15.

401
15.
401R
Recitation
ExtraSession:MidTerm Review

GeneralAdvice

Showyourwork!Answersonlygiveyoupartialcredit
Writedowntheformulasyouuse
Drawtimelinesforcashflows
Makesureyouapplytheannuity/perpetuityformulas
correctly Example:
correctly
Example:
Formula
refersto
valueint=0
t=1

t=0

...
t=1

t=2

t=3

t=4

t=T

Stateyourassumptions
Leaveplentyofdecimalplacesforinterestrates
(e.g.,1.2345%)
3

SampleMidtermSolutions
Q1 Compounding
D Q2 APREARConversion
D Q3 Common
D Q4 FixedIncomeSecurities
D Q5 PresentValue
D Q6 Forwards&Futures
D

Q1 Compo
pound
undiing
Iftheannualinterestrateis10percent,how

longwouldyouhavetowaitbeforea$17,500
investmentdoublesinvalue?

Q1 Compo
pound
undiing
Iftheannualinterestrateis10percent,how

longwouldyouhavetowaitbeforea$17,500
investmentdoublesinvalue?
Advice:
QuestionwhethertherateisexpressedasEAR,APR,

orother;andwhatisthecompoundingperiod
Ifsomeoftheaboveisnotcleartoyou,stateyour

assumptions

WritedowntheequationintermsofT
Computeprecisevalue,thenroundup
Showyourwork!
6

Q1 Compounding
Q1

LetT betheamountoftime(inyears)
required,then
T

17,500 (1 + 10% ) = 17,500 2

1.1T = 2
T Ln(1.1) = Ln(2)

ln 2
T=
= 7.2725
ln 1.1

Theminimumnumberofyearsis8.
7

Q2 APREA
EAR
RConversion

Yourcardealeroffersyoualoanforpartofthe
purchasepriceofanewcar,citinganannualpercentage
rate(APR)of8.5%.What

istheeffectiveannualrateof
suchaloan(recallthatanautoloantypicallyrequires
monthlypayments)?

Q2 APREA
EAR
RConversion

Yourcardealeroffersyoualoanforpartofthe
purchasepriceofanewcar,citinganannualpercentage
rate(APR)of8.5%.What

istheeffectiveannualrateof
suchaloan(recallthatanautoloantypicallyrequires
monthlypayments)?

Advice:
KnowhowtoEARAPR
EffectiveRateper =
CompoundingInterval

rAPR
k

APR:annualpercentagerate
EPR:effectiveannualrate
k:#compintervalperperiod

Leaveatleast2decimalplacesintheend

Q2 APR
Q2
APREARConversion

GivenmonthlycompoundedAPR,we
have
k

rEAR

rAPR
= 1 +
1
k

12

8.5%
= 1 +
1
12

= 8.8391%

10

Q3 CommonSStocks

CompanyABChasjustpaidadividendof50centsper
share.Becauseofitsgrowthpotential,itsdividendis
forecastedtogrowatarateof7percentperyear
indefinitely.Ifthecompany'sappropriatecostofcapital
(givenitsrisk)is11percent,whatwasABC'sshare
priceimmediatelybefore itpaidits50centdividend,i.e
thestockpricerightbeforetheexdividenddate?

11

Q3 CommonSStocks

CompanyABChasjustpaidadividendof50centsper
share.Becauseofitsgrowthpotential,itsdividendis
forecastedtogrowatarateof7percentperyear
indefinitely.Ifthecompany'sappropriatecostofcapital
(givenitsrisk)is11percent,whatwasABC'sshare
priceimmediatelybefore itpaidits50centdividend,i.e
thestockpricerightbeforetheexdividenddate?

Advice:
Becarefulwiththetimeswhendividendpayment
occurs drawatimeline!
Inthiscase,remembertoincludeD0
Writethegrowingperpetuityformula
Usetheformulacorrectly numeratorisD1,notD0
12

Q3 CommonStocks
Q3

Parameters:

D0 = 0.50; D1 = 0.50 1.07; g = 0.07; r = 0.11

D0

D4

...
t=1

t=2

t=3

t=4

t=

t=0

2
D0*(1+g) D0*(1+g)
D3
D2
D1

Dividenddiscountmodel:

