Financial Markets (BAFI1005) Final Assessment - RMIT University

This document presents a comprehensive solution to a Financial Markets final assessment, addressing four key problems. The first question analyzes the Federal Reserve's interest rate cuts, explaining their impact on the economy and introducing the instruments used. The second question delves into yield curves, using US Treasury data to illustrate their shape, interpretation, and market outlook implications. The third problem focuses on bond pricing, calculating the issuing price of a US 10-year Treasury bond under different market conditions and exploring the factors influencing price changes. The final question involves options trading, calculating the cost of a put option strategy on Tesla shares, and determining profit/loss scenarios. The assignment covers topics from the course including, the money market, the financial system, and the foreign exchange market.

FINAL ASSESSMENT COVER SHEET
Student Name:
Student Number:
EXAM DETAILS
Course Code: BAFI1005
Course Description: Financial Markets
Exam Date 21/04/2020
Release time: 9:00 am SGP Time
Submission cut off time: 11:30 am SGP time
Exam Duration: 2 hours + 15 min reading time + 15 additional
minutes for download and submission
Total number of pages: 11 pages
INSTRUCTIONS TO CANDIDATES
1
The assessment consists of a series of 4 problems with scenario analysis.
You must complete all problems and each component of the problem. The
assessment is worth a total of 50 marks.
2 This is an OPEN BOOK assessment.
3 You are expected to answer the questions within the scope of this course
covering Topic 1 to 8.
4 Please write your answers in the space provided on this assessment paper
after each question.
5
This exam paper adds to 50 marks and comprises 50% of the total marks
allocated in this course. To obtain a pass in this course, you must achieve at
least 50 % overall in course assessment
1

Submission:
1
This assessment must be submitted electronically via Canvas in .doc
or .docx format only and must constitute your own work. Submission for this
assignment is via Turnitin, therefore it is automatically checked for any form of
plagiarism, resulting in academic misconduct if plagiarism occurs. You are
required to upload the file in .doc or .docx format only; not as .pdf. If the file is
uploaded in any other format that is not recognised via Turnitin and you don’t
receive a similarity score – the assessment will not be marked and a grade of
zero for the assessment will be applied.
2 You can only submit once as your final answer.
3 Name your answer file as: surname_studentID before submission.
4
As this is a final assessment, late submissions will not be accepted. If
circumstances occur that prevent you being able to undertake the
assessment on the due date – you will have to apply for special
consideration: This webpage provides instructions about how to go about
this: https://www.rmit.edu.au/students/student-essentials/assessment-and-
exams/assessment/special-consideration
5
The submission window will close exactly at the cut-off time. Please
submit well before cut-off time to ensure that nothing impedes your ability to
upload the assessment, such as internet/wifi issues. This will not be a
sufficient excuse to grant extensions – you are responsible for ensuring that
you are able to submit the assessment on time.
Answer Requirement:
1 Where mathematical calculations are required you must state the equation
used as well as each step in your calculations.
2
Please write answers in the spaces provided. You can extend the space to fit
your answers, but please label the sub-question number clearly.
The format is detailed below:
Font type: Arial
Font size: 12pt
Spacing: 1.5 line spacing
2

Assessment Declaration
This is an individual piece of assessment. That means it must be your own
work and you can’t copy or have someone else complete any part of the work
for you.
By submitting this assessment, you are declaring that you have read,
understood and agree to the content and expectations of the Assessment
declaration.
3

Final Assessment Questions
The final assessment comprises four (4) questions. You are required to answer all
four (4) questions. This section is worth a total of 50 marks, with marks for each
question specified at the end of the question.
Question1
On 16th March 2020, the Federal reserve in the US announced that it will lower the
primary credit rate by 150 basis points to 0.25 percent to support the US economy
amid the coronavirus outbreak, effective March 16, 2020.
Jack is a new investor. He read the above news but could not figure out how the
“Federal Reserve could support the economy by cutting interest rates”. You are his
financial advisor, so he asked for your help.
REQUIRED:
a. Please explain in detail the reasoning or theories behind the statement -
“Federal Reserve could support the economy by cutting interest rates”.
b. Please introduce the main instrument used by Federal Reserve to achieve its
targeted interest rate.
c. Please explain how it works in detail.
(5+2+5=12marks)
a) A deduction in the interest rate by the Federal Reserves would be lowering down
the cost of borrowing and this would be helping the individuals, business entities and
corporation lower down the borrowing cost which would be helping them increase
the output production at a much higher set of returns. Lowering down the cost of
borrowing would not only reduce the finance cost but would also induce these parties
to borrow more from financial markets as money available in the market becomes
cheaper for borrowing and which can be well utilized for expanding the growth of the
company and economy as a whole.
4

