In 1990, the French bank, BNP, issued exchangeable bonds denominated in French
francs (FF). These are bonds issued for FF 100 on April 1, 1990, with an annual coupon
of FF 5, plus an exchange right. The bonds can be redeemed for FF 100 on April 1,
1996. The right can be exchanged on
April 1, 1991, with payment of an additional FF 100, for another bond identical to the
old bond (annual coupon of FF 5 and redeemed for FF 100 on April 1, 1996). If you
exercise your right, you will have paid an additional FF 100 on April 1, 1991, but you
will then hold two BNP bonds with maturity in 1996.
a. Under what scenario would you exercise the exchange right (exchange the right plus
FF 100 for an additional bond) on April 1, 1991? What is the attraction of such an
exchangeable bond for investors?
b. On April 1, 1990, the yield curve is flat at 6%. You can buy a call on a five-year bond
with a coupon of 5%. The call has a strike price of 100% and expires on April 1, 1991.
Its premium is 2%. Construct a replication portfolio to determine at what price the
exchangeable bond can be issued by BNP.
You consider investing in an emerging market. Its stock market volatility (standard
deviation of returns measured in U.S. dollars) is 25%. The volatility of the World index
of developed markets is 15%. The correlation between the emerging market and the
World index is 0.2.
a. What would be the volatility of a portfolio invested 95% in the World index and 5%
in this emerging market?
b. Compare the result found in the previous question with the volatility of the World
index and give an intuitive explanation.
Under a system of fixed exchange rates, a nation can try to remedy its balance of
payments deficit by:
a. Applying expansionary macroeconomic policy to drive prices up and interest rates
down.
b. Applying restrictive macroeconomic policy to keep prices down and interest rates up.
c. Reducing its income from investments abroad.
d. Building up its reserves of foreign currencies and reserve balances with the
International Monetary Fund.
Which of the following characteristics of financial markets are good for investors?
I. Availability of timely and accurate information.
II. Liquidity.
III. Large bid-ask spreads.
IV. Rapid price adjustment to new information.
a. I and IV only.
b. II and III only.
c. I, II, and IV only.
d. I, II, III, and IV.
In March 1993, the Student Loan Marketing Association (Sallie Mae) issued five-year
notes with a coupon set at 4.5% in the first year and reset quarterly subsequently. The
floating quarterly coupon rate was set to be the higher of either 4.125% or 50% of the
rate on ten-year Treasury notes plus 1.25%. At time of issue, the interest rates for all
maturities were well below 4%, and investors were attracted by the high current yield
(4.5%) compared to other straight bonds available.
Assume that in March 1994, interest rates have risen dramatically and that the U.S.
Treasury yield curve is now flat at 7% for all maturities.
a. What is the new coupon rate set on the Sallie Mae bond?
b. Why is the Sallie Mae bond now trading at a hefty discount?
Under a system of fixed exchange rates, a nation experiencing an excess of imports
over exports can try to remedy this situation by:
a. Adopting tariffs and quotas.
b. Reducing its income from investments abroad.
c. Applying an expansionary macroeconomic policy to drive prices up and interest rates
down.
d. Building up its reserves of foreign currencies and reserve balances with the
International Monetary Fund.
The annualized performance, in U.S. dollars, of the U.S. and European stock indices
are:
ReturnUS = 10%
US = 16%
Returneurope = 11%
europe =18%
Correlation = 0.60
a. What would be the return and risk of a portfolio invested half in the U.S. market and
half in the European index?
b. What if the correlation increases to 0.8?
Paf is a country with a fixed exchange rate with the U.S. dollar, set at 0.9 pifs per dollar.
The Paf government intends to defend this central parity but has no exchange controls;
it can only use an interest rate policy to defend its national currency, the pif. The pif
comes under severe speculative devaluation pressures because of a drop in the official
reserves of Paf. The current (annualized)
one-month interest rates are 18% for the pif and 6% for the dollar.
a. What type of borrowing/lending action could you take to try to take advantage of a
devaluation of the pif?
b. How much would you stand to lose if Paf is successful in defending its currency?
c. How much would you stand to gain if the pif is devalued to 1 pif per dollar within the
next month?
