# Fight Finance

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You deposit cash into your bank account. Have you or your money?

You deposit cash into your bank account. Have you or debt?

You deposit cash into your bank account. Does the deposit account represent a debt or to you?

You owe money. Are you a or a ?

You own a debt asset. Are you a or a ?

You are owed money. Are you a or a ?

A bank bill was bought for $99,000 and sold for$100,000 thirty (30) days later. There are 365 days in the year. Which of the following formulas gives the simple interest rate per annum over those 30 days?

Note: To help you identify which is the correct answer without doing any calculations yourself, the formulas used to calculate the numbers are given.

On 27/09/13, three month Swiss government bills traded at a yield of -0.2%, given as a simple annual yield. That is, interest rates were negative.

If the face value of one of these 90 day bills is CHF1,000,000 (CHF represents Swiss Francs, the Swiss currency), what is the price of one of these bills?

You want to buy an apartment priced at $300,000. You have saved a deposit of$30,000. The bank has agreed to lend you the $270,000 as a fully amortising loan with a term of 25 years. The interest rate is 12% pa and is not expected to change. What will be your monthly payments? Remember that mortgage loan payments are paid in arrears (at the end of the month). You want to buy an apartment worth$500,000. You have saved a deposit of $50,000. The bank has agreed to lend you the$450,000 as a fully amortising mortgage loan with a term of 25 years. The interest rate is 6% pa and is not expected to change.

What will be your monthly payments?

You want to buy an apartment worth $400,000. You have saved a deposit of$80,000. The bank has agreed to lend you the $320,000 as a fully amortising mortgage loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments? You want to buy an apartment priced at$500,000. You have saved a deposit of $50,000. The bank has agreed to lend you the$450,000 as a fully amortising loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments?

You just signed up for a 30 year fully amortising mortgage loan with monthly payments of $2,000 per month. The interest rate is 9% pa which is not expected to change. How much did you borrow? After 5 years, how much will be owing on the mortgage? The interest rate is still 9% and is not expected to change. You just signed up for a 30 year fully amortising mortgage with monthly payments of$1,000 per month. The interest rate is 6% pa which is not expected to change.

How much did you borrow? After 20 years, how much will be owing on the mortgage? The interest rate is still 6% and is not expected to change.

You just signed up for a 30 year fully amortising mortgage loan with monthly payments of $1,500 per month. The interest rate is 9% pa which is not expected to change. How much did you borrow? After 10 years, how much will be owing on the mortgage? The interest rate is still 9% and is not expected to change. Suppose you had$100 in a savings account and the interest rate was 2% per year.

After 5 years, how much do you think you would have in the account if you left the money to grow?

than $102,$102 or than $102? Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, would you be able to buy , exactly the as or than today with the money in this account? Do you think that the following statement is or ? “Buying a single company stock usually provides a safer return than a stock mutual fund.” Jan asks you for a loan. He wants$100 now and offers to pay you back $120 in 1 year. You can borrow and lend from the bank at an interest rate of 10% pa, given as an effective annual rate. Ignore credit risk. Remember: $$V_0 = \frac{V_t}{(1+r_\text{eff})^t}$$ Will you or Jan's deal? Katya offers to pay you$10 at the end of every year for the next 5 years (t=1,2,3,4,5) if you pay her $50 now (t=0). You can borrow and lend from the bank at an interest rate of 10% pa, given as an effective annual rate. Ignore credit risk. Will you or Katya's deal? For a price of$13, Carla will sell you a share which will pay a dividend of $1 in one year and every year after that forever. The required return of the stock is 10% pa. Would you like to Carla's share or politely ? For a price of$6, Carlos will sell you a share which will pay a dividend of $1 in one year and every year after that forever. The required return of the stock is 10% pa. Would you like to his share or politely ? For a price of$102, Andrea will sell you a share which just paid a dividend of $10 yesterday, and is expected to pay dividends every year forever, growing at a rate of 5% pa. So the next dividend will be $10(1+0.05)^1=10.50$ in one year from now, and the year after it will be $10(1+0.05)^2=11.025$ and so on. The required return of the stock is 15% pa. Would you like to the share or politely ? For a price of$1040, Camille will sell you a share which just paid a dividend of $100, and is expected to pay dividends every year forever, growing at a rate of 5% pa. So the next dividend will be $100(1+0.05)^1=105.00$, and the year after it will be $100(1+0.05)^2=110.25$ and so on. The required return of the stock is 15% pa. Would you like to the share or politely ? For a price of$10.20 each, Renee will sell you 100 shares. Each share is expected to pay dividends in perpetuity, growing at a rate of 5% pa. The next dividend is one year away (t=1) and is expected to be $1 per share. The required return of the stock is 15% pa. Would you like to the shares or politely ? For a price of$129, Joanne will sell you a share which is expected to pay a $30 dividend in one year, and a$10 dividend every year after that forever. So the stock's dividends will be $30 at t=1,$10 at t=2, $10 at t=3, and$10 forever onwards.

The required return of the stock is 10% pa.

Would you like to the share or politely ?

For a price of $95, Sherylanne will sell you a share which is expected to pay its first dividend of$10 in 7 years (t=7), and will continue to pay the same $10 dividend every year after that forever. The required return of the stock is 10% pa. Would you like to the share or politely ? 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. Would you like to her bond or politely ? For a price of$100, Rad 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 the same risk, maturity and coupon characteristics trade at a yield of 6% pa. Would you like to the bond or politely ? For a price of$100, Andrea will sell you a 2 year bond paying annual coupons of 10% pa. The face value of the bond is $100. Other bonds with the same risk, maturity and coupon characteristics trade at a yield of 6% pa. Would you like to the bond or politely ? For a price of$95, Nicole will sell you a 10 year bond paying semi-annual coupons of 8% pa. The face value of the bond is $100. Other bonds with the same risk, maturity and coupon characteristics trade at a yield of 8% pa. Would you like to the bond or politely ? The average weekly earnings of an Australian adult worker before tax was$1,542.40 per week in November 2014 according to the Australian Bureau of Statistics. Therefore average annual earnings before tax were $80,204.80 assuming 52 weeks per year. Personal income tax rates published by the Australian Tax Office are reproduced for the 2014-2015 financial year in the table below: Taxable income Tax on this income 0 –$18,200 Nil
$18,201 –$37,000 19c for each $1 over$18,200
$37,001 –$80,000 $3,572 plus 32.5c for each$1 over $37,000$80,001 – $180,000$17,547 plus 37c for each $1 over$80,000
$180,001 and over$54,547 plus 45c for each $1 over$180,000

The above rates do not include the Medicare levy of 2%. Exclude the Medicare levy from your calculations

How much personal income tax would you have to pay per year if you earned $80,204.80 per annum before-tax? In 2014 the median starting salaries of male and female Australian bachelor degree accounting graduates aged less than 25 years in their first full-time industry job was$50,000 before tax, according to Graduate Careers Australia. See page 9 of this report. Personal income tax rates published by the Australian Tax Office are reproduced for the 2014-2015 financial year in the table below.

Taxable income Tax on this income
0 – $18,200 Nil$18,201 – $37,000 19c for each$1 over $18,200$37,001 – $80,000$3,572 plus 32.5c for each $1 over$37,000
$80,001 –$180,000 $17,547 plus 37c for each$1 over $80,000$180,001 and over $54,547 plus 45c for each$1 over $180,000 The above rates do not include the Medicare levy of 2%. Exclude the Medicare levy from your calculations How much personal income tax would you have to pay per year if you earned$50,000 per annum before-tax?

Question 449  personal tax on dividends, classical tax system

A small private company has a single shareholder. This year the firm earned a $100 profit before tax. All of the firm's after tax profits will be paid out as dividends to the owner. The corporate tax rate is 30% and the sole shareholder's personal marginal tax rate is 45%. The United States' classical tax system applies because the company generates all of its income in the US and pays corporate tax to the Internal Revenue Service. The shareholder is also an American for tax purposes. What will be the personal tax payable by the shareholder and the corporate tax payable by the company? A small private company has a single shareholder. This year the firm earned a$100 profit before tax. All of the firm's after tax profits will be paid out as dividends to the owner.

The corporate tax rate is 30% and the sole shareholder's personal marginal tax rate is 45%.

The Australian imputation tax system applies because the company generates all of its income in Australia and pays corporate tax to the Australian Tax Office. Therefore all of the company's dividends are fully franked. The sole shareholder is an Australian for tax purposes and can therefore use the franking credits to offset his personal income tax liability.

What will be the personal tax payable by the shareholder and the corporate tax payable by the company?

A firm pays a fully franked cash dividend of $70 to one of its Australian shareholders who has a personal marginal tax rate of 45%. The corporate tax rate is 30%. What will be the shareholder's personal tax payable due to the dividend payment? A firm pays a fully franked cash dividend of$100 to one of its Australian shareholders who has a personal marginal tax rate of 15%. The corporate tax rate is 30%.

What will be the shareholder's personal tax payable due to the dividend payment?

The investment decision primarily affects which part of a business?

The financing decision primarily affects which part of a business?

The working capital decision primarily affects which part of a business?

The expression 'cash is king' emphasizes the importance of having enough cash to pay your short term debts to avoid bankruptcy. Which business decision is this expression most closely related to?

The expression 'you have to spend money to make money' relates to which business decision?

Which of the following decisions relates to the current assets and current liabilities of the firm?

The sayings "Don't cry over spilt milk", "Don't regret the things that you can't change" and "What's done is done" are most closely related to which financial concept?

Question 768  accounting terminology, book and market values, no explanation

Accountants and finance professionals have lots of names for the same things which can be quite confusing.

Which of the following groups of items are NOT synonyms?

If a firm makes a profit and pays no dividends, which of the following accounts will increase?

Where can a publicly listed firm's book value of equity be found? It can be sourced from the company's:

Where can a private firm's market value of equity be found? It can be sourced from the company's:

Which of the following statements is NOT correct?

Which of the following statements about book and market equity is NOT correct?

Which of the following statements is NOT correct? Lenders:

Which of the following statements is NOT correct? Bond investors:

Which of the following statements is NOT correct? Lenders:

You deposit money into a bank. Which of the following statements is NOT correct? You:

You deposit money into a bank account. Which of the following statements about this deposit is NOT correct?

Question 909  money market, bills

By convention, money market securities' yields are always quoted as:

Which of the following is NOT a money market security?

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

A 180-day Bank Accepted Bill has a face value of $1,000,000. The interest rate is 8% pa and there are 365 days in the year. What is its price now? A 90-day Bank Accepted Bill (BAB) has a face value of$1,000,000. The simple interest rate is 10% pa and there are 365 days in the year. What is its price now?

