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) Financial assets are claims on real assets or the income generated by them.

True

ii. (2 points) In a competitive market, you can sell or buy assets without affecting prices.

True

iii. (2 points) Valuation Principle states that the value of an asset to the firm or its investors is
determined by its competitive market price.

True

iv. (2 points) According to the NPV decision rule, you decide to invest in an investment opportunity if
the expected cash flows exceed the expected cost of the investment.

False

v. (2 points) The EAR increases with the frequency of compounding.

True

B. (5 points)

The stock of ABC, Corp has a return of 50% with probability 0.2, 10% with probability 0.6, and -20%
with probability 0.2. The risk-free rate is given by 5%.

i. (3 points) Calculate the expected return.

E[r] = .2*(50%)+.6*(10%)+.2*(-20%) = 12%

ii. (2 points) Calculate the risk premium of ABC stock.

Risk premium = 12% - 5% = 7%

C. (10 points)

Conman, Corp. is a company that specializes in producing widgets. Conman is expected to pay out a
dividend of $3 per share in the coming year, and dividends are expected to grow at 5% every year.
Conmans beta is equal to 1, and the market risk premium is 8%. The risk-free rate in the economy is
2%.

i. (2 points) Calculate the present value of the stock of Conman using the constant dividend growth
model.

Equity cost of capital = 2%+1*8% = 10%

PV = 3/(10%-5%) = $60

ii. (2 points) The stock of Conman, Corp is trading at $80 today. Is it undervalued or overvalued?
(Undervaluation means that the price is below its fundamental value, and overvaluation means that
the price is above its fundamental value.)

Price ($80) > fundament value ($60)

Thus, Conman is overvalued.

iii. (2 points) Using only the results in i and ii, explain whether you want to sell or buy Conman stock
if you can hold the stock indefinitely in the future.

You have to sell it because the present value is smaller than the price.

iv. (2 points) Suppose that you expect the price of Conman stock next year is $100. What is the
present value of buying Conman stock for one year and selling it next year? Should you buy or sell
Conman stock if you are a fund manager whose performance is evaluated at the end of every year.

PV of one-year investment = (3+100)/10% = $93.64 > $80

You would buy the stock because the present value is greater than the price.

v. (2 points) Using all the results in i, ii, iii, iv, briefly explain how bubbles can be created by frictions
in the market.

Conman stock is obviously overvalued given its fundament value, but investors with a short-horizon
of investment would still buy this overvalued asset if they expect the bubble is going to stay in the
near future. (Any argument about short investment horizon will do. You can further explain other
frictions such as short-sale constraint, etc can help creating such bubbles if you like)
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-
neutral investor is willing to bet on it if the gamble costs $8 to do it.

True

ii. (2 points) An investor with mean variance preference would prefer an asset with lower risk
regardless of its expected return.

False

iii. (2 points) Indifference curves of an investor with mean variance preference become steeper with
higher risk aversion.

True

iv. (2 points) Fluctuations of returns due to firm-specific news are related to systematic risk.

False

v. (2 points) You can reduce systematic risk by increasing the number of assets in your portfolio.

False

B. (5 points)

Assume all the assumptions of the CAPM model. Also, suppose that there are only two agents in the
economy: Mr. Robinson, and Ms. Robinson. Both of them have mean-variance preference as follows:

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

Mr. Robinson is more risk-averse than Ms. Robinson; the risk aversion parameter of Mr. Robinson is
given by A=4, but that of Ms. Robinson is given by A=2.

Briefly explain who will be lending money, and who will be borrowing money in equilibrium.

Mr. Robinson will be buying the market portfolio and the risk-free asset. On the other hand, Ms.
Robinson will be buying the market portfolio by selling the risk-free asset. That is, Mr. Robinson will
be lending money to Ms. Robinson in equilibrium.
C. (10 points)

Mrs. Robinson is a representative agent in the economy. She has mean-variance preference with a
risk aversion parameter of 2 (i.e., A=2):

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

The risk-free rate in the economy is 2%, and the market portfolio has a return volatility of 20%. ABC,
Corp is a publicly traded company in this economy, and its beta is 2. Calculate the expected return
of ABC, Corp according to the CAPM.

First, notice that Mrs. Robinsons allocation on the market portfolio is given by (E[rM]
2%)/(2*20%^2). Because she is the only agent in the economy, Mrs. Robinson has to hold
everything in equilibrium. Therefore, her capital allocation on the market portfolio should be one:

(E[rM] 2%)/(2*20%^2) = 1

Therefore, E[rM] = 10%.

According to the CAPM, the expected return on ABC is given by

E[r] = 2% + 2*(10%-2%) = 18%

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) Suppose that there is a representative agent in the economy. Then, the agent should
own all the supply of the risky assets in equilibrium.

