Suppose that you are the manager of a bank that has $ 15 million of fixed-rate assets, $30 million of

rate sensitive assets, $25 million of fixed-rate liabilities and $20 million of ratesensitive
liabilitiesFINC/ECON 3830 Solution to Assignment

Chapter1

4. Efficient Markets. Explain the meaning of efficient markets. Why might we expect markets to be
efficient most of the time? In recent years, several securities firms have been guilty of using inside
information when purchasing securities, thereby achieving returns well above the norm (even when
accounting for risk). Does this suggest that the security markets are not efficient? Explain.

ANSWER: If markets are efficient then prices of securities available in these markets properly reflect
all information. We should expect markets to be efficient because if they weren’t, investors would
capitalize on the discrepancy between what prices are and what they should be. This action would
force market prices to represent the appropriate prices as perceived by the market.

Efficiency is often defined with regard to publicly available information. In this case, markets can be
efficient, but investors with inside information could possibly outperform the market on a consistent
basis. A stronger version of efficiency would hypothesize that even access to inside information will
not consistently outperform the market.

5. Securities Laws. What was the purpose of the Securities Act of 1933? What was the purpose of the
Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment
decisions? Explain.

ANSWER: The Securities Act of 1933 was intended to assure complete disclosure of relevant
financial information on publicly offered securities, and prevent fraudulent practices when selling
these securities. The Securities Exchange Act of 1934 extended the disclosure requirements to
secondary market issues. It also declared a variety of deceptive practices illegal, but does not prevent
poor investments.

14. Mutual Funds. What is the function of a mutual fund? Why are mutual funds popular among
investors? How does a money market mutual fund differ from a stock or bond mutual fund?

ANSWER: A mutual fund sells shares to investors, pools the funds, and invests the funds in a
portfolio of securities. Mutual funds are popular because they can help individuals diversify while
using professional expertise to make investment decisions.

A money market mutual fund invests in money market securities, whereas other mutual funds
normally invest in stocks or bonds.

Interpreting Financial News

“Interpreting Financial News” tests your ability to comprehend common statements made by Wall Street
analysts and portfolio managers who participate in the financial markets. Interpret the following
statements made by Wall Street analysts and portfolio managers.

a. “The price of IBM stock will not be affected by the announcement that its earnings have
increased as expected.”
 The earnings level was anticipated by investors, so that IBM’s stock price already reflected this
anticipation.

b. “The lending operations at Bank America should benefit from strong economic growth.”

High economic growth encourages expansion by firms, which results in a strong demand for
loans provided by Bank America.

c. “The brokerage and underwriting performance at Merrill Lynch should benefit from strong
economic growth.”

High economic growth may result in a large volume of stock transactions in which Merrill Lynch
may serve as a broker. Also, Merrill Lynch underwriters new securities that are issued when
firms raise funds to support expansion; firms are more willing to issue new securities to expand
during periods of high economic growth.

Managing in Financial Markets

As a financial manager of a large firm, you plan to borrow $70 million over the next year.

a. What are the more likely alternatives for you to borrow $70 million?

You could attempt to borrow $70 million from commercial banks, savings institutions, or finance
companies in the form of commercial loans. Alternatively, you may issue debt securities.

b. Assuming that you decide to issue debt securities, describe the types of financial institutions that
may purchase these securities.

Financial institutions such as mutual funds, pension funds, and insurance companies commonly
purchase debt securities that are issued by firms. Other financial institutions such as commercial
banks and savings institutions may also purchase debt securities.

c. How do individuals indirectly provide the financing for your firm when they maintain deposits at
depository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions?

Individuals provide funds to financial institutions in the form of bank deposits, investment in
mutual funds, purchases of insurance policies, or investment in pensions. The financial
institutions may channel the funds toward the purchase of debt securities (and even equity
securities) that were issued by large corporations, such as the one where you work.
Chapter 2

3. Impact of Government Spending. If the federal government planned to expand the space program,
how might this affect interest rates?

ANSWER: An expanded space program would (a) force the federal government to increase its budget
deficit, (b) possibly force any firms involved in facilitating the program to borrow more funds.
Consequently, there is a greater demand for loanable funds. The additional spending could cause
higher income and additional saving. Yet, this impact is not likely to be as great. The likely overall
impact would therefore be upward pressure on interest rates.

4. Impact of a Recession. Explain why interest rates tend to decrease during recessionary periods.
Review historical interest rates to determine how they react to recessionary periods. Explain this
reaction.

ANSWER: During a recession, firms and consumers reduce their amount of borrowing. The demand
for loanable funds decreases and interest rates decrease as a result.

5. Impact of the Economy. Explain how the expected interest rate in one year is dependent on your
expectation of economic growth and inflation.

ANSWER: The interest rate in the future should increase if economic growth and inflation are
expected to rise, or decrease if economic growth and inflation are expected to decline.

6. Impact of the Money Supply. Should increasing money supply growth place upward or downward
pressure on interest rates?

ANSWER: If one believes that higher money supply growth will not cause inflationary expectations,
the additional supply of funds places downward pressure on interest rates. However, if one believes
that inflation expectations do erupt as a result, demand for loanable funds will also increase, and
interest rates could increase (if the increase in demand more than offsets the increase in supply).

8. Nominal versus Real Interest Rate. What is the difference between the nominal interest rate and
real interest rate? What is the logic behind the Fisher effect’s implied positive relationship between
expected inflation and nominal interest rates?
ANSWER: The nominal interest rate is the quoted interest rate, while the real interest rate is defined
as the nominal interest rate minus the expected rate of inflation. The real interest rate represents the
recent nominal interest rate minus the recent inflation rate.

Investors require a positive real return, which suggests that they will only invest funds if the nominal
interest rate is expected to exceed inflation. In this way, the purchasing power of invested funds
increases over time. As inflation rises, nominal interest rates should rise as well since investors would
require a nominal return that exceeds the inflation rate.

9. Real Interest Rate. Estimate the real interest rate over the last year. If financial market participants
overestimate inflation in a particular period, will real interest rates be relatively high or low? Explain.

ANSWER: This exercise forces students to measure last year’s nominal interest rate and inflation
rate.
 If inflation is overestimated, the real interest rate will be relatively high. Investors had required a
relatively high nominal interest rate because they expected inflation to be high (according to the
Fisher effect).