A 90 day bank bill has a face value of $100,000. Investor A bought the bill when it was first issued at a simple yield to maturity of 3% pa and sold it 20 days later to Investor B who expected to earn a simple yield to maturity of 5% pa. Investor B held it until maturity. Which of the following statements is NOT correct? To value a business's assets, the free cash flow of the firm (FCFF, also called CFFA) needs to be calculated. This requires figures from the firm's income statement and balance sheet. For what figures is the income statement needed? Note that the income statement is sometimes also called the profit and loss, P&L, or statement of financial performance. A credit card offers an interest rate of 18% pa, compounding monthly. Find the effective monthly rate, effective annual rate and the effective daily rate. Assume that there are 365 days in a year. All answers are given in the same order: $$r_\text{eff monthly} , r_\text{eff yearly} , r_\text{eff daily}$$ Which of the following is NOT a synonym of 'required return'? A firm has a debt-to-equity ratio of 25%. What is its debt-to-assets ratio? A firm has a debt-to-equity ratio of 60%. What is its debt-to-assets ratio? A firm has a debt-to-assets ratio of 20%. What is its debt-to-equity ratio? Safe firms with low chances of bankruptcy will tend to have: A three year bond has a face value of$100, a yield of 10% and a fixed coupon rate of 5%, paid semi-annually. What is its price?

A two year Government bond has a face value of $100, a yield of 0.5% and a fixed coupon rate of 0.5%, paid semi-annually. What is its price? A two year Government bond has a face value of$100, a yield of 2.5% pa and a fixed coupon rate of 0.5% pa, paid semi-annually. What is its price?

A bond maturing in 10 years has a coupon rate of 4% pa, paid semi-annually. The bond's yield is currently 6% pa. The face value of the bond is $100. What is its price? A three year bond has a fixed coupon rate of 12% pa, paid semi-annually. The bond's yield is currently 6% pa. The face value is$100. What is its price?

A four year bond has a face value of $100, a yield of 6% and a fixed coupon rate of 12%, paid semi-annually. What is its price? A five year bond has a face value of$100, a yield of 12% and a fixed coupon rate of 6%, paid semi-annually.

What is the bond's price?

A 10 year bond has a face value of $100, a yield of 6% pa and a fixed coupon rate of 8% pa, paid semi-annually. What is its price? Calculate the price of a newly issued ten year bond with a face value of$100, a yield of 8% pa and a fixed coupon rate of 6% pa, paid annually. So there's only one coupon per year, paid in arrears every year.

Calculate the price of a newly issued ten year bond with a face value of $100, a yield of 8% pa and a fixed coupon rate of 6% pa, paid semi-annually. So there are two coupons per year, paid in arrears every six months. Which one of the following bonds is trading at a discount? Which one of the following bonds is trading at a premium? An investor bought two fixed-coupon bonds issued by the same company, a zero-coupon bond and a 7% pa semi-annual coupon bond. Both bonds have a face value of$1,000, mature in 10 years, and had a yield at the time of purchase of 8% pa.

A few years later, yields fell to 6% pa. Which of the following statements is correct? Note that a capital gain is an increase in price.

"Buy low, sell high" is a phrase commonly heard in financial markets. It states that traders should try to buy assets at low prices and sell at high prices.

Traders in the fixed-coupon bond markets often quote promised bond yields rather than prices. Fixed-coupon bond traders should try to:

A firm wishes to raise $10 million now. They will issue 6% pa semi-annual coupon bonds that will mature in 8 years and have a face value of$1,000 each. Bond yields are 10% pa, given as an APR compounding every 6 months, and the yield curve is flat.

How many bonds should the firm issue?

A 10 year Australian government bond was just issued at par with a yield of 3.9% pa. The fixed coupon payments are semi-annual. The bond has a face value of $1,000. Six months later, just after the first coupon is paid, the yield of the bond decreases to 3.65% pa. What is the bond's new price? The below screenshot of Commonwealth Bank of Australia's (CBA) details were taken from the Google Finance website on 7 Nov 2014. Some information has been deliberately blanked out. What was CBA's market capitalisation of equity? The below graph shows the computer software company Microsoft's stock price (MSFT) at the market close on the NASDAQ on Friday 1 June 2018. Based on the screenshot above, which of the following statements about MSFT is NOT correct? MSFT's: The required return of a project is 10%, given as an effective annual rate. What is the payback period of the project in years? Assume that the cash flows shown in the table are received smoothly over the year. So the$121 at time 2 is actually earned smoothly from t=1 to t=2.

 Project Cash Flows Time (yrs) Cash flow ($) 0 -100 1 11 2 121 You have$100,000 in the bank. The bank pays interest at 10% pa, given as an effective annual rate.

You wish to consume an equal amount now (t=0) and in one year (t=1) and have nothing left in the bank at the end (t=1).

How much can you consume at each time?

A young lady is trying to decide if she should attend university or not.

The young lady's parents say that she must attend university because otherwise all of her hard work studying and attending school during her childhood was a waste.

What's the correct way to classify this item from a capital budgeting perspective when trying to decide whether to attend university?

The hard work studying at school in her childhood should be classified as:

A young lady is trying to decide if she should attend university. Her friends say that she should go to university because she is more likely to meet a clever young man than if she begins full time work straight away.

What's the correct way to classify this item from a capital budgeting perspective when trying to find the Net Present Value of going to university rather than working?

The opportunity to meet a desirable future spouse should be classified as:

A man is thinking about taking a day off from his casual painting job to relax.

He just woke up early in the morning and he's about to call his boss to say that he won't be coming in to work.

But he's thinking about the hours that he could work today (in the future) which are:

A man has taken a day off from his casual painting job to relax.

It's the end of the day and he's thinking about the hours that he could have spent working (in the past) which are now:

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 Net Present Value (NPV) of the project?

 Project Cash Flows Time (yrs) Cash flow ($) 0 -100 1 0 2 121 What is the Internal Rate of Return (IRR) of the project detailed in the table below? Assume that the cash flows shown in the table are paid all at once at the given point in time. All answers are given as effective annual rates.  Project Cash Flows Time (yrs) Cash flow ($) 0 -100 1 0 2 121

If a project's net present value (NPV) is zero, then its internal rate of return (IRR) will be:

A project has the following cash flows:

 Project Cash Flows Time (yrs) Cash flow ($) 0 -400 1 0 2 500 What is the payback period of the project in years? Normally cash flows are assumed to happen at the given time. But here, assume that the cash flows are received smoothly over the year. So the$500 at time 2 is actually earned smoothly from t=1 to t=2.

The below graph shows a project's net present value (NPV) against its annual discount rate.

For what discount rate or range of discount rates would you accept and commence the project?

All answer choices are given as approximations from reading off the graph.

The below graph shows a project's net present value (NPV) against its annual discount rate.

Which of the following statements is NOT correct?

You have $100,000 in the bank. The bank pays interest at 10% pa, given as an effective annual rate. You wish to consume an equal amount now (t=0), in one year (t=1) and in two years (t=2), and still have$50,000 in the bank after that (t=2).

How much can you consume at each time?

You're considering a business project which costs $11m now and is expected to pay a single cash flow of$11m in one year. So you pay $11m now, then one year later you receive$11m.

Assume that the initial $11m cost is funded using the your firm's existing cash so no new equity or debt will be raised. The cost of capital is 10% pa. Which of the following statements about the net present value (NPV), internal rate of return (IRR) and payback period is NOT correct? A firm is considering a business project which costs$10m now and is expected to pay a single cash flow of $12.1m in two years. Assume that the initial$10m cost is funded using the firm's existing cash so no new equity or debt will be raised. The cost of capital is 10% pa.

Which of the following statements about net present value (NPV), internal rate of return (IRR) and payback period is NOT correct?

Your neighbour asks you for a loan of $100 and offers to pay you back$120 in one year.

You don't actually have any money right now, but you can borrow and lend from the bank at a rate of 10% pa. Rates are given as effective annual rates.

Assume that your neighbour will definitely pay you back. Ignore interest tax shields and transaction costs.

The Net Present Value (NPV) of lending to your neighbour is $9.09. Describe what you would do to actually receive a$9.09 cash flow right now with zero net cash flows in the future.

A pharmaceutical firm has just discovered a valuable new drug. So far the news has been kept a secret.

The net present value of making and commercialising the drug is $200 million, but$600 million of bonds will need to be issued to fund the project and buy the necessary plant and equipment.

The firm will release the news of the discovery and bond raising to shareholders simultaneously in the same announcement. The bonds will be issued shortly after.

Once the announcement is made and the bonds are issued, what is the expected increase in the value of the firm's assets (ΔV), market capitalisation of debt (ΔD) and market cap of equity (ΔE)?

The triangle symbol is the Greek letter capital delta which means change or increase in mathematics.

Ignore the benefit of interest tax shields from having more debt.

Remember: $ΔV = ΔD+ΔE$

A mining firm has just discovered a new mine. So far the news has been kept a secret.

The net present value of digging the mine and selling the minerals is $250 million, but$500 million of new equity and $300 million of new bonds will need to be issued to fund the project and buy the necessary plant and equipment. The firm will release the news of the discovery and equity and bond raising to shareholders simultaneously in the same announcement. The shares and bonds will be issued shortly after. Once the announcement is made and the new shares and bonds are issued, what is the expected increase in the value of the firm's assets $(\Delta V)$, market capitalisation of debt $(\Delta D)$ and market cap of equity $(\Delta E)$? Assume that markets are semi-strong form efficient. The triangle symbol $\Delta$ is the Greek letter capital delta which means change or increase in mathematics. Ignore the benefit of interest tax shields from having more debt. Remember: $\Delta V = \Delta D+ \Delta E$ The first payment of a constant perpetual annual cash flow is received at time 5. Let this cash flow be $C_5$ and the required return be $r$. So there will be equal annual cash flows at time 5, 6, 7 and so on forever, and all of the cash flows will be equal so $C_5 = C_6 = C_7 = ...$ When the perpetuity formula is used to value this stream of cash flows, it will give a value (V) at time: A stock is expected to pay its next dividend of$1 in one year. Future annual dividends are expected to grow by 2% pa. So the first dividend of $1 will be in one year, the year after that$1.02 (=1*(1+0.02)^1), and a year later $1.0404 (=1*(1+0.02)^2) and so on forever. Its required total return is 10% pa. The total required return and growth rate of dividends are given as effective annual rates. Calculate the current stock price. A stock just paid a dividend of$1. Future annual dividends are expected to grow by 2% pa. The next dividend of $1.02 (=1*(1+0.02)^1) will be in one year, and the year after that the dividend will be$1.0404 (=1*(1+0.02)^2), and so on forever.

Its required total return is 10% pa. The total required return and growth rate of dividends are given as effective annual rates.

Calculate the current stock price.

