Answer Ten of the Eleven Questions Below. Clearly Mark the Question That You Wish to Omit

Answer Ten of the Eleven Questions Below. Clearly Mark the Question That You Wish to Omit

Quiz 2 – BA 4345

February 28, 2005Name:

Answer ten of the eleven questions below. Clearly mark the question that you wish to omit.

  1. What are the differences in the structures of the New York and Nasdaq exchanges? What role (or roles) does a specialist (or market maker) play in the two exchanges? The NYSE is an auction market; NASDAQ is a dealer market. Specialists (NYSE) and dealers (NASDAQ) quote bid and ask prices, bring buyers and sellers together, commit capital from their own account, take risk of price changes that occur on securities held in inventory.
  1. From the middle of 2001 into early 2002, the overnight federal funds rate dropped from just over 6.5 percent to 2 percent. During the same interval, the average interest rate on conventional, 30-year mortgages fell from just over 8.5 percent to just over 6.7 percent. Thus, even though the fall in the one-day federal funds rate exceeded 4.5 percentage points, the mortgage rate fell by less than 2 percentage points. Two members of Congress claimed that mortgage lenders conspired to keep mortgage rates high during this period. In their view, this experience is evidence that Congress should establish laws requiring mortgage rates to move in conjunction with short-term interest rates such as the federal funds rate. What other explanation might there be for the observed pattern of interest rates during 2001 and 2002? Mortgage rates are longer term and move in conjunction with T-bonds rather than the overnight Fed Funds rate.
  1. “Municipal-Bond Fans Get a Rude Awakening” (WSJ 2/8/05) Summary: Last week brought losses of 15% or more for a group of bonds with a solid triple-A rating. The losses occurred when New York City exercised the call feature on some of their municipal bonds. A call feature allows the issuer to redeem the bond early at a set price (usually a few percentage points above par value).
  2. What is a municipal bond? Why would an investor prefer a municipal bond to a non-municipal one? A municipal bond is exempt from Federal taxes. Investors in high tax brackets would prefer these bonds.
  1. How does a callable bond differ from a non-callable bond? Who holds the call option in a callable bond? A callable bond is a bond that can be paid off early. The bond issuer holds the call option.
  1. All else equal, should a callable bond have a higher or lower yield to maturity than an otherwise equivalent non-callable bond? Support your answer. Higher. The call feature is undesirable to the holder of the bond so bonds with call features have a higher yield.
  1. Explain the government bond quotes below. If you wanted to buy the 2nd bond listed, what price would you pay? Why are the bonds selling at different prices? What is the asked yield? Why do the bonds have the same asked yield when their prices are different?

Rate / Maturity
Mo/Yr / Bid / Asked / Asked
Yield
3 1/2 / Feb 10 n / 98:09 / 98:10 / 3.87
6 1/2 / Feb 10 n / 111:24 / 111:25 / 3.87

The asked price is $1,117.81. The bonds sell at different prices because of the different coupon rates. If you bought the first bond you would have less interest and more capital gain. With the 2nd bond you would have more interest and less capital gain. The asked yield is the yield to maturity.

  1. If you wanted to buy the T-bill below, what is the price that you would pay? Assume a face value of $1,000. What would be the yield to maturity (bond equivalent yield) on the T-bill?

Maturity / Days
to
Mat. / Bid / Asked
Jun 23 05 / 120 / 2.68 / 2.67

0.0267 = [(1000-P)/1000]*(360/120) Solve for P = $991.10.

YTM = [(1000-991.10)/991.10]*(365/120) = 2.73%

  1. Given the options data below, answer the following questions.

AppleC ( AAPL ) / Underlying stock price*: 85.29
Expiration / Strike / Call / Put
Last / Volume / OpenInterest / Last / Volume / OpenInterest
Apr / 65.00 / 22.30 / 40 / 14016 / 0.55 / 36 / 12377
Apr / 85.00 / 6.90 / 1530 / 39417 / 6.00 / 145 / 4165
Apr / 105.00 / 1.50 / 50 / 1482 / 19.80 / 455 / 19
  1. If you bought the April put with a strike price of 65, to what does this entitle you? The right to sell Apple at a price of 65 before the expiration.
  1. Why do the three call options sell at such different prices when they all expire at the same time? They have different prices because the exercise price is different.
  1. Which of the call option(s) are “out-of-the-money”? April 105
  1. Suppose you are a coffee producer. You observe a current spot price of 0.75 cents per pound (in June). You also observe that the July futures contract is trading at 85 cents. You want to sell your coffee in July and are afraid that the price of coffee might decline.
  2. How could you use the futures market to hedge against such a decline? Sell a coffee futures contract for delivery in July.
  1. Suppose July spot prices are actually 87 Cents. What will your profit/loss be in the cash market? What about the futures market? (Assume settlement by offset). Buy back the futures contract for 87 cents (loss of 2 cents). Sell coffee on the spot market for 87 cents (2 cent gain).
  1. Would you be considered a speculator or a hedger? Hedger
  1. The price of Microsoft is $25.26 and the July 2005 call options with a strike price of 27.50 sell for $0.24. You have $1,000 to invest. Describe the risks and returns of buying the stock outright, buying the stock on margin or buying the call options on the stock.

Buy the stock: risk is that the stock will go down. The worst thing that can happen is that the stock price goes to zero and you lose $1,000.

Buy the stock on margin: You buy twice as much stock and have the potential for twice the gains. However, you also have the potential for twice the loss.

Buy call options: call options are a wasting asset. If the stock price has not moved above 27.50 by July, your options will be worthless. Your potential for gains are unlimited. You have the highest risk and the chance for the most reward with this option.

  1. What is the difference between a brokered market and a dealer market? Give an example of each. Brokers match up buyers and sellers in a market with low liquidity. Muni bond and real estate markets are examples. Dealers continuously bid for securities. NASDAQ is an example.
  1. What characterizes securities with wide bid-asked spreads? Low liquidity, low volume, risk of large price changes is high.
  1. Define Eurodollar? What would you expect the Eurodollar yield to be relative to other money market instruments(higher, lower, the same)? Support your answer. A Eurodollar is a dollar denominated time deposit held abroad in foreign banks or foreign branches of U.S. banks. they have higher yields because of higher risk and less regulation.