrift would have to bear the burden of prepayment all alone, but by means of the pass-through securities it is ”investing” in the mortgages. The purchaser of the thrift’s mortgages will bear the full burden of prepayment of the thrift’s mortgages. On the other hand, the interest payments may be more than the thrift’s pro-rated share of the pass-through securities: this is the compensation for risk of prepayment.

59

The net gain to the system is that it keeps thrifts in the business of making mortgages and reduces the number of thrift failures. 9. What are the consequences of CMOs and pass-throughs for commercial bank and thrift institution proﬁts? Proﬁts are smaller than if all loans were kept and paid in full, but the risks of prepayment are reduced so that the “smaller” proﬁts are more stable and predictable (less ﬂuctuating). Dividing the mortgage pool into 4 parts increases the value of the mortgages and reduces their yields, a savings which is partially passed on to the borrowers in the form of lower interest rates. 10. Explain the diﬀerence between a mortgage guarantee from FHA or VA versus insurance from a private insurance company. FHA insures qualiﬁed borrowers, and the VA guarantees mortgages for veterans only. Both FHA and VA have caps on the maximum amount of the loan, while private companies do not have these caps. FHA and VA loan applications take a long time to process (up to 2 months), while private insurers can process loan applications much faster. FHA and VA have very rigid requirements on loans, while private insurers are more ﬂexible (e.g., speciﬁcations from appraisal). A private insurance company can itself go bankrupt and default on its insuranceobligations, while FHA and VA are backed by the Federal government. 11. Look in your local newspaper for interest rates on a long term ﬁxed rate and a variable rate mortgage. Report the loan initiation costs. How is the interest rate adjusted on the variable rate mortgage?

60

Chapter 13: Bond Investment Risks and Portfolio Strategies 1. Assume a yield to maturity of 8%. Compute the duration and elasticity for the following bonds. (a) 10 years, zero coupon, (b) 10 years, 8% coupon, (c) 10 years, 12% coupon. The price of a bond with a constant coupon, in general, is P = c/y (1 − (1 + y )−n ) + Ppar /(1 + y )n where c is the coupon, y is the yield to maturity, Ppar is the par value, and n is the maturity of the bond. The duration of a bond is deﬁned as D = −((1 + y )/P )dP/dy which is 1 P c(1 + y ) 1 1− 2 y (1 + y )n n(Ppar − c/y ) (1 + y )n

D=

+

The elasticity of the bond is deﬁned as E = −(y/P )dP/dy which is simply related to the duration by E = yD/(1 + y ) (a) For the zero coupon bond, c = 0 and the duration is simply the maturity of the bond, D = n, which in this case is 10 years. The elasticity is given by E = 0.7407. (b) For the 8% coupon, c = 0.08Ppar which is a par bond since the yield to maturity is also 8%: P = Ppar . Upon substitution, the duration for this bond is D = 7.247. The elasticity is given by E = 0.5368. (c) For the 12% coupon, c = 0.12Ppar which is a premium bond since the price is higher than the par value, P = 1.268Ppar . The duration is given by D = 6.744, and the elasticity is E = 0.4996. 2. In Problem 1, assume that yields change from 8% to 9%. Work out the exact change in price and compare it with the change in price predicted by duration. Explain the diﬀerence. The price of a bond with a constant coupon, in general, is P = c/y (1 − (1 + y )−n ) + Ppar /(1 + y )n where c is the coupon, y is the yield to maturity, Ppar is the par value, and n is the maturity of the bond. (a) Upon substitution, the exact new price is Pnew = 0.4224Ppar . The exact fractional change in price is ∆P/P = −0.0880. The fractional change using the ﬁrst duration approximation, ∆P/P ≈ −D∆y , is ∆P/P ≈ −0.10; using the second duration approximation, ∆P/P ≈ −D∆y/(1 + y ), is ∆P/P ≈ 0.0926. 61

(b) The exact new price is Pnew = 0.9358Ppar . The exact fractional change in price is ∆P/P = −0.0642. Using the ﬁrst duration approximation gives ∆P/P ≈ −0.0725, while using the second duration approximation gives ∆P/P ≈ −0.0671. (c) The exact new price is Pnew = 1.1925Ppar and the exact fractional change in price is ∆P/P = −0.0759. The ﬁrst duration approximation gives ∆P/P ≈ −0.0855, while the second duration approximation gives ∆P/P ≈ −0.0792. The calculation using the duration assumes very small changes in the interest rate. The ﬁrst duration approximation assumes small interest rates as well, that is, it assumes y << 1; the second duration approximation does not make that assumption, but they both assume the change in rates, ∆y is small. It should be noted that the equation in the text is oﬀ by a sign, that is, it gives only the magnitude change: it misleadingly suggests the prices increase with increasing interest rates and decrease with decreasing interest rates. 3. A perpetual bond has a coupon of $6 and a yield to maturity of 6%. Work out the actual percentage change in price and the ﬁrst three terms of the Taylor expansion in three cases: (a) The yield decreases by 1% (b) The yield increases by 1% (c) The yield increases by 8% Compare the value of the ﬁrst, second, and third derivative terms in these cases. For a perpetual bond, n → ∞, and so P = c/y . The value of the price is P = 5.66. The ﬁrst derivative is dP/dy = −c/y 2 , the second derivative is d2 P/dy 2 = 2c/y 3 , and the third derivative is d3 P/dy 3 = −6c/y 4 . The coeﬃcients of the Taylor series requires these derivatives at the initial yield to maturity, that is, at y = 0.06. Thus the ﬁrst three derivatives are a1 = −94.34, a2 = 3144.44, and a3 = −157222.22. These are “dangerously” large, and indicate the Taylor expansion will converge only for very small changes in the yield. The Taylor expansion is then given by ∆P/P ≈ (a1 /P )∆y + (a2 /2P )(∆y )2 + (a3 /6P )(∆y )3 ≈ −16.67∆y + 277.78(∆y )2 − 4583.33(∆y )3 . A table of values for the three cases is given below: 62

(a1 /P ) −16.67

(a2 /2P ) 277.78

(a3 /6P ) −4629.63 Third Order 0.00463 −0.00463 −2.370 Approx 0.199 −0.144 −1.925 Exact 0.2 −0.143 −0.25

First Order 0.167 −0.167 −1.333

Second Order 0.0278 0.0278 1.778

It would appear that the ﬁrst two cases converge nicely to the exact values, even though the coeﬃcients in the Taylor expansion seem relatively large. The third case, a change by 8% in yield, converges very slowly, if at all, and the third order approximation is not good enough for this case. 4. For an investor who desires to immunize a portfolio, compare the advantages and disadvantages of a duration strategy versus a dedicated strategy in a real world situation. How does the zero coupon bond strategy compare with each of these other strategies? This is actually a specialized problem: you have x dollars today to invest and you must achieve an investment goal of H dollars (H > x) in n years from now. There may be severe penalties if H is not obtained, but there will be no rewards if a value greater than H is obtained. The duration strategy is to invest in coupon bearing bonds with a maturity greater than the horizon date n. The cash ﬂows are the following: 0 −P 1 c 2 c 3 c ..... ...... n c .... ..... maturity c + Ppar

At time 0, buy the coupon bearing bond. At times 1 through n − 1 receive the coupons and reinvest the coupon. At time n, sell the original bond and the reinvested coupons. The coupons from t = 1 to t = n − 1 have to be reinvested at uncertain future interest rates. The bond is sold at the horizon date n, it has m − n coupon paying periods left, and the market value at the horizon date is uncertain. A decrease in interest rates means the reinvestment of coupons gives a low return although the market value of the bond at the horizon date is high; an increase in interest rates means the reinvestment of coupons gives a high return but the market value of the bond at the horizon date is low. You can lock in the liquidating value of the portfolio on the horizon date by setting the duration of the portfolio equal to the number of periods until the horizon date. In this case, obtain a bond with a duration equal to n. This 63

is completely eﬀective if (1) the yield curves are ﬂat and (2) only one small change in interest rates occurs immediately after the portfolio is chosen. The “oﬀsetting” eﬀects due to changes in interest rates “cancel” to “guarantee” the required amount by time t = n. Relaxing the two assumptions in the duration strategy requires rebalancing after each small change in interest rates occurs. The drawbacks of this approach are (1) expensive transaction costs and (2) since the maturity is longer than the horizon, there may not be any bonds available with a long enough maturity. The dedicated strategy is one which locks in the terminal value at the horizon date. It assumes a very low reinvestment rate on coupons, so you must initially invest more money than with the duration strategy. The initial cost of the dedicated strategy is higher than the duration strategy, but it avoids the rebalancing transaction costs. Zero coupon bonds are extremely desirable in a dedicated strategy as reinvestment vehichles for the coupons received. In a zero coupon strategy, simply buy a zero coupon bond with par value H and maturity t = n. However, relatively few long term zero coupon bonds exist (T-bills with maturities less than 1 year), and corporate zero coupon bonds have default risk. One can construct STRIPS in the following manner. Consider a 3 year T-bond with annual coupons. If the coupons are “stripped”, then the 3 year T-bond becomes 3 annual coupons and 1 par value sold as 4 separate securities: these represent default free zero coupon bonds: Bond STRIP STRIP STRIP STRIP 0 −P −cD1 −cD2 −cD3 −Ppar D3 1 c c 2 c c c Ppar 3 c + Ppar

The total value of the STRIPS is cD1 + cD2 + cD3 + Ppar D3 = P as it must be. 5. Compute the duration of the longest Treasury bond and longest maturity Treasury note listed in The Wall Street Journal.

64

Chapter 14: The Term Structure of Interest Rates Note : the yield curve is the relationship between interest rates and maturity for coupon bearing bonds. The term structure of interest rates is not directly observable since no tax free, default free, zero coupon bonds exist. Consequently, we must estimate the term structure from yields for coupon bearing bonds. 1. Describe the major empirical regularities of the term structure of interest rates. The three major regularities stated by B. Malkiel are: (1) short term interest rates are more variable than long term interest rates, (2) declining yield curves occur when interest rates are historically high, and (3) most common yield curve shape is upward sloping, that is, on the average, yield curves are upward sloping. An observed regularity due to R. Kessel is (4) for maturities of 6 months or less, the yield curve has an upward slope most of the time. A ﬁfth observed regularity due to Ibbotson and Sinqueﬁeld is (5) prices of long term bonds are more variable than prices of short term bonds. Note that although the prices of long term bonds are more variable than the prices of short term bonds (regularity 5), the yields of short term bonds are more variable than the yields of long term bonds (regularity 1). 2. Explain each of the major term structure theories. The segmented markets theory states that separate markets exist for each maturity. Interest rates are set by the demand and supply for funds for that maturity. Investors do not shift between diﬀerent maturities. Some investors (commercial banks) conﬁne holdings to short maturities, other investors (such as insurance companies) purchase long term bonds exclusively and hold to maturity. The increasing liquidity premiums theory states that yields increase as maturity increases. Bond investors are risk averse (they prefer lower variability of return) and consequently opt for short term maturities. Bond prices for longer term bonds are more variable and higher yields are required for longer term bonds as compensation for higher risk to the bond price. The preferred habitat theory states that investors prefer to purchase bonds of a particular maturity (not necessarily short or long term) and require

65

higher yields to buy bonds of other maturities. This is eﬀectively a combination of the segmented markets theory and the liquidity preference theory. Investors do not always prefer short maturities (as in liquidity preference theory) depending on investment objectives, and are not unwilling to purchase nearby maturities (as in segmented markets theory) but only at higher interest rates to compensate the buyer for increased risks. The money substitute theory states that very short term bonds are close substitutes for holding cash, and many investors restrict purchases to short term money market instruments because risks are very small. Prices of money market instruments are driven up and their rates down relative to longer maturity prices and rates. It assumes a large number of investors in short term bonds relative to the supply since buyers have a stronger preference for very short maturities than issuers (drives prices up, drives rates down). The expectations hypothesis is the most widely discussed theory. It is composed of several similar but diﬀerent theories. They all have the common thread that market participants are indiﬀerent about holding bonds of diﬀerent maturities. The local expectations hypothesis states that the expected rate of return over the next period for bonds of all maturities is the “risk free” interest rate (the return on the shortest maturity bond). It provides no insights about the shape of the yield curve or empirical regularities. It apparently is not empirically true: the holding period over the next period, (Pf − P0 + c)/P0 reveals diﬀerences in average returns. It is approximately the same as the “unbiased expectations hypothesis” both theoretically and empirically. The unbiased expectations hypothesis is the most widely discussed theory. It states that current forward interest rates are determined by the market’s anticipations of future interest rates, that is, the forward interest rate is determined by people’s anticipation of the average spot rate for the next period. The shape of the yield curve is linked to anticipations of interest rates in the future: fj (0) = E (R1 (j − 1)) where fj (0) is the forward rate for period j observed at time t = 0, R1 (j − 1) is the spot rate observed at time t = j − 1 lasting for one period, and E (x) is the expected value of x. A table may be constructed in the following fashion: Rates Observed t=0 t=1 t=2 66 0 −> R1 (0) 1 1 −> f2 (0) −> R1 (1) 2 2 2 −> f3 (0) −> f3 (1) −> R1 (2) 3 3 3 −> f4 (0) −> f4 (1) −> f4 (2) 4 4 4