11. Impact of Stock Market Crises. During periods in which investors suddenly become fearful that
stocks are overvalued, they dump their stocks, and the stock market experiences a major decline.
During these periods, interest rates tend to decline. Use the loanable funds framework discussed in
this chapter to explain how the massive selling of stocks leads to lower interest rates.

ANSWER: When investors shift funds out of stocks, they move it into money market securities,
causing an increase in the supply of loanable funds, and lower interest rates.

Chapter 3

1. Forward Rate. a. Assume that as of today, the annualized two-year interest rate is 13 percent, while
the one-year interest rate is 12 percent. Use only this information to estimate the one-year forward
rate.

ANSWER:

(1+t i 2 )2
t+1 r 1= −1
(1+ t i1 )
(1 .13 )2
¿ −1
1. 12
¿ 14 . 01%

2. Forward Rate. Assume that as of today, the annualized interest rate on a three-year security is 10
percent, while the annualized interest rate on a two-year security is 7 percent. Use only this
information to estimate the one-year forward rate two years from now.

ANSWER:

(1+t i3 )3 =(1+ t i 2 )2 (1+ t+2 r 1 )

(1+ t i 3 )3
1+ t +2 r 1 =
(1+ t i 2 )2
3
1 .10
¿ −1
1 . 072
¿ 16 . 25 %

3. Forward Rate. If , what is the market consensus forecast about the one-year forward rate one
year from now? Is this rate above or below today’s one-year interest rate? Explain.

ANSWER:
The one-year forward rate one year from now is:
 (1+ t i 2 )2
t+1 r 1= −1
(1+ t i 1 )

If , then the one-year forward rate one year from now must be below today’s one-year interest
rate.

4. After-tax Yield. You need to choose between investing in a one-year municipal bond with a 7
percent yield and a one-year corporate bond with an 11 percent yield. If your marginal federal income
tax rate is 30 percent and no other differences exist between these two securities, which one would
you invest in?

ANSWER:

Yat = Ybt(1 – T)
Yat = 11%(1 – 0.30) = 7.7%

[You should prefer the corporate bond.]

5. Deriving Current Interest Rates. Assume that interest rates for one-year securities are expected to
be 2 percent today, 4 percent one year from now and 6 percent two years from now. Using only the
pure expectations theory, what are the current interest rates on two-year and three-year securities?

ANSWER:

(1 + ti2 )2 = (1 + ti1)(1 + t+1r1)

(1 + ti2 )2 = (1 + 0.02)(1 + 0.04)
(1 + ti2 )2 = 1.0608
1+ ti2 = 1.02995
ti2 = 0.0299

(1 + ti3)3 = (1 + ti1)(1 + t+1r1)(1 + t+2r1)

(1 + ti3)3 = (1 + 0.02)(1 + 0.04)(1 + 0.06)
(1 + ti3)3 = 1.124448
1 + ti3 = 1.0398
ti3 = 0.0398

Chapter 4

2. FOMC. What are the main goals of the Federal Open Market Committee? How does it attempt to
achieve these goals?

ANSWER: The main goals of the FOMC are to promote high employment, economic growth, and
price stability.

3. Open Market Operations. Explain how the Fed increases the money supply through open market
operations.
 ANSWER: The Fed can increase money supply by purchasing securities in the secondary market.

9. Open Market Operations. Explain how the Fed uses open market operations to reduce the money
supply.

ANSWER: The Fed can sell holdings of its existing Treasury securities to various depository
institutions, which will cause a reduction in the account balances of these institutions.

Chapter 5

1. Impact of Monetary Policy. How does the Fed’s monetary policy affect economic conditions?

ANSWER: The Fed’s monetary policy can affect the supply of loanable funds available in financial
markets and therefore may affect interest rates. It may also affect inflation (with a lag) and therefore
affect the demand for loanable funds by influencing inflationary expectations.

2. Tradeoffs of Monetary Policy. Describe the economic tradeoff faced by the Fed in achieving its
economic goals.

ANSWER: In general, a stimulative monetary policy can increase economic growth and reduce
unemployment, but may increase inflation. A restrictive monetary policy can keep inflationary
pressure low but may cause low economic growth and higher unemployment.

Chapter 6

1. T-bill Yield. Assume an investor purchased a six-month T-bill with a $10,000 par value for $9,000
and sold it ninety days later for $9,100. What is the yield?

ANSWER:

2. T-bill Discount. Newly issued three-month T-bills with a par value of $10,000 sold for $9,700.
Compute the T-bill discount.

ANSWER:
3. Commercial Paper Yield. Assume an investor purchased six-month commercial paper with a face
value of $1,000,000 for $940,000. What is the yield?

ANSWER:

4. Repurchase Agreement. Stanford Corporation arranged a repurchase agreement in which it

purchased securities for $4,900,000 and will sell the securities back for $5,000,000 in 40 days. What
is the yield (or repo rate) to Stanford Corporation?

ANSWER:

5. T-bill Yield. You paid $98,000 for a $100,000 T-bill maturing in 120 days. If you hold it until
maturity, what is the T-bill yield? What is the T-bill discount?

ANSWER:

YT = (SP – PP/PP)(365 / n)
YT = (100,000 – 98,000/98,000)(365/120) = 6.2%
T-bill discount = (Par – PP/PP)(360 / n)
T-bill discount = (100,000 – 98,000/98,000)(360/120)
T-bill discount = 0.0612 = 6.12%

6. T-bill Yield. The Treasury is selling 91-day T-bills with a face value of $10,000 for $8,800. If the
investor holds them until maturity, calculate the yield.

ANSWER:
 YT = (SP – PP/PP)(365/n)
YT = (10,000 – 8,800/8,800)(365/91) = 5.46%

7. Required Rate of Return. A money market security that has a par value of $10,000 sells for
$8,816.60. Given that the security has a maturity of two years, what is the investor’s required rate of
return?

ANSWER:

$8,816.6 = 10,000/(1 + r)2

$8,816.6 (1 + r)2 = 10,000
(1 + r)2 = 1.1342
(1 + r) = 1.0649
r = 0.0649 = 6.49%

9. T-bill Yield.
a. Determine how the annualized yield of a T-bill would be affected if the purchase price is lower.

Explain the logic of this relationship.

