THE UNIVERSITY OF MELBOURNE THE UNIVERSITY OF MELBOURNE SEMESTER ONE 2000 DEPARTMENT CENTRE OF FINANCIAL STUDIES SuBJECT NUMBER 306 -816 SuBsect TITLE FINANCIAL MARKETS & INSTRUMENTS EXAM DURATION : 3 HOURS READING TIME : 15 MINUTES THIS PAPER HAS : 11 PAGES Authorised Materials: A. This exam is CLOSED book. ‘Students are NOT permitted to have any books, notes or other ‘materials in their possession other than: (= Caleutators, provided they are silent and battery operated. Trucions To Tnigator 1._No.writing is permitted during reading time. Seay See Eso352 2 306-816 Semester 1, 2000 THIS PAGE HAS BEEN LEFT BLANK INTENTIONALLY3 306-816 Semester 1, 2000 ANSWER ALL QUESTIONS. SHOW ALL WORKINGS. Question One (@) Distinguish between direct and indirect (intermediated) finance. (b) Explain the role a financial institution may play in direct finance. (©) You are given the following market yields for Commonwealth Government Securities: 30 day T-note 5.5% pa 1 year bond 5.9%pa 2 year bond 6.0% p.a 3 year bond 6.5% pa. 5 year bond 75% pa (@ Draw the yield curve implied by this data Gi) Discuss the assumptions of the unbiased expectations hypothesis and how it can explain the shape of the yield curve in part (i). (ii) Derive the 1 year forward rate assuming there is no liquidity premium. (@+3+5=10 marks) Question Two Consider the following information Strike Price $6.00 Standard Deviation 20% Continuously compounded risk free interest rate 5% Time to maturity (months) 3 Stock price $6.00 * One share underlies each option’s contract (@) Is the option in the money, out of the money ot at the money? (6) Determine the fair price of the call option. (©) A put option on the same stock with the same characteristics of the call option is trading at $0,202. (@ Draw the payoff diagram of a portfolio consisting of a short position in both the call and put option. (Use call price calculated in Part B) Gi) Under what circumstances will the strategy yield a profit. (Answers exceeding 5 lines will not be graded) (1 +4+5=10 Marks)4 306-816 Semester 1, 2000 Question Three Consider the following information Stock Price ‘$12 Continuously compounded risk free interest rate % (2) Calculate the price of a forward contract on one share with 9 months to maturity. (®) Determine the current value of the forward contract. (©) Name the strategy that will generate an arbitrage profit if the forward price is $15, @ Show all cash flows (now and at maturity) per contract if the strategy is implemented and the profit made at maturity. (441+ 144 =10 Marks) Question Four ‘Under the terms of the swap, a financial institution has agreed to pay 6-month LIBOR and receive 4%p.a (with semi-annual compounding) on a notional principal of $500 million. The swap has a remaining life of 16 months. The relevant discount rates with continuous compounding for 4-month, 10-month and 16-month maturities are 6%, 6.5% and 7% respectively. The 6-month LIBOR rate at the last payment was 5%, (@) Is the financial institution long or short in the above swap? (©) Compute the value of the swap. (1+9=10 Marks) Question Five Part One Consider the following information The Commonwealth Govemment of Australia through its agent the Reserve Bank of Australia (RBA) wants to raise $120 million through the issue of Treasury Bonds. The outcome of the competitive bids given below:5 306-816 Semester 1, 2000 investors Yields (%) Bids (S Millions) | _Alioiment ($ Millon) L A 4 30, 30, B 5 35, aa Cc 6 25 25 D 7 30 i0 Sub-Total 120 100 RBA = : 20 Total = : 120 The RBA makes a $100 million available for competitive bids and the remaining $20 million is taken by the RBA. (a) Compute the yield at which the RBA take up the $20 million of Treasury Bonds. Part Two (a) The price of a $1000 face value, 6%p.a coupon paying bond is $700.75. Determine the bond’s yield to maturity. (©) Do bond-rating institutions determine the interest rates paid by corporate borrowers? (Answers exceeding 10 lines will not be graded) (4 +3+3=10 marks) Question Six Consider the following information on company A: Price Earnings Ratio 40 Required Rate of Return 1% Retention Rate 20% (@) The market price of company A’s stock is $94.5. Determine the company A’s earnings per share if dividends are expected to grow at 5%p.a. in perpetuity. (®) Determine the value of company A’s stock if the required rate of return increases to 10%p.a. (Use the eamings per share computed in Part (a)). (©) Determine the price of company B has no growth prospects and pays all its earnings as dividends. Company B's price earnings ratio and earnings per share