FN2190 Commentary 2021

Examiners’ commentaries 2021

FN2190 Asset pricing and financial markets
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2020–21. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading

references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2018).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of the course and having completed the essential reading and activities you should be
able to:
describe the important differences between stock, bond and derivative securities
explain how to price assets using both present value and absence of arbitrage methods
apply present value techniques to price stocks and bonds
employ mathematical tools to compute risk and return for portfolios of securities
evaluate portfolio choice problems
present, explain and apply the Capital Asset Pricing Model for computing expected stock
returns
critically evaluate the evidence for informational efficiency of stock markets
price derivative securities using absence of arbitrage.
Covering the syllabus
In order to maximise your chances of performing well in the examination, you should ensure that
you have covered the entire syllabus. Focusing narrowly on a few topics in the hope that these
topics will cover enough material to pass the examination is a strategy which often backfires badly.
Furthermore, do not ignore the theoretical elements of the course – after all, this is a course on asset
pricing theory. Candidates often fall into the trap of assuming that asset pricing is just about doing
1
numerical calculations using a handful of equations. Yes, numerical calculations are important, but
your ability to interpret and evaluate is equally, if not more important, which is difficult to do well if
you do not understand where the equations come from and what they are saying. For example, there
is a lot more to the capital asset pricing model (CAPM) than just plugging numbers into the
security market line (SML) equation. Finally, be aware that, as asset pricing theories and methods
are often inter-related, examination questions can cover material from different chapters in the
subject guide (another reason not to focus too narrowly during your preparation).
Expectations of the examination paper
In general, the examiners are looking to gauge the breadth and depth of a candidate’s understanding
of the asset pricing theories and methods covered in the syllabus. In practice, this means the
examination questions cover a wide range of topics from the syllabus, with sub-questions being set
at varying levels of difficulty so that stronger candidates are able to differentiate themselves.
What does a ‘strong candidate’ look like? A key indicator that a student truly understands a
concept or method is their ability to correctly apply it in a novel context. Because of this, some
parts of the examination are likely to seem unfamiliar; by definition, these are questions which you
will likely not have come across previously. In other words, you should expect to be surprised by
some of the questions. Of course, you will only be examined on material in the syllabus, so all
questions can still be answered using the concepts covered in the syllabus. There will also be enough
routine, familiar content in the examination so that a candidate who has achieved basic competence
in the course should pass, but for candidates aspiring to a high(er) mark, more is expected. Simply
regurgitating previously seen material is not enough; you will have to demonstrate a mastery of the
material by solving new and unfamiliar problems.
Answer the question
A common bugbear among examiners, particularly relating to qualitative questions, is where

candidates simply reproduce materials from the subject guide verbatim without paying attention to
what the question actually asks. This approach results in answers that are often too general (or
sometimes too narrow) and contain irrelevant content. It is important that you read the question
carefully and address what it asks, and only what it asks, not what you would like it to. The
examiners are looking for succinct, focused answers tailored to the requirements of the question.
Although it can be enticing to write down everything you know about a topic so as not to miss
something, excessively long answers containing irrelevant material waste valuable examination time
and actually suggest a lack of understanding, not an abundance of it.
A related issue in the domain of quantitative questions pertains to the choice of solution method.
Often, there will be multiple routes that lead to the correct answer and you will have free rein to use
whichever method takes your fancy. Sometimes, however, a question will specify the exact approach
it would like you to take. Do not ignore this instruction. The examiner has specified an approach
because they want to test your ability to apply a specific technique. It is the technique they are
interested in, not the answer, so do not expect to be rewarded if you ignore the instructions, even if
you get the correct answer.
To avoid falling into these traps, it can be useful to take some time to think about what the question
is asking and how to best answer it before you start writing. This advice applies to any question
type and also to the examination as a whole. Regarding the latter, take some time to read through
the examination paper before deciding which 3 of the 4 questions you will attempt; candidates who
focus their energies on answering 3 questions well tend to do better than candidates who abandon a
question midway to start another. Given the three-hour length of the examination, you can afford to
spend a few minutes to consider your approach. It will be time well spent.
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Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sufficient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.
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Important note

references
section.
Comments on specific questions – Zone A
Candidates should answer THREE of the following FOUR questions. All questions carry equal
marks.
Question 1
Company XYZ has a liability of $100 million due in 5 years. The company’s only
asset is $70 million held in cash. Throughout this question, assume the term
structure of interest rates is flat at 10%.
(a) Determine the present value of the company’s liability.

(3 marks)
(b) Without doing any calculations, briefly explain why holding all its assets in cash
is problematic for XYZ from an interest rate risk management perspective.
(4 marks)
Two bonds, A and B, are currently trading in the market. Bond A is a 3-year
coupon bond with a face value of $100, selling for $93.783; coupons are paid
annually. Bond B is a perpetuity with an initial cash flow of $5 in one year’s time,
with cash flows growing thereafter at 2% per year.
(c) Determine Bond A’s coupon rate and the price of Bond B.
(6 marks)
(d) Calculate Bond A’s Macaulay Duration. Without recalculating the bond price,
estimate the percentage change in the price of Bond A if the entire term
4
structure were to immediately shift upwards by 100 basis points (1 basis point
is one hundredth of 1 percent, i.e. 0.01%).
(6 marks)
(e) Show that the Macaulay Duration of a growing perpetuity with initial cash flow
C1 (at time 1), cash flow growth rate g, and discount rate r is given by:
1+r
DM ac = .
r−g
Using this expression, calculate the Modified Duration of Bond B.

