FINM7006Final Prac Exam 3VIP

THE AUSTRALIAN NATIONAL UNIVERSITYSCHOOL OF FINANCE AND APPLIED STATISTICSSecond Semester Study Time: 15 minutes Writing Time: 180 minutesPermitted materials: Non-Programmable CalculatorDictionaryINSTRUCTIONS:1. This exam paper comprises a total of 5 pages. Please ensure your paper has the correct number of pages.2. The exam includes a total of 6 questions. The questions are of unequal value, with marks indicated for each question. You must attempt to answer all questions.3. Do not round calculations until providing your final answer to each question. Final answers should be rounded to 2 decimal places.4. Include all workings for each question, as marks will not be awarded for answers that do not include workings.5. Ensure you include both your name and student number on your answer book. Papers without this information will NOT be marked, with a zero mark awarded for such scripts. Total Marks = 60The exam counts towards 60% of your grade for the courseQuestion 1Students are to answer ALL parts of this question:a) Find the price of a 9%, $100 Commonwealth Government bond with exactly 6 and one quarter years to maturity given a required rate of return of 6% p.a.b) What are the four major types of corporate bonds? Be sure to provide a brief description of each one.1. Bank Accepted Bills Bank Accepted Bills are similar to T notes. The payment of the face value at maturity is guaranteed by the accepting bank. They are short-term zero coupon bonds and thus the only cash flow is the face value received at maturity. Typical maturities are 90 days and 180 days; 2. Mortgage bonds These bonds are secured by real property such as real estate or buildings. In the event of default the property can be sold and the bond holders repaid;3. Debentures These are coupon bonds. In the event of liquidation of the corporation, debenture holders are paid out in priority to stockholders; and,4. Convertible bonds These are bonds which can be exchanged for stock in the corporation.Question 2Students are to answer ALL parts of this question:After successfully completing Money Markets and Finance, you have decided to start your own investment portfolio. Although you know you should invest in many different companies to take advantage of the benefits of diversification, you have insufficient funds. As such, you have decided to invest your money in David Jones and Rio Tinto. The table below details some information for both stocks:StockDavid JonesRio TintoExpected Return (%)1211Variance (%2)10081Additionally, you know that the correlation between these two stocks is 1. Given this information, calculate the following:a) What weights would you need to hold of David Jones and Rio Tinto shares in order to obtain an expected return of 11.25% on your portfolio?b) What is the standard deviation of the portfolio comprising David Jones and Rio Tinto in the weights calculated in a)?c) What are the minimum variance portfolio weights for a portfolio comprising David Jones and Rio Tinto? Discuss the meanings of the weights you have calculated.The weights mean that 900% of the monies invested should be obtained from short selling shares in David Jones, with the resulting 1000% invested in Rio Tinto.Question 3Plasma Ltd, makers of plasma televisions, is considering also making DVD players. They have the choice of two machines with which to make the DVD players, and both could do the job adequately. They have called upon you to assist them in deciding whether Machine A or Machine B should be purchased. Both machines are to be depreciated straight line down to a book value of zero over their entire useful life. Despite this, it is anticipated that Machine A will be sold for $8,000 and Machine B for $12,000 at the end of their useful lives. Details of each projects cash flows are tabulated below:Machine AMachine BCost$450,000$624,000Pre-Tax Net Annual Inflow(these cash flows occur at the end of the year)$160,000$210,000Machine Life10 years12 yearsIn addition to the cash flow information, you have also been provided with the following details: The corporate tax rate is 30%; Tax is payable annually in arrears (ie tax is paid on profits one year after it is earned); The project is in an industry which is 15% less risky than the industry in which the firm currently operates; Plasma Ltd currently has a beta of 1.7; The market risk premium is 10% p.a.; and, The expected return on the market is 18% p.a.Given this information, which machine, if any, do you recommend Plasma Ltd purchase? In providing your answer, explain why you have made your recommendation.Now, as the projects have different lives, we must calculate the EA of each:As project B has the higher EA, it is appropriate that Plasma Limited should purchase Machine B.Question 4Students are to answer ALL parts of this question:a) Calculate the required rate of return for a risky asset whose correlation with the market is 0.85, given the standard deviation of the asset is 8% p.a., the standard deviation of the market is 11% p.a., the expected return on the market is 9% p.a. and the risk free rate is 5% p.a.b) Draw the graphical depiction of the relationship described by the Capital Asset Pricing Model. Be sure to clearly label the diagram.c) In a large portfolio, what is the appropriate measure of risk for an individual asset? Why is this so?The variance of a well-diversified portfolio like the market is equal to the average covariance of the assets in the portfolio. That is, the variance of a large portfolio is simply the average covariance between the pairs of individual stocks. Therefore, the