In other words, fj (0) = E (R1 (j − 1)) = E (f1 (j − 1)) and the relation between spot rates and forward rates remains as before, (1 + Rn (k ))n = (1+ Rn−1 (k ))n−1 (1+ fn (k )) where the subscript refers to the maturity period and the argument k refers to the time of observation. A more powerful theory combines the unbiased expectations hypothesis with the increasing liquidity premium theory. This is summarized by the statement that fj (0) = E (R1 (j − 1)) + Lj , where Lj is a liquidity premium for maturity j and may increase with maturity (that is, Lj −1 < Lj may hold). 3. To what extent are the theories consistent with the empirical regularities. The segmented markets theory does not predict any of the empirical regularities of the term structure. The increasing liquidity premiums implies yield curves that are always rising which contradicts regularity (2); it does, however, predict regularities (3) and (5). The preferred habitat theory does not predict any of the ﬁve empirical regularities. The money substitute theory predicts the tendency of the yield curve to have an upward slope for very short maturities, but it does not predict any of the other empirical regularities. Regularities (4) and (5) may be questionable in that regard. The unbiased expectations theory does not predict any empirical regularities by itself, but combined with the hypothesis of greater variability of nearer term expectations of future rates, “it” predicts regularity (1) and it is consistent with regularity (2) if the market forecasts declining interest rates. The unbiased expectations with liquidity premiums theory predicts an upward sloping yield curve “most” of the time, accounting for regularities (3) and (5), and is consistent with a declining term structure (although it doesn’t predict one). 4. Which of the term structure theories are consistent with rising, ﬂat, declining, or humped yield curves? The segmented markets theory is consistent with any shape of the yield curve. The increasing liquidity premiums theory is consistent with rising yield curves only. The preferred habitat theory is consistent with any shape of the yield curve. The money substitute theory is consistent with rising yield curves (in the short term). The unbiased expectations theory is consistent with any shape of the yield curve. The unbiased expectations theory with increasing liquidity premiums theory is consistent with any shape of the yield curve.

67

5. Explain the concepts of risk neutrality, risk aversion, and risk seeking in terms of marginal utility and certainty equivalents. The utility function is the relationship between utility (or subjective value) and terminal wealth resulting from an investment. Rational investors prefer more wealth to less, consequently all utility functions have a positive slope. However, the slopes will be either increasing (risk seeking), constant (risk neutral), or decreasing (risk averse): see Figure 14.5a. Risk aversion means additional dollars of wealth add smaller amounts of utility (subjective value) so that the resulting curve is concave. Risk neutrality means that additional dollars of wealth add the same amount of utility so that the resulting curve is a straight line. Risk seeking means additional dollars of wealth add increasing amounts of utility so that the resulting curve is convex. It may be that the utility function for an investor contains all elements: for example, the utility function may be concave (risk averse) for small wealth, a straight line (risk neutral) for intermediate wealth, and convex (risk seeking) for large wealth (see Figure 14.5b). The certainty equivalent is the amount of money with certainty making the investor indiﬀerent between certain cash an a gamble with risky outcomes. In other words, a decision must be made: leave with X dollars or take a gamble. Compute the value of the gamble by weighing each outcome of the gamble with its corresponding probability, E (G) = j pj Vj where pj is the probability that the j th outcome has the value Vj . If X > E (G), the investor is risk seeking; if X = E (G), the investor is risk neutral; and if X < E (G), the investor is risk averse. 6. How has the unbiased expectations hypothesis been tested? Is evidence in support of the theory? The holding period returns on bonds of diﬀerent maturities show a diﬀerence in average returns which eliminates local expectations hypothesis. In general, it doesn’t seem to have been tested in any scientiﬁc sense: the evidence is consistent with the biased expectations hypothesis, but not with the unbiased expectations hypothesis (see appendix, pp. 357 - 360). The hypothesis is faulted for making the unrealistic behavioral assumption that investors can forecast very distant future interest rates. It does not predict any empirical regularities, but it is consistent with any shape of the yield curve. 7. What additional assumptions would make the unbiased expectations hypothesis consistent with the empirical regularities? 68

If the market forecasts declining interest rates, then it is consistent with declining yield curves when rates are high by historical standards (seems like the market forecast is responsible for this “prediction”). The addition of greater variability of near term expectations of future rates hypothesis allows it to predict the tendency for short term rates to be more variable (this is due to the variability of near term rates hypothesis, not the unbiased expectations hypothesis). Clearly, anything that can be added to the unbiased expectations hypothesis in a logically consistent manner will help to make the unbiased expectations hypothesis consistent with the empirical regularities: but these additions will be responsible for the consistency, not the unbiased expectations hypothesis. 8. Michelle is indiﬀerent between $100 and the following gamble. Is she risk averse, risk neutral, or risk seeking? Outcomes Probabilities 0 0.2 $100 0.6 $200 0.2

This means that Michelle is risk averse with certainty equivalent of X = $100. The calculation for the expected value of the gamble is E (G) = $0(0.2) + $100(0.6) + $200(0.2) = $100. Since X = E (G), she is risk neutral. 9. How does your answer to the previous question change if Michelle is indiﬀerent between $80 and the gamble? What if she is indiﬀerent between $110 and the gamble? If she is indiﬀerent between X and E (G), then any dollar amount less than X dictates choosing the gamble and any dollar amount greater than X dictates choosing the cash X . Since E (G) = $100, for X = $80 she is risk seeking (choosing the gamble) and for X = $110 she is risk averse (choosing the cash). 10. You observe the following term structure. What term structure theories are consistent with it? Maturity (years) Spot Rate 1 0.12 2 0.14 3 0.05 4 0.04 The term structure shows an initial increase followed by a rapid drop in rates (see Figure 14.10). The segmented markets theory, the preferred habitat theory, the unbiased expectations theory, and the unbiased expectations 69

with increasing liquidity premiums are all consistent with such a term structure. 11. Assume the combined theory explains the term structure. The 1 period spot rate is 5%, the expected spot rate next period is 7%, and the liquidity premium is 2%. What is the two period spot rate? The 2 period forward rate follows from f2 (0) = E (R1 (1)) + L2 which yields f2 (0) = 0.09. The 2 period spot rate follows from R2 (0) = (1 + R1 (0)) × (1 + f2 (0)) − 1 which yields R2 (0) = 6.98%. 12. You observe the following interest rates for the current and next periods. Compute the exact holding period return for a 4 period zero coupon bond. Also compute the approximate return using the approximation in the text. R1 (0) = 0.05 R1 (1) = 0.055 f2 (0) = 0.06 f3 (1) = 0.065 f3 (0) = 0.07 f4 (1) = 0.078 f4 (0) = 0.08

The exact holding period return is given by HPR = Pn (1) −1 Pn (0)

where Pn (0) is the price observed at time t = 0 of a zero coupon bond that matures at time n, Pn (1) is the price observed at time t = 1 of a zero coupon bond that matures at time n, and HPR is the holding period return. In general, we have the following relations: Pn (k ) = Ppar (1 + Rn (k ))n

(1 + Rn (k ))n = (1 + R1 (k ))(1 + fk+2 (k ))(1 + fk+3 (k ))...(1 + fn (k )) Consequently, P4 (0) = 0.939018883Ppar and P4 (1) = 0.953223615Ppar and so HP R = 0.015127206 is the exact result. The approximate result quoted in the text is

HP R ≈ R1 (0) + (f2 (0) − R1 (1)) + (f3 (0) − f3 (1)) + ...(fn (0) − fn (1)) which, for n = 4 and substituting from the table, yields HPR ≈ 0.062. This is a poor approximation, giving a value which is too large by nearly 310%. 70

Chapter 15: International Financial Markets 1. Explain the theory of comparative advantage. Countries which are able to produce more cheaply than other countries because of resource availability or an expert work force may have an absolute advantage over another country in the production of all items. However, it may still be beneﬁcial if one country has a comparative advantage in one item by being relatively more eﬃcient in producing this item. For example, country A can produce an amount X> of item W or an amount Y> of item S or some combination of the two. Country B , with the same population as A, can produce X< = X> − 50 of item W or Y< = 0.5Y> of item S or a combination of the two. A has an absolute advantage in each item, but a comparative advantage in S : it is twice as eﬃcient in producing item S as country B . Before the trade agreement, A and B each devote half their resources to the production of W and half to the production of S . A produces 0.5X> of W and 0.5Y> of S ; B produces 0.5X< = 0.5X> − 25 of W and 0.5Y< = 0.25Y> of S . The total production is X> − 25 of W and 0.75Y> of S . After the trade agreement, A devotes 0.75 of its resources to produce 0.75Y> of S and 0.25 of its resources to produce 0.25X> of W ; B produces X< = X> − 50 of W exclusively. The total production is now 1.25X> − 50 of W and 0.75Y> of S . This is a larger total production than the amount before the trade agreement as long as X> > 100, otherwise the trade agreement is not beneﬁcial. Assuming that X> > 100, the trade agreement is beneﬁcial, making the total pie larger and the beneﬁts can be shared by the two economies. 2. Explain the terms depreciation and appreciation of U.S. currency. Depreciation means that the currency declines in value if more units of that currency are required to buy the same number of units of a foreign currency than previously. Appreciation means that the currency increases in value if less units of that currency are required to buy the same number of units of a foreign currency than previously. 3. The exchange rate between U.S. dollars and British pounds is 0.6 pounds per dollar. The exchange rate between U.S. dollars and Japanese yen is 100 71

yen to the dollar. Determine the exchange rate of yen per pound and pounds per yen. The given information is XB,U S = 0.6 pounds/dollar and XJ,U S = 100 yen/dollar. The quantities to be determined are XJ,B and XB,J = 1/XJ,B . The fundamental relation, resembling matrix multiplication, is XJ,B XB,U S = XJ,U S which can be solved for the Japan British exchange rate: XJ,B = XJ,U S XB,U S 1 XJ,B

XB,J =

Upon substitution, this gives XJ,B = 166.67 yen/pound and XB,J = 0.006 pounds/yen. 4. The U.S./Canadian exchange rate is 0.90 Canadian/US. The U.S./U.K. exchange rate is 2.00 US/UK. How many Canadian dollars are in one pound? The data given is XC,U S = 0.90 C/US and XU S,B = 2.00 US/B and so the Canadian/British exchange rate is XC,B = XC,U S XU S,B = 1.80 C/B or 1.80 Canadian dollars per British pound. 5. The exchange rate between U.S. dollars and British pounds is 0.6 pounds per dollar. You can invest in the US for one year at the spot interest rate of 8%. Alternatively, you can exchange dollars for pounds and invest in Britain at 12%. After one year, you exchange the pounds for dollars at the prevailing exchange rate. (a) At what exchange rate would your total return on the British investment be 15%? (b) At what exchange rate would the returns on the US and British investments be equal? (c) What should the forward exchange rate be? The appropriate information may be summarized by XB,U S = 0.6 pounds/dollar, RU S = 0.08, and RB = 0.12. The total US return is TU S = 1 + RU S while the total British return is TB = XB,U S (1 + RB ) and the converted US value of the total British return is Tcon = XU S,B (1 + RB ). This means that XB,U S = Tcon /TB . For (a), if Tcon = 1.15, then XB,U S = 1.15/(0.6 × 1.12) = 1.711, that is, the exchange rate must be 1.711 dollars/pound or 0.58 pounds/dollar. 72