b) The reduction in the cash rate is the key instrument is the key instrument that is
used by the Federal Reserves for the purpose of achieving its target rate. On the
other hand, there are various other instruments that are too used by the company for
the purpose of influencing the economy that are Fed Reserves and Open Market
Operations.
c) The United States have well lowered down the interest rate by about 1% point,
from an rate of 1% to around 0%, that has been specifically carried out by the FED
for the purpose of reviving the economy and the business, manufacturing and
services units operating in the economy. Availability of finance for carrying on
business expansions, current business activities and proposed business investment
projects, requires a hefty amount that needs to be financed. Now despite of the
COVID19 effect the business sectors are facing the global economy is falling into
recession and unemployment is expected to well increase. Now it becomes
important for the FED to take actions and affects that not only revives the economy
but also allows these business sectors revive their growth. These can be well done
by lowering the rate of interest which in turn would be allowing them to borrow at a
lower cost and finance their operations at a cheaper rate and investment into new
projects by these business sector in turn would create employment and help the
economy revive by increased economic, business and financial activities and
transactions.
Question 2
As a financial advisor, you have been asked a lot of questions recently on yield
curves. So, you decided to hold an online seminar for your clients to explain the
following questions using US yield curve as an example. You downloaded the data
of Daily Treasury Yield Rates of the U.S from the website of U.S. DEPARTMENT OF
THE TREASURY as below. (Mo=month, Yr=Year, Date format is Month/Date/Year)
Table1: Daily treasury yield rates of the US treasury bill and bond
Time to maturities of US Treasury bill and bond
Date 1 Mo 2 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr
5

08/15/19 2.08 1.97 1.91 1.86 1.72 1.48 1.44 1.42 1.47 1.52 1.8 1.98
08/16/19 2.05 1.95 1.87 1.85 1.71 1.48 1.44 1.42 1.49 1.55 1.82 2.01
03/16/20 0.25 0.25 0.24 0.29 0.29 0.36 0.43 0.49 0.67 0.73 1.1 1.34
REQUIRED:
a. Explain what a yield curve is by using the US treasury yield curves data on
15th Aug. 2019 and 16th March 2020 as an example. (Note: no diagrams of
yield curves are required since it may be difficult to draw in Word)
b. Further specify what is the shape of the yield curves on 15th Aug. 2019 and
16th March 2020 respectively? Please explain the potential reasons for that
shape.
c. Looking at the two US yield curves, what do you think is the implied
market outlook of them respectively? Please explain the reasons in detail.
(3+5+5=13 marks)
a) A yield curve is a plot of yields or interest rates, which is well graphed across a
line for bonds that have an equal credit quality, but at the different maturity dates.
The table presented above well shows the various range of interest rate that or yield
that an investor can well make out if he purchases a bond of a defined maturity level.
The table also reflects a relationship that is between the time and interest rate and
how the same is evolving.
b) The data for the time period of 15th August 2019, shows an upward sloping yield
curve on the other hand, data for the 16th March 2020 shows a downward sloping
yield curve. The shape of the yield curve that can be well observed following the
trend of the given rate and returns is in the form of downward sloping yield curves
which goes to well show that interest rate in future is going to decline. The potential
reason for the downward sloping yield curve is that investors are believing that the
interest rate would be low in the future terms and this will be primarily done by the
Central Bank in order to revive the growth of the economy which the FED is currently
doing for reviving the economy.
c) The yield curves drawn is well shedding lights in the future of US Economy
stating that the implied market outlook is weak or low.., i.e., the markets or economy
can go into recession and this has been primarily due to slowdown in the economy.
The terms structure of the interest rate is downward sloping which goes to well show
that the yield from the bond is falling i.e., interest rate would be falling in accordance
with the market outlook.
Question 3
6

