FIN

20150
Chapter 3 Review Problems

Time Value of Money

The cost of rebuilding the old county bridge in 2017 is $2,300,000.00. Engineers estimate
the cost will rise by 8% if the project is delayed one year until 2018. If the risk free rate is
4%, what is the cost of delaying the project in terms of 2017 dollars?

a. $ 276,000.00
b. $ 184,000.00
c. $ 92,000.00
d. $ 88,461.54
e. $ 0.00
f. None of the above answers is within $5,000 of the actual cost of delaying the
project one year.

Answer: D
 FIN 20150
Chapter 3 Review Problems

Your great aunt Matilda put some money in an account for you on the day you were born.
This account pays 3% interest compounded annually. On your 21st birthday the account
balance was $33,555.50.

1. The amount of money that your great aunt Matilda originally put into the account is
closest to:

a. $ 33,555.50
b. $ 19,136.23
c. $ 18,578.87
d. $ 18,037.73
e. $ 17,512.36
f. $ 17,002.29

Answer: D

2. The amount of money that would be in the account if you left the money there until
your 65th birthday is closest to:

a. $ 106,271.17
b. $ 112,743.09
c. $ 116,125.38
d. $ 119,609.14
e. $ 126,893.34
f. None of the above is within $1,000 of the amount of money that would be in the
account if you left it there until your 65th birthday.

Answer: F ($123,197.42)
 FIN 20150
Chapter 3 Review Problems

You have a risk free investment opportunity in India that requires an investment of
$600,000 today and will produce a cash flow of 45,500,000 Indian Rupees in one year.
Finally, assume that the one year risk-free rate of interest in India is 6.50%, the one year
risk free rate of interest is 0.75% in the United States, and the current competitive
exchange rate is $1.00 to 67.55 Indian Rupees.

Select the most accurate statement regarding the time t=0 net present value of the project.

a. You should take the project because it has a net present value equal to $32,464.91.
b. You should take the project because it has a net present value equal to $32,708.40.
c. You should take the project because it has a net present value equal to $68,560.92.
d. You should take the project because it has a net present value equal to $73,017.38.
e. You should reject the project because it has a negative net present value.

Answer: A

 FIN 20150
Chapter 3 Review Problems

Arbitrage and the Law of One Price

An exchange traded fund (ETF) is a security that represents a portfolio of individual

stocks. Consider an ETF for which each share represents a portfolio of two shares of
Apple Computer (AAPL), five shares of General Electric (GE), and one share of Amazon
(AMZN). Suppose the current market price of each individual stock are shown below:

Current Market
Stock Price

Amazon (AMZN) $ 836.52

Apple Computer (AAPL) $ 121.85

General Electric (GE) $ 30.37

Suppose that the ETF is selling for $1,233.79. You should ______________.

a. do nothing because the ETF is appropriately priced there is no arbitrage

opportunity.
b. buy the ETF, sell two shares of AAPL, sell five shares of GE, and sell one share of
AMZN.
c. buy the ETF, sell three shares of AAPL, sell five shares of GE, and sell one share
of AMZN.
d. sell the ETF, buy two shares of AAPL, buy five shares of GE, and buy one share
of AMZN.
e. sell the ETF, buy two shares of AAPL, buy five shares of GE, and sell one share
of AMZN.

Answer: D Construct replicating portfolio to mirror the composition of the ETF

portfolio. Compare the cost of each portfolio. By the law of one price, they
should be priced the same.
 FIN 20150
Chapter 3 Review Problems

You are a currency trader and observe the following currency rates in the market:

CURRENCY'RATES

CURRENCY CURRENCY
1 CHF = 0.6875 USD
1.5585 USD = 1 GBP
0.4431 GBP = 1 CHF

Is this market demonstrating the law of one price? Is there an arbitrage opportunity? If
so, how would you take advantage of it?

Answer: The CHF/GBP exchange rate implied by the first two currency pairs is
.4411 GBP per 1 CHF. This is different from the market price of .4431, thus
implying an arbitrage opportunity exists. By converting CHF to GBP, then
converting the resulting GBP to USD, and finally converting the USD back to CHF,
all at market prices, we generate arbitrage profits.
 FIN 20150
Chapter 3 Review Problems

A treasury bond is a security that makes periodic interest payments (based upon a stated
coupon rate applied to the bonds face value) to the holder of the bond. Additionally at
the bonds maturity, along with the final coupon payment, the face value, or principal is
paid back to the bond holder.
You are considering adding some bonds to your portfolio. You call your broker, and she
informs you that there is a 3 year treasury bond available with the following terms:
Time to Maturity: 3 years
Face Value: $10,000
Coupon Rate: 6%
Coupon Frequency: Annual
Current Bid Price: $9,673.25 Current Offer Price: $9673.75
Always one to shop around, you go to treasurydirect.gov and see what might be
available. You see that they are offering the following savings bonds for individual
purchase.
1) A one-year savings bond with a face value of $100, priced at $93.24
2) A two-year savings bond with a face value of $100, priced at $86.94
3) A three-year savings bond with a face value of $100, priced at $78.29
Assume the treasury bond has just made its most recent coupon payment. In other words,
you may assume that the time until the next coupon payment is 1 year. Is the Law of One
Price being upheld? Does an arbitrage opportunity exist? If so, how would you take
advantage of it?
Answer: By constructing a replicating portfolio composed of the savings bonds to
mirror the cash flows of the treasury bond, we can determine that an arbitrage
opportunity exists. The replicating portfolio would cost $9,379.82 to construct and
the treasury bond, with identical cash flows, is valued closer to $9,673.50. If we sell
the treasury bond in the market, and construct the replicating portfolio by buying
the savings bonds in the correct ratios, we collect $293.43 in riskless profits and the
future cash flows are cancelled out.
 FIN 20150
Chapter 3 Review Problems