For (b), if Tcon = 1.08, then XB,U S = 1.08/(0.6 × 1.12) = 1.607 that is, the exchange rate must be 1.607 dollars/pound or 0.62 pounds/dollar. For (c), the forward rate is given by Xf = XB,U S (1 + RB )/(1 + RU S ). The forward rate is greater than the spot rate if the foreign return is greater than the US return, is equal to the spot rate if the two returns are equal, and is less than the spot rate if the foreign return is less than the US return. For the numbers given, the forward rate is Xf = 0.6222 which reﬂects the fact that the British return is greater than the US return. 6. Bobby Boyd is considering investing in US 1 year bonds at 8% or Canadian bonds at 12%. The current exchange rate is $0.80 Canadian equals $1 US. If the Canadian bonds are chosen, Bobby intends to exchange US dollars for Canadian today in the spot market; then in one year, Bobby would exchange the $ Canadian for $ US at the spot exchange rate. At what spot exchange rate in one year would the two investments earn the same US dollar returns? The information may be summarized by RU S = 0.08, RC = 0.12, XU S,C = 0.80, TU S = 1.08, and TC = XU S,C (1 + RC ). If Tcon = XC,U S TC = TU S , then XC,U S = Tcon /TC = 1.205 US/Canadian. 7. The spot exchange rate is $0.85 Canadian equals $1 US. The forward exchange rate for delivery in one year is $0.90 Canadian equals $1 US. The one year spot interest rate in the US is 6%. What is the one year spot interest rate in Canada? The information may be summarized by XC,U S = 0.85 Canadian/US, Xf = 0.90 Canadian/US, and RU S = 0.06. Solving the forward rate equation for the foreign spot rate gives RC = XC,U S (1 + RU S )/Xf − 1 which, upon substitution, yields RC = 0.1224 or 12.24%. 8. Assume the US interest rate is 6%, the US inﬂation rate is 4%, the British inﬂation rate is 12%, and the current exchange rate is 0.60 pounds to one US dollar. If relative purchasing power parity holds, what should happen to the exchange rate? The given information is RU S = 0.06, pU S = 0.04, pB = 0.12, and XB,U S = 0.6 pounds/dollar. Relative purchasing power parity states that the rate of depreciation of the US dollar is given by x = pU S −pB which gives x = −0.08. That is, the dollar should “depreciate” −8% or actually appreciate 8%. The 73

exchange rate changes according to Xnew /XB,U S − 1 = 0.08 which gives the new rate Xnew = 0.648 pounds/dollar (more pounds may be purchased by a dollar). 9. Assume that relative purchasing power parity holds. The current exchange rate is $1 US = 300 Mexican pesos. The inﬂation rate in the US over the next year will be 5% and the inﬂation rate in Mexico will be 55%. If so, what should the exchange rate become in one year, other things held constant? $1 US equals how many pesos? The given information is XM,U S = 300 pesos/dollar, pU S = 0.05, and pM = 0.55. Since x = pU S − pM , x = −0.5: the dollar depreciates by −50% or appreciates by 50%. Consequently, Xnew /XM,U S − 1 = 0.5 which means that Xnew = 450 pesos/dollar (the dollar will buy 150 pesos more). 10. Explain how a change in the domestic interest rate aﬀects the spot and forward interest rate. Since Xf = Xspot (1 + Rf oreign )/(1 + Rdomestic ) it follows that Rdomestic = Xspot 1 + Rf oreign − 1 Xf

If the domestic interest rate increases, investors will be more attracted to invest domestically rather than in foreign investments. Investors will convert foreign money back into domestic currency for domestic investment purposes and this will drive the spot rate in favor of the domestic currency (more foreign currency per domestic currency). If the spot rate remains ﬁxed, then the forward rate (exchanging foreign currency for domestic currency) must decrease to gain more domestic currency upon conversion (1/Xf converts foreign into domestic currency). Xspot converts domestic currency into foreign currency before the investment, Xf converts domestic currency into foreign currency after the investment, and 1/Xf converts foreign currency into domestic currency after the investment. The time derivative of the domestic interest rate is

˙ ˙ ˙ ˙ ˙ domestic = Xspot (1 + Rf oreign ) + Xspot Rf oreign − Xf − Rdomestic Xf R Xf Xf

74

where the overhead dot denotes the time derivative, f˙ = df /dt. The equation provides the relationships among the changes in the variables. So, for ˙ domestic > 0, and the spot example, if the domestic interest rate increases, R ˙ rate remains ﬁxed, Xspot = 0, then equation for the time derivative of the domestic interest rate gives Xspot ˙ f oreign > X ˙f R 1 + Rdomestic The change in the forward rate is bounded from above by the term involving the change in the foreign interest rate. Since the quantity in parentheses is ˙ f oreign ≤ 0 positive deﬁnite, the forward rate decreases, Xf < 0 if only if R ˙ domestic > 0 and X ˙ spot = 0. for R

75

Chapter 16: Equities 1. Describe the price/earnings multiple approach to investing. What determines a company’s multiple? Are multiples stable over time? What does this approach assume about market eﬃciency? The P/E multiple is the ratio of current stock price to current earnings. A higher multiple indicates greater market price per dollar of earnings. Other things equal, a higher multiple is usually less desirable from a buyer’s viewpoint because the buyer is paying more per dollar of earnings. The multiple represents everything except earnings that aﬀect price, other factors such as growth rates and risk. Other things equal, a higher growth rate has a higher multiple because current earnings are low relative to future earnings, and a high-risk ﬁrm has a high multiple. Estimate fair value of a multiple, estimate future earnings, and then multiply to obtain the “intrinsic value,” Vintrinsic = (P/E )est Eest . If Vintrinsic >> Pcurrent , the security is undervalued and purchase is recommended: should expect market to eventually realize the undervaluing of the security so price should jump up generating high returns. Risk is not explicitly included, it is implicitly embedded in the multiple. The multiple tends to change over time, both for individual stocks and for the market as a whole: in optimistic periods, P/E > 20, while during pessimistic periods P/E < 10. The intrinsic value approach assumes the market is temporarily ineﬃcient, generating disparities between intrinsic values and prices. The ineﬃciencies are eliminated as the market discovers the “true values.” P was discussed as possibly behaving as a random walk: the evidence is relatively consistent with randomness. The evidence is also consistent with a random walk for E as well. This suggests that the P/E multiple may also follow a random walk behavior. 2. The asset valuation method assumes that the liquidating value of assets may be more than the market value of securities constituting a claim on those assets. How can such disparities exist in an eﬃcient market? In the asset valuation approach, one must ﬁgure the liquidating value of the individual assets of a ﬁrm. This is essentially the value the highest bidder is 76

willing to pay for those individual assets. This can be estimated by ﬁnding comparable assets that have known market values. This technique is used in mergers and takeovers: the acquiring ﬁrm estimates the liquidating value of prospective acquisitions and compares the current market price of stock to the liquidating value. If the stock price is much less than the liquidating value, acquisition makes sense. Assets may have value depending upon their use. Perhaps “new use” gives assets a higher value than was previously assumed, thus creating a temporary ineﬃcient market which approaches eﬃciency once the “real value” of the assets have been realized. 3. Assume that the constant growth rate dividend valuation model applies. You estimate that a company has a growth rate of 8%, the return required by investors is 14%, and the current dividend is $1. Determine the price of the stock. The information can be summarized by g = 0.08, R = 0.14, and D = 1.0. Since (1 + g )/(1 + R) < 1, the constant growth rate series converges. The price of the stock is given by

N

P0 =

k=1

D1 (1 + g )k−1 (1 + R)k

assuming the company lives for N years. The sum is a form of the geometric series, and can be summed in closed form to give

1+g 1 − 1+ R P0 = D1 R−g N

P0 →

D1 R−g

where the second form is the limit N → ∞. In this limit, the price is $16.67. 4. In the preceding problem, determine the price of the stock one period from now. What is the dividend yield, the percentage capital gains, and the total rate of return (ROR) over this period? The price at at the k th period is Pk = Po (1 + g )k and the dividend for the k th period is Dk = D1 (1 + g )k−1 . The dividend yield for the k th period is 77

yk =

Dk D1 = Pk P1

which shows that the dividend yield is constant. Substituting values gives the price P1 = 18.00 and yield y1 = 5.55%. The total rate of return is a solution of P0 = D1 + P1 1 + ROR

which gives ROR = (D1 + P1 − P0 )/P0 or ROR = 14%. In fact, since ROR = (Pk+1 + Pk+1 − Pk )/Pk , it follows that ROR = R in general. 5. In the CAPM, describe the CML and SML. What is the diﬀerence between these lines? The Capital Asset Pricing Model (CAPM) is a single period model relating a stock’s expected rate of return (ROR) to the risk-free interest rate and the risk of the individual stock. The advantage of this model is the explicit consideration of risk. Its disadvantages are the single period assumption and the speciﬁc types of risk preferences assumed. The CML is the Capital Market Line and is a straight line tangent to the eﬃcient frontier (the plot of E (R) versus σ , see Figure 16.5) at the market portfolio M . In equation form, E (R) = Rf + βCM L σR = CM L where σR is the standard deviation for return R, E (Rf ) = Rf and σRf = 0 since Rf is the risk-free rate of return, and βCM L is the beta for the CML. This beta can be eliminated in favor of market portfolio quantities: E (RM ) = Rf + βCM L σM βCM L = E (R) = Rf + E (RM ) − Rf σM

E (RM ) − Rf σR = CM L σM

78

where E (RM ) is the expected rate of return on the market portfolio. It should be noted that the CML assumes the existence of a risk-free security. All equilibrium portfolios lie along the CML, highly risk averse ones lie closer to Rf , risk seeking portfolios lie closer to the market portfolio M : each portfolio making use of some combination of the risk free return and the market portfolio M ). The CML is better than the line connecting Rf and portfolio G, where G lies below M on the eﬃcient frontier: for a given standard deviation σ (the measure of risk), portfolios on the CML give a larger expected return. The CML shows equilibrium properties for portfolios. For portfolios, risk is measured by the standard deviation of return σ . The CML is simply the statement that investors require higher returns for higher risk (larger σ ’s). In the CAPM, the risk of an individual security is not its standard deviation σ since part of the standard deviation of returns can be diversiﬁed away in a large portfolio. The net risk, after diversifying fully, is the only risk that matters to investors: this net risk is measured by the security’s beta. The Security Market Line (SML) is the expected return versus beta for individual securities, E (Rj ) = Rf + βj E (RM ) − Rf = SM L1 where E (Rj ) is the expected return on security j , Rf is the risk free rate of return, E (RM ) is the expected rate of return on the market, and βj is the beta for security j . βj is determined by a linear ﬁt to the data, βj = σj rj,M σM

where σj is the standard deviation for security j , σM is the standard deviation for the market, and rj,M is the correlation coeﬃcient of security j with the market M . The SML1 also assumes the existence of a risk free security, but this can be eliminated by ﬁnding a security with a zero beta: E (Rz ) = Rf for βz = 0 implies either σz = 0 (the risk free rate of return) or rz,M = 0 (security z is uncorrelated with the market). Thus, E (Rj ) = E (Rz ) + βj E (RM ) − E (Rz ) = SM L2 The SML shows the expected rate of return for individual securities. The risk of the individual security is measured by its beta. This measure of risk 79

is what matters to investors: investors require a higher rate of return on a security for a higher beta. 6. Assume that the expected return on the market is 15%, the risk free rate is 5%, and the standard deviation of the market is 10%. In the CAPM, determine the expected returns for stocks with the following betas: (a) −0.5, (b) 0.0, (c) 0.50, (d) 1.0, (e) 1.5. The CAPM assumption gives the equation E (Rj ) = 0.05 + βj (0.15 − 0.05) or E (Rj ) = 0.05 + 0.10βj . Plugging in the various values gives: (a) E (Ra ) = 0.0, (b) E (Rb ) = 0.05 (risk free), (c) E (Rc ) = 0.10, (d) E (Rd ) = 0.15 (market return), (e) E (Re ) = 0.2. 7. Using the same information as Problem 6, determine the expected return on your portfolio if you invest wf percent in the risk free security and the rest in the market portfolio for the following values of wf : (a) 1.0, (b) 0.50, (c) 0.0, (d), −0.50, (e) −1.0. Draw the CML line and plot these portfolios. The expected return on the portfolio is E (Rp ) = wf Rf +(1−wf )E (RM ) with a standard deviation given by σp = (1 − wf )σM since the risk free security, by deﬁnition, has σf = 0. Upon substitution, E (Rp ) = 0.15 − 0.10wf and σp = 0.10(1 − wf ). For the values of wf in the problem, the returns are: (a) wf = 1.0, E (Rp ) = 0.05, (b) wf = 0.5, E (Rp ) = 0.10, (c) wf = 0.0, E (Rp ) = 0.15, (d) wf = −0.5, E (Rp ) = 0.2, (e) wf = −1.0, E (Rp ) = 0.25. The CML is a straight line running through the pairs of points (σp , E (Rp )): (0.0, 0.05), (0.05, 0.10), (0.10, 0.15), (0.15, 0.20), and (0.20, 0.25); see Figure 16.7. The portfolios above M (0.10, 0.15) where wf = 0.0, such as wf = −0.5 and wf = −1.0 (that is, all wf < 0 for points above M ) involve borrowing at the risk free rate and investing borrowed amount plus original holdings in the market portfolio. 8. There are two securities, A and B, with expected returns of 0.02 and 0.14 respectively and standard deviations of 0.05 and 0.25. The correlation coeﬃcient between the two is 0.50. First, compute the expected return and standard deviation if portfolios have: (a) 0.25 in A and 0.75 in B, (b) one half in each, and (c) 0.75 in A and 0.25 in B. Next, plot these portfolios. The expected return on a portfolio containing wA in A and wB in B is E (Rp ) = wA E (RA )+ wB E (RB ) where wA + wB = 1. The standard deviation 2 = w 2 σ 2 + w 2 σ 2 + 2w w σ σ r of the portfolio is σp A B A B A,B where rA,B is the A A B B correlation coeﬃcient between A and B. Substituting values: (a) wA = 80

0.25, wB = 0.75, E (Rp ) = 0.115, σp = 0.194, (b) wA = 0.5, wB = 0.5, E (Rp ) = 0.080, σp = 0.139, and (c) wA = 0.75, wB = 0.25, E (Rp ) = 0.05, σp = 0.0875. A plot of E (Rp ) versus σp shows a curvature toward the σp axis, that is, the curve will saturate at E (Rp ) = 0.14 as σp approaches 0.25 (see Figure 16.8). 9. Compute the covariance of return and correlation coeﬃcient for the following information: Period 1 2 3 Return A −0.05 +0.05 +0.20 Return B −0.01 +0.04 +0.10

First, the means must be computed. The mean for A is E (RA ) = 0.06667 and the mean for B is E (RB ) = 0.04333. The variance for A is VA = 0.01056 and the variance for B is VB = 0.00202, while the standard deviation corresponding to these variances is σA = 0.10274 and σB = 0.04497. Using these results, the covariance between A and B is Cov(A, B ) = Cov(B, A) = 0.0046111 and the correlation coeﬃcient between A and B is rA,B = 0.99803.

