Question 1

1. What would happen in the options market if the price of an American call were less than the value Max (0, S0 − X)? Would your answer differ if the option were European? Explain.

2. Critique the following statement made by an options investor in American call option: “My call option is very deep in-the-money. I don’t see how it can go any higher. I think I should exercise it.”

3. Why do higher interest rates lead to higher call option prices but lower put option

prices?

4. Suppose a European put price exceeds the value predicted by put–call parity. How could an investor profit? Demonstrate that your strategy is correct by constructing a payoff table showing the outcomes at expiration.

5. Consider a two-period, two-state world. Let the current stock price be 45 and the risk-free rate be 5 percent. Each period the stock price can go either up by 10 percent or down by 10 percent. A call option expiring at the end of the second period has an exercise price of 40.
   1. Find the stock price sequence.
   2. Determine the possible prices of the call at expiration.
   3. Find the possible prices of the call at the end of the first period.
   4. What is the current price of the call?

Question 2

1. A portfolio manager desires to generate $10 million 100 days from now from a portfolio that is quite similar in composition to the S&P 100 index. She requests a quote on a short position in a 100-day forward contract based on the index with a notional amount of $I0 million and gets a quote of $25.2. If the index level at the settlement date is $35.7, calculate the amount the manager will pay or receive to settle the contract.

2. A forward contract covering a $10 million face value of T-bills that will have 100 days to maturity at contract settlement is priced at 1.96 on a discount yield basis. Compute the dollar amount the long must pay at settlement for the T-bills.

3. Consider an FRA that:
   • Expires/settles in 30 days.
   • Is based on a notional principal amount of $1 million.
   • Is based on 9O-day LIBOR.
   • Specifies a forward rate of 5%.

Assume that the annual 9O-day LIBOR 30-days from now (at expiration) is 6%. Compute the cash settlement payment at expiration and identify which party makes the payment.

4. Consider a long position of five July wheat contract futures contract each of which covers 5,000 bushels. Assume that the contract price is $2.00 per bushel and that each contract requires an initial margin deposit of $150 and a maintenance margin of $100. Compute the margin balance for this position after a 2-cent decrease in price on Day 1, a l-cent increase in price on Day 2, and a l-cent decrease in price on Day 3.

5. BB can borrow in the United States for 9%, while AA has to pay 10% to borrow in the United States. AA can borrow in Australia for 7%, while BB has to pay 8% to borrow in Australia. BB will be doing business in Australia and needs AUD, while AA will be doing business in the United States and needs USD. The exchange rate is 2AUD/USD. AA needs USD1.0 million, and BB needs AUD2.0 million. They decide to borrow the funds locally and swap the borrowed funds. The swap period is for five years. Calculate the cash flows for this swap.

Question 3

1. Explain why an option’s time value is greatest when the stock price is near the exercise price and why it nearly disappears when the option is deep-in- or out-of- the-money.

2. Call prices are directly related to the stock’s volatility, yet higher volatility means that

the stock price can go lower. How would you resolve this apparent paradox?

3. The value Max [0, X (1+r) ^−T − S0] was shown to be the lowest possible value of a European put. Why is this value irrelevant for an American put?

4. Buying an at-the-money put has a greater return potential than buying an out-of- the-money put because it is more likely to be in-the-money. Appraise this statement.

5. Explain the advantages and disadvantages to a covered call writer of closing out the position prior to expiration.

Question 4

Suppose that each of two investments has a 4% chance of a loss of $10 million, a 2% chance of a loss of $1 million, and a 94% chance of a profit of $1 million. They are independent of each other.

1. What is the VaR for one of the investments when the confidence level is

95%?

2. What is the expected shortfall when the confidence level is 95%?

3. What is the VaR for a portfolio consisting of the two investments when the

confidence level is 95%?

4. What is the expected shortfall for a portfolio consisting of the two

investments when the confidence level is 95%?

5. Show that, in this example, VaR does not satisfy the subadditivity condition, whereas expected shortfall does.

Q.6: Read the case and answer questions at the end adequately:                              12 marks

Imagine having a management system so successful people that refer to it with capital letters—the Lincoln Management System—and other businesses benchmark their own systems by it. That is the situation of Ohio-based Lincoln Electric. For a number of years, other companies have tried to figure out Lincoln Electric’s secret: how management coaxes maximum productivity and quality from its workers even during difficult financial times. Lincoln Electric is a leading manufacturer of welding products, welding equipment, and electric motors, with more than $1 billion in sales and 6,000 workers worldwide. The company’s products are used for cutting, manufacturing, and repairing other metal products.

