SCHOOL EXAMINATION

FIE 400 E
Spring, 2018

Date: May 30, 2018

Time: 09:00 – 13.00
Number of hours: 4 hours

An invigilator can contact course instructor by phone: 464 46 057

MATERIALS PERMITTED DURING THE EXAMINATION:

Cheat-sheet: Only the one attached to the exam
Electronic Calculator: Yes
Dictionary: one bilingual dictionary permitted

The exam consists of: 6 pages (the present page included) and three-page
cheat-sheet.
 Please note that some of the questions may depend on the answers to previous ques-
tions.

If you do not have the answer for one question, then assume an answer to move on to
the subsequent questions.

Throughout the exam, . is used as decimal mark while , is used as thousands separator.

Please use three decimal digits if decimals are required.

A cheat-sheet is attached in the end.

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 Group I (15 points; 3 independent questions)

Question I.1.

You have invested in an OBX fund in the beginning of the period. At the end of the
period its return is -30%, what next period return will be necessary to recover (to break
even)?

Question I.2.

Given the following relationship between x and y,

y = a + bx, b < 0

prove that x and y are perfectly negatively correlated.

Question I.3.

Let rC and rD be the returns for two securities with expected returns E[rC ] = 0.03 and
E[rD ] = 0.08, variances V ar[rC ] = 0.02, V ar[rD ] = 0.05, and covariance Cov(rC , rD ) =
−0.01. Assume that the two securities above are the only investment vehicles available.
a) Find the mean and standard deviation of a portfolio that is 25% in security C.
b) Find the mean and standard deviation of a portfolio that is 150% in security C.
c) If we want to minimize risk, how much of our portfolio will we invest in security C?
d) Sketch the set of feasible mean-standard deviation combinations of return.
e) Indicate the efficient frontier of this set.

Group II (20 points; 3 independent questions)

Question II.1.

a) Explain in less than 150 words the efficient market hypothesis and its different forms.

b) Given the following situations, determine in each case whether or not the hypothesis
of an efficient capital market is contradicted. If yes, then explain in less than 100 words
why there is contradiction and of which forms of the hypothesis.

b.1) You have discovered that the square root of any given stock price multiplied by
the day of the month provides an indication of the direction in price movement of that
particular stock with a probability of 0.7.

b.2) A Securities and Exchange Commission (SEC) suit was filed against Texas Gulf
Sulphur Company in 1965 because its corporate employees had made unusually high prof-
its on company stock that they had purchased after exploratory drilling had started in
Ontario (in 1959) and before stock prices rose dramatically (in 1964) with the announce-
ment of the discovery of large mineral deposits in Ontario.

Question II.2.

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 Assume that CAPM is valid. You believe that the Zenith Company will be worth $100
per share one year from now. How much are you willing to pay for one share today if the
risk-free rate is 8%, the expected rate of return on the market is 18%, and the company’s
beta is 2.0?

Question II.3.

Assume that CAPM is valid. The following data have been developed for the Gardiens
Company:

State Probability Market Return Return for the Gardiens Company

rm rj
1 .1 -.15 -.30
2 .3 .05 .00
3 .4 .15 .20
4 .2 .20 .50

The risk-free rate is 6%.

Calculate the following:

a) The expected market return.
b) The variance of the market return.
c) The expected return for the Gardian Company.
d) The covariance of the return for the Gardian Company with the market return.
e) Write the equation of the security market line.
f) What is the required return for the Gardian Company? How does this compare with
its expected return?
g) Is this stock underpriced or overpriced? Why?

Group III (20 points; 4 independent questions)

Question III.1.

Management has informed the market that it expects to earn 30% on project A and
40% on project B, and these expectations are already baked into the firm’s current stock
price. The equity cost of capital for both projects is 10%. The amount of investment
required for project A is $5 million, and project B requires $30 million. Just before it is
about to invest in project B, the company learns that the expected rate on the project
will be 30%, not 40%. The company makes public its revised estimate of the return on
Project B.
a) What will happen to the company’s stock price if management invests in B?
b) What will happen to the stock price if management does not invest in B and invests
only in A?
c) Should management make the investment in project B? Why?