One year ago you bought a $1,000,000 house partly funded using a mortgage loan. The loan size was$800,000 and the other $200,000 was your wealth or 'equity' in the house asset. The interest rate on the home loan was 4% pa. Over the year, the house produced a net rental yield of 2% pa and a capital gain of 2.5% pa. What was the return on your wealth over the past year? Assume that all cash flows (interest payments and net rental payments) were paid and received at the end of the year, and all rates are given as effective annual rates. The total return on your wealth over the past year was: Hint: Remember that wealth in this context is your equity (E) in the house asset (V = D+E) which is funded by the loan (D) and your deposit or equity (E). The theory of fixed interest bond pricing is an application of the theory of Net Present Value (NPV). Also, a 'fairly priced' asset is not over- or under-priced. Buying or selling a fairly priced asset has an NPV of zero. Considering this, which of the following statements is NOT correct? The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates. A stock has a beta of 0.7. What do you think will be the stock's expected return over the next year, given as an effective annual rate? The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates. A stock has a beta of 0.7. In the last 5 minutes, bad economic news was released showing a higher chance of recession. Over this time the share market fell by 2%. The risk free rate was unchanged. What do you think was the stock's historical return over the last 5 minutes, given as an effective 5 minute rate? A common phrase heard in financial markets is that ‘high risk investments deserve high returns’. To make this statement consistent with the Capital Asset Pricing Model (CAPM), a high amount of what specific type of risk deserves a high return? Investors deserve high returns when they buy assets with high: A stock has a beta of 1.2. Its next dividend is expected to be$20, paid one year from now.

Dividends are expected to be paid annually and grow by 1.5% pa forever.

Treasury bonds yield 3% pa and the market portfolio's expected return is 7% pa. All returns are effective annual rates.

What is the price of the stock now?

Treasury bonds currently have a return of 5% pa. A stock has a beta of 0.5 and the market return is 10% pa. What is the expected return of the stock?

A stock has a beta of 0.5. Its next dividend is expected to be $3, paid one year from now. Dividends are expected to be paid annually and grow by 2% pa forever. Treasury bonds yield 5% pa and the market portfolio's expected return is 10% pa. All returns are effective annual rates. What is the price of the stock now? According to the theory of the Capital Asset Pricing Model (CAPM), total variance can be broken into two components, systematic variance and idiosyncratic variance. Which of the following events would be considered the most diversifiable according to the theory of the CAPM? A stock's required total return will increase when its: A stock has a beta of 1.5. The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates. What do you think will be the stock's expected return over the next year, given as an effective annual rate? A stock has a beta of 1.5. The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates. In the last 5 minutes, bad economic news was released showing a higher chance of recession. Over this time the share market fell by 1%. The risk free rate was unchanged. What do you think was the stock's historical return over the last 5 minutes, given as an effective 5 minute rate? A stock has a beta of 1.5. The market's expected total return is 10% pa and the risk free rate is 5% pa, both given as effective annual rates. Over the last year, bad economic news was released showing a higher chance of recession. Over this time the share market fell by 1%. The risk free rate was unchanged. What do you think was the stock's historical return over the last year, given as an effective annual rate? You work in Asia and just woke up. It looked like a nice day but then you read the news and found out that last night the American share market fell by 10% while you were asleep due to surprisingly poor macro-economic world news. You own a portfolio of liquid stocks listed in Asia with a beta of 1.6. When the Asian equity markets open, what do you expect to happen to your share portfolio? Assume that the capital asset pricing model (CAPM) is correct and that the market portfolio contains all shares in the world, of which American shares are a big part. Your portfolio beta is measured against this world market portfolio. When the Asian equity market opens for trade, you would expect your portfolio value to: Diversification is achieved by investing in a large amount of stocks. What type of risk is reduced by diversification? A stock's required total return will decrease when its: A fairly priced stock has an expected return equal to the market's. Treasury bonds yield 5% pa and the market portfolio's expected return is 10% pa. What is the stock's beta? Your friend just bought a house for$1,000,000. He financed it using a $900,000 mortgage loan and a deposit of$100,000.

In the context of residential housing and mortgages, the 'equity' or 'net wealth' tied up in a house is the value of the house less the value of the mortgage loan. Assuming that your friend's only asset is his house, his net wealth is $100,000. If house prices suddenly fall by 15%, what would be your friend's percentage change in net wealth? Assume that: • No income (rent) was received from the house during the short time over which house prices fell. • Your friend will not declare bankruptcy, he will always pay off his debts. Your friend just bought a house for$400,000. He financed it using a $320,000 mortgage loan and a deposit of$80,000.

In the context of residential housing and mortgages, the 'equity' tied up in the value of a person's house is the value of the house less the value of the mortgage. So the initial equity your friend has in his house is $80,000. Let this amount be E, let the value of the mortgage be D and the value of the house be V. So $V=D+E$. If house prices suddenly fall by 10%, what would be your friend's percentage change in equity (E)? Assume that the value of the mortgage is unchanged and that no income (rent) was received from the house during the short time over which house prices fell. Remember: $$r_{0\rightarrow1}=\frac{p_1-p_0+c_1}{p_0}$$ where $r_{0-1}$ is the return (percentage change) of an asset with price $p_0$ initially, $p_1$ one period later, and paying a cash flow of $c_1$ at time $t=1$. You just bought a house worth$1,000,000. You financed it with an $800,000 mortgage loan and a deposit of$200,000.

You estimate that:

• The house has a beta of 1;
• The mortgage loan has a beta of 0.2.

What is the beta of the equity (the $200,000 deposit) that you have in your house? Also, if the risk free rate is 5% pa and the market portfolio's return is 10% pa, what is the expected return on equity in your house? Ignore taxes, assume that all cash flows (interest payments and rent) were paid and received at the end of the year, and all rates are effective annual rates. Which of the following assets would you expect to have the highest required rate of return? All values are current market values. A firm can issue 3 year annual coupon bonds at a yield of 10% pa and a coupon rate of 8% pa. The beta of its levered equity is 2. The market's expected return is 10% pa and 3 year government bonds yield 6% pa with a coupon rate of 4% pa. The market value of equity is$1 million and the market value of debt is $1 million. The corporate tax rate is 30%. What is the firm's after-tax WACC? Assume a classical tax system. A firm can issue 5 year annual coupon bonds at a yield of 8% pa and a coupon rate of 12% pa. The beta of its levered equity is 1. Five year government bonds yield 5% pa with a coupon rate of 6% pa. The market's expected dividend return is 4% pa and its expected capital return is 6% pa. The firm's debt-to-equity ratio is 2:1. The corporate tax rate is 30%. What is the firm's after-tax WACC? Assume a classical tax system. Here are the Net Income (NI) and Cash Flow From Assets (CFFA) equations: $$NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c)$$ $$CFFA=NI+Depr-CapEx - \varDelta NWC+IntExp$$ What is the formula for calculating annual interest expense (IntExp) which is used in the equations above? Select one of the following answers. Note that D is the value of debt which is constant through time, and $r_D$ is the cost of debt. The equations for Net Income (NI, also known as Earnings or Net Profit After Tax) and Cash Flow From Assets (CFFA, also known as Free Cash Flow to the Firm) per year are: $$NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c)$$ $$CFFA=NI+Depr-CapEx - \varDelta NWC+IntExp$$ For a firm with debt, what is the amount of the interest tax shield per year? A fairly priced unlevered firm plans to pay a dividend of$1 next year (t=1) which is expected to grow by 3% pa every year after that. The firm's required return on equity is 8% pa.

The firm is thinking about reducing its future dividend payments by 10% so that it can use the extra cash to invest in more projects which are expected to return 8% pa, and have the same risk as the existing projects. Therefore, next year's dividend will be $0.90. What will be the stock's new annual capital return (proportional increase in price per year) if the change in payout policy goes ahead? Assume that payout policy is irrelevant to firm value and that all rates are effective annual rates. Which firms tend to have low forward-looking price-earnings (PE) ratios? Only consider firms with positive PE ratios. Which firms tend to have high forward-looking price-earnings (PE) ratios? A company advertises an investment costing$1,000 which they say is underpriced. They say that it has an expected total return of 15% pa, but a required return of only 10% pa. Of the 15% pa total expected return, the dividend yield is expected to always be 7% pa and rest is the capital yield.

Assuming that the company's statements are correct, what is the NPV of buying the investment if the 15% total return lasts for the next 100 years (t=0 to 100), then reverts to 10% after that time? Also, what is the NPV of the investment if the 15% return lasts forever?

In both cases, assume that the required return of 10% remains constant, the dividends can only be re-invested at 10% pa and all returns are given as effective annual rates.

The answer choices below are given in the same order (15% for 100 years, and 15% forever):

A mature firm has constant expected future earnings and dividends. Both amounts are equal. So earnings and dividends are expected to be equal and unchanging.

Which of the following statements is NOT correct?

In the dividend discount model (DDM), share prices fall when dividends are paid. Let the high price before the fall be called the peak, and the low price after the fall be called the trough.

$$P_0=\dfrac{C_1}{r-g}$$

Which of the following statements about the DDM is NOT correct?

Question 625  dividend re-investment plan, capital raising

Which of the following statements about dividend re-investment plans (DRP's) is NOT correct?

To receive the dividend you must own the stock when the market closes on which date?

A company announces that it will pay a dividend, as the market expected. The company's shares trade on the stock exchange which is open from 10am in the morning to 4pm in the afternoon each weekday. When would the share price be expected to fall by the amount of the dividend? Ignore taxes.

The share price is expected to fall during the:

On which date would the stock price increase if the dividend and earnings are higher than expected?

A 2-for-1 stock split is equivalent to a 1-for-1 bonus issue or a 100% stock dividend. or ?

A 1-for-4 bonus issue is equivalent to a 4-for-1 stock split or a 25% stock dividend. or ?

You own an apartment which you rent out as an investment property.

What is the price of the apartment using discounted cash flow (DCF, same as NPV) valuation?

Assume that:

• You just signed a contract to rent the apartment out to a tenant for the next 12 months at $2,000 per month, payable in advance (at the start of the month, t=0). The tenant is just about to pay you the first$2,000 payment.
• The contract states that monthly rental payments are fixed for 12 months. After the contract ends, you plan to sign another contract but with rental payment increases of 3%. You intend to do this every year.
So rental payments will increase at the start of the 13th month (t=12) to be $2,060 (=2,000(1+0.03)), and then they will be constant for the next 12 months. Rental payments will increase again at the start of the 25th month (t=24) to be$2,121.80 (=2,000(1+0.03)2), and then they will be constant for the next 12 months until the next year, and so on.
• The required return of the apartment is 8.732% pa, given as an effective annual rate.
• Ignore all taxes, maintenance, real estate agent, council and strata fees, periods of vacancy and other costs. Assume that the apartment will last forever and so will the rental payments.

Which of the following statements about an asset’s standard deviation of returns is NOT correct? All other things remaining equal, the higher the asset’s standard deviation of returns:

Stock A and B's returns have a correlation of 0.3. Which statement is NOT correct?

The following table shows a sample of historical total returns of shares in two different companies A and B.

 Stock Returns Total effective annual returns Year $r_A$ $r_B$ 2007 0.2 0.4 2008 0.04 -0.2 2009 -0.1 -0.3 2010 0.18 0.5

What is the historical sample covariance ($\hat{\sigma}_{A,B}$) and correlation ($\rho_{A,B}$) of stock A and B's total effective annual returns?

