BUSN 20400

Final Examination
Winter 2021

Answer all of the questions on the exam. The exam is out of 270 points in total.

• The exam is open-book and open-notes, so you can use the lecture slides and/or the textbook. You
are not allowed to use the internet.

• Partial credit will be awarded, but you must show your work logically and clearly to receive it.

• Please report answers to 4 significant digits – report 7.4127528% as 7.413%.

• You are allowed to use a calculator for the exams; however, all optimization problems must be solved
using algebra (first-order conditions), not optimization software. For example, you will not be given
full credit if you calculate an answer by plugging inputs into Excel Solver or similar optimization
software.

• Some questions are labelled “hard”. If you get stuck on these, I would suggest working on other parts
first and coming back to these later.

• Remember to answer the questions using the tools, models, and frameworks we learned in class.

You must adhere to the standards of the Booth Honor Code and Booth Standards of Scholarship. You must
sign the following statement to receive credit for this exam. The relevant part for the exam is the following:
No student shall represent another’s work as his or her own. No person shall receive disallowed assistance of any
sort, or provide disallowed assistance to another student, at any time before, during, or after an examination or with
respect to other graded work for a course.
That is to say: you agree not to discuss or receive advice from anyone about this exam, including, but
not limited to, your classmates in this class.

Signed:

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Question 1
(70 points). Are the following statements true or false? Provide a short justification for your answer. (You
are evaluated on your justification.) Remember that a statement is false if any part of the statement is false.

a) (10 points). Suppose the CAPM holds. Suppose an asset A has a lower standard deviation than the
market portfolio, that is,
σA < σmkt
Then, the expected return on asset A must be lower than the expected return on the market portfolio.

b) (10 points). The CAPM states that returns are based on market risk. Thus, any two assets with the
same correlation with the market must have the same risk premium (and thus the same expected
return).

c) (10 points). Suppose that you are a mean-variance optimizer. The risk-free rate is rf . You can invest in
2 risky assets, with expected returns E [r̃A ] , E [r̃B ]. Suppose both risky assets have expected returns
strictly lower than the risk-free rate:

E [r̃A ] < rf , E [r̃B ] < rf

The risk-free asset mean-variance dominates both assets, so these risky assets do not expand your
investment opportunity set. Thus, a mean-variance investor would invest her entire portfolio in the
risk-free asset.

d) (10 points). Suppose arbitrage pricing theory holds, so returns of all assets are determined by their
factor loadings on a small set of priced risk factors. The risk-free rate is rf . Suppose two stocks, A and
B, are perfectly positively correlated. Both stocks are risky: the return standard deviation of both is
greater than 0. If stock A has an expected return greater than the risk-free rate rf , then stock B must
also have an expected return greater than rf .

e) (10 points). Suppose that the yield curve is upwards sloping, until time T . That is, spot rates r1 , . . . rT
satisfy:
r1 < r2 < . . . < rT
Then, the sequence of one-year forward rates rt,t+1 must be increasing, until time T . That is, we must
have:
r1 < f1,2 < f2,3 < . . . fT −1,T

f) (10 points). Consider two bonds, A and B, with face value $1000. The coupon rate of A is higher than
the coupon rate of B. As long as both bonds are trading below par, the yield-to-maturity of bond A
must be higher than the yield-to-maturity of bond B.

g) (10 points). A European call option on a non-dividend-paying stock, with a non-negative strike price,
cannot be worth more than twice as much as the price of the stock.

