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stock is 1.4, and the risk premium is 3%. What is the weighted average cost of capital of the firm
given the appropriate tax rate is 30%. (Hint: use excel model 120501) (answer: 5.35%)
11. Using the above assumptions, suppose the firm has an earnings before interest and tax of 2
millions. But the firm requires a capital expenditure of $400,000 annually. There is a depreciation
of $200,000 and there is no change of working capital needed, what is the free cashflow of the
firm. (answer: $1.2 million)
12. Using the assumption of question 1 and 2, suppose further that the firms free cashflow grows
at 1% annually forever, what is the value of the firm? (answer: $27.67 million)
13. Assume that the current exchange is 1.20 US dollar to a Euro. US and the Euro 3 year spot
rates are 2.5% and 4% respectively. What is the forward currency rate? (Hint: use interest rate
parity model) Answer: 1.1472
14. Using the assumptions of the above question, what is the price of a European call option on
the exchange rate with strike 1.2, expiring in 1 year, assuming that the exchange rate volatility is
14.1%? (Hint: use Garman-Kohlhagen model) Answer: 0.054.
15. Assume a one factor Ho-Lee model with a flat yield curve of 6% and decline term structure of
spot volatility starting 20% in year one and linearly decline 1% a year. Use one year step size in
the construction of the binomial lattice. There are 6 states of the interest rate level at the end of
the 5th year. What are the values of the Arrow Debreu securities for these states, using the forward
measure approach? (hint: use forward measure model) Answer: 0.0210, 0.1092, 0.2269, 0.2358,
0.1225, 0.0254.
16. We use the Ho-Lee model to value a call option on an 8 year zero coupon bond with
expiration 5 years and a strike price of 90. Assume a flat yield curve of 6% and a flat spot
volatility of 20%. We use an annual step size binomial model. What is the distribution of the
forward measure, if we use a 7 year bond as the numeraire. (Hint: use the change of numeraire
excel model) Answer: 0.0244, 0.1345, 0.2962, 0.3260, 0.1794, 0.0395.
17. Use the assumptions of the above question. We can derive the distribution of the forward
measure based on either the 5 year bond or the 7 year bond numeraire. What are the RadonNikodym derivative that translates the one forward measure to the other? (Hint: use RadonNikodym derivative excel model) Answer: 0.88310, .92652, .97208, 1.01988, 1.07003, 1.12264.