Hong Kong Baptist University

Msc in Finance (FinTech and Financial Analytics)

The First Trimester Examination, 2019-2020
FIN7810: Investment and Portfolio Analysis
Name: ID:

• Before you start

There are six big questions and you have two hours, from 7:00PM to 9:00PM, to work
on them. Read carefully each problem and make sure you answer all the questions.
There are 49 points in total.

• After you start

Write down your answers in white A4 papers. Clearly mark the question number, for
example, 1(a) and 1(b), before you provide the answers. Justify all answers and show
all work. Label all diagrams clearly. And most importantly, write legibly. In case
you can not answer a question, clearly state why not and what information
is missing.

• When you finish

1. Write your name and student ID on each page of your answer paper.
2. Take photos for each page of your answer. Ensure good lighting for legibility.
3. Combine all photos and convert them into ONE PDF file.
4. Submit your PDF by 9:15PM to avoid penalty.

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1. Consider the following Treasury securities.

• Security A is a 182-day T-bill with $200 par value and 0.5% yield
• Security B is a 52-week T-bill with $150 par value and 0.6% yield
• Security C is a 2-year T-note with $100 par value, 8% coupon, and 0.8% yield

Answer the following two questions.

(a) Calculate the prices of A, B, and C. [3 points]

(b) Calculate the price of the 1.5-year discount bond B1 1 , assuming $1 par value.
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[3 points]

2. Micah is investing in the stocks of the company KNS. KNS just paid a dividend of $1
per share (D0 = 1). Micah expects the dividend growth rate to be -10% for Year One
and 5% for Year Two. Afterwards, Micah believes the growth rate to be constant at
g forever. Micah uses CAPM model to determine the discount rate (expected rate of
return). And he calculates the following: E(rm ) = 6%, rf = 1%, and βKN S = 0.6.

(a) If g = 3%, what is Micah’s estimate of the current price using the Dividend
Discount Model? [3 points]
(b) Suppose that the current price of KNS is $120 and Micah decides to short sell 100
shares of KNS stock using margin. The initial margin requirement is 50%. How
much does Micah have to deposit into the margin account? [1 point]
(c) If the price goes up to $140 per share and the maintenance margin is 35%, will
Micah receive a margin call? [1 point]
(d) Suppose Micah receives a margin call under 2(c). What is the minimum amount
of cash that Micah can use to bring the margin back to 35%? [4 points]

3. Stocks A, B, C and D have the same standard deviation of 10% and the same expected
return of 5%. The following table shows the correlation coefficient between the returns
on these stocks. (note that correlation with itself is always 1).

Stock A Stock B Stock C Stock D

Stock A 1.0
Stock B -0.4 1.0
Stock C 0.9 0.1 1.0
Stock D -0.1 -0.2 -0.5 1.0

(a) Consider a portfolio P = 13 ◦ A + 13 ◦ B + 13 ◦ C, calculate the portfolio’s expected

return E(rP ) and its volatility σP . [3 points]
(b) If your current portfolio is entirely invested in Stock A and you have another
$100 that you can spend on ONLY one of these four stocks. Assume you are risk
averse, which stock would you choose? Explain your answer. [3 points]

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 (c) Would your answer to 3(b) change if you were risk loving? Explain. [2 points]
(d) Would your answer to 3(b) change if you can also invest in risk-free asset F with
interest rate of 5%? Again assume that the additional $100 can only be spend
entirely on A, or B, or C, or D, or F. Explain your answer. [4 points]
(e) Bonus: What is the optimal portfolio for a risk-averse investor? Assume the
investor can invest in Stock A, B, C, D, and risk free asset F (rf = 5%) simulta-
neously. [3 points]

4. The market has three assets. In addition, ρAB = −1.

F A B
E(r) 0.08 0.25 0.16
σ 0 0.3 0.1

(a) If a risk-averse investor can only choose to invest in ONE asset, which asset would
he choose? Why? [2 points]
(b) If a risk-averse investor can only choose EITHER A or B (but not a portfolio
consisting of A and B) to form a portfolio with F, which one would the investor
choose? Why? [2 points]
(c) Suppose that P ∗ is the tangent portfolio consisting of risky assets A and B. Let
the weight on A be ω. How do you solve for P ∗ ? Write down the objective
function. [Hint: you do not have to solve it. ] [2 points]
(d) The investor forms a new portfolio P̃ which combines P ∗ and F to maximize his
mean-variance utility. The investor’s utility at P̃ is U1 . Now suppose that the
rate of risk-free asset rf increases to 10%. The investors will recalculate P ∗ , form
a new P̃ , and achieve a new utility level of U2 . If the investor is extremely risk
averse, which utility level is greater, U1 or U2 ? Would your answer change if the
investor is less risk averse? [3 points]

5. Investors attribute all securities’ systematic risks to one single factor. Suppose portfo-
lios A and B are well-diversified. We know

A B
β 0.3 0.9
E(r) 8% 16%

(a) For a portfolio P = 0.2 ◦ A + 0.8 ◦ B, what is the expected return E(rP ) of the
portfolio? What is its beta βP ? [2 points]
(b) Bonus: What is σP , the volatility of the portfolio P ? Assume that the volatility
of the single factor is 20%. [3 points]

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 (c) If A and B are fairly priced, what is the risk-free interest rate? [Hint: risk-free
asset has zero beta and zero idiosyncratic volatility.] [3 points]
(d) Suppose that there is a portfolio D with βD = 1.2. What is E(rD ) under the
Arbitrage Pricing Theory? [3 points]

6. Sebastian believes in a two-factor model and the Arbitrage Pricing Theory. The two
factors are F1 and F2 . Let rF1 and rF2 be the monthly factor portfolio returns. Sebastian
employs the two-factor model to calculate the benchmark returns for Kainos Wealth
Fund’s portfolio P . P is well-diversified. Using historical monthly data, Sebastian
calculates the following parameters:

Historical Estimates
Average of rP 1.5% (monthly)
Average of rF1 2.5% (monthly)
Average of rF2 1.8% (monthly)
Beta βP 1 2/3
Beta βP 2 -0.2
Average of rf (91-day T-bill) 0.5%
Average of rf (28-day T-bill) 0.1%

Sebastian will only invest in Kainos if P earns positive alpha in the past 5-year window.
Will Sebastian invest? Numeric results required. [5 points]