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Exercise Set 1

Instructions:

• Type your answers into this document and then print it, or print it and then write in

your answers.

• You must show how you arrived at the answer, otherwise your mark will be zero;

but be very brief. Excessively long answers will be marked down.

• Each student should submit their own answers. You may discuss the questions in

general terms but your answers must be your own.

• Submit answers to Student Services in hard copy before the start of Class 3.

1. On 11 Feb 2011 the price of September 2011 wool futures on the ASX

is $8.20 bid and $8.50 ask. Each contract is for 200 kilograms of wool.

To hedge his wool price exposure a wool farmer named Bruce opens a

short position in three hundred September 2011 wool contracts. Bruce

closes out his hedge position on 13 June 2011 when the futures price

has risen to $9.90 bid and $10.00 ask. What is Bruce’s total gain on

the hedging position? (Ignore any margin account considerations).

A) -$88,000

B) -$98,000

C) -$108,000

D) -$118,000

E) None of the above

Selling @ $8.20

Buying @ $10.00

total return on the asset. Short selling delivers cash at the outset (just

like borrowing does) and then involves cash outflows (just like

borrowing) as payments are made to deliver income (to the original

lender of the asset) and to buy-back the asset.

Steve borrows 1000 shares of BHP and sells them for $45 each. Three

months later BHP pays a dividend of $1 per share, which Steve must

pay to the lender of the shares. Three months after that (six months

from the start), Steve buys back the shares for $46 to end the short.

Steve has had the use of the $45,000 for 6 months. At what APR (with

quarterly compounding) has Steve effectively borrowed money for six

months?

Hint: Just treat the question like a loan. You know the cashflow in

($45,000) and the cashflows out. What interest rate makes the PV of

the cashflows out equal the cashflow in.

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A) 7.89%

B) 8.89%

C) 9.99%

D) 10.99%

E) None of the above

Maturit PV of Cash

y Cash Flows Flows

$ $

0 (45,000.00) 45,000.00

$ $

0.25 1,000.00 978.26

$ $

0.5 46,000.00 44,021.74

3. The price of wheat today is $230 per tonne. The cost of storing wheat

for one year (payment in advance) is $25 per tonne and the 1 year

Libor rate is 5.25 percent. What is the upper bound on the futures

price of wheat? (The price level beyond which there is an arbitrage

opportunity).

A) $258.74

B) $268.74

C) $278.74

D) $288.74

E) None of the above

$

Spot 230.00

Storage $

cost 25.00

rate 0.0525

Futures $

Price 268.75

4. The spot Yen/$A exchange rate is 83.55 today. The six month forward

rate is 81.62. 6 month risk free rates (continuously compounded) are

4.95% in $A and 0.45% in ¥. If the maximum you can borrow today is

either $A1 million or Ұ100 million, then what is the maximum arbitrage

profit, measured in today’s dollars, that you can make from this

situation? (Hint: Use the equation for the forward price on an asset

that pays a continuous yield q. If the $A is the asset and Yen is cash,

then S0 = 83.55, F0 = 81.62. If the forward price is too low then we

borrow the asset and sell it today. If the forward price is too high, then

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we borrow cash to buy the asset today).

A) $1137

B) $134

C) $734

D) $871

E) None of the above

Spot Y/

$ 83.55

$ rate 0.0495

Y rate 0.0045

F Y/$ 81.62

F Y/$ 81.69

Borrow $A1m and convert it into yen @ 83.55 to get Y83, 550,000

Lend Y83, 550,000 for six months @ 0.45% to get Y83, 738,199.14

Covert Y83, 738,199.14 @ 81.62 to get $A1,025,951.96

Pay $A1,025,058.82 (interest rate 4.95%)

Calculate the value of the coupons on a two year floating rate note on 8

Feb 2011 and the the coupons on another 2 year note on 8 Feb 2012 after

interest rates have moved up. Calculate the 10 missing values and write

them in the table

Risk free PV floating rate Risk free PV floating rate

Maturity Coupons and

rates on note cashflows rates on note cashflows

(years) principal

8 Feb 2011 8 Feb 2011 8 Feb 2012 8 Feb 2012

30.55 32.00

0.5 4.95 C1 5.75

424 586

1 5.35 C2 29.68832 6.05 31.00563

28.71

1.5 5.80 C3 6.30

023 29.96916

2 6.20 C4 27.66737 6.50 28.92392

Principal 883.3798 878.0954

PV of note 1000.00 1000.00

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5. Consider a five year fixed for floating interest rate swap that is opened

on 8 Feb 2011. The swap has a notional value of $100 million. If the

zero (yield) curve is as shown below, then what is the swap rate (as an

APR) when the swap is opened on 8 Feb 2011.

Note: We can think of the party receiving fixed and paying floating as

being long a fixed rate bond with a face value of $100 million and

maturity of five years and short a corresponding floating rate note. At

the time of opening the swap has zero value to both parties. Therefore

Vfloating – Vfixed = 0 or equivalently Vfloating = Vfixed = $100 million at

the outset.

The swap rate, which is fixed when the swap is opened, is the coupon

rate on the fixed rate note. The fixed rate payments on the swap

(coupon payments on the fixed rate note) are made twice per year.

The swap rate is chosen to make Vfixed = $100 million at the opening of

the bond.