All things remaining equal, the variance of a portfolio of two positively-weighted stocks rises as:

Diversification in a portfolio of two assets works best when the correlation between their returns is:

 Portfolio Details Stock Expected return Standard deviation Covariance $(\sigma_{A,B})$ Beta Dollars invested A 0.2 0.4 0.12 0.5 40 B 0.3 0.8 1.5 80

What is the standard deviation (not variance) of the above portfolio? Note that the stocks' covariance is given, not correlation.

An investor wants to make a portfolio of two stocks A and B with a target expected portfolio return of 16% pa.

• Stock A has an expected return of 8% pa.
• Stock B has an expected return of 12% pa.

What portfolio weights should the investor have in stocks A and B respectively?

The standard deviation and variance of a stock's annual returns are calculated over a number of years. The units of the returns are percent per annum $(\% pa)$.

What are the units of the standard deviation $(\sigma)$ and variance $(\sigma^2)$ of returns respectively?

Hint: Visit Wikipedia to understand the difference between percentage points $(\text{pp})$ and percent $(\%)$.

A stock's returns are normally distributed with a mean of 10% pa and a standard deviation of 20 percentage points pa. What is the 90% confidence interval of returns over the next year? Note that the Z-statistic corresponding to a one-tail:

• 90% normal probability density function is 1.282.
• 95% normal probability density function is 1.645.
• 97.5% normal probability density function is 1.960.

The 90% confidence interval of annual returns is between:

A stock's returns are normally distributed with a mean of 10% pa and a standard deviation of 20 percentage points pa. What is the 95% confidence interval of returns over the next year? Note that the Z-statistic corresponding to a one-tail:

• 90% normal probability density function is 1.282.
• 95% normal probability density function is 1.645.
• 97.5% normal probability density function is 1.960.

The 95% confidence interval of annual returns is between:

A stock has an expected return of 10% pa and you're 90% sure that over the next year, the return will be between -15% and 35%. The stock's returns are normally distributed. Note that the Z-statistic corresponding to a one-tail:

• 90% normal probability density function is 1.282.
• 95% normal probability density function is 1.645.
• 97.5% normal probability density function is 1.960.

What is the stock’s standard deviation of returns in percentage points per annum (pp pa)?

You're the boss of an investment bank's equities research team. Your five analysts are each trying to find the expected total return over the next year of shares in a mining company. The mining firm:

• Is regarded as a mature company since it's quite stable in size and was floated around 30 years ago. It is not a high-growth company;
• Share price is very sensitive to changes in the price of the market portfolio, economic growth, the exchange rate and commodities prices. Due to this, its standard deviation of total returns is much higher than that of the market index;
• Experienced tough times in the last 10 years due to unexpected falls in commodity prices.
• Shares are traded in an active liquid market.
Your team of analysts present their findings, and everyone has different views. While there's no definitive true answer, who's calculation of the expected total return is the most plausible?

Assume that:

• The analysts' source data is correct and true, but their inferences might be wrong;
• All returns and yields are given as effective annual nominal rates.

Which of the following statements about standard statistical mathematics notation is NOT correct?

What is the covariance of a variable X with itself?

The cov(X, X) or $\sigma_{X,X}$ equals:

What is the correlation of a variable X with itself?

The corr(X, X) or $\rho_{X,X}$ equals:

What is the covariance of a variable X with a constant C?

The cov(X, C) or $\sigma_{X,C}$ equals:

What is the correlation of a variable X with a constant C?

The corr(X, C) or $\rho_{X,C}$ equals:

You just agreed to a 30 year fully amortising mortgage loan with monthly payments of $2,500. The interest rate is 9% pa which is not expected to change. How much did you borrow? After 10 years, how much will be owing on the mortgage? The interest rate is still 9% and is not expected to change. The below choices are given in the same order. You want to buy a house priced at$400,000. You have saved a deposit of $40,000. The bank has agreed to lend you$360,000 as a fully amortising loan with a term of 30 years. The interest rate is 8% pa payable monthly and is not expected to change.

What will be your monthly payments?

You want to buy an apartment priced at $300,000. You have saved a deposit of$30,000. The bank has agreed to lend you the $270,000 as an interest only loan with a term of 25 years. The interest rate is 12% pa and is not expected to change. What will be your monthly payments? Remember that mortgage payments are paid in arrears (at the end of the month). You just signed up for a 30 year interest-only mortgage with monthly payments of$3,000 per month. The interest rate is 6% pa which is not expected to change.

How much did you borrow? After 15 years, just after the 180th payment at that time, how much will be owing on the mortgage? The interest rate is still 6% and is not expected to change. Remember that the mortgage is interest-only and that mortgage payments are paid in arrears (at the end of the month).

You just borrowed $400,000 in the form of a 25 year interest-only mortgage with monthly payments of$3,000 per month. The interest rate is 9% pa which is not expected to change.

You actually plan to pay more than the required interest payment. You plan to pay $3,300 in mortgage payments every month, which your mortgage lender allows. These extra payments will reduce the principal and the minimum interest payment required each month. At the maturity of the mortgage, what will be the principal? That is, after the last (300th) interest payment of$3,300 in 25 years, how much will be owing on the mortgage?

You want to buy an apartment worth $300,000. You have saved a deposit of$60,000.

The bank has agreed to lend you $240,000 as an interest only mortgage loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments? You want to buy an apartment priced at$500,000. You have saved a deposit of $50,000. The bank has agreed to lend you the$450,000 as an interest only loan with a term of 30 years. The interest rate is 6% pa and is not expected to change. What will be your monthly payments?

Many Australian home loans that are interest-only actually require payments to be made on a fully amortising basis after a number of years.

You decide to borrow $600,000 from the bank at an interest rate of 4.25% pa for 25 years. The payments will be interest-only for the first 10 years (t=0 to 10 years), then they will have to be paid on a fully amortising basis for the last 15 years (t=10 to 25 years). Assuming that interest rates will remain constant, what will be your monthly payments over the first 10 years from now, and then the next 15 years after that? The answer options are given in the same order. A prospective home buyer can afford to pay$2,000 per month in mortgage loan repayments. The central bank recently lowered its policy rate by 0.25%, and residential home lenders cut their mortgage loan rates from 4.74% to 4.49%.

How much more can the prospective home buyer borrow now that interest rates are 4.49% rather than 4.74%? Give your answer as a proportional increase over the original amount he could borrow ($V_\text{before}$), so:

$$\text{Proportional increase} = \frac{V_\text{after}-V_\text{before}}{V_\text{before}}$$

Assume that:

• Interest rates are expected to be constant over the life of the loan.

• Loans are interest-only and have a life of 30 years.

• Mortgage loan payments are made every month in arrears and all interest rates are given as annualised percentage rates compounding per month.

In Australia in the 1980's, inflation was around 8% pa, and residential mortgage loan interest rates were around 14%.

In 2013, inflation was around 2.5% pa, and residential mortgage loan interest rates were around 4.5%.

If a person can afford constant mortgage loan payments of $2,000 per month, how much more can they borrow when interest rates are 4.5% pa compared with 14.0% pa? Give your answer as a proportional increase over the amount you could borrow when interest rates were high $(V_\text{high rates})$, so: $$\text{Proportional increase} = \dfrac{V_\text{low rates}-V_\text{high rates}}{V_\text{high rates}}$$ Assume that: • Interest rates are expected to be constant over the life of the loan. • Loans are interest-only and have a life of 30 years. • Mortgage loan payments are made every month in arrears and all interest rates are given as annualised percentage rates (APR's) compounding per month. How much more can you borrow using an interest-only loan compared to a 25-year fully amortising loan if interest rates are 6% pa compounding per month and are not expected to change? If it makes it easier, assume that you can afford to pay$2,000 per month on either loan. Express your answer as a proportional increase using the following formula:

$$\text{Proportional Increase} = \dfrac{V_\text{0,interest only}}{V_\text{0,fully amortising}} - 1$$

How much more can you borrow using an interest-only loan compared to a 25-year fully amortising loan if interest rates are 4% pa compounding per month and are not expected to change? If it makes it easier, assume that you can afford to pay $2,000 per month on either loan. Express your answer as a proportional increase using the following formula: $$\text{Proportional Increase} = \dfrac{V_\text{0,interest only}}{V_\text{0,fully amortising}} - 1$$ This annuity formula $\dfrac{C_1}{r}\left(1-\dfrac{1}{(1+r)^3} \right)$ is equivalent to which of the following formulas? Note the 3. In the below formulas, $C_t$ is a cash flow at time t. All of the cash flows are equal, but paid at different times. Telsa Motors advertises that its Model S electric car saves$570 per month in fuel costs. Assume that Tesla cars last for 10 years, fuel and electricity costs remain the same, and savings are made at the end of each month with the first saving of $570 in one month from now. The effective annual interest rate is 15.8%, and the effective monthly interest rate is 1.23%. What is the present value of the savings? There are many ways to write the ordinary annuity formula. Which of the following is NOT equal to the ordinary annuity formula? Some countries' interest rates are so low that they're zero. If interest rates are 0% pa and are expected to stay at that level for the foreseeable future, what is the most that you would be prepared to pay a bank now if it offered to pay you$10 at the end of every year for the next 5 years?

In other words, what is the present value of five $10 payments at time 1, 2, 3, 4 and 5 if interest rates are 0% pa? The following cash flows are expected: • 10 yearly payments of$80, with the first payment in 6.5 years from now (first payment at t=6.5).
• A single payment of $500 in 4 years and 3 months (t=4.25) from now. What is the NPV of the cash flows if the discount rate is 10% given as an effective annual rate? You are promised 20 payments of$100, where the first payment is immediate (t=0) and the last is at the end of the 19th year (t=19). The effective annual discount rate is $r$.

Which of the following equations does NOT give the correct present value of these 20 payments?

In the below term structure of interest rates equation, all rates are effective annual yields and the numbers in subscript represent the years that the yields are measured over:

$$(1+r_{0-3})^3 = (1+r_{0-1})(1+r_{1-2})(1+r_{2-3})$$

Which of the following statements is NOT correct?

The capital market line (CML) is shown in the graph below. The total standard deviation is denoted by σ and the expected return is μ. Assume that markets are efficient so all assets are fairly priced.

Which of the below statements is NOT correct?

A graph of assets’ expected returns $(\mu)$ versus standard deviations $(\sigma)$ is given in the graph below. The CML is the capital market line.

Which of the following statements about this graph, Markowitz portfolio theory and the Capital Asset Pricing Model (CAPM) theory is NOT correct?

Examine the graphs below. Assume that asset A is a single stock. Which of the following statements is NOT correct? Asset A:

Examine the following graph which shows stocks' betas $(\beta)$ and expected returns $(\mu)$:

Assume that the CAPM holds and that future expectations of stocks' returns and betas are correctly measured. Which statement is NOT correct?

