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FINM7006 Final Examination
Question 1 (24 marks)
Students are to answer ALL parts of this question.
Three of your friends and yourself are considering buying a house together after you graduate. On
investigating, you have determined that you can get a mortgage for (15 + ) years with a fixed interest rate
of 5.2% p.a. compounded monthly, if you make a (20 + )% deposit on the house. Your friends are planning
to split the weekly mortgage payments equally, and can contribute $300 per week each towards the
mortgage. Assuming you and your friends have the required deposit:
a) How expensive a house can you and your friends afford to buy? (14 marks)
b) You and your friends buy a house for exactly the price calculated in a), and live there happily for 2
years. After exactly 2 years, one of your friends wins the lottery and decides to leave the country.
The friend wishes to be paid out for the remainder of the loan (but are ignoring the initial deposit).
Calculate how much must be paid per person by the remaining three people to pay out the friend
after exactly two years in the house. (10 marks)
Question 2 (14 marks)
You are considering investing in a special type of bond, which is being issued with a maturity of 15 years. The
coupons are paid semi-annually for the first 10 years (20 coupons) and then are paid quarterly for the final 5
years of the bond. You have been provided with the following information:
Name Special Bond
Yield (years 1-10) 7.2% p.a.
Coupon Rate(years 1-10) 5.8% p.a.
Coupon Frequency(years 1-10) Semi-annually
Yield(10-15) 9.6% p.a.
Coupon Rate(years 10-15) 10.4 % p.a.
Coupon Frequency(years 10-15) Quarterly
Face Value $(40 + )*10,000
Time to Maturity 15 years
Using the above information, calculate the issue price of the bond. In answering the question, state any
assumptions you have made.
Question 3 (28 marks)
Students are to answer ALL parts of this question.
BB & Heni Co, growers of organic cauliflowers, are considering expanding their business to produce healthy
baked cauliflower chips and pizza bases. The company has called you, their trusted financial advisor, to
recommend whether to proceed with this project. BB & Heni Co provide you with the following information.
Specifically, they have an existing warehouse, which they lease at a cost of $20,000 p.a., that requires
renovation to enable production, which will cost $65,000. For tax purposes, these renovation costs will be
expensed at the beginning of the project. Machinery costs to produce these chips and bases are $120,000
for equipment and $20,000 installation costs. The machinery will be depreciated straight line on an annual
basis over its entire useful life of 10 years to a salvage value of $1000 ∗ (20 − ).
BB & Heni Co have acknowledged that in the first year of production, no sales will be made, as they want to
perfect their recipes and packaging. Expenses, however, will still occur in year 1 (and all subsequent years),
and are estimated to be $45,000 a year. Pre-tax revenues, from year 2 onwards, will be 10,000 ∗ (15 − ).
After ten years, the machine will receive $35,000 in the market.
FINM7006 Final Examination, S2 2022 4
The project’s risk is very similar to Chomp & Momo Inc.’s assets. This firm is currently financed by 180,000
shares worth $12.50 each, and $750,000 worth of debt. The beta of Chomp & Momo’s stock is 1.5, and the
company borrows at a rate of 11% (before tax). The risk-free rate in the economy is 6% p.a., and the expected
return on the market is 9.5% p.a. The current corporate tax rate is 30%.
Given this information, answer the following:
a) What is the required rate of return on BB & Heni Co’s project? (6 marks)
b) Do you recommend that BB & Heni Co proceed with this project and commence producing
cauliflower chips and pizza bases? Why or why not? (22 marks)
Question 4 (34 marks)
Students are to answer ALL parts of this question.
It is November and you are the Vice President in charge of risk management for JuicyJuz Inc, a juice company
that produces and supplies juice around the world. One of your biggest sellers internationally is frozen
concentrated orange juice, and as such, it is your job to monitor the market and protect your future sales,
ensuring the highest possible price is received. You are currently concerned about a big sale in January 2023
of 120,000 pounds of frozen concentrated orange juice, and you are considering a few different derivatives
to protect your sale.
You have been provided the following information about the futures and option contracts on frozen
concentrated orange juice (commodity code: FCOJ) (Please note, the options contracts underlying asset is
the frozen concentrated orange juice futures contract):
Contract Specifications: FCOJ, ICE Futures & Options
Contract Size 15,000 pounds
Price Quotation Cents and Hundredths of a cent (to two
decimal places) e.g. if the contract price is 200,
that equals 200c, or $2 per pound.
Contract Months Jan, Mar, May, Jul, Sep, Nov
Last Trading Day One business day prior to last notice day
Delivery Physical
To protect the company against adverse movements in frozen concentrated orange juice, you have decided
to utilise one of the following derivatives to put a floor in the amount you will receive for your sale in January.
The following derivatives are available:
A futures contract, expiring in January 2023, with a price of 207.50;
A European call option, expiring in January 2023, with a strike price of 205.00;
A European put option, expiring in January 2023, with a strike price of 200.00;
A futures contract, expiring in March 2023, with a price of 202.25; or
A European put option, expiring in March 2023, with a strike price of 215.00.
Given this information and the information provided in the tables above, answer the following questions:
a) Using one of the derivatives above, how would you create a floor in the sale of 120,000 pounds
of frozen concentrated orange juice? In providing your answer, show that your strategy works if
the frozen concentrated orange juice price in January 2023 is (220.00 + ) (195.00 − ). Be
sure to mention any assumptions, if necessary. (14 marks)
FINM7006 Final Examination
b) In trying to protect the sale of frozen concentrated orange juice, you believe you have identified
a mispricing in one of the frozen concentrated orange juice futures contracts, and think you could
exploit this mispricing to generate further profit for the firm. Specifically, you identify that the
March 2023 futures contract, with a price of 202.25 is mispriced in some way. Given the current
price of frozen concentrated orange juice is 202.84 today, the risk-free rate is 3.5% p.a. and the
cost of storage is 3% p.a.:
i. Does an arbitrage opportunity exist? If so, show how you could exploit the arbitrage
opportunity (including a table of cash flows). In performing this strategy, you should
assume that there are exactly twenty weeks until expiration of the futures contract. How
much profit is available per contract? (10 marks)
ii. Draw the terminal payoff diagrams for each part of the strategy you created in a. Ensure
the diagrams are labelled using the numbers from the question. Finally, show the overall
terminal payoff for the portfolio in one diagram. (10 marks)