ANSWER: The annualized Treasury bill yield is increased if the purchase price is lower, because the amount returned to the investor
would represent a larger gain relative to a smaller investment.

b. Determine how the annualized yield of a T-bill would be affected if the selling price is lower.
Explain the logic of this relationship.
ANSWER: The annualized Treasury bill yield is reduced if the selling price is lower, because the amount returned to the investor
would represent a smaller gain relative to the investment.

c. Determine how the annualized yield of a T-bill would be affected if the number of days is shorter,
holding the purchase price and selling price constant. Explain the logic of this relationship.
ANSWER: The annualized Treasury bill yield is increased if the number of days of the investment is shorter, because the amount
returned to the investor is earned over a shorter amount of time.

Chapter 8

1. Bond Valuation. Assume the following information for an existing bond that provides annual coupon
payments:
Par value = $1,000
Coupon rate = 11%
Maturity = 4 years
Required rate of return by investors = 11%
a. What is the present value of the bond?

ANSWER: FV=1000, PMT=110, n=4, I/Y=11, so PV=-1,000

 b. If the required rate of return by investors were 14 percent instead of 11 percent, what would be
the present value of the bond?

ANSWER: FV=1000, PMT=110, n=4, I/Y=14, so PV=-912.59

c. If the required rate of return by investors were 9 percent, what would be the present value of the
bond?
ANSWER: FV=1000, PMT=110, n=4, I/Y=9, so PV=1064.79

2. Valuing a Zero-Coupon Bond. Assume the following information for existing zero-coupon bonds:
Par value = $100,000
Maturity = 3 years
Required rate of return by investors = 12%
How much should investors be willing to pay for these bonds?

ANSWER: FV=100,000, PMT=0, n=3, I/Y=12, so PV=-71,178.02

3. Valuing a Zero-Coupon Bond. Assume that you require a 14 percent return on a zero-coupon bond
with a par value of $1,000 and six years to maturity. What is the price you should be willing to pay
for this bond?

ANSWER: FV=1000, PMT=0, n=1, I/Y=7, so PV=-455.59

5. Predicting Bond Values. (Use the chapter appendix to answer this problem.) Bulldog Bank has just
purchased bonds for $106 million that have a par value of $100 million, three years remaining to
maturity, and an annual coupon rate of 14 percent. It expects the required rate of return on these
bonds to be 12 percent one year from now.
a. At what price could Bulldog Bank sell these bonds for one year from now?

ANSWER: FV=100,000,000 N=2 PMT=0.14*100,000,000=14,000,000

I/Y=12, so PV=-103,380,102

b. What is the expected annualized yield on the bonds over the next year, assuming they are to be
sold in one year?

ANSWER: PV=-106,000,000 FV=103,380,102 N=1 PMT=0.14*100,000,000=14,000,000

So, I/Y=10.74%

7. Predicting Bond Values. (Use the chapter appendix to answer this problem.) Spartan Insurance
Company plans to purchase bonds today that have four years remaining to maturity, a par value of
$60 million, and a coupon rate of 10 percent. Spartan expects that in three years, the required rate of
return on these bonds by investors in the market will be 9 percent. It plans to sell the bonds at that
time. What is the expected price it will sell the bonds for in three years?
ANSWER: FV=60,000,000 N=1 PMT=0.10*60,000,000=6,000,000
I/Y=9, so PV=-60,550,458.72

Or PV=(60000000+6000000)/1.09=60,550,458.72

11. Valuing a Zero-Coupon Bond.

a. A zero-coupon bond with a par value of $1,000 matures in 10 years. At what price would this
bond provide a yield to maturity that matches the current market rate of 8 percent?

ANSWER:

C
= 1
PV (1+k )
1 , 000
= 10
PV (1+0 . 08)

PV = $463.19

b. What happens to the price of this bond if interest rates fall to 6 percent?

ANSWER:

C
=
PV (1+k )1

1 , 000
=
PV (1+0 . 06 )10

PV = $558.39

12. Bond Valuation. You are interested in buying a $1,000 par value bond with 10 years to maturity and
an 8 percent coupon rate that is paid semiannually. How much should you be willing to pay for the
bond if the investor’s required rate of return is 10 percent?
ANSWER: FV=1,000 N=10x2=20 PMT=0.08*1,000/2=40
I/Y=10/2=5, so PV=-875.38

13. Predicting Bond Values. A bond you are interested in pays an annual coupon of 4 percent, has a
yield to maturity of 6 percent and has 13 years to maturity. If interest rates remain unchanged, at what
price would you expect this bond to be selling 8 years from now? Ten years from now?

ANSWER: assume FV=1,000 N=5 PMT=0.04*1,000=40

I/Y=6, so PV=-915.75

assume FV=1,000 N=3 PMT=0.04*1,000=40

I/Y=6, so PV=-946.54
14. Sensitivity of Bond Values.
a. How would the present value (and therefore the market value) of a bond be affected if the coupon payments

are smaller and other factors remain constant?

ANSWER: The bond would have a lower present value, since the future cash flows would be smaller.

b. How would the present value (and therefore the market value) of a bond be affected if the
required rate of return is smaller and other factors remain constant?

ANSWER: The bond would have a higher present value, since the cash flows would be discounted at
a lower discount rate.

17 This question is outside of my teaching topics. So it is not required.

Chapter 9

4. Mortgage Maturities. Why is the 15-year mortgage attractive to homeowners? Is the interest rate
risk to the financial institution higher for a 15-year or a 30-year mortgage? Why?

ANSWER: The 15-year mortgage is popular because of the potential reduction in total interest
expenses paid on a mortgage with a shorter lifetime.

The interest rate risk is higher for a 30-year mortgage than for a 15-year mortgage, because the 15-
year mortgage exists for only half the period.

16. Mortgage Pass-Through Securities. Describe how mortgage pass-through securities are used. How
can the use of pass-through securities reduce a financial institution’s interest rate risk?

ANSWER: A financial institution that purchases or originates a portfolio of mortgages can finance
those mortgages issuing pass-through securities. The mortgages serve as collateral for the securities.
The interest and principal payments on the mortgages are transferred (passed through) to the owners
of the securities, after deducting fees for servicing and for guaranteeing payments to the owners.

