If the T-notes that Baker priced in the “simplified scenario” were not the cheapest to deliver, and the

Susan Baker is a new hire at Crinson Bank’s Chicago office. She has joined the risk arbitrage desk where she will be training to take advantage of price discrepancies in the U.S. T-note futures and spot markets.

Her managing director, Gerald Bigelow, has asked her to calculate parameters for potential arbitrage opportunities for the bank given current market conditions. At the time he asked the question, the cheapest-to-deliver T-notes were at par, with a coupon rate of 8.5 percent. When trading futures, the risk arbitrage desk borrows at 12 percent and lends at 4 percent.

Looking at the calendar, Baker calculates that there are 184 days to the first coupon payment and 181 days from the first coupon payment to the second. Any interest accrued will be paid when the T-note is delivered against the futures contract, but Bigelow asks Baker not to concern herself in the calculations with the impact of reinvesting the coupons or with transaction costs.

To get a feel for the market, Baker first prices a 6-month futures contract that has 184 days to expiration in a “simplified scenario.” She decides to use the same interest rate for borrowing and lending, taking the average of the bank’s borrowing and lending rates. Calculating the futures price under these simplified assumptions, Baker tells Bigelow that the futures contract should trade at 99.7059. Bigelow explains that the futures price is below par even though the spot price is at par because of the benefit to a short seller of receiving the T-note coupon payments.

Having calculated the futures price in the “simplified scenario,” Baker modifies it to reflect the bank’s current borrowing and lending rates, and calculates the corresponding no-arbitrage bands. She tells Bigelow that the lower band will be at 97.7468. Bigelow checks her calculations, confirming that the higher band will be at 101.6294.

Once they know the no-arbitrage bands for current market conditions, Baker and Bigelow check the screen. They see that the market price of the futures contract for which they’ve been calculating no-arbitrage bands is 103. Together, they execute Baker’s first arbitrage play.

Part 3)

Regarding Baker’s and Bigelow’s statements about the no-arbitrage bands, which is CORRECT?

A)Baker’s statement is correct and Bigelow’s statement is incorrect.

B)Baker’s statement is incorrect and Bigelow’s statement is incorrect.

C)Baker’s statement is correct and Bigelow’s statement is correct.

D)Baker’s statement is incorrect and Bigelow’s statement is correct.

Susan Baker is a new hire at Crinson Bank’s Chicago office. She has joined the risk arbitrage desk where she will be training to take advantage of price discrepancies in the U.S. T-note futures and spot markets.

Her managing director, Gerald Bigelow, has asked her to calculate parameters for potential arbitrage opportunities for the bank given current market conditions. At the time he asked the question, the cheapest-to-deliver T-notes were at par, with a coupon rate of 8.5 percent. When trading futures, the risk arbitrage desk borrows at 12 percent and lends at 4 percent.

Looking at the calendar, Baker calculates that there are 184 days to the first coupon payment and 181 days from the first coupon payment to the second. Any interest accrued will be paid when the T-note is delivered against the futures contract, but Bigelow asks Baker not to concern herself in the calculations with the impact of reinvesting the coupons or with transaction costs.

To get a feel for the market, Baker first prices a 6-month futures contract that has 184 days to expiration in a “simplified scenario.” She decides to use the same interest rate for borrowing and lending, taking the average of the bank’s borrowing and lending rates. Calculating the futures price under these simplified assumptions, Baker tells Bigelow that the futures contract should trade at 99.7059. Bigelow explains that the futures price is below par even though the spot price is at par because of the benefit to a short seller of receiving the T-note coupon payments.

Having calculated the futures price in the “simplified scenario,” Baker modifies it to reflect the bank’s current borrowing and lending rates, and calculates the corresponding no-arbitrage bands. She tells Bigelow that the lower band will be at 97.7468. Bigelow checks her calculations, confirming that the higher band will be at 101.6294.