Which of the following statements about the Macaulay duration of a zero-coupon bond
is true? The Macaulay duration of a zero-coupon bond:
a. Is equal to the bond’s maturity in years.
b. Is equal to one-half the bond’s maturity in years.
c. Is equal to the bond’s maturity in years divided by its yield-to-maturity.
d. Cannot be calculated because of the lack of coupons.
To capitalize on your expectation of a 10% gold price appreciation, you consider buying
futures or option contracts to speculate. The spot price of gold is $400. Near-delivery
futures contracts are quoted at $410 per ounce with a margin of $1,000 per contract of
100 ounces. Call options on gold are quoted with the same delivery date. A call with an
exercise price of $400 costs $20 per ounce. The rate of return on your speculation will
be the return on your invested capital, which is the initial margin for futures and the
option premium for options.
a. Based on your expectation of a 10% rise in gold price, what is your expected return at
maturity on futures contracts?
b. Based on your expectation of a 10% rise in gold price, what is your expected return
at maturity on option contracts?
c. Simulate the return of the two investments for various movements in the price of
gold.
Discuss the differences between a par and a discount Brady bond.
a. Take the viewpoint of the emerging country.
b. Take the viewpoint of the bondholder.
A Swiss portfolio manager has a significant portion of the portfolio invested in
dollar-denominated assets. The money manager is worried about the political situation
surrounding the next U.S. presidential election and fears a potential drop in the value of
the dollar. The manager decides to
sell the dollars forward against Swiss francs.
a. Give some reasons why the Swiss money manager should use futures rather than
forward currency contracts?
b. Give some reasons why the Swiss money manager should use forward currency
contracts rather than futures?
The current dollar yield curve on the dollar international bond market is flat at 7% for
top-quality borrowers. A company of good standing can issue plain-vanilla straight and
floating-rate dollar bonds under the following conditions:
·Bond A: Straight bond. Five-year straight dollar bond with a coupon of 7.25%.
·Bond B: FRN. Five-year dollar FRN with a semiannual coupon set at LIBOR plus
0.25% and
a cap of 14%. The cap means that the coupon rate is limited to 14% even if the LIBOR
passes 13.75%.
An investment banker proposes to a French company to issue bull and/or bear FRNs
under the following conditions:
·Bond C: Bull FRN. Five-year FRN with a semiannual coupon set at: 13.75% – LIBOR.
·Bond D: Bear FRN. Five-year FRN with a semiannual coupon set at: 2 x LIBOR – 7%
and a cap of 20.5%.
Coupons on all bonds cannot be negative. The investment bank also proposes a
five-year floor option at 3.5%. This floor will pay to the French company the difference
between 3.5% and LIBOR, if it is positive, or zero if LIBOR is above 3.5%. The cost of
this floor is spread over the payment dates andset at an annual 0.1%. The investment
bank also proposes a five-year cap option at a strike of 13.75%. The cost of this cap is
spread over the payment dates and set at an annual 0.05%. The company can also enter
into a five-year interest rate swap at 7% fixed against LIBOR.
a. Explain why it would be attractive to the French company to issue these FRNs
compared to current market conditions for plain-vanilla straight bonds and FRNs.
b. Find out the borrowing cost reduction that can be achieved by issuing bull notes
compared to a fixed-coupon rate of 7.25%.
c. Find out the borrowing cost reduction that can be achieved by issuing bear notes
compared to an FRN at LIBOR plus 0.25%.
A corporation rated AA issues a five-year FRN Eurobond in euros on November 1,
2005. The coupon is paid quarterly and is equal to euro-LIBOR plus a spread of ½ %.
On November 1, the three-month euro LIBOR is at 4%. The issuer remains rated at AA
during the life of the bond.
a. Three months later (February 1, 2006), the three-month euro-LIBOR has moved to
4.5%, and the market-required spread for AA borrowers has remained at ½ %. What
should the value of the bond on reset date be?
b. Three months later (May 1, 2006), the three-month euro-LIBOR is still at 4.5%, but
the market-required spread for AA borrowers has increased to ¾%. Give some
estimation of the new value of the FRN on the reset date.