The security market line (SML) shows the relationship between beta and expected return.

Investment projects that plot on the SML would have:

The security market line (SML) shows the relationship between beta and expected return.

Investment projects that plot above the SML would have:

Stock A has a beta of 0.5 and stock B has a beta of 1. Which statement is NOT correct?

Which statement is the most correct?

Assets A, B, M and $r_f$ are shown on the graphs above. Asset M is the market portfolio and $r_f$ is the risk free yield on government bonds. Which of the below statements is NOT correct?

Assets A, B, M and $r_f$ are shown on the graphs above. Asset M is the market portfolio and $r_f$ is the risk free yield on government bonds. Assume that investors can borrow and lend at the risk free rate. Which of the below statements is NOT correct?

The equations for Net Income (NI, also known as Earnings or Net Profit After Tax) and Cash Flow From Assets (CFFA, also known as Free Cash Flow to the Firm) per year are:

$$NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c)$$

$$CFFA=NI+Depr-CapEx - \varDelta NWC+IntExp$$

For a firm with debt, what is the formula for the present value of interest tax shields if the tax shields occur in perpetuity?

You may assume:

• the value of debt (D) is constant through time,
• The cost of debt and the yield on debt are equal and given by $r_D$.
• the appropriate rate to discount interest tax shields is $r_D$.
• $\text{IntExp}=D.r_D$

Unrestricted negative gearing is allowed in Australia, New Zealand and Japan. Negative gearing laws allow income losses on investment properties to be deducted from a tax-payer's pre-tax personal income. Negatively geared investors benefit from this tax advantage. They also hope to benefit from capital gains which exceed the income losses.

For example, a property investor buys an apartment funded by an interest only mortgage loan. Interest expense is $2,000 per month. The rental payments received from the tenant living on the property are$1,500 per month. The investor can deduct this income loss of $500 per month from his pre-tax personal income. If his personal marginal tax rate is 46.5%, this saves$232.5 per month in personal income tax.

The advantage of negative gearing is an example of the benefits of:

Which one of the following will decrease net income (NI) but increase cash flow from assets (CFFA) in this year for a tax-paying firm, all else remaining constant?

Remember:

$$NI=(Rev-COGS-FC-Depr-IntExp).(1-t_c )$$ $$CFFA=NI+Depr-CapEx - ΔNWC+IntExp$$

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? Use the below information to value a levered company with constant annual perpetual cash flows from assets. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. Both the cash flow from assets including and excluding interest tax shields are constant (but not equal to each other).  Data on a Levered Firm with Perpetual Cash Flows Item abbreviation Value Item full name $\text{CFFA}_\text{U}$$100m Cash flow from assets excluding interest tax shields (unlevered) $\text{CFFA}_\text{L}$ $112m Cash flow from assets including interest tax shields (levered) $g$ 0% pa Growth rate of cash flow from assets, levered and unlevered $\text{WACC}_\text{BeforeTax}$ 7% pa Weighted average cost of capital before tax $\text{WACC}_\text{AfterTax}$ 6.25% pa Weighted average cost of capital after tax $r_\text{D}$ 5% pa Cost of debt $r_\text{EL}$ 9% pa Cost of levered equity $D/V_L$ 50% pa Debt to assets ratio, where the asset value includes tax shields $t_c$ 30% Corporate tax rate What is the value of the levered firm including interest tax shields? Use the below information to value a levered company with constant annual perpetual cash flows from assets. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. Both the cash flow from assets including and excluding interest tax shields are constant (but not equal to each other).  Data on a Levered Firm with Perpetual Cash Flows Item abbreviation Value Item full name $\text{CFFA}_\text{U}$$48.5m Cash flow from assets excluding interest tax shields (unlevered) $\text{CFFA}_\text{L}$ $50m Cash flow from assets including interest tax shields (levered) $g$ 0% pa Growth rate of cash flow from assets, levered and unlevered $\text{WACC}_\text{BeforeTax}$ 10% pa Weighted average cost of capital before tax $\text{WACC}_\text{AfterTax}$ 9.7% pa Weighted average cost of capital after tax $r_\text{D}$ 5% pa Cost of debt $r_\text{EL}$ 11.25% pa Cost of levered equity $D/V_L$ 20% pa Debt to assets ratio, where the asset value includes tax shields $t_c$ 30% Corporate tax rate What is the value of the levered firm including interest tax shields? Use the below information to value a levered company with annual perpetual cash flows from assets that grow. The next cash flow will be generated in one year from now, so a perpetuity can be used to value this firm. Note that ‘k’ means kilo or 1,000. So the$30k is $30,000.  Data on a Levered Firm with Perpetual Cash Flows Item abbreviation Value Item full name $\text{CFFA}_\text{U}$$30k Cash flow from assets excluding interest tax shields (unlevered) $g$ 1.5% pa Growth rate of cash flow from assets, levered and unlevered $r_\text{D}$ 4% pa Cost of debt $r_\text{EL}$ 16.3% pa Cost of levered equity $D/V_L$ 80% pa Debt to assets ratio, where the asset value includes tax shields $t_c$ 30% Corporate tax rate

Which of the following statements is NOT correct?

A firm issues debt and uses the funds to buy back equity. Assume that there are no costs of financial distress or transactions costs. Which of the following statements about interest tax shields is NOT correct?

A company conducts a 4 for 3 stock split. What is the percentage change in the stock price and the number of shares outstanding? The answers are given in the same order.

A company conducts a 10 for 3 stock split. What is the percentage increase in the stock price and the number of shares outstanding? The answers are given in the same order.

A firm conducts a two-for-one stock split. Which of the following consequences would NOT be expected?

For certain shares, the forward-looking Price-Earnings Ratio ($P_0/EPS_1$) is equal to the inverse of the share's total expected return ($1/r_\text{total}$).

For what shares is this true?

Assume:

• The general accounting definition of 'payout ratio' which is dividends per share (DPS) divided by earnings per share (EPS).
• All cash flows, earnings and rates are real.

An investor bought a 20 year 5% pa fixed coupon government bond priced at par. The face value is $100. Coupons are paid semi-annually and the next one is in 6 months. Six months later, just after the coupon at that time was paid, yields suddenly and unexpectedly rose to 5.5% pa. Note that all yields above are given as APR's compounding semi-annually. What was the bond investors' historical total return over that first 6 month period, given as an effective semi-annual rate? The following equation is the Dividend Discount Model, also known as the 'Gordon Growth Model' or the 'Perpetuity with growth' equation. $$P_{0} = \frac{C_1}{r_{\text{eff}} - g_{\text{eff}}}$$ What would you call the expression $C_1/P_0$? The following is the Dividend Discount Model (DDM) used to price stocks: $$P_0=\dfrac{C_1}{r-g}$$ If the assumptions of the DDM hold, which one of the following statements is NOT correct? The long term expected: In the dividend discount model: $$P_0 = \dfrac{C_1}{r-g}$$ The return $r$ is supposed to be the: A stock pays annual dividends which are expected to continue forever. It just paid a dividend of$10. The growth rate in the dividend is 2% pa. You estimate that the stock's required return is 10% pa. Both the discount rate and growth rate are given as effective annual rates. Using the dividend discount model, what will be the share price?

A stock is expected to pay the following dividends:

 Cash Flows of a Stock Time (yrs) 0 1 2 3 4 ... Dividend ($) 0.00 1.00 1.05 1.10 1.15 ... After year 4, the annual dividend will grow in perpetuity at 5% pa, so; • the dividend at t=5 will be$1.15(1+0.05),
• the dividend at t=6 will be $1.15(1+0.05)^2, and so on. The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates. What will be the price of the stock in three and a half years (t = 3.5)? A fairly valued share's current price is$4 and it has a total required return of 30%. Dividends are paid annually and next year's dividend is expected to be $1. After that, dividends are expected to grow by 5% pa in perpetuity. All rates are effective annual returns. What is the expected dividend income paid at the end of the second year (t=2) and what is the expected capital gain from just after the first dividend (t=1) to just after the second dividend (t=2)? The answers are given in the same order, the dividend and then the capital gain. A stock is expected to pay its first dividend of$20 in 3 years (t=3), which it will continue to pay for the next nine years, so there will be ten $20 payments altogether with the last payment in year 12 (t=12). From the thirteenth year onward, the dividend is expected to be 4% more than the previous year, forever. So the dividend in the thirteenth year (t=13) will be$20.80, then $21.632 in year 14, and so on forever. The required return of the stock is 10% pa. All rates are effective annual rates. Calculate the current (t=0) stock price. A stock is expected to pay a dividend of$15 in one year (t=1), then $25 for 9 years after that (payments at t=2 ,3,...10), and on the 11th year (t=11) the dividend will be 2% less than at t=10, and will continue to shrink at the same rate every year after that forever. The required return of the stock is 10%. All rates are effective annual rates. What is the price of the stock now? Most listed Australian companies pay dividends twice per year, the 'interim' and 'final' dividends, which are roughly 6 months apart. You are an equities analyst trying to value the company BHP. You decide to use the Dividend Discount Model (DDM) as a starting point, so you study BHP's dividend history and you find that BHP tends to pay the same interim and final dividend each year, and that both grow by the same rate. You expect BHP will pay a$0.55 interim dividend in six months and a $0.55 final dividend in one year. You expect each to grow by 4% next year and forever, so the interim and final dividends next year will be$0.572 each, and so on in perpetuity.

Assume BHP's cost of equity is 8% pa. All rates are quoted as nominal effective rates. The dividends are nominal cash flows and the inflation rate is 2.5% pa.

What is the current price of a BHP share?

Itau Unibanco is a major listed bank in Brazil with a market capitalisation of equity equal to BRL 85.744 billion, EPS of BRL 3.96 and 2.97 billion shares on issue.

Banco Bradesco is another major bank with total earnings of BRL 8.77 billion and 2.52 billion shares on issue.

Estimate Banco Bradesco's current share price using a price-earnings multiples approach assuming that Itau Unibanco is a comparable firm.

Note that BRL is the Brazilian Real, their currency. Figures sourced from Google Finance on the market close of the BVMF on 24/7/15.