Once they know the no-arbitrage bands for current market conditions, Baker and Bigelow check the screen. They see that the market price of the futures contract for which they’ve been calculating no-arbitrage bands is 103. Together, they execute Baker’s first arbitrage play.

Part 2)

Which of the following most accurately describes the arbitrage strategy that Baker and Bigelow executed?

A)Sell futures contract, use proceeds to buy asset, borrow difference, sell asset, buy back futures, and collect difference between finance charges and interest from asset.

B)Borrow funds, buy spot asset, buy futures, deliver asset against long futures, and repay loan and finance charges.

C)Borrow funds, buy spot asset, sell futures, collect accrued interest on spot asset, deliver asset against short futures, and repay loan with interest.

D)Short spot asset, lend proceeds from short sale, buy futures contract, collect principal and interest on loan, pay interest on short asset, take delivery of asset against futures, and replace short asset.

Susan Baker is a new hire at Crinson Bank’s Chicago office. She has joined the risk arbitrage desk where she will be training to take advantage of price discrepancies in the U.S. T-note futures and spot markets.

Her managing director, Gerald Bigelow, has asked her to calculate parameters for potential arbitrage opportunities for the bank given current market conditions. At the time he asked the question, the cheapest-to-deliver T-notes were at par, with a coupon rate of 8.5 percent. When trading futures, the risk arbitrage desk borrows at 12 percent and lends at 4 percent.

Looking at the calendar, Baker calculates that there are 184 days to the first coupon payment and 181 days from the first coupon payment to the second. Any interest accrued will be paid when the T-note is delivered against the futures contract, but Bigelow asks Baker not to concern herself in the calculations with the impact of reinvesting the coupons or with transaction costs.

To get a feel for the market, Baker first prices a 6-month futures contract that has 184 days to expiration in a “simplified scenario.” She decides to use the same interest rate for borrowing and lending, taking the average of the bank’s borrowing and lending rates. Calculating the futures price under these simplified assumptions, Baker tells Bigelow that the futures contract should trade at 99.7059. Bigelow explains that the futures price is below par even though the spot price is at par because of the benefit to a short seller of receiving the T-note coupon payments.

Having calculated the futures price in the “simplified scenario,” Baker modifies it to reflect the bank’s current borrowing and lending rates, and calculates the corresponding no-arbitrage bands. She tells Bigelow that the lower band will be at 97.7468. Bigelow checks her calculations, confirming that the higher band will be at 101.6294.

Once they know the no-arbitrage bands for current market conditions, Baker and Bigelow check the screen. They see that the market price of the futures contract for which they’ve been calculating no-arbitrage bands is 103. Together, they execute Baker’s first arbitrage play.

Part 1)

Regarding Baker’s and Bigelow’s statements about the futures price in the simplified scenario:

A)Baker’s statement is correct and Bigelow’s statement is correct.

B)Baker’s statement is incorrect and Bigelow’s statement is correct.

C)Baker’s statement is incorrect and Bigelow’s statement is incorrect.

D)Baker’s statement is correct and Bigelow’s statement is incorrect.

James Sigmund, CFA, is the Head of International Equity for Pell Global Advisors (PGA). Sigmund is considering investing in the country of Zuflak as part of an emerging market portfolio. Sigmund is aware of the risks in investing in emerging markets and is preparing a valuation report regarding this investment. He estimates that Zuflak government debt would be rated BB, and has gathered the following market information for use in analyzing Zuflak.

Local Government Bond Yield= 11.50%

U.S. 10 year Treasury Bond Yield= 4.50%

U.S. BB rated Corporate Bond Yield= 7.75%

Local Inflation Rate= 6.50%

U.S. Inflation Rate= 3.00%

To assist in his analysis of Zuflak, Sigmund has asked Stefano Testorf, CFA, to estimate a value for Kiani Corporation (Kiani), Oleg Industries (Oleg), and Malik Incorporated (Malik) - the three primary companies domiciled in Zuflak that Sigmund has determined to have adequate liquidity for inclusion in PGA’s client portfolios. Testorf gives Sigmund a rough draft of his report and tells Sigmund that in order to account for country specific emerging market risks, he used a probability-weighted scenario analysis to adjust cash flows. Sigmund asks him, “Why didn’t you simply adjust the discount rate?” Testorf replies with three reasons:

Reason 1: The country risk attributable to Zuflak can be diversified away according to modern finance theory, and should not be included in the cost of capital.

