William L. Silber Foundations of Finance (COR1-GB.2311) Fall 2014 COMPLETE PROBLEM SET QUESTIONS Page PROBLEM SET I 3 PROBLEM SET II 5 REAL TIME EXERCISE: EQUITIES 9 PROBLEM SET III 10 PROBLEM SET IV 13 1INTRODUCTION These problem sets are not representative of questions on the exams. They are designed to complement our classroom discussions. Since the lectures focus on conceptual matters, the exercises are primarily for numerical drill. Some of the questions are quite easy, while others are more difficult. Do them all with equal care. It will be helpful to practice with your calculator so that you come up with the correct number even for simple questions. It's better to work out the kinks now rather than on the job. Although you should discuss these problems in a study group, you should calculate everything yourself, and, of course, write it up by yourself. These five-finger exercises will make you a better person. wls 2PROBLEM SET I 1. You are among the NASDAQ marketmakers in the stock of BioEngineering, Inc. and quote a bid and offer of 102 1/4-1/2. (a) On Day 1 you receive you receive market buy orders for 10,000 shares and market sell orders for 4,000 shares. How much do you earn during the day and what is the value of your inventory at the end of the day? (b) Before trading begins on Day 2 the company announces trial testing of a cure for acne in mice. The quoted bid and offer jumps to 110 1/4-1/2. During Day 2 you receive market sell orders for 8,000 shares and buy orders for 2,000 shares. What is your total profit and loss over the two-day period? What is the value of your inventory at the end of Day 2? (c) Is there anything you could have done at the end of Day 1, consistent with a pure marketmaker's objectives, that would have improved your performance over the two-day period? 2. Here are some alternative investments you are considering for one year. (i) Bank A promises to pay 8% on your deposit compounded annually. (ii) Bank B promises to pay 8% on your deposit compounded daily. (iii) Bank C promises to pay 8% on your deposit compounded continuously. Compare the effective annual rate (EAR) on these investments. 3. Suppose you have 2 mutual funds whose annual returns are shown in the following table. Assume you invest $100 in each, and the proceeds from year 1 are reinvested in year 2 and so on. How much money do you accumulate in each fund after 5 years? What is the single rate that properly measures the average return for each fund over the five-year period? Table Year Fund A Fund B 1 .16 .30 2 .10 -.10 3 .14 .28 4 .02 .17 5 .04 -.02 4. Suppose Mexico's one-year government bond rate is 35%, the U.S. one-year government bond rate is 5% and the exchange rate is currently 6 pesos per $1. Answer the following questions: (a) If you expect the exchange rate to be 7 pesos per $1 in one year, what transaction would you establish to produce an expected profit? (b) How would you supplement the transaction in (a) if you could currently arrange to buy or sell pesos for dollars for delivery in one year (this is called the one year forward exchange rate) at an exchange rate of 7 pesos per $1. Does this make the transaction in (a) more or less risky? (Note: Although you may never have heard of forward exchange rates before the idea is relatively straightforward. You may contract on January 1, 2014, to deliver on December 31, 2014, pesos for dollars at a fixed, currently agreed upon, rate. The example tells you to assume that the exchange rate for this contractual agreement is 7 pesos per dollar.) 3(c) What are the consequences of the transaction in (b) for the excess demand for or excess supply of pesos for dolIars for delivery in one year? What are the implications for the equilibrium one-year forward exchange rate? Will it be higher or lower than 7 pesos per $1? (d) Calculate the forward exchange rate in (b) which will make the entire transaction break even in terms of profit (ignore transactions cost). In light of your answer in (c), why might this be the equilibrium one year forward exchange rate? 5. Suppose a hedge fund manager earns 1% per trading day. There are 250 trading days per year. Answer the following questions: (a) What will be your annual yield on $100 invested in her fund if she allows you to reinvest in her fund the 1% you earn each day? (b) What will be your annual yield assuming she puts all of your daily earnings into a zero-interest-bearing checking account and pays you everything earned at the end of the year? (c) Can you summarize when it is proper to "annualize" using APR (annual percentage rate) versus EAR (effective annual rate)? 6. Suppose you bought a five-year zero-coupon Treasury bond for $800 per $1000 face value. Answer the following questions: (a) What is the yield to maturity (annual compounding) on the bond? (b) Assume the yield to maturity on comparable zeros increases to 7% immediately after purchasing the bond and remains there. Calculate your annual return (holding period yield) if you sell the bond after one year. (c) Assume yields to maturity on comparable bonds remain at 7%, calculate your annual return if you sell the bond after two years. (d) Suppose after 3 years, the yield to maturity on similar zeros declines to 3%. Calculate the annual return if you sell the bond at that time. (e) If yield remains at 3%, calculate your annual return after four years. (f) After five years. (g) What explains the relationship between annual returns calculated in (b) through (f) and the yield to maturity in (a)? 7. Suppose you are given a choice of the following two annuities: (a) $10,000 payable at the end of each of the next 6 years and zero thereafter; or (b) $10,000 forever, but payments do not begin until 10 years from now (the first cash payment from the annuity is at the end of the 11th year). Which annuity do you choose if the annual interest rate is 5%? Does your answer change if the interest rate is 10%? Explain why or why not. PROBLEM SET II 1. Here are some characteristics of two securities: 4Security 1 R1 = .10 0025.21=σ Security 2 R2 = .16 0064.22=σ Answer the following questions: (a) Which security should an investor choose if she wants to (i) maximize expected returns, (ii) minimize risk (assume the investor cannot form a portfolio)? (b) Suppose the correlation