[20 pts] 1- Some Financial Terms and Ideas(a) What is securitization?(b) What is financial engineering?(c) What is Credit Default Swap (CDS)?(d) How might CDS have contributed to the current financial crisis?The protection seller needs to cover its position when the reference entity is in high risk of default. One way to do this is to short the securities of the reference entity. But this will reduce the stock price of the reference entity leading to it collapse. When the reference entity goes bankrupt the position of all those institutions that hold its share becomes weaker. People that hold shares of these institutions buy CDS to cover this risk. The protection seller shorts the shares of these companies leading to their faster collapse. That is one event cascades to the other leading to a systematic collapse of the entire financial market.[11 pts] 2-Derivation of the formula for Growing Annuity[8 pts] 5- Effective versus Stated Annual Rates[12 pts] 6-Stock Valuation and Growth OpportunitiesFinanciad Economics ECN134Midterm 1Winter 2009 Prof. Farshid Mojaver************************************************************************[20 pts] 1- Some Financial Terms and Ideas (a) What is securitization?Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security.(b) What is financial engineering?Creating new financial instruments by combining other derivatives, or more generally, byusing derivatives pricing techniques(c) What is Credit Default Swap (CDS)?A CDS is a contract in which one party (the protection seller) agrees to reimburse anotherparty (the protection buyer) against a default on a financial obligation by a third party (the reference entity).(d) How might CDS have contributed to the current financial crisis?The protection seller needs to cover its position when the reference entity is in high risk of default. One way to do this is to short the securities of the reference entity. But this will reduce the stock price of the reference entity leading to it collapse. When the reference entity goes bankrupt the position of all those institutions that hold its share becomes weaker. People that hold shares of these institutions buy CDS to cover this risk. The protection seller shorts the shares of these companies leading to their faster collapse. That is one event cascades to the other leading to a systematic collapse of the entire financial market. [11 pts] 2-Derivation of the formula for Growing AnnuityShow that the present value of a growing annuity that pays a stream of cash flows C and grows at a constant rate g for a fixed number of periods T can be simplified to :[12 pts] 3- AnnuityTrggrCPV111Weak consumer spending has led automobile manufacturers to offer zero interest financing or cash back options to stimulate sales. Suppose you can buy the car of your choice for its negotiated price of $16,200 less $500 cash back, or you can finance the entire $16,200 car cost for 36 months at zero interest. You have the cash necessary to pay for the car in an account that earns a stated annual interest rate of 4%, compounded monthly. You will either finance it or pay cash depending on which is the best deal.a. What is the cost of the financed car to you right now?b. Should you pay cash, or finance the car, and why?c. Now suppose the manufacturers offer 2% rather than zero percent financing. Should you pay cash now or finance the car, and why?Answera. The monthly financed car payment with no interest is: $16,200/36=$450PV= 361204.01111204.0450111TrrC  PV=$15,241.84b. Finance it. By financing, we will actually make profit of $458.16=$15,700-$15,241.84c. First we need to find monthly payment when price is $16,200 ND financing is 2%.mTrACPV .. , PV =$16,200,  mTmTrmrmrA/111/1 A= 9.3412/02.11112/02.0136, C=$16,200/34.913=$464.01Now we need to calculate the PV of a constant stream of income using SAIR of 4%. This is the true value of the financing offer to us. 361204.1111204.0464PV=$15,716.34This is $16 only better than the cash price. I would be nearly indifferent between the two. [6 pts] 4- Annuity Pure Discount BondSuppose that you have a pure discount bond that pays $1,000 at maturity with 6 years remaining until payoff in order to yield a 7% return. a. How would you price the bond?b. Suppose the day after you buy the bond interest rate falls to 2%. What are your capital gain/loss and the new yield to maturity? Answera. PV=TrF)1(  =6)07.1(1000= $666.342b. PV=TrF)1(  =6)02.1(1000= $887.97 profit =$143, YTM =2%[8 pts] 5- Effective versus Stated Annual RatesIn all cases, give the formulas you used in obtaining the answers.a. Suppose the stated annual interest rate (SAIR) is 8% compounded quarterly; what is the quarterly effective rate?b. Suppose the SAIR is 8% compounded quarterly; what is the effective annual interest rate (EAIR)?c. Suppose the EAIR is 8%; what is the 3-month effective rate?d. Suppose the EAIR is 8%; what is the SAIR which when compounded continuously produces an 8% EAIR?Answer a. %24%8EQIR b.  %2432.8102.14EAIR c. %8EAIR  %927.1108.134/1 monthIRE d. %8EAIR  08.01 re 08.1re r =7.6961%[12 pts] 6-Stock Valuation and Growth OpportunitiesThe stock of Nogro Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $2. The company has a policy of paying out 50% ofits earnings each year in dividends. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is expected to continue indefinitely.a. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM, what rate of return do Nogro’s investors require?b. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested?c. If Nogro were to cut its dividend payout ratio to 25%, what would happen to its stock price? What if Nogro eliminated the dividend?Answer a. k = D1/P0 + gD1 = 0.5  $2 = $1g = b  ROE = 0.5  0.20 = 0.10Therefore: k = ($1/$10) + 0.10 =