2019 EXAMINATIONS

PART II (SECOND AND FINAL YEAR)

ACCOUNTING AND FINANCE

AcF 215 Advanced Principles of Finance

Total Time for the Examination: 2 hours

(+ 15 minutes reading time)

Instructions

• The examination is CLOSED BOOK (only a non-programmable calculator and

a dictionary are allowed).

• Section A is COMPULSORY (50 marks).

• In Section B, you are required to answer TWO questions from a choice of three
questions (25 marks each).

All questions should be attempted in the answer book(s) provided.

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Section A (Compulsory)
Answer True or False to each of the 24 statements; 1 mark will be given for
each correct answer.
For each false statement, also explain why the statement is false; 2 marks
will be given for each satisfactory explanation.

1. The value of a European put option increases if the volatility of the underlying
asset price decreases.

2. An American call can only be exercised at maturity.

3. A call option offers the purchaser unlimited upside gain.

4. A risk averse investor will never accept a fair game.

5. A power utility function exhibits increasing ARA and decreasing RRA.

6. The coefficient of risk aversion is negative for an investor with a high degree of
risk aversion.

7. An exponential utility function suggests that individuals become less likely to

gamble as the wealth increases.

8. The current risk-free rate is 0.5%. The Capital Asset Pricing Model states that it
is possible to have an asset with a standard deviation of returns of 5% per year
and an expected annual return of 0.3%.

9. In a complete market, a riskless portfolio with stocks and options may have a
return higher than the risk-free rate.

10. Being able to borrow British pounds at 1% interest and invest them in banks in
Venezuela promising a rate of return of 20% is an arbitrage opportunity.

11. One cannot reduce the systemic risk of the portfolio by including more risky assets.

12. There could be different risk-neutral measures if the market is complete.

13. Investors get rewarded for bearing idiosyncratic risk.

14. The efficient frontier consists of a subset of those portfolios lying along the mini-
mum variance frontier.

15. Investors wishing to reduce their exposure to risks can do so by changing either
their capital allocation decision or their asset allocation and security selection
decisions.

16. The separation theorem argues that investors should separate their overall port-
folio into different asset classes to simplify their investment decisions.

17. Two perfectly correlated assets must have the same expected excess return.
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18. An investment has a beta of 3. This means it will move at three percent above
the benchmark market portfolio.

19. In order for the binomial model to be free of arbitrage, the two stock price nodes
at the next time step cannot be greater or smaller than the current stock price.

20. If there exist two assets, which are perfectly negatively correlated, then it is pos-
sible to form a risk-free portfolio.

21. Assume that there exists a future point in time where the values of two self-
financing portfolios are the same in all states. Then their current values must also
be the same if there is no arbitrage.

22. Constant absolute risk aversion implies increasing relative risk aversion.

23. Two perfectly correlated assets must have the same expected excess return.

24. Assume that a European call with strike price £100 and a maturity in 1 month is
worth £5. The otherwise identical European call with a strike price of £101 has
to be worth strictly less in any arbitrage free market.

(Total for Section A: 50 marks)

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Section B: Answer TWO questions from this Section

Question 25
Answer all parts of the question.
You are an expected utility maximiser with a logarithmic utility function. You have a
house valued at £200,000 and £50,000 in your bank account with an interest rate of
6% per year. There are two states of nature one year later: in state 1, no accidents will
happen to the house while in state 2, an accident will happen and completely destroy
the house. The probability of state 2 is 0.001. Assume that house insurance policies are
available with the cost being 0.1% of the value insured.

REQUIRED

a) If you decide to insure half of the value of your house, what is the certainty
equivalence of your wealth in one year’s time? (8 marks)

b) If you decide to insure the full value of your house, what is the certainty equivalence
of your wealth in one year’s time? (4 marks)

c) Which one will you choose between the above two insurance policies? Explain. (4 marks)

d) An insurance policy is said to be actuarially fair if its cost is equal to the expected
loss. Are you willing to buy an actuarially fair insurance policy? Explain. (No
calculations are required.) (5 marks)

e) Calculate your absolute risk aversion measure and relative risk aversion measure. (4 marks)
(Total for Question 2: 25 marks)

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Question 26
Answer all parts of the question.
a) Suppose that in total there are three states of nature next period and three secu-
rities (A, B, C) in the market. The current prices of securities A and B are 1 and
5 respectively while the price of C denoted by x is unknown. A’s payoff vector is
(1.01, 1.01, 1.01); B’s payoff vector is (8, 6, 2); C’s payoff vector is (1, 2, 3).
Is it possible to determine a single value for the price, x? If so, explain how you
would calculate it. If not, explain why. (You do not have to perform numerical
calculations here). (6 marks)

b) Consider the economy with four assets all with price £1 and the following future
prices in different states of the economy:

Asset 1 Asset 2 Asset 3 Asset 4

State 1 1.05 1.70 2.20 3.00
State 2 1.05 1.20 1.50 1.50
State 3 1.05 1.00 0.70 0.50
State 4 1.05 0.60 0.50 0.20

Let D be the following matrix

 
1.05 1.05 1.05 1.05
1.70 1.20 1.00 0.60
 
2.20 1.50 0.70 0.50
3.00 1.50 0.50 0.20

It is calculated that the inverse matrix of D is

 
0.811 −0.247 −2.099 1.728
−1.605 −0.309 4.877 −2.840
 
−1.252 3.642 −1.543 −0.494
2.998 −3.086 −1.235 1.605

REQUIRED

i) What are the state prices consistent with the absence of arbitrage opportu-
nities? What are the corresponding risk-neutral probabilities? (8 marks)
ii) There is a call option contract available on asset 2 with an exercise price of
1 and one period until expiry. What is the fair price of this option? (6 marks)
iii) There are no call options on asset 3 traded in the market. Explain how to
use the four assets to replicate such a call option. (No numerical calculations
are required.) (5 marks)

(Total for Question 3: 25 marks)

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Question 27
Answer all parts of the question.
a) By considering the formulas for the expected return (µp ) and standard deviation
(σp ) of a portfolio with x invested in the market portfolio and 1 − x invested in
the risk-free asset, show that it is possible to write:

σp E(rM − rf )
µp = + rf .
σM
(8 marks)

b) Assume there are two assets: a risk free asset and the Market Asset, each with
current value of £1. There are two future states of the world with equal probability,
and the payoffs of the two assets are as follows:

Asset 1 Asset 2
State 1 1.05 1.20
State 2 1.05 0.93

REQUIRED

i) An investor, James, who has a logarithmic utility function, is considering

investments in the two assets. What proportion, x, of his wealth (£1) should
he invest in the Market Asset? (8 marks)
ii) Another investor, Tom, who has a utility function u(W ) = −W −1 , is also
considering investments in the two assets. Will he invest a higher proportion
of his wealth in the Market Asset? Explain. (5 marks)
iii) Another investor, William, who has the same utility function as James and
wealth of £200,000. He considers investing all his money in the two assets.
How much should he invest in the Market Asset? Explain. (4 marks)

(Total for Question 4: 25 marks)

END OF PAPER