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Question 2
(60 points). Suppose today the yield curve for the next 3 years is:

Maturity Yield
1 year 0.5%
2 year 1.0%
3 year 1.2%

a) (10 points). Compute the prices B1, B2 and B3 of the 1-year, 2-year and 3-year zero coupon bonds
with face value $100.

b) (10 points). Suppose your friend wants to engage today in a forward loan with you: she will borrow
money 1 year from now, and repay the loan 3 years from now. What is the fair annual rate that you
should charge for this loan?

c) (10 points). What is the fair price of a 3-year coupon bond with face value $1000 (to be paid in 3
years), and an annual coupon rate of 5%?

d) (10 points). Today you find that the market price of the bond in (c) is actually $1, 012.21. You want
to arbitrage this mispricing using the coupon bond, together with 1-year, 2-year, and 3-year strips
available at the fair prices computed in (a). You want to maximize your profits, but your broker does
not allow you to have more than $100,000 total in your short position. Explain how you would carry
an arbitrage. What is the maximum arbitrage profit you can obtain today? Indicate the exact holdings
in each asset. Assume that you are allowed to hold fractions of a strip.

e) (10 points). Now assume that the bond in (c) is correctly priced. You are told that the yield-to-maturity
of the bond is 1.18%. Compute its duration and modified duration. If all yields-to-maturity increased
by 1%, use the modified duration to give the approximate formula for the percentage change in the
price of the coupon bond. Compute also the exact percentage change in price, using the same method
you used in (c). What explains the difference?

f) (10 points). Assume that the yield curve is currently as in the table given at the beginning of this
problem. Your company has a liability of $1 million due in 2 years, that you must fund by only
investing in the coupon bond in (c) and a 1-year strip. What is the dollar amount that you should
invest in each asset so that you are immunized against changes in interest rates?

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Question 3
(50 points). You run an oil company, which can invest in three projects numbered 1, 2, 3. The projects’
returns depend on oil prices, F̃, and also project-specific risks, ˜ 1 , ˜ 2 , ˜ 3 . Payoffs of the projects are:

r̃1 = 0.02 + ˜ 1
1
r̃2 = 0.06 + F̃ + ˜ 2
3
r̃3 = 0.04 + F̃ + ˜ 3
The covariance matrix of ˜ 1 , ˜ 2 , ˜ 3 , is:
   
σ2,1 σ,1,2 σ,1,3 0.01 0.01 0.02
 σ,2,1 σ2,2 σ,2,3  =  0.01 0.08 −0.06 
σ,3,1 σ,3,2 σ2,3 0.02 −0.06 0.16

F̃ is independent of all ˜ 1 , ˜ 2 , ˜ 3 , and has mean 0 and standard deviation σF = 0.3. The risk-free rate is
rf = 1%.

a) (10 points). Calculate the covariance matrix between r̃1 , r̃2 , r̃3 .

b) (10 points). Suppose the firm owner is a mean-variance optimizer, whose only options for investment
are the three projects the firm has access to. The firm owner can borrow or lend an infinite amount
at the risk-free rate. Solve the firm owner’s optimal portfolio problem, by calculating the tangency
portfolio weights on assets 1, 2, and 3. What is the Sharpe ratio of the tangency portfolio?

c) (5 points). Now, suppose you have a security h whose payoff is:

r̃h = rf + 2F̃ + ˜ h

For the rest of the question, suppose that each unit of asset 1, asset 2, asset 3 and asset h has a fair
market price of $100. If you hold one unit of asset 2, how many units of asset h you should long or
short in order to neutralize your exposure to oil price risk (i.e. so that you have no exposure to F̃)?
How about using asset h to neutralize one unit of asset 3?

d) (5 points). Using your answer to part C, construct 3 “hedged assets” a, b, and c. Asset a is a
combination of one unit of asset 1 and some number of units of h, such that a has no exposure to
factor F̃. Likewise, b is a combination of one unit of 2 and some number of units of h, and c is a
combination of one unit of 3 and some number of units of h. Write expressions for the returns of these
hedged assets. These should express r̃a , r̃b , r̃c in terms of ˜ 1 , ˜ 2 , ˜ 3 , ˜ h , and numbers.

e) (10 points). Suppose ˜ h is uncorrelated with ˜ 1 , ˜ 2 , and ˜ 3 , and has a 0 mean and a standard deviation
of σh = 0.4. What is the variance-covariance matrix of r̃a , r̃b , r̃c ? What is the tangency portfolio of
these new assets, and what is its Sharpe ratio?

f) (10 points). Imagine you are a dealer, this oil company is your client, and you are trying to sell asset
h to this company. Building on the answers above, pitch asset h to the company. In particular, how
should the company use h? How does using h affect the company’s optimal project choice? How
does h affect the company’s optimal risk and return?