(6 marks)
(f ) To manage its interest rate risk exposure, XYZ proposes creating a portfolio of
bonds A and B such that the following two conditions are met:
• The current values of the bond portfolio and the company’s liability are the
same.
• The change in the value of the bond portfolio in response to a small, parallel
shift in the term structure matches the change in the value of the company’s
liability.
How many units of Bond A and B must the company purchase today? Briefly
explain why this strategy is not static, i.e. why the number of units of each
bond will need to change over time.
(8 marks)
Reading for this question
Subject guide, Chapters 2, 3 and 5.
Approaching the question
(a) Denote the present value of the company’s liability as L. We have:
100m
L= ≈ $62,092,132.
(1 + 10%)5
(b) The value of the company’s liability is interest-rate sensitive, whereas its asset is not,
leaving the company’s net worth/equity exposed to interest rate fluctuations. Net worth
may become negative if interest rates decline sufficiently, such that L > $70m, in which case
the company will be (economically) insolvent.
(c) Bond A: We have:
1 − (1.10)−3

100
PA = 93.783 = c + → c = 7.50.
0.10 (1.10)3
The coupon rate is 7.50/100 = 7.5%.

Bond B: We have:
C1 5
PB = = = $62.50.
r−g 0.10 − 0.02
(d) We have:
3
M ac
X Ct /(1 + 10%)t
DA = wt t where wt = .
t=1
PA
5
t Ct PV(Ct ) wt
1 7.5 6.818 0.0727
2 7.5 6.198 0.0661
3 107.5 80.766 0.8612
M ac
Plugging into the formula, we find DA = 2.789 years.
From the Duration approximation, the approximate percentage change in a bond’s price in
response to a 100 basis point upward shift in the term structure (i.e. ∆r = 0.01) is given by:
∆P
100 × ≈ 100 × (−DM od × ∆r) = 100 × (−DM od × 0.01) = −DM od .
P
Calculating the Modi
ed Duration of Bond A at r = 10%:
M ac
M od DA
DA = = 2.535.
1+r
Therefore, Bond A’s price will fall by approximately 2.535% if the term structure shifts
upwards by 100 basis points.
(e) Let P denote the present value of the perpetuity:

C1
P = .
r−g
Taking the first derivative of P w.r.t. r:
∂P C1
=− .
∂r (r − g)2
Using the definition of Macaulay duration:
−∂P/∂r × (1 + r) C1 (1 + r) (r − g) 1+r
DM ac = = 2
= .
P (r − g) C1 r−g
Since Bond B is a growing perpetuity, its Modified Duration is given by:
DM ac 1 1
DM od = = = = 12.5.
1+r r−g 0.10 − 0.02
(f) The first condition dictates that we need nA and nB units of Bonds A and B, respectively,
such that:
nA PA + nB PB = L.
Using the duration approximation ∆P ≈ −DM od × P × ∆r for each bond and the
company’s liability, and simplifying, we can express the second condition as:
M od M od M od
n A PA D A + n B PB D B = LDL .
We can solve this system of equations directly for the two unknowns, nA and nB .
Alternatively, dividing each equation by L, we arrive at equivalent expressions:
wA + wB = 1
M od M od M od
wA DA + wB DB = DL
where wA = nA PA /L and wB = nB PB /L.

M od M od
We know from (d) and (e) that DA = 2.535 and DB = 12.5. The company’s liability is
M od M ac
effectively a zero-coupon bond, so DL = DL /(1 + r) = 5/(1.10) = 4.545. Using these
inputs and solving for wA and wB :
wA ≈ 0.7982 and wB ≈ 0.2018.
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Then, using PA = $93.783, PB = $62.50, and L = $62.092132m, and solving for nA and nB :
nA ≈ 0.5285m and nB ≈ 0.2004m.
This strategy is dynamic – as time passes, all of the inputs will change (durations, bond
prices etc.), hence the bond portfolio will need be rebalanced (continuously) to maintain its
match with the value and duration of the liability.
Question 2
The table below displays some valuation characteristics for four stocks. Answer the
items below by assuming the CAPM holds, and the risk-free interest rate for
borrowing and lending is 4%.
Stock Share Expected Dividend Plowback Earnings ROE CAPM

Price (P0 ) return Yield (D1 /P0 ) ratio Growth Rate beta
A $50 11.2% 7% 30% 4.2%
B $75 9.4% 60% 6% 10% 0.90
C $64 8.5% 2.5% 50% 6% 12% 0.75
D $32 1.75% 45% 1.50
(a) ‘If a portfolio has a CAPM beta of 1.0, then its realised return must be the
same as that of the market portfolio’. True/false? Explain. (You will be marked
on the explanation(s) provided).
(4 marks)
(b) What is the ROE for Stock A? Explain any assumptions you need to make.
(4 marks)
(c) Determine the dividend yield for Stock B. Explain any assumptions you need to
make.
(4 marks)
(d) What is the Present Value of Growth Opportunities (PVGO) implied by the
price of Stock C? Explain in detail your calculations.
(5 marks)
(e) What is the earnings growth rate for Stock D? Explain in detail your
calculations.
(6 marks)
(f ) Now suppose that the risk-free interest rate for borrowing is greater than 4%
(lenders still receive 4%). For simplicity, assume the optimal risky portfolio is
unchanged. How would the share prices of the four stocks be affected? Explain
fully.
(10 marks)
(a) False. Although the portfolio’s expected return is the same as the market portfolio’s (same
beta), its realised return is not necessarily the same due to the presence of idiosyncratic risk.
7
(b) Using g = ROE × plowback → ROE = 0.042/0.3 = 14%.

