Finance 119
Tom.Root@Drake.edu
STUDY GUIDE FOR FINAL
Office 317 Aliber Hall
Spring 2009
(515) 271-4163
OFFICE HOURS WEEK OF FINAL: 10:00-11:30am Tues, 1:30-3:30pm Tues, 2-4 Weds
THE FINAL EXAM IS THURSDAY, MAY 14 FROM 12 NOON TO 2:00 PM IN ALIBER 101
The final exam will not be moved on an individual basis due to multiple finals in one day unless the guidelines
set by University Policy are met. University policy states that if a student has 4 or more finals scheduled for
the same day a request to change the schedule so that not more than 3 finals are scheduled can be made.
Requests for the final exam to be moved due to schedule conflicts associated with multiple exams are subject to
verification of the student’s finals schedule by the Dean’s Office.
CHAPTER 12 THE TERM STRUCTURE OF INTEREST RATES
CALCULATIONS: Be able determine the zero spot level of interest rates given the price and coupons of treasury
securities using the bootstrapping method (similar to the homework). Be able to use your zero coupon rates to
determine the yield curve. Be able to determine the forward rate given the appropriate information. Be able to
price a bond using your zero coupon rates and discuss whether or not arbitrage opportunities exist.
CONCEPTS AND IDEAS: What is meant by the yield curve? Explain how a bond can be thought of as a portfolio
of zero coupon instruments. How does this relate to the idea of the yield curve? What is meant by the “n-year
spot interest rate”? What does the spot rate assume about the timing of coupon payments? What is the
difference between on the run Treasury securities and off the run treasury securities? Be able to determine the
zero spot rate coupon rate given a series of interest rates. What is the relationship between the spot level of
interest rates and forward level of interest rates? If the implied forward rate is actually realized how would the
actual return realized relate to the zero coupon level of rates?
THE MORTGAGE MARKET AND MORTGAGE BACKED SECURITIES CHAPTERS 23 AND 24
CALCULATIONS: Be able to calculate the Single month mortality rate and the CPR. Be able to find the single
month mortality rate given the appropriate information. Be able to find the conditional prepayment rate given
the appropriate information. Be able to use the PSA benchmark, SMM and CPR to develop a forecasted
prepayment schedule for a hypothetical mortgage.
CONCEPTS AND IDEAS: What are three sources of income to originators of mortgages? How are the PTI and
LTV ratios used in the origination process? What is outlined in a lenders commitment letter? How doe the
letter create price risk and fallout risk for the lender? Be able to explain both price risk and fallout risk. What
options does an originator have after issuing a mortgage? How can price risk be decreased via the use of
forward contracts? Does the use of forward contracts bring about a second risk? How do options address the
risk associated with the use of forward contracts? What is the Tilt Problem? Are simple adjusted rate mortgages
a good solution for the tilt problem? Be able to explain how Graduated Payment Mortgages, Price Level
Adjusted Mortgages and Dual Rate Mortgages can account for the tilt problem. What risks are faced by
investors (buyers) of mortgages in the secondary market? Be able to explain and illustrate each type of risk. Be
able to explain the process of asset securitization. How is securitization supposed to spread risk? Be able to
explain how a mortgage pass through security is set up. What government agencies issue mortgage pass through
securities? Be able to explain the difference between pass throughs offered by Ginnie Mae, Freddie Mac, and
Fannie Mae. For each organization be able to discuss specifics of the mortgage pass through securities they
offer and be ale to compare across agencies. What is the guarantor / swap program offered by Freddie Mac?
What accounting advantages are there to being part of the swap program? Be able to find the single month
mortality rate given the appropriate information. Be able to find the conditional prepayment rate given the
appropriate information. Be able to use the PSA benchmark, SMM and CPR to develop a forecasted
prepayment schedule for a hypothetical mortgage. What are collateralized Mortgage Obligations? Be able to
explain what is meant by payment tranches. What is the difference between a Sequential pay CMO, Planned
Amortization Class CMO and Stripped Mortgage Class CMO. In each case be able to explain the payment
based upon the different tranches. Be able to relate the recent credit crisis to MBA securities. Be able to
summarize the explanations of the credit crisis discussed in class. What role did international capital flows play
in the crisis (how did that impact mortgage markets?) How does that relate to the yield curve and our theories of
the yield curve?
FORWARD AND FUTURES MARKETS CHAPTER 26, PARTS OF CHAPTER 29
Be able to draw and interpret payoff diagrams for both short and long futures contracts. What is the difference
between a long and short position in the futures market? Explain the intuition behind the determination of a
futures price (use supply and demand). If most participants in the futures market believe that the spot price is
increasing what will happen to the futures price (explain using the supply and demand for short and long
positions). What is the difference between the Chicago Board of Trade and the Chicago Mercantile Exchange?
