1. (Problem 1.12) Suppose bank’s loan officer tells you that if you take out a mortgage (i.e., you borrow money to buy a house) you will be permitted to borrow no more than 80% of the value of the house. Describe this transaction using the terminology of short-sales.
We are interested in borrowing the asset “money” to buy a house. Therefore, we go to an owner of the asset, called Bank. The Bank provides the dollar amount, say $250,000, in digital form in our mortgage account. As $250,000 is a large amount of money, the bank is subject to substantial credit risk (e.g., we may lose our job) and demands a collateral. Although the money itself is not subject to large variations in price (besides inflation risk, it is difficult to imagine a reason for money to vary in value), the Bank knows that we want to buy a house, and real estate prices vary substantially. Therefore, the Bank wants more collateral than the $250,000 they are lending. In fact, as the Bank is only lending up to 80% of the value of the house, we could get a mortgage of $250,000 for a house that is worth $250,000 ÷ 0.8 = $312,500. We see that the bank factored in a haircut of $312,500 - $250,000 = $62,500 to protect itself from credit risk and adverse fluctuations in property prices. We buy back the asset money over a long horizon of time by reducing our mortgage through annuity payments.
2. What do hedge funds do:
(d) None of the above
(a), (b), (c)
3. During the growing season a corn farmer sells short corn futures contracts in an amount equal to her crop. If after harvesting and selling her crop she maintains the contracts, she is then considered a:
(d) None of the above
4. A firm provides a service that benefits from decreasing employment. This firm has a risk exposure to macro event. All other variables being equal, which of the following derivative securities is the firm most likely use to hedge its exposure?
(a) Short position in an economic futures
(b) Long position in an economic futures
(c) Short position in an interest rate futures
(d) Long position in an interest rate futures
5. Assume that you purchase 100 shares of Jiffy, Inc. common stock at the bid-ask prices of $32.00 – $32.50. When you sell the bid-ask prices are $32.50 – $33.00. If you pay a commission rate of 0.5%, what is your profit or loss?
(b) $16.25 loss
(c) $32.50 gain
(d) $32.50 loss
(d) –(100*32.5)*1.005 + (100*32.5)*0.995 = –3,266.25 + 3,233.75 = –32.5
6. Assume that you open a 100 share short position in Jiffy, Inc. common stock at the bid-ask prices of $32.00 – $32.50. When you close your position the bid-ask prices are $32.50 – $33.00. You pay a commission rate of 0.5 %. The market interest rate is 5.0 % and the short rebate rate is 3.0 %. What is your additional gain or loss due to leasing the asset?
(a) $64.00 loss
(b) $160.00 loss
(c) $96.00 gain
(a) 100*32*(0.03–0.05) = –64
7. Catastrophe bonds are bonds that the issuer need not repay if there is a specific event, e.g. earthquake, causing large insurance claims.
a) Who do you think issue catastrophe bonds?
b) Are catastrophe bonds long-term or short-term?
c) Are catastrophe bonds risky or safe investment?
d) Who are the buyers of catastrophe bonds?
e) Why would investors invest into catastrophe bonds?
f) Can catastrophe bonds replace insurance?
a) Usually insurance and reinsurance companies. Sometimes private companies. b) Long-term.
d) Hedge funds, mutual funds.
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