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Financial Economics2024 Model 1 Solutions July
Financial Economics2024 Model 1 Solutions July
1000 975 2
R= 975 = 2: 564 102 564 10
Since correlation is not perfect, all portfolios of those two assets will be on
a curve as shown below. Clearly, only answer B is correct.
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2
4. Consider two assets, A and B, with expected returns equal to 5% and 20%,
respectively, and standard deviations of 15% and 20%, respectively.
Correlation is -0.5. If the risk-free rate is 5%, which one of the portfolios below
has the largest Sharpe ratio?
A. wA = 0; wB = 1
B. wA = 0:2; wB = 0:8
C. wA = 0:4; wB = 0:6
D. wA = 1; wB = 0
The tangency portfolio has the highest Sharpe ratio, we compute that for
each portfolio:
SA = 0:2p 0:05 = 0:75
0:22
0:2 0:05+0:8 0:2 0:05
SB = p0:22 0:152 +0:8 2 0:22 2 0:5 0:2 0:8 0:15 0:2
= 0:814 613 080 0
0:4 0:05+0:6 0:2 0:05
SC = p0:42 0:152 +0:62 0:22 2 0:5 0:4 0:6 0:15 0:2 = 0:866 025 403 8
SD = 0
5. The tangency portfolio has a standard deviation of 20%. You have a total
of 100,000 euros to invest. How much money will you invest in the tangency
portfolio so the standard deviation of your total portfolio is 15%? (You will
invest the rest of the money in the risk-free asset)
A. 25,000 euros
B. 50,000 euros
C. 75,000 euros
D. 100,000 euros
6. A stock has an expected return of 23% and a beta of 1.2. If the market’s
expected return is 20% and the CAPM holds, what is the risk-free rate?
A. 2%
B. 3%
C. 4%
D. 5%
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7. Consider a risky investment project that o¤ers an expected cash-‡ow of 2
million euros in 1 year and 3 million euros in 2 years. The analysts estimate
that the beta of this project is 1.2. The expected market return is 15% and
the risk-free interest rate is 3% for all maturities. If the CAPM holds, what is
the present value of investing in this project?
A. 3,880,209 euros
B. 4,258,943 euros
C. 4,769,535 euros
D. 5,000,000 euros
We …rst need to compute the asset’s expected return in order to discount its
future expected payo¤s.
8. In a market in which the CAPM assumptions hold, there are only 2 risky
assets, A and B; with betas A = 0:25 and B = 1:5: Use the properties of
beta to determine which of the following portfolios is the market portfolio:
A. wA = 0:75; wB = 0:25
B. wA = 0:6; wB = 0:4
C. wA = 0:4; wB = 0:6
D. wA = 0:25; wB = 0:75
M =1
M = wA A + wB B
9. A company’s stock return has the same standard deviation as the market
portfolio return, _{M}. The correlation between the stock’s return and the
market portfolio return is 0.5. If the expected return of the market portfolio is
10% and the risk-free rate is 2%, what is the expected return of this stock
according to the CAPM?
A. 4%
B. 5%
C. 6%
D. It is impossible to know with the available information
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2
cov(R ;R
j M ) 0:5
= var(R M)
= 2
M
= 0:5
M
E(Rj ) = 0:02 + 0:5 (0:10 0:02) = 0:06
10. In a market that consists of multiple risky assets and one risk-free asset,
which of the following statements is FALSE?
A. E¢ cient portfolios in the mean-variance framework are obtained by
combining the risk-free asset with the tangency portfolio.
B. E¢ cient portfolios in the mean-variance framework have the maximum
Sharpe ratio.
C. E¢ cient portfolios in the mean-variance framework are portfolios with
the maximum expected return for a given level of standard deviation.
D. E¢ cient portfolios in the mean-variance framework are
portfolios with the minimum standard deviation for a given level of
expected return.
