313 Final Exam

Final Exam - Finance I

Practice Exam 2015

Instructions
WRITE ALL YOUR ANSWER ON YOUR ANSWER SHEETS (DO NOT WRITE YOUR
ANSWERS ON THE EXAM PAPERS)
Use a calculator which is allowed by the exam policy of the school.
Use the formula sheet provided. It also includes a table of cumulative normal
distribution.
Use answer sheets provided by the school. Do not use any blank papers as answer
sheets.
Answer each question (Question 1-4) on a separate answer sheet.
Dont forget to write your name and student ID number on each page of the answer
sheet.
Write clearly. Illegible answers will not be marked.

Important Information
(1) Answer briefly, and show how you got the answer for a numerical question.

(2) You may round to two decimal places to answer numerical questions. (In case of an
interest rate or a probability, you may round to two decimal places in percentage. For
example, you can either answer 0.12% or 0.0012.)

(3) You can state the assumptions you made in your answers in case you cannot understand
the questions properly. However, unnecessarily lengthy answers will be penalized.
Question 1. (25 points)
A. (10 points)

Answer True or False. (WRITE ALL YOUR ANSWERS ON THE ANSWER SHEET. DO NOT WRITE THEM
ON THE EXAM PAPERS.)

i. (2 points) Participating in financial markets allows you to smooth your consumption.

True

ii. (2 points) Debt, equity, and derivatives are examples of real assets.

False

iii. (2 points) Financial markets can channel resources to efficient use.

True

iv. (2 points) APR is the actual amount of interest that will be earned at the end of one year in case
of annual compounding.

True

v. (2 points) In the dividend discount model (DDM), small changes in the assumed dividend growth
rate may lead to large changes in the estimated stock price.

True

B. (5 points)

Lanni Products is a start-up computer software development firm. It currently owns computer
equipment worth $30,000 and has cash on hand of $20,000 contributed by Lanni's owners. For each
of the following transactions, identify the real and/or financial assets that trade hands. Choose all
the transactions where financial assets are created or destroyed.

(a) Lanni issues corporate bonds with 3 year maturities to finance new investment in manufacturing
equipments.

(b) Lanni uses the cash from the bank plus $20,000 of its own funds to finance the development of
new financial planning software.

(c) Lanni sells the shares of stock for $80 per share and uses part of the proceeds to pay off the bank
loan.

(d) Lanni pays out a dividend of $2 per share to their shareholders.

Answer: (a), (c)

C. (10 points)

Suppose that the risk-free rate is given by 10%, and you can borrow or invest at the risk-free rate.
There is a riskless bond that pays $1000 in one year.

i. (2 points) What is the present value of the bond?

PV = 1000/1.1=909.09

ii. (3 points) Suppose that the price of the bond is $900 today. Briefly explain why there is an
arbitrage opportunity.

Because the present value of the riskless bonds cash flows is higher than its price, there is a
violation of law of one price. This implies that there is an arbitrage opportunity.

iii. (5 points) Explain how you will exploit the arbitrage opportunity.

You can first borrow $1000/1.1 = $909.09 today at the risk-free rate. Using the borrowed money,
you can buy the bond at $900. Therefore, you get $909.09 - $900 = $9.09 today. In one year, you
do not owe anything because you owe $1000 from your borrowing, but receive $1000 from the
bond.
Question 2. (25 points)
A. (10 points)

Answer True or False. (WRITE ALL YOUR ANSWERS ON THE ANSWER SHEET. DO NOT WRITE THEM
ON THE EXAM PAPERS.)

i. (2 points) Suppose that there is a gamble that pays $20 or $0 with equal probabilities. A risk-
averse investor is willing to pay $10 for the gamble.

False

ii. (2 points) Two portfolios on the same capital allocation line have the same Sharpe ratio.

True

iii. (2 points) A risk-free asset pays the same amount of money regardless of the state of the world.

True

iv. (2 points) According to Mean-variance analysis, you can rank portfolios by their Sharpe ratios.

True

v. (2 points) With a passive investment strategy, investors should do security analysis.

False

B. (3 points)

Monsters, Inc. is expected to pay $2 per share as a dividend next year, and it is expected to grow at
8%. The beta of Monsters stock is given by 2. The risk-free rate is 2%, and the market risk premium
is 8%.
i. (2 points) Assuming the law of one price, what should be the stock price of Monsters?

Equity cost of capital (or discount rate) = 2% + 2*8% = 18%

Using Gordon growth formula, we have
PV = $2/(18%-8%) = $20

Therefore, the price should be $20 assuming the law of one price.

ii. (1 point) Suppose that the current stock price is actually $25. Choose one of the following that
may contribute to such an overvaluation (or bubbles) in Monsters stock.

(a) passive investment

(b) short sale constraint

(c) active investment

(d) market efficiency

Answer: (b)

C. (12 points)

You are a finance advisor. You must recommend a portfolio that consists of the risk-free asset and
one of the following funds to your client. The client has a mean-variance preference with the
parameter A=5, i.e.,

A
EU (r ) E (r ) Var (r )
2

The risk-free rate is 2%.

Expected return Volatility

Fund A 5% 15%

Fund B 17% 20%

Fund C 22% 40%

i. (2 points) Calculate the Sharpe ratios of the funds.

Sharpe ratio of Fund A = (5%-2%)/15% = 0.2

Sharpe ratio of Fund B = (17%-2%)/20% = 0.75

Sharpe ratio of Fund C = (22%-2%)/40% = 0.5

ii. (1 point) Which fund of the three available funds would you recommend? Briefly explain why.

Fund B is the best because it has the highest Sharpe ratio.

iii. (4 points) Suppose that the client has $50,000. Recommend the optimal portfolio for the client
including the risk-free asset.

