UNIVERSITY OF CAPE TOWN

SCHOOL OF ECONOMICS
ECO400W / ECO401W
FINANCIAL ECONOMICS I
FINAL EXAMINATION

NOVEMBER 2003

Time: 3 hours

PART 1: PORTFOLIO THEORY AND CORPORATE FINANCE S. J. HASSAN

Instructions for Part 1:
Answer any two of the following three questions.
All questions carry equal weight.
This section is closed-book. [i.e. no formulae or notes of any kind allowed.]
QUESTION 1
You know from microeconomic theory that, if investors preferences satisfy the rationality
axioms (completeness and transitivity), as well as continuity and independence, optimal
choice under uncertainty can be reduced to maximisation of expected utility. The following
(quadratic) utility of wealth or money function has been used in the finance literature to
describe investor behaviour:
u ( w) w bw 2
a) Show that, for quadratic utility investors, expected utility is determined by mean and
variance of wealth. (i.e. that mean-variance optimisation can be rationalised by
expected utility maximisation.)
b) Criticise this specification of the utility function with reference to implied attitudes
to risk.
c) How can mean-variance analysis be justified without assuming quadratic utility?
Prove any statement, and include brief discussion of implications for the
computation of returns in empirical finance and applications of portfolio theory.
QUESTION 2
a) Consider an investment universe consisting of N risky securities and one risk-free
asset. (i) Illustrate the mean-variance efficient frontier; and (ii) derive and briefly
explain the Capital Market Line. [Hint: The Capital Market Line is not the Securities
Market Line.]
b) Suppose there exist only three securities, two risky and one risk-free. The risk-free
rate is 10%. The expected returns and standard deviations of the risky securities are
as follows:

Security 1
Security 2

Expected return
10%
4%

Standard deviation
5%
2%

What is the optimal investment for a mean-variance optimiser? Why?

c) Return to the N-risky securities and one risk-free asset world. Assume the Capital
Market Line is upward sloping. Argue, with the aid of a diagram, that a risk-averse
investor will never optimally invest all her wealth in the risk-free asset, irrespective
of his degree of risk aversion. [State all/any assumptions.]

QUESTION 3
a) A firm has R100 000 to invest. It is faced with two investment opportunities, A and B.
Both projects are scalable (i.e. there is no limit on the number of A or B projects that can
be invested in). The cash-flows (in thousands) from each project are given below:

Project A
Project B

T0 (initial outlay)
-10
-50

T1
220
440

T2
-145.2
-254.1

The risk-free rate of interest is 5%. Both projects have a CAPM-Beta of 2. The expected
return on the market portfolio is 7,5% Which project should the firm choose? Why?
[Hint: be careful.]
b) How can free-riding by small shareholders of (potential) takeover targets preclude
hostile takeover bids? (State all assumptions.)
c) How can two-tiered offers resolve the problem in b?
[You may use a numerical example to support your answers to b and c. Answers should
be concise.]

PART 2: DERIVATIVES MARKETS PROF H. ABRAHAM

Answer all questions

All questions carry equal weight
QUESTION 4
(a) A 1-year call option on a stock with a strike price of R30 costs R3; a 1-year
put option on the stock with a strike price of R30 costs R4. Suppose that a trader
buys two call options and one put option.
(i)
What is the breakeven stock price above which the trader makes a
profit?
(ii)
What is the breakeven stock price below which the trader makes a
profit?
(b)
A company enters into a long futures contract to buy 1000 barrels of oil
for $20 per barrel. The initial margin is $6000 and the maintenance margin is
$4000. What price of oil futures will allow $2000 to be withdrawn from the
margin account?

QUESTION 5
(a) The 3-year zero rate is 7% and the 4-year zero rate is 7.5% (both
continuously compounded). What is the forward rate for the 4th year?
(b) The 6-month zero rate is 8% with semiannual compounding. The price
of a 1-year bond that provides a coupon of 6% per annum semiannually is 97.
What is the 1-year continuously compounded zero rate?
QUESTION 6
The term structure is flat at 5% per annum with continuous compounding. Some
time ago a financial institution entered into a 5-year swap with a principal of R100
million in which every year it pays 12-month LIBOR and receives 6%. The swap
now has two years eight months to run. Four months ago 12-month LIBOR was 4%
(with annual compounding). What is the value of the swap today?
QUESTION 7
A stock price is currently R40. Over each of the next two 3-month periods it is
expected to go up by 10% or down by 10%. The risk-free interest rate is 12% per
annum with continuous compounding.
(a) What is the value of a 6-month European put option with a strike price of
R42?
(b) What is the value of a 6-month American put option with a strike price of
R42?