D1
P0 = D0 +
rg
0.50 1.07
= 0.50 +
0.11 0.07
= $13.88

13

Q3 CommonStocks
Q3

Parameters:
D0 = 0.50; D1 = 0.50 1.07; g = 0.07; r = 0.11

Dividenddiscountmodel:
D1
P0 = D0 +
rg
0.50 1.07
= 0.50 +
0.11 0.07
= $13.88

14

Q4 FixedInc
nco
omeSecur
uriities

Thecurrentmarketpriceofatwoyear25percent
couponbondwitha$1,000facevalueis$1,219.71
(recallthatsuchabondpayscouponsof$250atthe
endofyears1and2,andtheprincipalof$1,000atthe
endofyear2).The
currentmarketpriceofaoneyear
purediscountbondwitha$50facevalueis$44.64.
a)Whatmustthepriceofatwoyearpurediscount
bondwitha$2,500facevaluebeinordertoavoid
arbitrage?
Advice:
Donotconfuser1 withr2 andYTM
Inthiscase,donotdiscountthecouponwiththeYTM

15

Q4
FixedInc
nco
omeSecur
uriities

Thecurrentmarketpriceofaoneyearpurediscount
bondwitha$50facevalueis$44.64:

50
= 44.64 r1 = 12.0072%
(1+ r1 )

The
twoyear25percent
Thecurrentmarketpriceofatwoyear
couponbondwitha$1,000facevalueis$1,219.71:

250
1,250
+
= 1,279.71
2

(1+ r1 ) (1+ r2 )

250
1,250

+
= 1,279.71 r2 = 11.9990%
2
(1+ 0.120072) (1+ r2 )

Nowweknowthespotrates,r1 andr2

16

Q4 FixedIncomeSecurities
Q4

Thepriceofthetwoyearpurediscountbondmustbe
2,500
2,500
P=
=
= $1,993.02
2
2
(1 + r2 ) (1 + 0.119990)

17

Q4 FixedInc
nco
omeSecur
uriities

Thepriceofthetwoyearpurediscountbondmustbe

2,500
2,500
P=
=
= $1,993.02
2
2
(1+ r2 ) (1+ 0.119990)

b)Suppose
b)
Supposetheprice
priceofthetwo
twoyear
yearpur
pureediscount
bondwitha$2,500facevalueisonly$1,900.Is
thereanarbitrageopportunity?Isyes,howwould
youstructureatradethathaszerocashflowin
years1and2andapositivecashflowonlyinyear0
(i.e.now).

Theremustbeanarbitrageopportunitybecause$1,900

isnotthefairpriceof$1,993.02!Howtocapitalizeit?

18

Q4 FixedInc
nco
omeSecur
uriities

Thepriceofthetwoyearpurediscountbondmustbe
2,500
2,500
=
= $1,993.02
P=
2
2
(1+ r2 ) (1+ 0.119990)

b)Suppose
b)
Supposetheprice
priceofthetwo
twoyear
yearpur
pureediscount
bondwitha$2,500facevalueisonly$1,900.Is
thereanarbitrageopportunity?Isyes,howwould
youstructureatradethathaszerocashflowin
years1and2andapositivecashflowonlyinyear0
(i.e.now).

Theremustbeanarbitrageopportunitybecause$1,900

isnotthefairpriceof$1,993.02!Howtocapitalizeit?

19

Q4 FixedIncomeSecurities
Q4
Advice:
Consideralltheinstrumentsyoumayuse 3inthisexample
Buildatablethatshowsforeveryyearthatareexpectedto
comefromeachbond(seebelow)
Inthiscase,startbywritingthecashflowsforthebondthat
isnotfairlypriced,ortheonewithlongermaturity
Useyourlogic!

Bond

Position

CFat0

CFat1

CFat2

+?

1yr,ZeroCoupon,$50Par,
sellsfor$44.64
2year,25%coupon,$1,000
Par,sellsfor$1,219.71
2yr,ZeroCoupon,$2,500
Par,sellsfor$1,900
TOTAL:

20

Q4 FixedIncomeSecurities
Q4
Advice:
Consideralltheinstrumentsyoumayuse 3inthisexample
Buildatablethatshowsforeveryyearthatareexpectedto
comefromeachbond(seebelow)
Inthiscase,startbywritingthecashflowsforthebondthat
isnotfairlypriced,ortheonewithlongermaturity
Useyourlogic!

Bond

Position

CFat0

Buy(Long)
1bond

1,900

CFat1

CFat2

1yr,ZeroCoupon,$50Par,
sellsfor$44.64
2year,25%coupon,$1,000
Par,sellsfor$1,219.71
2yr,ZeroCoupon,$2,500
Par,sellsfor$1,900

TOTAL:

+?

2,500
0

21

Q4 FixedIncomeSecurities
Q4
Advice:
Consideralltheinstrumentsyoumayuse 3inthisexample
Buildatablethatshowsforeveryyearthatareexpectedto
comefromeachbond(seebelow)
Inthiscase,startbywritingthecashflowsforthebondthat
isnotfairlypriced,ortheonewithlongermaturity
Useyourlogic!