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Question 4
(40 points total)

a) (10 points). You are a junior trader at ALZ Investments Corp, responsible for trading gold futures
contracts. The price of one ounce of gold is $1,800. For simplicity, suppose the interest rate is 0%. The
annual storage cost of gold is $20 per ounce per year. Consider two gold futures contracts, expiring 1
year from now (2022) and 2 years from now (2023), respectively. What are the fair prices of these 2
contracts?

b) (10 points). Suppose, next year in 2022, the price of gold rises to $2,000. The interest rate remains at
0%, and the storage cost remains at $20 per year. What will the fair price of the 2023 contract be, in
2022?

c) (10 points). We are back in the present, in 2021. Suppose you think that interest rates will stay the
same, but gold storage costs are likely to decline: you think the cost of storing gold will be $10 from
2022 onwards. However, you have a brokerage account, but no storage space for gold, so you can’t
actually buy any physical gold. How can you use gold futures contracts to make a bet on gold storage
costs declining, without holding any exposure to the risk that gold prices change, and also without
holding any physical gold at any point? Formally, construct a portfolio which profits from gold
storage costs declining, but whose value is unaffected by changes in the level of gold prices, and
which does not require ever buying and storing (or selling) any physical gold.

d) (10 points). You have made substantial profits speculating on storage costs using gold futures
contracts, so you have been promoted to run the firm’s wheat futures desk. For simplicity, assume
interest rates are 0%. We are in March 2021 (month 3), and the price of wheat is currently $5 per
bushel. Consider two wheat futures contracts, expiring in June 2021 (month 6) and September 2021
(month 9). Wheat can be stored for $1 per bushel per month. Wheat can also be planted in March. The
total cost of buying a bushel of wheat seeds, planting the seeds, and growing the seeds into a bushel
of wheat is $3. However, wheat takes six months to grow (i.e. if planted now, it can be harvested in
September). For simplicity, suppose that one bushel can be harvested in September for each bushel
planted in March. What are the fair prices of the June and September wheat futures contracts?

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Question 5
(30 points) You are considering buying options on ALZ Investments Corp (ticker: ALZ) stock. The stock
price could be either 10 or 20 next period. There are two options you are considering. The first is a European
call option with strike 17, whose price is 1.56. The second is a European put option with strike 12, whose
price is 0.92. Calculate the risk-free rate, and the current price of ALZ stock. (Hint: use a one-step binomial
tree).

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Question 6
(20 points) (Note: this question is hard! You may want to treat it as a bonus question.)
A binary option is an option which pays you 1 if a certain event happens, and 0 otherwise. Suppose
there are two time periods t = 1, 2. You buy the option in t = 1, and it pays you in t = 2. In the second
period, the market return r̃m is normally distributed, with expected return E [r̃m ] = 0.06, and and standard
deviation σm = 0.08. The risk-free rate is rf = 0.02. Consider a binary option, which pays 1 if the market’s
return is above 0.06, and 0 otherwise.

a) (5 points) Calculate the expected payoff of the binary option (note: the payoff means how much you
expect to make from holding the option, ignoring how much you paid upfront to get it)

b) (5 points) Suppose the price of the binary option in period 1 is p. Calculate the covariance of the binary
option’s return with the market return r̃m . The answer should be a function of p. (Hint: suppose √
r̃
follows a normal distribution with mean µ and standard deviation σ, then E [(r̃ − µ) | r̃ > µ] = σ√π2 .)

c) (5 points) For (c)-(d), suppose that CAPM holds and that the covariance between the binary option’s
return and the market return is σm,option . Calculate what the expected return on the binary option
must be. The answer should be a function of σm,option .

d) (5 points) What must be the price of the binary option in t = 1?