(products traded, start up of exchange, etc..). What is the difference between a hedger and speculator? What is
meant by the statement: “futures markets are zero sum games”? Be able to calculate when margin calls occur,
and associated changes in margin accounts given the relevant data. Does a futures contract usually result in the
delivery of the underlying asset? Explain what is meant by closing out a position. Be able to explain the
different specifications of futures contracts discussed in class (contract size, price quotes,…). Why are the
specifications of the asset so important to the contract. What would happen if the asset was not specified in
detail? Does your answer to the previous question depend upon whether you have a long or short position?
Explain. Why do speculators and hedgers have different position limits? How does open interest differ from
volume? When a contract trades does the open interest increase, decrease, or not change? Explain. How do
margin accounts lower default risk? Be able to explain how margin accounts work. What are the differences
between the initial margin, and maintenance margin? What is a margin call? Can the balance in a margin
account earn interest? Who determines the maintenance and initial margin? Be able to calculate the balance in a
margin account and find the margin. What is the basis? Why does the basis converge toward zero as a futures
contract expires? What is basis risk? Explain the difference between a “normal” market and an “inverted”
market. What happens when the futures market for an asset exhibits normal backwardation? What if it exhibits
Contango? If delivery occurs which open spot position will receive the delivery? What is the difference
between a forward and futures contract? (think about each of the contract specifications; delivery,
standardization, settlement options etc.)
OPTIONS CHAPTERS 27, 28, AND 29
Throughout the chapter when it refers to an option -- it implies that you are considering the case of both put and
call options.
CALCULATIONS: Be able to present the profit diagram and/or payoff table from “complex” trading strategies
(complex -- implies that it involves more than one option) Be able to intuitively explain any of the “Greeks”
their use.
CONCEPTS AND IDEAS: What is the difference between an American and European option? What are the
assumptions underlying the Black Scholes model? Be able to explain each of the following terms: In-the-money
option, at-the-money option and out-of-the money options. Be able to distinguish the different between short
and long positions for both put an call options. Be able to explain the relationship between options on the prie
of a bond and their use to hedge interest rate risk. Be able to draw simple payoff and profit diagrams for long
call, long put, short call, and short put options. Be able to explain the profit and payoffs fro both short and long
positions. Be able to explain the difference between a short and long position in an option. What is the intrinsic
value of a European call option. What is the intrinsic value of a European Call option? How does the intrinsic
value relate to the payoff of an option? How do changes in the key inputs in the option pricing equation (Spot
price, Exercise price, Volatility, Interest Rates, and Time to expiration) impact the value of a call option and the
value of a put option? What is implied volatility? Be able to explain trading strategies that might exist if
implied volatility is not equal to your expectations of volatility. What does “delta” tell us? How is it
calculated? Keeping the exercise price fixed, how is delta impacted by a change in the stock price? Is the delta
higher for an in-the-money or out-of-the money option? Explain. How does delta relate to the probability that
the option will be in the money? What does this imply about buying significantly out-of-the money options
(With a low delta?) What is measured by “gamma”? How does it relate to delta? How does gamma relate to
the ability of a participant to maintain a hedged position? Explain how gamma is related to the stock price of
the underlying stock. How does the price of an option vary with the strike price? (Given the same stock, with a
constant spot price, would you expect the price of an option to increase or decrease as the strike price changes?
Be able to diagram the profit function of each of the complex trades discussed in class: Be able to do variations
of these strategies. (If given two option positions and a spot be able to show the resulting combined position and
discuss the profit from the combined position)
SWAPS CHAPTER 29
What is a swap? What is meant by notional principal? Explain the basic idea of a “plain vanilla” swap. Be able
to explain how a simple fixed for floating swaps cash flows can be calculated. Explain how a swap can
transform a fixed rate liability into a floating and vice versa. Be able to design an interest rate swap based upon
the comparative advantage of each firm. Be able to complete a simple swap diagram as shown in the class
notes.
COMPREHENSIVE PORTION
The final will consist of 165 points that cover the material above (the last 1/4 of the class). The other 100 points
will be comprehensive (covering the entire class). The comprehensive portion can be broken into two parts.
The first part will be short answer and problems similar to the questions below and worth approximately 70
points. The second part will be two essay questions each worth approximately 15 points. (there are three
different possibilities for the two essay questions below (questions 2 a) 2 b) and 2 c) could each be a possible
separate question). The length of each answer should be about one hand written page.
