EC3214: FINANCIAL ECONOMICS II

Answer ALL the questions

Question 1

Why is credit rating of corporate bonds important for credit analysts and investors? How can discriminant analysis be helpful? (5 marks)

Question 2

A bond’s ask price is quoted at 99.125 by a trading platform. The Par Value is £1,000,000; the coupon rate is 3% per annum, and this bond makes two payments per year. The last payment was made 60 days ago and there are 180 days per semi-annual period. Calculate the price that an investor will pay for the bond. (5 marks)

Question 3

Explain the mechanics and market behaviour behind the fact that short term and medium zero strips were selling well above par value across Europe at the beginning of 2020. What has corrected this anomaly in early 2022? (5 marks)

Question 4

The prices of zero-coupon bonds with various maturities are given in the following table below. Suppose that you want to construct a 3-year maturity forward loan commencing in 2 years. The face value of each bond is £1,000.

Maturity (Years) Price (£)

1 900

2 880

3 820

4 750

5 660

Demonstrate how you can construct a synthetic forward loan today, using only the bonds given above in the table. Assume you are the borrower. Demonstrate all your transactions. What are the cash flows on this strategy in each year?

What is the effective 3-year interest rate on the effective 2-year-ahead forward loan? Write out what the effective 3-year forward interest rate equals in terms of forward rates obtained from the table above. (10 marks)

Question 5

The fact that we detect a liquidity premium in the yield curve must mean that short term investors outnumber long term investors in the market. Assess this statement and discuss the implications for the term structure of interest rates. (10 marks)

Question 6

A young person starting university will be paying £9,250 in tuition expenses at the end of each of the next three years. Bonds currently yield 5% per annum.

a)What is the present value, and duration of the prospective student’s obligation? (5 marks)

b)What maturity zero coupon bond would immunize this obligation? What would be the total Par value of such a zero (or portfolio of zeros)? (5 marks)

c)Suppose the student can buy a zero-coupon bond with value and duration equal to that obligation. Now suppose that rates immediately rise to 7.5%per annum. What happens to the net position? (this is the difference between the value of the bond and that of the tuition obligation). (5 marks)

Question 7

A trader sells two July futures contracts on gold. Each contract is for the delivery of 100 oz of gold. The current futures price is $600 per oz, the initial margin is $15,000 per contract, and the maintenance margin is $12,000 per contract. What price change would lead to a margin call? Explain. Under what circumstances could $1,000 be withdrawn from the margin account? (5 marks)

Question 8

Suppose that the risk-free rate is 6% p.a. with continuous compounding and that the dividend yield on a stock index is 4% p.a. The index is standing at 400, and the futures price for a contract deliverable in 3 months is 405. Identify the arbitrage opportunity, and demonstrate how you make a profit from this. (5 marks)

Question 9

A European call expires in six months and has a strike price of £30. It is currently selling at £1. The underlying stock is priced at £28, and does not pay any dividends.

The term structure is flat and all risk free interest rates are 0% per annum, continuously compounded.

What is the theoretical price of a European put option that expires in six months and has a strike price of £30? Demonstrate the methodology used. Explain carefully the arbitrage opportunities if the European put is actually trading at £2. (10 marks)

Question 10

A trader wants to form a position by combining two different European calls and two different European puts. The calls have the same expiration dates but have different strike prices. The trader sells one call with strike price of £48 at a price of £1.50, and buys one call with strike price of £50 at £1.00. He buys one put at a strike price of £48 at £0.50 and sells one put at a strike price of £50 at £2.50. Demonstrate how to graph the profits from this spread strategy by first producing a profits table, and then sketching the graph. (15 marks)

Question 11

A stock currently sells at £100 and can either increase to £120 or decrease to £90 in one year’s time. Assume the risk-free interest rate is 10% per annum. There is a European call option on the stock with strike price of £110 that expires in one year.

Calculate the price of the call today using the replicating portfolio method. (5 marks)

Question 12

Two corporate giants, ABC and XYZ have been offered the following rates per annum on a $100 million five-year loan:

ABC requires a floating-rate loan while XYZ requires a fixed-rate loan.

Identify and explain the comparative advantage in this situation. In the absence of an intermediary, ABC would have swapped LIBOR with XYZ for a fixed rate. Design a swap that will net a bank, acting as intermediary, 0.1% per annum and that will appear equally attractive to both companies. (10 marks)