Practice Final Exam III

FM423
Asset Markets

Suitable for all candidates

Instructions to candidates

Time allowed: 3 hours + 10 mins reading time.

The first 10 minutes is a reading period. You may not make notes during the reading
period.

This paper contains four questions, one in Part A (consisting of question 1) and three in
Part B (consisting of questions 2, 3 and 4). Answer all four questions.

Each question carries 25 marks, out of a total of 100. Marks for each part of each question
are indicated.

You may use a calculator (as prescribed in the regulations).

If, at any point, you feel that you require additional information to answer a question, please
feel free to make additional assumptions and state them clearly.

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Part B
Question 2. (25 marks)

(a) (8 marks) Consider a perpetuity with annual payments starting in year 5. The first
payment in year 5 is £15; the payment then grows at a constant rate of 1.5% per year
forever. Consider a forward contract that delivers this perpetuity in year 3 (that is,
the forward price is paid in year 3).

(i) (4 marks) What is the forward price at date 0 if the term structure is flat at
r=1.8%?
(ii) (4 marks) What is the value of a long position in this forward contract one year
later, if in year 1 the term structure shifts to 1.6% and remains flat?

(b) (8 marks) Consider the following two-factor model for the returns of three well-diversified
assets (i.e., with no idiosyncratic risk):

rA = 0.4 + I1 + 2I2
rB = 0.5 + 2I1 + I2
rC = 0.1 − I1 − I2

(i) (4 marks) Assume that the APT holds, compute the expected return of factor
replicating portfolio 1 (with respect to I1 ), the expected return of factor replicating
portfolio 2 (with respect to I2 ), and the risk-free rate. Assume that we have a
new asset, asset D (also with no idiosyncratic risk), with exposures 1 to factor 1
and -1 to factor 2. What is its expected return?
(ii) (2 marks) Without knowing the return generating processes of the three assets
described above, how would you empirically estimate the risk premia of the two
factors.
(iii) (2 marks) Suppose that the two factors above are drawn from a large pool of
potential factors—for example, by selecting the ones with statistically significant
risk premia. What is a potential issue of this approach? What would you do to
mitigate the issue?

(c) (9 marks)

(i) (3 marks) When a company announces surprisingly good earnings, its stock price
jumps up immediately, but then keeps rising in the weeks thereafter. A recent
study has found that this effect (i.e., the subsequent upward drift) is particularly
strong for firms that announce earnings on the same day as many other firms.
In other words, the greater the number of firms announcing earnings on a par-
ticular day, the stronger the subsequent drift for those firms after their earnings
announcements. What is a plausible interpretation of this evidence?

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 (ii) (3 marks) A recent study shows that most of the long-run return reversal is con-
centrated around subsequent earnings announcement dates. For example, a firm
with high past 5-year returns as of April 2013 tends to have low stock returns
around the subsequent earnings announcement (e.g., July 2013). What is a plau-
sible interpretation of this evidence?
(iii) (3 marks) Two securities with identical future cash flows may at times be traded
at different prices (e.g., the twin stock puzzle). List two possible explanations for
this phenomenon.

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Question 3. (25 marks)

(a) (10 marks) Consider a binomial model with the up move u = 1.2, down move d = 0.9,
risk free rate R = 1+10% = 1.1, and initial stock price S = 100.

(i) (3 marks) Calculate the price of a European call option with exercise price K =
100 and n = 3 periods left until expiry.
(ii) (3 marks) Calculate the price of an American put option with the same exercise
price and time to expiry as in (a)(i).
(iii) (4 marks) Calculate the price of an option which, at the end of the third period,
gives its holder the right to purchase the underlying stock at the minimum price
realized over the life of the option.

(b) (5 marks) Consider two European-type

(c) (10 marks) Now consider a stock with Geometric Brownian Motion dynamics as in the
Black & Scholes model:

dSt
= µdt + σdWt ,
St
µ and σ are positive known constants. There is also a money-market account with
dynamics

dBt
= rdt,
Bt
where r is a positive known constant.

(i) (5 marks) What is the ∆ (i.e., the sensitivity of the price with respect to the
underlying asset price) and Γ (i.e., the sensitivity of the ∆ with respect to the
underlying asset price) of a straddle portfolio (i.e., buying a European call and a
European put together with same strike price K and maturity T ), as a function
of the delta and gamma of the corresponding call option, ∆C and ΓC ? Explain
under which condition the straddle is delta-neutral.
(ii) (2 marks) Explain why investors prefer low gamma or even gamma-neutral port-
folios.
(iii) (3 marks) What is the sign of ν (i.e., the sensitivity of the price with respect to
σ) of this straddle and what is ν right before the straddle expires?