Assumptions: constant earnings growth rate and plowback.
(c) Assuming a constant plowback and ROE, so that the dividend growth rate = earnings
growth rate and the stock value follows the Gordon growth model:
D1 D1
P0 = ⇒ r= + g.
r−g P0
Therefore, the dividend yield is:
D1
= r − g = 0.094 − 0.06 = 3.4%.
P0
(d) We have:
EPS1
P0 = + PVGO
r
where:
D1 64 × 0.025
EPS1 = = = 3.20.
(1 − plowback) 1 − 0.5
Therefore:
3.2
PVGO = 64 − = 64 − 37.65 = $26.35.
0.085
(e) Stock D has a CAPM β = 1.5 and the rf = 4%. From the information on Stock C (or B),
determine the expected market risk-premium:
0.085 − 0.04
rC = rf + βC (rm − rf ) → rm − rf = = 6%.
0.75
Therefore, the expected return on stock D is:
rD = 0.04 + 1.5(0.06) = 13%.
Applying the Gordon growth model to Stock D:
D1
g=r− = 0.13 − 0.0175 = 11.25%.
P0
(f) If the risk-free borrowing rate (rfb ) > risk-free lending rate (rfl = 4%), but the optimal risky
portfolio (i.e. market portfolio, M ) is unchanged, then:
• The CML is kinked at M .
∗ The CML to the left of M is the same as before (corresponding to rfl = 4%), whereas
the slope of the CML to the right of M is flatter (corresponding to rfb > 4%).
∗ Therefore, CML portfolios with β > 1 (i.e. those to the right of M ) will have lower
expected returns compared to when rfb = rfl = 4%.
• The impact on each stock’s price will depend on its CAPM β. Since M is unchanged,
there is no change to the β of any stock.
∗ β < 1: Stocks B and C.
∗ β > 1: Stocks A and D (βA = 1.2 is not given but can be inferred from its expected
return using the CAPM and rf = 4%).
• Therefore, all else equal, the price of any stock with β > 1 (Stock A and D) will be
higher (lower expected return); the price of any stock with β < 1 (Stock B and C) will be
the same as before (no change in expected return).
8
Question 3
Answer the following unrelated items.
(a) In a single sentence, explain why an American option is worth at least as much
as its equivalent European option.
(3 marks)
(b) Consider an at-the-money European call option and a European put option on
the same underlying asset (non-dividend paying). Both options have the same
exercise price and same expiration date. Which option has the higher value?
Explain.
(5 marks)
(c) A stock with spot price S is expected to pay a dividend of D in t years.
European call and put options on the stock with exercise price X and maturity
T > t are trading at prices c and p, respectively. The continuously compounded
risk-free rate is r.
i. Show that the following put-call parity relationship holds:
c + Xe−rT + De−rt = p + S.
(6 marks)
ii. The stock price is $4. A 6-month at-the-money European put on the stock
trades at $0.50. The corresponding call trades at $0.30. The continuously
compounded risk-free rate is 10%. Do these prices imply the existence of an
arbitrage opportunity? Explain.
(5 marks)
(d) A house in Sydney has recently sold for $1.5 million. Renting an equivalent
house costs $200,000 per year (paid at year-end). The risk-free rate is 5%
(annually compounded). Suppose the house can either increase in price each
year by 20% or decrease by 10% before rent is paid out (i.e. cum-dividend). For
example, the price can increase from $1.5 million to $1.8 million, so that after
$200,000 rent is paid out (i.e. ex-dividend), the house is worth $1.6 million.
i. What is the price of a 2-year at-the money American call option on the
house? State any assumptions you need to make.
(8 marks)
ii. Holding all else constant, how would each of the following affect your answer
to part (i):
• a decrease in the rent
• an increase in the price of the house
• an increase in the strike price of the option.
In each case, state the direction of the change (i.e. increase the price,
decrease the price, or uncertain) and provide a brief explanation of your
reasoning.
(6 marks)
Subject guide, Chapter 11.
(a) In addition to conferring all the same rights as the equivalent European option, an
American option gives the the holder the right to early exercise.
9
(b) Using put-call parity and noting that the options are at-the-money (i.e. S = X):
c − p = S − PV(X) = S − PV(S) > 0
prior to maturity (assuming a positive rate of interest). Therefore, the call is worth more.
Equivalently, the intrinsic value of both options is zero (the options are at-the-money) but
the call has more time value since, unlike the put, its upside is unlimited.
(c) i. Strategy 1: buy the call, lend risk-free the present value of X due in T years, and lend
risk-free the present value of D due in t years.
Strategy 2: buy the put and buy the stock.
Both strategies produce a cash flow of D at time t (from the risk-free lending of PV(D)
in Strategy 1, and from the stock in Strategy 2) and a cash flow of max(X, ST ) at time T
(from the combination of the long call and the risk-free lending of PV(X) in Strategy 1,
and from the combination of long put and stock in Strategy 2).
Since both strategies produce the same future cash flows, the absence of arbitrage
implies they should cost the same today.
ii. Not necessarily. We have:

