Question 1

The price of an asset will either rise by 25% or fall by 40% in 1 year, with equal probability. A European put option on this asset matures after 1 year. Assume the following:

• Price of the asset today: 100

• Strike price of the put option: 130

• Put option premium: 7

What is the expected profit for this asset?

Question 2

Masters Corp. issues two bonds with 20-year maturities. Both bonds are callable at $1,050. The first bond is issued at a deep discount with a coupon rate of 4%and a price of $580 to yield 8.4%. The second bond is issued at par value with a coupon rate of 8.75%.

What is the yield to maturity of the par bondand why? Why is it higher than the yield of the discount bond?

If you expect rates to fall substantially in the next two years, which bond would prefer to hold?

Question 3

Security A has a beta of 1.0 and an expected return of 12%. Security B has a beta of 0.75 and an expected return of 11%. The risk-free rate is 6%.Both these two securities are in the same market. Explain the arbitrage opportunity that exists; explain how an investor can take advantage of it. Give specific details about how to form the portfolio, what to buy and what to sell (we assume that the company-specific risk can be neglected).