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Question 4. (25 points)
(a) (5 points) A UK-based trader is given the following quotes (where GBP is the home
currency):

Spot exchange rate St [GBP/U SD] = 0.7000

Is there an arbitrage opportunity based on these quotes? If yes, describe the strategy
(i.e., describe both the long and short sides of the arbitrage trade). Further assume
that the trader has £1 million to work with (i.e., the absolute value of the long or short
position at time 0 cannot exceed £1 million), what is the maximum profit realized in
month 6?
(b) (3 points) Do you expect the covered interest parity (CIP) to hold in the market?
Justify your answer and state any necessary conditions.
(c) (5 points) The return of the US stock market index, in US dollar (USD) terms, has a
variance of 0.09. The return of the UK market index, in British pound (GBP) terms,
has a variance of 0.04. The correlation in returns between the US and UK markets,
both expressed in GBP terms, is 0.1. Finally, the variance of the changes in the ex-
change rate of GBP/USD (i.e., the variance of the currency return) is 0.03.

A UK-based asset manager invests 75% of his capital in the UK stock market index
and 25% in the US stock market index. What is the approximate standard deviation
of the portfolio return expressed in GBP terms? State any assumptions you make in
your calculation.
(d) (6 points) A UK-based investor has £1 million of capital. The investor wants to
construct a portfolio that invests only in stocks A and B and that is uncorrelated with
the market. The table below shows the regression results of stocks A and B’s excess
returns on contemporaneous excess market returns (i.e., regression results based on
the CAPM).

Stock A Stock B
Total Variance 0.1125 0.05
Intercept and Beta 0.01 + 1.5(rm − rf ) 0.03 + 0.5(rm − rf )
Standard deviation of residual 0.15 0.2

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 The average excess return of the market is 10% and the risk free rate is 2%. Assume
that the idiosyncratic risk of stocks A and B is uncorrelated. What weights should the
investor have in stocks A and B? What is the Sharpe ratio of the portfolio?

(e) (3 points) In event studies, we often have to calculate abnormal returns. How are
abnormal returns defined? What assumptions do we have to make?

(f) (3 points) Suppose, in an event study of how analyst downgrades might impact firm
value, we observe the following pattern of average cumulative abnormal returns (day
0 is the announcement day of the downgrade). What can we infer from this pattern?
Is this pattern consistent with market efficiency?

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 Useful facts [Note: You may use these facts without proof, unless specifically requested
to prove the fact in question.]
• Geometric Brownian Motion
Let Itô process X satisfy the following equation
dXt = αXt dt + βXt dWt ,
where α and β are known constants, and W is standard Brownian Motion. Then given
the value of the process at time t, Xt , we have for all T > t > 0,
  
1 2
XT = Xt exp α − β (T − t) + β(WT − Wt ) .
2
• Itô’s Lemma
Let X be an Itô process with
dXt = M (t, Xt )dt + Σ(t, Xt )dWt ,
where M (·, ·), Σ(·, ·) are smooth functions, and W is a standard Brownian Motion.
Define a new process Zt = g(Xt , t), where g(·, ·) is also a smooth function. Then,
∂g ∂g 1 ∂ 2g
dZt = dt + dXt + [dXt ]2 ,
∂t ∂x 2 ∂x2
or
1
dZt = gt dt + gx dXt + gxx [dXt ]2 .
2
or
 
1 2
dZt = gt + gx M (t, Xt ) + gxx Σ(t, Xt ) dt + gx Σ(t, Xt )dWt
2
• Log-normal variables
Let Z be a normal random variable with mean m and variance s2 , i.e., Z ∼ N (m, s2 ),
then (where a and b are known constants),
 
1 2 2
E[exp(a + bZ)] = exp a + bm + b s .
2
• Put-Call Parity
We have that
CtEU = PtEU + St − PVTt (K),
where CtEU , PtEU are the prices at time t (0 ≤ t < T ) of a European call option and a
European put option, respectively, that expire at time T ; St is the stock price at time
t of a non-dividend paying stock; K is the common strike price of the call and the put,
and the PVTt (·) operator is between t and T .

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