FINANCIAL MODELLING AND

D E R I VAT I V E S
TUTORIAL 3

1
INTRODUCTION
• Contact quizzes and tutorials
• Discussion board on Canvas or e-mail (Dutch or English): m.a.dijkstra@vu.nl
• Please enter your studentnumber and name as:
• 1234567, Mark Dijkstra
• Make sure you enter it correctly!! Entering your student number correctly
makes it easy for me to find you in a lot of data, and you want to be
found! Deal sweetener: Any student that inputs their student number
correctly for every week of the tutorial gets 5 bonus points on the tutorial!

2
QUESTION 0
• Please fill in your name and student number on Mentimeter in the following format:
• Student number, name
• Example: 1234567, Mark Dijkstra
• Please insert your information correctly, especially your student number! This makes
grading easier.

3
QUESTION 1
• True or false? The efficient market hypothesis (EMH) only holds if all investors are
rational.
A. True
B. False

4
QUESTION 1
• False.
• EMH also holds if investors hold non-
systematic biases (they cancel each other
out), or when rational investors have deep
enough pockets
• The correct answer is: B

5
QUESTION 2
• Portfolio B:
A. Is as risky as the market portfolio
B. Is underpriced
C. Has a negative alpha
D. Falls on the SML

6
QUESTION 2
• Portfolio B plots below the SML and
has negative alpha (𝛼𝑖 = 𝔼 𝑟𝑖 −
𝑟𝑖 ).
• The correct answer is: C
Required return
• More information: Chapter 13 of Expected return

Berk and DeMarzo

7
QUESTION 3
• Portfolio A:
A. Has a relatively lower expected
return than predicted
B. Has zero alpha
C. Is more diversified than the market
portfolio
D. Is underpriced

8
QUESTION 3
• “The difference between a stock’s
expected return and its required return
according to the security market line is
the stock’s alpha.” (Chapter 13)
• Alpha is positive when the stock lies
above the SML (stock undervalued) Expected return

• The correct answer is: D

Required return
• More information: Chapter 13 of Berk
and DeMarzo

9
QUESTION 4
• Portfolio C:
A. Is as risky as the market portfolio
B. Has an expected return that is in line
with its predicted return
C. Is overpriced
D. Has a positive alpha

10
QUESTION 4
• Portfolio C plots on the SML.
• The 𝛽 of portfolio C is lower than the
𝛽 of the market portfolio.
• The correct answer is: B
• More information: Chapter 13 of Berk
and DeMarzo

11
QUESTION 5
• Portfolio D
A. Falls above the SML
B. Has a positive alpha
C. Is overpriced
D. Is risk-free

12
QUESTION 5
• Answers A, B and C apply to portfolios
that plot either below or above the SML.
• Portfolio D plots on the SML.
• The average excess (subtracting 𝑟𝑓 )
return of Portfolio D is zero, so its
expected return must equal the risk-free
rate.
• The correct answer is: D
• More information: Chapter 13 of Berk
and DeMarzo

13
QUESTION 6
• Refinery Notorious O.I.L. needs to buy 250,000 barrels of crude oil in one week. Suppose it goes
long on 250 crude oil futures contracts, each for 1000 barrels. The current futures price is $71.60
per barrel. Suppose futures prices change each day over the next week as follows (see table).
• What is the cumulative mark to market profit or loss (in dollars) that Notorious O.I.L. will have on
day 1?
Day Futures price ($/bbl)
A. - $750,000
1 65
B. -$1,650,000 2 65.50
C. -$1,700,000 3 68

D. -$3,325,000 4 67.25
5 76.60

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QUESTION 6
• The correct answer is: B
• More information: Lecture 6

Day 1
Futures price $65
Daily mark to market profit/loss (one contract) 65 − 71.6 × 1,000 = −$6,600
Daily mark to market profit/loss (250 contracts) −6,600 × 250 = −$1,650,000
Cumulative mark to market profit/loss (one contract) − $6,600
Cumulative mark to market profit/loss (250 contracts) − $1,650,000

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QUESTION 7
• Same company:
• Refinery Notorious O.I.L. needs to buy 250,000 barrels of crude oil in one week. Suppose it goes long on
250 crude oil futures contracts, each for 1000 barrels. The current futures price is $71.60 per barrel.
Suppose futures prices change each day over the next week as follows (see table).