Estimate Microsoft's (MSFT) share price using a price earnings (PE) multiples approach with the following assumptions and figures only:

• Apple, Google and Microsoft are comparable companies,
• Apple's (AAPL) share price is $526.24 and historical EPS is$40.32.
• Google's (GOOG) share price is $1,215.65 and historical EPS is$36.23.
• Micrsoft's (MSFT) historical earnings per share (EPS) is $2.71. Source: Google Finance 28 Feb 2014. Estimate the Chinese bank ICBC's share price using a backward-looking price earnings (PE) multiples approach with the following assumptions and figures only. Note that the renminbi (RMB) is the Chinese currency, also known as the yuan (CNY). • The 4 major Chinese banks ICBC, China Construction Bank (CCB), Bank of China (BOC) and Agricultural Bank of China (ABC) are comparable companies; • ICBC 's historical earnings per share (EPS) is RMB 0.74; • CCB's backward-looking PE ratio is 4.59; • BOC 's backward-looking PE ratio is 4.78; • ABC's backward-looking PE ratio is also 4.78; Note: Figures sourced from Google Finance on 25 March 2014. Share prices are from the Shanghai stock exchange. When using the dividend discount model, care must be taken to avoid using a nominal dividend growth rate that exceeds the country's nominal GDP growth rate. Otherwise the firm is forecast to take over the country since it grows faster than the average business forever. Suppose a firm's nominal dividend grows at 10% pa forever, and nominal GDP growth is 5% pa forever. The firm's total dividends are currently$1 billion (t=0). The country's GDP is currently $1,000 billion (t=0). In approximately how many years will the company's total dividends be as large as the country's GDP? Two companies BigDiv and ZeroDiv are exactly the same except for their dividend payouts. BigDiv pays large dividends and ZeroDiv doesn't pay any dividends. Currently the two firms have the same earnings, assets, number of shares, share price, expected total return and risk. Assume a perfect world with no taxes, no transaction costs, no asymmetric information and that all assets including business projects are fairly priced and therefore zero-NPV. All things remaining equal, which of the following statements is NOT correct? You are an equities analyst trying to value the equity of the Australian telecoms company Telstra, with ticker TLS. In Australia, listed companies like Telstra tend to pay dividends every 6 months. The payment around August is called the final dividend and the payment around February is called the interim dividend. Both occur annually. • Today is mid-March 2015. • TLS's last interim dividend of$0.15 was one month ago in mid-February 2015.
• TLS's last final dividend of $0.15 was seven months ago in mid-August 2014. Judging by TLS's dividend history and prospects, you estimate that the nominal dividend growth rate will be 1% pa. Assume that TLS's total nominal cost of equity is 6% pa. The dividends are nominal cash flows and the inflation rate is 2.5% pa. All rates are quoted as nominal effective annual rates. Assume that each month is exactly one twelfth (1/12) of a year, so you can ignore the number of days in each month. Calculate the current TLS share price. Private equity firms are known to buy medium sized private companies operating in the same industry, merge them together into a larger company, and then sell it off in a public float (initial public offering, IPO). If medium-sized private companies trade at PE ratios of 5 and larger listed companies trade at PE ratios of 15, what return can be achieved from this strategy? Assume that: • The medium-sized companies can be bought, merged and sold in an IPO instantaneously. • There are no costs of finding, valuing, merging and restructuring the medium sized companies. Also, there is no competition to buy the medium-sized companies from other private equity firms. • The large merged firm's earnings are the sum of the medium firms' earnings. • The only reason for the difference in medium and large firm's PE ratios is due to the illiquidity of the medium firms' shares. • Return is defined as: $r_{0→1} = (p_1-p_0+c_1)/p_0$ , where time zero is just before the merger and time one is just after. An Australian company just issued two bonds: • A 6-month zero coupon bond at a yield of 6% pa, and • A 12 month zero coupon bond at a yield of 7% pa. What is the company's forward rate from 6 to 12 months? Give your answer as an APR compounding every 6 months, which is how the above bond yields are quoted. An equity index is currently at 4,800 points. The 1.5 year futures price is 5,100 points and the total required return is 6% pa with continuous compounding. Each index point is worth$25.

What is the implied dividend yield as a continuously compounded rate per annum?

Which of the following statements about European call options on non-dividend paying stocks is NOT correct?

A put option written on a risky non-dividend paying stock will mature in one month. As is normal, assume that the option's exercise price is non-zero and positive $(K>0)$ and the stock has limited liability $(S>0)$.

Which of the following statements is NOT correct? The put option's:

You just paid $4 for a 3 month European style call option on a stock currently priced at$47 with a strike price of $50. The stock’s next dividend will be$1 in 4 months’ time. Note that the dividend is paid after the option matures. Which of the below statements is NOT correct?

The standard deviation of monthly changes in the spot price of corn is 50 cents per bushel. The standard deviation of monthly changes in the futures price of corn is 40 cents per bushel. The correlation between the spot price of corn and the futures price of corn is 0.9.

It is now March. A corn chip manufacturer is committed to buying 250,000 bushels of corn in May. The spot price of corn is 381 cents per bushel and the June futures price is 399 cents per bushel.

The corn chip manufacturer wants to use the June corn futures contracts to hedge his risk. Each futures contract is for the delivery of 5,000 bushels of corn. One bushel is about 127 metric tons.

How many corn futures should the corn chip manufacturer buy to hedge his risk? Round your answer to the nearest whole number of contracts. Remember to tail the hedge.

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?

A one year European-style put option has a strike price of $4. The option's underlying stock pays no dividends and currently trades at$5. The risk-free interest rate is 10% pa continuously compounded. Use a single step binomial tree to calculate the option price, assuming that the price could rise to $8 $(u = 1.6)$ or fall to$3.125 $(d = 1/1.6)$ in one year. The put option price now is:

A one year European-style call option has a strike price of $4. The option's underlying stock pays no dividends and currently trades at$5. The risk-free interest rate is 10% pa continuously compounded. Use a single step binomial tree to calculate the option price, assuming that the price could rise to $8 $(u = 1.6)$ or fall to$3.125 $(d = 1/1.6)$ in one year. The call option price now is:

An equity index fund manager controls a USD1 billion diversified equity portfolio with a beta of 1.3. The equity manager fears that a global recession will begin in the next year, causing equity prices to tumble. The market does not think that this will happen. If the fund manager wishes to reduce her portfolio beta to 0.5, how many S&P500 futures should she sell?

The US market equity index is the S&P500. One year CME futures on the S&P500 currently trade at 2,062 points and the spot price is 2,091 points. Each point is worth $250. How many one year S&P500 futures contracts should the fund manager sell? A bank buys 1000 European put options on a$10 non-dividend paying stock at a strike of $12. The bank wishes to hedge this exposure. The bank can trade the underlying stocks and European call options with a strike price of 7 on the same stock with the same maturity. Details of the call and put options are given in the table below. Each call and put option is on a single stock.  European Options on a Non-dividend Paying Stock Description Symbol Put Values Call Values Spot price ($) $S_0$ 10 10 Strike price ($) $K_T$ 12 7 Risk free cont. comp. rate (pa) $r$ 0.05 0.05 Standard deviation of the stock's cont. comp. returns (pa) $\sigma$ 0.4 0.4 Option maturity (years) $T$ 1 1 Option price ($) $p_0$ or $c_0$ 2.495350486 3.601466138 $N[d_1]$ $\partial c/\partial S$ 0.888138405 $N[d_2]$ $N[d_2]$ 0.792946442 $-N[-d_1]$ $\partial p/\partial S$ -0.552034778 $N[-d_2]$ $N[-d_2]$ 0.207053558 Gamma $\Gamma = \partial^2 c/\partial S^2$ or $\partial^2 p/\partial S^2$ 0.098885989 0.047577422 Theta $\Theta = \partial c/\partial T$ or $\partial p/\partial T$ 0.348152078 0.672379961

Which of the following statements is NOT correct?

Below are some statements about futures and European-style options on non-dividend paying stocks. Assume that the risk free rate is always positive. Which of these statements is NOT correct? All other things remaining equal:

Below are some statements about European-style options on non-dividend paying stocks. Assume that the risk free rate is always positive. Which of these statements is NOT correct?

Question 860  idiom, hedging, speculation, arbitrage, market making, insider trading, no explanation

Which class of derivatives market trader is NOT principally focused on ‘buying low and selling high’?

The 'futures price' in a futures contract is paid at the start when the futures contract is agreed to. or ?

Which of the below formulas gives the payoff at maturity $(f_T)$ from being long a future? Let the underlying asset price at maturity be $S_T$ and the locked-in futures price be $K_T$.

Which of the following statements about futures is NOT correct?

Which of the below formulas gives the payoff at maturity $(f_T)$ from being short a future? Let the underlying asset price at maturity be $S_T$ and the locked-in futures price be $K_T$.

A trader buys one crude oil futures contract on the CME expiring in one year with a locked-in futures price of $38.94 per barrel. If the trader doesn’t close out her contract before expiry then in one year she will have the: A trader sells one crude oil futures contract on the CME expiring in one year with a locked-in futures price of$38.94 per barrel. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before expiry then in one year she will have the: Which of the following statements about futures contracts on shares is NOT correct, assuming that markets are efficient? When an equity future is first negotiated (at t=0): The current gold price is$700, gold storage costs are 2% pa and the risk free rate is 10% pa, both with continuous compounding.

What should be the 3 year gold futures price?

A 2-year futures contract on a stock paying a continuous dividend yield of 3% pa was bought when the underlying stock price was $10 and the risk free rate was 10% per annum with continuous compounding. Assume that investors are risk-neutral, so the stock's total required return is the risk free rate. Find the forward price $(F_2)$ and value of the contract $(V_0)$ initially. Also find the value of the contract in 6 months $(V_{0.5})$ if the stock price rose to$12.

In February a company sold one December 40,000 pound (about 18 metric tons) lean hog futures contract. It closed out its position in May.

The spot price was $0.68 per pound in February. The December futures price was$0.70 per pound when the trader entered into the contract in February, $0.60 when he closed out his position in May, and$0.55 when the contract matured in December.

What was the total profit?

Which of the following statements about futures is NOT correct?

An equity index stands at 100 points and the one year equity futures price is 102.

The equity index is expected to have a dividend yield of 4% pa. Assume that investors are risk-neutral so their total required return on the shares is the same as the risk free Treasury bond yield which is 10% pa. Both are given as discrete effective annual rates.

Assuming that the equity index is fairly priced, an arbitrageur would recognise that the equity futures are:

The 'option price' in an option contract is paid at the start when the option contract is agreed to. or ?

The 'option strike price' in an option contract, also known as the exercise price, is paid at the start when the option contract is agreed to. or ?

Which option position has the possibility of unlimited potential losses?

A man just sold a call option to his counterparty, a lady. The man has just now:

A European call option will mature in $T$ years with a strike price of $K$ dollars. The underlying asset has a price of $S$ dollars.

What is an expression for the payoff at maturity $(f_T)$ in dollars from owning (being long) the call option?

A European put option will mature in $T$ years with a strike price of $K$ dollars. The underlying asset has a price of $S$ dollars.

What is an expression for the payoff at maturity $(f_T)$ in dollars from owning (being long) the put option?

A European call option will mature in $T$ years with a strike price of $K$ dollars. The underlying asset has a price of $S$ dollars.

What is an expression for the payoff at maturity $(f_T)$ in dollars from having written (being short) the call option?

A European put option will mature in $T$ years with a strike price of $K$ dollars. The underlying asset has a price of $S$ dollars.

What is an expression for the payoff at maturity $(f_T)$ in dollars from having written (being short) the put option?

