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Question 56 income and capital returns, bond pricing, premium par and discount bonds

Which of the following statements about risk free government bonds is NOT correct?

Hint: Total return can be broken into income and capital returns as follows:

###\begin{aligned} r_\text{total} &= \frac{c_1}{p_0} + \frac{p_1-p_0}{p_0} \\ &= r_\text{income} + r_\text{capital} \end{aligned} ###

The capital return is the growth rate of the price.
The income return is the periodic cash flow. For a bond this is the coupon payment.

Question 69 interest tax shield, capital structure, leverage, WACC

Which statement about risk, required return and capital structure is the most correct?

(a) The before-tax cost of debt is less than the before-tax cost of equity. Therefore debt is a cheaper form of financing than equity so companies should try to finance their projects with debt only.

(b) Debt makes a firm's equity more risky. Therefore the higher the amount of debt, the higher the cost of equity.

(c) The more debt a firm has, the higher its tax shields. Therefore firms should seek to have as much debt and as little equity as possible.

(d) The more debt, the lower the firm's after tax WACC. The after tax WACC is the discount rate that discounts the firm's cash flows, so the lower it is the more the firm is worth. Therefore firms should try to make their after tax WACC as low as possible by using as much debt as possible.

(e) The less debt, the lower the chance of bankruptcy. Therefore firms should try to pay off all of their debt so that they are financed by equity only.

Question 219 profitability index

A project has the following cash flows:

Project Cash Flows
Time (yrs)	Cash flow ($)
0	-90
1	30
2	105

The required return of a project is 10%, given as an effective annual rate. Assume that the cash flows shown in the table are paid all at once at the given point in time.

What is the Profitability Index (PI) of the project?

Question 292 standard deviation, risk

Find the sample standard deviation of returns using the data in the table:

Stock Returns
Year	Return pa
2008	0.3
2009	0.02
2010	-0.2
2011	0.4

The returns above and standard deviations below are given in decimal form.

Question 614 debt terminology

Question 827 future, basis risk, no explanation

You intend to use futures on oil to hedge the risk of purchasing oil. There is no cross-hedging risk. Oil pays no dividends but it’s costly to store. Which of the following statements about basis risk in this scenario is NOT correct?

Question 902 Basel accord

Below is a table of the 'Risk-weights for residential mortgages' as shown in APRA Basel 3 Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk January 2013.

LVR (%)	Standard eligible mortgages		Non-standard eligible mortgages
	Risk-weight (no mortgage insurance) %	Risk-weight (with at least 40% of the mortgage insured by an acceptable LMI) %	Risk-weight (no mortgage insurance) %	Risk-weight (with at least 40% of the mortgage insured by an acceptable LMI) %
0 – 60	35	35	50	35
60.01 – 80	35	35	75	50
80.01 – 90	50	35	100	75
90.01 – 100	75	50	100	75
> 100.01	100	75	100	100

A bank is considering granting a home loan to a man to buy a house worth $1.25 million using his own funds and the loan. The loan would be standard with no lenders mortgage insurance (LMI) and an LVR of 80%.

What is the minimum regulatory capital that the bank requires to grant the home loan under the Basel 3 Accord? Ignore the capital conservation buffer.

Question 930 arbitrage table, future, no explanation

A non-dividend paying stock has a current price of $20.

The risk free rate is 5% pa given as a continuously compounded rate.

A 2 year futures contract on the stock has a futures price of $24.

You suspect that the futures contract is mis-priced and would like to conduct a risk-free arbitrage that requires zero capital. Which of the following steps about arbitraging the situation is NOT correct?

Question 941 negative gearing, leverage, capital structure, interest tax shield, real estate

Last year, two friends Lev and Nolev each bought similar investment properties for $1 million. Both earned net rents of $30,000 pa over the past year. They funded their purchases in different ways:

Lev used $200,000 of his own money and borrowed $800,000 from the bank in the form of an interest-only loan with an interest rate of 5% pa.
Nolev used $1,000,000 of his own money, he has no mortgage loan on his property.

Both Lev and Nolev also work in high-paying jobs and are subject personal marginal tax rates of 45%.

Which of the below statements about the past year is NOT correct?

Question 956 option, Black-Scholes-Merton option pricing, delta hedging, hedging

A bank sells a European call option on a non-dividend paying stock and delta hedges on a daily basis. Below is the result of their hedging, with columns representing consecutive days. Assume that there are 365 days per year and interest is paid daily in arrears.

Delta Hedging a Short Call using Stocks and Debt

Description	Symbol	Days to maturity (T in days)
		60	59	58	57	56	55
Spot price ($)	S	10000	10125	9800	9675	10000	10000
Strike price ($)	K	10000	10000	10000	10000	10000	10000
Risk free cont. comp. rate (pa)	r	0.05	0.05	0.05	0.05	0.05	0.05
Standard deviation of the stock's cont. comp. returns (pa)	σ	0.4	0.4	0.4	0.4	0.4	0.4
Option maturity (years)	T	0.164384	0.161644	0.158904	0.156164	0.153425	0.150685
Delta	N[d1] = dc/dS	0.552416	0.582351	0.501138	0.467885	0.550649	0.550197
Probability that S > K at maturity in risk neutral world	N[d2]	0.487871	0.51878	0.437781	0.405685	0.488282	0.488387
Call option price ($)	c	685.391158	750.26411	567.990995	501.487157	660.982878	?
Stock investment value ($)	N[d1]*S	5524.164129	5896.301781	4911.152036	4526.788065	5506.488143	?
Borrowing which partly funds stock investment ($)	N[d2]K/e^(rT)	4838.772971	5146.037671	4343.161041	4025.300909	4845.505265	?
Interest expense from borrowing paid in arrears ($)	rN[d2]K/e^(r*T)		0.662891	0.704985	0.594994	0.551449	?
Gain on stock ($)	N[d1]*(SNew - SOld)		69.052052	-189.264008	-62.642245	152.062648	?
Gain on short call option ($)	-1*(cNew - cOld)		-64.872952	182.273114	66.503839	-159.495721	?
Net gain ($)	Gains - InterestExpense		3.516209	-7.695878	3.266599	-7.984522	?

Gamma	Γ = d^2c/dS^2	0.000244	0.00024	0.000255	0.00026	0.000253	0.000255
Theta	θ = dc/dT	2196.873429	2227.881353	2182.174706	2151.539751	2266.589184	2285.1895

In the last column when there are 55 days left to maturity there are missing values. Which of the following statements about those missing values is NOT correct?