Assignment 2 (Assessment worth 15%) Due Date 22 January at 4pm (due date will be strictly observed)

Assignment 2 (Assessment worth 15%)
Due Date 22 January at 4pm (due date will be strictly observed)

Question 1

Is the following statement true or false? Explain why it is true or false stating any assumptions.

“Calls increase in value while puts decrease in value as interest rates increase with all else remaining the same”. (3 marks)

Question 2

Two companies in chemical industry are P and Q. The high quality borrower (P) prefers to raise $50 million in five years floating rate funding. The low quality company (Q) prefers to raise $50 million in five years fixed rate funding. This is explained in table presented below.

Required

(a) Explain in which rate does (P)and (Q) has comparative advantage. What is the strategy to create a swap contractbetween P and Q?What are the gains from swap? (5 marks)

(b) Let X= total basis point. Show that net cash outflow to P is L-2% +X and Q is 7.50%-X.Suppose X=1.49% and X=0.51% then explain how the net cash outflow of each parties satisfy the overall gain from swap of 1% under the two X values. (3 marks).

(c) A range of values is possible for X that satisfies the Pareto-improvement condition. For example If X = 1.0% explain the net cost to each parties and show that your resultsmatches gains from swap in part (a). (4 marks)