Problem

1. Monthly Mortgage Payment. Use an amortization table that determines the monthly mortgage
payment based on a specific interest rate and principal with a 15-year maturity, and then for a 30-year
maturity. Is the monthly payment for the 15-year maturity twice the amount as for the 30-year
maturity, or less than twice the amount? Explain.
 ANSWER: The monthly mortgage payment on a 15-year mortgage is less than twice the payment on
a 30-year mortgage, because the principal is paid off at a faster rate.

Chapter 10

1. Shareholder Rights. Explain the rights of common stockholders that are not available to other
individuals.

ANSWER: Common stockholders are permitted to vote on key matters concerning the firm such as
the election of the board of directors, authorization to issue new shares of common stock, approval of
amendments to the corporate charter, and adoption of by-laws.

14. ADRs. Explain how ADRs enable U.S. investors to become part owners of foreign companies.

ANSWER: American depository receipts (ADRs) are certificates that represent ownership of a
foreign stock. They are traded in the United States. U.S. investors can purchase ADRs as a method of
investing in foreign securities.

Problem

1. Dividend Yield. Over the last year, Calzone Corporation paid a quarterly dividend of $0.10 in each
of the four quarters. The current stock price of Calzone Corporation is $39.78. What is the dividend
yield for Calzone stock?

ANSWER:

4×$ 0.10
=1.01%
Dividend yield = $39.78

Chapter 11

Questions and Applications

3. Impact of Economic Growth. Explain how economic growth affects the valuation of a stock.

ANSWER: The firm’s value should reflect the present value of its future cash flows. Because
earnings are a primary component of corporate cash flows, many investors use forecasted earnings to
determine whether a firm’s stock is over- or undervalued.

4. Impact of Interest Rates. How are the interest rate, the required rate of return on a stock, and the
valuation of a stock related?

ANSWER: Given a choice of risk-free Treasury securities or stocks, stocks should be purchased only
if they are appropriately priced to reflect a sufficiently high expected return above the risk-free rate.

The relation between interest rates and stock prices is not constant over time. However, most of the
 largest stock market declines have occurred in periods when interest rates increased substantially.
Furthermore, the stock market’s rise in the late 1990s is partially attributed to the low interest rates
during that period, which encouraged investors to shift from debt securities (with low rates) to equity
securities.

5. Impact of Inflation. Assume that the expected inflation rate has just been revised upward by the
market. Would the required return by investors who invest in the stocks be affected? Explain.
ANSWER: An increase in expected inflation can increase the risk-free interest rate, which is a key
component of the required rate of return on stocks. Therefore, it should cause an increase in the
required rate of return on stocks.

9. Earnings Surprises. How do earnings surprises affect valuations of stocks?

ANSWER: Favorable earnings surprises increase the values of stocks. Negative earnings surprises
decrease the values of stocks.

16. Market Efficiency. Explain the difference between weak-form, semistrong-form, and strong-form
efficiency. Which of these forms of efficiency is most difficult to test? Which is most likely to be
refuted? Explain how to test weak-form efficiency in the stock market.

ANSWER: The weak form suggests that security prices reflect recent price movements and trading
information. The semistrong form suggests that security prices reflect all publicly traded information.
The strong form suggests that security prices reflect public and private information.

Weak-form efficiency can be tested by searching for a nonrandom pattern in stock prices. If future
price movements can be predicted by assessing the past movements, a market inefficiency is detected.

Problems

9. Deriving the Required Rate of Return. A stock has a beta of 2.2, the risk-free rate is 6 percent, and
the expected return on the market is 12 percent. Using the CAPM, what would you expect the
required rate of return on this stock to be? What is the market risk premium?

ANSWER:

Rj = Rf + Bj(Rm – Rf )
Rj = 6% + 2.2(12% – 6%)
Rj = 19.2%

The market risk premium is 6 percent.

10. Deriving the Stock’s Beta. You are considering investing in a stock that has an expected return of 13
percent. If the risk-free rate is 5 percent and the market risk premium is 7 percent, what must the beta
of this stock be?
 ANSWER:

Rj = Rf + Bj(Rm – Rf )
0.13 = 0.05 + Bj (0.07)
Bj = 1.142

11. Measuring Stock Returns. Suppose you bought a stock at the beginning of the year for $76.50.
During the year, the stock paid a dividend of $0.70 per share and had an ending share price of $99.25.
What is the total percentage return from investing in that stock over the year?

ANSWER:

( SP−INV )+ D
R=
INV

(99 . 25−76 . 5)+0. 70

=
76 . 5

=30 . 6%

Chapter 13

1. Profit from T-bill Futures. Spratt Company purchased Treasury bill futures contracts when the
quoted price was 93-50. When this position was closed out, the quoted price was 94-75. Determine
the profit or loss per contract, ignoring transaction costs.

ANSWER:
Purchase price = $935,000
Selling price = $947,500
Profit = $947,500 – $935,000
= $12,500

2. Profit from T-bill Futures. Suerth Investments Inc. purchased Treasury bill futures contracts when
the quoted price was 95-00. When this position was closed out, the quoted price was 93-60.
Determine the profit or loss per contract, ignoring transaction costs.

ANSWER:
Purchase price = $950,000
Selling price = $936,000
Profit = $936,000 – $950,000
= –$14,000

3. Profit from T-bill Futures. Toland Company sold Treasury bill futures contracts when the quoted
price was 94-00. When this position was closed out, the quoted price was 93-20. Determine the profit
or loss per contract, ignoring transaction costs.

ANSWER:
Selling price = $940,000
Purchase price = $932,000
Profit = $940,000 – $932,000
 = $8,000

4. Profit from T-bill Futures. Rude Dynamics Inc. sold Treasury bill futures contracts when the quoted
price was 93-26. When this position was closed out, the quoted price was 93-90. Determine the profit
or loss per contract, ignoring transaction costs.

ANSWER:
Selling price = $932,600
Purchase price = $939,000
Profit = $932,600 – $939,000
= –$6,400

5. Profit from T-bond Futures. Egan Company purchased a futures contract on Treasury bonds that
specified a price of 91-00. When this position was closed out, the price of the Treasury bond futures
contract was 90-10. Determine the profit or loss, ignoring transaction costs.