p + S = 0.5 + 4 = $4.50
and:
c + Xe−rT = 0.3 + 4e−0.1×0.5 = 4.105.
However, from the put-call parity relationship in (i), this does not imply the presence of
an arbitrage as long as:
De−rt = 4.5 − 4.105 = 0.395.
Otherwise, there is an arbitrage opportunity.
(d) i. Noting that u = 1.2 and d = 0.9, the house (underlying) price dynamics (in $m) over the
next two years are as follows:
where q, the risk-neutral probability of a year-on-year increase in the house price is:
1 + rf − d 1.05 − 0.9
q= = = 0.5.
u−d 1.2 − 0.9
10
The corresponding tree (in $m) for the American call option (X = 1.5) is:
where the call option at the d-node is worthless because it is certain to expire worthless
if held and is not worth exercising immediately. At the u-node, the value of holding on to
the option (cH E
u ) versus exercising immediately (cu ) is:
qcuu + (1 − q)cud
cH
u = = 0.2 < cE cum
u = max(Su − X, 0) = 0.3.
1 + rf
Hence, early exercise is optimal at the u-node. Therefore, the value of the American call
option today is:
qcu + (1 − q)cd 0.5 × 0.3
c0 = = = $0.143m.
1 + rf 1.05
ii. Holding all else constant, the value of the option will:
∗ Uncertain: if the decrease in the rent (i.e. dividend) is insufficient to change the
optimal exercise policy in the u-node and/or continuation value in the d-node, then
the price of the option will remain unchanged. However, if the decline in rent is large
enough to change either of these (for example, early exercise is no longer optimal),
then holding on to the option becomes more valuable and the option price will rise.
∗ Increase: call option value is increasing in the price of the underlying asset (larger
expected payoff).
∗ Decrease: call option value is decreasing in the exercise price (smaller expected
payoff).
Question 4
(a) Leasing a machine requires making monthly payments of $5,000 for the next 5
years (i.e. at t = 1, 2, . . . , 60). Buying the machine today (t = 0) will cost you
$250,000. Assume the machine is worthless after 5 years. You can borrow and
lend at a quarterly compounded interest rate of 6% (APR). Would you be
better off by buying or leasing? Explain.
(5 marks)
(b) We are currently at year 0. Consider a perpetuity that pays $150 at the end of
each odd year and $250 at the end of each even year. The term structure is flat
at 10% per year. Determine the present value of the perpetuity.
(5 marks)
(c) Assume the CAPM holds. The return on asset ABC is perfectly correlated with
the return on the market portfolio. Your friend makes the following claim: a
portfolio that invests one dollar in ABC and shorts one dollar of the market
portfolio will have no systematic risk. Comment on the validity of your friend’s
claim and explain briefly.
(4 marks)
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(d) Portfolios A, B, and C all lie on the efficient frontier that allows for risk-free
borrowing and lending. Portfolios A and B have the following expected returns
2 2
and return variances: A: µA = 0.06, σA = 0.01; B: µB = 0.08, σB = 0.0225.
2
Portfolio C’s return has variance σC = 0.0289. What is the expected return and
Sharpe ratio of Portfolio C? What is the risk-free interest rate? Explain your
calculations.
(5 marks)
(e) Consider a forward contract on a storable commodity. Is the forward price
likely to increase or decrease relative to the spot price if global inventories of
the commodity fall? Explain.
(4 marks)
(f ) The price of Stock X, which is currently $120, can go to $160, $120, or $100 in 6
months’ time. Security A pays $1 if the price of Stock X in 6 months is $160,
and zero otherwise. Security B pays $1 if the price of Stock X in 6 months is
$120, and zero otherwise. Security C pays $1 if the price of Stock X in 6 months
is $100, and zero otherwise. The prices of these securities are pA , pB , and pC ,
respectively. The discretely compounded risk-free interest rate is 5% per
half-year (not annualised). When answering the questions below, explain your
calculations.
i. In the absence of arbitrage, what is the total cost of purchasing one unit each
of securities A, B, and C?
(3 marks)
ii. If pA = 0.4/1.05 ≈ 0.380952, what is the value of a 6-month European call on
Stock X with an exercise price of $110?
(7 marks)
Subject guide, Chapters 3, 4, 7, 8, 10 and 11.
(a) First, determine the monthly effective rate (r12 ) that corresponds to a 6% quarterly APR:
4/12
0.06
r12 = 1 + − 1 = 0.00497521.
4
Using the monthly discount rate, determine the present value of the monthly lease payments:
1 − (1 + r12 )−60

PVlease = 5,000 ≈ $258,813.
r12
This is larger than the up-front cost ($250,000), hence you are better off buying the machine
up-front today, either using your own cash or by borrowing $250,000 from the bank.
(b) This perpetuity can be replicated by:

• Purchasing a perpetuity that pays $150 at the end of each year. The present value of this
perpetuity is:
150
PV1 = = 1,500.
0.10
• Plus buying a second perpetuity that pays $100 at the end of each even year
(t = 2, 4, 6, . . .). To determine the present value of this perpetuity, we discount its
biennial cash flows using the effective two-year discount rate:
(1 + 0.10)2 − 1 = 21%.
The present value of the second perpetuity is:
100
PV2 = ≈ 476.19.
0.21
12
Therefore, by the law of one price, the present value of the full perpetuity is:
PV1 + PV2 = 1,500 + 476.19 = $1,976.19.
(c) Your friend is essentially claiming that asset ABC has a CAPM β = 1. This claim is false in
general. From the definition of beta:
σi
βi = ρi,m .
σm
Perfect (positive) correlation with the market (ρi,m = 1) does not necessarily imply a unit
beta (i.e. if σi 6= σm ). For example, all CML portfolios (which have zero idiosyncratic risk)
are perfectly correlated with market, but with the exception of the market portfolio itself,
have β 6= 1. Hence, any portfolio that invests $1 in such an asset and shorts an equal
amount of the market will generally not be a zero-beta portfolio.
(d) Portfolios A, B, and C all lie on the CML. Hence, the gradients of the line segments in µ–σ
space from the risk-free asset to A, from A to B, and B to C are the same, and equal to the
Sharpe ratio of the market.
µB − µA 0.08 − 0.06
SC = SM = = = 0.4.
σB − σA 0.15 − 0.10
Similarly:
µC − µB µC − 0.08
= = 0.4 ⇒ µC = 0.088.
σC − σB 0.17 − 0.15
Similarly, solving for the risk-free rate:
µA − rf 0.06 − rf
= = 0.4 ⇒ rf = 0.02.
σA − σrf 0.10 − 0
(e) Decrease. Consider the one-period no-arbitrage relationship between the forward and spot
prices:
F = S(1 + rf − N CY )
where N CY = convenience yield − storage cost.
Falling inventories free up storage space (reducing storage costs) and probably increase
convenience yield, both increasing N CY , thus driving down the forward price relative to the
spot.
(f) i. Purchasing one unit each of A, B, and C will yield $1 with certainty in 6 months’ time.
Therefore:
1 1
pA + pB + pC = = ≈ $0.952.
1 + rf 1.05
ii. In a risk-neutral world we must have, from the ‘pure’ security A:
1qH + 0qM + 0qL
pA =
1 + rf
where rf = 5%, and qH , qM , and qL = 1 − qH − qM are the risk-neutral probabilities of

the high, medium, and low stock price states in 6 months, respectively. We know that:
0.4 qH
pA = = ⇒ qH = 0.4.
1.05 1 + rf
Similarly, for Stock X:

