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Melbourne Business School Corporate Finance

Exercise Set 1
Instructions:
• Type your answers into this document and then print it, or print it and then write in
your answers.
• You must show how you arrived at the answer, otherwise your mark will be zero;
but be very brief. Excessively long answers will be marked down.
• Each student should submit their own answers. You may discuss the questions in
general terms but your answers must be your own.
• Submit answers to Student Services in hard copy before the start of Class 3.

1. On 11 Feb 2011 the price of September 2011 wool futures on the ASX
is $8.20 bid and $8.50 ask. Each contract is for 200 kilograms of wool.
To hedge his wool price exposure a wool farmer named Bruce opens a
short position in three hundred September 2011 wool contracts. Bruce
closes out his hedge position on 13 June 2011 when the futures price
has risen to $9.90 bid and $10.00 ask. What is Bruce’s total gain on
the hedging position? (Ignore any margin account considerations).
A) -$88,000
B) -$98,000
C) -$108,000
D) -$118,000
E) None of the above

Selling @ $8.20
Buying @ $10.00

Total loss = 200*300*(8.2-10) = -$108,000

2. Short selling is effectively borrowing at an interest rate equal to the


total return on the asset. Short selling delivers cash at the outset (just
like borrowing does) and then involves cash outflows (just like
borrowing) as payments are made to deliver income (to the original
lender of the asset) and to buy-back the asset.
Steve borrows 1000 shares of BHP and sells them for $45 each. Three
months later BHP pays a dividend of $1 per share, which Steve must
pay to the lender of the shares. Three months after that (six months
from the start), Steve buys back the shares for $46 to end the short.
Steve has had the use of the $45,000 for 6 months. At what APR (with
quarterly compounding) has Steve effectively borrowed money for six
months?
Hint: Just treat the question like a loan. You know the cashflow in
($45,000) and the cashflows out. What interest rate makes the PV of
the cashflows out equal the cashflow in.

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A) 7.89%
B) 8.89%
C) 9.99%
D) 10.99%
E) None of the above

Maturit PV of Cash
y Cash Flows Flows
$ $
0 (45,000.00) 45,000.00
$ $
0.25 1,000.00 978.26
$ $
0.5 46,000.00 44,021.74

At Rate = 8.79%; PV of cash outflow = PV of cash inflow

3. The price of wheat today is $230 per tonne. The cost of storing wheat
for one year (payment in advance) is $25 per tonne and the 1 year
Libor rate is 5.25 percent. What is the upper bound on the futures
price of wheat? (The price level beyond which there is an arbitrage
opportunity).
A) $258.74
B) $268.74
C) $278.74
D) $288.74
E) None of the above

$
Spot 230.00
Storage $
cost 25.00
rate 0.0525
Futures $
Price 268.75

4. The spot Yen/$A exchange rate is 83.55 today. The six month forward
rate is 81.62. 6 month risk free rates (continuously compounded) are
4.95% in $A and 0.45% in ¥. If the maximum you can borrow today is
either $A1 million or Ұ100 million, then what is the maximum arbitrage
profit, measured in today’s dollars, that you can make from this
situation? (Hint: Use the equation for the forward price on an asset
that pays a continuous yield q. If the $A is the asset and Yen is cash,
then S0 = 83.55, F0 = 81.62. If the forward price is too low then we
borrow the asset and sell it today. If the forward price is too high, then

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we borrow cash to buy the asset today).
A) $1137
B) $134
C) $734
D) $871
E) None of the above

Spot Y/
$ 83.55
$ rate 0.0495
Y rate 0.0045
F Y/$ 81.62
F Y/$ 81.69

Borrow $A1m and convert it into yen @ 83.55 to get Y83, 550,000
Lend Y83, 550,000 for six months @ 0.45% to get Y83, 738,199.14
Covert Y83, 738,199.14 @ 81.62 to get $A1,025,951.96
Pay $A1,025,058.82 (interest rate 4.95%)