ANSWER:
Purchase price = $91,000
Selling price = $90,312
Profit = $90,312 – $91,000
= –$688

6. Profit from T-bill Futures. R. C. Clark sold a futures contract on Treasury bonds that specified a
price of 92-10. When the position was closed out, the price of Treasury bond futures contract was 93-
00. Determine the profit or loss, ignoring transaction costs.

ANSWER:
Selling price = $92,312
Purchase price = $93,000
Profit = $92,312 – $93,000
= –$688

7. Profit from Stock Index Futures. Marks Insurance Company sold S&P 500 stock index futures that
specified an index of 1690. When the position was closed out, the index specified by the futures
contract was 1,720. Determine the profit or loss, ignoring transaction costs.

ANSWER:
Selling price = $250 × 1,690 = $422,500
Purchase price = $250 × 1,720 = $430,000
Profit = $422,500 – $430,000
= –$7,500

Chapter 14

14. Speculating with Stock Options. The stock price of Garner stock is $40. There is a call option on
Garner stock that is at the money, with a premium of $2.00. There is a put option on Garner stock that
is at the money, with a premium of $1.80. Why would investors consider writing this call option and
this put option? Why would some investors consider buying this call option and this put option?
 ANSWER: If the investors expected that the stock price would remain somewhat stable, they could
benefit from selling both options. They would receive more from premiums than their cost of
fulfilling their obligations if the stock price remains close to its prevailing value.

Some other investors may expect that the stock price will be very volatile, although they do not know
which direction the price will move. Therefore, they expect that they will exercise only one of their
options, but a large price movement could earn a large gain that would more than offset the premiums
they paid for both options.

Problems
1. Writing Call Options. A call option on Illinois stock specifies an exercise price of $38. Today’s
price of the stock is $40. The premium on the call option is $5. Assume the option will not be
exercised until maturity, if at all. Complete the following table:

Assumed Stock Price at the Time Net Profit or Loss per Share to Be Earned
the Call Option Is About to Expire by the Writer (Seller) of the Call Option
$37
$39
$41
$43
$45
$48

ANSWER:

Assumed Stock Price at the Time Net Profit or Loss per Share to Be Earned
the Call Option Is About to Expire by the Writer (Seller) of the Call Option
$37 $5
$39 $4
$41 $2
$43 $0
$45 –$2
$48 –$5

2. Purchasing Call Options. A call option on Michigan stock specifies an exercise price of $55. Today
the stock’s price is $54 per share. The premium on the call option is $3. Assume the option will not
be exercised until maturity, if at all. Complete the following table for a speculator who purchases the
call option:
 Assumed Stock Price at the Time Net Profit or Loss per Share
the Call Option Is About to Expire to Be Earned by the Speculator
$50
$52
$54
$56
$58
$60
$62

ANSWER:

Assumed Stock Price at the Time Net Profit or Loss per Share
the Call Option Is About to Expire to Be Earned by the Speculator
$50 –$3
$52 –$3
$54 –$3
$56 –$2
$58 $0
$60 $2
$62 $4

3. Purchasing Put Options. A put option on Iowa stock specifies an exercise price of $71. Today the
stock’s price is $68. The premium on the put option is $8. Assume the option will not be exercised
until maturity, if at all. Complete the following table for a speculator who purchases the put option
(and currently does not own the stock):

Assumed Stock Price at the Time Net Profit or Loss per Share
the Put Option Is About to Expire to Be Earned by the Speculator
$60
$64
$68
$70
$72
$74
$76

ANSWER:

Assumed Stock Price at the Time Net Profit or Loss per Share
the Put Option Is About to Expire to Be Earned by the Speculator
$60 $3
$64 –$1
$68 –$5
$70 –$7
$72 –$8
$74 –$8
$76 –$8

4. Writing Put Options. A put option on Indiana stock specifies an exercise price of $23. Today the
 stock’s price is $24. The premium on the put option is $3. Assume the option will not be exercised
until maturity, if at all. Complete the following table:

Assumed Stock Price at the Time Net Profit or Loss per Share to Be Earned
the Put Option Is About to Expire by the Writer (Seller) of the Put Option
$20
$21
$22
$23
$24
$25
$26

ANSWER:

Assumed Stock Price at the Time Net Profit or Loss per Share to Be Earned
the Put Option Is About to Expire by the Writer (Seller) of the Put Option
$20 $0
$21 $1
$22 $2
$23 $3
$24 $3
$25 $3
$26 $3

5. Covered Call Strategy.

a. Evanston Insurance Inc. has purchased shares of Stock E at $50 per share. It will sell the stock in
six months. It considers using a strategy of covered call writing to partially hedge its position in
this stock. The exercise price is $53, the expiration date is six months, and the premium on the
call option is $2. Complete the following table.

Profit or Loss per Share Profit or Loss per Share

Possible Price of Stock E If a Covered Call Strategy If a Covered Call Strategy
in 6 Months Is Used Is Not Used
$47
$50
$52
$55
$57
$60
 ANSWER:

Profit or Loss per Share Profit or Loss per Share

Possible Price of Stock E If a Covered Call Strategy If a Covered Call Strategy
in 6 Months Is Used Is Not Used
$47 –$1 –$3
$50 $2 $0
$52 $4 $2
$55 $5 $5
$57 $5 $7
$60 $5 $10

b. Assume that each of the six stock prices in the first column in the table have an equal probability
of occurring. Compare the probability distribution of the profits (or losses) per share when using
covered call writing versus not using it. Would you recommend covered call writing in this
example? Explain.

ANSWER: There is a 50 percent chance that covered call writing will result in an additional $2
per share gain. There is a 16.7 percent chance that the two possible strategies will generate the same
gain. There is a 33.3 percent chance that covered call writing will result in a lower gain.

