FINS2624 S1 2013

Mockterm

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THE UNIVERSITY OF NEW SOUTH WALES

SCHOOL OF BANKING AND FINANCE

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FINS2624 PORTFOLIO MANAGEMENT

MOCK MID-TERM EXAMINATION - SEMESTER 1, 2013
TIME ALLOWED: N/A

To make sure that we can identify your exam if your student ID number is hard to read,
please tick the boxes below to fill in your seven digit student ID number. Detailed instructions
are on the next page.
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FINS2624 S1 2013

Mockterm

INSTRUCTIONS
1) Write your name, student ID number and signature in the assigned space on the front page.
2) To make sure that we can identify your exam if your student ID number is hard to read,
please tick the boxes corresponding to your student ID number on the front page. Do this by
marking the box corresponding to each of the digits in your seven digit student ID number,
going from left to right. For example, my ID number is z3352704, so I would fill in the boxes
as below.

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3) Fill in the details requested by the generalized answer sheet.

4) This paper has two sections:
Section A: 30 multiple choice questions (worth a total of 30 marks)
Section B: 5 free-format problem (worth a total of 42 marks)
5) Mark your answers to the multiple choice questions of section A in the generalized answer
sheet using a 2B pencil. Write down the solution of the free format problem in the answers
sheets in the back. All answers and solutions must be written in ink. Pencils may not be
used.
6) Notation and terminology in this exam are as defined in the lectures.
7) Assumptions that have been made throughout the lectures may be assumed throughout the
exam unless otherwise stated. For instance, unless explicitly relaxed, you may assume that
there are no transaction costs, that bonds have no default risk, that investors are rational,
that there are no restrictions on short positions etc.
8) Total number of marks for this paper is 72.
9) This is a closed book exam. Except calculators according to the UNSW guidelines, no other
means are allowed.
10) This question sheet and the generalized answer sheet must be returned in full. Do not
tear the pages.
11) You must prove your identity using your student ID card when turning in the exam.

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FOMRULA SHEET

The price of a bond, P , is given by:



c
1
FV
P =
1
+
T
y
(1 + y)
(1 + y)T
where c is the dollar coupon, y is the yield-to-maturity, T is the time to maturity and F V
is the face value.
If X and Y are two stochastic variables and and are two constants then:
E(X + Y ) = E(X) + E(Y )
E(X) = E(X)
V ar(X) = Cov(X, X)
Cov(X, Y ) = Cov(Y, X)
Cov(X, Y ) = XY X Y
Cov(X, Y ) = Cov(X, Y )
The solution to the quadratic equation
ax2 + bx + c = 0
is
x1/2 =

b2 4ac
2a

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SECTION A OF THE MOCKTERM EXAM

30 MARKS IN TOTAL
THIRTY MULTIPLE CHOICE QUESTIONS

Mark the answers in the generalized answer sheet using a 2B pencil. Or dont, since this
is a mockterm.
Each question is worth one mark and there is no negative marking.

1. Which of the following statements about bonds is true?

a) A bond with a higher coupon rate must be a better investment than a bond with a lower
coupon rate.
b) A bond that trades at a discount must be a better investment than a bond that trades
at a premium.
c) A bond with a higher yield-to-maturity is a better investment than a bond with a lower
yield to maturity.
d) Several of the above statements are true.
e) None of the above statements are true.
2. Which of the following statements about the efficient frontier is true?
a) In practice, only the market portfolio is on the efficient frontier.
b) The portfolios on the efficient frontier are only dominated by other portfolios on the
efficient frontier.
c) The efficient frontier tends to be concave.
d) Several of the above statements are true.
e) None of the above statements are true.
3. Which of the following statements about the yield-to-maturity is true?
a) Discounting all cash flows of a bond with the bonds yield-to-maturity only gives us the
correct price if we have a flat term structure of interest rates.
b) The yield-to-maturity is upwards sloping.
c) The yield-to-maturity is always a spot rate.
d) Several of the above statements are true.
e) None of the above statements are true.

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4. Which of the following statements about bonds is true?

a) A zero-coupon bond always trades at a discount as long as its yield-to-maturity is
positive.
b) A zero-coupon bond tends to have a lower yield-to-maturity than a coupon bond with
the same time to maturity.
c) In reality, zero-coupon bonds have higher default risk than coupon bonds.
d) Several of the above statements are true.
e) None of the above statements are true.
5. Which of the following statements about investors are true?
a) A mean-variance investor will always choose the asset with the highest return.
b) A mean-variance investor will always choose the asset with the lowest risk.
c) A mean-variance investor will trade off expected returns and risk.
d) Several of the above statements are true.
e) None of the above statements are true.
6. Which of the following statements about duration are true?
a) The duration of a liability is always negative.
b) The duration of a bond is always positive.
c) The duration of a portfolio is a weighted average of the duration of the bonds that are
included in that portfolio.
d) Several of the above statements are true.
e) None of the above statements are true.
7. Which of the following statements about yield-to-maturity are true?
a) A bond with a yield-to-maturity of 7% is never more sensitive to changes in the yield
than a bond with a yield to maturity of 5%.
b) A bond with a yield-to-maturity of 7% is always more sensitive to changes in the yield
than a bond with a yield to maturity of 5%.
c) A bond with a yield-to-maturity of 5% is never more sensitive to changes in the yield
than a bond with a yield to maturity of 7%.
d) A bond with a yield-to-maturity of 5% is always more sensitive to changes in the yield
than a bond with a yield to maturity of 7%.
e) None of the above statements are true.