Bond

Position

CFat0

CFat1

CFat2

500

2,500

1yr,ZeroCoupon,$50Par,
sellsfor$44.64
2year,25%coupon,$1,000 Sell(Short)
+2,439.42
Par,sellsfor$1,219.71
2bonds
2yr,ZeroCoupon,$2,500
Par,sellsfor$1,900

Buy(Long)
1bond
TOTAL:

1,900
+?

2,500
0

22

Q4 FixedIncomeSecurities
Q4
Advice:
Consideralltheinstrumentsyoumayuse 3inthisexample
Buildatablethatshowsforeveryyearthatareexpectedto
comefromeachbond(seebelow)
Inthiscase,startbywritingthecashflowsforthebondthat
isnotfairlypriced,ortheonewithlongermaturity
Useyourlogic!

Bond

Position

1yr,ZeroCoupon,$50Par, Buy(Long)
sellsfor$44.64
10bonds

CFat0

CFat1

446.40

+500

2year,25%coupon,$1,000 Sell(Short)
+2,439.42
Par,sellsfor$1,219.71
2bonds
2yr,ZeroCoupon,$2,500
Par,sellsfor$1,900

Buy(Long)
1bond

1,900

TOTAL:

+93.02

500

CFat2

2,500
2,500

23

Q4 FixedInc
nco
omeSecur
uriities

Bond

Position

1yr,ZeroCoupon,$50Par, Buy(Long)
sellsfor$44.64
10bonds

CFat0

CFat1

446.40

+500

2year,25%coupon,$1,000 Sell(Short)
+2,439.42
Par,sellsfor$1,219.71
2bonds
2yr,ZeroCoupon,$2,500
Par,sellsfor$1,900

Buy(Long)
1bond

1,900

TOTAL:

+93.02

500

CFat2

2,500
2,500

Note:
Wecanmakefreemoneytoday,withnorisk arbitrage!
Inourexampletheprofitis$93.02,thesameamountby
whicheach2year,zerocoupon,isunderpriced
Thereismorethansolutiontothisproblem,butallofthem
aremultiplesofthissimplecase
24

Q4 FixedIncomeSecurities
Q4
Alternativemethod:
Solveandequationsystem:
CFat0

CFat1

CFat2

n1 xB1

n1 x1219.71

n1 x250

n1 x1250

n2 xB2

n2 x44.64

n2 x50

n3 xB3

n3 x1900

n3 x2500

25

Q4 FixedIncomeSecurities
Q4

Thisportfolioisanarbitrageportfolioif

w1 1250 + w3 2500 = 0

w1 250 + w2 50 = 0
w 1219.71 w 44.64 w 1900 > 0
2
3
1

Solutionofthesystem:

w1 = 2k

w2 = 10k for any k > 0

w = k
3
26

Q5 PresentValue

Yourfriendiscelebratingher35thbirthdaytodayandwants
tostartsavingforheranticipatedretirementatage65(she
willretireonher65thbirthday).Shewouldliketobeableto
withdraw$80,000fromhersavingsaccountoneachbirthday
foratleast20yearsfollowingherretirement(thefirst
withdrawalwillbeonher66thbirthday).Your

friendintends
toinvesthermoneyinthelocalsavingsbankwhichoffers4%
peryear.Shewantstomakeequalannualdepositsoneach
birthdayinanewsavingsaccountshewillestablishforher
retirementfund.
Ifshestartsmakingthesedepositsonher36thbirthdayand
continuestomakedepositsuntilsheis65(thelastdeposit
willbeonher65thbirthday),whatamountmustshedeposit
annuallytobeabletomakethedesiredwithdrawalsupon
retirement?
27

Q5 PresentValue
Q5
Advice:
Drawatimeline!
Shiftthetimelinesothatnowist=0
Writedowntheannuityformula
Findoutthecorrectdiscountrateforthecashflows,in
thiscase4%

28

Q5 PresentValue
Q5
Advice:
Drawatimeline!
Shiftthetimelinesothatnowist=0
Writedowntheannuityformula
Findoutthecorrectdiscountrateforthecashflows,in
thiscase4%
80k

80k

80k 80k

...
...
A

Age:

35 36

37

64

65 66

67

84

85

Time:

29

30 31

32

49

50

29

Q5 PresentValue
Q5
80k

80k

80k 80k

...
...
Age:
Time:

A
35 36
0 1

A
37
2

A
64
29

A
65 66
30 31

67
32

84
49

85
50

LetA bethenecessaryannualdeposit,then,usingthe
annuityformulas:
PV (withdraws ) = PV (savings )

