FINANCE 350 Global Financial Management

Final Exam Fall 2001

Professors Brav and Roberts

NAME:
SECTION:
LOCKER #:

Question

Maximum

Question 1

Bonds

15

Question 2

Portfolio Analysis

10

Question 3

CAPM

15

Question 4

Futures, Forwards & Options

25

Question 5

Options

20

Question 6

Leverage

15

TOTAL

100

Student Score

Question 1: (Bonds, 15 points)

a) Find the price of a 10% Government coupon bond that pays annual coupons, matures
in exactly 2 years, and has a face value of $1,000. The yield to maturity is 4.09% p.a.
compounded annually. The bond has just paid its annual coupon, hence you need to price
it assuming that the first coupon that you will receive is due in exactly one year. (5
points)
Answer: The value of this bond is:
1 (1.0409) 2
1,000
= $1,111.3
P0 = 100
+
2
.0409

(1.0409)

b) You have the following data on spot and forward rates on US treasury securities:
Time horizon
r0,1
f1,2
f2,3
f3,5

Rates
4.12%
4.06%
4.36%
4.18%

For example, the one-year spot interest rate, r0,1, is 4.12%. The one-year forward rate
starting in one year for one year, f1,2, is 4.06%. All rates compound annually.
Construct the term structure of interest rates from the data above. That is, calculate the
implied yields on a 1, 2, 3, and 5-year zero coupon bonds using the information about the
forward rates. (6 points)
Answer: the yield on a one-year zero coupon bond is given as 4.12%. The yield on the 2year zero coupon bond is obtained by noting that: (1+ r0,2)2 = (1+ r0,1)*(1+ f1,2) so r0,2 =
4.09%. The rest of the yields are calculated similarly and given in the next table:
Time horizon
r0,1
f1,2
f2,3
f3,5

Rates
4.12%
4.06%
4.36%
4.18%

4.12%
r0,2 = 4.09%
r0,3 = 4.18%
r0,5 = 4.18%

c) What is the forward rate f1,5; that is, the forward rate on a four-year loan starting in
one year? (4 points)
Answer: We know that the following relationship holds:
(1+ r0,5)5 = (1+ r0,1)*(1+ f1,5)4, so (1.0418)5 = (1.0412)*(1+ f1,5)4, therefore f1,5 =
4.195%

Question 2: (Portfolio Analysis, 10 points)

Asset A has an expected return of 18% and a standard deviation of 38%. Asset B has an
expected return of 14% and a standard deviation of 21%. The correlation between asset
A and B is 0.4.
a) How much should you invest in asset A and asset B in order to obtain an expected
return of 17%? (3 points)
Answer:
17% = w * 14% + (1 w) * 18% w = 25%

We need to invest 25% of our wealth in asset B and 75% in asset A.

b) Assuming you can borrow and lend at the risk-free rate of 8%, which asset (A or B)
offers a better investment opportunity? Explain why. (3 points)
Answer: We can compare the Sharpe ratio for each asset as:

Sharpe( A) =

E (rA ) rf

E (rB ) rf

0.18 0.08
= 0.263
0.38

0.14 0.08
= 0.286
0.21
B
Since asset B has a greater Sharpe ratio, it offers a better investment opportunity.
Sharpe( B ) =

c) Can you construct a risk-free portfolio using only assets A and B, assuming you may
short-sell either asset? If so, what are the weights of your portfolio. In not, explain. (4
points)
Answer: Without perfect correlation, or inclusion of the risk-free asset, it is not
possible to eliminate all uncertainty (SD = 0) in a portfolio of just assets A and B.
This can be confirmed by computing the SD of the minimum variance portfolio, which
is greater than 0.

Question 3: (CAPM, 15 points)

Stock A has a beta equal to 1 and stock B has a beta equal to 1.5. The expected market
return is 11% and the risk-free return is 5%.
a) Construct a portfolio with a beta equal to zero using stock A and stock B. (4 points)
Answer: The asset weights are 300% long in stock A and short 200% in stock B
b) Assuming the CAPM model is correct, what is the expected return on the portfolio in
part a)? (3 points)
Answer: It is just equal to the risk-free return, 5%.
c) Over the last decade stock A realized an average annual return of 12%, while stock B
realized an average annual return of 13%. According to the CAPM, which security
was the better buy? Explain why. (4 points)
Answer: According to the CAPM, stock As expected return is:

E (rA ) = r f + E (rm ) r f = 5% + 1(11% 5% ) = 11%

implying that stock A earned, on average, an excess return of 1% per year.

