Academic excellence for business

and the professions

The Business School (formerly Cass)

MSc Finance/MSc Corporate Finance

Alternative Timed Assessment

Module Code Module Title

SMM148 Theory of Finance

January 2021 3 hrs 00 mins

Division of Marks: The allocated marks are indicated for each question

Instructions to students: Answer any THREE questions out of FIVE

This paper contains FIVE questions and comprises FIVE pages including the title
page

Additional materials or tables to be provided: None

Your work should be in your own words, it should NOT contain material copied
straight from lecture notes, textbooks, or other resources. If you do rely on external
sources within your answer, these should be properly referenced/cited.

Students are expected to show all necessary workings to obtain their final
solution. If this is not done, then marks will be deducted even when the
correct numerical solution is obtained.

Internal Examiner(s): Dr Dirk Nitzsche

External Examiner: Professor Pasquale Scaramozzino
Question 1

(a.) To simplify the equation of the dividend discount model we make some assumptions about
future dividends. Outline two different assumptions which are often used about future
dividends. Which one is more realistic? Briefly comment on how well the model works to
explain equity values [30 marks]

(b.) Use the concepts of the dividend discount model to explain to a potential investor what they
could expect from the aggregate US Stock market over the longer term (say over the next 30
to 40 years). [40 marks]

(c.) Use the concept of indifference curves to show how different investors make different
investment decisions. [30 marks]

Question 2

(a.) Carefully explain to someone who is not an expert in finance how they should allocate their
wealth if they have TEN risky assets and ONE risk free rate to choose from. The investor is
risk averse. You might want to use diagrams and state key equations and provide a step by
step guide as regards what needs to be done. It is important that your explanations are
clear, well structured and that by following them you should achieve the optimum outcome
based on the theory. [70 marks]

(b.) Suppose you are a US (Dollar) based investor and your financial advisor has calculated the
optimum portfolio weights using historic data and the optimisation proposed by H.
Markowitz. The financial advisor suggest that you should invest 10% in the US, 75% into
Europe and 15% into Asian equities. Discuss briefly whether you should diversify
internationally and whether you should follow the advice regarding the optimum weights.
[30 marks]

Page 2 of 5
Question 3

(a.) The CAPM states that only market risk should be priced. Explain to someone who is not an
expert in finance why only market risk should be considered when pricing risk and derive the
CAPM equation. How can you measure market risk? Mention any practical/statistical issues
you might have to deal with. [40 marks]

(b.) You have the following information

ER Volatility Beta
(Standard
deviation)
Asset 1 8% 25 0.9
Asset 2 12% 27 1.2
Market 10% 22
Risk free rate 3%

(i.) Calculate the ‘firm specific’ risk of the two risky assets; asset-1 and asset-2.

(ii.) Based on the CAPM, what should be the expected return of the two assets? Explain,
what an investor would do, based on the CAPM, when you compare the expected
return based on the CAPM and the expected return given in the table.

(iii.) Suppose the market ER is 10% and the expected returns for asset 1 and asset 2 are
8%and 12% respectively. With the risk free rate being 3% what would be the beta of
the two assets based on the CAPM?
[30 marks]

(c.) By giving straightforward instructions, carefully explain to someone who is not an expert in
finance how you could test the CAPM and what findings you might expect.
[30 marks]

Page 3 of 5
Question 4

(a.) Carefully explain to your dad whether an arbitrage profit is possible and why.

You have the following information.

- A 2-year, 2.5% coupon paying bond with a face value of £1,000. The yield to maturity is
2.2% and coupon payments are made semi-annually.
- Zero coupon paying bond prices.

Maturity of Zero Price (Face value 1)

Coupon Paying Bond
6 month 0.9901
12 month 0.9793
18 month 0.9677
24 months 0.9553

Carefully explain what you would do regarding buying/selling those different fixed income
securities so that you can realise an arbitrage profit. [40 marks]

(b.) Calculate the duration of the bonds stated in part (a.) [30 marks]

(c.) Your friend wants to invest in a money market instrument for 3 months. He/she is
considering buying a UK Treasury Bill (TB) or UK Certificate of Deposit (CD). Carefully explain
to your friend how you would calculate the price of a UK Treasury Bill and UK CD and how
you can work out which investment yields a higher return. Your answer needs to be well
structured and clear to someone who is not an expert in finance. [30 marks]

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Question 5

(a.) Carefully explain how an airline could eliminate the uncertainty of oil price movements using
oil futures contracts. It is important that you include relevant details in your answer and
that your answer is well structured and clear to someone who is not an expert in finance.
[35 marks]

(b.) Draw the payoff profile of being long a put option on the day of expiry and before expiry.
Clearly mark in the diagram, time value and intrinsic value if the put option is in-the money
or out-of-the money. [30 marks]

(c.) A stock market index is S0 = 95 and the put premium for an option on the index with 1 year
to expiry and a strike price of 100 costs 9.29. Short term interest rates with 1 year to
maturity are 2% (simple rate).

You work for a retail bank and are asked to structure a guarantee bond using call options
written on the stock market index. The guarantee bond has the following features. It
guarantees to repay a customer’s investment of 100 under any circumstances, but if the
stock market increases it passes on the higher value. An administration fee applies which
will not be repaid.
(i.) To avoid an arbitrage profit what would the call premium have to be?
(ii.) Explain how you would structure such a guarantee bond using calls.
(iii.) What would your administration fees have to be so that you could structure such a
bond and break even?
(iv.) Suppose in one year’s time the stock index (S1) is either 85 or 120. What would a
customer receive and assuming the retail bank charges an administration fee which
allows you to break even what would the return for the investor be?
[35 marks]

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