1
(1.04)30

80,000
1
1
A

=
1
1
20
30
0.04 1.04 0.04 1.04
335,212.11 = A 17.2920
A = $19,385.35

Notethatthe$80Kannuityhasbeendiscounted30years30

Q5 PresentValue
Q5
80k

80k

80k 80k

...
...
Age:
Time:

A
35 36
0 1

A
37
2

A
64
29

A
65 66
30 31

67
32

84
49

85
50

LetA bethenecessaryannualdeposit,then,usingthe
annuityformulas:
PV (withdraws ) = PV (savings )

1
(1.04)30

80,000
1
1
A

=
1
1
20
30
0.04 1.04 0.04 1.04
335,212,11 = A 19.3854
A = $19,385.35

Notethatthe$80Kannuityhasbeendiscounted30years31

Q6 Forwards&Fut
utur
urees

ThecurrentleveloftheS&P500is$1040.Theriskfree
interestrateperyearis2%.Assume

negligibledividends.
The6monthfuturescontractistradingat$1060.
a)Isthereanarbitrageopportunity?Brieflyexplain.

Advice:
Writedownthespotfuturesparity
MakesurethatT,r
fandyarebasedonthesame

unitoftime

32

Q6 Forwards&Futures
Q6

Spotfuturesparityrequires
T

FT = S 0 (1 + r y )
0.5

1040(1 + 2% )

= 1050.35 1060

There
The
reis
isanar
anarbitrage
bitrageoppor
opportunity
tunitybecause
becausethetrading
trading
priceisnotequaltothefairprice(calculatedwiththe
spotfuturesparity)

b)Ifthereisanarbitrageopportunity,whatstrategy
wouldyouusetoexploititwithoutusinganyfunds
ofyourown?
33

Q6 Forwards&Futures
Q6
Advice:
DrawtheCFtable similartothatinquestion4,withallthe
instrumentsyouhave
Notethatyoucanalwaysborroworlendmoneyattherisk
freerate eg.1,040*(1+0.02)0.5 =$1,050.35
Useyourlogic Andifyouarrivetotheinverseconclusion
justinverseallthesignsinthetable
Security

Position

CFat0

CFat6
months

S&P500stocktradingat$1,040
Borrow/LendMoney
6monthfuturetradingat$1,060
TOTAL:
34

Q6 Forwards&Futures
Q6
Advice:
DrawtheCFtable similartothatinquestion4,withallthe
instrumentsyouhave
Notethatyoucanalwaysborroworlendmoneyattherisk
freerate eg.1,040*(1+0.02)0.5 =$1,050.35
Useyourlogic Andifyouarrivetotheinverseconclusion
justinverseallthesignsinthetable
Security

Position

CFat0

CFat6
months

Short1

1,060 ST

$0

1,060 ST

S&P500stocktradingat$1,040
Borrow/LendMoney
6monthfuturetradingat$1,060

TOTAL:

35

Q6 Forwards&Futures
Q6
Advice:
DrawtheCFtable similartothatinquestion4,withallthe
instrumentsyouhave
Notethatyoucanalwaysborroworlendmoneyattherisk
freerate eg.1,040*(1+0.02)0.5 =$1,050.35
Useyourlogic Andifyouarrivetotheinverseconclusion
justinverseallthesignsinthetable
Security

Position

CFat0

CFat6
months

S&P500stocktradingat$1,040

Buy1

1,040

ST

Short1

1,060 ST

$1,040

$1,060

Borrow/LendMoney
6monthfuturetradingat$1,060

TOTAL:

36

Q6 Forwards&Futures
Q6
Advice:
DrawtheCFtable similartothatinquestion4,withallthe
instrumentsyouhave
Notethatyoucanalwaysborroworlendmoneyattherisk
freerate eg.1,040*(1+0.02)0.5 =$1,050.35
Useyourlogic Andifyouarrivetotheinverseconclusion
justinverseallthesignsinthetable
Security

Position

CFat0

CFat6
months

S&P500stocktradingat$1,040

Buy1

1,040

ST

Borrow/LendMoney

Borrow$1,040

1,040

1,050.35

6monthfuturetradingat$1,060

Short1

1,060 ST

$0

$9.65

TOTAL:

37

Q6 Forwards&Futures
Q6
Note:
Arbitrage!In6months,wewillhavemade$9.65
withoutanyriskorinvestment

Security

Position

CFat0

CFat6
months

S&P500stocktradingat$1,040

Buy1

1,040

ST

Borrow/LendMoney

Borrow$1,040

1,040

1,050.35

6monthfuturetradingat$1,060

Short1

1,060 ST

$0

$9.65

TOTAL:

38

MIT OpenCourseWare
http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008

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