Lincoln uses a diverse control approach. Tasks are precisely defined, and individual employees must exceed strict performance goals in order to achieve top pay. The incentive and control system is powerful. Production workers are paid on a piece-rate basis, plus merit pay based on performance. Employees are eligible for annual bonuses, which fluctuate according to the company’s profits, and they participate in stock purchase plans. A worker’s bonus is based on four factors: work productivity, work quality, dependability, and cooperation with others. Some factory workers at Lincoln have earned more than $100,000 a year.

However, the Lincoln system succeeds largely because of an organizational culture based on openness and trust, shared control, and an egalitarian spirit. Though the line between managers and workers at Lincoln is firmly drawn, managers respect the expertise of production workers and value their contributions to many aspects of the business. The company has an open-door policy for all top executives, middle managers, and production workers, and regular face-to- face communication is encouraged. Workers are expected to challenge management if they believe practices or compensation rates are unfair. Most workers are hired right out of high school, and then trained and cross-trained to perform different jobs. Some are promoted to executive positions because Lincoln believes in promoting from within.

One of Lincoln’s founders felt that organizations should be based on certain values, including honesty, trustworthiness, openness, self-management, loyalty, accountability, and cooperativeness. These values continue to form the core of Lincoln’s culture, and management regularly rewards employees who manifest them. Because Lincoln so effectively socializes employees, they exercise a great degree of self-control on the job. There are 100 workers for each foreman. There are less tangible rewards to complement the piece-rate incentive system. Pride of workmanship and feelings of involvement, contribution, and esprit de corps are intrinsic rewards that flourish at Lincoln Electric. Cross-functional teams, empowered to make decisions, take responsibility for product planning, development, and marketing. Information about the company’s operations and financial performance is openly shared with workers.

Lincoln places emphasis on anticipating and solving customer problems. Sales representatives are given the technical training they need to understand customer needs, help customers understand and use Lincoln’s products, and solve problems. This customer focus is backed up by attention to the production process through the use of strict accountability standards and formal measurements for productivity quality, and innovation for all employees. In addition, a software program called Rhythm is used to streamline the flow of goods and materials in the production process.

Lincoln’s system worked so well in the United States that senior executives decided to extend it overseas. Lincoln built or purchased eleven plants in Japan, South America, and Europe, with plans to run the plants from the United States using Lincoln’s expertise with management control systems. Managers saw the opportunity to beat local competition by applying manufacturing control incentive systems to reduce costs and raise production in plants around the world. The results were abysmal and nearly sunk the company. Managers at international plants failed to meet their production and financial goals every year; they exaggerated the goals sent to Lincoln’s managers to receive more resources, especially during the recession in Europe and South America. Many overseas managers had no innate desire to increase sales, and workers were found sleeping on benches because of not enough work. The European labor culture was hostile to the piecework and bonus control system. The huge losses in the international plants, which could not seem to adopt Lincoln’s vaunted control systems, meant the company would have to borrow money to pay U.S. workers’ bonuses, or forgo bonuses for the first time in Lincoln’s history. Top managers began to question whether the Lincoln Management System could be transferred to other countries and wondered whether they simply misunderstood how to apply it in other cultures.

Questions

1. What types of control —feedforward, concurrent, or feedback—are illustrated in this case?                                                                                                                                  4 marks
2. Based on what you have read, what do you think makes the Lincoln System so successful in the United States?                                                                                                 4 marks         

3 -What is the problem with transporting Lincoln’s control systems to other national cultures? What suggestions would you make to Lincoln’s managers to make future international manufacturing plants more successful? 4 marks

The following transactions occurred for White Rock Ltd during year ended May 31, 2020.

As of the start of the year, June 1, 2019, White Rock had $3,500 of automotive

supplies on hand. During the year, it purchased $9,100 in automotive supplies. At

year end, $1,300 of automotive supplies were on hand.

On October 31, 2019, White Rock purchased $88,000 of automotive repair

equipment on account. The equipment has an 8-year useful life.

White Rock signed an agreement to rent warehouse space, starting on February 1,

2020. White Rock paid $8,250 to its new landlord on that date, for six months of

rent paid in advance.

White Rock sold equipment it doesn’t need to another business for $45,000 (e.g.

credit equipment) on March 1, 2020. The buyer paid $5,000 in cash and signed a

9%, 9-month promissory note for the remaining $40,000. The amount owed plus

accrued interest will be received from the buyer on November 30, 2020.

White Rock is open seven days a week. Employees are paid $4,900 in salaries

every two weeks. Employees were last paid on Friday, May 25 (up to and

including Friday of that week). Employees will next be paid on Friday, June 8.

For journal entries, write all your calculations instead of explanations. Record the

journal entries in proper form using the attached blank general journal sheets. Do

not abbreviate the names of the ledger accounts. Marks may be deducted for any

journal entries that do not show calculations.

REQUIRED

(a) Prepare the journal entries to record transactions on October 31, 2019, and

March 1, 2020.

(b) Prepare year-end adjusting journal entries that should be made on May 31,

2020.

