313 Final Exam

Final Exam - Finance I

Practice Exam 2015

Instructions
WRITE ALL YOUR ANSWER ON YOUR ANSWER SHEETS (DO NOT WRITE YOUR
ANSWERS ON THE EXAM PAPERS)
Use a calculator which is allowed by the exam policy of the school.
Use the formula sheet provided. It also includes a table of cumulative normal
distribution.
Use answer sheets provided by the school. Do not use any blank papers as answer
sheets.
Answer each question (Question 1-4) on a separate answer sheet.
Dont forget to write your name and student ID number on each page of the answer
sheet.
Write clearly. Illegible answers will not be marked.

Important Information
(1) Answer briefly, and show how you got the answer for a numerical question.

(2) You may round to two decimal places to answer numerical questions. (In case of an
interest rate or a probability, you may round to two decimal places in percentage. For
example, you can either answer 0.12% or 0.0012.)

(3) You can state the assumptions you made in your answers in case you cannot understand
the questions properly. However, unnecessarily lengthy answers will be penalized.
Question 1. (25 points)
A. (10 points)

Answer True or False. (WRITE ALL YOUR ANSWERS ON THE ANSWER SHEET. DO NOT WRITE THEM
ON THE EXAM PAPERS.)

i. (2 points) Participating in financial markets allows you to smooth your consumption.

True

ii. (2 points) Financial market is where real assets are traded.

False

iii. (2 points) Land, buildings, equipment, and knowledge are examples of real assets.

True

iv. (2 points) Risk neutral investors require risk premium for holding risky assets.

False

v. (2 points) No arbitrage opportunity implies that equivalent investment opportunities must be

traded at the same price.

True

B. (5 points)

You are an international widget trader. A manufacturing firm in Norway offers to pay you 1 million
NOK today in exchange for a years supply of widgets. Your German supplier will provide you with
the same supply for 0.1 million EUR today. If the current competitive market exchange rates are
0.9491 NOK per SEK and 0.1059 EUR per SEK, what is the value of this deal? (Hint: To use the
valuation principle, you need to convert everything to a common unit such as SEK.)

Norwegian buyers offer = 1,000,000 NOK / (0.9491 NOK/SEK) = 1,053,629.75 SEK.

German suppliers offer = 100,000 EUR / (0.1059 EUR/SEK) = 944,287.06 SEK.

The value of the deal is 1,053,629.75 944,287.06 = 109,342.69 SEK today.

C. (10 points)
The table here shows the prices of securities A and B in each state of the economy. Assume that the
economy is weak with probability 0.3 and strong with probability 0.7 in one year.

Cash Flow in One Year

Security Market Price Today Weak Economy Strong Economy
A 40 20 100
B 80 100 60

i. (2 points) What are the payoffs of a portfolio of one share of security A and one share of security B?

ii. (3 points) What is the market price of this portfolio? What expected return will you earn from
holding this portfolio?

iii. (5 points) Assuming the law of one price, calculate the risk-free rate in this economy. Briefly
explain why (within 100 words).

i. A+B pays $120 in weak economy and $160 in strong economy.

ii. Market price = $120. The expected return is (0.3*120+0.7*160)/120 1 = 23.33%

iii. Suppose that you buy x of A and y of B. Then, you receive 20x+100y in weak economy, and
100x+60y in strong economy. Then, you can choose x and y that equates 20x+100y and 100x+60y to
construct a risk-free portfolio. That is,

20x+100y = 100x + 60y y = 2x

Therefore, you need to buy twice more shares of B than A. For example, you can buy one share of A
and two shares of B. Then, the price is 40+2*80 = $200. The payoff is $220 in any economy.
Therefore, the risk-free rate is 220/200 1 = 10%.

If the risk-free rate is higher or lower than 10%, this gives an arbitrage opportunity. In case the risk-
free rate is higher, you can short sell one share of A and two shares of B, then invest the proceed
into the risk-free asset. If the risk-free rate is lower, you can long one share of A and two shares of B
by borrowing the risk-free rate.
Question 2. (25 points)
A. (10 points)

Answer True or False. (WRITE ALL YOUR ANSWERS ON THE ANSWER SHEET. DO NOT WRITE THEM
ON THE EXAM PAPERS.)

i. (2 points) Capital allocation line (CAL) describes all feasible risk-return combinations available from
allocating the complete portfolio between a risky portfolio and the risk-free asset.

