EC333:23-4 Review session

Based on 22-3 Final exam

Q1
Are the following statements True, False, or Ambiguous? Provide a
short justification for your answer. (You will be evaluated mostly on the
basis of your justification.)
A)
Suppose that there are n>2 risky assets in the economy but not a risk
free one. It is impossible for a single asset to be efficient.

False- As we saw in the example in class with n=3 stocks, while it is rare
it is possible for a single stock to be on the frontier
B)
According to CAPM, an investor will not invest a positive amount in an
asset with an expected return that is lower than the risk-free rate.

False- An investor may invest in such an asset provided that it has a

negative correlation with the market
C)
Consider the multifactor APT with two factors when the risk-free rate
of return is 5%. A Stock has an expected return of 17.5%, a beta of 1.5
on factor 1 and a beta of one on factor 2. Assuming the risk premium
on factor 1 is more than 5%. then the risk-premium on factor 2 is less
than 5%.

True- The stock has a risk premium of 12.5%. The contribution due to
its exposure to factor 1 is more than 1.5*5%=7.5%. Hence, the
contribution from its exposure to factor 2 is less than 5%. Given the
beta of one the statement is correct.
For the next two statements consider 1-year American call options on
Microsoft.
D)
Microsoft currently pays negligible dividends and plans to increase its
dividend yield. It is more likely that an American call option would be
exercised early.

True- The owner of an option does not receive dividends and hence a
high dividend rate may trigger early exercise
E)
We compare two alternative: (i) two options with a strike of $225. (ii)
One option with a strike of $ 200 and one option with strike of $250.
The second alternative is more valuable.

True- Consider the payoff of the two options with strike of 225.
Suppose that we exercise exactly at the same time the option with a
strike of 200 and 250. The second alternative provides higher payoff in
any contingency (Microsoft stock price at the time).
Part B
Answer ONE question (Q2 or Q3)
Q2
We examine a setup with two independent risky securities. The expected returns of the two assets
are given by r_1=0.3, r_2=0.12 with a standard deviation of σ_1=0.2, σ _2=0.1$.

a) Suppose that there is no borrowing or lending. Find the standard deviation of portfolios that
yield expected returns of 0.12, 0.23 and 0.3.
a)
For an expected return of 12% it is clear that we talk about the second asset so the standard
deviation is 10%
- For an expected return of 30% it is clear that we talk about the second asset so the standard
deviation is 20%
- For an expected return of 23%

0.23 = 0.3 ⋅ 𝜔 + 0.12 ⋅ 1 − 𝜔 ⇒ 𝜔 = 11/18

2 2
11 7
σ𝑝 = ⋅ 0.22 + ⋅ 0.12 = 12.82%
18 18
b)
It is now assumed that an investor who borrows pays an interest rate of
0.1. When this investor saves money he receives an interest rate of
0.06. redo part a).
10%

6%
We first find the two tangency portfolios:

25 0 0.2 0.24
Σ෠ −1 = ҧ𝑒 =
, 𝑟0.1 ҧ𝑒 =
, 𝑟0.06 ,
0 100 0.02 0.06

25 0 0.2 5
Σ෠ −1 𝑟0.1
ҧ𝑒 = =
0 100 0.02 2

25 0 0.24 6
Σ෠ −1 𝑟0.06
ҧ𝑒 = =
0 100 0.06 6
 5/7 0.5
So the tangency portfolios are 2/7
for 10% interest rate and 0.5
for 6% interest rate.

The expected return of the first tangency portfolio is 5/7 * 30%+ 2/7*12% =24.86% with a standard deviation of

5 2
14.56% = ( ∗ 0.2)2 +( ∗ 01)2
7 7

The expected return of the second tangency portfolio is 21% 0.5 * 30%+ 0.5*12% = with a standard deviation of

1 1
11.18% = ( ∗ 0.2)2 +( ∗ 0.1)2
2 2
i) An expected return of 12% is lower than the expected return of both tangency portfolios so it is
based on lending at 6% combined with the ‘6% tangency portfolio’. 0.12 = 0.21 ⋅ 𝜔 + 0.06 ⋅ (1
2
− 𝜔) ⇒ 𝜔 =
5

2
The standard deviation is ∗ 11.18 = 4.47%
5
i) An expected return of 30% is higher than the expected return of both
tangency portfolios so it is based on borrowing at 10% combined with the
10% tangency portfolio. 0.3 = 0.2486 ⋅ 𝜔 + 0.1 ⋅ 1 − 𝜔 ⇒ 𝜔1.346=

The standard deviation is 1.346 ∗ 14.56 = 19.61%

i) An expected return of 23% is between the two tangency portfolios so it

based on an investment in only the risky securities and the answer is the
same as part a) 12.82%
C)
Are your answer to parts a) and b) different and if so why?

For the portfolios of 10% and 30% we have used in part b) borrowing
and lending so we have lowered the risk. For the portfolio of 23% we
have used only the two assets so we have obtained the same answer as
in a).
D)
Does the two-fund separation hold in part b)? Explain

The two-fund separation does not hold as we use different two assets
for the different combinations.
Q3
In this question, we examine a 1-year put option on a 2-year European call option.
Currently, Netflix is trading for $200. In each of the next two years, the stock may increase
by 20% or decrease by 15%. The annual interest rate is 5%.

We first consider the European two-year (T=2) call option on Netflix with a strike of K=210.
a) What is the risk-neutral probability?

0.2⋅p-0.15⋅(1-p)=0.05⇒p=4/7
 S2 =u2 S 288

240
S1 =uS

200
S0 =S S2 =duS 204
170
S1 =dS

S2 =d2 S 144.5
t= 0 t=1 t=2
b) What are the values of the call option at
t=0 and t=1?
The stock price at t=2 can take the values 144.5, 204, 288, so the
option payoffs at expiration are 0, 0, 78. The risk-neutral probabilities
of the three events are:
2 2
3 4 3 4
,2⋅ ⋅ ,
7 7 7 7
4 2
⋅78
7
=>The option value at t=0 is: = 23.1
1.052
=>The option value at t=1 is 0 when the stock price is 170 and when
4
⋅ 78
7
the stock price is 240 it equals = 42.4
1.05
C+d
Next, we consider a 1-year put option with a strike of K=40 where the underlying asset is the call
option you examined before.

c) What is the value of the put option at expiration (t=1)?

Based on b), the payoff of the put option is 0 when the stock price is 240 and 40 when the stock
price is 170.

d) What is the value of the put option today (t=0)?

Based on c) the value of the put option at t=0 is:
3
⋅ 40
7
= 16.3
1.05