• What is the cumulative mark to market profit or loss (in dollars) that Notorious O.I.L. will have on
day 5? Day Futures price ($/bbl)
A. - $750,000 1 65
B. $500,000 2 65.50
3 68
C. $750,000
4 67.25
D. $1,250,000 5 76.60

16
QUESTION 7
• The profit is: $5 ×
1,000 barrels per contract =
$5,000
• So profit:
250*$5000=1250000
• The correct answer is: D
• More information: Lecture 6

17
QUESTION 8
• Same company:
• Refinery Notorious O.I.L. needs to buy 250,000 barrels of crude oil in one week. Suppose it goes long on
250 crude oil futures contracts, each for 1000 barrels. The current futures price is $71.60 per barrel.
Suppose futures prices change each day over the next week as follows (see table).
• Suppose the margin requirement is $2000 per contract, and Notorious O.I.L. currently has $750
000 in its margin account (so: $3000 per contract). How many margin calls will Notorious O.I.L.
receive over the next week?
Day Futures price ($/bbl)
A. 0
1 65
B. 1 2 65.50
C. 2 3 68
D. 3 or more 4 67.25
5 76.60
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 QUESTION 8
• The correct answer is: B
Day 1 2 3 4 5

Margin account (per contract) at start of day 3000 2000 2500 5000 4250

Futures price 65.00 65.50 68.00 67.25 76.60

(76.60-
Daily mark to market profit/loss (one contract) (65-71.6)*1000=-6600 (65.5-65)*1000=500 (68-65.5)×1000=2500 (67.25-68)*1000=-750 67.25)*1000=9350

Margin account (per contract) at end of day 3000-6600=-3600 500+2000=2500 2500+2500=5000 5000-750=4250 4250+9350=13600

Margin call per contract 3600+2000=5600 0 0 0 0

Margin account (per contract) after margin call 2000 2500 5000 4250 13600

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QUESTION 9
• Which of the following statements is FALSE?
A. Adding more and more stocks typically decreases the risk of your portfolio.
B. A portfolio that lies below the Capital Market Line has a higher Sharpe Ratio
than the market portfolio has.
C. Combining stocks with positive non-perfect correlation in a portfolio will have
diversification benefits
D. The CAPM assumes investors have homogenous expectations

20
QUESTION 9
• Adding more and more stocks typically decreases the risk of your portfolio
• See picture (Chapter 11 of Berk and DeMarzo)

• A portfolio that lies below the Capital Market Line has a higher Sharpe Ratio
than the market portfolio has.
• Lower return, higher standard deviation: Lower Sharpe Ratio. So: false

• Combining stocks with positive non-perfect correlation in a portfolio will have

diversification benefits
• This is true (see lecture 3).

• The CAPM assumes investors have homogenous expectations

• This is true. It is one of the key assumptions of the model

• The correct answer is: B

• More information: Chapter 11 of Berk and DeMarzo

21
QUESTION 10
• 𝔼 𝑟𝑠 − 𝑟𝑓 = 𝛽𝑠𝑀𝑘𝑡 𝔼 𝑟𝑚𝑘𝑡 − 𝑟𝑓 + 𝛽𝑠𝑆𝑀𝐵 𝔼 𝑟𝑆𝑀𝐵 + 𝛽𝑠𝐻𝑀𝐿 𝔼 𝑟𝐻𝑀𝐿 + 𝛽𝑠𝑃𝑅1𝑌𝑅 𝔼 𝑟𝑃𝑅1𝑌𝑅

• The term 𝛽𝑠𝑀𝑘𝑡 measures the sensitivity of the securities' returns to:
A. Size
B. Book-to-market
C. Momentum
D. The overall market

