Financial Economics 2023/24 - FINAL EXAM - Model 2

1. Suppose that an investor invests in Italian Government bonds that pay a

…xed coupon for 10 years. Which of the following risks a¤ect her investment?
A. In‡ation risk
B. Interest rate risk
C. Default risk
D. All of the above

2. What is the DIFFERENCE between short selling a stock and selling a

futures on that stock?
A. Short selling a stock is a bet that the stock price will decline
B. When short selling a stock, the investor receives an initial
positive cash-‡ow
C. There is a margin requirement only for positions in futures
D. It is possible to lose money through futures

3. Consider two risky assets, A and B, with the same standard deviation, .
The correlation between the returns of these two assets is -0.5. Which of the
following statements is correct?
A. Any portfolio of these two assets will have the same standard deviation
B. A portfolio of these two assets, with positive weights in both
assets, will have a standard deviation lower than
C. It is possible to form a risk-free portfolio consisting of these two assets
D. None of the above statements is true

Since correlation is not perfect, all portfolios of those two assets will be on a
curve. Portfolios with positive weights in both assets have volatility lower than
: Portfolios with short positions in one of the assets have higher volatility.

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4. Consider a market with only three assets, A, B, C, with expected returns
equal to 10%, 15% and 16.5%, respectively, and standard deviations of 12%,
14% and 16%, respectively. Correlations are zero. If the risk-free rate is 10%,
which one of the portfolios below is the tangency portfolio?
A. wA = 0:21; wB = 0:31; wC = 0:48
B. wA = 0:31; wB = 0:34; wC = 0:35
C. wA = 0; wB = 0:5; wC = 0:5
D. wA = 0:5; wB = 0:5; wC = 0

The tangency portfolio has the highest Sharpe ratio, we compute that for
each portfolio:
0:21 0:1+0:31 0:15+0:48 0:165 0:1
SA = p0:21 2 0:122 +0:312 0:142 +0:482 0:162
= 0:509 028 788 4
0:31 0:1+0:34 0:15+0:35 0:165 0:1
SB = p0:31 2 0:122 +0:342 0:142 +0:352 0:162
= 0:482 550 761 6
0:5 0:15+0:5 0:165 0:1
SC = p0:52 0:142 +0:52 0:162 = 0:540 914 499 3
SD = p0:5 0:1+0:5 0:15 0:1
0:52 0:122 +0:52 0:142
= 0:271 163 072 3

5. Which of the following statements is true?

A. It is generally riskier to invest in multiple countries than in just one
country because an international portfolio is exposed to more sources of risk
B. A well-diversi…ed portfolio has no risk.
C. A portfolio with a weight of 50% in each one of 2 risky assets
with equal variance, 2 , and perfectly and positively correlated
returns has the same variance, 2
D. A portfolio with a weight of 50% in each one of 2 risky assets with equal
variance, 2 , and perfectly and negatively correlated returns has the same
variance, 2

A and B are false. We verify if C and D are true:

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C: p = 0:52 2
+ 0:52 2
+ 2 0:52 2
= 4 0:52 2
= 2
2
D: p = 0:52 2
+ 0:52 2
2 0:52 2
=0< 2

6. Suppose we estimate the single-index model for a stock and estimate a

beta of 0.9. If the standard deviation of the stock is 30% and the standard
deviation of the market portfolio is 20%, what is the standard deviation of the
idiosyncratic shock (")?
A. 24%
B. 22%
C. 20%
D. 18%

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 Single-index model: Rj = a + j RM + "j

Computing the variance of q

Rj :
2 2 2 2 2 2 2
p
j = j M + " > "= j j M = 0:32 :92 0:22 = 0:24

7. Consider a risky asset that o¤ers an expected cash-‡ow of 10 euros per

share in 1 year and 20 euros per share in 2 years. The standard deviation of
the asset’s return is 25%, the standard deviation of the market portfolio return
is 20% and the correlation between them is 0.8. The expected market return is
20% and the risk-free interest rate is 4% for all maturities. If the CAPM
holds, what is the price per share of this asset?
A. 21.67 euros
B. 22.22 euros
C. 24.61 euros
D. 27.66 euros

We …rst need to compute the asset’s expected return in order to discount its
future expected payo¤s.
0:25 0:2 0:8
= 0:22 = 1:0

E(R) = 0:04 + 1 (0:2 0:04) = 0:2

10 20
P = 1:2 + 1:22 = 22: 222 222 22

8. Suppose that the Security Market Line (SML) does not hold for some
assets, which of the following statements is FALSE?
A. The market portfolio does not have the maximum Sharpe ratio
B. Actively managed portfolios could in principle beat passively managed
portfolios
C. There must exist arbitrage opportunities in this market
D. It is possible to earn abnormal returns by buying assets above the SML and
short-selling assets below the SML