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8. Which of the following statements about diversification are true?

a) The diversification benefits in a portfolio of two assets are smaller when the correlation
between the returns of the assets is larger.
b) The diversification benefits in a portfolio of two assets are larger when the correlation
between the returns of the assets is larger.
c) The diversification benefits of combining three perfectly correlated assets is typically
larger than the diversification benefits of combining two perfectly correlated assets.
d) Several of the above statements are true.
e) None of the above statements are true.
9. Which statement is true regarding the market portfolio?
a) It includes all publicly traded financial assets.
b) It lies on the efficient frontier.
c) All securities in the market portfolio are held in proportion to their market values.
d) It is in principle unobservable.
e) All of the above statements are true.
10. Which of the following statements is false about the capital allocation line (CAL)?
a) It includes all publicly traded financial assets.
b) Investors prefer assets further to the right on the CAL to assets further to the left on
the CAL.
c) The risk-free asset plots on the CAL.
d) More than one of the above statements are false.
e) None of the above statements is false.
11. Which of the following statements is false about the CAPM?
a) The CAPM describes the required return of any risky asset.
b) The CAPM assumes that investors agree on the statistical properties of all assets.
c) The CAPM assumes that all investors have the same preferences.
d) More than one of the above statements are false.
e) None of the above statements is false.
12. The risk free rate is 4% and the expected return of the market portfolio is 12%. If a stock
has a CAPM of 1.5, a standard deviation of returns of 20% and a current price of $100,
what is the expected price one year from now?
a) $100
b) $116
c) $120
d) Theres not enough information to say.
e) None of the above.
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13. If the standard deviation of a stocks return increases, what happens to its required return?
a) It decreases.
b) It increases.
c) It stays the same.
d) Theres not enough information to tell.
e) None of the above.
14. Suppose a stock that was traded on the market magically disappears. What happens to
the CAL?
a) Its slope decreases.
b) Its slope increases.
c) Its slope stays the same.
d) Theres not enough information to tell.
e) None of the above.
For the next 3 questions, assume that there is some risky portfolio Q, which has an expected
return of 15%, and a standard deviation of 12%. The risk-free rate is 5%. There is also
some asset P that is not part of Q, which has an expected return of 10%, and a standard
deviation of 7%.
15. What is the Sharpe ratio of Q?
a) 0.71
b) 1
c) 1.34
d) 0.83
e) Theres not enough information to tell
16. What is the Sharpe ratio of the market portfolio?
a) Between 0.71 and 1.34
b) Larger than or equal to 0.83
c) Exactly 1
d) Lower than or equal to 0.83
e) Theres not enough information to tell
17. You want to invest in some combination of the Q and the risk-free asset to achieve an
expected return of 40%. What is the standard deviation of your returns?
a) 42%
b) 32%
c) 16%
d) 40%
e) Theres not enough information to tell
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For the next 4 questions, consider a market where the risk free rate is 3% and the expected
return on the market portfolio is 10%.
18. What is the required rate of return of an investment with a beta of 0.5?
a) 10%
b) 5%
c) 3%
d) Theres not enough information to tell.
e) None of the above.
19. What is the standard deviation of the market portfolio returns?
a) 1
b) 20%
c) 22.59%
d) Theres not enough information to tell.
e) None of the above.
20. An investment has a beta of 0.8 and an expected return of 8%. Should you undertake the
investment?
a) Yes.
b) No.
c) It doesnt matter.
d) Theres not enough information to tell.
e) None of the above.
21. If the market expects a return of 20.5% from a certain stock, what is its beta?
a) 21
b) 2.5
c) 2.45
d) Theres not enough information to tell.
e) None of the above.
22. According to the CAPM a well-diversified portfolios rate of return is a function of
a) market risk.
b) unsystematic risk.
c) unique risk.
d) reinvestment risk.
e) liquidity risk.