Given A=5, we need to find an optimal portfolio according to mean-variance preference. The
optimal portfolio weight on the risky asset = (17%-2%)/(4*20%^2) = 0.75. That is, the optimal
portfolio consists of 75% fund B, and 25% risk-free asset. Therefore, you recommend investing
$37,500 on Fund B, and $12,500 on the risk-free asset.
iv. (5 points) Suppose that there is another client who already invested $50,000 in Fund C and the
risk-free asset because she didnt have any information about Fund A nor Fund B. She has initially
invested $15,000 in Fund C, and $35,000 in the risk-free asset (i.e., her portfolio consists of 30% of
Fund C and 70% of the risk-free asset). She wants to change her portfolio according to your advice.
What would you recommend about her portfolio choice if she can create a portfolio that consists of
one of the three funds and the risk-free asset? Answer how much she should invest her $50,000 in
the recommended fund and the risk-free asset.

(Hint: Use the revealed preference from her initial choice of capital allocation)

Portfolio choice (22%-2%)/(A*40%^2) = 30%. Solving for A yields A=4.17. Therefore, her risk-
aversion parameter is A=4.17 by the revealed preference. Because Fund B is superior to others, you
recommend a portfolio that consists of Fund B and the risk-free asset.

We find the optimal portfolio choice is given by the weight on Fund B (17%-2%)/(4.17*20%^2) =
89.93%

Therefore, you should recommend investing $44,964 (=$50,000*89.93%) in Fund B, and $5,036
(=$50,000-$44,964) in the risk-free asset.
Question 3. (25 points)
A. (10 points)

Answer True or False. (WRITE ALL YOUR ANSWERS ON THE ANSWER SHEET. DO NOT WRITE THEM
ON THE EXAM PAPERS.)

i. (2 points) With a perfect negative correlation of asset returns, you can completely eliminate risk in
your portfolio.

True

ii. (2 points) The efficient frontier dominates all the other possible choices in the investment
opportunity set.

True

iii. (2 points) Under the CAPM assumptions, the required risk premium and the expected risk
premium should be equal in equilibrium.

True

iv. (2 points) In Security Market Line (SML), total risk is measured by a stocks volatility.

False

v. (2 points) Anomalies such as size and value effects may be still consistent with an efficient market.

True

B. (3 points)

Suppose you own a diversified portfolio which includes shares of ABC, corp. ABC stock has a return
volatility of 20%, and the correlation of 0.5 with your portfolio.
i. (2 points) If the weight on ABC Stock in your portfolio is 10%, what is the contribution of ABC stock
to the volatility of your portfolio?
Incremental volatility due to ABC stock = 10%*0.5*20% = 1%

ii. (1 point) What would be the contribution of ABC stock to the volatility of your portfolio if the
correlation was one?
Incremental volatility due to ABC stock = 10%*1*20% = 2%

C. (12 points)
Suppose that the expected return of the market portfolio is 10%, and the return volatility of the
market portfolio is given by 20%. The risk-free rate is given by 2%. Calculon, Inc. is a film production
company which specializes in science fiction films. Calculon has a return correlation of 0.4 with the
market portfolio, and the return volatility of 30%.

i. (2 points) Calculate the beta of Calculon.

Beta = 0.4*30%/20% = 0.6

ii. (2 points) Calculate the expected return of Calculon according to the CAPM

Expected return = 2% + 0.6*(10%-2%) = 6.8%

iii. (4 points) How much of the volatility of Calculon stock is due to the market risk, and due to the
idiosyncratic risk?

Volatility due to the market risk = 0.6*20% = 12%

Volatility due to the idiosyncratic risk = 30% - 12% = 18%

iv. (4 points) If you are an investor who wants to achieve the same expected return of Calculon
stock with a minimum risk, what kind of portfolio should you hold? Then, what is the volatility of
your portfolio in that case?

To achieve this, you have to have a portfolio on the CML that has the same expected return as
Calculon. For this, you can hold 60% of market portfolio, and 40% of the riskfree asset. This will
give you the expected return of 0.6*10% + 0.4*2% = 6.8%. The volatility is given by 0.6*20% = 12%.

(Or, let y be the weight on the market portfolio. Then, you can solve 6.8% = (1-y)*2% + y*10% = 2%
+ y*8%. Solving this equation gives you y = 0.6)

v. (2 points) Using iii and iv, briefly explain why the investor could reduce the risk of your portfolio.

By buying only Calculon stock, the investor exposes herself to the idiosyncratic risk of Calculon as
well as the market risk. However, buying a portfolio on the CML allows her to exploit diversification
effects that eliminate any idiosyncratic risk.
Question 4. (25 points)
A. (10 points)

Answer True or False. (WRITE ALL YOUR ANSWERS ON THE ANSWER SHEET. DO NOT WRITE THEM
ON THE EXAM PAPERS.)

i. (2 points) The YTM for a bond is the IRR of investing in the bond and holding it to maturity without
any default.

True

ii. (2 points) A bond may trade at a discount when coupon rate is less than the yield.

True

iii. (2 points) In case of an out-of-the money option, the payoff would be negative if immediately
exercised.

True

iv. (2 points) Holders of bullish spreads benefit from stock price decreases.

False

v. (2 points) Option delta of a call option measures the change in the price of the call option given a
$1 change in the price of the stock.

True

B. (4 points)

Consider an 8% coupon, 20-year maturity bond with par value of $1000 paying semi-annual coupon
payment of $40. Suppose the interest rate is 8% APR with semiannual compounding. Calculate the
value of the bond.

Bond value must be equal to the face value because coupon rate is equal to the interest rate, i.e.,
Bond value is $1000

C. (11 points)

REMOVED (because it is not covered)