80277 THE UNIVERSITY OF MELBOURNE ‘THE UNIVERSITY OF MELBOURNE SEMESTER ONE ASSESSMENT 1999 DEPARTMENT ACCOUNTING & FINANCE SuBsJECT NUMBER 306 -816 SUBJECT TITLE FINANCIAL MARKETS & IINSTRUMENTS EXAM DURATION : 3HOURS READING TIME : 15 MINUTES THIS PAPER HAS : 8PAGES Authorised Materials: 1 This exam is CLOSED book. Students are NOT permitted to have any books, notes or other ‘materials in their possession other than: @ Writing Instructions (ii) Calculators, provided they are silent and battery operated. Instructions To Invigilators: 1. No writing is permited during reading time 2. This paper may be removed from the examination venue after the exam Instructions To Students: 1. This paper consists of Nine (9) questions. Answer ALL Questions 2. Commence your answer to each question on a new page in your script book 3. Clearly indicate the question number 4. A formulae sheet is included 5. A table of the cumulative distribution function for the standard normal random variable is included Bailliew Library: 1. This paper may be held in the Bailliew Library after the 30 June, 19990n278 2 306-816 Semester 1, 1999 Question One i. Briefly outline the functions performed by a financial system. ii. “As secondary markets do not facilitate the flow of funds from surplus to deficit units they are not considered by investors to be as important as primary markets”. Is this statement true or false? Explain. ii, On the risk/return trade-off speculative shares are generally placed at the top and treasury notes at the bottom, Explain the characteristics of these instruments that cause them to be placed in this way. (B+344=10 marks) Question Two i, Bank Red & Blue has the following simple balance sheet. In addition management has calculated a value at risk of $1 million. Does Bank Red & Blue satisfy the Australian Prudential Regulatory Authority (APRA) capital adequacy guidelines for credit & market risk? Note: the conversion factor for a letter of credit is 100%. Show all workings. Assets $m. cash 5 CGS < 12 months 50 loans to local government 20 housing loans 500 small business loans 400 corporate loans 300 1275 Off balance sheet assets letter of credit to a corporate 10 abilities and Shareholders Funds deposits 800 certificates of deposit 400 subordinated debt 10 perpetual floating rate notes 15 provision for doubtful debts 5 share premium reserve 5 general reserve issued capital3 306-816 Semester 1, 1999 ii, What are exchange settlement accounts? Are they important for the stability of the financial system? Why? iii, “The trustee of a superannuation fund plays an important role in the prudential supervision of that fund”. Is this statement true or false? Briefly justify your answer. (4+6+42=12 marks) Question Three i. Distinguish between a bank accepted bill, a bank-endorsed bill and a non-bank bill ii, How docs a promissory note differ from a bill of exchange? What are the advantages of borrowing by issuing a promissory note instead of a bill of exchange? iii, Suppose the yield curve displays the following rates: 1 year 4.0% p.a. 2 years 5.0% p.a. 3 years 5.5% p.a. 4 years 5.75% p.a. Derive the 1 year forward rate assuming the Pure Expectations Theory explains the shape of the yield curve. iv. A Treasury Note with a face value of $1 million and 16 weeks to maturity is currently trading at a yield of 3.5%p.a. What is the price of this Treasury Note? y. What is an unused limit fee on an overdraft and why do banks charge such a fee? (442424244514 marks) Question 4 i, Assume that the buy/sell spread is zero and there are no transaction costs. You observe the following information on Australia and Utopia Spot rate: $A1 = $U 4.5700 3 month $A interest rate: 3.0 % per 3 months. 