Corporate Finance Test #3 (Ch. 20, 21, 23, 24, 26, 27)
The value of N(d), which is used in the Black-Scholes model, can take any value between
0 and +1.
Which of the following rated bonds has the least risk?
AAA
Which of the following statements regarding American puts is/are true?
An American put can be exercised any time before expiration. All of the options are true. An American put is always at least as valuable as an equivalent European put. A multiperiod binomial model can be used to value an American put.
Four investors enter into long sugar contracts. Three are speculators and one is hedging. Which of the following is hedging?
Cereal company
A $1,000 face value bond can be exchanged any time for 25 shares of stock. Then the conversion price is
Conversion price = 1,000/25 = $40.
Which of the following bonds is typically not secured?
Debenture
If a government were to seize the assets of a multinational company and not provide adequate compensation to its owners, the government would be following which practice?
Expropriation
The spot peso/$US exchange rate is peso 10.9892/$US. The three-month forward rate is peso 11.0408/$US. What is the peso's forward premium (or discount) on the U.S. dollar, expressed as an annual percentage?
Forward (premium or discount) = 4[(10.9892/11.0408) - 1] = -1.9% = 1.9% discount.
What is the most important difference between a corporate bond and an equivalent U.S. Treasury bond?
In the case of corporate bonds, firms have sometimes defaulted, whereas the U.S. government has not.
Chapter 23
McGraw Hill Connect
Chapter 24
McGraw Hill Connect
Chapter 26
McGraw Hill Connect
Assume that international capital markets are competitive and that global real interest rates are the same. The one-year interest rate is 9 percent in the United States and 5 percent in Switzerland. If the expected inflation rate is 6 percent in the United States, what is the expected inflation rate in Switzerland?
Real interest rate = [1.09/1.06] -1 = 2.83%; Inflation rate = [1.05/1.0283] - 1 = 2.1%.
The beta of a firm's equity in Switzerland is 1.25. The risk-free rate is 4 percent and market risk premium is 8.4 percent. Calculate the required rate of return for the equity of this firm.
Required return = 4 + (1.25)(8.4) = 14.5%.
Briefly explain the term conversion premium.
The conversion premium is the difference between the conversion price and stock price expressed as a percent of stock price. Suppose the stock price is $25 and the conversion price is $45. Then the conversion premium is (45 - 25)/25 = 80 percent. This shows that the conversion price is 80 percent higher than the stock price.
What are the four basic types of contracts or instruments used in financial risk management?
The four basic types of contracts or financial instruments used in financial risk management are forwards, futures, options, and swaps.
From a geometric viewpoint, how is the position diagram for a put option related to the diagram of a call option on the same stock having the same exercise price and maturity?
The mirror image of the call diagram, reflected around the exercise price
When estimating the cash flows and NPV for a foreign project, there is no need to forecast exchange rates for the life of the project.
True
One can describe a forward contract as agreeing today to buy a product
at a later date at a price set today.
The difference between the value of a call option and the stock price less the exercise price is greatest when the option is
at the money.
The term [N(d2) × PV(EX)] in the Black-Scholes model represents the
bank loan
Insurance companies, by issuing Cat bonds (catastrophe bonds), share their risks with
bond investors.
Generally, you can insure corporate bonds through a(n)
credit default swap.
The recovery rate on defaulting debt is the least for the following type of debt:
junior subordinated bonds.
If a Big Mac costs $C3 in Canada and $2.31 in the United States, according to purchasing power parity, what is the implied exchange rate in terms of $C/$US?
$C/$US = 3/2.31 = 1.2987.
If the standard deviation of the continuously compounded returns on the asset is 30 percent and the interval is a year, then the downside change is equal to
(1 + downside change) = [1/e^(0.3)] = 1/1.3498, or (1 + downside change) = 1/1.34982 = 0.74 or downside change = -26%.
If the standard deviation of the continuously compounded returns on the asset is 40 percent and the interval is a year, then the downside change is equal to
1 + downside change = 1/(e^(0.4 × 1.0)) = 1/1.4918 = 0.67032; downside change = -32.96%.
The median total debt ratio (Total debt/(total debt + equity in %) for industrial firms with an A rating is
38.6 percent.
Define the term call option.
A call option is defined as a right, but not an obligation, to buy an underlying asset at a fixed price during a specified period of time.