81

Chapter 17: Futures Contracts 1. The open interest includes: Shorts Bill Helen Longs Bob Lois 10 contracts 10 contracts 15 contracts 5 contracts

Determine the new open interest under the following assumptions: (a) Bill goes long 1 contract and Gene shorts 1 contract (b) Bill goes long 1 contract and Bob shorts one contract. The open interest consists of 20 short contracts balanced by 20 long contracts. The number of short and long contracts must be the same, that is, they must balance. The new open interest for case (a) is: Shorts Bill Helen Gene Longs Bob Lois Bill 10 contracts 10 contracts 1 contract 15 contracts 5 contracts 1 contract

and the new open interest for case (b) is: Shorts Bill Helen Bob Longs Bob Lois Bill 10 contracts 10 contracts 1 contract 15 contracts 5 contracts 1 contract

Note that the open interest for case (a) still consists of 20 shorts balanced by 20 longs since Bill has one oﬀsetting position. The open interest for case (a) then is actually:

82

Shorts Bill Helen Gene Longs Bob Lois

9 contracts 10 contracts 1 contract 15 contracts 5 contracts

since Bill’s long contract “cancels” one of his shorts and one of Bill’s short contracts is “replaced” by Gene’s short contract. The open interest for case (b) now consists of 19 shorts balanced by 19 longs since both Bill and Bob each have one oﬀsetting position. The open interest for case (b) is then: Shorts Bill Helen Longs Bob Lois 9 contracts 10 contracts 14 contracts 5 contracts

since Bill’s long contract “cancels” one of his short contracts, as for case (a) above, and Bob’s short contract “cancels” one of his long contracts. 2. Explain the diﬀerence between forward and futures contracts. The diﬀerences between forward and futures contracts can be summarized in a table: Collateral (margin) Marking to Market Cash ﬂow before delivery date Compensating Balances Resale Contract terms Delivery Market Size Forward None None Usually Limited Custom made Usually delivered Small, private, proponents usually know each other Futures Yes Daily None Active trading on organized exchanges Standardized Usually Oﬀset Large, public, impersonal

83

Forward markets exist in foreign exchange markets; futures markets exist on many physical commodities and also on ﬁnancial commodities. A futures contract has the following structure: Now Enter into contract: one short, one long Delivery Date Short delivers commodity and receives payment Long receives commodity and makes payment

The short can “cancel” the contract by oﬀsetting the short futures: Now Enter into contract: One short, one long Intermediate Date Short enters new contract as long with a new short Delivery Date

Consequently, the short now has the original short contract with a someone as the long and an oﬀsetting contract as a long with someone else as a short. 3. What are price and position limits on futures contracts? What are the purposes of price and position limits? Price limits are set on individual futures contracts except during delivery months. They restrict the change in price on a particular day to some maximum amount up or down. Position limits are set on the total number of contracts in which a position as either a short or long can be taken. The purposes of price limits are to restrict the price volatility of futures contracts. They allow the clearinghouse time to collect more collateral from traders who have taken losses and help to maintain the ﬁnancial integrity of the traders’ positions. The purpose of position limits is the desire to keep markets competitive. Price manipulation might occur if a single trader, or syndicate of traders, controls too many contracts. 4. Assume the following information about the futures price for gold. Delivery Dates (Number of Years into Future) Current price of futures contract per ounce of gold 1 2 3

300 84

350

400

If the current spot price of gold is $260, determine spot interest rates for periods 1, 2, and 3 and forward interest rates for periods 2 and 3, assuming no marking to market and no storage or transactions costs. The futures price is Fn = Pn + interest + storage until delivery. Since there are no interest nor storage costs by assumption, this means Fn = Pn . And since P0 = Pn /(1 + Rn )n , this requires Rn = (Fn /P0 )1/n − 1. This value of the spot rate can then be used to determine the forward rates from fn = (1 + Rn )n /(1 + Rn − 1)n−1 − 1. Substituting the values given, yields the following table: R1 R2 R3 f2 f3 0.1538 0.1602 0.1544 0.1666 0.1429

5. Assume no marking to market or storage costs. The spot price of gold is $300 and the futures price for delivery in 1 year is $360. The annual interest rate is 10%. Is the preceding information mutually consistent? If not, how can investors exploit the situation for their own proﬁt? Since the spot price of gold must satisfy the equation P0 = Pn /(1 + Rn )n , using P1 = F = 360, the spot price should be P0 = 327.27, which is greater than the quoted spot price. Consequently, the information is not mutually consistent. Investors can exploit the situation by going long in the spot market (paying less than the ”market value” for the gold) and going short in the futures market (selling at the ”market value”) contracting to deliver gold in 1 year at $360 per ounce. This gives a return of 20% rather than the quoted 10%: r1 = (360/300) − 1 = 0.20. This can be represented in a table: Action Short futures Borrow funds Buy Commodity Repay Loan + interest Deliver Commodity Net cash ﬂow t=0 +P −P −P (1 + R) 0 F − P (1 + R) t = delivery +F

The equilibrium futures price is Feq = P (1 + R) = 330 per ounce. Thus, one can either consider the quoted futures price to be too high, or the quoted 85

spot price of $300 to be too low. In any case, there is a risk free proﬁt of F − P (1 + R) = 30 per ounce: this proﬁt utilizes other peoples’ money (borrowing and repaying the loan with interest). 6. Investors can reduce their risk by using a futures market hedge to oﬀset a spot market position. What happens to this risk? What are the consequences for the hedger? A futures hedge is an oﬀsetting position in the spot market with a nearly opposite position in the futures market with the objective of reducing the overall risk of the position. The hedged position has lower expected return than the unhedged position. The hedger transfers risk to another party willing and able to take on risks for the associated possible rewards. A long hedge is a long position in futures and a short position in the spot market: Now Delivery Date Short spot position +P Long futures market −F Net proﬁt P −F In the short spot position, the short sells a produced commodity at price P; in the futures market, F is the price of supplies needed to produce a commodity. Some proﬁts are lost if P (Td ) < F ; some proﬁts are saved if P (Td ) > F . A short hedge is a short position market: Now Long spot position −P Short futures market Net proﬁt in futures and a long position in the spot Delivery Date +F F −P

In the long spot position, the long pays the cost of producing a commodity; in the futures market, F is the price obtained by delivering the commodity. Some proﬁts are lost if P (Td ) > F ; extra proﬁts are gained if P (Td ) < F . 7. A farmer plants enough wheat to harvest 10,000 bushels. The cost of planting the wheat is $2.50 per bushel. On the harvest date, the wheat price will be one of three prices with equal probability: $2.00, $4.00, or $6.00. Compute the farmer’s proﬁt for each of these possibilities. The futures price for wheat is $3.80. Compute the farmer’s proﬁt for this price. When is hedging with futures the best choice for the farmer. 86

The total cost of producing the 10,000 bushels is $25, 000. At the harvest date, the total amount sold will be either $20, 000, $40, 000, or $60, 000 yielding proﬁts of −$5, 000, $15, 000, or $35, 000 with equal probability. The amount sold at the futures price would be $38, 000 for a proﬁt of $13, 000. A short hedge (long in the spot market, short in the futures market) would eliminate the loss for the $2.00 per bushel case, but would also reduce the proﬁts for the other two cases. If the farmer can absorb the possible loss of $5, 000, hedging would not be particularly useful and a 2 out of 3 chance to beat the futures proﬁt would be a risk worth taking; however, if the farmer would experience catastrophic problems if $5, 000 were lost, it would be better to assure a $13, 000 proﬁt instead. 8. Look up in The Wall Street Journal prices for gold futures. From the spot and futures prices for gold, determine the term structure of interest rates under the assumption of zero storage costs. Compare your answers with the yields on Treasury securities and explain the diﬀerences. If Fn is the futures price for the nth year into the future, Pn is the spot price for the nth period (P0 is the current price), then P0 = Pn /(1 + Rn )n = (Fn − R0 )/(1 + Rn )n since there are no storage costs (and interest costs are based on current rates). This gives Rn = (Fn − R0 )/Po )1/n − 1. Purchasing futures contracts is the equivalent of borrowing the purchase price of a commodity (P ), buying the commodity, and storing it until the delivery date. At the delivery date, the loan principal, interest charges, and storage charges must be paid: F = P + interest + storage charges. Consequently, the above calculated term structure ignores the eﬀect of storage charges.

87

Chapter 18: Financial Futures Contracts 1. Assume that a 180 day Treasury bill has a discount rate of 10% and a 90 day Treasury bill has a 12% discount rate. In perfect markets without marking to market, what would be the discount rate and price quotation for a Treasury bill futures contract with delivery date in 90 days? Compute the actual price and compare it with the futures quotation. The forward rate can be determined from 1− d2 t2 = 360 1− f (t2 − t1 ) 360 1− d1 t1 360

by solving for the variable f f= 1 d2 t2 − d1 t1 1 t1 (t2 − t1 ) 1 − d 360

Substituting t2 = 180, t1 = 90, d2 = 0.10, and d1 = 0.12 gives f = 0.08247. The futures quotation is Q = 100(1 − f ) which, upon substitution of values, gives Q = 91.753. The actual price is determined by P = Ppar 1 − 90f 360 = Ppar 1 − f 4

which yields P = 979, 382.50. The relation between the futures quotation and the price can be obtained by eliminating the forward rate f in the two equations. That is, substituting f = 1 − Q/100 in the price equation yields P 1 Q = +3 Ppar 4 100 Solving this equation for the quotation gives Q = 100 4P −3 Ppar 88

Since the same forward rate was used in computing Q and P , these equations are clearly satisﬁed. 2. Assume that a 120 day Treasury bill has a discount rate of 10% and a 30 day Treasury bill has a discount rate of 12%. Answer the same questions as in Problem 1 if the futures delivery day is in 30 days. Making substitutions in the equations used in Problem 1 gives f = 0.09428, Q = 90.57, and P = 992, 143.66. However, since P = Ppar (1 − f /12) in this case, the relation between the quotation and the price is diﬀerent from that in Problem 1. In this case, f = 12(1 − P/Ppar ) = (1 − Q/100) which gives Q = 100(12P/Ppar − 11) or P/Ppar = (Q/100 + 11)/12. 3. Assume that the Treasury bill futures contract price changes from 92.24 at settlement on Monday to 92.43 at settlement on Tuesday. What are gains and losses to the short and long position as a result of marking to market? Since QT − QM = 0.19, PT − PM = 0.000475Ppar = 475. Consequently, the short’s account loses $475 and the long’s account gains $475. 4. An investor purchases a 180 day Treasury bill with $1, 000, 000 par value for $940, 000. Simultaneously, the investor shorts a Treasury bill futures contract for delivery in 90 days at a quote of 90.00. Determine the liquidating value of this investor’s position as of the futures delivery date. This position is a short hedge for T-bill futures, maintaining the hedge until the delivery date. Since Q = 90.00, this means the forward rate is f = 0.10. Thus, the forward price is Pf = Ppar (1 − 90f /360) = 975, 000. Therefore, the actions are: (a) at t = 0, buy the 180 day T-bill for 940,000 and short the T-bill futures for a cash outﬂow of 940,000; (b) on the futures delivery date, obtain the futures price of 975,000 and deliver the T-bill giving a liquidating value of $35, 000; and (c) at the 180 day maturity of the Tbill the investor is no longer involved but the new owner of the T-bill then obtains the $1, 000, 000 for a proﬁt of $25, 000. 5. Assume the price quotation of the CBT Treasury bond futures contract changes from 76-14 to 77-09. What are gains and losses to the short and long as a result of marking to market for 1 contract with $100, 000 par value? The translation of price quotation into prices is accomplished in the following fashion: F1 = (76 + 14/32) × 103 and F2 = (77 + 9/32) × 103 . Consequently, 89

the price diﬀerence is F2 − F1 = 843.75. The short’s account loses this amount while the long’s account gains this amount. 6. An individual own a 21 year maturity bond with an annual coupon of 10%, a face value of $100, 000 and a price of $95, 000. To protect against rising interest rates, this individual shorts one CBT Treasury bond futures contract with a delivery date 2 years hence and a futures price of 92-16. In the course of the next year, interest rates rise. The bond price drops to $88, 000 and the futures price drops to 86-16. Overlooking bond coupon and marking to market, compute the gains or losses on the bond position, the futures position, and the net position. Notice that since the initial price was $95, 000 that this is already a discount: the rates must have risen above 10%. Converting the price quotes into prices, F1 = (92 + 16/32) × 103 = 92, 500 and F2 = (86 + 16/32) × 103 = 86, 500. Consequently, the bond position changes by P2 − P1 = 88, 000 − 95, 000 = −7, 000 and the futures position changes by F2 − F1 = −6, 000, that is, the short gains $6, 000 by shorting the futures contract. The net position is −7, 000 + 6, 000 = −1, 000. 7. An investor shorts Treasury bill futures for June delivery at 92.00 and goes long in Treasury bill futures for September delivery at 94.00. On the June delivery date, 90 day Treasury bills have a discount rate of 6%. At what forward interest rate will the position just break even? At what forward interest rates will the position have a $10, 000 gain and a $10, 000 loss? For the June delivery date, the forward interest rate is 8%, while for the September delivery date the forward rate is 6%. The investment actions can be summarized in the following table: t=0 Action Short T-bill Long T-bill t = 90 June Deliver T-bill, receive payment t = 180 September

