@o NOT write your name anywhere on this exam booklet) THE UNIVERSITY OF MELBOURNE Department of Finance Faculty of Economics and Commerce Semester 1 Examination, 2004 SUBJECT NUMBER: 333-816 SUBJECT NAME: Financial Markets and Instruments EXAM DURATION: 3 hours READING TIME: 15 minutes TOTAL MARKS: 100 NO. OF PAGES: 22 (including cover page and formulae sheets) Authorised Materials: 1. 2, 3. ‘This exam is CLOSED book. Students are NOT permitted to have any books, notes or other materials in their possession other than the following, Non-programmable calculators are permitted. Calculators with the ability to enter and/or retrieve text are not permitted. Students are PERMITTED to use a foreign language dictionary. Instructions to Invigilators: 1 2) 3 Students may request additional script books. Writing is not permitted during reading time, Please collect this booklet. Instructions to Students: 1 2 3 4, 5, 6. ‘This examination contains THREE SECTIONS for a total of 100 marks. Part A consists of 10 multiple choice questions for a total of 20 marks. Answer all questions. Part B consists of 20 True/False short answer questions for a total of 20 marks. Answer all questions, Part C consists of 6 questions for a total of 60 marks. Answer all questions, Show ail calculations. Answer all questions in the ruled space provided. Do not detach any pages from this booklet Paper to be held by Bailliew Library after 23" July 2004, A B cl cz 7 C3 C4 cs Co TotalTHIS PAGE HAS BEEN LEFT BLANKSection A ‘* Section A contains 10 multiple-choice questions. Attempt ALL questions. . SLEARLY mark your choice in the boxes provided as follows: Xx + If there is any doubt as to which box has been chosen, NO marks will be awarded, AL FEE AL. LILILI & OOO ‘The unbiased expectations hypothesis ignores: 8) Price risk. b) Transaction costs, ©) Reinvestment risk, 4) All of the above The forward exchange rate refers to: a) The exchange rate that is determined at a specified future date, ') The exchange rate that is determined at a specified future date with payment and delivery to occur at that specified future date. ©) The exchange rate that is determined now but with payment and delivery to occur at a specified future date. 4) The expected future spot rate If the AUD/USD exchange rate is USD 0.6800 and the GBP/USD exchange rate is USD 1.6000, the AUD/GBP exchange rate should be: a) GBP 0.4250. b) GBP 0.6800. ) GBP 1.0880. d) GBP 2.3529,Ad, L] a L) A 5 a Which of the following statements about the yield to maturity and eoupon rate for @ coupon- paying corporate bond are true? L_ For bonds selling t par the yield to maturity and coupon rate will be equal, IL For bonds selling at a premium the yield to maturity will be higher than the. coupon rate, IH. For bonds selling at a discount the Yield to maturity will be lower than the coupon rate. 4) Tonly. b) Land H only. ©) Tand IT only. @) L,Mand I. Which of the following statements relating to the constant dividend growth model are false? L. The required rate of return must be greater than the growth rate of dividends, IL. ‘The growth rate of dividends must be greater than zero. U1. The model is ideally suited for valuing high-growth stocks, 8) and I only. ) T and I only. ©) Mand IM only. 4) I, Mand tt, ‘A bull spead is ceated by: a) Buying a call with one exercise price and selling a put with another exercise price. +) Buying a put with one exercise price and selling a call with another exercise price. ©) Buying a call with one exercise price and selling a call with another exercise price. 4) Selling both a put and a call with the same exercise priceThe Reserve Bank of Australia is responsible for which of the following: L._ The implementation of monetary policy. Il, Supervision of the payments system. IL. The prudential supervision of financial institutions. IV, The management of exchange settlement accounts. a) and IM only. ) Mand IM only. ©) I, and IV only. ) Mand If only. Which of the following statements are true? 1, Time value is higher for at-the-money calls than for out- or in-the-money calls, Tl. Time value is higher for longer term calls than for shorter term calls. MI Time value is based on the chance that the option will capture value from future ‘movements in the stock price, TV. Dividend payments do not affect time value. V. The prevailing interest rate is a determinant of time value. a) Land {11 only. b) I, Hand II only. ) 1,1, Ill and IV only, 4) 1,1, 1 and V only.Which of the following group of instruments contains instruments that are all fixed rate derivatives? 8) Options, options on futures, futures. ) Options on futures, forwards, forward rate agreements ©) Futures, forwards, swaps. ) Options, forwards, swaps. ‘The Reserve Bank of Australia (RBA) enters a repurchase agreement with Rogue Bank on Commonwealth Government Securities (CGS) in which the RBA agrees to buy CGS which have a market value of $25,000,000. The prevailing market yield on these bonds is 6 % pa, the coupon rate is 6% p.a and the term to maturity is 12 months exactly, The prevailing cash rate is 4.75% p.a. The term of the repurchase agreement is 5 days. What will be the cash flow from Rogue bank to the RBA (to the nearest dollar)? a) $26,500,000, L LC] 'b) $23,500,000. fl L] ©) $25,016,627. 4) $25,001,027.Section B contains 20 True/False questions. Attempt ALL questions, CLEARLY mark your choice in the boxes provided as follows: If there is any doubt as to which box has been chosen, NO. marks will be awarded. BL B2. BS. BG, By. If the unbiased expectations hypothesis is correct investors will be indifferent to bond yields on various maturities. Sia = If interest rates in the US are higher than interest rates in Singapore then the Singapore dollar should be selling at a forward premium, In the constant dividend growth model, g refers to the growth rate in past dividends. ce ae] Rights issues are more commonly used in the US than in Australia, True False [| ‘The notion that long-term bond yields include risk premiums is generally supported by empirical evidence. Covered interest arbitrage describes the movement of funds between two currencies to profit from interest rate differences, In recent times, the amount of Treasury bonds on issue has fallen because of increased investor preference