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　　10.(7points)YouaretheChiefRiskOfficerforaUSlifeinsurancecompanywhichownsa
　　portfolioofcorporatebonds.TheALMcommitteehasproposedareductioninthecredit
　　exposureoftheirportfoliothroughtheuseofderivatives.Youhavebeenaskedto
　　analyze4potentialsolutions:
　　(i)AssetSwaps
　　(ii)SingleNameDefaultSwaps
　　(iii)BasketDefaultSwaps
　　(iv)PortfolioDefaultSwaps
　　(a)(5points)Describeeachderivativeandtheadvantagesanddisadvantagesof
　　each.
　　(b)(2points)Assumingyoudecidetorecommendadefaultswap,outlinethe
　　accountingconsiderations.
　　COURSE8:Fall2005-2-GOTONEXTPAGE
　　Investment
　　AfternoonSession
 
　　11.(6points)Overthepastseveraldays,ABCCorporation’sstockhasbeentrading
　　around$25.50.
　　YouaregiventhefollowingfinancialinformationforABCCorporation.
　　NetIncome250,000
　　GoodwillAmortization40,000
　　InterestExpense45,000
　　CapitalExpenditures30,000
　　TaxRate35%
　　CompanyBeta1.2
　　Risk-FreeRate6.0%
　　MarketRiskPremium5.0%
　　MarketValueofDebt2,000,000
　　Pre-TaxCostofDebt10.0%
　　EstimatedPerpetualGrowthRateofCashflows4.0%
　　NumberofSharesOutstanding100,000
　　ABC’scapitalstructureis20%debtand80%equity.
　　UsetheeconomicmodelapproachtocalculateABC’smarketvaluepershareand
　　determinewhetherornotthesharepriceiscurrentlyover-orunder-valued.
　　COURSE8:Fall2005-3-GOTONEXTPAGE
　　Investment
　　AfternoonSession
 
　　12.(4points)Youaregiventheprojectedliabilitycashflowsofacompanyanddecideto
　　usethedirectmethodtocalculateitsfairvalue.Thediscountrateusedinyourinitial
　　calculationwasdeterminedastherisk-freerateplusthecreditspreadcorrespondingto
　　thecompany’srating.
　　(a)Analyzetheargumentsforandagainstaddingthefirm’screditspreadtotheriskfree
　　rateincalculatingfairvalueofliabilities.
　　(b)Explainhowtheindirectmethodofestimatinginsuranceliabilitiescanbelinked
　　totheModiglianiandMillerpropositionandput-callparity.
　　COURSE8:Fall2005-4-GOTONEXTPAGE
　　Investment
　　AfternoonSession
 
　　13.(4points)Yourcompanyentersintoaoneyearforwardcontracttosell100U.S.dollars
　　for130EuroinNewYork.
　　Youaregiventhefollowing:
　　?contractisinitiallyat-the-money
　　?oneyeardollarrisk-freerateofinterestis5%perannum
　　?oneyeardollarrateofinterestatwhichthecounterpartycanborrowis5.5%per
　　annum
　　?exchangeratevolatilityis12%perannum
　　?defaultsarerecognizedonlyattheendofthelifeofthecontract
　　?recoveryrateiszerowhendefaultoccurs
　　(a)Calculatethepercentagelossfromdefaultsduringthelifeofthecontract.
　　(b)Calculateth*ueofanat-the-moneycalloptiontobuy130Euroinoneyear.
　　(c)Estimatethepresentvalueofthecostofdefaultsontheforwardcontract.
　　COURSE8:Fall2005-5-GOTONEXTPAGE
　　Investment
　　AfternoonSession
 
　　14.(6points)
　　(a)Explainthedifferencebetweenthenetpresentvalueapproachandtherisk-neutral
　　valuationapproachforvaluingacapitalinvestmentproject.
　　(b)Listtheadvantagesoftherisk-neutralvaluationapproachforvaluingrealoptions.
　　(c)Describetheimpactontheexpectedreturnandvolatilityinmovingfromreal
　　worldtorisk-neutralworld.
　　(d)Distinguishbetweentherealworldandtherisk-neutralapproachesofvaluinga
　　derivative.
　　(e)Describetheconditionsunderwhichbothapproachesin(d)givethesam*ue
　　ofaderivative.
　　COURSE8:Fall2005-6-GOTONEXTPAGE
　　Investment
　　AfternoonSession
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