9. Suppose that the market portfolio’s Sharpe ratio is 0.5 and the CAPM
holds. If the interest rate is 5%, what is the minimum standard deviation that
an investor would need to bear in order to achieve an expected return of 10%?
A. 10%
B. 15%
C. 20%
D. It is impossible to know with the available information

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 To minimize risk for a given level of expected return, the investor must choose
an e¢ cient portfolio (combination of the risk-free rate with the market portfolio.
The relation between expected return and volatility for e¢ cient portfolios is
given by the Capital Market Line.
CML: E(Rp ) = r + SM p > 0:1 = 0:05 + 0:5 p , Solution is: f[ p = 0:1]g

10. Which of the following statements related to the E¢ cient Market

Hypothesis (EMH) is TRUE?
A. Weak Form E¢ ciency states that all information, including inside
information, is fully re‡ected in stock prices, making it impossible to achieve
abnormal returns.
B. Semi-Strong Form E¢ ciency suggests that stock prices fully
re‡ect all publicly available information, so it is impossible to
achieve abnormal returns based on public information.
C. Strong Form E¢ ciency implies that only information derived from market
trading data, such as past stock prices and trading volume, is re‡ected in stock
prices.
D. Weak Form E¢ ciency indicates that stock prices re‡ect all publicly
available information, making insider trading the only way to achieve
abnormal returns.

11. Three risk-free bonds are traded in the market.

Bond A is a one-year zero-coupon bond with nominal of 500 euros.
Bond B is a two-year zero-coupon bond with nominal of 1000 euros.
Bond C is a two-year coupon bond with annual coupon of 10 euros and
nominal of 120 euros.
Prices of bonds A, B and C are BA = 485 euros, BB = 940 euros and BC =
132.5 euros. Which of the following strategies is an arbitrage?
A. Buy 1 unit of Bond C, short sell 0.02 units of bond A, short sell 0.13 units
of bond B
B. Short sell 1 unit of Bond C, buy 0.02 units of bond A, buy 0.13
units of bond B
C. Short sell 1 unit of Bond C, buy 0.02 units of bond A, buy 0.12 units of
bond B
D. There is no arbitrage in this market

We obtain the prices of basic bonds from the fundamental pricing equation

applied to bonds A and B:

485 = 500b1
, Solution is: f[b1 = 0:97; b2 = 0:94]g
940 = 1000b2

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 We use b1 and b2 to compute the no-arbitrage price of C:

10 0:97 + 130 0:94 = 131: 9 < 132:5 > Bond C is too expensive. We want
to short it and buy its replicating portfolio.

Replicating portfolio for C:

500nA = 10
, Solution is: f[nA = 0:02; nB = 0:13]g
1000nB = 130

CF(t=0) CF(t=1) CF(t=2)

short sell 1 unit of 132:5 10 130
buy 0.02 units of A 0:02 485 = 9: 7 0:02 500 = 10:0
buy 0.13 units of B 0:13 940 = 122: 2 0:13 1000 = 130:0
Total 132:5 9: 7 122: 2 = 0:6 0 0

12. A two-year bond that has a nominal of 100 euros and pays an annual
coupon of 4%, is currently trading at par value (price = nominal). Compute
the bond’s modi…ed duration.
A. 1.971
B. 1.962
C. 1.913
D. 1.886

We know that when the bond trades at par value, its yield-to-maturity equals
the coupon rate: i = ic = 4%
2
D = 4=1:04+2100104=1:04 = 1: 961 538 462

mD = D=(1 + i) = 1: 961 538 462=1:04 = 1: 886 094 675

13. The 1-year and 2-year interest rates, r1 and r2 , are 4% and 3%,
respectively, and today it is possible to sign a forward contract for lending and
borrowing in one year with maturity in two years at an interest rate, f2 , of
2.51%. Therefore, there is an arbitrage strategy that involves:
A. Borrowing 100 euros today over two years, lending 103.5 euros
between year 1 and year 2 through the forward contract, and
lending 99.52 euros today over 1 year.
B. Borrowing 100 euros today over two years, lending 103.5 euros between year
1 and year 2 through the forward contract, and lending 100.5 euros today over
1 year.

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C. Lending 100 euros today over two years, borrowing 103.5 euros between
year 1 and year 2 through the forward contract, and borrowing 99.52 euros
today over 1 year.
D. Lending 100 euros today over two years, borrowing 103.5 euros between
year 1 and year 2 through the forward contract, and borrowing 100.5 euros
today over 1 year.

