Economics 122 Financial Economics PROBLEM SET 1 Note: Please submit as a group. Deadline for submission is 16 July 2013.

1. How risk-free are bonds? 2. Stocks usually carry more risk than bonds. Why? 3. What is the difference between entering into a long futures contract with a futures price of $100 and buying a call option with a strike price of $100? 4. What is the difference between entering into a long futures contract with a futures price of $100 and selling (writing) a call option with a strike price of $100? 5. Which security should sell at a greater price? Explain. a. A January 2014 put option with an exercise price of $25 or a December 2013 call option with an exercise price of $20? b. A Treasury note with 6 months remaining maturity or a newly issued 3-month Treasury bill? c. A 5-year Treasury bond with 5% coupon rate or a 5-year Treasury bond with 5.5% coupon rate? d. A 9-month maturity put option with an exercise price of $35 or a 9-month put on the same stock with an exercise price of $30? 6. Suppose you buy a European put on the stock of Better Options, Inc. with a 3-month maturity and strike price of $44. You pay $1 for the option. a. If the market price of the stock is $50 before maturity, what would be your profit or loss? b. If the market price of the stock is $50 at maturity, what would be your profit or loss? c. What would be your profit or loss if the market price of the stock is $40 at maturity? d. Suppose you bought a call option instead of a put (same premium and exercise price) and the market price of the stock at maturity is $44. What would be your profit or loss? 7. Techno Tim opens a brokerage account and purchases 200 shares of Orange, Inc. at $50 per share. He borrows $5,000 from her broker to help pay for the purchase. The interest rate on the loan is 6%. a. What is the margin in Tims account when he first purchases the stock? b. If the share price falls to $40 per share by the end of the year, what would be the remaining margin in his account? c. If the maintenance margin requirement is 30%, would he receive a margin call? (When would he receive a margin call?) d. What would be the rate of return on his investment? 8. Speculator Sam opened an account to short sell 1,000 shares of Orange, Inc. from the previous problem. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Orange, Inc. has risen from $50 to $60, and the stock has paid a dividend of $1 per share. a. What is the remaining margin in the account? b. If the maintenance margin requirement is 30%, will Sam receive a margin call? (When would he receive a margin call?) c. What is the rate of return on the investment?

9. You borrowed $20,000 on margin to buy shares in Candycrash, Inc., which is selling at $40 per share. Your account starts at the initial margin requirement of 50%. The maintenance margin is 40%. Two days later, the stock price falls to $35 per share. a. Will you receive a margin call? b. How low can the price of Candycrash shares fall before you receive a margin call? 10. On January 1, you sold short one round lot (i.e., 100 shares) of Candycrash stock at $40 per share. On March 1, a dividend of $2 per share was paid. On April 1, you covered the short sale by buying the stock at a price of $35 per share. You paid 50 cents per share in commissions for each transaction, what is the value of your account on April 1?