(c) Show the presentation of the automotive repair equipment on the May 31,

2020 classified balance. sheet in proper form (e.g. don’t forget the

classification name).

(d) Prepare the journal entry to record payment of employee salaries on Friday,

June 8th

Buffalo Inc., a greeting card company, had the following statements prepared as of December 31, 2020.

Additional information:

Prepare a statement of cash flows using the indirect method. (Show amounts that decrease cash flow with either a - sign e.g. -15,000 or in parenthesis e.g. (15,000).)

Suppose that you are part of the Management team at Porsche. Suppose that it is the end of December 2019 and a novel coronavirus that causes a respiratory illness was identified in Wuhan City, Hubei Province, China. The illness was reported to the World Health Organization and there is heightened uncertainty around the Globe. You (as part of the management team) are reviewing Porsche’s hedging strategy for the cash flows it expects to obtain from vehicle sales in North America during the calendar year 2020. Assume that Porsche’s management entertains three scenarios:

Scenario 1 (Expected): The expected volume of North American sales in 2020 is 35,000 vehicles.

Scenario 2 (Pandemic): The low-sales scenario is 50% lower than the expected sales volume.

Scenario 3 (High Growth): The high-sales scenario is 20% higher than the expected sales volume.

Assume, in each scenario, that the average sales price per vehicle is $85,000 and that all sales are realised at the end of December 2020. All variable costs incurred by producing an additional vehicle to be sold in North America in 2020 are billed in euros (€) and amount to €55,000 per vehicle. Shipping an additional vehicle to be sold in North America in 2020 are billed in € and amount to €3,000 per vehicle.

The current spot exchange rate is (bid-ask) $1.11/€ - $1.12/€ and forward bid-ask is $1.18/€ - $1.185/€. The option premium is €0.025, and option strike price is €0.922. Your finance team made the following forecasts about the exchange rates at the end of December 2020:

• bid-ask will be $1.45/€ - $1.465/€ if the investors (and speculators) consider the euro (€) a safe haven currency during the pandemic.

• bid-ask will be $0.88/€-$0.90/€ if the investors (and speculators) consider the U.S. dollar ($) a safe haven currency during the pandemic

5. Assume that the Scenario 2 (Pandemic) took place in 2020 and the U.S. dollar became a safe haven currency during the pandemic. What are your cash flows (profits) if you did not hedge, hedged using forward contracts, and hedged using option contracts?

6. Based on the calculations in Part B, do you believe that it is a good policy to hedge Porsche’s currency exposure? Why?

Suppose that you are part of the Management team at Porsche. Suppose that it is the end of December 2019 and a novel coronavirus that causes a respiratory illness was identified in Wuhan City, Hubei Province, China. The illness was reported to the World Health Organization and there is heightened uncertainty around the Globe.

You (as part of the management team) are reviewing Porsche’s hedging strategy for the cash flows it expects to obtain from vehicle sales in North America during the calendar year 2020. Assume that Porsche’s management entertains three scenarios:

Scenario 1 (Expected): The expected volume of North American sales in 2020 is 35,000 vehicles.

Scenario 2 (Pandemic): The low-sales scenario is 50% lower than the expected sales volume.

Scenario 3 (High Growth): The high-sales scenario is 20% higher than the expected sales volume.

Assume, in each scenario, that the average sales price per vehicle is $85,000 and that all sales are realised at the end of December 2020. All variable costs incurred by producing an additional vehicle to be sold in North America in 2020 are billed in euros (€) and amount to €55,000 per vehicle. Shipping an additional vehicle to be sold in North America in 2020 are billed in € and amount to €3,000 per vehicle.

The current spot exchange rate is (bid-ask) $1.11/€ - $1.12/€ and forward bid-ask is $1.18/€ - $1.185/€. The option premium is 2.5% of US$ strike price, and option strike price is $1.085/€. Your finance team made the following forecasts about the exchange rates at the end of December 2020:

• bid-ask will be $1.45/€ - $1.465/€ if the investors (and speculators) consider the euro (€) a safe haven currency during the pandemic.
• bid-ask will be $0.88/€-$0.90/€ if the investors (and speculators) consider the U.S. dollar ($) a safe haven currency during the pandemic

1. Assume that the Scenario 2 (Pandemic) took place in 2020 and the U.S. dollar became a safe haven currency during the pandemic. What are your cash flows if you did not hedge, hedged using forward contracts, and hedged using option contracts?   

2. Based on the calculations in Part B, do you believe that it is a good policy to hedge Porsche’s currency exposure? Why?

Question 3 (30 pts)

Kobani Corporation produces high quality Greek yogurts that pass through three departments – Fermentation Department (Department I), Mixing Department (Department II), and Packaging Department (Department III).