Which of the following bonds is secured by assets?
A mortgage bond
In general, which of the following statements is (are) true?
Bonds issued in the United States are registered and Eurobonds are normally issued in a major currency (e.g., $US, euro, or yen).
The holders of ZZZ Corporation's bonds with a face value of $1,000 can exchange that bond for 35 shares of stock. The stock is selling for $25. What is the conversion value of the bond?
Conversion value = 35 × 25 = $875.
Which of the following is the most sensible reason for issuing convertibles?
Convertibles are convenient and flexible-they're usually unsecured and subordinated, and cash requirements for debt service are relatively low.
Bonds rated BBB (Baa) and above are called junk bonds.
False
Which of the following statements about forwards, futures, and options is correct?
Forward contracts and futures contracts are economically similar, but vary greatly in how they are traded.
The spot price for home heating oil is $0.55 per gallon. The futures price for one year from now is $0.57. If the risk-free rate is 6 percent per year, what is the net convenience yield?
Futures price = spot price x (1 + rf - net convenience yield). 0.57 = 0.55 x (1 + 0.06 - net convenience yield); net convenience yield = +0.0236.
Chapter 20
McGraw Hill Connect
Suppose Ralph's stock price is currently $50. In the next six months it will either fall to $30 or rise to $80. What is the option delta of a call option with an exercise price of $50?
Option delta = (30 - 0)/(80 - 30) = 30/50 = 0.6.
If the discount rate on a bond is 7 percent and the expected payment in year 1 is $952.50, calculate the price of the bond.
PV = 952.50/(1.07) = 890.19.
The spot USD/GBP exchange rate is USD1.99/GBP. What is the indirect quote?
Spot rate: 1/(1.99) = GBP 0.5025/USD.
An 8 percent debenture has five years of call protection and is thereafter callable at 100 percent, except that it is nonrefundable below interest cost. Which of the following statements is correct?
The debenture may not be called during the next five years.
Suppose an investor buys one share of stock and a put option on the stock. What will be the value of her investment on the final exercise date if the stock price is below the exercise price? (Ignore transaction costs.)
The exercise price
What are the three elements of convertible bond value?
The value of a convertible bond is determined by straight bond value, conversion value, and the option value. Value of a convertible bond = higher of [straight bond value, conversion value] + option value. The straight bond value and the conversion values provide the floor for the convertible bond value.
For financial futures, Futures price = (spot price)/(1 + rf - y)^t.
True
In addition to bearing risk, insurance companies also bear
administrative costs, moral hazard costs, and adverse selection costs.
Firms often bundle up a group of assets and then sell the cash flows from these assets in the form of securities. They are called
asset-backed securities.
According to SEC Rule 144A,
bonds issued through private placements can be bought and sold by institutional investors and SEC registration is not needed for privately placed bonds.
A put option gives the owner the right
but not the obligation to sell an asset at a given price.
Buying a call option, investing the present value of the exercise price in T-bills, and short-selling the underlying share is the same as
buying a put.
If you write a put option, you acquire the right to buy stock at a fixed strike price.
False
Chapter 21
McGraw Hill Connect
Which of the following are included in the typical bond indenture?
The basic terms of the bond, details of the protective covenants, sinking fund arrangements, and call provisions
Project finance is extensively used in developing countries to finance
power projects. telecommunications projects. transportation projects. All of the options are correct.
Define the term credit risk.
Credit risk or default risk is the risk that payments on a security will not be made under the original contract terms.
Most of the world's largest companies use derivatives to manage risk.
True
One should use a multiperiod binomial model to evaluate an American put option because the Black-Scholes formula does not allow for early exercise.
True
Consider the following data for a European option: Expiration = 6 months; Stock price = $80; Exercise price = $75; Call option price = $12; Risk-free rate = 5 percent per year. Using put-call parity, calculate the price of a put option having the same exercise price and expiration date.
Value of put = value of call - share price + PV of exercise price = 12 - 80 + 75/(1.05^0.5) = 12 - 80 + 73.19 = $5.19.
Hedging contracts on a futures exchange eliminates
counterparty risk.
If the one-year spot interest rate is 6 percent and the two-year spot interest rate is 7 percent, calculate the one-year forward interest rate one year from today.
Forward interest rate = ((1.07)^2/1.06) - 1 = 8%.