Receive T-bill, make payment

As the investment stands, the investor receives $980, 000 in June and will pay $985, 000 in September. This corresponds to a $5, 000 loss. The rates are connected in the following way:

90

Now dJ = fJ

June fS dS

Sept

Algebraically, (1 − 180dS /360) = (1 − 90fS /360)(1 − 90dJ /360). If the rates satisfy this equation, then this guarantees that the position will break even. For the quotes and corresponding forward rates given, this would require the spot rate on the June delivery date to be 6.94% which is greater than the quoted rate for that date. If the two spot rates are as given, then if the forward rate from June to September is 4.08%, the position will break even. 8. In the preceding problem, assume that the investor goes long in the June contract and short the September contract. Answer the same questions as in the preceding problem. The investment actions may now be summarized as: t=0 Action Long T-bill Short T-bill t = 90 June Receive T-bill, make payment t = 180 September

Deliver T-bill, receive payment

As the investment stands, in June the investor pays $980, 000 and in September the investor receives $985, 000. This corresponds to a $5, 000 gain. It would appear that if the forward rate from June to September was 4.08%, this would make the position break even. 9. The S&P Stock Index is quoted at 450.00. The index pays a cash dividend of $18. The interest rate is 8%. S&P Stock Index Futures for delivery in one year are quoted at 468.00. Are these prices consistent with equilibrium? If not, what is the arbitrage opportunity? The equilibrium futures price is given by Feq = P (1 + R)d − Div where R is the interest rate, d is the period which is 1 in this case, and Div is the dividend. For the numbers given, Feq = 468 = Qsp . Consequently, the futures price is consistent with equilibrium and no arbitrage opportunities exist. 10. Toy World is considering purchase of plastic building blocks from Germany for the Christmas season. It is now August 1 and Toy World would 91

like to purchase and receive the blocks on November 1. The order is for 12,500,000 marks. Currently, the spot exchange rate is 0.70 dollars per mark. The forward exchange rate for delivery on November 1 is 0.69 dollars per mark. The management feels that the exchange rate on November 1 will be one of three values with equal probabilities - 0.75, 0.70, 0.65. The blocks can be sold in the U.S. for $8, 750, 000. Is it better to hedge with foreign exchange futures or wait until November and purchase at the spot exchange rate on that date? Explain. At what forward exchange rate would the ﬁrm just break even? On August 1, the dollar cost of 12,500,000 marks is $8, 750, 000: so at the current exchange rate the ﬁrm would just break even. If the November 1 exchange rate is 0.75, the ﬁrm will lose $625, 000; if the exchange rate is 0.70, the ﬁrm will break even; and if the exchange rate is 0.65, the ﬁrm will make $625, 000. The exchange rate for the futures contract is ﬁxed at 0.69 which guarantees the ﬁrm a gain of $125, 000 (from this gain, the cost of the foreign exchange futures contract must be subtracted). Since there is only a 1 in 3 chance of making a proﬁt by waiting for the November 1 exchange rate, it would appear to be better to hedge with the futures contract. Neglecting the cost of the contract, if the forward exchange rate was 0.70 then the ﬁrm would just break even. The expected payoﬀ, the weighted average, for the spot November 1 exchange rate is 0: that is, the expected payoﬀ is for the ﬁrm to break even.

92

Chapter 19: Put And Call Options 1. A call option with exercise price of $90 sells for $8. The call option has three months until expiration. The underlying asset sells for $90. A put with the same exercise price sells for $6. a. Draw a proﬁt proﬁle for buying the call option. See Figure 19.1a. b. Draw a proﬁt proﬁle for writing the call. See Figure 19.1b. c. Draw a proﬁt proﬁle for writing the call and buying the underlying security. Compare with your answer to Part b. See Figure 19.1c. d. Draw a proﬁt proﬁle for buying the put. See Figure 19.1d. e. Draw a proﬁt proﬁle for writing the put. See Figure 19.1e. f. Draw a proﬁt proﬁle for shortselling the underlying asset. See Figure 19.1f. g. Draw a proﬁt proﬁle for shortselling the underlying asset and buying the call. Compare with your answer to Part f. See Figure 19.1g. h. Draw a proﬁt proﬁle for buying the underlying asset and buying a put option. Compare this with your answer to Part a. See Figure 19.1h. 2. On expiration date of a call option, the price of an underlying security is $115, the exercise price is $100, and the call sells for $5. What arbitrage opportunity is available? Since the present value of the underlying asset is greater than the sum of the exercise price and price of the option, the following arbitrage opportunity occurs: buy the option, short sell the underlying asset, and exercise the call. The table of transactions is given below: Action Buy call Short sell asset Exercise call t=0 −5 +115 P <E P =E P >E

−P

100

100

The investor is guaranteed a proﬁt of $10; if the price of the underlying stock falls below the exercise price, then the call can be allowed to expire and the asset purchased at the going price of P so that the proﬁt is then 110 − P . 93

3. A call option has an exercise price of $100, the underlying security sells for $150, and the call sells for $200. Is this consistent with equilibrium? Are there arbitrage opportunities? Since the price of the underlying security is greater than the exercise price (P > E ) and the price of the call is greater than the diﬀerence between the price of the underlying security and the exercise price (C > P − E ), these prices are consistent with equilibrium and no arbitrage opportunities exist. 4. A one year put with exercise price of $100 sells for $13, the underlying security sells for $90, and the interest rate is 10%. What is the price of a call with the same exercise price? Assume no premature exercise of the option. From put - call parity, Pput = C − (P − ED) where D = 1/(1 + r) and r is the interest rate. Solving for the price of the call, C = Pput + (P − ED) and, upon substitution, C = 12.09. 5. A one year call option has an exercise price of $100, the underlying security sells for $113, and the interest rate is 10%. From Merton’s bound, what is the lowest possible price of the call option? Merton’s bound states that C ≥ P − ED where D = 1/(1+ r) is the discount factor. Upon substitution, Merton’s bound requires C ≥ 22.09. 6. Explain why a call option has a larger percentage change than the underlying security. The buyer of a call has a position equivalent to buying a put, buying the underlying asset, and borrowing the present value of the exercise price: C = Pput + Passet − ED. The call buyer eﬀectively borrows the present value of the exercise price and creates the equivalent of a type of levered or margined position in the underlying asset. Any levered position must have a greater percentage price change than the underlying asset, since the holder of the levered position (the call buyer) invests less than the investor who buys the underlying asset for cash. If the call price changes by ∆C = C1 − C0 while the price of the underlying asset changes by ∆P = P1 − P0 , then the fractional change if the call position is ∆C/C0 = −1 for P1 ≤ E (C1 = 0) but the fractional change of the asset price is ∆P/P0 = P1 /P0 − 1 > −1: thus the call position looses more than a position in the underlying asset. For P1 > E , C1 = P1 − E and since 94

C0 ≥ P0 − ED, then ∆C ≥ ∆P − E (1 − D). Dividing by C0 , the fractional change in the call position is ∆C/C0 ≥ ∆P/C0 − E (1 − D)/C0 . And since C0 ≤ P0 and D approaches 1 at expiration, then ∆C/C0 ≥ ∆P/P0 : the call position gains more than a position in the underlying asset. 7. Explain the impact of each of the following upon the value of a call option. (a.) Price of the underlying. (b.) Exercise price. (c.) Time to expiration. (d.) Volatility of the underlying asset. (a.) The value of a call is a positive function of the price of the underlying asset: the call value increases as the value of the underlying asset increases. (b.) The value of a call in inversely related to the exercise price. The lower the exercise price, the higher the value of the call, that is, the call option is “more in-the-money.” (c.) The value of a call option is a positive function of the time until expiration. The longer the time until expiration, the higher the value of the call. A longer-lived call equals a shorter-lived call plus some additional value like “interest.” (d.) The greater the volatility of the underlying asset, the higher the value of the call since the payoﬀ to a call buyer are asymmetric. If the underlying asset does poorly, the call buyer loses everything which is just the cost of the call; if the underlying asset does well, the call buyer does very well. The greater dispersion in possible underlying asset values implies bigger payoﬀs on the upside but the same payoﬀ (loss of call cost) on downside, making the call option more valuable. Two other factors also come into play in valuing a call option: the risk free interest rate and dividends or interest paid by the underlying asset. (e.) The higher the risk free interest rate, the greater value of the call option since Merton’s lower bound rises as the interest rate rises. (f.) The higher the cash payments in dividends or interest by the underlying asset, the lower the value of the call option. For a given total return (cash payment of dividends or coupon interest plus price appreciation), higher cash payments lowers the price increase of the underlying asset which implies a reduced increase in call option value. 95

8. Treasury bond futures are currently trading at 90 for a contract with delivery in 90 days. A 90 day call option with exercise price of 88 is currently selling for 4. Explain what would happen if this option were exercised immediately. Since F = 90 and E = 88, F − E = 2. Since the option is exercised, the call writer gives the call buyer a long futures position plus $2; the call writer receives $4. At the delivery date of the futures contract, the call buyer purchases the T-bond from the call writer for $88. Thus, the call writer has made +4 − 2 + 88 = 90 while the call buyer has purchased the T-bond for +2 − 88 = −86. If call writer did not hold the T-bond futures put had to purchase it, then the call writer simply broke even; if the call buyer sells the T-bond futures on the open market for $90, the the call buyer nets 90 − 86 = 4. 9. An investor has a long position in a Treasury bond currently selling for 86. Treasury bond futures for delivery in 90 days are currently trading at 86. A 90 day put on Treasury bond futures with an exercise price of 88 is currently trading for 5. If both Treasury bonds and Treasury bond futures trade at 80 in 90 days, compare the results with two hedge positions: (a) shorting Treasury bond futures, and (b) buying a put option. See Figure 19.9. 10. Explain the diﬀerence between a call option on an underlying bond versus a call option on a bond futures contract. A call option on a bond gives the call buyer the right to purchase a bond at a speciﬁed exercise price. The option will be exercised if the spot price of the bond is greater than the exercise price at the expiration date. The call writer gives the call buyer a long bond position for the price of the option. A call option on a bond futures gives the call buyer the right to purchase bond futures at a speciﬁed exercise price. The option will be exercised if the spot price of the futures contract is greater than the exercise price at the expiration date. The call writer gives the call buyer a long bond futures position for the price of the option. In addition, the call writer must pay the call buyer the diﬀerence between the futures price and the exercise price at the time of the exercise of the call.