Short answer questions / Problems
1) Be able to explain each of the following terms or concepts in detail (You may be ask to explain or define the
term, to compare similar terms, or a true / false questions relating to one of terms may be asked)
a) Intermediation (Denomination and Maturity)
b) Securitization
c) Repurchase Agreement
d) Regulatory Dialectic
e) Duration and Convexity
f) Effective Duration
g) Modified Duration
h) Yield Curve
i) TIPS
j) Mortgage Back Security
k) Tranches used in Mortgage Backed Securities
l) Single Price Auction Process in Treasury Auctions
m) When Issued Market for Treasury Security
n) On-the-run Treasury Security and Off-the-run Treasury Security
o) Federal Funds Rate
p) General Obligation Municipal Security
q) Revenue backed Municipal Security
r) Treasury Bill vs. Treasury Bonds
s) Commercial Paper
t) Medium Term Notes
u) Fannie Mae, Freddie Mac, Ginnie Mae
2) Be able to explain the justifications for regulation discussed in class (For example to promote stability and
soundness). Be able to relate the reasons for regulation to the goal of making financial markets competitive.
(don’t just look at stability and soundness – there were many other reasons we discussed)
3) Be able to calculate Macaulay duration and explain what duration shows. Be able to utilize duration and the
concept of convexity to discuss and calculate expected changes in a bonds price given a change in the level of
interest rates. Be able to find the estimated price change associated with the duration of a bond.
4) Be able to use the loanable funds theory to explain how a change in the market would change the level of
interest rates in the economy.
5) Be able to explain the treasury auction process in detail. What is a dutch (single price) auction? What are
the stop yield and tail in an auction?
6) Be able to interpret and explain each of the following statements relating to financial markets that have been
made by analysts.
a) “The financial modernization act of 1999 created a wave of demutualization in the insurance industry.”
b) “Low rated bond yields rose as recession fears caused a flight to quality.”
c) “The switch from bank deposits to US stocks will put an upward pressure on interest rates.”
d) “The large tail on the recent treasury auction signals uncertainty about the future level of interest rates in the
economy.”
e) “The large amount of foreign demand for US Treasuries combined with a large demand for long term bonds
by institutional investors in the United States has kept long term interest rates low, as predicted by the
segmented markets theory of the term structure of interest rates.”
Essay Questions
I can not read example answers to essay questions prior to the test – I will answer specific questions
relating to your answer, but will not read a “practice answer” and provide feedback on it.
1. In the first portion of the class we discussed the idea of a “regulatory dialectic.” Write a short essay
explaining what is meant by the phrase regulatory dialectic and use examples from our discussion of changes in
regulations relating to the commercial banking industry to illustrate the concept of a regulatory dialectic. Your
answer should include an explanation the role the commercial banking industry plays as an intermediary and
changes in that role. Your answer should also include specific examples of changes in regulation that have
occurred in the United States including the Glass Steagall Act and the Financial Modernization Act of 1999 (and
some regulations in between) and the reasoning behind the changes.
2. As an analyst for helping to manage a bond portfolio you have been observing changes in the level of interest
rates over the last year. Your boss has asked you to present an analysis of the changes in interest rates over the
past 8 years along with some predictions concerning the future. The Treasury yield curves for February, March,
and April can be found on the web. Use the graphs of the recent yield curves as supporting evidence of your
discussion of how rates have changed in the past year. Specifically, your boss would like a short essay
answering the following questions.
a) Many business leaders and economists are beginning to talk about the economy emerging from recession.
Do you see any evidence of this looking at the recent changes in the yield curve? If not, what signs would you
look for (what might signal that there is an expectation of increased growth in the economy in the future?) How
would the changes in the yield curve impact businesses desire to raise funds and what will be the resulting
impact on the level of interest rates. Relate your interest rate prediction to the theories of the Yield curve
(expectations, preferred habitat, market segmentation etc..) Be specific about the difference between changes in
short term rates and long term rates. What does the shape of the yield curve imply about profitability over the
next few years for financial institutions who make money from maturity intermediation?
b) Given your expectation about future interest rates and the markets for different types of corporate debt, what
type(s) of debt do you believe business will be offering over the next year to help finance the recovery? Include
in your answer specific answers relating to commercial paper, medium term notes, and corporate senior debt to
explain why firms will or will no be using each type of financing in your opinion. What rte will firms need to
pay (Specifically what is the role of credit risk and how has it recently impacted the willingness and ability of
firms to borrow? – Do you see any signs of this changing?)
c) There has been much talk in the financial press about the causes of the credit crisis. One school of thought
focuses on the low interest rate environment that existed from 2001 to 2004. Do you believe that the low federal
funds rate target during this time was a large factor in the credit crisis? What role did the difference between
short term and long term interest rates play? Relate your answer to the graph we discussed in class showing the
mortgage rate vs. the fed funds rate. Discuss the role international capital flows played in the profits made by
financial firms during 2004 – 2008 and use the segmented markets theory to discuss how the spread between
short run and long run interest rates was impacted during this time.