9. Covered Call Strategy. Coral Inc. has purchased shares of stock M at $28 per share. It will sell the
stock in six months. It considers using a strategy of covered call writing to partially hedge its position
in this stock. The exercise price is $32, the expiration date is six months, and the premium on the call
option is $2.50. Complete the following table:

Possible Price of Stock M Profit or Loss per Share If a

in 6 Months Covered Call Strategy Is Used
$25
$28
$33
$36

ANSWER:

Possible Price of Stock M Profit or Loss per Share If a

in 6 Months Covered Call Strategy Is Used
$25 –$0.50
$28 $2.50
$33 $6.50
$36 $6.50

Chapter15

1. Vanilla Swaps. Cleveland Insurance Company has just negotiated a three-year plain vanilla swap in
which it will exchange fixed payments of 8 percent for floating payments of LIBOR + 1 percent. The
notional principal is $50 million. LIBOR is expected to 7 percent, 9 percent, and 10 percent,
respectively, at the end of each of the next three years.
a. Determine the net dollar amount to be received (or paid) by Cleveland each year.
 ANSWER:

End of Year:

1 2 3

LIBOR 7% 9% 10%

Floating Rate Received 8% 10% 11%

Fixed Rate Paid 8% 8% 8%

Swap Differential 0% 2% 3%

Net Dollar Amount Received

(Based on a Notional Value
of $50 Million) $0 $1,000,000 $1,500,000

b. Determine the dollar amount to be received (or paid) by the counterparty on this interest rate
swap each year based on the forecasts of LIBOR assumed above.

ANSWER: Year 1 = $0; Year 2 = $1,000,000 paid; Year 3 = $1,500,000 paid

Chapter 16

Solution to Integrative Problem for Part V

Choosing Among Derivative Securities

1. The scenario suggests that the United States will rebound from the recession, which should place
upward pressure on interest rates (primarily because of an increase in the demand for loanable funds,
as spending increases). If interest rates rise, the savings institution should hedge. Assuming that
interest rates are expected to increase for at least a few years, the fixed-for-floating swap would be
appropriate. While this may limit the return to the institution, it provides a proper hedge. The
floating-for-fixed swap is not appropriate because it would expose the institution to even more
interest rate risk. The put option on futures could be a useful hedge, but a premium must be paid for
the option. The option offers more flexibility than the interest rate swap because it does not have to be
exercised. Yet, if interest rates are almost definitely expected to rise, there is no reason to pay a
premium for the extra flexibility.

2. Economic conditions will likely improve, so that stock prices will rise. While this is a subjective
assessment, there is no reason to expect a major decline in stock prices. Therefore, a hedge (such as
selling stock index futures) is not appropriate. The insurance company should remain unhedged.
3. Since interest rates will likely increase, there is reason to consider hedging the bond portfolio. The
proper hedge would be to sell bond index futures. The pension fund would not wish to buy bond
index futures because it would be even more exposed to interest rate risk.
 Some people might suggest that hedging the bond portfolio of a pension fund is not necessary
because the income received will ultimately be transferred to participants. The situation is different
than that of a savings institution, which attracts deposited funds (at a cost) to make investments that
are exposed to interest rate risk. The pension fund receives its funds from contributions and therefore
may not be as concerned about rising interest rates over time (since it does not pay an interest rate on
incoming funds). Nevertheless, it could be better off by hedging in this situation if it is confident that
interest rates will rise. The proper hedge is to sell bond index futures.

Chapter 17

2. Bank Sources of Funds. What are four major sources of funds for banks? What alternatives does a
bank have if it needs temporary funds? What is the most common reason that banks issue bonds?

ANSWER:
1. Transaction deposits
2. Savings deposits
3. Time deposits
4. Money market deposit accounts

Sources of temporary funds include:

1. Federal funds market
2. Discount window
3. Repos
4. Eurodollar borrowings

Banks may issue bonds to purchase fixed assets.

4. Money Market Deposit Accounts. How does the money market deposit account differ from other
bank sources of funds?

ANSWER: MMDAs differ from conventional time deposits in that they do not specify a particular
maturity. In addition, a limited number of checks can be written against these accounts.

5. Federal Funds. Define federal funds, federal funds market, and federal funds rate. Who sets the
federal funds rate? Why is the federal funds market more active on Wednesday?

ANSWER: Federal funds are loaned in the federal funds market from one bank (or other depository
institution) to another at an interest rate known as the federal funds rate.

The federal funds rate is not directly set by anyone, but is determined by the market. The rate changes
frequently in response to changing supply and demand conditions. The Fed influences the federal
funds rate by adjusting the money supply.

8. Repurchase Agreements. How does the yield on a repurchase agreement differ from a loan in the
federal funds market? Why?

ANSWER: Repo rates are usually slightly lower than federal fund rates because a repo is backed by
securities.
 The federal funds market is active on Wednesday because depository institutions use the market to
adjust their required reserve position on that day (it is the final day of the settlement period for
required reserves).

Chapter 18

2. Off-Balance Sheet Activities. Provide examples of off-balance sheet activities. Why are regulators
concerned about them?

ANSWER: Off-balance sheet commitments occur when a bank guarantees a customer payment,
through a standby letter of credit, or an interest rate swap, or foreign exchange commitments. Under
some economic conditions, the bank could be exposed to too much risk. For example, if it guaranteed
payments to back corporations that issued commercial paper, and those corporations fail, it will have
to make the payments. Regulators are concerned about this risk.

7. CAMELS Ratings. Explain how the CAMELS ratings are used.

ANSWER: Regulators monitor banks periodically so that if any deficiencies are detected, they may
be corrected before the bank fails. CAMELS ratings are used to assess the capital, asset quality,
management, earnings potential, liquidity, and sensitivity of banks.

Chapter 19

3. Illiquidity. How do banks resolve illiquidity problems?

ANSWER: Banks can resolve illiquidity by selling some assets to obtain funds, or borrowing funds in
the federal funds market or from the discount window.

4. Managing Interest Rate Risk. If a bank expects interest rates to decrease over time, how might it
alter the rate sensitivity of its assets and liabilities?

ANSWER: It may increase its concentration of rate-sensitive liabilities and reduce its concentration
of rate-sensitive assets.

6. Managing Interest Rate Risk. If a bank is very uncertain about future interest rates, how might it
insulate its future performance from future interest rate movements?

ANSWER: It can attempt to match the degree of rate sensitivity of assets and liabilities, through
maturity matching, interest rate futures contracts, or interest rate swaps.

