Your current portfolio consists of three assets, the common stock of IBM and The following is a list of yields

yields to maturity for one-year, two-year, three-

GM combined with an investment in the risk-free asset. You know the year, and four-year risk-free zero-coupon bonds.
following about the stocks: ρIBM,M =0.50; ρGM,M =0.80 // σ IBM = 0.16; σ a). Suppose a three-year zero-coupon bond with a par value of $1,000 is to be
issued at the end of Year 1, and you aim to make an investment of this bond
GM = 0.09 where ρi,j denotes the return correlation between asset i and
at the issuance date. Assume that the expectations theory of term structure of
asset j, σi = denotes the return variance of asset i, and M denotes the market
portfolio. You also know that the expected return on the market portfolio M
is 0.14 and its return variance is 0.04. The risk-free rate is 0.04.
Suppose that investors can borrow and lend at the risk-free rate and that the
CAPM correctly describes expected returns on assets. You have $200,000
invested in IBM, $200,000 invested in GM, and $100,000 invested in the risk-
free asset. a). Calculate the expected rates of return IBM stock and GM stock.
0.5 =
%&'()*+,+)
→ 𝐶𝑜𝑣(𝐼𝐵𝑀, 𝑀) = >0.5 ∗ .√0.042 ∗ .√0.162B = 0.04 interest rates holds, and you hold the three-year zero-coupon bond until
.√0.012∗.√0.452 maturity (i.e., the end of Year 4). Calculate the expected price of the three-
%&'(D+,+)
0.8 = → 𝐶𝑜𝑣(𝐺𝑀, 𝑀) = >0.8 ∗ .√0.042 ∗ .√0.092B= 0.048 year zero-coupon bond at the end of Year 1.You will purchase bond at the
.√0.012∗.√0.0E2
%&'()*+,+) %&'(D+,+) end of Year 1. And you will hold until year 4. Therefore we need to find spot
Beta of IBM = = 0.04/0.04 = 1// Beta of GM = = rate future rate of that year for 3 year bond. Ie. Need to find 1f 4 =
H I+ HI +
c
0.048/0.04=1.2 (4.0`)a d
Expected Return IBM = 0.04 + 1(0.14-0.04) = 14% > B − 1 = 8.3676%
4.0b
Expected Return GM = 0.04 +1.2(0.14-0.04) = 16% 4000
Expected price of bond at the end of year 1: (4.0fb5`5)d = $785.78
b). Calculate the beta of your portfolio: Since OBECO is a giant “funds of funds” company that resembles a well-diversified
L00000 L00000 400000
b). Based on the current yield curve, a risk-free 3-year 10% annual coupon portfolio with the same risk-return profile as that of the market portfolio, we should
𝛽K = 1> B + 1.2 > B+ 0> = 0.88
B bond is issued today (i.e., to mature at the end of Year 3). You buy the
M00000 M0000 M00000 use the Treynor ratio to explain whether they should add FULLERTON to their
c). Assume that the return correlation between IBM and GM is 0.40. coupon bond at the issuance, and reinvest the coupons until the end of year 2,
portfolio. Since the idiosyncratic risk of OBECO has been diversified away, the relevant
Calculate the return standard deviation of your portfolio: and resell the bond at the end of Year 2. Assume that the expectations theory
of term structure of interest rates holds. risk we should be interested in is the systematic risk. This is because this ratio will be
𝐶𝑜𝑣(𝐼𝐵𝑀, 𝐺𝑀) = >0.4 ∗ .√0.162 ∗ .√0.092B = 0.048 able to provide OBECO with information relating to how much risk premium is
Calculate the price of the coupon bond at the issuance and the “Realized
𝞂p = (W1 * 𝞂2 + W2* 𝞂2 + 2W1 *W2 * correlation * 𝞂1* 𝞂2)1/2 or Covariance Compound Yield” for the investor over the two-year period. awarded per unit of market risk. OBECO would not want to add a fund to their
𝞂p = √0.4L ∗ 0.16 + 0.4L ∗ 0.09 + 2 ∗ 0.4 ∗ 0.4 ∗ 0.048= 23.53% 400 400 4400 portfolio which underperforms the market. The Treynor Ratio for FULLERTON is: =
Price of Coupon Bond today: + I
+ d
= $1113.12 [4.bh0.4]
4.0b 4.01 4.05
d). After reviewing your risk preference and the risk-return profile of your = 2% (because treynor is adding to an already diversified fund, whereas
(4.05)d 4 0.5
portfolio in part c), your investment analyst made a surprising comment that Expected Future rate end of Year 2: 2f3 = >(4.01)IB − 1 = 10.1161% sharpe ratio is for a whole portfolio) This means for every unit of market risk,
“irrespective of your risk preference, your current portfolio is NOT the Price of bond when sold end of year 2:
4400
= $998.95 FULLERTON provides 2% risk premium. For a large fund, this is a desirable outcome
optimal investor portfolio”. Assume that you can also invest in the market 4.4044
and would support an argument for adding FULLERTON to the portfolio. Furthermore,
portfolio and make riskless lending and borrowing. Explain whether you Coupon re-investment:
(4.01)I this is a higher result than the Treynor ratio for Brighton (1.7-0.1/1.16 = 1.3793…).