Reason 2: Companies in emerging markets tend to exhibit wild price swings both up and down, therefore adjusting cash flows is the best way to account for these symmetrical country risks.

Reason 3: Although Kiani, Oleg, and Malik are all domiciled in Zuflak, each of these companies will tend to respond differently to country risks. This makes it virtually impossible to adjust the discount rate for country specific risk and come up with an accurate valuation estimate.

After careful analysis by Sigmund and his team, Sigmund decides that he wants to have exposure to Zuflak in his international portfolios. He is still unsure however, what the best way would be to establish the exposure. Sigmund discusses his concerns with Steve Solak, another portfolio manager with PGA. Solak suggests that Sigmund consider using a closed-end country fund to invest in Zuflak. Solak hands Sigmund a copy of a note that he had provided to a client listing facts about country-specific closed end funds. The note contained the followingstatements:

Closed-end country funds provide an excellent means to access local foreign markets. Even nations that have restrictions on foreign investment are sometimes accessible using closed-end country funds.

Closed-end country funds issue a fixed number of shares and are a great way to diversify a U.S.-dollar stock portfolio because of their low correlation with the U.S. stock market.

Sigmund thanks Solak for the information and heads back to his office. As he is leaving, Solak asks him if he would have time later that afternoon to discuss the use of American Depository Receipts (ADRs).

Part 6)

Which of the following statements regarding American Depository Receipts (ADRs) is TRUE?

A)It is usually less expensive for large institutional investors to purchase ADRs than to directly purchase securities in the local markets.

B)Level 1 ADRs are not required to comply with SEC registration and reporting requirements.

C)ADRs are denominated in dollars and eliminate currency risk when trading foreign securities.

D)Level 2 ADRs enable the issuer to raise capital in theU.S. financial markets.

James Sigmund, CFA, is the Head of International Equity for Pell Global Advisors (PGA). Sigmund is considering investing in the country of Zuflak as part of an emerging market portfolio. Sigmund is aware of the risks in investing in emerging markets and is preparing a valuation report regarding this investment. He estimates that Zuflak government debt would be rated BB, and has gathered the following market information for use in analyzing Zuflak.

Local Government Bond Yield= 11.50%

U.S. 10 year Treasury Bond Yield= 4.50%

U.S. BB rated Corporate Bond Yield= 7.75%

Local Inflation Rate= 6.50%

U.S. Inflation Rate= 3.00%

To assist in his analysis of Zuflak, Sigmund has asked Stefano Testorf, CFA, to estimate a value for Kiani Corporation (Kiani), Oleg Industries (Oleg), and Malik Incorporated (Malik) - the three primary companies domiciled in Zuflak that Sigmund has determined to have adequate liquidity for inclusion in PGA’s client portfolios. Testorf gives Sigmund a rough draft of his report and tells Sigmund that in order to account for country specific emerging market risks, he used a probability-weighted scenario analysis to adjust cash flows. Sigmund asks him, “Why didn’t you simply adjust the discount rate?” Testorf replies with three reasons:

Reason 1: The country risk attributable to Zuflak can be diversified away according to modern finance theory, and should not be included in the cost of capital.

Reason 2: Companies in emerging markets tend to exhibit wild price swings both up and down, therefore adjusting cash flows is the best way to account for these symmetrical country risks.

Reason 3: Although Kiani, Oleg, and Malik are all domiciled in Zuflak, each of these companies will tend to respond differently to country risks. This makes it virtually impossible to adjust the discount rate for country specific risk and come up with an accurate valuation estimate.