is the same as. company A. (Use information about company A from Part (a)). (@ Explain the relevance of the terms SEATS and CHESS in the Australian Stock Market (ASX). (Answers exceeding 10 lines will not be graded). (3 +2+2+3=10 Marks)306-816 Semester 1, 2000 Question Seven Consider the following balance sheet: Assets Cash CGS > 12 months loans to local government small business loans corporate loans Off balance sheet assets letter of credit to a corporate Liabilities and Sharcholders Funds Deposits certificates of deposit subordinated debt (assume perpetual) perpetual floating rate notes provision for doubtful debts share premium reserve general reserve issued capital 50 20 600 600 1275 10 800 400 10 10 5 10 15 25 1275 (@)__ Briefly explain the role of the balance sheet item “issued capital” in prudential regulation. () Assume the bank has no market risk. Does the bank satisfy the Australian Prudential Regulatory Authority guidelines for capital adequacy? Show all workings. (©) The bank has now calculated its market risk exposure as a VAR of $2 million, How does this affect its capital adequacy? (@ How might the bank improve its capital adequacy? Question Eight (2+4+24+2=10 marks) (@) __ Describe the usual roles of the acceptor, discounter and holder-in-due-course of a bill of exchange. (b) — Whatare the normal terms applying to ‘11.00am money’? What factors will affect the interest rate offered? (©) Whats the price of a 90-day bill of exchange with a face value of $100,000 if the yield is 6.5% p.a.? If the purchaser then sells the bill 30 days later at which time its7 306-816 Semester 1, 2000 yield is 11.30% p.a., what effective annual interest rate has been earned? Show all workings. (“A promissory note will always have a higher yield than a treasury note”. Is this statement true or false? Explain (© Bank Parkview is facing a liquidity shortage. It enters a 3-day repurchase agreement with the Reserve Bank of Australia on 15 June 2000 on Commonwealth Government Securities. The securities have a face value of $20 million, 10% p.a. coupon rate (paid semi-annually and a coupon has just been paid) and mature in 4 years. The prevailing cash rate is 5.75% p.a. What are the cash flows for each part of the repurchase agreement? Show all workings, (2+243+2+3=12 marks) Question Nine (@) Assume the buy/sell spread is zero and there are no transaction costs. You observe the following information on Australia and Paradiseland: Spot rate: SA1 = $P1.4715 L-month SA interest rate: 0.6% per month 1-month SP interest rate: 0.5% per month ‘Use interest rate parity to calculate the 1-month forward rate. Explain your result. If Australian interest rates increased to 0.7% per month, what would the forward rate become? Explain your result. (6) Asa football manufacturer you are excited to have gained a contract to sell footballs to Foreignland. You have asked the Victorian Bank of Australia for a quote on the 3- month forward rate on “foreigns” (the currency of Foreignland) and have received the following reply: Spot rates: 4.6220/90 3 months forward margin: 227/237 The footballs will be delivered in 3 months time. You agree to sell F 6,500,000 in 3 months’ time. How much AUD will you get? Explain briefly how and why you chose the exchange rate you did. (4+ 4=8 marks) Question Ten (@) _ Anissue of mortgage backed securities is based on a pool of mortgages with a face value of $200 million dollars and a fixed interest rate of 9% p.a. In this environment the transaction costs associated with refinancing are 1.5% of the principal amount. Draw the prepayment function and compare the price/yield relationship for fixed interest and mortgage-backed securities.o ort a 8 306-816 Semester 1, 2000, ) © Consider a mortgage pool with principal of $10 million. The maturity is 20 years with ‘a monthly mortgage payment of 10% p.a. The insurance fee is 60 basis points per annum and the servicing fee 40 basis points per annum, Assume no prepayments. ‘What is the monthly payment on the pass-through security? Show all workings. ‘What types of transactions are generally classified as high-value and what types are generally classified as low value in a payments system, (4+4+2=10 marks) *End of examination* *9 306-816 Semester 1, 2000 FORMULAE SHEET ' 1 _i-(1+r)* m= (1+r)! r 2 3. 4 5, 6 1 8. 9. 0 Ge 0 YSpsX SX ifS;>X Pr= X-Sr ‘fSrpSX o Sp>X oi FV=Ae™ 12, C=S.N(d,)- Xe". N(d,) s oa Ha) a ovT ° 8 I+i, ff _E(s)_ 1+E(p,) Ute eS 5 V+ E( Paw ) 14. P= FV(( +1/100x1/365) d,=d,-oJT10 306-816 Semester 1, 2000Table for N(x) When x < 0 306-816 Semester 1, 2000 0.0016 oot