True

ii. (2 points) Passive investment strategy attempts to identify mispriced securities or to forecast
broad market trends

False

iii. (2 points) The Sharpe ratio of the market portfolio should be one.

False

iv. (2 points) Short selling is an advantageous strategy if you expect a stock price to decline in the
future.

True

v. (2 points) Under the CAPM assumptions, stocks of small firms cannot have higher returns than
those of big firms.

False

B. (5 points)

Mr. Simpson has mean-variance preference. That is, his expected utility function is given by

A
EU (r ) E (r ) Var (r )
2

Mr. Simpson has a risk aversion parameter of A = 2. Suppose that the market portfolio has an
expected return of 8%, and its return volatility is 20%. The risk-free rate is given by 3%. What would
be his optimal portfolio choice using those two assets (i.e., the market portfolio and the risk-free
asset)?

YM = (ErM rf)/(A Var(rM)) = (8% - 3%)/(2*20%^2) = 0.625 (62.5%)

1-YM = 0.375 (37.5%)

Therefore, Mr. Simpson invests 62.5% of his wealth in the market portfolio, and 37.5% in the risk-
free asset.
C. (10 points)

Suppose that Mr. Smile have some amount of cash, and he found that he can borrow money at the
risk-free rate of 2% in order to invest more money in the market portfolio. The market portfolio has
an expected return of 8%, and the risk-free rate is 2%.

i. (5 points) Suppose that Mr. Smile wanted to have an expected return of 14%, and decided to
borrow $40,000 at 2% interest rate. What is the initial amount of cash Mr. Smile had? (Hint: Mr.
Smile invests all his money in the market portfolio including his own cash and the amount he has
borrowed at the risk-free rate.)

The portfolio weight on the market portfolio = x

The portfolio weight on the risk-free asset = 1-x

Expected return of the portfolio = 2% + x*6% = 14%

x = 2 or 200%

Therefore, he initially had $40,000.

ii. (5 points) If the return volatility of Mr. Smiles levered portfolio in the previous question is 24%,
what is the return volatility of the market portfolio?

x*SD(RM) = 2* SD(RM) = 24%

SD(RM) = 12%
Question 3. (25 points)
A. (10 points)

Answer True or False. (WRITE ALL YOUR ANSWERS ON THE ANSWER SHEET. DO NOT WRITE THEM
ON THE EXAM PAPERS.)

i. (2 points) Empirical evidence shows that the CAPM has a significant predictability of stocks returns.

False

ii. (2 points) The portfolio weights of a self-financing portfolio sum to one.

False

iii. (2 points) The CAPM may be wrong even when the market is efficient.

True

iv. (2 points) If market is strong-form efficient, past prices do not give any information.

True

v. (2 points) High book-to-market stocks have historically earned higher average returns than low
book-to-market stocks.

True

B. (5 points)

Consider an economy with two types of firms, S and I. S firms always move together, but I firms
move independently of each other. For both types of firms there is a 50% probability that the firm
will have a 30% return and a 50% probability that the firm will have a -20% return.

i. (1 point) What is the expected return for an individual firm?

Expected return = 0.5*30%+0.5*(-20%) = 5%

ii. (3 points) What is the standard deviation for the return of an individual firm?
Standard deviation = sqrt((30%-5%)^2*0.5+(-20%-5%)^2*0.5) = 0.25 or 25%

iii. (3 points) What is the standard deviation for the return of a portfolio of 20 type S firms? Explain
the results within a couple of sentences.
Because all S firms in the portfolio move together there is no diversification benefit, the standard
deviation of the portfolio is the same as the standard deviation of the stocks, which is 25%.

iv. (3 points) What is the standard deviation for the return of a portfolio of 20 type I firms? Explain
the results within a couple of sentences.
The standard deviation of the portfolio is 25%/sqrt(20) = 5.59%. Because Type I stocks move
independently, they only have idiosyncratic risk. Therefore, you can enjoy the benefits of
diversification.