Zero yields on

Maturity (years) 8 Feb 2011

0.5 4.95

1 5.35

1.5 5.8

2 6.2

2.5 6.45

3 6.65

3.5 6.8

4 6.9

4.5 6.95

5 7.00

A) 7.0506%

B) 7.0606%

C) 7.0706%

D) 7.08065%

E) None of the above

Matur Cash PV of Cash

ity Libor Flows Flows

0.5 0.0495 3.525 3.439

1 0.0535 3.525 3.342

1.5 0.058 3.525 3.232

2 0.062 3.525 3.114

2.5 0.0645 3.525 3.000

3 0.0665 3.525 2.888

3.5 0.068 3.525 2.779

4 0.069 3.525 2.675

4.5 0.0695 3.525 2.579

103.52

5 0.07 5 72.953

100.000

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Coupo 7.050

n 6%

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and $US risk free rates are 4.92% and 0.44% respectively. What is the

6 month forward exchange rate? (Hint: If we write the exchange rate

as $US0.8628/$A, then is the $A the currency or is it the asset?).

like a negative income; instead of the underlying asset (the

commodity) delivering income (or yield) to the holder of the asset, it

consumes cash through the storage cost. On 1 July 2010 the price of

gold is $1250. If the one year risk free rate is 5.05% and the annual

cost of storage is 0.6% of today’s price (continuously compounded),

then what is the one year forward price of gold.

$1,000 and its current price is $1020. The bond pays coupons twice

per year and the next coupon is due 3 months from today. The 3

month and 6 month Libor rates are both 5%. What is the futures price

of a six month futures contract on the Treasury bond.

million and on 1 April 2010 has 3 years to maturity. The fixed rate

party receives $3.22 million on 1 Oct and 1 April dates. The floating

party receives Libor (set 6 months earlier) on the same dates.

Calculate the value of the swap to the fixed rate party on 1 April 2010,

after payments have been exchange, by calculating the difference

between the value of a fixed rate bond and a floating rate bond.

(years) 1 Apr 2010

0.5 4.75

1 5.05

1.5 5.30

2 5.50

2.5 5.65

3.0 5.80

2010. Fixed payments at the swap rate are swapped for 6 month Libor

twice per year. The notional value of the swap is $100 million. Use

the data in the following table to calculate the swap rate (annual

percentage rate of fixed rate payments).

y rate 1 Aug

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(years) 2010

0

0.5 4.55

1.0 5.10

1.5 5.45

2.0 5.70

2.5 5.80

3.0 5.90

straight corporate bond that has 7 years to maturity, a face value of

$10,000, a coupon rate of 7.35% and a spread to swap rate of 235bp.

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and $US risk free rates are 4.92% and 0.44% respectively. What is the

6 month forward exchange rate?

(r $ US

)

− r $A .( 0.5 )

F0 = S0 .e = 0.8628.e( 0.0044 −0.0492 ) .( 0.5 ) = $US0.8437

like a negative income; instead of the underlying asset (the

commodity) delivering income (or yield) to the holder of the asset, it

consumes cash through the storage cost. On 1 July 2010 the price of

gold is $1250. If the one year risk free rate is 5.05% and the annual

cost of storage is 0.6% of today’s price (continuously compounded),

then what is the one year forward price of gold.

u = cost of storage

$1,000 and its current price is $1020. The bond pays coupons twice

per year and the next coupon is due 3 months from today. The 3

month and 6 month Libor rates are both 5%. What is the futures price

of a six month futures contract on the Treasury bond.

(

F0 = S0 − I .e rT )

(

= 1020 − 22.22 .e(0.05)(0.5) )

= $1,023.04

million and on 1 April 2010 has 3 years to maturity. The fixed rate

party receives $3.22 million on 1 Oct and 1 April dates. The floating

party receives Libor (set 6 months earlier) on the same dates.

Calculate the value of the swap to the fixed rate party on 1 April 2010,

after payments have been exchange, by calculating the difference

between the value of a fixed rate bond and a floating rate bond.

(years) 1 Apr 2010

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0.5 4.75

1 5.05

1.5 5.30

2 5.50

2.5 5.65

3.0 5.80

VFixed = ( 3.22 ) .e( 0.0475) .( 0.5) + ( 3.22 ) .e( 0.0505 ).(1 ) + . . . + ( 3.22) .e(0.0565 ). (2.5 ) + ( 103.22) .e(0.0580 ). (3.0 )

= 101.596

2010. Fixed payments at the swap rate are swapped for 6 month Libor

twice per year. The notional value of the swap is $100 million. Use

the data in the following table to calculate the swap rate (annual

percentage rate of fixed rate payments).

y rate 1 Aug

(years) 2010

0

0.5 4.55

1.0 5.10

1.5 5.45

2.0 5.70

2.5 5.80

3.0 5.90

100 = .e + .e +. . .+ 100 + 2 .e

2 2

C =

(

2.100. 1 - e ()

−0.0590. 3

) = 0.059592 or 5.96%

(e ( )

−0.0455. 0.5

+e ()

−0.0510. 1

+. . .+e ()

−0.0590. 3

)

6. The seven year mid-swap rate is 6.15%. Calculate the price of a

straight corporate bond that has 7 years to maturity, a face value of

$10,000, a coupon rate of 7.35% and a spread to swap rate of 235bp.

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Melbourne Business School Corporate Finance

Yield = Swap rate + credit spread = 0.0615 + 0.0235 = 0.0850

Coupon = FV. = 10000. = 367.50

2 2

PV = + + ... +

0.0850 0.0850

2

0.0850

14

1 +

2 1 + 2 1 + 2

367.50

1 + 10000

= . 1− = $9402.52

0.0850 0.0850

14 0.0850

14

2 1 + 2

1 + 2

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