APS 1002 Financial Engineering May 25 2009 Name_______________________________________ Student number_______________________________ Exam 1 Instructions: Closed notes and book.

Non-programmable calculator permitted. Problem 1 (30 points, 10 points per part) Part 1: Suppose $1 dollar were invested in 1776 at 6.6% interest compounded yearly. Approximately how much would that investment be worth today? Choose one: (a) $500,000 (b) $1,750,000 (c) 1,000,000 (d) $2,000,000. Part 2: Consider two 5-year bonds (with face values of $100 for both): one has a 9% coupon and currently sells for 101.00, the other has a coupon of 7% and currently sells for 93.20. What is the price of a synthetic 5 year 0-coupon bond? Choose one: (a) $50.75 (b) $65.90 (c) $68.00 (d) $57.85. Part 3: What is the effective annual rate for 18% compounded quarterly? Choose one: (a) 19.56% (b) 19.77% (c) 18.99% (d) 19.25%? Problem 2 (40 points, 10 points for each part) Consider the four bonds having annual payments as shown in the table below. end of year payment Bond A year 1 year 2 year 3 100 100 Bond B 50 50 Bond C Bond D 0 0 01000 0

1001000 501000 01000 0

Suppose the yield to maturity of all the bonds is 15%. (a) Determine the price of bonds A and C. (b) Which bond is most sensitive to a change in yield? and why? (c) Suppose that you owe $2,000 at then end of 2 years. Concern about interest rate risk suggests that a portfolio consisting of the bonds and the obligation should be immunized. If V A ,V B , V c , V d are the total value of bonds of types A,B,C, and D to buy,respectively, write down the equations that represent the immunization. (Do not solve the equations, but explain what each equation does.) (d) In order to immunize the portfolio, you decide to use bond C and one other bond. Which other bond should you choose? Then, find the total amounts of each of the bonds to purchase for the immunization. Problem 3 (20 points) Suppose that a bank receives the following liability schedule year 1 year 2 year 3 i.e. the bank needs to pay 12,000 at the end of the first 12,000 18,000 20,000 year, 18,000 at the end of the second year, and 20,000 at the end of the third year.

The bank wishes to use the three bonds below to form a portfolio that will generate the required cash to meet the liabilities. All bonds have face value of a 100 and the coupons are annual (with one coupon per year). For example, one unit of Bond 2 costs 99 now and the holder will receive 3.5 after 1 year and then 3.5 plus the face value of 100 at the end of the second year. Bond Price Coupon 1 5 2 3 98 3 102 99 2

3.5 3.5

Maturity year 1

Formulate an optimization model that can be used to find the lowest cost bond portfolio consisting of bonds 1,2, and 3 above that will meet the liabilities. In your model you wish to allow carry over of money to future periods [i.e. you may generate more cash than needed to meet a liability] (the money should be carried over at 0% interest earned i.e. assume you earn no interest for extra cash carried over time). (Note: you must write out the detailed model showing all coefficients and variables in all constraints and objective function, explain all decision variables. DO NOT WRITE A GENERAL MODEL, Do not solve the model.) Problem 4 (10 points) You wish to invest in 3 securities S, B, and M. The expected returns for each security are S 10. 73%, B 7. 37%, M 6. 27%. The standard deviations of returns of the securities are S 16. 67%, B 10. 55%, M 3. 40%. The correlations of the returns between securities are given in the following table: ij S S B M 1 B 1 M -0.0545 1 0.2199 0.0366

Formulate an appropriate optimization model whose solution will give the optimal portfolio weightings for stocks, bonds, and money market (optimal in the sense of finding the minimum variance portfolio that achieves a desired level of return). The formulation must write out all of terms of the objective and the constraints with all coefficients taking on their appropriate numerical values! Define all decisions variables as well. DO NOT WRITE A GENERAL MODEL. And of course, you do not have to solve the model!!