Question 432  option, option intrinsic value, no explanation

An American call option with a strike price of $K$ dollars will mature in $T$ years. The underlying asset has a price of $S$ dollars.

What is an expression for the current intrinsic value in dollars from owning (being long) the American call option? Note that the intrinsic value of an option does not subtract the premium paid to buy the option.

Which one of the following statements about option contracts is NOT correct?

Which of the following statements about option contracts is NOT correct? For every:

If trader A has sold the right that allows counterparty B to buy the underlying asset from him at maturity if counterparty B wants then trader A is:

After doing extensive fundamental analysis of a company, you believe that their shares are overpriced and will soon fall significantly. The market believes that there will be no such fall.

Which of the following strategies is NOT a good idea, assuming that your prediction is true?

Which of the below formulas gives the payoff $(f)$ at maturity $(T)$ from being long a call option? Let the underlying asset price at maturity be $S_T$ and the exercise price be $X_T$.

Which of the below formulas gives the payoff $(f)$ at maturity $(T)$ from being short a call option? Let the underlying asset price at maturity be $S_T$ and the exercise price be $X_T$.

Which of the below formulas gives the payoff $(f)$ at maturity $(T)$ from being long a put option? Let the underlying asset price at maturity be $S_T$ and the exercise price be $X_T$.

Which of the below formulas gives the payoff $(f)$ at maturity $(T)$ from being short a put option? Let the underlying asset price at maturity be $S_T$ and the exercise price be $X_T$.

Which one of the below option and futures contracts gives the possibility of potentially unlimited gains?

A trader buys one crude oil European style call option contract on the CME expiring in one year with an exercise price of $44 per barrel for a price of$6.64. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before maturity, then at maturity she will have the: Which of the below formulas gives the profit $(\pi)$ from being long a call option? Let the underlying asset price at maturity be $S_T$, the exercise price be $X_T$ and the option price be $f_{LC,0}$. Note that $S_T$, $X_T$ and $f_{LC,0}$ are all positive numbers. Which of the below formulas gives the profit $(\pi)$ from being short a call option? Let the underlying asset price at maturity be $S_T$, the exercise price be $X_T$ and the option price be $f_{LC,0}$. Note that $S_T$, $X_T$ and $f_{LC,0}$ are all positive numbers. Which of the below formulas gives the profit $(\pi)$ from being long a put option? Let the underlying asset price at maturity be $S_T$, the exercise price be $X_T$ and the option price be $f_{LP,0}$. Note that $S_T$, $X_T$ and $f_{LP,0}$ are all positive numbers. Which of the below formulas gives the profit $(\pi)$ from being short a put option? Let the underlying asset price at maturity be $S_T$, the exercise price be $X_T$ and the option price be $f_{LP,0}$. Note that $S_T$, $X_T$ and $f_{LP,0}$ are all positive numbers. A trader sells one crude oil European style call option contract on the CME expiring in one year with an exercise price of$44 per barrel for a price of $6.64. The crude oil spot price is$40.33. If the trader doesn’t close out her contract before maturity, then at maturity she will have the:

A trader buys one crude oil European style put option contract on the CME expiring in one year with an exercise price of $44 per barrel for a price of$6.64. The crude oil spot price is $40.33. If the trader doesn’t close out her contract before maturity, then at maturity she will have the: Which of the following statements about call options is NOT correct? Will the price of a call option on equity or if the standard deviation of returns (risk) of the underlying shares becomes higher? Will the price of an out-of-the-money put option on equity or if the standard deviation of returns (risk) of the underlying shares becomes higher? Two call options are exactly the same, but one matures in one year and the other matures in two years. Which option would you expect to have the higher price, the option which matures or , or should they have the price? Two put options are exactly the same, but one matures in one year and the other matures in two years. Which option would you expect to have the higher price, the option which matures or , or should they have the price? Two call options are exactly the same, but one has a low and the other has a high exercise price. Which option would you expect to have the higher price, the option with the or exercise price, or should they have the price? Two put options are exactly the same, but one has a low and the other has a high exercise price. Which option would you expect to have the higher price, the option with the or exercise price, or should they have the price? 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: Below are 4 option graphs. Note that the y-axis is payoff at maturity (T). What options do they depict? List them in the order that they are numbered. You have just sold an 'in the money' 6 month European put option on the mining company BHP at an exercise price of$40 for a premium of $3. Which of the following statements best describes your situation? You operate a cattle farm that supplies hamburger meat to the big fast food chains. You buy a lot of grain to feed your cattle, and you sell the fully grown cattle on the livestock market. You're afraid of adverse movements in grain and livestock prices. What options should you buy to hedge your exposures in the grain and cattle livestock markets? Select the most correct response: It's possible for both parties in a futures or forward contract to be hedging, so neither are speculating. or ? Being long a call and short a put which have the same exercise prices and underlying stock is equivalent to being: A stock, a call, a put and a bond are available to trade. The call and put options' underlying asset is the stock they and have the same strike prices, $K_T$. Being long the call and short the stock is equivalent to being: A stock, a call, a put and a bond are available to trade. The call and put options' underlying asset is the stock they and have the same strike prices, $K_T$. You are currently long the stock. You want to hedge your long stock position without actually trading the stock. How would you do this? A 12 month European-style call option with a strike price of$11 is written on a dividend paying stock currently trading at $10. The dividend is paid annually and the next dividend is expected to be$0.40, paid in 9 months. The risk-free interest rate is 5% pa continuously compounded and the standard deviation of the stock’s continuously compounded returns is 30 percentage points pa. The stock's continuously compounded returns are normally distributed. Using the Black-Scholes-Merton option valuation model, determine which of the following statements is NOT correct.

A one year European-style call option has a strike price of $4. The option's underlying stock currently trades at$5, pays no dividends and its standard deviation of continuously compounded returns is 47% pa.

The risk-free interest rate is 10% pa continuously compounded.

Use the Black-Scholes-Merton formula to calculate the option price. The call option price now is:

A one year European-style put option has a strike price of $4. The option's underlying stock currently trades at$5, pays no dividends and its standard deviation of continuously compounded returns is 47% pa.

The risk-free interest rate is 10% pa continuously compounded.

Use the Black-Scholes-Merton formula to calculate the option price. The put option price now is:

Which of the following quantities from the Black-Scholes-Merton option pricing formula gives the Delta of a European call option?

Where:

$$d_1=\dfrac{\ln⁡[S_0/K]+(r+\sigma^2/2).T)}{\sigma.\sqrt{T}}$$ $$d_2=d_1-\sigma.\sqrt{T}=\dfrac{\ln⁡[S_0/K]+(r-\sigma^2/2).T)}{\sigma.\sqrt{T}}$$

Which of the following quantities from the Black-Scholes-Merton option pricing formula gives the Delta of a European put option?

Which of the following quantities from the Black-Scholes-Merton option pricing formula gives the risk-neutral probability that a European call option will be exercised?

Question 903  option, Black-Scholes-Merton option pricing, option on stock index

A six month European-style call option on the S&P500 stock index has a strike price of 2800 points.

The underlying S&P500 stock index currently trades at 2700 points, has a continuously compounded dividend yield of 2% pa and a standard deviation of continuously compounded returns of 25% pa.

The risk-free interest rate is 5% pa continuously compounded.

Use the Black-Scholes-Merton formula to calculate the option price. The call option price now is:

Question 906  effective rate, return types, net discrete return, return distribution, price gains and returns over time

For an asset's price to double from say $1 to$2 in one year, what must its effective annual return be? Note that an effective annual return is also called a net discrete return per annum. If the price now is $P_0$ and the price in one year is $P_1$ then the effective annul return over the next year is:

$$r_\text{effective annual} = \dfrac{P_1 - P_0}{P_0} = \text{NDR}_\text{annual}$$

For an asset's price to double from say $1 to$2 in one year, what must its continuously compounded return $(r_{CC})$ be? If the price now is $P_0$ and the price in one year is $P_1$ then the continuously compounded return over the next year is:

$$r_\text{CC annual} = \ln{\left[ \dfrac{P_1}{P_0} \right]} = \text{LGDR}_\text{annual}$$

Question 908  effective rate, return types, gross discrete return, return distribution, price gains and returns over time

For an asset's price to double from say $1 to$2 in one year, what must its gross discrete return (GDR) be? If the price now is $P_0$ and the price in one year is $P_1$ then the gross discrete return over the next year is:

$$\text{GDR}_\text{annual} = \dfrac{P_1}{P_0}$$

If a variable, say X, is normally distributed with mean $\mu$ and variance $\sigma^2$ then mathematicians write $X \sim \mathcal{N}(\mu, \sigma^2)$.

If a variable, say Y, is log-normally distributed and the underlying normal distribution has mean $\mu$ and variance $\sigma^2$ then mathematicians write $Y \sim \mathbf{ln} \mathcal{N}(\mu, \sigma^2)$.

The below three graphs show probability density functions (PDF) of three different random variables Red, Green and Blue.

Select the most correct statement:

The below three graphs show probability density functions (PDF) of three different random variables Red, Green and Blue. Let $P_1$ be the unknown price of a stock in one year. $P_1$ is a random variable. Let $P_0 = 1$, so the share price now is $1. This one dollar is a constant, it is not a variable. Which of the below statements is NOT correct? Financial practitioners commonly assume that the shape of the PDF represented in the colour: If a stock's future expected continuously compounded annual returns are normally distributed, what will be bigger, the stock's or continuously compounded annual return? Or would you expect them to be ? If a stock's expected future prices are log-normally distributed, what will be bigger, the stock's or future price? Or would you expect them to be ? A stock has an arithmetic average continuously compounded return (AALGDR) of 10% pa, a standard deviation of continuously compounded returns (SDLGDR) of 80% pa and current stock price of$1. Assume that stock prices are log-normally distributed.

In one year, what do you expect the mean and median prices to be? The answer options are given in the same order.