Question III.2.

The expected dividend of Deadpool Ltd. at the end of the current period (t1 ) is $1.
Dividends are expected to grow at a rate of 5% until the end of period 20 (t20 ). Then an
important patent expires and the growth rate after t20 is expected to be only 2%. The

4
equity cost of capital of Deadpool Ltd. is 8%. What is the value of a share S0 at the
beginning of the current period?

Question III.3.

Consider a mutual fund that manages a portfolio of securities worth $120 million.
Suppose the fund owes $4 million to its investment advisers and another $1 million for
rent, wages due, and miscellaneous expenses. The fund has 5 million shares outstanding.
What is the net asset value of the fund?

Question III.4.

Classify each of the following strategies as directional or nondirectional. Briefly justify

your choice.

a) The fund buys shares in Nestle and sells Milka, which is a major component of
Nestle’s balance sheet.

b) The fund buys shares in Norwegians betting that it will be acquired at a premium
by British Airways.

Group IV (20 points; 2 independent questions)

Question IV.1.

a) Suppose that Siemens issues two bonds with identical coupon rates and maturity
dates. One bond is callable, however, the other is not. Which bond will sell at a lower
price? Why?

b) Should a convertible bond issued at par value have a higher or lower coupon rate
than a non-convertible bond issued at par? Why?

Question IV.2.

Consider the following information about the yield curve (constructed using prices of
risk-free Zero-Coupon Bonds (ZCB) with different maturities):

Maturity Yield
1 year 1.2%
2 years 1.4%
3 years 1.5%
4 years 1.6%
5 years 1.8%
10 years 2.4%

a) Determine the price of a 5-year risk-free coupon bond, with annual coupon of 4.5%
and face value of $1,000.
b) Determine the duration of this coupon bond.
c) Determine the duration of the following portfolio of bonds:

5
 Bond Face Value
3-year ZCB $4,045,230
10-year ZCB $7,256,480
5-year Coupon bond, 4.5% coupon $5,230,120

d) You want to construct a portfolio that is immune to parallel shifts of the yield
curve. To do so, on top of the bond portfolio you had in part c), you intend to sell 5-year
ZCBs. All the money from selling 5-year ZCBs is immediately invested in 1-year ZCBs.
Determine the new bond portfolio that achieves your desired goal.

Group V (25 points; 3 independent questions)

Question V.1.
Explain in less than 100 words, why will the value of an American put always be greater
than or equal to the value of a corresponding European put?

Question V.2.

Determine the arbitrage-free price and hedging strategies of the sum of European
call option with a strike 294.74 and a European put option with a strike 266.02 on the
same underlying in a two-period binomial model (t0 , t1 , t2 ). The initial underlying value
is 250 and u = 1.14, d = 0.98. The one-year riskless interest rate r is 8%.
The steps you will need to follow include

Determine the risk neutral probability.

Create the event tree for the underlying risky asset.
Calculate whether to exercise the options on the end nodes.
Use replicating portfolio technique to value the arbitrage-free price.
Compute the hedging strategies (a trading strategy in the underlying asset and riskless
bond) both at t0 and t1 .

Question V.3.

Determine the arbitrage-free price of Lookback European call option with a floating
strike in a three-period binomial model (t0 , t1 , t2 , t3 ). The initial underlying value is 20
and u = 1.5, d = 0.6. The one-year riskless interest rate r is 5%.
For the European call option with a floating strike, the strike price is fixed at the
asset’s lowest price during the option’s life.
The payoff function for the lookback call is given by LCf loat = max(ST − Smin , 0)
The steps you will need to follow include

Determine the risk neutral probability.

Create the event tree for the underlying risky asset.
Calculate the option payoffs on the end nodes. (Hint: 8 payoffs)
Determine the arbitrage-free price of this option.

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Cheat Sheet: Investments

P (T )−P (0)
• Total return: r(T ) = P (0)

• Effective annual rate: 1 + EAR = [1 + r(T )]1/T

• Annual percentage rate: AP R = n ∗ r(T )

• Annual percentage rate with continuous compounding: ln(1 + EAR) = rcc

P1 −P0 Div1
• ”Holding-period return” from period 0 till period T for a stock: HP R = P0 + P0

r̄P −r̄F
• Sharpe ratio: SP = σP

***

P
• E[X] = s p(s)X(s)

− E[X]]2
P
• V ar[X] = s p(s)[X(s)

P
• Cov[X, Y ] = s p(s)[X(s) − E[X]][Y (s) − E[Y ]]

Cov[X,Y ]
• Corr[X, Y ] = σX σY

• Cov[X, X] = V ar[X]

• Z = aX + bY

E[Z] = E[aX + bY ] = aE[X] + bE[Y ]

V ar[Z] = V ar[aX + bY ] = V ar[aX] + V ar[bY ] + 2Cov[aX, bY ] = a2 V ar[X] + b2 V ar[Y ] +

2abCov[X, Y ]

***

1 Pn
• Arithmetic average: r̄ = n s=1 r(s)

1
• Geometric average: 1 + g = [(1 + r1 )(1 + r2 )...(1 + rn )] n

1 Pn
• Sample variance: σ̂ 2 = n−1 s=1 [r(s) − r̄]2

1
• Variance for asset i: σi2 = βi2 σ 2 (m) + σ 2 (ei )

• Cov(ri , rj ) = βi βj σ 2 (m), for i 6= j

Cov(ri , rj ) = βi βi σ 2 (m) + σ 2 (ei ), for i = j

E[rm ]−rf
• Capital market line: E[rp ] = rf + σ(rm ) σ(rp )

• Security market line: E[ri ] = rf + βi (E[rm ] − rf ), where

σi ρi,m
βi = σm

***
F
• Price of a bill: P0 = d
1+r 365

d
• Price of a bond d days till next coupon payment: P0 = (1 + Y T M )(1− 365 ) ( Y TCM [1 −
1 FV
(1+Y T M )n ] + (1+Y T M )n )

365−d
• Accrued interest:AI = 365 C

• The flat (or clean) price:Kt = Pt − AI

PT tCt
PT P V (Ct ) t=1 (1+y )t
• Duration: Dur = t=1 t T otalP V = PT Ct
t
, y:=YTM
t=1 (1+y )t
t

• Absolute price change approximated using duration and convexity: ∆P ≈ −P0 D∗ ∆y +

1 ∗ 2
2 P0 C (∆y)

1 2 Pn
C∗ = 1
P0 ( 1+y ) t=1 t(t
CFt
+ 1) (1+y)t

D∗ = D
1+y

***

Divt+1 Et+1
• Gordon’s formula: Pt = rE −g = rE + P V GO

Et+1 b(ROE−rE )
P V GO = (rE −g)rE

Divt+1 = (1 − b)Et+1

Et+1 = Et ∗ (1 + g)

g = ROE ∗ b

2
 Divt+1 (1+g1 )T Divt+1 (1+g1 )T −1 (1+g2 )
• Gordon’s formula with two growth rates, g1 and g2 : Pt = rE −g1 (1− (1+rE )T )+ (1+r1 T rE −g2
E)

Pt ROE−rE
• Price/book model: constant growth, g, infinite horizon: Bt =1+ rE −g

Pt
• Price/book model: constant growth until time T , after which ROE = rE : Bt = 1+
ROE−rE (1+g)T
rE −g [1 − (1+rE )T
]

***

• Put-Call Parity: St + Pt = Ct + P Vt (X) + P Vt (Div)

• Derivative price: Z0 = ∆S0 + B, where

Zu −Zd
∆= Su −Sd

1 Zd Su −Zu Sd
B= 1+r ( Su −Sd )

Su = S0 ∗ u and Sd = S0 ∗ d

(1+r)−d
Risk-neutral probability of an increase in the stock price: π = u−d

1
Then, the derivative price can be expressed as Z0 = 1+r [πZu + (1 − π)Zd ]

1+r T
• Forward price (with yearly interest/dividends): F0 = S0 ( 1+d )

***

M arket value of assets − Liabilities

• N et asset value = Shares outstanding

N AVt+1 − N AVt + Income + capital gains

• Rate of return = N AVt