1. Consider the following bond: annual coupon 5%, maturity 5 years, annual compounding frequency.
i. What is its relative price change if its required yield increases from 10% to 11%?
ii. What is its relative price change if its required yield increases from 5% to 6%?
iii. What conclusion can you draw from these examples? Explain why.
2. The Pamodzi Dairy Company has just come up with a new lactose-free dessert product for people who can’t eat or drink ordinary dairy products. Management expects the new product to fuel sales growth at 30% for about two years. After that competitors will copy the idea and produce similar products, and growth will return to about 3%, which is normal for the dairy industry in the area. Pamodzi recently paid an annual dividend of K2.60, which will grow with the company. The return on stocks similar to Pamodzi’s is typically around 10%. What is the most you would pay for a share of Pamodzi?
3. What are the implications of random walks and efficient markets for technical analysis? For fundamental analysis? Do random walks and efficient markets mean that technical analysis and fundamental analysis are useless? Explain.
4. With aid of payoff diagrams explain carefully the difference between selling a call option and buying a put option.
5. Suppose a stock currently trades at a price of K150. The stock price can go up 33 percent or down 15 percent. The risk-free rate is 4.5 percent.
i. Use a one-period binomial model to calculate the price of a put option with exercise price of K150.
ii. Suppose the put price is currently K14. Show how to execute an arbitrage transaction that will earn more than the risk-free rate. Use 10,000 put options.
iii. Suppose the put price is currently K11. Show how to execute an arbitrage transaction that will earn more than the risk-free rate. Use 10,000 put options.
6. With particular reference to the local market, identify and explain six constraints to portfolio revision process.
7. Use the Black-Scholes-Merton model to calculate the prices of European call and put options on an asset priced at K68.5. The exercise price is K65, the continuously compounded risk-free rate is 4 percent, the options expire in 110 days, and the volatility is 0.38. There are no cash flows on the underlying.
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