Essay Examination 2
Corporate Finance

These questions are from the test bank. An "A" answer requires at least three or four intelligent sentences. Some questions may require more sentences if they have multiple parts.

Lecture 7 - Currency and Commodity Derivatives

1. Please answer the following parts.

(a) Distinguish Collateralized Debt Obligations (CDOs) from Mortgage Asset-Backed securities.

(b) How did Collateralized Debt Obligations lead to the rapid appreciation of U.S. home prices?

2. Please answer the following parts.

(a) Identify the purpose of Credit Default Swaps (CDS).

(b) Appraise the flaws of Credit Default Swaps.

(c) Defend the premise that Collateralized Debt Obligations and Credit Default Swaps led to the world’s financial crisis in 2008.

3. (a) What is the difference between a speculator and hedger?

(a) What three cases can an investor (or hedger) use a derivatives contract?

(b) Who is Nick Leeson?

4. (a) What is the difference between a Futures and a Forward?

(a) What is the difference between a “short” and a “long?”

(b) What three things does every futures/forward contract have?

5. (a) What were the problems with Collateralized Debt Obligations (CDOs) and Securitization for the U.S. mortgage market?

(b) How could a company use CDOs to convert debt to assets on a firm’s balance sheet?

(c) What is a subprime (or toxic) mortgage?

6. (a) What is the difference between a call and put option?

(b) What is the difference between an American and European option?  Does it make a difference?

(c) What is an option premium?

7. (a) What is securitization?

(b) What is a tranche?

(c) How did securitization contribute to the 2008 Financial Crisis (or housing crisis)?

(d) How do banks earn profits from securitization?

8. You are a speculator, and you want to profit from the silver market. Please use the information for all questions that the spot price of silver is $31 per ounce.

a) If you bought a silvers futures for $25 per ounce, who pays the margin to the exchange?

b) If you bought 20 contracts with a contract size of 1,000 ounces, and the futures mature today, what is your profit or loss?

c) If you bought 20 American put options with a strike price of $35 per ounce, a premium of $1 per ounce, and quantity is 1,000 ounces, what is your profit or loss?

d) If you bought 20 American call options with a strike price of $25 per ounce, a premium of $1 per ounce, and quantity is 1,000 ounces, what is your profit or loss?

9. (a) Distinguish the Volatility Index (VIX) from a stock market index, such as the Dow Jones Industrial Average.

b) If the Volatility Index is 50, what does this number mean?

c) Judge the use of investors buying and selling put and call options tied to the value of the Volatility Index.

Lecture 8 - Market Evaluation of Derivatives

10. You may need the following equation to answer this question:

Evaluation of a futures contract

a) If the spot price of gold is $31 per ounce, the riskless interest rate is 1% per year, and the storage cost is 2% per year, then evaluate the market price of a one-year gold forward contract.

b) If the volatility for a commodity's spot price increases, what happens to the value of European call and put options?

c) If the spot price increases for a commodity, what happens to the premiums of European call and put options?

d) Identify the change for call and put option premiums, if the maturity increases for the European options.

Lectures 10 - Capital Investment Decisions

11. (a) What is capital budgeting?

(b) Identify the changes to a new project’s cash flow to account for non-cash expenses.

(c) When you evaluate a new project, how do you account for taxes?

(d) Evaluate the change in Net Present Value, if the discount rate (or capitalization rate) increases.

12. You have the following project information in a table below:

Item Year 0 Year 1 Year 2
Sales Revenue - $120,000 $150,000
Operating costs - 30,000 20,000
Investment $250,000 - -
Depreciation - 10,000 10,000

If the tax rate is 25% and the discount rate is 10%, evaluate the Net Present Value of this project.

Lecture 12 - Capital Asset Pricing Model (CAPM)

13. You may use the following equation for this question:   

The formula for CAPM

a) What is the Capital Asset Pricing Model?

b) Identify the use of Beta in the Capital Asset Pricing Model.

c) Appraise the Capital Asset Pricing Model, if Beta > 1.

d) If Beta = 0.8, the expect market return is 10%, and a comparable U.S. Treasury security is 3%, what should be the expected return of your investment?