3 month $U interest rate: 2.0% per 3 months 4) Use interest rate parity to calculate the 3 month forward rate. Show all calculations. >) If Utopian interest rates increased to 4.0% per 3 months (but there was no change in either the spot or Australian interest rates), what would the forward rate become? ©)Explain the results from a) and b) ii. Why can a mortgage-backed security be considered as having a bond and an option component? How does the option component impact upon the yield of the security?0n280 306-816 Semester 1, 1999 iii. “Securitisation has helped to complete financial markets”. Is this statement true or false? Justify your answer. (6+44+4=14 marks) Question 5 Consider the following information on two call options, A and B, written on the same stock with the same time to maturity. [ Option A; Strike Price ($) $25 7 | Option B: Strike Price ($) $30 ‘Standard Deviation (%) 40 Continuously Compounded Risk Free Interest Rate (% p.a.) 5 _ ‘Term to maturity (months) 6 Stock price ($) $30 * One share underlies each option contract i, Determine the intrinsic value of both call options. ii. Compute the Black-Scholes value for both call options. Show your calculations. iii, Suppose you purchase option A and sell option B. (Use the Black-Scholes prices computed above). (a) Name the strategy and sketch the profit diagram. (b) Compute the profit from the strategy if the share price at maturity is $40, (24+444=10 marks)AR2R1 5 306-816 Semester 1, 1999 Question Si Gold is currently wading at $650 per ounce and the price of one gold futures contract deliverable in a year is $600 per ounce. The quantity of gold underlying a gold futures contract is equivalent to 10 ounces. ‘The current continuously compounded risk free interest rate is 7.0% p.a. i, Name the strategy that will generate an arbitrage profit. ii, Show alll cash flows (at t=0 and t=1) per contract if the strategy is implemented and the profit made at maturity (t=1). iii, Discuss the implications of transaction costs on your arbitrage strategy. (Answers exceeding 10 lines will not be graded.) iv. Briefly explain how the Sydney Futures Exchange copes with counter party or default risk. (Answers exceeding 7 lines will not be graded.) (24+44242=10 marks) Question Seven Company A and Compa $100 million 20 year loan. 1y B have been offered the following interest rates per annum on a Fixed Rate Floating Rate_ Company A 8.00% pa BBSW ~ 0.25% Company B. 10.00% p.a. BBSW+0.25% | Company A requires a floating rate exposure, while Company B requires a fixed rate exposure, i, Inwhich market does Company B have a comparative advantage? ii, What is the total benefit (in % p.a.) to all parties from the swap? ili, Design a swap that is equally attractive to both A and B. Set out clearly the interest rates and the net interest rates for both A and B. iv. Design a swap that will net a swap arranger 0.2% per annum, and which will be equally attractive to both A and B. Set out clearly the interest rate cash flows and the net interest rate cash flows for both A and B. (1+14444= 10 marks)Question iff iv, 6 306.816 Semester 1, 1999 Company A has no growth prospects, its price-carnings ratio and current dividend is 9.528 and $0.12 per share respectively. Determine the value of Company A’s stock. Company B’s current dividend of $0.12 per share, which has just been paid, is expected to grow at 5% p.a, forever, and its required rate of return is 7% p.a. Determine the value of Company B’s stock Company C’s current eamings per share of $0.25 is expected to grow at 10% p.a. for two years and thereafter at 6% p.a. ‘The company’s required rate of return is 8% p.a. and its payout ratio is 0.80. Determine the value of Company C’s stock, “Companies with large growth opportunities have high PEs”. Comment. (Answers exceeding 10 lines will not be graded.) (2+2+343= 10 marks) Question Nine ii, iii, iv. The current price of a 10 year zero coupon bond with a face value of $1000 is $220. Compute the bond’s yield to maturity. Determine the price of a $1000 face value, 10 year, 12% p.a. coupon bond which pays coupons annually. Similar bonds have a yield to maturity of 10% p.a. A floating rate bond with the coupon rate reset annually to the prevailing LIBOR has 4.5 years to maturity. ‘The bond has a face value of a $1000, coupons are paid annually and the one-year LIBOR rate at the last payment date was 12%p.a, Furthermore, the prevailing 6-month LIBOR rate is 11%p.a. Compute the price of the bond Briefly outline the difference between Matilda and Kangaroo bonds. (Answers exceeding 7 lines will not be graded.) Why do governments issue debt securities? (Answers exceeding 7 lines will not be graded.) (2424242+42=10 marks)OE? 1 306-816 Semester 1, 1999 FORMULAE SHEET aa Aer r ele Lay a _ yr cashflow, rad (ery D, i +r) Cree if SrsX SX ifSp>X Pr= X-S;ifSysX ag Sr>X f fH _ MEGS) “igup s 5 1+E(pAUD ) P= FV((1 +1/100 x n/365)O = XUaYM (X)N 405 21921 ‘worrejodnu is pos aq pynoysayge ay, 9 = 3 O = x uayM (X)N 405 age],