The Black-Scholes formula represents the option delta as
N(d1).
Briefly explain the expectations theory of forward exchange rates.
The expectations theory of exchange rate states that the forward rate equals the expected future spot rate.
What does an equity option's delta reflect?
The number of shares needed to replicate one call option
Briefly explain the term option delta.
The option delta is the ratio of spread of possible option prices to the spread of possible share prices. This is also known as the hedge ratio.
Briefly explain the restrictive covenants in a bond indenture.
The restrictive covenants, also called protective covenants, are placed in the bond indenture to protect the bondholders' interests. There are two types of covenants, negative and positive (affirmative). Negative covenants limit or prohibit the company from taking certain actions like paying huge dividends to stockholders. Affirmative covenants specify certain duties on the company. These have to be exhaustive, as courts have held that only written covenants count.
In bearing risk, what disadvantages do insurance companies face?
There are three major disadvantages faced by insurance companies in bearing risk. They are • administrative costs. • adverse selection. • moral hazard.
A knock-in barrier option might be used if the investor is looking to reduce the cost of buying a call option.
True
One can describe a currency forward contract as
agreeing today to buy or sell a specified amount of a currency at a later date at a price set today.
Suppose you buy a call and lend the present value of its exercise price. You could match the payoffs of this strategy by
buying the underlying stock and buying a put.
The trust company for a bond issue represents the
firm's bondholders.
The price for immediate delivery of a commodity is called the
spot price.
All else equal, as the underlying stock price increases,
the call price increases.
For European options, the value of a call plus the present value of the exercise price is equal to
the value of a put plus the value of a share.
A derivative is a financial instrument whose value is determined by
the value of an underlying asset.
Privately placed loans are advantageous because
there is direct contact with the lender and renegotiations can be handled more easily.
Currency risk exposure can be categorized as
transaction exposure. economic exposure. None of these options are correct. All of these options are correct.
The value of a call option is positively related to the following:
underlying stock price, risk-free rate, time to expiration, and volatility of the underlying stock price.
All else equal, if the volatility (variance) of the underlying stock increases, then the
value of both a put option and a call option increase.
If the volatility of the underlying asset decreases, then the
value of both the put and call option will decrease.
Warrants are sometimes issued
with private placement bonds, to investment bankers as compensation, to creditors in the event of bankruptcy, and to common stockholders.
The spot yen/$US exchange rate is yen119.795/$US, and the one-year forward rate is yen114.571/$US. If the annual interest rate on dollar CDs is 6 percent, what annual interest rate would you expect on yen CDs?
1 + rYen = (114.571/119.795)(1 + r$US) = 1.01377; rYen = 1.38%.
Use the following data: ROA = 10%; Total liabilities = 90% of assets; EBITDA = 10% of liabilities. Calculate the relative chance of failure using the following model: Log (relative chance of failure) = -6.445 - 1.192 ROA + 2.307 (liabilities/assets) - 0.346(EBITDA/liabilities).
1.09 percent
Explain how a firm wishing to invest in floating-rate investments can use a swap to manage its interest rate exposure?
A firm desiring a floating-rate investment but with a comparative advantage in obtaining a fixed-rate investment can invest in a fixed-rate investment and then enter into a swap arrangement with a counterparty to exchange the fixed rate of return for a floating-rate return.
Your firm operates an oil refinery and is therefore naturally short on crude oil. You buy offsetting oil market futures to hedge your natural position. Shortly thereafter, local pipelines were damaged in a recent earthquake, leaving you with the highest local crude oil prices in decades. Simultaneously, unexpectedly high recent production from Mexico, Brazil, and the Baltic Sea has driven down the global price of crude and your financial hedge has lost you millions. You have fallen victim to what kind of risk?
Basis risk
Briefly describe bond ratings.
Bond ratings are a qualitative measure of a bond's default risk. Moody's, Standard & Poor's, and Fitch assign these ratings for a fee. AAA (S&P) or Aaa (Moody's) rated bonds have the least default risk. Bonds rated BBB (Baa) and above are known as investment-grade bonds. Bonds rated below BBB (Baa) are known as junk bonds as these have much higher default probabilities.
In general, which of the following statements is true?
Bonds issued in the United States pay interest semiannually, while bonds issued in other countries pay interest annually.