True

ii. (2 points) Under the CAPM assumptions, the Sharpe ratio of any portfolio cannot be higher than
that of the market portfolio.

True

iii. (2 points) Under the CAPM assumptions, a passive investment strategy is efficient.

True

iv. (2 points) According to the semi-strong form efficiency, fundamental analysis should be useful.

False

v. (2 points) To find anomalies, the CAPM beta is often used to calculate the risk-adjusted returns.

True

B. (3 points)

Which of the following observations would provide evidence against the weak form of the efficient
market theory? Explain.

a. Mutual fund managers do not on average make superior returns.

b. You cannot make superior profits by buying (or selling) stocks after the announcement of an
abnormal rise in dividends.

c. In any year approximately 50% of pension funds outperform the market.

d. By buying the top 30% of stocks in terms of the return in the previous year and by short selling the
bottom 30%, investors can achieve an abnormal return (i.e., higher expected returns than the risk-
adjusted returns)

d. Momentum effect would provide evidence against the weak form of the efficient market theory.
C. (12 points)

Suppose there is only one factor (market factor) in the economy. The risk-free rate is 2%. Portfolios
A has a beta of 1.2 on the market factor, and the expected return of 14%.

i. (4 points) What is the expected return-beta relationship in this economy?

We can solve the following equation to obtain the risk premium on the market factor:

14% = 2% + 1.21

The solution is 1 = 10%

Thus, the expected return-beta relationship is:

E(rP) = 2% + (10%)

ii. (2 points) Portfolio B is well diversified, and it has a beta of 0.6 on the market factor. Using the
result in i, calculate the expected return of Portfolio B.

Expected return = 2% + 10% (0.6) = 8%

iii. (6 points) Suppose that the expected return of Portfolio B is 10%. What is the alpha of Portfolio B?
Using the result in ii, construct an arbitrage portfolio.

Alpha = expected return required return given beta = 10% - 8% = 2%

We can buy portfolio B and short sell portfolio A, and invest any remaining proceeds in the risk-free
asset (in this case, we need to short sell the risk-free asset because we need extra money to buy
portfolio B). Then, this produces an arbitrage portfolio with zero investment, zero risk because the
beta of the portfolio is zero. But, the excess return is positive.

Portfolio Weight In Asset Contribution to Contribution to Excess Return

 -0.5 Portfolio A -0.5 x A = -0.6 -0.5 x (14%- 2%) = -6%

1 Portfolio B 1 x B = 0.6 1 x (10% - 2%) = 8%

Risk-free
-0.5 asset -0.5 x 0 = 0 0

Investment = 0 Arbitrage = 0 = 2%
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)

A zero coupon-bond with face value $1000 and maturity of two year sells for $850 today. What is its
yield to maturity?

850 = 1000/(1+YTM)^2

YTM = sqrt(1000/850) 1 =8.47%

C. (11 points)

The stock of Stark Industries is trading at $20 today. It can either go up by 10% or go down by 10%
in one year. The risk-free rate is 2% (EAR). Mr. Smithers at Montgomery Burns Bank recently
created a new financial product called digital option on Stark industries. This option pays $1 if the
stock price of Stark goes up above $20 in one year, and pays zero otherwise.
i. (6 points) Calculate the price of the digital option assuming the law of one price.

Using the Binomial Option Pricing Model, we have

Su = 22 or Sd = 18 (Cu =1 or Cd = 0)

Delta = (1-0)/(22-18) = 0.25

B = (0-18*0.25)/1.02 = -4.41

That is, the replicating portfolio of the option is 0.25 share of Stark and borrowing $4.41 at 2%. The
present value of the portfolio is given by

C0 = 0.25*20 4.41 = $0.59

Therefore, the option price should be equal to the present value of $0.59 in the absence of any
arbitrage opportunity.

ii. (5 points) Lisa Simpson found that the digital option is trading at $1 today. Explain how she can
exploit the situation if there is any arbitrage opportunity. Assume the law of one price. Also,
assume that Lisa can borrow and invest at the risk-free rate.

Notice that the value of the option is lower than the price ($0.59 < $1). Therefore, Lisa should buy
cheap (replicating portfolio) and sell expensive (the option).

For example, Lisa can buy 0.25 share of stock and borrow $4.41 at the risk-free rate. To finance this,
she can short sell the option. Then,

Today If S1 = 22 in one year If S1 = 18 in one year

Buy 0.25 share of Stark -0.25*20 = -5 0.25*22 0.25*18
borrow $4.41at 2% +4.41 -4.41*1.02 = -4.50 -4.41*1.02 = -4.50
Sell the option at $1 1 -1 0
Sum $0.61 $0 $0

Therefore, Lisa is earning $0.61 without any risk, thus, this is an arbitrage.