160qH + 120qM + 100qL
S0 = 120 = .
1 + rf
13
Re-arranging and simplifying yields:
60qH + 20qM = 26.
Substituting for qH and solving for qM , and consequently qL , we have:
qM = 0.1 and qL = 0.5.
The no-arbitrage price of the call option with X = 110 is therefore:
qH max(160 − 110, 0) + qM max(120 − 110, 0) + qL max(100 − 110, 0)

c=
1 + rf
(0.4)(50) + (0.1)(10) + (0.5)(0)
=
1.05
= 20.
14

Important note

references
section.
Comments on specific questions – Zone B
Candidates should answer THREE of the following FOUR questions. All questions carry equal
marks.
Question 1
(a) Leasing a machine requires making monthly payments of $6,000 for the next 5
years (i.e. at t = 1, 2, . . . , 60). Buying the machine today (t = 0) will cost you
$320,000. Assume the machine is worthless after 5 years. You can borrow and
lend at a semi-annually compounded interest rate of 6% (APR). Would you be
better off by buying or leasing? Explain.
(5 marks)
(b) We are currently at year 0. Consider a perpetuity that pays $250 at the end of
each odd year and $150 at the end of each even year. The term structure is flat
at 10% per year. Determine the present value of the perpetuity.
(5 marks)
(c) Assume the CAPM holds. The return on asset ABC is perfectly correlated with
the return on the market portfolio. Your friend makes the following claim: a
portfolio that invests one dollar in ABC and shorts one dollar of the market
portfolio will have no systematic risk. Comment on the validity of your friend’s
claim and explain briefly.
(4 marks)
(d) Portfolios A, B, and C all lie on the efficient frontier that allows for risk-free
borrowing and lending. Portfolios A and B have the following expected returns
15
2 2
and return variances: A: µA = 0.0925, σA = 0.0225; B: µB = 0.11, σB = 0.04.
2
Portfolio C’s return has variance σC = 0.1225. What is the expected return and
Sharpe ratio of Portfolio C? What is the risk-free interest rate? Explain your
calculations.
(5 marks)
(e) Consider a forward contract on a storable commodity. Is the forward price
likely to increase or decrease relative to the spot price if global inventories of
the commodity rise? Explain.
(4 marks)
(f ) The price of Stock Y, which is currently $80, can go to $120, $90, or $60 in 6
months’ time. Security A pays $1 if the price of Stock Y in 6 months is $120,
and zero otherwise. Security B pays $1 if the price of Stock Y in 6 months is
$90, and zero otherwise. Security C pays $1 if the price of Stock Y in 6 months
is $60, and zero otherwise. The prices of these securities are pA , pB , and pC ,
respectively. The discretely compounded risk-free interest rate is 5% per
half-year (not annualised). When answering the questions below, explain your
calculations.
i. In the absence of arbitrage, what is the total cost of purchasing one unit each
of securities A, B, and C?
(3 marks)
ii. If pB = 0.2/1.05 ≈ 0.190476, what is the value of a 6-month European call on
Stock Y with an exercise price of $75?
(7 marks)
Subject guide, Chapters 3, 4, 7, 8, 10 and 11.
(a) First, determine the monthly effective rate (r12 ) that corresponds to a 6% semi-annual APR:
2/12
0.06
r12 = 1 + − 1 = 0.00493862.
2
Using the monthly discount rate, determine the present value of the monthly lease payments:
1 − (1 + r12 )−60

PVlease = 6,000 ≈ $310,904.
r12
This is smaller than the up-front cost ($320,000), hence you are better off leasing the
machine.
(b) This perpetuity can be replicated by:

• Purchasing a perpetuity that pays $150 at the end of each year. The present value of this
perpetuity is:
150
PV1 = = 1,500.
0.10
• Plus buying a second perpetuity that pays $100 at the end of each odd year
(t = 1, 3, 5, . . .). To determine the present value of this perpetuity, we discount its
biennial cash flows to t = 1 using the effective two-year discount rate and then discount
this t = 1 value to t = 0 at 10%. The two-year discount rate is:
(1 + 0.10)2 − 1 = 21%.
The present value of the second perpetuity is:

1 100
PV2 = 100 + ≈ 523.81.
1.10 0.21
16
Therefore, by the law of one price, the present value of the full perpetuity is:
PV1 + PV2 = 1,500 + 523.81 = $2,023.81.
(c) Your friend is essentially claiming that asset ABC has a CAPM β = 1. This claim is false in
general. From the definition of beta:
σi
βi = ρi,m .
σm
Perfect (positive) correlation with the market (ρi,m = 1) does not necessarily imply a unit
beta (i.e. if σi 6= σm ). For example, all CML portfolios (which have zero idiosyncratic risk)
are perfectly correlated with market, but with the exception of the market portfolio itself,
have β 6= 1. Hence, any portfolio that invests $1 in such an asset and shorts an equal
amount of the market will generally not be a zero-beta portfolio.
(d) Portfolios A, B, and C all lie on the CML. Hence, the gradients of the line segments in µ–σ
space from the risk-free asset to A, from A to B, and B to C are the same, and equal to the
Sharpe ratio of the market.
µB − µA 0.11 − 0.0925
SC = SM = = = 0.35.
σB − σA 0.20 − 0.15
Similarly:
µC − µB µC − 0.11
= = 0.35 ⇒ µC = 0.1625.
σC − σB 0.35 − 0.20
Similarly, solving for the risk-free rate:
µA − rf 0.0925 − rf
= = 0.35 ⇒ rf = 0.04.
σA − σrf 0.15 − 0
(e) Increase. Consider the one-period no-arbitrage relationship between the forward and spot
prices:
F = S(1 + rf − N CY )
where N CY = convenience yield − storage cost.
Rising inventories reduce storage space (increasing storage costs) and probably decrease
convenience yield, both decreasing N CY , thus driving up the forward price relative to the
spot.
(f) i. Purchasing one unit each of A, B, and C will yield $1 with certainty in 6 months’ time.
Therefore:
1 1
pA + pB + pC = = ≈ $0.952.
1 + rf 1.05
ii. In a risk-neutral world we must have, from the ‘pure’ security B:
0qH + 1qM + 0qL
pB =
1 + rf
where rf = 5%, and qH , qM , and qL = 1 − qH − qM are the risk-neutral probabilities of