The Mexican economy is predicted to average double-digit inflation over the next two years at 10 percent per year. The inflation forecast for the United States for the same period is 4 percent per year. If the current exchange rate is $0.091/peso, what is the expected exchange rate two years from now?
E(Spot) = (0.091)[(1.04/1.10)^2] = $0.08134/peso.
A corporate bond matures in one year. The bond promises a $50 coupon and a principal payment of $1,000 at maturity. If the bond has a 15 percent probability of default and payment under default is $400, calculate the expected payment from the bond.
Expected payment = 1,050(0.85) + 400(0.15) = $952.50.
The spot exchange rate for British pounds is 0.5025 (GBP/USD). The one-year risk-free rates in the United States and Britain are 3 percent and 2.75 percent, respectively. What is the forward exchange rate in GBP/USD?
F = (0.5025)(1.03/1.0275) = 0.5013.
An increase in exercise price results in an equal increase in the call option's price.
False
As you increase the time per interval in a binomial model, the result will approach the Black-Scholes model.
False
It is extremely rare for a corporate bond to have a higher expected yield than a government bond.
False
Position diagrams and profit diagrams are one and the same.
False
The Black-Scholes model is a discrete time model.
False
The difference between the price of callable and noncallable bonds is greatest when bond prices are lowest.
False
The option delta for a put option is always positive.
False
The term bearer bond refers to bonds that bear little interest via coupon payments.
False
The true cost of hedging foreign currency risk is the difference between the forward rate and today's spot rate.
False
Briefly explain the term marked to market.
Futures contracts are marked to market. This means that each day any profit or loss on the contract is calculated. At the end of each day, the investor's margin account is adjusted to reflect the day's profit or loss. If the margin account falls below a prespecified "maintenance margin," then the investor is asked to deposit sufficient funds to bring the margin account up to the maintenance margin. In case the investor has profits, he or she can withdraw funds from his or her margin account.
Suppose that the current level of the S&P 500 Index is 1,100. The prospective dividend yield is 3 percent, and the current risk-free interest rate is 7 percent. What is the value of a one-year futures contract on the index? (Assume all dividends are paid at the end of the year.)
Futures price = 1,100 x (1 + 0.07 - 0.03) = 1,144.
What is the difference between hedging, speculation, and arbitrage?
Hedging consists of using financial instruments or contracts to reduce or eliminate the risk from fluctuating interest rates, exchange rates, and/or commodity prices. The purpose of speculation is to profit from a change in future rate or price and not to offset some preexisting risk. Arbitrage is the process of buying in one market and simultaneously selling in another market in order to earn a risk-free profit, in theory.
Briefly explain why a currency forecast is not necessarily required when a multinational firm estimates the cash flows from an international project?
If the firm can hedge its foreign currency exposure from the cash flows generated from an international project, then there is no need to forecast exchange rates for future cash flows. The project NPV can be calculated using the appropriate discount rate, and the NPV in a different currency can be found by converting the foreign-currency-valued NPV using the current spot rate.
A call option has an exercise price of $150. At the option expiration date, the stock price could be either $100 or $200. Which investment would combine to give the same payoff as the stock?
Lend PV of $100 and buy two calls. (Value of two calls: 2(200 - 150) = 100 or value of two calls = 2(100 - 150) = 0 (not exercised); payoff = 100 + 100 = 200, or payoff = 0 + 100 = 100.)
Chapter 27
McGraw Hill Connect
The three main bond rating agencies in the United States are
Moody's, Standard and Poor's, and Fitch.
XJ Company from the United States is evaluating a proposal to build a new plant in the United Kingdom. The expected cash flows in pounds are as follows: Year 0, -50; Year 1, 25; Year 2, 35; Year 3, 40. The discount rate in BP is 14 percent and the discount rate in the $US is 12 percent. The spot rate is $US1.99/BP. Calculate the NPV in $US.
NPV = -50 + (25/1.14) + (35/1.14^2) + (40/1.14^3) = 25.86 in BP. (25.86)(1.99) = 51.46.
Commercial banks and several other financial institutions are not permitted to invest in bonds unless they are investment grade. What is the definition of an investment-grade bond?
One with a rating of Baa or better.