A stock has an arithmetic average continuously compounded return (AALGDR) of 10% pa, a standard deviation of continuously compounded returns (SDLGDR) of 80% pa and current stock price of $1. Assume that stock prices are log-normally distributed. In 5 years, what do you expect the mean and median prices to be? The answer options are given in the same order. Here is a table of stock prices and returns. Which of the statements below the table is NOT correct?  Price and Return Population Statistics Time Prices LGDR GDR NDR 0 100 1 99 -0.010050 0.990000 -0.010000 2 180.40 0.600057 1.822222 0.822222 3 112.73 0.470181 0.624889 0.375111 Arithmetic average 0.0399 1.1457 0.1457 Arithmetic standard deviation 0.4384 0.5011 0.5011 Which of the following quantities is commonly assumed to be normally distributed? The below three graphs show probability density functions (PDF) of three different random variables Red, Green and Blue. Which of the below statements is NOT correct? If a stock's future expected effective annual returns are log-normally distributed, what will be bigger, the stock's or effective annual return? Or would you expect them to be ? The symbol $\text{GDR}_{0\rightarrow 1}$ represents a stock's gross discrete return per annum over the first year. $\text{GDR}_{0\rightarrow 1} = P_1/P_0$. The subscript indicates the time period that the return is mentioned over. So for example, $\text{AAGDR}_{1 \rightarrow 3}$ is the arithmetic average GDR measured over the two year period from years 1 to 3, but it is expressed as a per annum rate. Which of the below statements about the arithmetic and geometric average GDR is NOT correct? Fred owns some Commonwealth Bank (CBA) shares. He has calculated CBA’s monthly returns for each month in the past 20 years using this formula: $$r_\text{t monthly}=\ln⁡ \left( \dfrac{P_t}{P_{t-1}} \right)$$ He then took the arithmetic average and found it to be 1% per month using this formula: $$\bar{r}_\text{monthly}= \dfrac{ \displaystyle\sum\limits_{t=1}^T{\left( r_\text{t monthly} \right)} }{T} =0.01=1\% \text{ per month}$$ He also found the standard deviation of these monthly returns which was 5% per month: $$\sigma_\text{monthly} = \dfrac{ \displaystyle\sum\limits_{t=1}^T{\left( \left( r_\text{t monthly} - \bar{r}_\text{monthly} \right)^2 \right)} }{T} =0.05=5\%\text{ per month}$$ Which of the below statements about Fred’s CBA shares is NOT correct? Assume that the past historical average return is the true population average of future expected returns. Here is a table of stock prices and returns. Which of the statements below the table is NOT correct?  Price and Return Population Statistics Time Prices LGDR GDR NDR 0 100 1 50 -0.6931 0.5 -0.5 2 100 0.6931 2 1 Arithmetic average 0 1.25 0.25 Arithmetic standard deviation -0.6931 0.75 0.75 Fred owns some BHP shares. He has calculated BHP’s monthly returns for each month in the past 30 years using this formula: $$r_\text{t monthly}=\ln⁡ \left( \dfrac{P_t}{P_{t-1}} \right)$$ He then took the arithmetic average and found it to be 0.8% per month using this formula: $$\bar{r}_\text{monthly}= \dfrac{ \displaystyle\sum\limits_{t=1}^T{\left( r_\text{t monthly} \right)} }{T} =0.008=0.8\% \text{ per month}$$ He also found the standard deviation of these monthly returns which was 15% per month: $$\sigma_\text{monthly} = \dfrac{ \displaystyle\sum\limits_{t=1}^T{\left( \left( r_\text{t monthly} - \bar{r}_\text{monthly} \right)^2 \right)} }{T} =0.15=15\%\text{ per month}$$ Assume that the past historical average return is the true population average of future expected returns and the stock's returns calculated above $(r_\text{t monthly})$ are normally distributed. Which of the below statements about Fred’s BHP shares is NOT correct? A risk manager has identified that their investment fund’s continuously compounded portfolio returns are normally distributed with a mean of 10% pa and a standard deviation of 40% pa. The fund’s portfolio is currently valued at$1 million. Assume that there is no estimation error in the above figures. To simplify your calculations, all answers below use 2.33 as an approximation for the normal inverse cumulative density function at 99%. All answers are rounded to the nearest dollar. Assume one month is 1/12 of a year. Which of the following statements is NOT correct?

Which of the following statements about probability distributions is NOT correct?

The arithmetic average continuously compounded or log gross discrete return (AALGDR) on the ASX200 accumulation index over the 24 years from 31 Dec 1992 to 31 Dec 2016 is 9.49% pa.

The arithmetic standard deviation (SDLGDR) is 16.92 percentage points pa.

Assume that the log gross discrete returns are normally distributed and that the above estimates are true population statistics, not sample statistics, so there is no standard error in the sample mean or standard deviation estimates. Also assume that the standardised normal Z-statistic corresponding to a one-tail probability of 2.5% is exactly -1.96.

If you had a $1 million fund that replicated the ASX200 accumulation index, in how many years would the median dollar value of your fund first be expected to lie outside the 95% confidence interval forecast? The arithmetic average continuously compounded or log gross discrete return (AALGDR) on the ASX200 accumulation index over the 24 years from 31 Dec 1992 to 31 Dec 2016 is 9.49% pa. The arithmetic standard deviation (SDLGDR) is 16.92 percentage points pa. Assume that the log gross discrete returns are normally distributed and that the above estimates are true population statistics, not sample statistics, so there is no standard error in the sample mean or standard deviation estimates. Also assume that the standardised normal Z-statistic corresponding to a one-tail probability of 2.5% is exactly -1.96. If you had a$1 million fund that replicated the ASX200 accumulation index, in how many years would the mode dollar value of your fund first be expected to lie outside the 95% confidence interval forecast?

Note that the mode of a log-normally distributed future price is: $P_{T \text{ mode}} = P_0.e^{(\text{AALGDR} - \text{SDLGDR}^2 ).T}$

The below table summarises the borrowing costs confronting two companies A and B.

 Bond Market Yields Fixed Yield to Maturity (%pa) Floating Yield (%pa) Firm A 3 L - 0.4 Firm B 5 L + 1

Firm A wishes to borrow at a floating rate and Firm B wishes to borrow at a fixed rate. Design an intermediated swap (which means there will actually be two swaps) that nets a bank 0.1% and shares the remaining swap benefits between Firms A and B equally. Which of the following statements about the swap is NOT correct?

The below table summarises the borrowing costs confronting two companies A and B.

 Bond Market Yields Fixed Yield to Maturity (%pa) Floating Yield (%pa) Firm A 2 L - 0.1 Firm B 2.5 L

Firm A wishes to borrow at a floating rate and Firm B wishes to borrow at a fixed rate. Design an intermediated swap (which means there will actually be two swaps) that nets a bank 0.15% and grants the remaining swap benefits to Firm A only. Which of the following statements about the swap is NOT correct?

A company can invest funds in a five year project at LIBOR plus 50 basis points pa. The five-year swap rate is 4% pa. What fixed rate of interest can the company earn over the next five years by using the swap?

Which derivatives position has the possibility of unlimited potential gains?

Which of the following terms about options are NOT synonyms?

What derivative position are you exposed to if you have the obligation to sell the underlying asset at maturity, so you will definitely be forced to sell the underlying asset?

A European call option should only be exercised if:

An equity index fund manager controls a USD500 million diversified equity portfolio with a beta of 0.9. The equity manager expects a significant rally in equity prices next year. The market does not think that this will happen. If the fund manager wishes to increase his portfolio beta to 1.5, how many S&P500 futures should he buy?

The US market equity index is the S&P500. One year CME futures on the S&P500 currently trade at 2,155 points and the spot price is 2,180 points. Each point is worth $250. The number of one year S&P500 futures contracts that the fund manager should buy is: You bought a 1.5 year (18 month) futures contract on oil. Oil storage costs are 4% pa continuously compounded and oil pays no dividends. The futures contract is entered into when the oil price is$40 per barrel and the risk-free rate of interest is 10% per annum with continuous compounding.

Which of the following statements is NOT correct?

Question 831  option, American option, no explanation

Which of the following statements about American-style options is NOT correct? American-style:

A risk manager has identified that their hedge fund’s continuously compounded portfolio returns are normally distributed with a mean of 10% pa and a standard deviation of 30% pa. The hedge fund’s portfolio is currently valued at $100 million. Assume that there is no estimation error in these figures and that the normal cumulative density function at 1.644853627 is 95%. Which of the following statements is NOT correct? All answers are rounded to the nearest dollar. Question 954 option, at the money option If a put option is at-the-money, then the spot price ($S_0$) is than, than or to the put option's strike price ($K_T$)? Question 950 futures, backwardation If futures prices are in backwardation, then futures prices ($F_{0,T}$) are than, than or to spot prices ($S_0$)? If futures prices are in contango, then futures prices ($F_{0,T}$) are than, than or to spot prices ($S_0$)? The 'initial margin', also known as the performance bond in a futures contract, is paid at the start when the futures contract is agreed to. or ? Which of the following statements about futures and forward contracts is NOT correct? A trader buys one December futures contract on orange juice. Each contract is for the delivery of 10,000 pounds. The current futures price is$1.20 per pound. The initial margin is $5,000 per contract, and the maintenance margin is$4,000 per contract.

What is the smallest price change would that would lead to a margin call for the buyer?

If a call option is in-the-money, then the spot price ($S_0$) is than, than or to the call option's strike price ($K_T$)?

If a put option is in-the-money, then the spot price ($S_0$) is than, than or to the put option's strike price ($K_T$)?

Below are 4 option graphs. Note that the y-axis is payoff at maturity (T). What options do they depict? List them in the order that they are numbered

Which one of the following is NOT usually considered an 'investable' asset for long-term wealth creation?

If a call option is out-of-the-money, then the spot price ($S_0$) is than, than or to the call option's strike price ($K_T$)?

If a put option is out-of-the-money, then the spot price ($S_0$) is than, than or to the put option's strike price ($K_T$)?

A non-dividend paying stock has a current price of $20. The risk free rate is 5% pa given as a continuously compounded rate. Options on the stock are currently priced at$5 for calls and $5.55 for puts where both options have a 2 year maturity and an exercise price of$24.

You suspect that the call option 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 948  VaR, expected shortfall

Below is a historical sample of returns on the S&P500 capital index.

 S&P500 Capital Index Daily Returns Ranked from Best to Worst 10,000 trading days from 4th August 1977 to 24 March 2017 based on closing prices. Rank Date(DD-MM-YY) Continuously compounded daily return (% per day) 1 21-10-87 9.23 2 08-03-83 8.97 3 13-11-08 8.3 4 30-09-08 8.09 5 28-10-08 8.01 6 29-10-87 7.28 … … … 9980 11-12-08 -5.51 9981 22-10-08 -5.51 9982 08-08-11 -5.54 9983 22-09-08 -5.64 9984 11-09-86 -5.69 9985 30-11-87 -5.88 9986 14-04-00 -5.99 9987 07-10-98 -6.06 9988 08-01-88 -6.51 9989 27-10-97 -6.55 9990 13-10-89 -6.62 9991 15-10-08 -6.71 9992 29-09-08 -6.85 9993 07-10-08 -6.91 9994 14-11-08 -7.64 9995 01-12-08 -7.79 9996 29-10-08 -8.05 9997 26-10-87 -8.4 9998 31-08-98 -8.45 9999 09-10-08 -12.9 10000 19-10-87 -23.36 Mean of all 10,000: 0.0354 Sample standard deviation of all 10,000: 1.2062 Sources: Bloomberg and S&P.

Assume that the one-tail Z-statistic corresponding to a probability of 99.9% is exactly 3.09. Which of the following statements is NOT correct? Based on the historical data, the 99.9% daily:

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 ($) N[d2]*K/e^(r*T) 4838.772971 5146.037671 4343.161041 4025.300909 4845.505265 ? Interest expense from borrowing paid in arrears ($) r*N[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?