# Finance

1. Which, if any, of the following statements are false?

A. Market interest rates and bond prices vary inversely.

B. For a given absolute change in interest rates from the same base level, the proportionate increase in bond prices when rates fall is smaller than the proportionate decrease in bond prices when rates rise.

C. For identical coupon rates and a given absolute change in interest rates from the same base level, long-term bonds change proportionately more in price than short-term bonds.

D. For identical maturities and a given absolute change in interest rates from the same base level, low-coupon bonds change proportionately less in price than high-coupon bonds.

2 What is the duration of a six-year, 4.5 percent coupon rate, annual coupon payment, $1000 par value government bond priced today to yield 4 percent to maturity (use the text formula or Excel's MDuration function)? What is the convexity of this instrument? [Recall that Bonds and Bond Prpoerties.xls illustrates the duration and convexity calculations.] Using one of the following approximation formulas with yield data in decimal form,

[if text formula] % Change in Price * 100 * (-1.0 * Duration * (YieldNew-YieldOld)/(1+YieldOld)),

[if Excel function] % Change in Price * 100 * (-1.0 * MDuration * (YieldNew-YieldOld)),

what is the approximate percentage change in this bond's price if yields on comparable securities rise to 5 percent? What is the actual percentage change in this bond's price if yields on comparable securities rise to 5 percent (use a financial calculator or Excel's PV function)?

3. Consider the dividend discount model, the capital asset pricing model, the arbitrage pricing model and the firm valuation model. If these accurately portray the intrinsic values of stock prices and stock returns, then what is the corresponding fundamental relationship between stock prices and interest rates? Explain your answers.

PART II

1. Suppose the Federal Reserve sells government securities from its existing holdings to the financial sector and the non-bank public. Trace through the expected consequences of this secondary market action on the banking system - reserves, loanable and investable funds, and deposits; financial markets - bond and stock prices, and interest rates; inflationary pressures; credit-sensitive spending; and the general state of the economy as measured by real GDP (or real income) and unemployment.

2. Deficit spending at the Federal level involves increased government purchases or reduced net taxation with new bonds issued by the US Treasury. The Federal Reserve must sell these new bonds to the public. It can do so without adjusting its own policies or, by combining this sale with open market purchases, it can, in effect, monetize the debt. What are the consequences for interest rates, spending financed by private borrowing, the money supply, the bond supply and inflation from each of these two options for dealing with new Treasury issues? In the second case for simplicity, assume the open market purchase matches in value the auction and sale of new Treasury securities.

PART III

1. The portfolio managers of a bank determined that over the next year interest-sensitive assets are in the amount of $1.1 billion while interest-sensitive liabilities are in the amount of $1.5 billion. Moreover, when considering all of the bank's financial assets and liabilities, they determined that the average duration of assets is 3.6 years while the average duration of liabilities (adjusted for net worth) is 2.5 years. Considering your text's discussion in Chapter 19 of a firm's GAP and Duration GAP (DGAP), what is the interest rate risk facing this institution for net income and market value? Consider and discuss each by thinking about what happens to net interest income and relative asset prices (market values) as interest rates rise or fall. What strategies could management employ to hedge against this risk by buying or selling futures, call options or put options (that is, for each derivative, should they buy or sell?)?

2. Suppose you believe that D's stock price is going to decline from its current level sometime during the next 6 months. Suppose you buy a 6-month put option on D's stock for $200. This put option gives you the right to sell 100 shares of D's stock at an exercise price of $45 per share. What is the most you could lose in this purchase, at what price for D's stock would you break even by exercising this option and how much would you make if D's stock fell to $42 per share?

3. A U.S. importer makes a purchase from a German firm in the amount of 27,200 Euros. At the current spot rate of 0.85 Euros per dollar, how much is this purchase in U.S. dollars? Next, consider that this U.S firm will not have to pay the German firm for 90 days and that the U.S. firm is concerned that the dollar might weaken over this 90-day period. Suppose the U.S. firm completes a forward hedge at the 90-day forward rate of 0.85 Euros per dollar (that is, the 90-day forward rate currently is the same as the spot rate). If in 90 days the dollar weakens so that the spot rate is 0.80 Euros per dollar, how much of a loss (in dollars) will the U.S. firm have avoided by hedging its exchange rate exposure?

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This solution provides assistance with each of the finance problems.