Derivatives Markets, 3e (McDonald)

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Chapter 15 Financial Engineering and Security Design

15.1 Multiple Choice

1) Mel, Inc. stock is $135.00 per share. The company's semi-annual dividend is forecasted as
$2.10 per share, indefinitely. What is the price of a zero-coupon equity-linked bond, promising to
pay one share in 3 years, given annual interest rates of 5.0%?
A) $101.35
B) $110.26
C) $123.45
D) $155.22
Answer: C

2) Albert, Inc. stock is $42.00 per share. The company's quarterly dividend is forecasted as $0.50
per share, increasing 10.0% at the start of every year. What is the price of a zero-coupon equity-
linked bond, promising to pay one share in 3 years, given annual interest rates of 8.0%?
A) $32.60
B) $36.20
C) $42.60
D) $62.40
Answer: B

3) Dawn, Inc. stock is $37.00 per share. The company's semi-annual dividend is forecasted as
$0.25 per share, increasing every 6 months by 20.0%. What is the price of a zero-coupon equity-
linked bond, promising to pay one share in 4 years, given annual interest rates of 6.0%?
A) $32.29
B) $33.49
C) $34.39
D) $35.69
Answer: B

4) Wayne, Inc. stock is $40.00 per share. The company's quarterly dividend is forecasted as
$0.45 per share, indefinitely. A coupon equity-linked bond, promising to pay one share of
Wayne, Inc. in 3 years pays a quarterly coupon of $0.50. If annual interest rates are 4.0%, what is
the price of the bond?
A) $40.56
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B) $42.60
C) $44.56
D) $46.60
Answer: A

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5) Will, Inc. stock is $63.35 per share. The company's quarterly dividend is forecasted as $0.10
per share, increasing 5.0% every quarter. A coupon equity-linked bond, promising to pay one
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share of Will, Inc. in 2 years pays a semi-annual coupon of $0.20. If annualized interest rates
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are 8.0%, what is the price of the bond?
A) $59.55
B) $61.14
C) $63.12
D) $65.22
Answer: C

6) Assume the spot price of gold is $750 per ounce, the 1-year forward price is $770, and the
annual interest rate is 4.5%. What is the price of a zero-coupon note paying 1 ounce of gold in
one year?
A) $770
B) $750
C) $725
D) $736
Answer: D

7) Assume the spot price of gold is $745 per ounce and the 2-year forward price is $773.
Annualized 1-year and 2-year forward interest rates are 5.0% and 5.2%, respectively. For a
commodity-linked note to sell at par, what is the annual coupon?
A) $23.09
B) $24.09
C) $25.09
D) $26.09
Answer: D

8) Assume oil prices rise dramatically and the spot price of oil is $230 per barrel and the 3-year
forward price is $245. Annualized 1-year, 2-year, and 3 year interest rates are 4.2%, 4.4%, and
4.6%, respectively. For a commodity-linked note to sell at par, what is the annual coupon?
A) $6.00
B) $16.00
C) $26.00
D) $36.00
Answer: A

9) Assume the price of Mary, Inc. stock is $56.00, interest rates are 4.8%, div yield = 0, and
σ = 0.35. What is the price of a $1,000 par value 2-year price-participation note paying a 5.0%
annual coupon and receiving 50.0% of all price appreciation above $65.00?
A) $896.44
B) $996.44
C) $1006.44
D) $1106.44
Answer: C

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10) What is the price of a 2-year equity-linked CD under the following terms? No coupon is
paid. At maturity the CD pays 80.0% of the S&P 500 index appreciation. The S&P 500 price =
900, div = 0.02, σ = 0.20, and interest rates are 5.0%.
A) $890.22
B) $990.23
C) $1064.20
D) $1110.55
Answer: A

11) We wish to cap participation in a 3-year equity-linked option at 50.0% return. Our profit
alpha is 3.0%. The S&P 500 price = 950, div = 0.015, σ = 0.22, and interest rates are 4.8%. What
is the implied participation rate?
A) 0.66
B) 0.76
C) 0.96
D) 1.16
Answer: B

12) A commodity linked bond is issued with an embedded call option. The current commodity
price is $110, as is the exercise price on the call option. The call option is priced at $3.41. If the
promised payment on the bond is the same as the issue price of $100, what is the implied coupon
if effective interest rates are 3.0% and the bond has a 1-year maturity?
A) $0.66
B) $0.77
C) $0.88
D) $0.99
Answer: D

13) A commodity linked bond is issued with an embedded call option. The current commodity
price is $52, as is the exercise price on the call option. The call option is priced at $5.56. If the
promised payment on the bond is the same as the issue price of $40, what is the yield on the
bond if effective interest rates are 4.0% and the bond has a 1-year maturity?
A) 2.24%
B) 2.80%
C) 3.50%
D) 4.0%
Answer: A

14) Which of the following financially engineered products is NOT used to defer the payment of
capital gains taxes on securities that have appreciated?
A) Commodity Linked Options
B) DECS
C) Equity Linked Notes
D) PEPS
Answer: A

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15.2 Short Answer Essay Questions

1) For whom would the issue of an oil-linked debt instrument not be considered a risky issue?
Answer: Any firm engaged in oil production would be perfectly hedged by the issuance of oil-
linked debt.

2) Instead of issuing a pure commodity-linked debt, why would the commodity producing firm
consider a combining interest plus participation in the commodity price appreciation?
Answer: With the coupon interest, the bondholder assumes price risk in the commodity. The
combination implies a coupon plus a call option.

3) What possible tax advantage exists in equity-linked notes?

Answer: Equity-linked notes can be used to defer income, thus delay taxes. Such schemes delay
taxes and act like interest free loans.

4) How does a coupon bond differ from an equity-linked bond?

Answer: Instead of paying cash at maturity the equity-linked bond pays the bondholder equity
shares.

5) What is the primary difference between an equity-linked bond and a currency-linked bond?
Answer: Instead of the dividend yield on stock, the currency-linked bond considers the foreign
interest rate.

15.3 Class Discussion Question

1) The chapter discusses the merging of debt and options. Ask the class why firms would
consider such instruments. Highlight the use of a PERC by a company that has difficulty issuing
debt, yet can offer the carrot of price appreciation.

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