the high, medium, and low stock price states in 6 months, respectively. We know that:
0.2 qM
pB = = ⇒ qM = 0.2.
1.05 1 + rf
Similarly, for Stock Y:
120qH + 90qM + 60qL
S0 = 80 = .
1 + rf
Re-arranging and simplifying yields:
60qH + 30qM = 24.
17
Substituting for qM and solving for qH , and consequently qL , we have:
qH = 0.3 and qL = 0.5.
The no-arbitrage price of the call option with X = 75 is therefore:
qH max(120 − 75, 0) + qM max(90 − 75, 0) + qL max(60 − 75, 0)

c=
1 + rf
(0.3)(45) + (0.2)(15) + (0.5)(0)
=
1.05
≈ 15.71.
Question 2
(a) In a single sentence, explain why it is useful from a risk-management perspective

for the writer of a call option to simultaneously hold the underlying asset.
(3 marks)
(b) Consider an at-the-money European call option and a European put option on
the same underlying asset (non-dividend paying). Both options have the same
exercise price and same expiration date. Which option has the higher value?
Explain.
(5 marks)
(c) A stock with spot price S is expected to pay a dividend of D in t years.
European call and put options on the stock with exercise price X and maturity
T > t are trading at prices c and p, respectively. The continuously compounded
risk-free rate is r.
i. Show that the following put-call parity relationship holds:
c + Xe−rT + De−rt = p + S.
(6 marks)
ii. The stock price is $20. A 3-month at-the-money European put on the stock
trades at $0.75. The corresponding call trades at $1. The continuously
compounded risk-free rate is 10%. Do these prices imply the existence of an
arbitrage opportunity? Explain.
(5 marks)
(d) A house in Melbourne has recently sold for $2.5 million. Renting an equivalent
house costs $250,000 per year (paid at year-end). The risk-free rate is 7.5%
(annually compounded). Suppose the house can either increase in price each
year by 20% or decrease by 20% before rent is paid out (i.e. cum-dividend). For
example, the price can increase from $2.5 million to $3.0 million, so that after
$250,000 rent is paid out (i.e. ex-dividend), the house is worth $2.75 million.
i. What is the price of a 2-year at-the money American call option on the
house? State any assumptions you need to make.
(8 marks)
ii. Holding all else constant, how would each of the following affect your answer
to part (i):
• an increase in the rent
• a decrease in the price of the house
• a decrease in the strike price of the option.
18
In each case, state the direction of the change (i.e. increase the price,
decrease the price, or uncertain) and provide a brief explanation of your
reasoning.
(6 marks)
Subject guide, Chapter 11.
(a) Being long in the underlying asset hedges the potentially unlimited downside that the writer
is exposed to from the short call.
(b) Using put-call parity and noting that the options are at-the-money (i.e. S = X):
c − p = S − PV(X) = S − PV(S) > 0
prior to maturity (assuming a positive rate of interest). Therefore, the call is worth more.
Equivalently, the intrinsic value of both options is zero (the options are at-the-money) but
the call has more time value since, unlike the put, its upside is unlimited.
(c) i. Strategy 1: buy the call, lend risk-free the present value of X due in T years, and lend
risk-free the present value of D due in t years.
Strategy 2: buy the put and buy the stock.
Both strategies produce a cash flow of D at time t (from the risk-free lending of PV(D)
in Strategy 1, and from the stock in Strategy 2) and a cash flow of max(X, ST ) at time T
(from the combination of the long call and the risk-free lending of PV(X) in Strategy 1,
and from the combination of long put and stock in Strategy 2).
Since both strategies produce the same future cash flows, the absence of arbitrage
implies they should cost the same today.
ii. Not necessarily. We have:
p + S = 0.75 + 20 = $20.75
and:
c + Xe−rT = 1 + 20e−0.1×0.25 ≈ 20.506.
However, from the put-call parity relationship in (i), this does not imply the presence of
an arbitrage as long as:
De−rt = 20.75 − 20.506 = 0.244.
Otherwise, there is an arbitrage opportunity.
(d) i. Noting that u = 1.2 and d = 0.8, the house (underlying) price dynamics (in $m) over the
next two years are as follows:
19
where q, the risk-neutral probability of a year-on-year increase in the house price is:
1 + rf − d 1.075 − 0.8
q= = = 0.6875.
u−d 1.2 − 0.8
The corresponding tree (in $m) for the American call option (X = 2.5) is:
where the call option at the d-node is worthless because it is certain to expire worthless
if held and is not worth exercising immediately. At the u-node, the value of holding on to
the option (cH E
u ) versus exercising immediately (cu ) is:
qcuu + (1 − q)cud
cH
u = ≈ 0.5116 > cE cum
u = max(Su − X, 0) = 0.5.
1 + rf
Hence, early exercise is not optimal at the u-node. Therefore, the value of the American
call option today is:
qcu + (1 − q)cd 0.6875 × 0.5116

c0 = = ≈ $0.327m.
1 + rf 1.075
ii. Holding all else constant, the value of the option will:
∗ Decrease (up to a point): holding the option becomes less attractive as the rent (i.e.
dividend) increases, so the value of the call will fall until it is optimal to exercise early
(at the u-node), after which any further increase in the dividend will have no effect on
the value of the option.
∗ Decrease: call option value is increasing in the price of the under-lying asset (larger
expected payoff).
∗ Increase: call option value is decreasing in the exercise price (smaller expected payoff).
Question 3
LNP is a company with a liability of $110 million due in 10 years. The company’s
only asset is $70 million held in cash. Throughout this question, assume the term
structure of interest rates is flat at 5%.
(a) Determine the present value of the company’s liability.

