FINA 403 - Derivatives Spring 2013 Assignment 1 Please type up a written response to the questions below and e-mail

l your response to me at rmckeon@sandiego.edu by the end of Friday, Feb 15th. Please save your document as [your last name]_assignment1 before submitting it. 1) The Iowa Electronic Market offers futures contracts where the future payoff is tied to some
political event. For example, leading up to last years presidential election they had a Romney contract, where the seller would have to pay out $1 at expiry to the buyer if Mitt Romney won and $0 if he lost, and an Obama contract where the seller would have to pay out $1 if President Obama won and $0 if he lost.

a) Why would somebody trade these contracts? Is it purely speculative or can you think of any risk-management motivations. b) Suppose you inspected this market in the middle of last year and saw both contracts trading at $0.45 each. Is this pricing correct? Is there any way to make an arbitrage profit here? Explain your thinking in as much detail as possible. 2) In 1994 the Bulgarian government issued bonds on which the coupon payments were tied to the GDP of the country. Im simplifying here, but basically a low level of GDP would reduce the interest payments on the bonds, and a high level of GDP would increase the interest payments. Suppose a US investor buys these bonds. What risks is the investor exposed to? (list everything which could negatively affect the investment and in each case explain how/why this is a risk factor.) 3) In the 1970s Yale University implemented a system for students in which the students would receive loans to pay their tuition. Repayment of the loans involved the following arrangement: -after graduation all students enrolled in the program would pay 0.4% of their annual income per $1,000 borrowed until the entire cohort had paid off their collective debt, or until 35 years had passed (whichever came sooner). (Source: The New Financial Order by Robert Shiller, 2004, Princeton University Press, page 143)
a) b)

What risks are the students exposed to? Explain each risk that you identify. What risks are the lenders of money exposed to? Explain each risk that you identify.

4) In 1997 so-called Bowie bonds were issued. These were 10 year bonds paying a 7.9% annual interest coupon, where the money for meeting the payments on the bonds was to come from the future income of musician David Bowie (see http://en.wikipedia.org/wiki/David_bowie if youve never heard of him!).

What is the purpose of issuing bonds of this nature (i.e. whats in it for the issuer)? b) What risks are investors in the bonds exposed to? c) How easy is managing/offsetting the risks of this investment compared to the bond in question (2)? (Consider how things are different conceptually or in terms of implications, not the direct differences in mechanics.)
a)

5) In The New Financial Order by Robert Shiller, the author proposes livelihood insurance in the form of derivative contracts on the performance of particular professions. In brief, the way it would work is: -we construct an index which broadly captures the current levels of compensation in a particular profession based on market data. If demand (and salary) for people in a certain profession increases then so would the index, and if salaries generally decrease then so would the index. In other words, the index attempts to capture the current career prospects in that particular field.
a)

Why might people be interested in derivatives contracts derived from the value of such an index? (Think of both speculation and hedging when considering this question.) How is this proposal different to an individual simply taking out an insurance policy against failing to succeed in his/her chosen profession? (for example, an aspiring musician taking out an insurance contract which pays out if the person never actually ever gets offered a recording contract) (Think of this question from both points of view: how is it different for the person taking out insurance and how is it different for the person providing insurance? Consider how things are different conceptually or in terms of implications, not the direct differences in mechanics.)

b)

6) In recent history several large investment banks required government and central bank funding in order to prevent them from bankruptcy. Many market commentators worried that this created moral hazard. What is moral hazard and how does it relate to the actions, which the government and central banks took with respect to these investment banks?