We obtain the prices of basic bonds from the fundamental pricing equation
applied to bonds A and B:
30b1 + 1030b2 = 992:503
, Solution is: f[b1 = 0:970 883 ; b2 = 0:935 317 ]g
40b1 + 1040b2 = 1011:565
p p
r2 = 1=b2 1= 1=0:935 317 1 = 0:034
12. A two-year zero coupon bond that has a nominal of 100 euros is currently
trading at 89.1 euros. Compute the bond’s modi…ed duration.
A. 2
B. 1.782
C. 1.803
D. 1.888
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We need to compute its yield-to-maturity …rst:
q
100 100 2
89:1 = (1+i)2 >i= 89:1 1 = 5: 940 287 694 10
We know that when the bond pays no coupon, the duration equals its ma-
turity
D=2
13. Suppose you can lend and borrow without risk over 2 years and 3 years, at
r2 = 1% and r3 = 2%, respectively. It is also possible to write a forward
contract to lend or borrow between t=2 years and t= 3 years at an interest
rate of 3.2%. Which of the strategies below is an arbitrage?
A. Sign a forward contract to lend 102.83 euros between t = 2 years and t = 3
years. Borrow 100.8 euros over two years. Borrow 100 euros over 3 years.
B. Sign a forward contract to borrow 102.83 euros between t = 2 years and t
= 3 years. Lend 100.8 euros over two years. Borrow 100 euros over 3 years.
C. Sign a forward contract to borrow 102.83 euros between t = 2
years and t = 3 years. Borrow 100.8 euros over two years. Lend 100
euros over 3 years.
D. None of the above
1:023
f NA = 1:012 1 = 4: 029 801 000 10 2
> 3:2%
Arbitrage:
CF(t=0) CF(t=1)
Lend 100 over 3 years 100
Borrow 102:83 between 2 and 3 +102:83
Borrow 100:8 between 0 and 2 100:8 100:8 1:012 = 102: 826 08
Total 0:8 +102:83 102: 826 08 = 0:003 92
CF(t=2)
100 1:023 = 106: 120 8
102:83 1:032 = 106: 120 56
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14. Which of the following statements is TRUE:
A. Under the preference for liquidity hypothesis, the yield curve is always
upward sloping (long term interest rates are higher than short term interest
rates)
B. Under the preference for liquidity hypothesis, an upward sloping yield
curve means that the one-year interest rate in the future is expected to be
higher than the current one-year interest rate
C. Under the market segmentation hypothesis, expected spot interest rates
are equal to implicit forward rates
D. Under the pure expectations hypothesis, an upward sloping
yield curve means that the one-year interest rate in the future is
expected to be higher than the current one-year interest rate
15. One share of company XYZ, that pays no dividends, currently trades at 8
euros. The price of a European call option on one XYZ share with strike price
of 10 euros and maturity in one year is 0.5 euros. Assuming no arbitrage
opportunities, what is the price of a European put option on one XYZ share
with strike price of 10 euros and maturity in one year if the interest rate is 0%?
A. 1
B. 1.5
C. 2
D. 2.5
K
c + 1+r =p+S
0:5 + 10 = p + 8, Solution is: f[p = 2: 5]g
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F N A = S0 (1 + r) = 20:0 1:02 = 20: 4 < 20:91 = F
t = 0 : 20 + 20:5 = 0:5
t = 1 : S1 + 20:91 S1 20:5 1:02 = 0:0
17. Suppose you run a company that produces olive oil. Olive oil currently
sells for 7,000 euros per Ton in the wholesale market but you are worried that
the price will fall between now and 6 months, when you take your production
to the market. What would you do in order to eliminate ALL uncertainty due
to changing prices?
A. Buy call options on olive oil with maturity in 6 months.
B. Buy put options on olive oil with maturity in 6 months.
C. Sign a forward contract to buy olive oil with maturity in 6 months.
D. Sign a forward contract to sell olive oil with maturity in 6
months.
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80 = 120 + n 20, Solution is: f[n = 2:0]g
Cost of the risk-free portfolio must be the present value of 80: