Solution to Practice Final Exam

I. The cut-off point = Mean – 1.645*St.Dev = 2% – 10%*1.645 = -14.45%

Value at Risk = $3,900 mil * 14.45% = $563.55mil

II. Total Investment = 20 shares * $87 = $1,740 Total percentage return = -10%
(1) Total Dollar Gain = 1,740 * -10% = -$174
(2) 2-year holding period return = (1-0.1)(1+0.1) = 0.99
Annualized Return r is: (1 + r) 2 = 0.99 Thus, r = 0.99(1/2) – 1 = – 0.501%
Therefore, this comment is incorrect.

III.
( )
(1) Sharpe Ratio = = (7.16% - 1%) / 8.62% = 0.7146
(2) Let’s define: Weight of risk-free = w, Weight of P = (1-w)
At Z*, 𝐸(𝑟 ) = 4% Thus, 4% = w × 1% + (1 − w) × 7.16%
Weight on risk free (w) = 51.30%, Weight on P (1-w) = 48.70%

Further, we need to figure out how P is composed of stock and bond funds.
𝐸(𝑟 ) = 10% 𝐸(𝑟 ) = 4% With the weight of stock fund, 𝑤
We have 𝐸(𝑟 ) = 7.16% = 𝑤 × 10% + (1 − 𝑤 ) × 4%
𝑤 = 52.67% Therefore, 𝑤 = (1 − 𝑤 ) = 47.33%

Thus, Z* is composed of
Risk-free asset: 51.30%
Stock fund: 48.70% * 0.5267 = 25.65%
Bond fund: 48.70% * 0.4733 = 23.05%

(3) While bond fund has 4% expected return with 8% standard deviation, Z* provide the
same expected return with much lower standard deviation (risk).
You can also compute the standard deviation at Z* from the CAL: E(r) = 1% + 0.7146 σ
Since E(r) = 4% at Z*, 4% = 1% + 0.7146 σ Thus at Z*, σ = 4.20%

(4) For 10% return on CAL, using w as the weight of risk-free asset,
10% = w × 1% + (1 − w) × 7.16%
w = − 46.10% This means that if you have $100, you borrow $46.10 at 1% (at risk-free
rate) and invest 146.10% in the tangential portfolio, P.
To verify, -0.4610*1% + 1.4610*7.16% = 9.99976% = 10%
IV.
(1) Since Price > Par value, IRR of the bond, i.e. YTM will be lower than the coupon rate of
8%.

,
(2) a. P = .
1− .
+ .
= $2,485.09
b. FV(Coupon) = .
(1.05 − 1) = $442.05
c. 1,400 × (1 + r) = 2,485.09 + 442.05 = 2,927.14 r = 15.89%

(3) KEPCO could have considered issuing this long-term bond as a callable bond so that
when the rate falls substantially, the company can retire this bond and float a new one at a
lower rate.

V.
(1) Modified Duration (D*) = D / (1 + r) = 3.6481 / 0.072 = 3.403 years.
(2) Percentage change in price = - (-0.3%) * 3.403 = 1.0209% = + 1.02%
Current price = $973.02 With 1.02% increase, new price = 973.02 * (1+0.0102) =
$982.94
,
(3) (No need to show this) P = .
1− .
+ .
= 983.03 The answers are
different by $0.09.

The reason is that using modified duration gives an approximation of the percentage change
in price. It should only be used for small changes in yields because of bond price convexity.
As you move farther away from the original yield, the slope of the straight line that shows the
duration approximation no longer matches the slope of the curved line that shows the actual
price changes.