After careful analysis by Sigmund and his team, Sigmund decides that he wants to have exposure to Zuflak in his international portfolios. He is still unsure however, what the best way would be to establish the exposure. Sigmund discusses his concerns with Steve Solak, another portfolio manager with PGA. Solak suggests that Sigmund consider using a closed-end country fund to invest in Zuflak. Solak hands Sigmund a copy of a note that he had provided to a client listing facts about country-specific closed end funds. The note contained the followingstatements:

Closed-end country funds provide an excellent means to access local foreign markets. Even nations that have restrictions on foreign investment are sometimes accessible using closed-end country funds.

Closed-end country funds issue a fixed number of shares and are a great way to diversify a U.S.-dollar stock portfolio because of their low correlation with the U.S. stock market.

Sigmund thanks Solak for the information and heads back to his office. As he is leaving, Solak asks him if he would have time later that afternoon to discuss the use of American Depository Receipts (ADRs).

Part 5)

With regard to Solak’s note concerning closed end-country funds:

A)statement 1 is correct, statement 2 is correct.

B)statement 1 is incorrect, statement 2 is incorrect.

C)statement 1 is correct, statement 2 is incorrect.

D)statement 1 is incorrect, statement 2 is correct.

James Sigmund, CFA, is the Head of International Equity for Pell Global Advisors (PGA). Sigmund is considering investing in the country of Zuflak as part of an emerging market portfolio. Sigmund is aware of the risks in investing in emerging markets and is preparing a valuation report regarding this investment. He estimates that Zuflak government debt would be rated BB, and has gathered the following market information for use in analyzing Zuflak.

Local Government Bond Yield= 11.50%

U.S. 10 year Treasury Bond Yield= 4.50%

U.S. BB rated Corporate Bond Yield= 7.75%

Local Inflation Rate= 6.50%

U.S. Inflation Rate= 3.00%

To assist in his analysis of Zuflak, Sigmund has asked Stefano Testorf, CFA, to estimate a value for Kiani Corporation (Kiani), Oleg Industries (Oleg), and Malik Incorporated (Malik) - the three primary companies domiciled in Zuflak that Sigmund has determined to have adequate liquidity for inclusion in PGA’s client portfolios. Testorf gives Sigmund a rough draft of his report and tells Sigmund that in order to account for country specific emerging market risks, he used a probability-weighted scenario analysis to adjust cash flows. Sigmund asks him, “Why didn’t you simply adjust the discount rate?” Testorf replies with three reasons:

Reason 1: The country risk attributable to Zuflak can be diversified away according to modern finance theory, and should not be included in the cost of capital.

Reason 2: Companies in emerging markets tend to exhibit wild price swings both up and down, therefore adjusting cash flows is the best way to account for these symmetrical country risks.

Reason 3: Although Kiani, Oleg, and Malik are all domiciled in Zuflak, each of these companies will tend to respond differently to country risks. This makes it virtually impossible to adjust the discount rate for country specific risk and come up with an accurate valuation estimate.

After careful analysis by Sigmund and his team, Sigmund decides that he wants to have exposure to Zuflak in his international portfolios. He is still unsure however, what the best way would be to establish the exposure. Sigmund discusses his concerns with Steve Solak, another portfolio manager with PGA. Solak suggests that Sigmund consider using a closed-end country fund to invest in Zuflak. Solak hands Sigmund a copy of a note that he had provided to a client listing facts about country-specific closed end funds. The note contained the followingstatements:

Closed-end country funds provide an excellent means to access local foreign markets. Even nations that have restrictions on foreign investment are sometimes accessible using closed-end country funds.

Closed-end country funds issue a fixed number of shares and are a great way to diversify a U.S.-dollar stock portfolio because of their low correlation with the U.S. stock market.

Sigmund thanks Solak for the information and heads back to his office. As he is leaving, Solak asks him if he would have time later that afternoon to discuss the use of American Depository Receipts (ADRs).