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Chapter 20: Call Features On Bonds 1. In a perfectly eﬃcient market, what is gain to a ﬁrm to issue callable bonds instead of noncallable bonds? In a perfectly eﬃcient market, bondholders have the same information about prospects for the future exercise of call options on bonds as ﬁrms do. All compensation for call risks (higher coupon, call premium, period of call protection, etc) should be fair at issue date. Thus, there is no advantage for the ﬁrm to issue callable rather than noncallable bonds: the higher cost of the callable bond should exactly oﬀset any anticipated gains from future refunding. 2. Explain the impact of call deferment and call premiums on the coupon of a callable bond. 3. A ﬁrm has decided to immediately refund an existing callable bond issue. Under what circumstances is there an immediate beneﬁt to refunding? What does that beneﬁt depend upon? The ﬁrm gains the present value of all coupons saved, and the earlier refunding occurs the more coupons that are recovered. This saving has to be balanced against costs of refunding, including the payment of the call premium, ﬂotation costs for the replacement bond issue, and the loss of opportunity to call the bond in the future if interest rates drop even further. 4. Instead of refunding a callable bond issue immediately, a ﬁrm has the choice of waiting to refund until some future date. Explain the possible advantages and disadvantages of waiting to refund. Waiting to refund means giving up a deﬁnite gain in refunding at present time for some potential larger gain in the future. For instance, suppose refunding at time t results in an immediate beneﬁt of refunding of $x. Waiting until time t + 1 (the next period) opens three possibilities: the beneﬁt of refunding could be less than, equal to, or greater than $x depending on whether interest rate at time t + 1 are greater than, equal to, or less than interest rate at time t, respectively. 5. Some have argued that market imperfections provide an incentive to issue callable bonds. Explain the pros and cons of these market imperfections arguments. 97

There are four basic market imperfection arguments. These are: (1) Superior knowledge on the part of corporate management about the future course of interest rates is an incentive to issue callable bonds. But such an ability to forecast interest rates seems unlikely. (2) Risk aversion on the part of both borrowers and lenders. Borrowers are averse to being locked-in to paying high interest rates and desire the call feature; lenders are averse to bond price declines and do not value the call feature highly. But this view of the lender’s risk preference is unsatisfactory, since it is known that institutional lenders desire an immunizer to lock-in the total return over the life of the bond. (3) Asymmetric information due to corporate management’s superior knowledge of the ﬁrm’s individual prospects. Management expects to reﬁnance at a future date on more favorable terms when the ﬁrm’s performance has improved. But asymmetric information should justify on half of the ﬁrms with positive asymmetric information, the other half have negative asymmetric information, unless the security markets are biased against positive asymmetric information which has no apparent justiﬁcation. Further, some ﬁrms issue both callable and noncallable bonds which asymmetry does not seem able to explain. In addition, if there is a diﬀerence between private corporate information and public information, the ﬁrm could reduce its current ﬁnancing costs by immediately divulging favorable information to the market; since ﬁrms would pay higher ﬁnancing costs by not releasing such information, ﬁrms would need a strong reason not to release it if the asymmetric information explanation of call features is to be viable. (4) Firm which has issued noncallable bonds and has favorable investment opportunities may have an incentive not to undertake the investments because of the possibility that bondholders may get a large share of the rewards if the investments are successful. Since debtholders bear a large proportion of bankruptcy costs, proﬁtable investments reduce the likelihood of bankruptcy costs, thus beneﬁtting debtholders by “reducing their risks” but still paying them for their risks. If callable bonds are issued instead, then the bonds can be called if the investments are favorable and thus beneﬁtting the ﬁrm rather than the debtholders.

6. How can callable bonds be a substitute for short-term bonds? 98

Short-term bonds require reﬁnancing with more short-term bonds as the bonds mature, generating a series of short-term bonds. This is viable if interest rates remain constant or decrease, but the risk of this strategy is that interest rates may increase. This also ignores ﬂotation costs for each new issue of short-term bonds. Issuing long-term callable bonds locks-in the prevailing interest rate protecting the ﬁrm against rate increases but also permits calling the bond and reﬁnancing if rates decrease suﬃciently to cover the costs (ﬂotation costs, etc). But it should also be remembered that callable bonds require higher coupons as well as call premiums. 7. Sinking fund provisions are widely used. What is a sinking fund? How are bonds retired under the sinking fund provisions? Explain the advantages and disadvantages of a sinking fund to the bond issuer and to the bondholder. What are the impacts of sinking funds on yields? Municipal bonds have serial maturities. Compare a serial maturity with a sinking fund. A sinking fund consists of equal payments at speciﬁed, usually equal, intervals of time; basically the opposite of an annuity. An issuing ﬁrm retires part of its bond issue at intervals stated in the bond indenture. For example, for a 25 year bond, 2% of principal in the 10th through 24th years (15 sinking fund payments) and 70% of par value to be repaid at maturity in the 25th year. At the sinking fund dates, the ﬁrm has the option to purchase the required number of bonds in the open market or to call these bonds. A special call provision allows the ﬁrm to call bonds at random on the required sinking fund dates: the ﬁrm can choose the cheaper option. The call feature tends to raise the coupon rate on bonds. And, as the principal is repaid in the sinking fund payments, the coupon becomes a larger fraction of the outstanding balance. Either the ﬁrm is paying the stated interest on the part of the principal that has been repaid or it is paying a higher than stated interest on the remaining balance. In either case, the yield would appear to have increased. Serial maturities, staggered over a number of years, is similar to a sinking fund but the maturities are not necessarily at equal intervals. In any event, a proportion of the total bond principal is repaid over a number of years as it is in a sinking fund strategy. 8. A ﬁrm has a perpetual callable bond outstanding with a par value of $100 and an annual coupon of $14. The ﬁrm can refund this with a new noncallable perpetual bond having an 8% coupon. The call price on the old

99

bond is $114. Flotation costs for a new issue are 2% of par. What is the myopic beneﬁt of refunding? Assuming the replacement bond has the same par value, coupon, and maturity date, then the price of a $100 par bond with $14 coupon with prevailing interest rate of 8% is Pnew = 14/0.08 = 175. Thus the myopic beneﬁt is a positive cash ﬂow of Pnew − Pcall − Pf lot = 175 − 114 − 2 = 59. 9. In Problem 8, how would your answer change if the new bond was callable and had a coupon of 10 percent? The price of the of the old bond at the new rate is now Pnew = 140 and the cash ﬂow beneﬁt exclusive of the new call premium is 24. This is reduced by the new premium for the callable feature. The premium is simply the par value ($100) minus the call price, 124 − Pcall . 10. If there is a corporate income tax rate of 30%, how does your answer to Problem 8 change? The positive cash ﬂow of 59 of Problem 8 is now reduced due to taxes, requiring a payment of 30% of 59 or a myopic beneﬁt of 70% of 59. This is now 41.30. 11. A ﬁrm has a perpetual callable bond with a 12% coupon. The bond has a call premium of 12 percent. Flotation costs are 2% and there are no taxes. The ﬁrm can refund immediately with a 9% noncallable perpetual bond. If it decides to postpone refunding until next period, interest rates on noncallable bonds will be 6%, 9%, or 12%, each with probability of 1/3. Should the ﬁrm refund immediately or wait? Initially, consider the case where the ﬁrm is risk neutral. Then, introduce risk aversion. The immediate beneﬁt of refunding, in this case, is 19.33. This assumes the initial bond was a par bond, that is, that Ppar = 100. If the next period rate is 6%, the undiscounted beneﬁt would be 86; if the next period rate is 9%, the undiscounted beneﬁt would be 19.33; and if the next period rate is 12%, there would be no beneﬁt from refunding. Thus, the expected 1 beneﬁt from waiting, discounted for the one period rate of 9%, is 3 (0 + 19.33 + 86)/1.09 = 32.21. Since this is larger than the immediate beneﬁt of 19.33, there is an advantage to waiting until the next period. As more risk aversion is introduced, the advantage to waiting for the next period becomes less appealing, since there is a 1/3 chance of losing the beneﬁt of refunding. 100

The question of risk aversion concerns the chance of gaining a signiﬁcant increase in beneﬁt by refunding next period (the 6% interest case) versus the chance of losing the opportunity to refund next period (the 12% interest case).

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Chapter 21: Default Risk 1. Describe the functions of a corporate bond indenture. What role does the bond trustee play? The indenture speciﬁes obligations of the ﬁrm to the bondholders, including coupon payments, maturity, call feature, call price, and sinking fund requirements. The bond trustee is appointed to act on behalf of the bondholders and must be independent of the issuing ﬁrm to protect the bondholders’ interests. 2. Why do bond indentures include protective covenants? Give some examples of protective covenants and the reasons why they might be included. Protective covenants are prohibitions on actions of the issuing ﬁrm, to protect bondholders form possible ﬁrm or stockholder actions that might be harmful to the bondholders. The most common are restriction on the issuance of (1) additional debt, (2) dividend payments, (3) mergers, and (4) disposition of assets. For example, a mortgage bond is issued with speciﬁc assets pledged as collateral. The indenture includes protective covenants prohibiting the sale of the pledged asset or the use of the pledged asset as collateral for another loan, and it will require the proper upkeep of the asset. As mentioned, other common protective covenants are restricting payment of dividends to stockholders and preventing the liquidation of assets and paying the proceeds to stockholders or underinvesting in new assets. 3. Why do special bankruptcy courts exist? They perform a special and important function for the legal system: they solve the common pool problem. Without them, creditors have incentives to sue the defaulting ﬁrm and try to rapidly seize, individually, as many assets for themselves as possible. These actions of competing creditors can easily destroy a sizable part of the value of a ﬁrm. Bankruptcy courts settle creditors’ claims jointly so that creditors can act in concert for their mutual beneﬁt. 4. Deﬁne ﬁnancial distress. What alternatives are available to ﬁrms in ﬁnancial distress instead of defaulting? Describe the pros and cons of each alternative. 102

If the operating income (or earnings before interest and taxes) is less than interest payments (ﬁxed charges), the ﬁrm is in imminent danger of default and is said to be in ﬁnancial distress. The alternatives to default are: (1) sell assets and use the proceeds to pay interest. However, assets of a ﬁrm in ﬁnancial distress typically have low market value since the assets’s proﬁt potential is questionable. This is a clear-cut cost of the strategy. (2) raise more equity capital. Although ﬁnancial distress often results in low current stock price, which may be attractive to some investors, the sale of equity at depressed prices is costly to existing stockholders. (3) merge with another ﬁrm. However, the poor status of the ﬁrm may create unfavorable merger terms. On the other hand, the merger may reduce tax liabilities of the acquiring ﬁrm. (4) borrow more money, either new loans or renegotiation/rescheduling of old loans. This may require a premium interest rate and/or protective covenants for a new loan, while renegotiation may allow lender to recover more than if lender forces troubled ﬁrm to retrench. (5) pay interest with funds needed to replace depreciating equipment. This allows the physical plant to deteriorate: in the short term, it buys time and lets the ﬁrm continue to exist; in the long term, it destroys the physical plant. (6) obtain governmental assistance. This depends on the current political climate and the economic importance of the ﬁrm. A large ﬁrm, especially in an industry with few participants, might have a greater chance of aid (Chrysler is by now a classic example).

5. Describe the costs associated with ﬁnancial distress and bankruptcy. All of the preceding strategies for avoiding default have costs outlined above. In addition, a ﬁrm in ﬁnancial distress may suﬀer lost sales since it is unlikely to obtain trade credit and will be required to make cash payments when merchandise is delivered. 6. What does the term secured debt mean?

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Unsecured debt has a general claim on assets of a ﬁrm rather than a claim on speciﬁc assets. Secured debt has a claim on a speciﬁc asset, such as mortgage bonds backed by speciﬁc assets. 7. Describe the ﬁnancial characteristics that determine bond ratings. Ratings agencies do not reveal the exact procedure used to derive ratings, but they are related to debt levels, proﬁtability, and risk levels. The higher the rating, the more of the following are true: (1) low debt ratios (debt/assets, debt/equity) (2) high interest coverage ratios (earnings before interest and taxes/interest) (3) high rates of return on assets (proﬁt/assets, proﬁt/equity) (4) low relative variation in earnings over time (5) ﬁrm is of large size (6) unsubordinated bond issue

8. Are junk bonds good investments? Why or why not? Junk bonds (S & P ratings of BB and lower, Moody’s ratings of Ba and lower) are broken into two classes: (a) fallen angels, ﬁrms originally with higher ratings but that have declined as the ﬁrm has fallen on hard times, and (b) original-issue. Original issue is further divided into (1) high business operating risk and (2) highly levered ﬁrms. Investing in junk bonds is a specialized ﬁeld and requires detailed knowledge of bankruptcy law as well as individual ﬁrms. Junk bond mutual funds, on the other hand, allow diversiﬁcation and do not require the knowledge and time to evaluate each junk bond issue. 9. Assume a 1-period world with risk neutral investors. The default free interest rate is 5 percent. XYZ Corporation issues 1-year bonds. The probability that XYZ will not default on these bonds is 85 percent. If there is a default, the bondholders will recover 70 cents on the dollar. What is the contractual interest rate under these assumptions? The contractual interest rate is given by 104

y=

R1 + p − rp 1 − p + rp

where R1 is the one period default free interest rate, p is the probability of default, r is the recovery rate, and y is the contractual rate. For R1 = 0.05, p = 0.85, and r = 0.70, the contractual rate is y = .4094. 10. Assume the same information as the preceding example except that the recovery rate is zero. Determine the contractual interest rate. Compare your answer to the previous problem and explain the reasons for the diﬀerence. In this case, r = 0 with all other parameters the same. The contractual rate is now y = 5.7167, more than a factor of 10 larger. The diﬀerence between the results of problems 10 and 9, due to the diﬀerence in values for r, can be interpreted in the following way: for r = 0 the contractual rate is the default free rate plus a default premium for possible loss of interest plus a premium for possible loss of principal; for r = 0, the contractual rate is the default free rate plus a premium for expected loss of interest plus a premium for expected loss of principal since nothing is recovered. Note that for r = 1 there is full recovery and the contractual rate is the default free rate, the default probability playing no role at all.