Thailand limits foreign ownership of Thai companies to a maximum percentage of all
the shares issued. The limit in 2002 was generally 49%, but could be lower for some
industries or firms. Once a company has reached this limit, it starts to be traded on two
different boards. Foreigners trade on the Alien Board, while, Thai investors must still
trade in the same share on the Main Board. Thai investors are allowed to purchase
shares on the Alien Board, but not to sell them. Main and Alien Board shares are
identical in all other respects.
a. Why does this segmentation ensure that the limit on foreign ownership is respected?
b. Shares listed on the Alien Board trade at a fairly large premium over their Main
Board counterparts. Give some likely explanations.
An analyst is evaluating a real estate investment project using the discounted cash flow
approach.
The net purchase price is $10 million, which is financed 20% by equity and 80% by a
five-year mortgage loan. The loan carries an interest rate of 7%. Annual interest
expenses on the $8 million loan are $560,000 and the loan is repaid in full after the fifth
year.
The net operating income for the first year is estimated at $800,000 and is expected to
grow annually at a 3% growth rate. Using straight-line depreciation over 50 years, the
annual tax depreciation of the real estate project is equal to $200,000. It is expected that
the property will be sold in five years
(just after the end of the fifth year) at a net price of $11 million.
The marginal income tax rate for this project is 30%. The capital gains tax rate is 20%.
The investor’s cost of equity for projects with level of risk comparable to this real estate
investment project is 15%.
a. Compute the after-tax cash flows resulting from the operating income for each of the
first
five years.
b. Compute the after-tax cash flow for the fifth year, taking into account the resale
value.
c. Compute the expected net present value (NPV) of the project and its internal rate of
return (IRR).
d. State whether the investor should decide to invest in the project.
e. Compute the expected NPV and IRR of the project if the resale price is expected to
be only
$10 million.
f. State whether the investor should decide to invest in this project under this new
scenario.
A Dutch institutional investor has decided to bet on a drop in U.S. dollar bond yields. It
engages in a leveraged strategy, borrowing $100 million at LIBOR plus 0.25% and
investing the proceeds in attractive, newly issued, long-term dollar international bonds.
Suddenly, the investor becomes worried that bond yields have hit bottom and will rise
because of inflationary pressures. The investor wishes to keep the specific international
bonds that have been selected, partly because of their attractiveness and partly because
of their lack of market liquidity. What kind of swap could be arranged to hedge this
U.S. dollar bond yield risk?
You believe that the U.S. dollar will strongly appreciate against the euro in the next few
weeks. What action can you take?
Should real interest rates be equal across countries? Can a financial arbitrage take place
in case of significant and persistent real interest rate differences? To this question:
a. First assume that exchange rates are fully predictable and follow purchasing power
parity (PPP).
b. Then assume that they are uncertain but that PPP holds.
c. Finally, assume that exchange rates are uncertain and that PPP does not hold.
A foreign exchange trader quotes the dollar value of one euro as = 1.1510-1.1520.
These are direct bid-ask rates for a New York trader. What would be the implicit
indirect
quotes for ?
Should nominal interest rates be equal across countries? Why or why not?
You are a French institutional investor and wish to buy 1,000 shares of General Motors.
Your U.S. broker quotes 45-45 ¼, with a commission of 0.20% of the transaction value.
Your bank quotes the rate at 1000-1100 net. What would be your total cost in euros?
A money manager holds $50 million worth of top-quality international bonds
denominated in dollars. Their face value is $40 million, and most issues are highly
illiquid. She fears a rise in U.S. interest rates and decides to hedge, using U.S. Treasury
bond futures. Why would it be difficult to achieve a perfect hedge (list the various
reasons)?