C. (10 points)

Assume that the yields on risk-free zero-coupon bonds are given by the following table:

Maturity (years) 1 2 3 4
Zero-coupon YTM 8% 6% 5% 3%

i. (5 points) Assuming the Law of One Price, what is the price of a three-year, risk-free, coupon bond
with a face value of $1000 and an annual coupon rate of 5%?

$50/(1+0.08)+ $50/(1+0.06)^2+$1050/(1+0.05)^3 = $997.83

ii. (5 points) Choose an appropriate answer which will go into the parenthesis:

A three-year, risk-free, coupon bond with a face value of $1000 and an annual coupon rate of 5%
trades ( (a) at a discount ).

(a) at a discount
(b) at par
(c) at a premium
Question 4. (25 points)
A. (10 points)

Answer True or False. (WRITE ALL YOUR ANSWERS ON THE ANSWER SHEET. DO NOT WRITE THEM
ON THE EXAM PAPERS.)

i. (2 points) Yield to maturity is the discount rate that sets the present value of the promised bond
payments equal to the current market price of the bond.

True

ii. (2 points) An American option cannot be worth less than its European counterpart.

True

iii. (2 points) The value of an option generally decreases with the volatility of the stock.

False

iv. (2 points) OTC markets have advantages such as ease of trading, high liquidity.

False

v. (2 points) Option delta measures the change in the price of the call option given a 1% change in
the price of the stock.

False

B. (7 points)

The current stock price of ABC, Corp is $10. Suppose that an at-the-money call option on ABC stock
is price is trading at $0.50. The stock does not pay any dividend, and risk-free rate is 2% (EAR).

i. (3 points) Calculate the price of a 1 year, at-the-money put option price on ABC stock using put-call
parity.

10 + P = 9.80 + 0.50 P = $0.30

ii. (4 points) You are expecting that the market will be more volatile in the future. To exploit the
higher volatility of ABC in the future, what kind of position would you choose using the results from i
and ii? Briefly explain why (within 100 words).

You can choose either straddle or strangle. For example, in case of a straddle strategy, you would
long one call option and one put option.

Cost = 0.50 + 0.30 = $0.80

If the price goes up above $10 at the maturity, the position returns the payoff of the call option
whose payoff is given by S-10. On the other hand, if the price goes down below $10 at the maturity,
the position returns the payoff of the put option, 10-S. The position returns a positive profit below
$9.2 or above $10.8. As the price goes out of the bound further, this position brings a higher profit.
On the other hand, you lose the initial investment of $0.8 if the price stays within the bound.

C. (8 points)

Suppose that it will be a good market next year with a probability of 70%, but will be a bad market
with a probability of 30%. The market portfolio will go up by 15% in the good market but will go
down by 5% in the bad market. Also, suppose that the current stock price of Montgomery Burns
Bank is $20. It goes up by $4 in the good market but goes down by $2 in the bad market. The one-
year risk-free rate (EAR) is fixed to 2%.

i. (3 points) Assuming the law of one price, calculate the call option price of a one-year, at-the-
money European call option for Montgomery Burns Bank stock.

At-the-money call option pays max(24-20,0) = 4 in the good market, and max(18-20,0) = 0 in the bad
market. Therefore, the replicating portfolio is given by

Delta = (4-0)/(24-18) = 2/3 = 0.66

B = (0-18*(2/3))/1.02 = -11.76

Option price = 20*(0.66) - 11.76 = 1.44

ii. (5 points) Calculate the option elasticity (or leverage ratio) of the call option. When the stock
price changes 1%, what happens to the option value? Discuss the riskiness of this call option relative
to that of Montgomery Burns Bank stock (within 200 words).

Option elasticity (Leverage ratio) = S*Delta/(S*Delta+B) = 20*0.66/1.44 = 9.17

When the stock price increases (or decreases) by 1%, the call options value increases (or decreases)
by 9.17%.

The option elasticity (or leverage ratio) for the call option is 9.17, which is much greater than 1. This
means that a replicating portfolio would have a highly-levered position that involves a long position
on the stock financed by borrowing (or short-selling the risk-free bond). Consequently, the value of
the call option (or the replicating portfolio) is much more volatile than that of the underlying stock
itself. This is why the call option is riskier than the stock.