1:032
f NA = 1:04 1 = 2: 009 6 10 2
< 2:5%

Arbitrage:
CF(t=0) CF(t=1) CF(t=2)
Borrow 100 over 2 years 100 100 1:032 = 106: 09
+103: 5 (1:0251)
lend 103:5 between 1 and 2 103: 5
= +106: 098
Lend 99:52 between 0 and 1 99:52 +99: 52 1:04 = +103: 5
Total 0:48 0 0:008

14. The one-year risk-free interest rate is r1 =3% and the two-year rate is
r2 =3%. If the Preference for Liquidity Hypothesis of the term structure of
interest rates is true (the liquidity premium is positive), which of the following
statements is true?
A. Investors expect the one-year interest rate next year to be higher than the
current one-year interest rate
B. Investors expect the one-year interest rate next year to be equal to the
current one-year interest rate
C. Investors expect the one-year interest rate next year to be lower
than the current one-year interest rate
D. It is impossible to say whether Investors expect the one-year interest rate
next year to be higher, lower, or equal to the current one-year interest rate

(1:03)2 = (1:03)(1 + f2 ), Solution is: f[f2 = 0:03]g

Under the PLH:
f2 = E(1 r2 ) +1 L2 > E(1 r2 ) = f2 1 L2 = 0:03 1 L2 < 0:03 = r1

15. One share of a company that pays no dividends currently trades at 10

euros. The price of a European call option on one share with strike price of
10.5 euros and maturity in one year is 1.2 euros. The price of a European put

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option on one share with strike price of 10.5 euros and maturity in one year is
0.80 euros. If the interest rate is 5%:
A. There is an arbitrage opportunity consisting of buying one call on the
stock, lending 10 euros over 1 year, selling one put and short selling one share.
B. There is an arbitrage opportunity consisting of selling one call on the stock,
lending 10 euros over 1 year, selling one put and short selling one share.
C. There is an arbitrage opportunity consisting of selling one call on
the stock, borrowing 10 euros over 1 year, buying one put and
buying one share.
D. There is an arbitrage opportunity consisting of buying one call on the
stock, borrowing 10 euros over 1 year, buying one put and buying one share.

We check if put-call parity holds

K
c + 1+r =p+S
1:2 + 10:5
1:05 = 11: 2 < 0:8 + 10 = 10: 8

The call is relatively too expensive and the put is relatively too cheap
16. Why does the price of a European put option decrease as interest rates
increase?
A. Because higher interest rates make investors more risk-averse, thus
decreasing the demand for options.
B. Because higher interest rates increase the price of the underlying asset,
making the option less attractive.
C. Because higher interest rates decrease the present value of the
strike price.
D. Because higher interest rates decrease the future uncertainty of the
underlying asset, leading to lower option prices.

17. Suppose you work for the risk management department of an airline
company, Greenwinds. The company is planning to buy 15 million barrels of
fuel in December 2024. A barrel of fuel currently trades at USD 80. Given the
current geopolitical and economic uncertainty, the company would like to
hedge against the downside risk of the price increasing with respect to the
price today, but would like to keep the upside risk. What would you do?
A. Sell futures on 15 million barrels of fuel with maturity in December 2024.
B. Buy put options on 15 million barrels of fuel with maturity in December
2024 and strike price = USD 80 per barrel.
C. Sell call options on 15 million barrels of fuel with maturity in December
2024 and strike price = USD 80 per barrel.
D. Buy call options on 15 million barrels of fuel with maturity in
December 2024 and strike price = USD 80 per barrel.

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 If ST < 80; the call options will not be exercised, and the …rm will buy the

fuel for a low price

If ST > 80; the call options will pay ST 80 per barrel, o¤setting the losses

due to the higher purchase price

18. Consider a stock that pays no dividends, which currently trades at

S0 =20. Assume that only two scenarios are possible at the end of the year:
S1 (d)=16 and S1 (u)=28. The interest rate is 0% and a European put on that
stock with maturity in 1 year and strike price K = 18 is currently trading at p
= 1.5 euros. Which of the following statements is true?

A. There is an arbitrage strategy that consists of short-selling 1 share,

selling 3 put options and borrowing 28 euros over 1 year.
B. There is an arbitrage strategy that consists of buying 1 share, buying 6
put options and lending 28 euros over 1 year.
C. There is an arbitrage strategy that consists of short-selling 1
share, selling 6 put options and lending 28 euros over 1 year.
D. There is an arbitrage strategy that consists of buying 1 share, buying 3
put options and borrowing 28 euros over 1 year.

Payo¤ of the put option.

pd1 = 2
pu1 = 0

Risk-free portfolio consists of 1 unit of the stock and np puts:

16 + 2np = 28, Solution is: f[np = 6:0]g

Cost of the risk-free portfolio must be the present value of 28:

28 = 20 + 6 p, Solution is: f[p = 1: 333 333 333]g < 1:5 = p

The put is too expensive:

Arbitrage:
CF(t=0) CF(t=1)
S1 = 16 S1 = 28
Short 1 share 20 -16 -28
Sell 6 put options 6x1:5 = 9 -6 x 2 0
Lend 28 -28 28 28
Total 1 0 0