agree or disagree on the analyst’s comment, and why? I agree with the First payment invested at 1f2 = > B-1 = 5.0097% During the meeting, Mike proposes that they should also allocate investments to
4.0b
analysts comment because there is a way to create a portfolio that is less risky (100*1.05009)+100 = $205.01 from coupons BRIGHTON. He argues the fund manager of BRIGHTON is able to generate superior
and offers a higher return than this portfolio. The expected return of this Ending Wealth = 998.95+205.01 = $1203.96 profits in the future, which is evidenced by the regression output in the table that
portfolio is 12.8% (2/5*0.14+2/5*0.16+1/5*0.04). As seen from c, the 𝞂 of c
BRIGHTON generated strong positive alphas relative to the benchmark during the past
4L0b.E5 I
the portfolio is 23.53%. We can notice that the expected return of the Realized compound Yield = > B – 1 = 0.040002 = 4% five years. He also adds that the large alpha generated by BRIGHTON is a clear
444b.4L
market portfolio is 14% and has 𝞂 of 20% (0.04^1/2). An investment into the _____________________________________________________________ indication of market inefficiency. However, Jennifer disagrees on Mike’s proposal and
market portfolio is therefore better than an investment of our weighted our A risk-free 3-year 10% annual coupon bond is scheduled to be issued at the arguments. Based on her knowledge of mutual fund performances and market
portfolio showing that our portfolio is not the optimal investor portfolio. end of Year 1 (to mature at the end of Year 4). An investor is planning to buy efficiency, Jennifer believes Mike’s arguments have several flaws and there are caveats
the coupon bond at the issuance, (at the end of Year 1), reinvest the coupons in the regression analysis performed by Mike. Provide two valid reasons to explain why
Suppose the spot price of gold is $1,500 per troy ounce today. The futures
until the end of Year 3, and resell the bond at the end of Year 3. Assume that we should refute Mike’s proposal and arguments. The alpha provided by the regression
price of gold for delivery in 1 year is $1,530 per troy ounce. Assume that the
the expectations theory of term structure of interest rates holds. Required: analysis are only estimates. There is the possibility for there to be sampling errors
one-year gold futures contract is correctly priced and there are no storage
Calculate i) the expected price of the bond at the end of Year 1, ii) the expected which reduce the statistical significance of the alpha. Mike proposes, that the alphas is
and insurance costs. Also assume that the risk-free rate is compounded
total cash flow for the investor at the end of Year 3, and iii) “Realized a ‘clear’ indication of market inefficiency. For the reason mentioned above this cannot
annually and you can borrow and lend money at the risk-free rate. a). What
Compound Yield” for the investor over the two-year period - from the end of certainly be said to be the case. The regression analysis is merely a model. Models are
is the theoretical parity price of a two-year gold futures contract, assuming a Year 1 to the end of Year 3. useful for providing an indication to market performance, however, they are not
flat yield curve (same interest rates for all maturities)? 2
1 f2 = 1.05 /1.03-1 = 7.04% perfect. Secondly, there is the caveat of whether the markets are efficient. In a semi-
F0 = S0 (1 + Rf )T 3
1 f3 = (1.07 /1.03)
1/2
– 1 = 9.06% strong or strong EMH, it should be not be common for abnormal profits to be
1530 = 1500(1 + Rf)1 4
1 f4 = (1.06 /1.03)
1/3
– 1 = 7.02% consistently made. It is possible that previous five years performance has come down
(1 + Rf) = 1530/1500
to luck. Brighton may perform well in the short term, but over a longer investment
1 + Rf = 1.02
horizon the benchmarked performance may not be as relevant.
Rf = 2% Under the expectations theory, expected future spot rates are equal to the
During the meeting, Harry told Mike that he identified another good-performing fund
Let X = theoretical parity price for a two-year gold futures contract: corresponding forward rates. Assuming a par value of $1,000:
NEURIZON. The fund adopts a long-term investment strategy by investing in stocks of
X = 1500(1+0.02)2 = $1560.60 Price at the end of Year 1 = 100/1.0704 + 100/1.09062 + 1100/1.07023 =
which the prior 5-year cumulative returns were among the bottom 20% of all stocks in
b). Suppose you short 10 one-year gold futures contracts today and the 1074.944838
the market. That is, NEURIZON buys these “fallen angels”, which had a prior 5-year
contract size is 100 troy ounces. The initial margin requited by the clearing Reinvested coupons: 100×(1.09062/1.0704)+100 = 211.115 (or calculate 2f3)
underperformance, and holds them for about 3 years before rebalancing. It turns out that
house is $10,000 for your 10 futures contracts. After three months, the Price of the bond: 1100×1.09062/1.07023 = 1067.383677 (or calculate 3f4)
NEURIZON’s investment strategy works well for its fund investors. Not only for
futures price decreases to $1,525 per troy ounce. Assume that you did not The expected total Year 3 cash flow = 1278.498689
NEURIZON, other funds adopting NEURIZON’s investment strategy also performs
replenish the margin and there was no margin calls over the three months. RCY = (1278.498689/1074.944838)1/2 – 1 = 9.06
well for their investors. On average, these NEURIZON-type funds have earned superior
What is the balance in your margin account in three months? cumulative abnormal returns over and above the CAPM for decades. Please interpret
Contract with leverage, means you own 100*10 = 1000 troy ounces whether the superior performance of NEURIZON’s investment strategy is a violation of
When you short a position, you profit when the value of the position the Efficient Market Hypothesis or not. The superior performance of NEURIZON’s
decreases. The price of the future fell from 1530 to 1525. Meaning we investment strategy is a violation of the Efficient Market Hypothesis. This is because in
receive $5 profit per troy ounce we hold. Inflow from short position = 1000 an efficient market, prices should be an accurate information of information relating
*(1530-1525) = $5000 to the security. The possibility to consistently make abnormal returns from historic
Therefore, Balance in margin account = 10000 + 5000 = $15000 information over the ex-ante expected return is a direct contradiction of the EMH.