(3 marks)
(b) Without doing any calculations, briefly explain why holding all its assets in cash
is problematic for LNP from an interest rate risk management perspective.
(4 marks)
Two bonds, A and B, are currently trading in the market. Bond A is a 3-year
coupon bond with a face value of $100, selling for $113.616; coupons are paid
annually. Bond B is a perpetuity with an initial cash flow of $1 in one year’s time,
with cash flows growing thereafter at 1% per year.
20
(c) Determine Bond A’s coupon rate and the price of Bond B.
(6 marks)
(d) Calculate Bond A’s Modified Duration. Without recalculating the bond price,
estimate the percentage change in the price of Bond A if the entire term
structure were to immediately shift downwards by 100 basis points (1 basis
point is one hundredth of 1 percent, i.e. 0.01%).
(6 marks)
(e) Show that the Modified Duration of a growing perpetuity with initial cash flow
C1 (at time 1), cash flow growth rate g, and discount rate r is given by:
1
DM od = .
r−g
Using this expression, calculate the Macaulay Duration of Bond B.

(6 marks)
(f ) To manage its interest rate risk exposure, LNP proposes creating a portfolio of
bonds A and B such that the following two conditions are met:
• The current values of the bond portfolio and the company’s liability are the
same.
• The change in the value of the bond portfolio in response to a small, parallel
shift in the term structure matches the change in the value of the company’s
liability.
How many units of Bond A and B must the company purchase today? Briefly
explain why this strategy is not static, i.e. why the number of units of each
bond will need to change over time.
(8 marks)
(a) Denote the present value of the company’s liability as L. We have:
110m
L= ≈ $67,530,458.
(1 + 5%)10
(b) The value of the company’s liability is interest-rate sensitive, whereas its asset is not,
leaving the company’s net worth/equity exposed to interest rate fluctuations. Net worth
may become negative if interest rates decline sufficiently, such that L > $70m, in which case
the company will be (economically) insolvent.
(c) Bond A: We have:
1 − (1.05)−3

100
PA = 113.616 = c + → c = 10.
0.05 (1.05)3
The coupon rate is 10/100 = 10%.

Bond B: We have:
C1 1
PB = = = $25.
r−g 0.05 − 0.01
21
(d) First, calculate the bond’s Macaulay Duration:

3
M ac
X Ct /(1 + 5%)t
DA = wt t where wt = .
t=1
PA
t Ct PV(Ct ) wt
1 10 9.524 0.0838
2 10 9.070 0.0798
3 110 95.022 0.8363
M ac
Plugging into the formula, we find DA = 2.753 years. Then, calculating the Modified
Duration of Bond A at r = 5%:
M ac
M od DA
DA = = 2.621.
1+r
From the Duration approximation, the approximate percentage change in a bond’s price in
response to a 100 basis point downward shift in the term structure (i.e. ∆r = −0.01) is
given by:
∆P
100 × ≈ (−DM od × ∆r) = 100 × (DM od × 0.01) = DM od .
P
Therefore, Bond A’s price will rise by approximately 2.621% if the term structure shifts
downwards by 100 basis points.
(e) Let P denote the present value of the perpetuity:

C1
P = .
r−g
Taking the first derivative of P w.r.t. r:
∂P C1
=− .
∂r (r − g)2
Using the definition of Modified duration:
−∂P/∂r C1 (r − g) 1
DM od = = 2
= .
P (r − g) C1 r−g
Since Bond B is a growing perpetuity, its Macaulay Duration is given by:
1+r 1.05
DM ac = DM od (1 + r) = = = 25(1.05) = 26.25.
r−g 0.05 − 0.01
(f) The first condition dictates that we need nA and nB units of Bonds A and B, respectively,
such that:
nA PA + nB PB = L.
Using the duration approximation ∆P ≈ −DM od × P × ∆r for each bond and the
company’s liability, and simplifying, we can express the second condition as:
M od M od M od
n A PA D A + n B PB D B = LDL .
We can solve this system of equations directly for the two unknowns, nA and nB .
Alternatively, dividing each equation by L, we arrive at equivalent expressions:
wA + wB = 1
M od M od M od
wA DA + wB DB = DL
where wA = nA PA /L and wB = nB PB /L.
22
M od M od
We know from (d) and (e) that DA = 2.621 and DB = 25. The company’s liability is
M od M ac
effectively a zero-coupon bond, so DL = DL /(1 + r) = 10/(1.05) = 9.524. Using these
inputs and solving for wA and wB :
wA ≈ 0.6916 and wB ≈ 0.3084.
Then, using PA = $113.616, PB = $25, and L = $67.530458m, and solving for nA and nB :
nA ≈ 0.4110m and nB ≈ 0.8332m.
This strategy is dynamic – as time passes, all of the inputs will change (durations, bond
prices etc.), hence the bond portfolio will need be rebalanced (continuously) to maintain its
match with the value and duration of the liability.
Question 4
The table below displays some valuation characteristics for four stocks. Answer the
items below by assuming the CAPM holds, and the risk-free interest rate for
borrowing and lending is 5%.
Stock Share Expected Dividend Plowback Earnings ROE CAPM

