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Pre-FM exams questions

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2.

3.

4.

SOLUTION:

At expiration, the stock price is 50 and therefore both options are out-ofthe-money; A and B are eliminated.

With a strike price of 45 and a minimum stock price of 46, option A is

never in the money; D is eliminated.

With a strike price of 55, option B will be in the money at the time the

stock price is 58; C is eliminated and E is the answer.

5.

6. Jeff deposits 10 into a fund today and 20 fifteen years later. Interest for

the first 10 years is credited at a nominal discount rate of d compounded

quarterly, and thereafter at a nominal interest rate of 6% compounded

semiannually. The accumulated balance in the fund at the end of 30 years

is 100.

Calculate d.

7. John borrows 10000 for 10 years and uses a sinking fund to repay the

principal. The sinking fund deposits earn an annual effective interest rate

of 5 percent. The total required payment for both the interest and the

sinking fund deposit made at the end of each year is 1445.04.

Calculate the annual effective interest rate charged on the loan.

par to yield a nominal annual rate of 13.66% convertible semi-annually.

The redemption value is what percent of the par value?

9. Jim buys a 10-year bond with par value of 10000 and 8 percent

semiannual coupons. The redemption value of the bond at the end of 10

years is 10500.

Calculate the purchase price to yield 6 percent convertible quarterly.

SOLUTION :

Note: The coupons are paid out semiannually, interest is convertible quarterly,

hence we need to translate it into semiannual interest.

10. Travis purchased a soccer team and financed the purchase with a 15 year

loan.

Interest was charged at 6.00% per annum and payments were made on

an annual basis

with the first payment made one year after the loan was originated.

Travis's principal payment in the 14th year was $73,309.19.

How much interest was paid with the payment in the 4th year?

SOLUTION:

exemplify the use of derivatives as a risk management tool by an

organization in the United States.

a) A commercial airline enters into long future fuel contracts for60% of its fuel needs.

b) An oil firm that will deliver 2 million barrels enters into short forward oil contracts over

the following 18 months.

c) An investment bank enters into long future S&P index contracts given its view that the

index will increase over the next 30 days.

d) A computer manufacturer will make a payment to its German supplier, and enters into a

long future Euro contract.

e)An insurance company investing in floating-rate instruments swaps floating interest rates

for fixed interest rates.

SOLUTION: All but (C) reduce risk by locking in a given result. Answer (C)

involves taking on additional risk.

12.

Additional info :

i)

The total profit from a bear spread created by selling a 40 strike call

and buying a 45 strike call

ii)

The total profit from a bull spread created by buying a 40 strike put and

selling a 45 strike put

iii)

The total profit from a straddle created by selling a 40 strike call and

selling a 40 strike put

iv)

The total profit from a strangle created by buying a 40 strike put and

buying a 45 strike call

4.6% (1-year)

5.3% (2-year)

5.4% (3-year)

payment.

SOLUTION:

14.

SOLUTION:

15. Professor JT receives a perpetuity for his retirement that pays $300 at

the end of year 6, $600 at the end of year 10,

$900 at the end of year 14, with payments continuing to be made every

four years thereafter at an amount equal to $300 more than the

immediately preceding payment.

The present value of the third payment is $535.35.

Calculate the present value of this perpetuity.

SOLUTION:

with payments every 4 years that starts with a payment of $300 in year 6,

and each payment increases by $300.

So, to find the value of the perpetuity, we see that

P = 300, Q = 300 and we have to solve for the 4 year effective rate, i.

We know the present value of the 3rd payment is $535.35.

The 3rd payment is $900, payable at time 14.

So, the present value of that is $900 discounted back for 3.5 four-year

periods.

i equals 16%.

Now, if we use the formula for a perpetuity immediate the present value

at the start of the perpetuity is

That is the value at the start of the perpetuity- that is at time 2 because it

is the value of a perpetuity immediate!

We must discount that back to time zero to get the present value.

That is discount for 2 years, or one-half of a 4 year period.

16.

The current price of a medical companys stock is 75. The expected value

of the stock price in three years is 90 per share. The stock pays no

dividends.

You are also given:

I.

II.

III.

price an investor is willing to enter into the forward.

Determine what can be concluded about X

SOLUTION:

For stocks without dividends and in the absence of transaction costs, the

stocks forward price is the future value of its spot price based on the riskfree interest rate; otherwise there would be an arbitrage opportunity.

Because the risk-free interest rate is positive, the forward price must be

greater than the spot price of 75.

Because these investors are risk-averse (i.e. they prefer not to take risks if

the average rate of return is the same) they need to receive on the

average a greater return than the risk-free interest rate on the shares they

invest in this stock. In other words, they need to receive a risk premium

(incentive) for taking on risk.

The forward price only includes the risk-free interest rate and not the risk

premium, so the forward price is less than the expected value of the

future stock price, namely 90.

17. Gertrude deposits 10,000 in a bank. During the first year, the bank

credits an annual effective rate of interest i. During the second year, the

bank credits an annual effective rate of interest (i 5 percent). At the end

of two years, she has 12,093.75 in the bank.

What would Gertrude have in the bank at the end of three years, if the

annual effective rate of interest were (i + 9%) for each of the three years?

SOLUTION:

years.

Based on an annual effective interest rate of 4%, Andy, the companys

actuary, uses full immunization strategy to construct a portfolio of assets

using a 2-year zero-coupon bond and a 4-year zero-coupon bond.

Calculate the par amount for the 2-year zero-coupon bond assuming full

immunization is met.