Part 4)

Due to the high inflation rate of the local country, Testorf calculates the return on invested capital (ROIC) for Kiani by revaluing the company’s fixed assets. In comparing the performance of Zuflak to other local companies, the ROIC calculation should:

A)exclude goodwill.

B)exclude depreciation.

C)not revalue fixed assets.

D)exclude net operating profit adjusted for taxes.

James Sigmund, CFA, is the Head of International Equity for Pell Global Advisors (PGA). Sigmund is considering investing in the country of Zuflak as part of an emerging market portfolio. Sigmund is aware of the risks in investing in emerging markets and is preparing a valuation report regarding this investment. He estimates that Zuflak government debt would be rated BB, and has gathered the following market information for use in analyzing Zuflak.

Local Government Bond Yield= 11.50%

U.S. 10 year Treasury Bond Yield= 4.50%

U.S. BB rated Corporate Bond Yield= 7.75%

Local Inflation Rate= 6.50%

U.S. Inflation Rate= 3.00%

To assist in his analysis of Zuflak, Sigmund has asked Stefano Testorf, CFA, to estimate a value for Kiani Corporation (Kiani), Oleg Industries (Oleg), and Malik Incorporated (Malik) - the three primary companies domiciled in Zuflak that Sigmund has determined to have adequate liquidity for inclusion in PGA’s client portfolios. Testorf gives Sigmund a rough draft of his report and tells Sigmund that in order to account for country specific emerging market risks, he used a probability-weighted scenario analysis to adjust cash flows. Sigmund asks him, “Why didn’t you simply adjust the discount rate?” Testorf replies with three reasons:

Reason 1: The country risk attributable to Zuflak can be diversified away according to modern finance theory, and should not be included in the cost of capital.

Reason 2: Companies in emerging markets tend to exhibit wild price swings both up and down, therefore adjusting cash flows is the best way to account for these symmetrical country risks.

Reason 3: Although Kiani, Oleg, and Malik are all domiciled in Zuflak, each of these companies will tend to respond differently to country risks. This makes it virtually impossible to adjust the discount rate for country specific risk and come up with an accurate valuation estimate.

After careful analysis by Sigmund and his team, Sigmund decides that he wants to have exposure to Zuflak in his international portfolios. He is still unsure however, what the best way would be to establish the exposure. Sigmund discusses his concerns with Steve Solak, another portfolio manager with PGA. Solak suggests that Sigmund consider using a closed-end country fund to invest in Zuflak. Solak hands Sigmund a copy of a note that he had provided to a client listing facts about country-specific closed end funds. The note contained the followingstatements:

Closed-end country funds provide an excellent means to access local foreign markets. Even nations that have restrictions on foreign investment are sometimes accessible using closed-end country funds.

Closed-end country funds issue a fixed number of shares and are a great way to diversify a U.S.-dollar stock portfolio because of their low correlation with the U.S. stock market.

Sigmund thanks Solak for the information and heads back to his office. As he is leaving, Solak asks him if he would have time later that afternoon to discuss the use of American Depository Receipts (ADRs).

Part 3)

In regard to Testorf’s reasons for incorporating emerging market risk into the valuation of Zuflak by adjusting cash flows rather than adjusting the discount rate, which of the following is TRUE?

A)Reasons 1 and 3 support Testorf’s cash flow adjustment, but reason 2 does not.

B)All three of the reasons given support Testorf’s cash flow adjustment.

C)Reasons 2 and 3 support Testorf’s cash flow adjustment, but reason 1 does not.

D)Reason 1 supports Testorf’s cash flow adjustment, but reasons 2 and 3 do not.

James Sigmund, CFA, is the Head of International Equity for Pell Global Advisors (PGA). Sigmund is considering investing in the country of Zuflak as part of an emerging market portfolio. Sigmund is aware of the risks in investing in emerging markets and is preparing a valuation report regarding this investment. He estimates that Zuflak government debt would be rated BB, and has gathered the following market information for use in analyzing Zuflak.

