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# Determining the Interest Rates and Valuation of Financial Derivatives

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2. Calculate a table of interest rates based on the following information:

•The pure interest rate is 2.5%.
•Inflation expectations for year 1 = 2%, year 2 =4%, years 3-5 =5%.
•The default risk is .1% for year one and increases by .1% over each year.
•Liquidity premium is 0 for year 1 and increases by .15% each year.

3. Valuation - options.

The following information refers to a six-month call option on the stock of XYZ, Inc.

•Price of the underlying stock: \$100.
•Strike price of the three-month call: \$92.
•Market price of the option: \$18 .

a) What is the intrinsic value of the option?

b) What is the option's time premium at this price?

4. Calculate the sustainable growth based on the following information:

•Earnings after taxes = \$23,000.
•Equity = \$110,000.
•d=48.7%

5. Valuation - convertible bond.

You purchased one of Big Corp.'s 8%, 10-year convertible bonds at its \$1,000 par value a year ago when the company's common stock was selling for \$20. Similar bonds without a conversion feature returned 12% at the time. The bond is convertible into stock at a price of \$30. The stock is now selling for \$35.

Assume no dividends.
a) You exercise the conversion feature today and immediately sold the stock you received. Calculate the total return on your investment.
b) What would your return have been if you had invested \$1,000 in Big's stock instead of the bond?

6. Present value of annuity problem.

You will receive \$2,000 at the end of the next 12 years, assuming a 6% discount rate, what is the present value of the cash flows?

7. Risk & Return and the CAPM.

Based on the following information, calculate the required return based on the CAPM:
Risk Free Rate = 3.75%
Market Return =10%
Beta = 1.32

#### Solution Summary

The expert determines the interest rates and valuations of financial derivatives.

\$2.19