Net Profit = $A893.14

Calculate the value of the coupons on a two year floating rate note on 8
Feb 2011 and the the coupons on another 2 year note on 8 Feb 2012 after
interest rates have moved up. Calculate the 10 missing values and write
them in the table
Risk free PV floating rate Risk free PV floating rate
Maturity Coupons and
rates on note cashflows rates on note cashflows
(years) principal
8 Feb 2011 8 Feb 2011 8 Feb 2012 8 Feb 2012
30.55 32.00
0.5 4.95 C1 5.75
424 586
1 5.35 C2 29.68832 6.05 31.00563
28.71
1.5 5.80 C3 6.30
023 29.96916
2 6.20 C4 27.66737 6.50 28.92392
Principal 883.3798 878.0954
PV of note 1000.00 1000.00

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5. Consider a five year fixed for floating interest rate swap that is opened
on 8 Feb 2011. The swap has a notional value of $100 million. If the
zero (yield) curve is as shown below, then what is the swap rate (as an
APR) when the swap is opened on 8 Feb 2011.

Note: We can think of the party receiving fixed and paying floating as
being long a fixed rate bond with a face value of $100 million and
maturity of five years and short a corresponding floating rate note. At
the time of opening the swap has zero value to both parties. Therefore
Vfloating – Vfixed = 0 or equivalently Vfloating = Vfixed = $100 million at
the outset.

The swap rate, which is fixed when the swap is opened, is the coupon
rate on the fixed rate note. The fixed rate payments on the swap
(coupon payments on the fixed rate note) are made twice per year.
The swap rate is chosen to make Vfixed = $100 million at the opening of
the bond.

Zero yields on
Maturity (years) 8 Feb 2011
0.5 4.95
1 5.35
1.5 5.8
2 6.2
2.5 6.45
3 6.65
3.5 6.8
4 6.9
4.5 6.95
5 7.00

A) 7.0506%
B) 7.0606%
C) 7.0706%
D) 7.08065%
E) None of the above
Matur Cash PV of Cash
ity Libor Flows Flows
0.5 0.0495 3.525 3.439
1 0.0535 3.525 3.342
1.5 0.058 3.525 3.232
2 0.062 3.525 3.114
2.5 0.0645 3.525 3.000
3 0.0665 3.525 2.888
3.5 0.068 3.525 2.779
4 0.069 3.525 2.675
4.5 0.0695 3.525 2.579
103.52
5 0.07 5 72.953
100.000

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Coupo 7.050
n 6%

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Optional practice questions. Solutions follow

1. On 1 July 2010 the USD/$A exchange rate is 0.8628. The 6 month $A


and $US risk free rates are 4.92% and 0.44% respectively. What is the
6 month forward exchange rate? (Hint: If we write the exchange rate
as $US0.8628/$A, then is the $A the currency or is it the asset?).

2. In forwards and futures calculations on commodities, storage costs are


like a negative income; instead of the underlying asset (the
commodity) delivering income (or yield) to the holder of the asset, it
consumes cash through the storage cost. On 1 July 2010 the price of
gold is $1250. If the one year risk free rate is 5.05% and the annual
cost of storage is 0.6% of today’s price (continuously compounded),
then what is the one year forward price of gold.

3. A 3 year Treasury bond has a coupon rate of 4.50%, a face value of


$1,000 and its current price is $1020. The bond pays coupons twice
per year and the next coupon is due 3 months from today. The 3
month and 6 month Libor rates are both 5%. What is the futures price
of a six month futures contract on the Treasury bond.

4. Consider an interest rate swap that has a notional value of $100


million and on 1 April 2010 has 3 years to maturity. The fixed rate
party receives $3.22 million on 1 Oct and 1 April dates. The floating
party receives Libor (set 6 months earlier) on the same dates.
Calculate the value of the swap to the fixed rate party on 1 April 2010,
after payments have been exchange, by calculating the difference
between the value of a fixed rate bond and a floating rate bond.

Maturity Risk free rates


(years) 1 Apr 2010

0.5 4.75
1 5.05
1.5 5.30
2 5.50
2.5 5.65
3.0 5.80

5. Consider a 3 year interest rate swap which is created on 11 August


2010. Fixed payments at the swap rate are swapped for 6 month Libor
twice per year. The notional value of the swap is $100 million. Use
the data in the following table to calculate the swap rate (annual
percentage rate of fixed rate payments).

Maturit Libor zero


y rate 1 Aug

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(years) 2010
0
0.5 4.55
1.0 5.10
1.5 5.45
2.0 5.70
2.5 5.80
3.0 5.90

6. The seven year mid-swap rate is 6.15%. Calculate the price of a


straight corporate bond that has 7 years to maturity, a face value of
$10,000, a coupon rate of 7.35% and a spread to swap rate of 235bp.