Stock Bs expected return is:

E (rB ) = rf + [E (rm ) rf ] = 5% + 1.5(11% 5% ) = 14%

implying that stock B experienced, on average, a loss relative to its CAPM expectation.

d) Assume that Stock Bs return has a covariance of 0.0938 with the market return. First,
determine the covariance of stock As return with the market return. Second,
determine the correlation between stock As return and the market return? If this is
not possible, explain why. (4 points)
Answer:
1.5 =
1=

0.09375

M = 0.0625
2

cov
cov = 0.0625
0.0625

We cannot compute the correlation of stock As returns and the market without
knowing the standard deviation of Stock As returns.

Question 4: (Futures and Forwards and Options, 25 points)

a) The spot price of wheat is 550 cents per bushel and the six-month forward price is
582.1 cents per bushel. The riskless rate of interest is 5% p.a. and the cost of carry
(i.e., storage costs) is 6% p.a. Is there an arbitrage opportunity in this market?
Assume that interest and costs of carry are continuously compounded. (10 points)
Answer: We know that in the absence of arbitrage the forward price is given by: F =
S0e(q+r)T . Therefore, F = 550e(0.06+0.05)0.5 = 581.1. Since the forward price in the
market is 582.1 we have an arbitrage opportunity, which is given in the following
arbitrage table:

Position

Initial Cashflow

Terminal Cashflow

Buy one unit of the commodity

-550

ST

Pay cost of carry

-550(e0.06*0.5 1)

Borrow

550e0.06*0.5

-550e(0.06+0.05)*0.5

Enter Forward sale

582.1-ST

Net payoff

582.1-550e(0.06+0.05)*0.5=1

The arbitrage can also be done as follows

Position

Initial Cashflow

Terminal Cashflow

Buy the commodity

-550e0.06*0.5 = -566.75

ST

Borrow

582.1e-0.05*0.5 = 567.73

-582.1

Enter Forward sale

582.1-ST

Net payoff

0.98

b) This section is independent of part (a). For this section assume that the six-month
forward price is equal to 581.1 cents per bushel.
Consider a miller who needs to buy 20,000 bushels of wheat in exactly six months
and wishes to hedge his exposure to fluctuations in the price of wheat.
If one wheat forward contract obligates the buyer to purchase 5,000 bushels at the
forward price, describe how the miller can hedge the commodity price risk using a
position in forward contracts. Be sure to specify the position (buy/sell), number of
contracts, and the guaranteed dollar cost in six months (6 points)
Answer:
The miller needs to buy 20,000/5,000 = 4 forward contracts. The resulting dollar cost
is: 5.811*20,000 =$116,220.
c) If the spot price of wheat in six months is 600 cent per bushel numerically illustrate
how the position in forwards from part b) completely insulates the millers cost from
the change in wheat price. (4 points)
Answer:

At 600 cents per bushel buying 20,000 bushels costs 120,000 dollars. Note that since
we locked in a lower forward price are notional dollar gain is 4*5,000*(65.811)=$3,780. Hence, total cost is 120,000-3,780=$116,220.
d) Construct the hedge for the miller using options rather than forwards. Specifically,
you can buy or sell either put or call options given in the following table:
Strike Price
Call premium
Put premium
(cents per bushel) (cents per bushel) (cents per bushel)
585
30
34
Option contracts are per 5,000 bushels. Hence, the table reads as follows: If you buy
one put option contract on wheat for six months with a strike price of 585 cents, you
will have a right to sell 5,000 bushels at a price of 585 cents per bushel. Today you
have to pay 34 cents per bushel for this option.
Similarly, if you buy one call option contract on wheat for six months with a strike
price of 585 cents, you will have a right to buy 5,000 bushels at a price of 585 cents
per bushel. Today you have to pay 30 cents per bushel for this option.
Which option do you buy/sell and how many? What is the maximum cost including
the option premiums that the miller guarantees by hedging with options? (5 points)
Answer:
The miller should buy 20,000/5,000 = 4 call option contracts to hedge the price of
wheat going up. The maximum cost including the cost of the options in dollars is:
5.85*20,000 + 0.30*20,000 = 123,000 dollars.

Question 5: (Options, 20 points)

A stock is currently selling for $100. The current price of a 6-month call option on the
stock with an exercise price of $105 is selling for $12. The risk-free interest rate is 5%,
compounded continuously.

a) Assuming there are no dividends paid on the stock, compute the price of a 6-month
put option on the stock with exercise price equal to $105. (5 points)
Answer: Using put-call parity we get:
p = c S + Xe rT
= 12 100 + 105 * e 0.05(0.5 )
= 14.408
b) Imagine that the put is selling in the market for $13. Is there an arbitrage opportunity?
If so, execute a strategy to take advantage of the arbitrage. Clearly state your
positions and cash flows in an arbitrage table. (7 points)
Answer:
From put-call parity, the strategy is to buy the cheap put and sell the replicating
portfolio, which consists of selling the call, buy the stock and borrowing cash.
Today
Buy Put
Sell a Call
Buy the Stock
Borrow