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Chapter 22: Taxation 1. Describe the tax treatment for discount and premium bonds. Discounts from par are treated as capital gains as of tax year 1987, taxed at regular income tax rate at maturity on disposition. For tax years before 1987, discounts from par were taxed at the lower capital gains tax rate if the bond ws issued before 7/84 and at the regular tax rate if issued after 7/84. Tax arbitrage for discount bonds has eﬀectively been eliminated by this procedure and the elimination of personal interest loan deductibility. Premiums above par, originally issued before 9/27/85 can either be treated as a capital loss at maturity or it can be amortized on a straight line basis and deducted over the bond’s life (depreciation). Premiums above par, originally issued after 9/27/85: premium is amortized over bond’s remaining life by the constant yield method (which has smaller amortization in early years and larger amortization in later years compared to the linear method) - the change in the bond’s tax basis is the amount amortized. 2. Describe the tax treatment for U.S. Treasury STRIPS, taxed as original issue zero coupon bonds. A 4 period zero coupon bond is issued by a corporation for $80 per $100 of par value. Determine the tax liabilities over the next four years for an investor in the 28% tax bracket. STRIPS are taxable with the discount from par amortized by the constant yield method. Bn = P (1 + y )n is the basis for the nth year, so the change for basis from year n + 1 to year n is ∆Bn = Bn − Bn−1 = P (1 + y )n − P (1 + y )n−1 = P (1 + y )n−1 y . This is the amount of amortization for n = 1, 2, 3, .... The stripped parts of U.S. Treasury securities created zero coupon bonds out of coupons and the par value and are taxed as if each were an Original Issue Discount Bond (OID). For example, if Ppar = 100, P = 80, and n = 4, then the equation P = Ppar /(1 + y )n implies y = (Ppar /P )1/n − 1. Consequently, in this case, y = 0.0574. The amortization and tax table for the four years is: Year (n) 1 2 3 4 Amortiztion (∆Bn ) 4.5807 4.85302 5.13144 5.42584 Tax 3.3046 3.4942 3.6946 3.9066 106

3. What is the tax treatment of municipal bonds? What factors make municipal bonds riskier than Treasuries? The coupon interest on most municipal bonds is exempt from federal income tax. Discounts from par are taxed at maturity as capital gains. Municipal bonds issued by another state are subject to state and local taxes of the investor’s residence. The tax exemption of municipal bonds represents a subsidy to the municipalities from the federal government as well as a tax subsidy to individuals in high tax brackets: why not have a direct subsidy to the municipalities eliminating the subsidy to wealthy individuals (since they are in high tax brackets)? Industrial development bonds are sold to attract business to a municipality, to build new plants which may be leased to business - this tax break is a subsidy to business in the form of lowered lease payments due to lower (tax-free) bond interest rates: is this appropriate? Revenue bonds are sold to ﬁnance a particular project. General obligation bonds are backed by the full taxing power of the municipality, so the chance of default is much lower for these bonds than for revenue bonds and typically have lower yields than revenue bonds due to this lessened default risk. Default risk on revenue bonds can be considerable: the revenue from the project may be insuﬃcient to repay the interest and principal of the bond. 4. What is a ﬂower bond? How can you identify a ﬂower bond? A ﬂower bond is a U.S. Treasury bond that is used at par value to pay federal estate taxes. If the ﬂower bond has a relatively low coupon and was purchased below par, the estate of the individual can reap considerable beneﬁt from the individual’s death. These bonds are priced diﬀerently from other U.S. Treasury securities. Low coupon ﬂower bonds sell at unusually high prices and low yields to maturity: the unusually low yields make them easy to identify when reading listings of U.S. Treasury bonds. 5. Theoretically, what should determine the tax rate of the marginal investor in the bond market? How can this marginal tax bracket be estimated empirically? The marginal tax rate is the corporate tax rate. If it is less, then corporations borrow money until the marginal tax rate is driven up to the level of the corporate rate. It is determined by tax rates faced by bond investors, 107

comparing tax free investments with taxable investments, switching to investments with the highest after tax return. In equilibrium, after tax returns are equal for nontaxable and taxable instruments for the marginal tax bracket. The marginal investor is not necessarily the one with the highest tax rate for a progressive tax system: investors in tax brackets above the marginal tax rate (rf ree = rtax (1 − ttax )) ﬁnd higher returns by investing in tax free securities. The investor in the marginal tax bracket is indiﬀerent between investing in taxable bonds or tax-exempts. U.S. law prohibits the simultaneous (buy/short sell) of tax free bonds and (short sell/buy) of taxable securities since these are proﬁtable arbitrage positions. Estimating the marginal tax rate. Would like to know the n after tax discount rates (R1 , R2 , R3 , ...Rn ) and the regular income tax rate and capital gains tax rate for each maturity: this consists of 3n variables. If the regular income tax rate equals the capital gains tax rate for every maturity, there are then only n + 1 variables to estimate. But there is still not enough data to derive all these variables from existing U.S. Treasury securities. For n strips and 1 tax rate, there are n + 1 unknowns and still not enough data to deduce the tax free term structure and tax rate from data for n STRIPS. yt (1 − t) = ym where yt is the yield on a taxable Treasury par bond and ym is the yield on a AAA municipal par bond with the same maturity, and t is the marginal tax rate. However, Treasury securities have no default risk, so this assumes that the municipal has no default risk. The tax status of Treasuries is not the same as municipals since Treasury securities are exempt from state income taxes but municipals may be subject to state tax if they are held by a non-resident of the state. The equation is valid only for par bonds, and is not true for discount or premium bonds. Since there is a limited number of par bonds, the par bond yield needs to be extrapolated form non par bond yields. Finally, U.S. Treasury securities are substantially more liquid than municipals. Treasuries are issued in large amounts and are actively traded while municipals are issued in relatively small amounts and are not actively traded. Other things equal, municipals have higher yields.

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Chapter 23: Financial Engineering: Specialized Financial Instruments 1. Describe a ﬂoating rate note. There are two components of an interest rate - changes in the general level of interest rates and changes in the default risk of a particular issuer. How do each of these aﬀect the interest rate on ﬂoating rate debt? How does a reset note diﬀer from a ﬂoating rate note? A ﬂoating rate note is a bond with a variable interest rate: adjustable rate mortgages are a variety of ﬂoating rate debt. The coupon on a ﬂoating rate note is tied to a particular short term interest rate. It is a long term bond with short term interest rate and is a substitute for repeated short term loans. The ﬂoating rate note has a low price risk, since the coupon is reset periodically (e.g., every 6 months) to bring the price closer to par. The default premium for a long term ﬂoating rate loan diﬀers from the default premium for a sequence of short term loans: with repeated short term loans, the default risk premium is renegotiated with each new loan, increasing as the ﬁrm becomes riskier and decreasing as the ﬁrm becomes less risky; with a ﬂoating rate note, the default risk premium is set initially and is not changed. The ﬂoating rate note combines the default premium of a long term bond with the sensitivity of short term bond changes to the default free interest rate. Periodic resetting of the bond’s coupon brings the bond price to par if the default risk of the ﬁrm remains unchanged but if the market perceives new information about the default risk, the bond price may not adjust to par. A reset note is a special variety of ﬂoating rate notes. A coupon is reset periodically (e.g., every 2 years) by the investment banker to bring the market price to par. If the default risk increases, the reset coupon reﬂects a higher default risk and after resetting, the bond sells at par. With a standard ﬂoating rate note, the default premium is ﬁxed, and resetting the coupon reﬂects changes in the default free interest rate only and the bond price can deviate from par. 2. Explain the reasons why ﬁrms might swap their debt obligations. An interest rate swap is an agreement to exchange cash ﬂows from debt obligations with diﬀerent maturities. For example, ﬁrm L borrows long term while ﬁrm S borrows at a variable rate. The two ﬁrms agree to swap interest payments: this is a ﬁxed/ﬂoating or “plain vanilla” swap. Note 109

that interest payments are swapped but not principal payments: a default involves interest payments only. Reasons for swaps: claimed to have comparative advantage, ﬁrm L enjoys comparative advantage and both ﬁrms enjoy lower borrowing costs. Firm L wants to borrow short term, but it can reduce costs by borrowing long term and swapping: is this an indication of market imperfection? Low transaction costs induce ﬁrms to swap rather than reﬁnance existing debt; complicated swaps allow some ﬁrms to signiﬁcantly alter their capital structures: rather than try to repurchase bonds during call deferment periods, they engage in forward swaps. See Figure 23.2. 3. Describe the impact of changing interest rates upon the default risk of a swaps dealer. If default occurs, the dealer replaces the defaulting party by a new counter party, and may also sue the defaulting party. If L defaults: (a) if there is no change in interest rates, simply replace L; (b) if interest rates decrease, the dealer gains since the dealer can pay less than L +C RF DL to the new counter party; (c) if interest rates increase, the dealer L +C loses since the dealer must pay more than RF DL to the new counter party. If S defaults: (a) if there is no change in interest rates, simply replace S; (b) if interest rates increase, the dealer gains since ﬁrm S is replaced by a new L +C counter party paying more then RF SD ; (c) if interest rates decrease, the L +C dealer loses since the new counter party pays the dealer less than RF SD . 4. What are the possible motivations behind issuing convertible bonds? There are no evident disadvantages, so why not issue them? Negative private information may be available to management, so by issuing convertibles the ﬁrm is able to sell common stock at an inﬂated price. Positive private information may by available to management, so issuing common stock at the current price may not reﬂect the true value of the stock: issuing stock would be unwise. The typical convertible is issued when the stock value is substantially less than par, so issuing convertibles allows the ﬁrm to eﬀectively sell stock at a higher price. When convertibles are issued the stock price tends to decline somewhat, indicating convertibles are issued when management has some negative information. 5. Describe the diﬀerences between preferred stock and bonds. 110

Preferred stock lies somewhere between bonds and stock. It pays dividends rather than interest but the amount of the dividend is speciﬁed. If the dividend is not paid, it is owed with cumulative interest whereas the bond would be in default. Bondholders have priority over preferred stockholders in the event of bankruptcy. Preferred dividends are not tax deductible for corporate income tax while bond interest is deductible. 6. Index-linked bonds have several attractions. What are they? These are inﬂation protected bonds, the coupons and par value are adjusted to reﬂect actual inﬂation experience. They are a low risk investment with inﬂation protection, but no protection against changes in real interest rates. The issuer of index-linked bonds is protected from inﬂation risk as well: inﬂation risk premiums are unnecessary, reducing interest costs. 7. What are the disadvantages of index-linked bonds? They are largely conﬁned to British and Israeli government bonds. Taxation of the indexed part of the return: if the coupon is indexed, it necessarily increased less than the inﬂation rate since it is taxed; if the principal is indexed, the indexed amount is a capital gain. Tax exemption is a problem since coupons on standard bonds are taxed. It may violate uniform commercial code and state usury laws in the U.S. The ﬁrm’s inﬂation rate can diﬀer from the inﬂation rate of the overall economy, making the ﬁrm reluctant to issue an indexed bond. Floating rate bonds are tied to short term interest rates: if short term role is highly correlated with realized inﬂation rates, the ﬁrm can inﬂation-index the coupon but not the principal providing only partial indexation protection.