8. Managing Interest Rate Risk. Assume that a bank expects to attract most of its funds through short-
term CDs and would prefer to use most of its funds to provide long-term loans. How could it follow
this strategy and still reduce interest rate risk?

ANSWER: It could use floating-rate loans, so that its assets are rate-sensitive even with long-term
maturities.
15. Bank Loan Diversification. In what two ways should a bank diversify its loans? Why? Is
international diversification of loans a viable solution to credit risk? Defend your answer.

ANSWER: Banks should diversify across geographic regions and industries, to reduce exposure to
specific events.

Not necessarily. If the countries receiving loans tend to experience similar business cycles,
international diversification of loans has only limited effectiveness. International diversification of
loans to creditworthy borrowers has some merit, but the creditworthiness criterion should not be
ignored just to achieve international diversification.

16. Commercial Borrowing. Do all commercial borrowers receive the same interest rate on loans?

ANSWER: Interest rates on loans at a given point in time are dependent on the degree of risk of the
borrower.

Chapter 21

1. SI Sources and Uses of Funds. Explain in general terms how savings institutions differ from
commercial banks with respect to their sources of funds and uses of funds. Discuss each source of
funds for savings institutions. Identify and discuss the main uses of funds for savings institutions.

ANSWER: Savings institutions obtain a large portion of their funds from savings deposits, more so
than large commercial banks. While savings institutions can offer NOW accounts, they cannot offer
the traditional demand deposits.

Savings institutions concentrate on mortgages as their main use of funds. This differs from
commercial banks, which concentrate on commercial loans and some consumer loans. Commercial
banks offer a relatively small amount of mortgage loans compared to savings institutions.

The major sources of funds for savings institutions are as follows:

1. Deposits, which include passbook savings, retail CDs, and money market deposit accounts;
2. Borrowed funds, which come from either their district Federal Home Loan Bank for an extended
length of time, the Federal Reserve discount window for very short-term loans, through
repurchase agreements, and in the federal funds market;
3. Capital obtained by issuing stock and retaining earnings.

The main uses of funds for savings institutions are:

1. Cash to satisfy reserve requirements enforced by the Federal Reserve System and to
accommodate withdrawal requests of depositors;
2. Mortgages where the real estate represented serves as collateral to guard against default risk;
3. Mortgage-backed securities issued by other savings institutions that were in need of funds;
4. Investment securities like Treasury securities and corporate bonds that provide savings
institutions with liquidity;
5. Consumer and commercial loans where consumer loans are typically for home improvements and
education; the Garn-St Germain Act of 1982 allowed them to use up to 10 percent of their assets
for commercial loans;
6. Other uses include providing temporary financing to other institutions through repurchase
agreements, and the federal funds market.
6. Liquidity and Credit Risk. Describe the liquidity and credit risk of savings institutions, and discuss
how each is managed.

ANSWER: Savings institutions experience liquidity risk since they commonly use short-term
liabilities to finance long-term assets. They commonly increase their liabilities rather than reduce
their assets in order to increase liquidity. Since mortgages represent their primary asset, they are the
main reason for default risk. Insurance is available for the many types of mortgages issued. In
addition, savings institutions perform credit analysis and geographically diversity their mortgage
loans to guard against default risk.

8. Use of Financial Futures. Explain how savings institutions could use interest rate futures to reduce
interest rate risk.

ANSWER: Savings institutions can sell financial futures in order to hedge against interest rate risk. If
interest rates rise, the futures position will generate a gain that can offset the likely reduction in a
savings institution’s spread.
9. Use of Interest Rate Swaps. Explain how savings institutions could use interest rate swaps to reduce
interest rate risk. Will savings institutions that use swaps perform better or worse than those that were
unhedged during a period of declining interest rates? Explain.

ANSWER: A savings institution can swap fixed payments in exchange for variable payments. If
interest rates rise, variable inflow payments to the savings institution increase while the outflow
payments remain fixed. Thus, the favorable effect of the swap will offset the unfavorable effect of
higher interest rates on the savings institution’s cost of funds. If interest rates declined, savings
institutions that used swaps would perform worse than savings institutions that were unhedged. The
favorable effect on the spread could be offset by lower swap payments received during a period of
declining interest rates.

11. Hedging Interest Rate Movements. If market interest rates were expected to decline over time, will
a savings institution with rate-sensitive liabilities and a large amount of fixed-rate mortgages perform
best by (a) using an interest rate swap, (b) selling financial futures, or (c) remaining unhedged?
Explain.

ANSWER: A savings institution would perform best by not hedging since it could benefit from lower
interest rates. Its cost of funds would decline and its spread would increase. The hedging techniques
can offset adverse effects during periods of rising interest rates but also offset favorable effects during
periods of declining interest rates.

Chapter 23

2. Open- versus Closed-End Funds. How do open-end mutual funds differ from closed-end mutual
funds?

ANSWER: Shares of open-end mutual funds can be sold back to the sponsoring investment company,
whereas shares of closed-end mutual funds cannot.

3. Load versus No-Load Mutual Funds. Explain the difference between load and no-load mutual
funds.

ANSWER: Load mutual funds require a fee to help pay for marketing commissions. No-load mutual
funds do not require such a fee.

14. Diversification among Mutual Funds. Explain why diversification across different types of mutual
funds is highly recommended.

ANSWER: The performance of each type of mutual fund is influenced by a particular economic
factor. Thus, diversifying within one specific type of mutual fund creates significant exposure to that
factor. The stock market movements influence stock fund performance, interest rate movements
influence bond fund performance, and exchange rates and foreign market movements influence
international funds. Diversification across stock funds, bond funds, and international funds limits the
exposure to any single economic factor.
16. REITs. Explain the difference between equity REITs and mortgage REITs. Which type would likely
be a better hedge against high inflation? Why?

ANSWER: Equity REITs invest directly in properties, while mortgage REITs invest in mortgage and
construction loans. Equity REITs would likely be a better hedge against inflation because rents and
property (the sources of income for equity REITs) tend to rise with inflation.

17. Comparing Management of Open- Versus Closed-End Funds. Compare the portfolio managers of
closed-end funds versus an open-end fund. Given the differences in the fund characteristics, explain
why the portfolio manager’s management of liquidity is different in the open-end fund as compared
to the closed-end fund. Assume that the size of each fund is the same and that the goal is to invest in
stocks and to earn a very high return. Which manager do you think will achieve higher increase in the
fund’s net asset value? Explain.