Price (P0 ) return Yield (D1 /P0 ) ratio Growth Rate beta
A $24.50 12.7% 5.2% 50% 7.5%
B $100 9.2% 40% 5% 12.5% 0.60
C $72 19% 15% 20% 4% 20% 2.0
D $44 1.1% 60% 0.3
(a) ‘If a portfolio has a CAPM beta of 1.0, then its realised return must be the
same as that of the market portfolio’. True/false? Explain. (You will be marked
on the explanation(s) provided).
(4 marks)
(b) What is the ROE for Stock A? Explain any assumptions you need to make.
(4 marks)
(c) Determine the dividend yield for Stock B. Explain any assumptions you need to
make.
(4 marks)
(d) What is the Present Value of Growth Opportunities (PVGO) implied by the
price of Stock C? Explain in detail your calculations.
(5 marks)
(e) What is the earnings growth rate for Stock D? Explain in detail your
calculations.
(6 marks)
(f ) Now suppose that the risk-free interest rate for borrowing is greater than 5%
(lenders still receive 5%). For simplicity, assume the optimal risky portfolio is
unchanged. How would the share prices of the four stocks be affected? Explain
fully.
(10 marks)
23
(a) False. Although the portfolio’s expected return is the same as the market portfolio’s (same
beta), its realised return is not necessarily the same due to the presence of idiosyncratic risk.
(b) Using g = ROE × plowback → ROE = 0.075/0.5 = 15%.

Assumptions: constant earnings growth rate and plowback.
(c) Assuming a constant plowback and ROE, so that the dividend growth rate = earnings
growth rate and the stock value follows the Gordon growth model:
D1 D1
P0 = ⇒ r= + g.
r−g P0
Therefore, the dividend yield is:
D1
= r − g = 0.092 − 0.05 = 4.2%.
P0
(d) We have:
EPS1
P0 = + PVGO
r
where:
D1 72 × 0.15
EPS1 = = = 13.5.
(1 − plowback) 1 − 0.2
Therefore:
13.5
PVGO = 72 − = 72 − 71.05 = $0.95.
0.19
(e) Stock D has a CAPM β = 0.3 and the rf = 5%. From the information on Stock C (or B),
determine the expected market risk-premium:
0.19 − 0.05
rC = rf + βC (rm − rf ) → rm − rf = = 7%.
2
Therefore, the expected return on stock D is:
rD = 0.05 + 0.3(0.07) = 7.1%.
Applying the Gordon growth model to Stock D:
D1
g=r− = 0.071 − 0.011 = 6%.
P0
(f) If the risk-free borrowing rate (rfb ) > risk-free lending rate (rfl = 5%), but the optimal risky
portfolio (i.e. market portfolio, M ) is unchanged, then:
• The CML is kinked at M .
∗ The CML to the left of M is the same as before (corresponding to rfl = 5%), whereas
the slope of the CML to the right of M is flatter (corresponding to rfb > 5%).
∗ Therefore, CML portfolios with β > 1 (i.e. those to the right of M ) will have lower
expected returns compared to when rfb = rfl = 5%.
• The impact on each stock’s price will depend on its CAPM β. Since M is unchanged,
there is no change to the β of any stock.
∗ β < 1: Stocks B and D.
∗ β > 1: Stocks A and C (βA = 1.1 is not given but can be inferred from its expected
return using the CAPM and rf = 5%).
• Therefore, all else equal, the price of any stock with β > 1 (Stock A and C) will be
higher (lower expected return); the price of any stock with β < 1 (Stock B and D) will be
the same as before (no change in expected return).
24

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Examiners’ commentaries 2021

Examiners’ commentaries 2021

Information about the subject guide and the Essential reading

Covering the syllabus

Expectations of the examination paper

Answer the question

A common bugbear among examiners, particularly relating to qualitative questions, is where

Examination revision strategy

Examiners’ commentaries 2021

Information about the subject guide and the Essential reading

Comments on specific questions – Zone A

(a) Determine the present value of the company’s liability.

Using this expression, calculate the Modified Duration of Bond B.

Reading for this question

Subject guide, Chapters 2, 3 and 5.

Approaching the question

(a) Denote the present value of the company’s liability as L. We have:

(c) Bond A: We have:

The coupon rate is 7.50/100 = 7.5%.

(e) Let P denote the present value of the perpetuity:

where wA = nA PA /L and wB = nB PB /L.

wA ≈ 0.7982 and wB ≈ 0.2018.

nA ≈ 0.5285m and nB ≈ 0.2004m.

Stock Share Expected Dividend Plowback Earnings ROE CAPM

Reading for this question

Subject guide, Chapters 6, 7 and 8.

Approaching the question

(b) Using g = ROE × plowback → ROE = 0.042/0.3 = 14%.

Therefore, the dividend yield is:

rD = 0.04 + 1.5(0.06) = 13%.

Applying the Gordon growth model to Stock D:

Answer the following unrelated items.

Reading for this question

Subject guide, Chapter 11.

Approaching the question

c − p = S − PV(X) = S − PV(S) > 0

ii. Not necessarily. We have:

Otherwise, there is an arbitrage opportunity.

Answer the following unrelated items.

Reading for this question

Subject guide, Chapters 3, 4, 7, 8, 10 and 11.

Approaching the question

(b) This perpetuity can be replicated by:

PV1 + PV2 = 1,500 + 476.19 = $1,976.19.

where rf = 5%, and qH , qM , and qL = 1 − qH − qM are the risk-neutral probabilities of

Similarly, for Stock X:

Re-arranging and simplifying yields:

60qH + 20qM = 26.

Substituting for qH and solving for qM , and consequently qL , we have:

qM = 0.1 and qL = 0.5.

The no-arbitrage price of the call option with X = 110 is therefore:

qH max(160 − 110, 0) + qM max(120 − 110, 0) + qL max(100 − 110, 0)

Examiners’ commentaries 2021

Information about the subject guide and the Essential reading

Comments on specific questions – Zone B

Answer the following unrelated items.

Reading for this question