For full immunization, the following conditions must hold:

I.

PV(assets) = PV(liabilities)

II.

III.

There is one asset cash inflow before the liability cash outflow, and

one asset cash inflow after the liability cash outflow.

the maximum gain is the future value of the derivatives premium.

Which of the following best describes the situation above?

SOLUTION:

The bond is redeemed at par value of 10,000 at maturity.

How much would the price increase if the yield rate changes to 6.25%

convertible semi-annually?

SOLUTION:

Using your calculator

For Bond A:

N = 40

I/Y = 2.9563 (6% annual effective converted to semi-annual effective)

PMT = 287.50

FV = 10,000

CPT PV = 9810.74

For Bond B, only change needed is the interest rate

I/Y = 3.125

CPT PV = 9433.63

Difference is 9433.63 9810.74 = 377.11

21. Liek enters into a long forward contract. If the spot price at expiration

were S, his payoff would be 20.

If the spot price at expiration were 1.2S, his payoff would be X.

Xin enters into a short forward contract. If the spot price at expiration

were 0.8S, her payoff would be 40.

If the spot price at expiration were 1.1S, her payoff would be Y.

The forward price for both Liek's and Xin's contract is the same.

Calculate X + Y.

SOLUTION:

22. A 10,000 par value 10-year bond with 8% annual coupons is bought

at a premium to yield an annual effective rate of 6%.

Calculate the interest portion of the 7th coupon.

23. The President of SALT Solutions would like to reward his staff by paying

each employee a bonus. The President has informed his staff that the

bonuses totaling 25,000 will be paid on Bonus Day but the exact date is

not given.

In order to fund this bonus payment, the President invests in a zero

coupon bond with a face amount of 20,016 that matures 1 year before

Bonus Day. He also invests in a zero coupon bond with a face amount of

B that matures 5 years after Bonus Day.

Assuming a force of interest of 4%, determine the minimum value for B so

that the investments will be sufficient to pay the bonus on Bonus Day

regardless of the size of interest rate changes.

SOLUTION:

1. PA = PL

2. P'A = P'L

3. The portfolio consists of at least one asset that has a duration shorter

AND longer than the duration for the liability. This condition is met by the

problem, assuming t is positive.

combination of $40-strike call options, $48-strike call options and $50strike call options.

What combination of options should Angus use to create the desired

spread?

SOLUTION:

Therefore, for every K2-strike call we write, we buy 0.2 units of K1-strike call

and 0.8 units of K3-strike call.

In particular, for every 48-strike call that we write, we buy 0.2 units of 40strike calls and 0.8 units of 50-strike calls.

Hence, to create an asymmetric butterfly spread, if Angus writes 10 units

of 48-strike calls, he has to:

years from now. The technique of full immunization is to be employed.

Asset I will provide a cash flow of 300,000 exactly 6 years from now. Asset

II will provide a cash flow of X, exactly y years from now, where y>8.

The annual effective interest rate is 4%. Calculate X.

26.

A three year annual coupon $1000 par bond has a coupon rate of 4%. Use the

yield curve above to find the price P and then use this price to find the yield to

maturity.

N=3

PV = 999.28

PMT = 40

FV = 1000

CPT I/Y = 4.03%

27.

SOLUTION:

28. All of the following are reasons for a corporation not to engage in hedging,

except:

SOLUTION:

29. An insurance company wants to match liabilities of 25,000 payable in one

year and 20,000 payable in two years with specific assets. The following assets

are currently available:

Calculate the smallest amount the company needs to disburse today to purchase

assets that will exactly match these liabilities.

SOLUTION:

The strategy is to use the two highest yielding assets: the one-year

coupon bond and the two-year zero coupon bond.

The cost of these bonds is

30. A perpetuity of $1 each year, with the first payment due immediately, has a

present value of $25 at an annual effective rate of i%. The owner exchanges it

for another perpetuity with the first payment due immediately and subsequent

payments due at two year intervals. What should the payment of the second

perpetuity be, in order to keep the same interest rate, i%, and the same present

value?

SOLUTION:

31. Larry is repaying a loan with payments of $2,500 at the end of every

two years. If the amount of interest in the fourth installment is $2,458,

find the amount of principal in the seventh installment.

Assume an annual effective interest rate of 13%.

SOLUTION:

32. Calculate the nominal rate of interest convertible once every three years

that is equivalent to a nominal rate of discount convertible monthly.

SOLUTION:

Redington immunization.

a) Modified duration may change at different rates for each of the assets and liabilities as

time goes by.

b) Redington immunization requires infrequent rebalancing to keep modified duration of

assets equal to modified duration of liabilities.

c) This technique is designed to work only for small changes in the interest rate.

d) The yield curve is assumed to be flat.

e) The yield curve shifts in parallel when the interest rate changes.

ANSWER:

All are true except B. Immunization requires frequent rebalancing.

34. Sally lends 10,000 to Tim. Tim agrees to pay back the loan over 5

years with monthly payments payable at the end of each month.

Sally can reinvest the monthly payments from Tim in a savings account

paying interest at 6%, compounded monthly. The yield rate earned on

Sallys investment over the five-year period turned out to be 7.45%,

compounded semi-annually.

What nominal rate of interest, compounded monthly, did Sally charge Tim

on the loan?

SOLUTION:

35. On December 31, 1984, Smith borrowed $5,000 to be repaid in four years

with level payments made at the end of every quarter. The first payment was

made on March 31, 1985. The effective annual interest rate was 4%. What was

the amount of interest paid in 1986?

SOLUTION:

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