Midterm Exam

Investments
May 2010
Instructions:
This exam has seven questions worth a total of 100 points. Be sure to attempt to answer
all questions.
Provide neat, concise answers.
Please show your work. Partial credit will be given for incorrect answers.
Budget your time carefully. The maximum total time available for the exam is 2.5 hours.

Q1. (10 points) Based on the information given in the table (P: price. Q: quantity), calculate:

P0 Q0 P1 Q1 P2 Q2
Stock A $70 200 $72 200 $36 400
Stock B $85 500 $81 500 $81 500
Stock C $105 300 $98 300 $98 300
A) (3 points) For each stock, calculate the rate of return for the first period (t=0 to t=1).
Stock A: 2/70=2.9%, Stock B: -4/85=-4.7% Stock C: -7/105=-6.7%
B) (3 points) For a price-weighted index of the three stocks, calculate the rate of return for
the second period. Assume that Stock A had a 2-1 split during this period.
Index1=(72+81+98)/3 Index2=(36*2+81+98)/3 Rate=(index2-index1)/index1=0
C) (4 points) Calculate the first-period rates of return (from t=0 to t=1) on a
market-value-weighted index, an equally-weighted index, and a geometric index.
The total market value at time 0 is $70*200 + $85*500 + $105*300 = $88,000. The total
market value at time 1 is $72*200 + $81*500 + $98*300 = $84,300. The return is
$84,300/$88,000 – 1 = -4.20%.
The return on Stock A for the first period is $72/$70-1 = 2.86%. The return on Stock B for
the first period is $81/$85-1 = -4.71%. The return on Stock C for the first period is
$98/$105-1 = -6.67%. The return on an equally weighted index of the three stocks is
(2.86%-4.71%-6.67%)/3 = -2.84%.
The geometric average return is [(1+.0286)(1-.0471)(1-.0667)](1/3)-1 =
[(1.0286)(0.9529)(0.9333)]0.3333 -1 = -2.92%

Q2. (5 points) Suppose you purchased 500 shares of ABC Corp. at $50 per share using margin.
The margin requirement is 60% and the annual interest on margin is 10% per year. If you sold the
stock after a year for $45 and had received no margin calls, what return did you make on your
investment?

(((45-50) 500-500 50 0.4 0.1)/(500 50 0.6))= -0.233

Q3. (16 points) You are in charge of the bond trading and forward loan department of a large
investment bank. Market prices for 1, 2 and 3 year pure discount bonds (zero coupon bonds) with
face value of $100 are displayed on your computer terminal as follows:
 Years to Maturity 1 2 3
Price 98 96 90

(a) ( 8 points) A new summer intern from Tsinghua has just told you that he thinks that 3
year treasury notes with annual coupons of $30 and face value of $1,000 are trading for
$1,000. Would you ask the intern to recheck the price of this coupon bond? If so, why? If
the intern did find such a price from the market, what action would you recommend?
(b) (4 points) A customer approaches you looking for a quote on a loan of $20 million
dollars to be received by the customer one year from now. The customer will repay the
loan two years from now. What forward interest rate would you quote for your
customer?
(c) (4 points) Suppose that your customer is willing to enter into the loan agreement of part b.
How would you structure your holdings of pure discount bonds so that you can exactly
match the future cash flows of this loan?

Q4. (10 points) Suppose an insurance company must make payments to a customer of $10
million in 1 year and $4 million in 5 years. Assume the yield curve is flat at 10%.
A) (5 points) What are the duration and convexity of the insurance company’s liability?
PV=10/(1+0.1)+4/(1+0.1)^5=11.575
PV1=10/(1+0.1)=9.091 PV2=2.484
Duration=9.091/11.575*1+2.484/11.575*5=1.86
Convexity=[9.091/11.575*(1+1)+2.484/11.575*(5+5^2)]/(1+0.1)^2=6.62

B) (5 points) If the company wants to fully fund and immunize its obligation with 1
zero-coupon bond, what should it buy? What will the zero-coupon bond cost? (Assume
the company’s primary concern is duration)
Cost=11.575, a zero coupon bond with 1.86 years to maturity.
Q5. (8 points) Suppose you are a financial analyst for XYZ Company, and you are required to
evaluate the impact of an acquisition of ABC on XYZ’s risk. You have collected the following
data:
XYZ ABC
Stock price $60 $20
Outstanding Number 13.25 million 10 million
beta 1.0 2.0
standard deviation 20% 80%
Your estimation shows that correlation coefficient between XYZ and ABC stock returns is 0.3
A) (4 points) How would acquiring ABC Company affect XYZ Company’s beta?
Beta=(60*13.25*1+20*10*2)/( 60*13.25+20*10)=1.2