for short-term securities. True [| True [I True False All else being the same, the price-eanings ratio of a stock will increase if the retention rate decreases, True FalseOne implication of the liquidity premium theory is that the yield curve should slope upwards ‘more often than downwards feel Fate ig Power parity states that the expected change in the exchange rate between two ‘is due to differences in expected interest rates in the respective countries. False (BL Finance companies are not financial intermediaries because they do not take deposits True False [ Since the early 1980s the increase in asset values has been more significant than net earnings in the growth of superannuation funds. True False L Mortgage securitisers are not deposit-taking institutions and are therefore not considered ‘competitors to banks. True False U Mutual funds achieve higher returns for investors through the benefits of diversification, True False ‘An increase in the interest rate causes the premiums on put and call options to decrease, tme [| False Counterparties to an interest rate swap face default te [ ] False U* UU A position in the underlying security can be synthetically replicated by buying a put option and selling a call option ($ = P - C). True False LU -neutral’ hedge means to hedge 100% of your exposure. LU FalseB19. Alll other things equal, the premium on a call option is higher when the exercise price is higher. i ee eee The liabilities of a defined benefit superannuation find are guaranteed by the sponsor. a aaSection C [60 marks} + Section C consists of § questions. Attempt ALL questions. ‘+ For full credit you must clearly show ALL your calculations, including formulas used. (Question C1 R42+3= Assume that you purchase a 180-day bank bill with a face value of $1,000,000 at 7% pa. a) How much would you pay to purchase the bank bill? Show all calculations. if you held the bill for 60 days and then sold it at a yield of 8% p.a. what amount would you receive? Show all calculations. ‘What (annual) rate of return have you eared over this holding period? Show all calculations.(Question C2 [3+ 7=10 marks] a) You observe that one AUD is worth USD 0.6700, one CAD is worth AUD 0.9600 and one USD is worth CAD 1.5700. Are there any arbitrage opportunities available to currency traders? If yes, then indicate what specific arbitrage can be conducted and the percentage profit that can be made by the trader. If not, explain why not. Show all calculations. Suppose that the riskfree interest rates in Australia and Japan are 6% p.a. and 2% paa., respectively, The AUD/JPY spot rate is 70.00 and the AUD/JPY one-year forward rate is 68.00, Do any arbitrage opportunities exist? If so, explain what these arbitrage opportunities are and outline the steps you would take to exploit them. Calculate the arbitrage profit that you could eam on AUD 1,000,000, or its JPY equivalent. If no arbitrage opportunities exist then explain why they do not exist. Show all ealeulations,Question C. Suppose the term structure of Treasury bond rates is as follows, Tyear spot rate 2-year spot rate 3-year spot rate year spot rate What are the respective one-year forward rates implied by the above information? Show all calculations. ‘What is the two-year forward rate, one year from now, implied by the above information? Show all calculations. ©) What is the three-year forward rate, one year from now, implied by the above information? ‘Show all calculations,Question C4 [6 marks} ASL Ltd is experiencing a period of rapid growth. Earnings and dividends are expected to grow at a rate of 20% p.a. during the next two years, at 15% p.a. in the third year, and at a constant rate of 8% P.a. thereafter. ASL’s most recent dividend per share was $1.00, and the required rate of return on the stock is 12% p.a. Estimate the price at which ASL Ltd’s stock should be selling today. Show all calculations.[Question C5 [4+3+444=15 marks] 4) Briefly outline the functions of the clearinghouse in the futures market, 4b) lori Dog Food Lid takes a 3/6 FRA to hedge a loan for $10 million. The FRA has a fixed rate of 8.4% p.a. On the settlement date, the reference rate is 7.8% p.a. Deseribe the settlement in detail. What is the effective borrowing rate for Glori Dog Food Ltd?You are the fund manager of a share portfolio worth $10 million. The beta of the portfolio is 1.1 In 4 weeks you will be selling 20% of your portfolio. At present SPI futures are quoted at 3125. How can this position be hedged in the futures market? What is the total cost of the hedge? Show all calculations.@) Under the terms of a swap, a financial institution has agreed pay 6-month LIBOR and receive 8% p.a (with semiannual cash flows) on a notional principat of $100 million. The swap has a remaining life of .75 years. The relevant discount rates with continuous compounding for 3- ‘month, 6-month, and 9-month maturities are 10% p.a, 10.5% p.a and 10.75% pa respectively. ‘The 6-month LIBOR rate at the last payment date was 10.2% p.a. What is the value of the swap? Show all calculations. ”Question C6 [443 +3+5=15 marks] Davey Bank has the following balance sheet (in $ millioris) and has no off-balance-sheet activities: ASSETS Sm| LIABILITIES Cash 20] Deposits Treasury notes 20] Subordinated debentures 60 Residential mortgages 800} Provision for bad debts 2 Other loans 900] Common stock 40 Fixed Assets, 2| Retained earnings 10 Total Assets 1,742| Total Liabilities and Equity 1,742 Use the data in this balance sheet to answer the following questions. ) Does Davey Bank satisfy the prudential regulations for capital adequacy? Show all calculations.b) An extremely valued customer inherits $10 million dollars and deposits the funds at Davey Bank. Given the current balance sheet, how would you recommend Davey Bank invest the $10 million? Explain, ©) During the current financial year Davey Bank has reported a profit of $261 million but has announced that no dividend will be paid. Using only the information provided in the balance sheet above, explain this decision,Over the past decade Davey Bank has reduced its interest rate spreads from a peak of 5% points down to 2.7 % points. However, during the same time Davey's profitability has increased. 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