1.A bull spread, or split strike conversion, strategy has the following components:. Buy a security at price S. Buy one share of the stock. Buy an out of the money (OTM) put option at strike price K1...

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1.A bull spread, or split strike conversion, strategy has the following components:.   Buy a security at price S. Buy one share of the stock.   Buy an out of the money (OTM) put option at strike price K1 where K1 < s. =""   sell="" an="" otm="" call="" option="" at="" strike="" price="" k2="" where="" k2=""> S.    Invest the difference between the call and put premiums at the risk free rate. Assume that a stock has price S=$20 You will invest your whole portfolio in the stock. Assume that you can buy a partial share of the stock if needed. The new 10% OTM put option has a total cost (premium) of $1.05 and the new 10% OTM call option has a total cost (premium) of $1.20. Both options expire in 1 month. The risk free rate is 6% annually. (I am intentionally not giving you the strike prices for the call and put here; you will need to calculate them based on your total investment in the stock). Assume that the put and call premiums are for the whole option position, which includes a partial share in the stock. e. Describe the cash flows at the end of month 1/beginning of month 2.    f. Assume that the stock earns 12% in the second month. What is your portfolio worth? g. What is your rate of return at the end of the second month, relative to the portfolio's value at the end of the first month? (do not round)   h. What would your rate of return had been if you just bought the stock and did not engage in the option trades? 2. Assume that Bank A wishes to protect the value of its loan portfolio. The portfolio is worth $18 billion and has an average rating of BBB. Bank B agrees to protect the entire portfolio with a CDS that costs 90 basis points per year.  Bank B then creates a CDO for $1 billion, and protects the remainder of the assets in a super senior tranche ($17 billion) with a CDS with a large insurer (Insurer A). The annual cost of the super senior CDS is 20 basis points per year. This super senior tranche has a rating of (better than) AAA. The CDO sells $1 billion worth of securities: $700 million of which are rated AAA and have a rate of 3%, and $300 million of which are rated BBB and have a rate of 7%,  The CDO is a separate entity (a special purpose vehicle) that does not have to be consolidated on Bank B's balance sheet. The transaction in this example also includes a CDS between the bank and the synthetic funded CDO with an annual cost of 400 basis points per year. 1) As noted above, the CDO in this example also includes a CDS between Bank B and the CDO with an annual cost of 400 basis points per year. Is the CDO in the example acting as the credit protection seller or the credit protection buyer? (Circle one). Why? 2) What type of assets will the CDO invest in? 3) What is the annual cost to Bank A, in dollars, for this transaction? Note that the cost for Bank A is revenue for Bank B.     4) What is the annual cost to Bank B, in dollars, for this transaction? 5) What is the net revenue to Bank B from this transaction?   6) Why does the insurance on the $1,000,000,000 cost so much more than the insurance on the $17,000,000,000? 3. Assume that you are planning doing a convertible arbitrage trade. Convertible bond characteristics: Annual pay bond: Maturity: 5 years, Par value: $1000, Coupon rate 10%, Price $950  Non-convertible bonds (AKA "straight bonds") are trading for $837.21, implying a YTM of 13% for these bonds. Conversion ratio: 40 (each individual bond is convertible into 40 shares of stock) Conversion price: Par/conversion ratio: $25/share Current stock price: $22/share Stock annual dividend: $2/share Conversion value: Market price of stock x conversion ratio: $22 x 40 = $880 Bond delta: 0.90 a. How many shares of stock do you need to short for each bond in order to be properly delta-hedged?  Conversion ratio x delta = 40 shares x .90 (bond price sensitivity per share) = 36 shares b. What is the trade that you will make? Be specific as to which asset you are buying and what it costs/generates and which you are short-selling and what it costs/generates and what the net cash flow is. c. Calculate the net cash flows and market value gains and losses at the end of one year assuming that the stock price goes down by 20%. Assume that the YTM on the straight bond is 18%. Ignore any interest on short proceeds to make the problem easier. Be sure to consider all other appropriate cash flows and changes in value that happened over this period.  d. What is your return on investment? e. What would your return on investment had been if you had simply purchased the convertible bond and held it for one year? (Hint: Redo #d & #e above without the position in the stock) (You don't need to rewrite everything!)