Local Government Bond Yield= 11.50%

U.S. 10 year Treasury Bond Yield= 4.50%

U.S. BB rated Corporate Bond Yield= 7.75%

Local Inflation Rate= 6.50%

U.S. Inflation Rate= 3.00%

To assist in his analysis of Zuflak, Sigmund has asked Stefano Testorf, CFA, to estimate a value for Kiani Corporation (Kiani), Oleg Industries (Oleg), and Malik Incorporated (Malik) - the three primary companies domiciled in Zuflak that Sigmund has determined to have adequate liquidity for inclusion in PGA’s client portfolios. Testorf gives Sigmund a rough draft of his report and tells Sigmund that in order to account for country specific emerging market risks, he used a probability-weighted scenario analysis to adjust cash flows. Sigmund asks him, “Why didn’t you simply adjust the discount rate?” Testorf replies with three reasons:

Reason 1: The country risk attributable to Zuflak can be diversified away according to modern finance theory, and should not be included in the cost of capital.

Reason 2: Companies in emerging markets tend to exhibit wild price swings both up and down, therefore adjusting cash flows is the best way to account for these symmetrical country risks.

Reason 3: Although Kiani, Oleg, and Malik are all domiciled in Zuflak, each of these companies will tend to respond differently to country risks. This makes it virtually impossible to adjust the discount rate for country specific risk and come up with an accurate valuation estimate.

After careful analysis by Sigmund and his team, Sigmund decides that he wants to have exposure to Zuflak in his international portfolios. He is still unsure however, what the best way would be to establish the exposure. Sigmund discusses his concerns with Steve Solak, another portfolio manager with PGA. Solak suggests that Sigmund consider using a closed-end country fund to invest in Zuflak. Solak hands Sigmund a copy of a note that he had provided to a client listing facts about country-specific closed end funds. The note contained the followingstatements:

Closed-end country funds provide an excellent means to access local foreign markets. Even nations that have restrictions on foreign investment are sometimes accessible using closed-end country funds.

Closed-end country funds issue a fixed number of shares and are a great way to diversify a U.S.-dollar stock portfolio because of their low correlation with the U.S. stock market.

Sigmund thanks Solak for the information and heads back to his office. As he is leaving, Solak asks him if he would have time later that afternoon to discuss the use of American Depository Receipts (ADRs).

Part 2)

To determine a valuation estimate for Oleg, Testorf assumes that local investors require a 5 percent real rate ofreturn on companies with similar risk to Oleg. What is Oleg’s price-to-earnings (P/E) ratio, if the company has an inflation flow-through rate of 65 percent?

A)13.75.

B)5.33.

C)3.00.

D)21.25

James Sigmund, CFA, is the Head of International Equity for Pell Global Advisors (PGA). Sigmund is considering investing in the country of Zuflak as part of an emerging market portfolio. Sigmund is aware of the risks in investing in emerging markets and is preparing a valuation report regarding this investment. He estimates that Zuflak government debt would be rated BB, and has gathered the following market information for use in analyzing Zuflak.

Local Government Bond Yield= 11.50%

U.S. 10 year Treasury Bond Yield= 4.50%

U.S. BB rated Corporate Bond Yield= 7.75%

Local Inflation Rate= 6.50%

U.S. Inflation Rate= 3.00%

To assist in his analysis of Zuflak, Sigmund has asked Stefano Testorf, CFA, to estimate a value for Kiani Corporation (Kiani), Oleg Industries (Oleg), and Malik Incorporated (Malik) - the three primary companies domiciled in Zuflak that Sigmund has determined to have adequate liquidity for inclusion in PGA’s client portfolios. Testorf gives Sigmund a rough draft of his report and tells Sigmund that in order to account for country specific emerging market risks, he used a probability-weighted scenario analysis to adjust cash flows. Sigmund asks him, “Why didn’t you simply adjust the discount rate?” Testorf replies with three reasons:

Reason 1: The country risk attributable to Zuflak can be diversified away according to modern finance theory, and should not be included in the cost of capital.