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23. Which of the following statements is true about the security market line, SML?
a) It is a different name for the CAL.
b) It contains all efficient portfolios.
c) It is convex for risk averse investors.
d) More than one of the above statements are true.
e) None of the above statements are true.
24. The total value of the market portfolio is $100,000. Stock A is trading at $10. The company
has issued 1,000 stocks. There are 5 other companies on the market. What is the weight
of company A in the market portfolio?
a) 20%
b) 0.01%
c) 10%
d) 1%
e) 25%
25. The shape of the term structure of interest rates is determined by
a) Expectations on future spot rates
b) The risk aversion of investors
c) Mismatches between the investment horizon of investors in bonds and issuers of bonds
d) A and C
e) All of the above
26. The convexity of a bond...
a) Leads to an undesirable asymmetry in the price response to yield changes
b) Leads to a desirable asymmetry in the price response yield changes
c) Is a measure of the bonds time to maturity
d) A and C
e) B and C
27. If all spot rates decreased by 1%, the duration of a 10-year 5%-coupon bond would...
a) Increase
b) Decrease
c) Be unaffected
d) Change in a direction that depends on its convexity
e) Theres not enough information to tell

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28. Duration...
a) Is a measure of the time to maturity of a bonds cash flows
b) Is a measure of the sensitivity of a bonds price to changes in the yield
c) Can be used to approximate the price of a bond at other yields
d) A and B
e) All of the above
29. According to the expectations hypothesis
a) The term structure of interest rates is upwards sloping
b) Investors are risk-neutral
c) Future spot rates are known today
d) All of the above
e) None of the above
30. A synthetic instrument...
a) Is typically a portfolio of other instruments
b) Is typically used to set up an arbitrage trade
c) Cannot be traded
d) A and B
e) All of the above

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SECTION B OF THE MOCKTERM EXAM

42 MARKS IN TOTAL
FIVE FREE-FORMAT QUESTIONS

1. Assume that the interest rate is flat, with spot rates of 11% for all maturities. Consider a
market with the following two bonds:
Bond A is a one-year zero-coupon bond with a face value of $100. It trades for $90.09.
Bond B is a three-year zero-oupon bond with a face value of $100. It trades for $73.12.
(a) (1 mark) Which of the two bonds is more sensitive to changes in the yield and why?
(b) (5 marks) Suppose you have a liability of $1,000 maturing in 4 years. Set up a portfolio
of bonds that immunizes the liability. Your final answer should specify what position
in each bond you should take, e.g. Buy 4 of bond A and sell 1 of bond B.
(c) (2 marks) What practical problems can you forsee with this immunization?

2. You find the following term structure of interest rates in the market (where rt denotes the
spot rate for time t):
r1
r2
r3
r4
r5

= 6%
= 8%
= 8.5%
= 9%
= 10%

(a) Assume that this term structure is explained by the liquidity theory of the term structure of interest rates. What does this tell you about each of the following
(i) (1 mark) the market expectations on future spot rates
(ii) (1 mark) the risk preferences of investors
(iii) (1 mark) the relative investment horizons of issuers of bonds and investors in bonds
(b) (5 marks) What is the arbitrage free forward rate for an investment that begins at time
2 and ends at time 5, 2 f5 ?

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3. (5 marks) You observe the following bonds in the market:

Bond A is a three-year bond with a face value of $100 that pays an annual coupon of
$10. It trades for $117.02.
Bond B is a two-year zero-coupon bond with a face value of $200. It trades for $188.52.
Bond C is a two-year zero-coupon bond with a face value of $1000. It trades for
$961.17.
Show that there is an arbitrage opportunity in this market by describing a set of trades
that would result in an arbitrage profit. Your final answer should specify what position in
each bond you should take, e.g. Buy 4 of bond A and sell 1 of bond B.
4. Consider a market with the following three bonds (note the non-standard face value of bond
B):

Bond
A
B
L

YTM
4%
5.93%
?

Price
96.15
?
90.7

t=1
100
5
0

Cash flows
t=2
0
5
100

t=3
0
100
0

a) (1 mark) What is the price of bond B?

b) (2 marks) Determine all spot rates.
c) (2 marks) Calculate the duration of all bonds.
d) (4 marks) Suppose that bond L is a liability that your company has. Form a portfolio
consisting of bonds A and B that immunizes that liability. How much do you invest in
bonds A and B respectively? Please show all the steps leading up to your answer.
e) (4 marks) Determine the forward rate between t = 1 and t = 3, 1f 3, through a noarbitrage argument. That is, you must describe the potential arbitrage trades that
motivate your answer.

5. Suppose there are three bonds trading in the market with a face value of $100 and maturing
in two years. The bonds all pay annual coupons. Their coupon rates are 10%, 20% and
30% respectively and they trade for $97.40, $115.08 and $132.48 respectively.
a) (5 marks) Show that there is an arbitrage opportunity.
b) (3 marks) Now assume that there is also a zero-coupon bond maturing in one year with
a face value of $100, a price of $97.09 and a yield of 3%. Show how you can exploit the
mispricing you found in (a).

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