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Optional practice questions Solution

1. On 1 July 2010 the USD/$A exchange rate is 0.8628. The 6 month $A


and $US risk free rates are 4.92% and 0.44% respectively. What is the
6 month forward exchange rate?

$A is the asset and $US is the currency

(r $ US
)
− r $A .( 0.5 )
F0 = S0 .e = 0.8628.e( 0.0044 −0.0492 ) .( 0.5 ) = $US0.8437

2. In forwards and futures calculations on commodities, storage costs are


like a negative income; instead of the underlying asset (the
commodity) delivering income (or yield) to the holder of the asset, it
consumes cash through the storage cost. On 1 July 2010 the price of
gold is $1250. If the one year risk free rate is 5.05% and the annual
cost of storage is 0.6% of today’s price (continuously compounded),
then what is the one year forward price of gold.

u = cost of storage

F0 = S0 .e( r + u ) .( 1) = 1250.e( 0.0505+0.0060 ).(1) = $US1322.66

3. A 3 year Treasury bond has a coupon rate of 4.50%, a face value of


$1,000 and its current price is $1020. The bond pays coupons twice
per year and the next coupon is due 3 months from today. The 3
month and 6 month Libor rates are both 5%. What is the futures price
of a six month futures contract on the Treasury bond.

I = 22.5.e −(0.05)(0.25) = 22.22

(
F0 = S0 − I .e rT )
(
= 1020 − 22.22 .e(0.05)(0.5) )
= $1,023.04

4. Consider an interest rate swap that has a notional value of $100


million and on 1 April 2010 has 3 years to maturity. The fixed rate
party receives $3.22 million on 1 Oct and 1 April dates. The floating
party receives Libor (set 6 months earlier) on the same dates.
Calculate the value of the swap to the fixed rate party on 1 April 2010,
after payments have been exchange, by calculating the difference
between the value of a fixed rate bond and a floating rate bond.

Maturity Risk free rates


(years) 1 Apr 2010

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0.5 4.75
1 5.05
1.5 5.30
2 5.50
2.5 5.65
3.0 5.80

VFloating = 100 because a coupon payment has just been made

VFixed = ( 3.22 ) .e( 0.0475) .( 0.5) + ( 3.22 ) .e( 0.0505 ).(1 ) + . . . + ( 3.22) .e(0.0565 ). (2.5 ) + ( 103.22) .e(0.0580 ). (3.0 )

= 101.596

Vswap = VFixed - VFloating = $1.596 million

5. Consider a 3 year interest rate swap which is created on 11 August


2010. Fixed payments at the swap rate are swapped for 6 month Libor
twice per year. The notional value of the swap is $100 million. Use
the data in the following table to calculate the swap rate (annual
percentage rate of fixed rate payments).

Maturit Libor zero


y rate 1 Aug
(years) 2010
0
0.5 4.55
1.0 5.10
1.5 5.45
2.0 5.70
2.5 5.80
3.0 5.90

 C  −0.0455.(0.5)  C  −0.0510.(1)  C  −0.0590.(3)


100 =   .e +   .e +. . .+  100 + 2  .e
 2  2

C =
(
2.100. 1 - e ()
−0.0590. 3
) = 0.059592 or 5.96%
(e ( )
−0.0455. 0.5
+e ()
−0.0510. 1
+. . .+e ()
−0.0590. 3
)
6. The seven year mid-swap rate is 6.15%. Calculate the price of a
straight corporate bond that has 7 years to maturity, a face value of
$10,000, a coupon rate of 7.35% and a spread to swap rate of 235bp.

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Yield = Swap rate + credit spread = 0.0615 + 0.0235 = 0.0850

 Coupon rate   0.0735 


Coupon = FV.  = 10000. = 367.50
 2   2 

367.50 367.50 10367.50


PV = + + ... +
 0.0850   0.0850 
2
 0.0850 
14
1 +
 2   1 + 2   1 + 2 

   
 367.50   
 1  + 10000
=   . 1− = $9402.52
  0.0850     0.0850 
14   0.0850 
14

  2     1 + 2  

 1 + 2 
  

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