contribution of an individual asset to the risk of the portfolio will be through its contribution to the average covariance of the portfolio. Thus the appropriate measure of the risk of an individual asset i is .Question 5 Students are to answer ALL parts of this question:a) Draw payoff diagrams for a long position in a forward contract and a short position in a futures contract. Be sure to clearly label both diagrams. b) Draw the profit diagrams for a long position in a European put option, and a short position in a European call option. Be sure to clearly label both diagrams. c) You have the following information regarding European options written on Telstra. Using this information, discuss whether put-call parity holds in this instance? If it doesnt, indicate what strategy you would implement on taking advantage of any arbitrage opportunity and the profit you would earn from your strategy (Note: You are required to provide a table outlining the initial and terminal values of your strategy). A Telstra share is currently selling for $9 in the market place. A 10-month European call option contract on Telstra with a strike price of $8 is priced at $2. A 10-month European put option contract on Telstra with a strike price of $8 is priced at $1.50. The risk-free rate of interest is 8% p.a. compounded quarterly.First, see if put call parity holds:r=(1+0.08/4)4 - 1=8.243216%Therefore, as put call parity does not hold, there is an arbitrage strategy available. As the left hand side of the equation is worth less than the right hand side, the strategy is: Buy the European call; Sell the European put with the same exercise price and maturity date; Short sell the underlying stock; and invest the present value of the exercise price. The table is which indicates the profit earned is below:PositionInitial ValueTerminal ValueIf ST$20If ST $20Buy call-$2.00(ST-$8)0Sell put$1.500-($8-ST)Short sell stock$9-ST-STInvest $8(1.08243216)10/12 -$7.48988Net Portfolio Value$1.011$0$0Hence, the riskless profit that may be earned from this strategy is $1.011.d) Suppose an American put option on Coles Myer stock struck at $9.00 is currently selling for $0.50, and the current stock price is $8.35. How can a straightforward arbitrage be executed? How would you answer change if it were a European put option with exactly the same cost and strike price? An arbitrage can be executed by buying the option, buying the stock, and immediately exercising the option. The cost of the option and the stock is $8.85 per share, and each share is sold for $9.00 when the put option is exercised, yielding an immediate profit of $0.15 per share.Question 6Students are to answer ALL parts of this question:You are the Chief Financial Officer for a major Australian mining company called ABC Mining. As a result of the booming commodity prices over the last year, your company is expecting to have a surplus of almost $20 million cash on hand at the end of September. The Board of Directors of ABC Mining wants you to invest the cash for a period of 90 days. The September 90-day BAB futures contract is currently trading at 92. Given this information, answer all three of the following questions: a) Advise the Board of ABC Mining how they can lock in an interest rate, and show that the strategy works if interest rates rise or fall. 1. First, ABC Mining wants to ensure that they can BUY 90-day BABs at the end of September. As each BAB is for a notional $1million, we want to ensure that ABC Mining can purchase 20 90-day BABs at the end of September with an interest rate of 8%.2. In order to do this, ABC Mining will purchase (take a long position) in 20 September 90-day BAB futures contracts which are trading at 92. This will cost ABC Mining:90 days later, ABC Mining will receive back $20million.3. Now, suppose that in December the 90-day BAB interest rate turns out to be 10% p.a. The amount ABC Mining will pay when they buy the 20 90-day BABs is:The loss on the futures position is:The net amount paid for the BABs the $19,518,716.58 paid for the BABs plus the $94,392.65 loss on the futures which equals $19,613,111.23. This is equivalent to purchasing a BAB with an interest rate of 8%.4. Now, suppose that in December the 90-day BAB interest rate turns out to be 6% p.a. The amount ABC Mining will pay when they buy the 20 90-day BABs is:The gain on the futures position is:The net amount paid for the BABs the $19,708,423.33 paid for the BABs less the $95,312.10 gain on the futures which equals $19,613,111.23. This is equivalent to purchasing a BAB with an interest rate of 8%.Hence, with the above, we have shown that regardless what happens to interest rate, ABC Mining have locked in an interest rate of 8% p.a. which they will receive from purchasing the BABs.b) How could ABC Mining take advantage of any favourable movements in interest rates, while insuring that they are protected against adverse movements? Again, be sure to show that strategy works if interest rates rise or fall. 1. First, ABC Mining wants to ensure that they can BUY 90-day BABs at the end of September. As each BAB is for a notional $1million, we want to ensure that ABC Mining can purchase 20 90-day BABs at the end of September with an interest rate of at least 8%.2. In order to do this, ABC Mining will purchase (take a long position) in 20 September 90-day BAB call futures options contracts which are trading at 92. 3. Now suppose that in December the interest rate has fallen to 6% p.a. The amount ABC Mining will pay to purchase the 20 90-day BABs is:Furthermore, ABC Mining would elect to exercise the call option