You are now a fund manager. Your boss asks you to prepare a report regarding
following questions:
a. Please calculate the issuing price of U.S. 10 Year Treasury bond on 16th Aug.
2019 and 16th March 2020 respectively with information given below.
US 10-year Treasury Notes Fact Sheet
Issuing date 16th Aug. 2019 16th March 2020
Bond expiration date 16th Aug. 2029 16th March. 2030
Face value 100 100
Coupon rate (annual) 1.50% 1.50%
Coupon payment semi-annual semi-annual
Tips: the market yield of 10-year treasury notes can be found in the data provided in Question 2
b. Compared to the price on 16th Aug. 2019, how has the issuing price of US 10
Year treasury bond changed after the Federal Reserve’s rate cutting on 16th March
2020? Please explain the potential reason for this.
(6+6=12 marks)
a) The price for each of the bond is calculated as shown:
US 10-year Treasury Notes Fact Sheet
Issuing Date 16th Aug. 2019 16th March 2020
Bond Expiration Date 16th Aug. 2029 16th March. 2030
Face value 100 100
Coupon rate (annual) 1.50% 1.50%
Coupon payment semi-annual semi-annual
Time Period (In Years) 10 10
Market Yield 1.55% 0.73%
Price (Present Value) $ -99.54
$ -
107.41
b. Interest Rate and Bond prices have an inverse relationship and the same can be
well seen in this case whereby if the interest rate or market yield was around 1.55%
on 16th March 2019, then the price of the bond that was calculated turned out to be
around $99.54, however in the case of Year 2020, 16th March when the market yield
turned out to be 0.73% the price of the bond that was calculated turned out to be
7

around $107.41. Now this change in the market yield goes to well explain the change
in the bond prices. If interest rate falls then bond prices rices and vice versa.
Question 4
As a hedge fund manager, you have a bearish view on Tesla Inc. shares (NASDAQ:
TSLA) for the following 2 months given the uncertainties related to the Covid-19.
Assuming Tesla Inc is currently trading at $467.00, the put options with a maturity
of two month and an exercise price of $442 per share, have a premium (cost) of
$1.5 per share. The call option with a maturity of two month and an exercise price of
$487 per share, have a premium (cost) of $3 per share.
a. Calculate the cost if you purchase 1,000,000 of the above put options.
b. Determine the share price for Tesla shares at which you would choose to
“exercise” the above put options.
c. Determine the share price for Tesla shares at which the decision to purchase
the above put options effectively “breaks even” for the fund manager.
d. If you don’t own any shares, but you still want to make profits during this
period. How can you use put and call options to take advantage of the fall in
the share price?
(2+2++3+6=13 marks)
a) Cost of Put Option: Number of Put Options*Put Price
Cost of Put Option: 1,000,000*1.5
Cost of Put Option: $1,500,000.
8

b) The share price at which we would choose the above the put option would be at a
price which is below the strike price that is the when the stock price is below the
strike price of $442.
c) The breakeven point for the fund manager can be well calculated as follows:
Breakeven Point: Exercise Price-option Cost
Breakeven Point: $442-$1.5
Breakeven Point: $440.5
This is the point at which the fund manager would be at a breakeven point covering
down its costs that is involved in purchasing the put options. Now levels below the
price range of $440.5 would be marked as for profit for the fund manager.
d) Given the price premiums for Put and Call option it can be well seen that the Put
Option has a higher weightage of Price and Call has less, given the trend we expect
that the stock price will fall we will be purchasing Put Options at a strike price of $442
at the price of $1.5. At the same time we are also concerned that the share price
does not rises rapidly so what one can do is buy a call option at the strike price of
$487 at $3 to reduce the upside movement of share rapidly.
Other strategies like a call can be well written at the strike price of $487
whereby we will get a inflow of $3. Now range estimation is a key point we do believe
that the stock price would be staying in a range of $442-$487 but the share price can
fall below $442 given negative trend for market, economy and stock. Thus at the
same time would also purchase a put option which will involve a cost of $1.5 and the
investors on a whole make a profit of $1.5, given his belief of market of bearish
signal.
9

10