Reason 2: Companies in emerging markets tend to exhibit wild price swings both up and down, therefore adjusting cash flows is the best way to account for these symmetrical country risks.

Reason 3: Although Kiani, Oleg, and Malik are all domiciled in Zuflak, each of these companies will tend to respond differently to country risks. This makes it virtually impossible to adjust the discount rate for country specific risk and come up with an accurate valuation estimate.

After careful analysis by Sigmund and his team, Sigmund decides that he wants to have exposure to Zuflak in his international portfolios. He is still unsure however, what the best way would be to establish the exposure. Sigmund discusses his concerns with Steve Solak, another portfolio manager with PGA. Solak suggests that Sigmund consider using a closed-end country fund to invest in Zuflak. Solak hands Sigmund a copy of a note that he had provided to a client listing facts about country-specific closed end funds. The note contained the followingstatements:

Closed-end country funds provide an excellent means to access local foreign markets. Even nations that have restrictions on foreign investment are sometimes accessible using closed-end country funds.

Closed-end country funds issue a fixed number of shares and are a great way to diversify a U.S.-dollar stock portfolio because of their low correlation with the U.S. stock market.

Sigmund thanks Solak for the information and heads back to his office. As he is leaving, Solak asks him if he would have time later that afternoon to discuss the use of American Depository Receipts (ADRs).

Part 1)

What is the best estimate of the country risk premium for Zuflak?

A)0.25%.

B)1.50%.

C)2.75%.

D)6.00%.

Tess Mulroney, a veteran options investor, wishes to do some speculating and hedging with options, but isn’t sure the derivatives currently available are attractively priced. Before making any transactions, Mulroney puts her calculator to work to determine a fair price for the options.

First, Mulroney seeks to protect a large variable-rate investment. She has loaned $40 million to her nephew’s construction company. The loan is payable in one year, and the current interest rate is 7.6 percent. Based on data provided by her brokerage house, Mulroney believes interest rates will fall sharply over the next year, with a 70 percent chance of a decline to 5.9 percent and a 30 percent chance of a decline to 4.7 percent.

To protect her cash flows, Mulroney is considering the purchase of a 6.2 percent floor. Mulroney knows a banker who writes such options, but she must come to him with a price in mind.

Next on Mulroney’s list is call options on Merrill Materials stock. She has obtained the followingassumptions through a subscription options service:

The stock trades for $35 per share.

The chance of an upward movement over the next year is 60 percent.

The likely downward movement is 20 percent.

At-the-money calls currently sell for $4.75.

Despite her experience, Mulroney knows she always has more to learn. So she then reviews some technical material on options that she found on the Internet. Mulroney spends the next hour reading up on sensitivity factors related to option pricing.

Later that day, Mulroney meets with Ben Glanda, her financial adviser. He has prepared some investment recommendations and advice for Mulroney.

His first suggestion addresses a series of investments Mulroney was considering. She had proposed buying a stock, buying a European put option on the stock, and writing a call option. Glanda has proposed an alternative investment that will be simpler to make.

Next Glanda attempts to convince Mulroney to start using an alternate method for valuing her options. Glanda suggests using the Black-Scholes-Merton model because of its precision and ability to consider more factors, but Mulroney prefers the binomial model because it requires fewer assumptions.

Mulroney doesn’t like the Black-Scholes Merton model for the following reasons:

It does not work for American options.

It does not consider volatility of interest rates.

It does not reflect the compounding of returns.

It does not work for assets that generate cash flows.

Part 6)

If Glanda is attempting to duplicate the effects of Mulroney’s proposed stock and option investment, he should recommend the:

A) sale of a riskless bond.

B) purchase of a riskless bond.

C) purchase of a stock.

D) sale of a stock.