Suppose VS's stock price is currently $20. In the next six months it will either fall by 50 percent or rise by 50 percent. What is the current value of a call option with an exercise price of $15 and expiration of one year? The six-month risk-free interest rate is 5 percent (periodic rate). Use the two-stage binomial method.
Risk-neutral valuation: 20 = [x (30) + (1 - x)(10)]/1.05; x = 0.55 and (1 - x) = 0.45. Call option price in six months = C6 = [(30 × 0.55)/(1.05)] = 15.714. Call option price now = (15.714 × 0.55)/1.05 = 8.23. $8.23
What is a major drawback to value-at-risk calculations?
The calculation of value at risk requires a level of subjective input. The firm must determine the confidence level of the risk measurement as well as the time frame being covered. A firm requiring a VAR at the 99 percent confidence level over a one-day time period is much more risk averse than a firm requiring a VAR at the 95 percent confidence level over one month. During the financial crisis of 2008, sophisticated financial firms were criticized for their inability to forecast the risks in their portfolios.
Briefly explain what is meant by protective put.
The combination of a stock and a put option is known as a protective put. It effectively provides insurance against a declining stock price. The exercise price of the put option provides a floor to investment in the stock. The cost of this insurance is the price of the put option.
Suppose an investor sells (writes) a put option. What will happen if the stock price on the exercise date exceeds the exercise price?
The owner will not exercise the option.
A call option has an exercise price of $100. At the exercise date, the stock price could be either $50 or $150. Which investment strategy provides the same payoff as the stock?
The payoff of two calls equals Lend PV of $50 and buy two calls if stock price is $150, 2(150 - 100) = 100, or Lend PV of $50 and sell two calls if stock price is $50, value of two calls: 2(0) = 0 (not exercised). Total payoff including repayment of loan equals Lend PV of $50 and buy two calls, 100 + 50 = 150, or Lend PV of $50 and sell two calls, 0 + 50 = 50. Total payoff is the same as the stock's payoff. Note that this question discusses the replication of the stock's payoff, not the replication of the option's payoff.
What is wrong with the following news report? "Today the dollar ended the trading session stronger."
The phrase is incomplete. The dollar cannot end stronger if we do not know against which currencies. It is likely that the dollar will end the trading day stronger against some currencies and weaker against others. The statement, as presented, needs more detail to be correct. However, most statements of this type imply that the dollar strengthened against a majority of the major currencies. To be more precise, there needs to be an explicit weighting mechanism to determine the strengthening/weakening of the dollar.
Briefly explain put-call parity.
The relationship between the payoffs of a European call option and the payoffs of an equivalent put option is called put-call parity. In particular, the payoff of owning a European call option and the present value of the exercise price equals the payoff of owning both the underlying stock and an equivalent put option. Since the payoffs of these two positions are the same, the cost to establish these two positions must therefore also be the same. If put-call parity does not hold, then investors have an arbitrage opportunity.
All else equal, which of the following features will increase the value of a convertible bond?
The risk-free interest rate is higher. The conversion ratio is higher. The conversion price is lower. All of the features increase the value.
Discuss the factors that determine the value of a call option.
The value of a call option is determined by five factors. They are stock price, exercise price, risk-free interest rate, volatility of the stock price, and time to expiration. An increase in exercise price will decrease the value of the option. An increase in any of the other factors will increase the value of the option.
Briefly explain the term transaction exposure.
This is the risk that exchange rate movements would change the amount received or payment to be made in a foreign currency between the time a transaction is contracted and the time it is fulfilled. Corporate treasurers can easily identify and hedge transaction exposure using the forward market, options market, or money market.
A company that wishes to lock in an interest rate on future borrowing can either enter into a forward rate agreement (FRA) or it can borrow long-term funds and lend short term.
True
Affirmative covenants impose certain duties on the company.
True
All else equal, the closer an option gets to expiration, the lower the option price.
True
An American call option gives its owner the right to buy stock at a fixed strike price during a specified period of time.
True
An option holder is not entitled to any dividends paid on the underlying stock.
True
Bonds issued in the United States are usually registered.
True
Buying a stock and a put option and lending the present value of the exercise price provide the same payoff as buying a call option.
True
Convertible bonds can also have a call feature.
True
Disadvantages faced by insurance companies in bearing risk include administrative costs, adverse selection, and moral hazard.
True
For a European option, Value of put = (value of call) - share price + PV (exercise price).