ANSWER: The closed-end fund manager does not need to worry about redemptions since the fund is
closed, whereas the open-fund manager must worry about accommodating redemptions and therefore
must always maintain some liquidity for this purpose. Therefore, the closed-end fund manager has
more flexibility to invest. It can invest in illiquid stocks without having to worry about selling those
stocks to accommodate redemptions.

19. Comparing Hedge Funds to Mutual Funds. Explain why hedge funds may be able to achieve
higher returns for their investors than mutual funds. Explain why the risk of hedge funds may differ
from mutual funds. When the market is overvalued, why might hedge funds be better able to
capitalize on the excessive market optimism than mutual funds?

ANSWER: The hedge funds are subject to fewer restrictions on what they can invest in than mutual
funds. For example, they are not limited to just investing in stocks. They can engage in short selling
and therefore take advantage of expectations that the stock prices will decline, while many mutual
funds are not allowed to take such positions. Hedge funds typically have a high degree of risk because
they are not subject to restrictions on their investment strategy. When hedge funds engage in short
selling, there is downward pressure on the stock’s price. To the extent that the stock was overvalued,
short selling can correct the price. Mutual funds are normally subject to restrictions on short selling.

Chapter 24

4. Origination Process. Describe the origination process for corporations that are about to issue new
stock.

ANSWER: A corporation about to issue new stock contacts an IBF, which recommends the amount
of stock to issue along with the suggested price and other provisions. The corporation then registers
with the SEC with a registration statement.

5. Underwriting Function. Describe the underwriting function of an investment bank.

ANSWER: An IBF may be willing to underwrite the stock of an issuing corporation, which
guarantees the price to be received by the corporation. The IBF assumes the risk that the securities
 could sell for a lower price than anticipated.

6. Best-Efforts Agreement. What is a best-efforts agreement?

ANSWER: In a best-efforts agreement, the IBF does not guarantee a price to the issuing corporation,
but only promises to offer its best efforts in selling the securities. Thus, the issuing corporation bears
the risk that the securities may sell for a lower price than anticipated.

10. Arbitrage Activities. Explain how some investment banking firms (IBFs) facilitate arbitrage activity
in the securities industry.

ANSWER: IBFs can search for undervalued firms for an arbitrage firm to acquire. In addition, IBFs
may obtain financing by issuing securities (such as junk bonds) for the arbitrage firm, or providing
bridge loans to the firm.

11. Asset Stripping. What is asset stripping?

ANSWER: Asset stripping is a form of arbitrage in which after a firm is acquired, some of its
divisions are sold.

Chapter 25

1. Life Insurance. How is whole life insurance a form of savings to policyholders?

ANSWER: Whole life insurance is permanent as it protects the policyholder until death or as long as
premiums are promptly paid. It is a form of savings as it builds a cash value the policyholder is
entitled to even if the policy is canceled.

2. Whole Life versus Term Insurance. How do whole life and term insurance differ from the
perspective of insurance companies? From the perspective of the policyholders?

ANSWER: Term insurance provides insurance only over a specified term; it is not permanent like
whole life insurance. Term insurance does not build a cash value, so it is not a savings mechanism.
Also, term insurance is less expensive than whole life insurance.

5. Assets of Life Insurance Companies. What are the main assets of life insurance companies? Identify
the main categories. What is the main use of funds by life insurance companies?

ANSWER: Life insurance companies invest in government securities, corporate securities,

mortgages, real estate, and policy loans.

The main investment by life insurance companies is corporate bonds.

8. Managing Interest Rates. Why are life insurance equity values sensitive to interest rate movements?
What are two strategies that reduce the impact of changing interest rates on the market value of life
insurance companies’ assets?
 ANSWER: Life insurance companies maintain large positions in bonds. As interest rates rise, the
market value of their assets declines.

To reduce the impact of changing interest rates on the market value of assets, insurance companies
have been reducing their average maturity on securities and investing in long-term assets with
floating rates.

9. Managing Credit Risk and Liquidity Risk. How do insurance companies manage credit risk and
liquidity risk?

ANSWER: To deal with default risk, life insurance companies typically invest in securities with high
ratings and then diversify among security issuers. To reduce liquidity risk, they diversify the age
distribution of customers.

10. Liquidity Risk. Discuss the liquidity risk experienced by life insurance and property and casualty
(PC) insurance companies.

ANSWER: Life insurance companies have somewhat predictable payouts over time. However, a high
frequency of claims can cause the insurance companies to be illiquid. To boost liquidity, the
companies could maintain some liquid assets. PC insurance companies have claims that are less
predictable, and need to maintain sufficient liquid assets to cover any payouts.

14. Reinsurance. What is reinsurance?

ANSWER: Reinsurance permits companies to write large policies by allocating a portion of the risk
to other insurance companies, but they then must share the return.

21. Exposure to Interest Rate Risk. How can pension funds reduce their exposure to interest rate risk?

ANSWER: Pension funds could reduce the average maturity of bonds held to reduce interest rate risk.
They could also take positions in financial futures or options on futures as was described in earlier
chapters.

24. Adverse Selection and Moral Hazard Problems in Insurance. Explain the adverse selection
problem and the moral hazard problem in insurance. Gorton Insurance Co. wants to properly price the
insurance for car accidents. If Gorton wants to avoid the adverse selection and moral hazard
problems, do you think it should assess the behavior of insured people, uninsured people, or both
groups? Explain.

ANSWER: When insurance companies assess the probability of a condition that will result in a
payment to the insured, they rely on statistics about the general population. However, an individual
person has private information (about himself) that is not available to the insurance company. The
individuals who have private information that makes them more likely to need insurance will buy it,
while the individuals who have private information that makes them less likely to need insurance will
not buy it. This is referred to as an adverse selection problem, which in general means that bad
customers are selected.
In the insurance industry, the moral hazard problem represents insured policyholders taking more
risks because they are insured. If the insurance company did not consider this when setting insurance
premiums, it may have set the premium too low.

Thus, Gorton Insurance Co. should assess the sample of insured policyholders rather than the entire
sample because this subsample more properly reflects the behavior of the people that it would insure.