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ECONOMICS 372 Business Finance 2 Winter 2012

Assignment 2 Due on February 27th Important: Handed-in the assignment to me in the class or during my office hours on 27th of February. Late assignment will be marked zero.

Problem 1 (5 points) An interest rate is quoted as 5% per annum with semiannual compounding. What is the equivalent rate with (a) annual compounding, (b) monthly compounding, and (c) continuous compounding.

Problem 2 (15 points) The 6-month, 12-month, 18-month, and 24-month zero rates are 4%, 4.5%, 4.75%, and 5% with semiannual compounding, respectively. a) What are the rates with continuous compounding? b) What is the forward rate for the six-month period beginning in 18 months c) What is the value of an FRA that promises to pay you 6% (compounded semiannually) on a principal of $1 million for the six-month period starting in 18 months? Problem 3 (10 points) Why are U.S. Treasury rates significantly lower than other rates that are close to risk free? (hint: see business snapshot 4.1).

Problem 4 (10 points) The current USD/euro exchange rate is 1.4000 dollar per euro. The six month forward exchange rate is 1.3950. The six month USD interest rate is 1% per annum continuously compounded. Estimate the six month euro interest rate.

Problem 5 (10 points) The spot price of oil is $80 per barrel and the cost of storing a barrel of oil for one year is $3, payable at the end of the year. The risk-free interest rate is 5% per annum, continuously compounded. What is an upper bound for the one-year futures price of oil?

Problem 6 (20 points) The December Eurodollar futures contract is quoted as 98.40 and a company plans to borrow $8 million for three months starting in December at LIBOR plus 0.5%. (a) What rate can then company lock in by using the Eurodollar futures contract? (b) What position should the company take in the contracts? (c) If the actual three-month rate turns out to be 1.3%, what is the final settlement price on the futures contracts.

Note: Ignore timing mismatches between the cash flows from the Eurodollar futures contract and interest rate cash flows.

Problem 7 (10 points) A Eurodollar futures quote for the period between 5.1 and 5.35 year in the future is 97.1. The standard deviation of the change in the short-term interest rate in one year is 1.4%. Estimate the forward interest rate in an FRA.

Problem 8 (20 points) It is June 25, 2010. The futures price for the June 2010 CBOT bond futures contract is 118-23. (a) Calculate the conversion factor for a bond maturing on January 1, 2026, paying a coupon of 10%. (b) Calculate the conversion factor for a bond maturing on October 1, 2031, paying coupon of 7%. (c) Suppose that the quoted prices of the bonds in (a) and (b) are 169.00 and 136.00, respectively. Which bond is cheaper to deliver? (d) Assuming that the cheapest to deliver bond is actually delivered, what is the cash price received for the bond?