True
For a European option: Value of call + PV(exercise price) = Value of put + Share price.
True
For a project's cost of capital measured in Swiss francs, one should use Swiss interest rates and beta with respect to Swiss market.
True
Futures contracts are usually marked to market.
True
Generally, promised yields are at least as great as expected yields.
True
In general, the countries with the highest interest rates also have the highest inflation rates.
True
In the forward exchange market, currency is traded for future delivery.
True
Interest rate parity gives the relationship between the forward rate and the spot rate of exchange in terms of interest rates.
True
It is possible to replicate an investment in a call option by a levered investment in the underlying asset.
True
Suppose that the possibility of default on a firm's bond is totally unrelated to other events in the economy. In this case, the beta of the bond will equal zero and the discount rate will equal the risk-free rate.
True
The strength of a currency is directly related to its interest rate and inflation expectations.
True
The value of a call option increases as the risk-free interest rate increases.
True
The value of a risky bond equals asset value - value of call option on assets.
True
If the value of d2 is -0.5, then the value of N(d2) is
Use the Cumulative Probabilities of the Standard Normal Distribution Table. NORMSDIST(-0.5) = 0.3085.
Suppose VS's stock price is currently $20. A six-month call option on VS's stock with an exercise price of $15 has a value of $7.14. What is the price of an equivalent put option? The six-month risk-free interest rate is 5 percent per six-month period.
Using put-call parity, the value of the put = 7.14 + 15/(1.05) - 20 = $1.43.
The relationship between the spot and futures prices of financial futures is given by
[Futures price] = Spot price x (1 + rf - y)^t (where y = dividend yield or interest rate).
Corporations often have the right to repurchase a debt issue prior to maturity at a fixed price. Such debt issues are said to be
callable.
In a "total return swap," the underlying asset(s) might be a
common stock, loan, commodity, and market index.
The holder of a $1,000 face value bond has the right to exchange the bond any time before maturity for shares of stock priced at $50 per share. The $50 is called the
conversion price.
Firms regularly use the following to reduce risk:
currency options, interest-rate options, and commodity options.
A call option with an exercise price of $50 expires in six months, has a stock price of $54, and has a standard deviation of 80 percent. The risk-free rate is 9.2 percent per year annually compounded. Calculate the value of d2.
d2 = 0.4967 - 0.8(0.5^0.5) = -0.0690.
Long-term bonds that are unsecured obligations of a company are called
debentures.
The U.S. government agrees to guarantee a bond issue planned by Demurrage Associates (DA). The value of this guarantee
equals the value of the guaranteed loan minus the value of the loan without a guarantee, is a subsidy to DA's equity investors, and equals the value of a put option on the firm's assets with an exercise price equal to the bond's promised payments.
The value of a put option is positively related to the
exercise price, time to expiration, and volatility of the underlying stock price.
When a standardized forward contract is traded on an exchange, it becomes a(n)
futures contract.
An organized market for currency for future delivery that conducts trades on an exchange is called a(n)
futures market.
The writer (seller) of a regular exchange-listed put-option on a stock
has the obligation to buy 100 shares of the underlying stock at the exercise price.
The owner of a regular exchange-listed put-option on a stock
has the right to sell 100 shares of the underlying stock at the exercise price.
The following are various types of secured debt:
mortgage bonds, collateral trust bonds, and equipment trust certificate only.
The written agreement between a corporation and its bondholders contains a limitation on the dividends that the corporation can pay. This limitation is a
negative covenant.
PIKs are
pay-in-kind bonds.
The risk associated with unanticipated actions by the host country government or its courts towards a multinational firm is called
political risk.
Generally, convertible bonds are issued by
smaller and more speculative firms.
A "samurai bond" is a bond
sold in Japan by a company from some other country.
A "foreign" bond is a bond
sold to investors in the local market but issued by a company from some other country.
For lookback options,
the option holder chooses as the exercise price any of the asset prices that occurred before the final date.
Put-call parity can be used to show
the precise relationship between put and call option prices, given equal exercise prices and equal expiration dates.
An important aspect of international finance includes
the process of foreign exchange valuation of different currencies.
Insurance companies have some advantages in bearing risk. These include
the superior ability to estimate the probability of loss, extensive experience and knowledge about how to reduce the risk of a loss, and the ability to pool risks and thereby gain from diversification.