Expiration of Options Contracts

ST<X
ST>X
105-ST
0
0
105- ST
ST
ST
-105
-105

-13
+12
-100
+102.4

The future net payoff from the position in the put and the replicating portfolio is 0,
regardless of the future price of the stock. However, the payoff today is $1.04.
We can also gear the strategy to payoff in the future, as follows:
Today
Buy Put
Sell a Call
Buy the Stock
Borrow

Expiration of Options Contracts

ST<X
ST>X
105-ST
0
0
105- ST
ST
ST
-103.557
-103.557

-13
+12
-100
+101

The future profit is 1.44.

c) This section is independent of parts (a) and (b).
Imagine that you are unable to short-sell a particular stock. Using put-call parity,
replicate a short position in the stock, assuming that the stock pays no dividends,
there is a put and a call option, both of which have the same exercise price, X, and the
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same time to expiration, T. You are able to borrow and lend at the continuously
compounded risk-free rate, r. Use an arbitrage table to support your argument. (4
points)
Answer: To replicate shorting a stock, we need to buy a put, sell an otherwise
identical call and borrow the present value of the strike price. This is seen in the
table.
Today
Short stock
Buy a Put
Sell a Call
Borrow

Expiration of Options Contracts

ST<X
ST>X
-ST
-ST
X-ST
0
0
X-ST
-X
-X

+S
-P
+C
X*e-rT

d) This section is independent of parts (a) and (b) and (c).

A collar is a combined position in which the investor:

buys the underlying asset,

buys an out-of-the-money put option (i.e. underlying asset price > strike price)

sells an out-of-the-money call option (i.e. strike price > underlying asset price),

where both options have the same expiration date. Assume that the current stock price
is 100, the strike price of the put option is 90 and the strike price of the call option is
110. Draw the payoff diagram for a collar position, excluding the initial costs (or
revenues) from the purchase or sale of the asset and options. On your diagram, clearly
label both axes, the current asset price, and the strike prices of the two options. (4
points)

Answer: The payoff diagrams of the individual positions are:

Individual Position Payoffs (excluding initial
costs/revenues)
200

Payoff at Maturity

150
100

Asset
Buy Put

50

Sell Call

0
0

50

100

150

200

-50
-100
Stock Price at Maturity

The payoff of the collar position (adding the individual positions together) is

Payoff at Maturity

Collar Payoff (excluding initial

costs/revenues)
120
110
100
90
80
60
40

Put

20
0
0

50

Call

90 110
100

150

200

Stock Price at Maturity

Question 6: (Leverage, 15 points)

The Bear Company and the Bull Company are identical in every respect except that the
Bear Company is unlevered (i.e. no debt), while the Bull Company has bonds outstanding
paying 12% interest and worth $2 million. There are no taxes, all cash flows may be
viewed as perpetual streams, and capital markets are assumed to be perfect.
Accounting data on the two firms is as follows:

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Bear

Bull

$600,000

$600,000

$240,000

Earnings to Equity holders

$600,000

$360,000

Required Return on Equity

15%

16%

Market Value of Stock

$4,000,000

$2,250,000

Market Value of Debt

$2,000,000

$4,000,000

$4,250,000

15%

14.12%

0.89

Net Operating Income

Interest on Debt

Total Value of Firm

WACC
Debt-to-Equity Ratio

a) Do the values of these companies offer an arbitrage opportunity? If not, what action(s)
by investors will change their relative value? Assume that you can buy and/or sell
fractions of Bull and Bears outstanding equity and debt, if necessary. (10 points)
Answer: No. Without taxes and other imperfections we know that Vu = Vl. Hence, Bull,
the levered firm, is overvalued and investors will sell its equity and debt and buy the
equity of the un- levered firm. This strategy will decrease the value of the levered firm
and simultaneously increase the value of the unlevered firm.
In particular, supposed that we buy 1% of Bears equity and short sell 1% of
Bulls equity and debt. Here is the resulting arbitrage table with the resulting
arbitrage profit:
Action

Payoff Today

Payoff in each of
the following years

Buy 1% of Bears equity

-40,000

+6,000

Short sell 1% of Bulls equity

+22,500

-3,600

Short sell 1% of Bulls debt

+20,000

-2,400

Net Cashflows

+2,500

b) For this section assume that the correct weighted average cost of capital (WACC) for
both companies is 15%. If the cashflows to Bulls debt and equity holders are as

11

described in the above table and Bulls debt is correctly priced in the market what is
the required return on Bulls equity and what is the value of Bulls equity? (5 points)
Answer: We know that WACC = rE

E
D
+ rD
, therefore we can calculate rE
D+E
D+E

2 4
D D+E

as follows: rE = WACC rD
= 0.15 0.12 = 0.18 or 18% and

4 2
D+E E

the market value of Bulls equity is: 360,000/0.18 = $2,000,000.

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