Fight Finance

For a price of $100, Carol will sell you a 5 year bond paying semi-annual coupons of 16% pa. The face value of the bond is $100. Other bonds with similar risk, maturity and coupon characteristics trade at a yield of 12% pa.

A firm is considering a new project of similar risk to the current risk of the firm. This project will expand its existing business. The cash flows of the project have been calculated assuming that there is no interest expense. In other words, the cash flows assume that the project is all-equity financed.

In fact the firm has a target debt-to-equity ratio of 1, so the project will be financed with 50% debt and 50% equity. To find the levered value of the firm's assets, what discount rate should be applied to the project's unlevered cash flows? Assume a classical tax system.

A company runs a number of slaughterhouses which supply hamburger meat to McDonalds. The company is afraid that live cattle prices will increase over the next year, even though there is widespread belief in the market that they will be stable. What can the company do to hedge against the risk of increasing live cattle prices? Which statement(s) are correct?

(i) buy call options on live cattle.

(ii) buy put options on live cattle.

(iii) sell call options on live cattle.

Select the most correct response:

Suppose that the US government recently announced that subsidies for fresh milk producers will be gradually phased out over the next year. Newspapers say that there are expectations of a 40% increase in the spot price of fresh milk over the next year.

Option prices on fresh milk trading on the Chicago Mercantile Exchange (CME) reflect expectations of this 40% increase in spot prices over the next year. Similarly to the rest of the market, you believe that prices will rise by 40% over the next year.

What option trades are likely to be profitable, or to be more specific, result in a positive Net Present Value (NPV)?

Assume that:

• Only the spot price is expected to increase and there is no change in expected volatility or other variables that affect option prices.
• No taxes, transaction costs, information asymmetry, bid-ask spreads or other market frictions.

Suppose the Australian cash rate is expected to be 8.15% pa and the US federal funds rate is expected to be 3.00% pa over the next 2 years, both given as nominal effective annual rates. The current exchange rate is at parity, so 1 USD = 1 AUD.

What is the implied 2 year forward foreign exchange rate?

An economy has only two investable assets: stocks and cash.

Stocks had a historical nominal average total return of negative two percent per annum (-2% pa) over the last 20 years. Stocks are liquid and actively traded. Stock returns are variable, they have risk.

Cash is riskless and has a nominal constant return of zero percent per annum (0% pa), which it had in the past and will have in the future. Cash can be kept safely at zero cost. Cash can be converted into shares and vice versa at zero cost.

The nominal total return of the shares over the next year is expected to be:

The Capital Asset Pricing Model (CAPM) and the Single Index Model (SIM) are single factor models whose only risk factor is the market portfolio’s return. Say a Solar electricity generator company and a Beach bathing chair renting company are influenced by two factors, the market portfolio return and cloud cover in the sky. When it's sunny and not cloudy, both the Solar and Beach companies’ stock prices do well. When there’s dense cloud cover and no sun, both do poorly. Assume that cloud coverage risk is a systematic risk that cannot be diversified and that cloud cover has zero correlation with the market portfolio’s returns.

Which of the following statements about these two stocks is NOT correct?

The CAPM and SIM:

Which of the following statements is NOT correct? Money market securities are:

Suppose that the yield curve in the United States of America and Australia is flat and that the current:

• USD federal funds rate is 1% pa;
• AUD cash rate is 1.5% pa;
• Spot AUD exchange rate is 1 USD per AUD;
• One year forward AUD exchange rate is 0.97 USD per AUD.

You suspect that there’s an arbitrage opportunity.

Which one of the following statements about the potential arbitrage opportunity is NOT correct?

This question is about the Balance of Payments.

Assume that all foreign and domestic assets are either debt which makes interest income or equity which makes dividend income, and vice versa for liabilities which cost interest and dividend payments, respectively.

Which of the following statements is NOT correct?