111

Appendix 1: Markets A. Spot market B. Forward market C. Futures Market: Commodities D. Futures Market: Financial Instruments E. Options Market: Puts and Calls F. Specialized Instruments 1. To liquidate a short position in a given market, go long in the same market 2. To liquidate a long position in a given market, go short in the same market

1. U.S. Treasury Securities a. Bills (maturities less than 1 year, discounted, no coupon) b. Notes (maturities between 1 year and 10 years, semiannual coupon) c. Bonds (maturities greater than 10 years, semiannual coupon) 2. Government Agencies a. GNMA debt obligations b. Export-Import Bank debt obligations c. Tennessee Valley Authority debt obligations d. FNMA (Fannie Mae) e. FHLMC (Freddie Mac) f. Federal Home Loan Banks g. Farm Credit Bank

112

3. Municipalities: Bonds 4. Corporations a. Bonds b. Stock 5. Mortgages

113

Appendix 2: The Long and Short of It A. Spot Market 1. Long in the spot market: buy a security at time t = 0 for price P (0) and hold to sell at time t for price P (t). See Figure A.1. 2a. Short in the spot market (uncovered): borrow security at time t = 0 and sell at price P (0), then buy security at later time t for price P (t) and return as borrowed security. See Figure A.2a. 2b. Short in the spot market (covered): borrow security at time t = 0 and sell at price P (0), then buy and return security at later time t for price P (t) if P (t) is less than the price previously paid for security, else return presently owned security to lender. See Figure A.2b B. Forward Market 1. Long in forward market has zero cash ﬂow at time t = 0, an outﬂow at an intermediate time t = 1, and an inﬂow at the terminal time t = 2: Action Long in 2 period security Short in 1 period securities Net Long Forward t=0 −D2 D1 (D2 /D1 ) 0 t=1 t=2 1

−(D2 /D1 ) −(D2 /D1 ) 1

The forward price F1 = D2 /D1 = 1/(1 + f2 ) is the value at t = 1 of $1 received at t = 2. Thus, the net long forward position is 1 − F1 . See Figure B.1. 2. Short in forward market has zero cash ﬂow at t = 0, inﬂow at an intermediate time t = 1, and an outﬂow at the terminal time t = 2: Action Short in 2 period security Long in 1 period securities Net Long Forward t=0 D2 −D1 (D2 /D1 ) 0 t=1 t=2 −1

(D2 /D1 ) (D2 /D1 ) −1

The forward price F1 = D2 /D1 = 1/(1 + f2 ) is the value at t = 1 of $1 received at t = 2. Thus, the net short forward position is F1 − 1. See Figure B.2. 114

It would appear that the short forward position is useful only for arbitrage purposes. If the market forward rate is not the same as the forward rate implicit in the spot rates, then arbitrage is possible: Action Short forward (implicit rate) Long forward (market rate) Net Long Forward t=0 0 0 0 t=1 D2 /D1 −FM D2 /D1 − FM t=2 −1 1 0

This position nets a riskless proﬁt if the implicit forward rate is larger than the stated market rate. If, on the other hand, the implicit forward rate is smaller than the stated market rate, the following position will yield a riskless proﬁt: Action Short forward (market rate) Long forward (implicit rate) Net Long Forward t=0 0 0 0 t=1 FM −D2 /D1 FM − D2 /D1 t=2 −1 1 0

Apart from arbitrage, there does not appear to be any particular use for the short forward position that does not incurr a loss. C. Futures Market: Commodities 1. A long position in futures commodities is contracted at time t = 0 with a short. At the delivery date speciﬁed in the contract, the long receives the commodity and makes payment. This is a method of locking in the price of a needed commodity or of speculating that the price of the commodity will exceed that of the futures price before the delivery date. See Figure C.1. 2a. Short in futures commodities (uncovered) is contracted at time t = 0 with a long. At the delivery date speciﬁed in the contract, the short must deliver the commodity and receives payment. Since this is an uncovered position, the short must ﬁrst purchase the commodity or produce the commodity and then make delivery. This is a method of locking in the selling price of a product or of speculating that the price of the commodity will not exceed that of the futures price before the delivery date. See Figure C.2a. 2b. Short in futures commodities (covered) is contracted at time t = 0 with a long. At the delivery date speciﬁed in the contract, the short must deliver 115

the commodity and receives payment. Since this is a covered position, the short delivers the commodity that has either been previously purchased, produced, or from inventory at price Pi , whichever is cheaper. See Figure C.2b. 3. Oﬀsetting a short with a long: there is no actual delivery. Transaction fees for delivery exceed the oﬀsetting futures position. See Figure C.3. 4. Oﬀsetting a long with a short: there is no actual delivery. Transaction fees for delivery exceed the oﬀsetting futures position. See Figure C.4. 5. Long hedge is a long position in futures commodities to lock-in the purchase price of a commodity needed in a production process to guarantee a proﬁt for the production process. The position forgoes gains if the price of the commodity is below the contracted futures price, but potentially large losses are avoided if the commodity price is high. 6. Short hedge is a long position in the spot market with a short position in the futures market. This locks-in the price of a commodity for sale. See Figure C.6. D. Futures Market: Financial (T-bills, T-bonds, Stock Index, Currency) 1. Long in futures is contracted at time t = 0 with a short. At the delivery date speciﬁed in the contract, the long receives the ﬁnancial instrument and makes payment. See Figure D.1. 2a. Short in futures (uncovered) is contracted at time t = 0 with a long. At the delivery date speciﬁed in the contract, the short delivers the ﬁnancial instrument and receives payment. Since this the uncovered case, the short must ﬁrst purchase the ﬁnancial instrument prior to delivery. See Figure D.2a. 2b. Short in futures (covered) is contracted at time t = 0 with a long. At the delivery date speciﬁed in the contract, the short delivers the ﬁnancial instrument and receives payment. Since this is the covered case, the short can either deliver a previously owned instrument (at price Pi ) or deliver a newly purchased instrument, whichever is cheaper. See Figure D.2b. 3. Oﬀsetting a short with a long: no delivery is made (similar to case for commodities). 4. Oﬀsetting a long with a short: no delivery is made (similar to case for commodities).

116

5. Short hedge is a long position in the spot market hedged with a short futures position. The hedge can be (a) maintained until the delivery date or (b) liquidated before the delivery date. See Figures D.5a and D.5b. 6. Long hedge is a long position in the futures market to lock-in the purchase price of a ﬁnancial instrument, to sell the instrument at a later time. This is useful if the futures price is below the spot price at the time of purchase. 7. T-bill Futures 0 Delivery 90 day T-bill The maturity of a T-bill purchased at t = 0 for delivery at time t = Delivery = td must be td + 90. More generally, the maturity of a T-bill purchased at t=0 for delivery at t = td must be td + tm where tm is the maturity of the T-bill in the futures contract. 0 d1 = f1 d2 The connection between the quote and the price of a T-bill futures can be derived in the following way. Since Q = 100(1 − f ), a change in the quote is given by ∆Q = Q2 − Q1 = −100(f2 − f1 ) = 100(f1 − f2 ). And since the price of a T-bill is P = Ppar (1 − f t/360), the corresponding change in the price is ∆P = P2 − P1 = Ppar (f1 t1 − f2 t2 )/360 and for t1 = t2 = t, ∆P = Ppar (f1 − f2 )t/360. Using the quote equation to eliminate the forward rates, ∆P = Ppar t∆Q/36000. For Ppar = 1, 000, 000 and t = 90, ∆P = 2500∆Q: the price increases by 25 for each basis point (∆Q = 0.01), by 250 for each 10 basis points (∆Q = 0.1), by 2500 for each 100 basis points (∆Q = 1.0), etc. A short hedge in T-bills requires the purchase of a 180 day T-bill to deliver as a short in a futures contract in 90 days so that at the delivery date the long will obtain a 90 day T-bill: P (t0 ) = Ppar 1 − P (t1 ) = Ppar 1 − F (t0 ) = Ppar 1 − 117 d0 (tf − t0 ) 360 d1 (tf − t1 ) 360 f0 (tf − td ) 360 t1 f2 t2 Delivery +90

F (t1 ) = Ppar 1 −

f1 (tf − td ) 360

The short purchases the T-bill at time t0 for price P (t0 ). In the futures contract, the short agrees to sell the T-bill at the delivery date td for the price F (t0 ). The proﬁt from this position is F (t0 ) − P (t0 ) or Ppar (d0 (tf − t0 ) − f0 (tf − td ))/360. On the other hand, if the short hedge is liquidated before the delivery date, then the “short” also goes long in T-bill futures and sells the T-bill in the spot market. The proﬁt from this position is F (t0 ) − P (t0 ) − (F (t1 ) − P (t1 )) or P (t1 ) − P (t0 ) + F (t0 ) − F (t − 1) which is simply a linear combination of positions in the spot market and in the futures market. 8. T-bond Futures The par value of the bonds is typically 100,000 and the time to maturity is greater than or equal to 15 years or the ﬁrst call date, whichever is sooner. The T-bond futures quote is given in terms of two integers, Q = Q1 − Q2 and these integers are related to the futures price in the following fashion: F = (Q1 + Q2 /32) × 1000. On the delivery date, the futures price is equal to the spot price, F = P (td ). There is no marking-to-market, so that the futures price also equals the forward price. The forward price, Pf or , is set at time t = 0 but payment does not take place until the delivery date t = td . A forward position in a coupon bearing bond looks like the following: 0 1 2 ... td −Pf or td + 1 c td + 2 c ... ... n c + Ppar

The forward price is Pf or = (P0 − cAd )/Dd where P0 is the spot price of the bond with coupon c, Ad = D1 + D2 + D3 + ... + Dd is the present value of $1 received for each of the next d periods, and Dd = 1/(1 + rd ) is the discount for time d. A forward position can be created from a spot position in the following way:

118

Action Buy nperiod bond Short dperiod annuity Present value Time d value

0 −P cAd −(P − cAd )

1 c -c

... ... ...

d c -c

d+1 c

... ...

n c + Ppar

c −(P − cAd )/Dd c

... ...

c + Ppar c + Ppar

A short hedge for T-bond futures: e.g., an underwriter anticipates a waiting period (e.g., two weeks) of owning the bond issue before selling it to the public. If interest rates rise during this period, the bond value declines and the underwriter would have to sell the bonds at a price less than the purchase price. An underwriter can protect himself against this type of event by shorting T-bond futures. 9. Stock Index Futures Creating a long futures position in a stock index: Action Borrow funds Buy stocks Repay loan + interest Receive dividends Deliver commodity Net cash ﬂow t=0 +P −P t=delivery date

0

−P (1 + Rd )d + div (no delivery) div −P (1 + Rd )d

Thus, the futures price on the stock index must be Feq = P (1 + Rd )d div. The quote on stock index futures is given by Q = 100(1 − f ) and the dollar amount is PI = 500Q. If F = P (1 + Rd )d - div, then arbitrage opportunities arise and is given the name “program trading:” a computer program is required to uncover the arbitrage opportunities and buy and sell orders for large numbers of stocks must be executed rapidly by computer before the arbitrage opportunity disappears. For instance, if F > Feq , then short stock index futures at F and buy stocks in the index at P : when the futures price settles at Feq , then close both the short futures position and the long spot position. The futures proﬁt is F − Feq and the spot proﬁt is Pt − P so that the total proﬁt is F − Pt [(1 + Rt )t − 1] + divt − P . 10. Currency futures

119

Currency futures are typically used to hedge against foreign exchange risk, to encourage international trade. In essence, it permits the use of the forward exchange rate rather than gambling on the use of the spot exchange rate at a future time. E. On Futures Hedging Some positions can be hedged with futures in the same commodity or instrument. Others can be hedged with futures in a similar item, such as a long position in corporate bonds with a short position in T-bonds: this is known as a “cross hedge.” A spread is a simultaneous long and short position in two similar futures contracts. A common spread consists of a long position in futures with a particular delivery date and a short position in futures in the same commodity or instrument but with a diﬀerent delivery date. long t=1 at QL,1 short t=2 at QS,1 spread0 = QS,1 − QL,1 short t=1 at QS,2 ∆Q1 = QS,2 − QL,1 long t=2 at QL,2 ∆Q2 = QL,2 − QS,1 spread1 = QS,2 − QL,2 Net = ∆Q2 + ∆Q1 If spread1 = spread0 , then the net is zero; if spread1 > spread0 , then the net is less than zero or a loss; and if spread1 < spread0 , then the net is greater than zero or a gain.

120

Appendix 3: Notes On Put And Call Options The call buyer acquires the right to purchase the underlying asset for the speciﬁed exercise price by the speciﬁed expiration date; the call writer agrees to sell the underlying asset at the speciﬁed exercise price if the option is exercised by the call buyer by the expiration date. Call options are zerosum games: the buyer’s gains are the writer’s losses and vice versa. The put buyer acquires the right to sell the underlying asset for the stated exercise price by the stated expiration date (“similar to short selling”); the put writer agrees to buy the underlying asset for the stated exercise price if the put buyer chooses to exercise the put option by the stated expiration date. Put options are also zero-sum games: the buyer’s gains are the seller’s losses and vice versa. At expiration, the value of a call option is zero unless the price of the underlying asset is greater than the exercise price: Pcall = 0 if PA ≤ E and Pcall = PA − E if PA > E . Before expiration, the feasible range of call prices consists of the band bounded by Pcall > 0 for PA ≤ E , Pcall < PA , and Pcall > PA − E for PA > E . Merton’s lower bound, Pcall ≥ PA − ED follows from the non-negative value for the price of a put option (E D is the present value of the exercise price E , with D = 1/(1 + r)). See Figures 3A.1 and 3A.2. In the Black Scholes model, Pcall ≥ PA − Ee−rτ where Ee−rτ is the present value of the exercise price E for continuously compounded interest rates: r is the continously compounded rate and τ is the remaining life of the call option (T − t). See Figure 3A.3. In the Black Scholes model, the solution for the valuation of a call option is Pcall = P N (d1 ) − Ee−rτ N (d2 ) where N (x) is the cumulative probability of the normal distribution of getting the value x, d1 = (ln(P/E ) + (r + √ √ 0.5σ 2 )τ )/σ τ , d2 = d1 − σ τ , σ is the standard deviation of the continuously compounded rate of return of the underlying asset, P is the current price of the underlying asset, and E is the exercise price. The function e−rτ is the present value of $ 1 received τ periods from the present, the continuously compounded equivalent of D. Note that as σ → 0+ , d1 → ∞, d2 → ∞, and Pcall → PA − Ee−rτ . Also, as PA → ∞, d1 → ∞, d2 → ∞, and Pcall → PA − Ee−rτ .

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