c). The price of 1-year index futures contract for S&P 500 is 3,000, while the Although there may be some anomalies to the EMH that can be explained, the fact
current S&P 500 index value is 2,952. It is also known that the dividend yield that other funds have adopted the same approach and receive the same result is more
on S&P 500 is 1% per year compounded annually. Assume you can borrow proof against the EMH. The Weak form EMH would suggest that no abnormal returns
and lend money at the riskless rate of 2% per year compound annually. Also, can be achieved by studying past price and volume movements. NEURIZON’s strategy
you can buy and short sell the S&P 500 index now. violates this notion as they make consistent profits from past prices. Since weak EMH
Design an arbitrage strategy and show that the strategy has a zero cost with is a subset of strong and semi-strong EMH, all of EMH forms are violated.
a sure profit at the end of Year 1. F0 = 2952(1+0.02-0.01)1 = $2981.66 The
current futures price for one year is $3000, since 3000>2981.66, we can say
that the futures contract is overpriced. There is an opportunity for arbitrage.
We should short the futures contract, long the underlying asset (S&P 500
contract) and borrow proceeds. Initial Cash flow: Short Futures (0), long the
underlying asset (-2952) + borrow (2952) = 0, therefore there is zero cost.
Terminal Cash flow: Pay back loan(-2952*e^(0.02)) Sell Shares to settle
futures(3000) + proceeds from dividend (2952*0.01) = -3011.63 + 3000 +
29.52 = $17.89 arbitrage profit.
Consider the following information about a non-dividend paying stock: The
current stock price is $36, and its return standard deviation is 30% per year.
The continuous compound risk-free rate is 3% per year. Assume that the
Black-Scholes model correctly prices all the options written on the stock
given the information above. a). A call option written on the stock expires in 1
year and has an exercise price of $36. Calculate the Black-Scholes value of
the call option using the provided cumulative normal density table with
arguments rounded to two decimal places.
S0 = 36, σ =0.3 , r = 0.03, X = 36, T=1
Value of the Call (B-S Formula):
dl o.dI
jk> Bmn0.0bh0m p∗4
dl I
D1 = = 0.25
0.b∗√4
N(-d1) = 0.4013, // N(d1) = 1 - 0.4013 = 0.5987
D2 = D 1 – 0.3*√1 = -0.05 // N(d2) = 0.4801
C0 = 36 ∗ 𝑒 0 ∗ 𝑁(𝑑4 ) − 36 ∗ 𝑒 h0.0b∗4 ∗ 𝑁(𝑑L )
=(36*1*0.5987)-(36*𝑒 h0.0b∗4 *0.4801)
= 21.5532 – 16.7728
C = $4.78
b). A put option written on the stock expires in 1 year and has an exercise
price of $36. Find the value of the put option using your answer in part a).
Value of a put found using put-call parity:
P = C + 36𝑒 h0.0b∗4 – 36 = 4.78 + 34.9360 -36 = 3.71603 = $3.72
c). You find that a risk-less zero-coupon bond that pays $36 in 1 year is
currently priced at $35.50. Assume that you can buy and short sell i) the stock
at $35.50 and ii) the call and put options at the prices you calculated in parts
a) and b). Further assume that any fraction of the bond can be bought or short
sold – that is, if you buy (short sell) N bonds, then you would pay (receive)
$35.50×N today and receive (pay) $36×N in 1 year for any real number N.
Design an arbitrage strategy show that the strategy has a zero cost with a sure
profit at the end of Year 1. Check if the parity is violated:
P = C + Xe^(-rt) - S
P+ S = C + Xe^(-rt)
3.72 + 35.5 = 36*e^-0.03 +4.78
39.22 ⍯ 39.72
Therefore, the parity is violated, there is mispricing and an opportunity for
arbitrage.The call is overpriced. In order to create an arbitrage profit, we
should short the call, open a long position on the bond, open a long position
on the put and borrow the PV of the put.The profit at the end of year one
can be seen by:
Long Bond (-35.50) + Borrow PV (36*e^(-0.03)) + Short call (4.78) – Long Put
(-3.72) = 0.5 This results in an arbitrage profit of $0.50