B) (4 points) If the acquisition is successful, what is the standard deviation of the merged
firm’s stock return?
W1=0.8 w2=0.2
Std=(0.8^2*0.2^2+0.2^2*0.8^2+2*0.2*0.8*0.2*0.8)^0.5=32%

Q6. (18 points) Based on the risk and return relationships of the CAPM, supply the missing values
in the following table (Show your calculation):

Security Expected Return Beta Standard Deviation Non-Market Risk

(%) (%) ( 2 i) ((%)2)
A 0.8 81
B 19.0 1.5 36
C 15.0 12 0
D 7.0 0 8
E 16.6 15

Solution:

From security D, we know R_{f}=0.07

From security B, we have: 0.19=0.07+1.5 (R_{m}-0.07), so
R_{m}=0.15.
From security C, we know 0.15=0.07+ (0.15-0.07), = 1.0
We have _{m}=0.12
A: expected return=0.07+0.8 (0.15-0.07)= 0.134
std.=(0.0081+0.8² 0.12²)^{0.5}= 0.13159
B: std.=(0.0036+1.5² 0.12²)^{0.5}= 0.18974
C: beta=1
D: non-market risk=0.0064
 E: 0.166=0.07+ (0.15-0.07), beta= 1. 2
non-market risk=0.15²-1.2² 0.12²= 1. 764×10 ³

Q7. (15 points) Suppose that there are two independent economic factors F1 and F2. The risk-free
rate is 6%, and all stocks have independent firm-specific components with a standard deviation of
45%. The following are well-diversified portfolios:

Portfolio Beta on F1 Beta on F2 Expected return

A 1.5 2.0 31%
B 2.2 -0.2 27%

A) (5 points) What is the factor 1 mimicking portfolio’s expected return?

B) (5 points) What is the expected return-beta relationship (or the pricing equation) in this
economy?
C) (5 points) There is a well-diversified portfolio C with beta 1 on F1 and beta 0.5 on F2.
Its expected return is 20%. Is there any arbitrage opportunity? What will you do?
Solve: 0.31=0.06+1.5x+2y
0.27=0.06+2.2x-0.2y
X=0.1 y=0.05;
A) E(F1)=0.06+1*0.1=0.16
B) Pricing equation: E(r)=0.06+beta1*0.1+beta2*0.05
C) E(r)=0.06+1*0.1+0.5*0.05=0.185<0.2
Buy C, short a portfolio of A and B, and risk-free asset.
In the portfolio of A &B, A and B’s weights are solved by:
1.5x+2.2y=1
2x-0.2y=0.5
X+y+z=1
Solution: [x=0.27660,y=0.26596,z=0.45745]

Q8. (18 points) Assume CAPM correctly prices all the assets. You have the following data:

A) (3 points) Find the expected returns of Stock A, B, and C.

E(A)=0.05+2*0.10=25%
E(B)=0.05+3*0.1=35%
E(C)=0.05+0.5*0.1=10%
B) (5 points) Assume you have a risk aversion coefficient of 5. Also assume that you can
only hold one of the three risk assets (A, B, or C) in combination with the risk-free asset.
Which of the three should you hold, and why? How would you answer change if your risk
aversion coefficient were very large?
Compare Sharpe ratio S(A)=0.2/0.25=0.8, S(B)=0.6, S(C)=0.5.
Answer has nothing to do with risk aversion coefficient.

C) (10 points) Now assume you have a restricted pension plan, and as a consequence must
put all of your wealth in some combination of A, B, and the risk-free asset. However you
can choose any combination you want. Determine the relative weight of stock A to stock
B in your final portfolio. For this calculation, you should assume that the correlation
between the returns of A and B is 48%.
Solve r(A)-rf=Z1*sigma(A)^2+Z2*sigma(A*B)
r(B)-rf=Z1*sigma(A*B) +Z2*sigma(B)^2
Z1/Z2=relative weight=0.5322/0.1123=