The production process in the Mixing Department requires the input of two main types of ingredients. One is the basic ingredients and the other one is the special ingredients. 100% of the basic ingredients are added at the beginning of the process. For the special ingredients, they are added gradually. 30% of these special ingredients are added at the beginning of the process, 50% are added midway through the process and the remainder of the special ingredients are added at the three-quarter way through the process.

The following information was available concerning the operation of the Mixing Department for the month of October 2020.

Beginning work-in process (WIP) (1 October 2020): 2,500 units were 40% completed with respect to conversion costs (CC). Costs pertaining to the beginning WIP as at 1 October 2020 were: Department I $10,000, Basic Ingredients $30,000, Special Ingredients $15,000 and CC $10,000.

Units started in the month were 15,000 units. Costs added to production during the month of October 2020 were: Department I $60,000, Basic Ingredients $188,750, Special Ingredients $203,400, and CC $154,500.

Ending WIP as at 31 October 2020 were 3,500 units and 70% completed with respect to CC.

Required:

A) Use of the weighted average (WA) process costing method, calculate

i. the units completed in October 2020.
ii. the equivalent units for the Special Ingredients.
iii. the total costs per equivalent unit.

iv. the total costs of completed products transferred to the Packaging Department.

B) Use the first-in-first-out (FIFO) process costing method, calculate

v. the units completed in October 2020.
vi. the equivalent units for the Special Ingredients.
vii. the total costs per equivalent unit.

viii) the total costs of completed products transferred to the Packaging Department.

C) Discuss the main differences of the FIFO method as compared to the weighted average method. In what situation will the results from the two methods produce similar result?

Problem-Solving Case: Motivating Employees at Nucor Corporation Today Nucor Corporation is the largest producer of steel in the United States, so it is hard to believe it was once an underdog in a struggling industry. What has set the company apart is a focus on moti- vating and empowering employees. The employee focus is illustrated by the custom of printing each individual’s name on the cover of Nucor’s annual report. But the concern for employees is much more practical and goes far beyond symbols. Nucor’s pay system is remarkable. At all lev- els of the company, the largest share of employ- ees’ income is tied to their performance. Base pay for a Nucor steelworker is near $10 per hour, far below the industry range of $16 to $21. But on top of that, steelworkers can earn a bonus based on the amount of defect-free steel pro- duced during their shift. Those bonuses can tri- ple the workers’ pay, taking it far above the industry average. Tying the bonus to the entire shift’s performance also motivates employees to cooperate to get the job done. In addition, the company pays out profit sharing, encouraging employees to care about the entire company’s performance. The company computes the bonus on every order of steel and pays it weekly, so employees have plenty of reinforcement. In 2005, a typical Nucor steelworker earned $79,000 plus $2,000 from a special bonus celebrating record earnings for the company plus nearly $18,000 in profit sharing. Managers receive sim- ilarly large amounts of their pay in the form of bonuses and profit sharing. For employees new to Nucor, often used to relying on base pay, the compensation arrange- ment seems alarming at first. Once they get a taste of bonuses, however, they become highly moti- vated. When Nucor acquired a steel plant in Auburn, New York, workers wanted to keep their old pay system, so management simply contin- ued paying them the old way but announcing what they would have made under Nucor’s sys- tem. Eventually employees began to see that a new way of thinking could fill up their pocket- books. Auburn, says that before Nucor acquired his plant, workers in his group tended to relax when- ever an earlier stage of operations slowed down. But with a bonus riding on their shift’s output, the employees no longer think of themselves as separate groups: “Wherever the bottleneck is,” explains Hutchins, “we go there, and everyone works on it.” Before long, output in Auburn was up, and so were paycheck totals. Motivation at Nucor is about more than pay, however. The company encourages employees to share ideas and empowers them to make deci- sions and solve problems. Supervisors, for exam- ple, make decisions more typical of a plant manager. Once, following the failure of an electri- cal grid at the Hickman, Arkansas, plant, a group of electricians at Nucor facilities in Decatur, Alabama, and Hertford County, North Carolina, traveled to Hickman to work on the problem. They did not need to get a supervisor’s approval; they just needed to do what they determined was most important. Along with cooperation, Nucor fosters friendly competition in order to stimulate creative think- ing. For example, plants often hold contests among the shifts to see which one can meet a goal related to output, safety, or efficiency.

Questions -

How does performance-based pay motivate Nucor employees? Would this pay system be effective if Nucor did not also empower employees to make decisions? Why or why not?

Supervisors do not set up the pay system for a large company like Nucor. How can Nucor’s supervisors contribute to employee motivation?

Does the description of Nucor sound like an organization in which you would feel motivated? Why or why not? Which theory of motivation would best explain your feelings?

Please do some outside research, and provide guidance as to which states are favorable sites for incorporation and why. Your answer should contain an assessment of at least four states you deem favorable; you should look at the issue from various perspectives such as management, legal issues, takeovers, etc.