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SCHOOL OF ECONOMICS
ECO4053Z
FINANCIAL ECONOMICS
EXAMINATION NOVEMBER 2006
Instructions:
Answer all questions.
Mathematical or numerical answers must be accompanied by clear explanations
All questions carry equal weight.
This is a closed-book exam.
Question 1 [Portfolio Theory]
a) Consider an investment set with only three securities, two risky and one risk-free. The
risk-free rate is 10%. The expected returns and standard deviations of the risky
securities are as follows:
Security 1
Security 2
Expected return
10%
4%
Standard deviation
5%
2%
Fixed rate $
Floating rate
Company A
Company B
Treasuries+0.6%
LIBOR+0.15%
Treasuries+1.8%
LIBOR+1.6%
The spot exchange rate is 1.5$=1. Company A and company B enter into a 2-year swap
agreement via a financial intermediary. The notional principal is 100 million. Assume that
the yield on treasuries is 7% in each year. The LIBOR is 5% in the first year and 5 % in the
second year. Assume that company A takes 60% of the total gain from the swap, company B
takes 24% and the financial institution takes 16%.
Conclude the swap transaction.
Question 5
The prices of bonds are as follows,
Principal (R)
100
100
100
100
(i)
(ii)
(iii)
Time to maturity
(years)
1
1
2
Question 6
A stock price is currently R30. Each month for the next two months it is expected to increase
by 8% or reduce by 10%. The risk-free interest rate is 5%.
(i)
Use a two-step tree to calculate the value of a derivative that pays off
max [(30 S T ) 2 ,0] , where ST is the stock price in two months?
If the derivative in (i) is American-style, should it be exercised early?
(ii)
Question 7
(a) Construct a table showing the payoff from a bull spread when puts with strike
prices K 1 and K 2 ( K 2 K 1 ) are used.
(b) What is the result if the strike price of the put is higher than the strike price of
the call in a strangle?