22
QUESTION 10
• 𝔼 𝑟𝑠 − 𝑟𝑓 = 𝜷𝑴𝒌𝒕
𝒔 𝔼 𝑟𝑚𝑘𝑡 − 𝑟𝑓 + 𝛽𝑠𝑆𝑀𝐵 𝔼 𝑟𝑆𝑀𝐵 + 𝛽𝑠𝐻𝑀𝐿 𝔼 𝑟𝐻𝑀𝐿 + 𝛽𝑠𝑃𝑅1𝑌𝑅 𝔼 𝑟𝑃𝑅1𝑌𝑅

• It is the factor 𝛽 for the market factor.

• It measures the sensitivity of the stock to the market factor.
• The correct answer is: D
• More information: Lecture 5 and Chapter 13 of Berk and DeMarzo

23
QUESTION 11
• 𝔼 𝑟𝑠 − 𝑟𝑓 = 𝛽𝑠𝑀𝑘𝑡 𝔼 𝑟𝑚𝑘𝑡 − 𝑟𝑓 + 𝛽𝑠𝑆𝑀𝐵 𝔼 𝑟𝑆𝑀𝐵 + 𝛽𝑠𝐻𝑀𝐿 𝔼 𝑟𝐻𝑀𝐿 + 𝛽𝑠𝑃𝑅1𝑌𝑅 𝔼 𝑟𝑃𝑅1𝑌𝑅

• The term 𝛽𝑠𝐻𝑀𝐿 measures the sensitivity of the securities' returns to:
A. Book-to-market
B. Momentum
C. Size
D. The overall market

24
QUESTION 11
• 𝔼 𝑟𝑠 − 𝑟𝑓 = 𝛽𝑠𝑀𝑘𝑡 𝔼 𝑟𝑚𝑘𝑡 − 𝑟𝑓 + 𝛽𝑠𝑆𝑀𝐵 𝔼 𝑟𝑆𝑀𝐵 + 𝜷𝑯𝑴𝑳
𝒔 𝔼 𝑟𝐻𝑀𝐿 + 𝛽𝑠𝑃𝑅1𝑌𝑅 𝔼 𝑟𝑃𝑅1𝑌𝑅

• HML stands for high-minus-low:

• Long in high BTM (value stocks) and short in low BTM (growth stocks)
• “High book-to-market stocks have historically earned higher average returns
than low book-to-market stocks.” (Lecture 5)
• The correct answer is: A
• More information: Chapter 13 of Berk and DeMarzo

25
QUESTION 12
• Consider the following information regarding the Fama-French-Carhart four factor
model (see table). Using the FFC four factor model and the historical average
monthly returns, the expected monthly excess return (above the risk-free rate) for
refrigerator company Ghostface Chiller (GC) is closest to:
A. 0.79% Factor Average monthly GC factor
portfolio return (%) betas
B. 0.53% 𝑟𝑚 − 𝑟𝑓 0.64 0.712

C. 0.71% SMB 0.17 -0.103

HML 0.53 0.124

D. 1.01%
PR1YR 0.76 0.276

26
QUESTION 12
• The excess return calculation involves
multiplying the average monthly
return by the factor betas of GC.
• The correct answer is: C Factor Average monthly GC factor GC return
portfolio return (%) betas calculation
• More information: Chapter 13 of Berk 𝑟𝑚 − 𝑟𝑓 0.64 0.712 0.456

and DeMarzo SMB 0.17 -0.103 -0.018

HML 0.53 0.124 0.066
PR1YR 0.76 0.276 0.210
𝔼 𝑟𝑠 = 0.714

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QUESTION 13
• Your friend Big Kim trades equities based on confidential information she overhears at
her workplace. This information is not available to the general public. Big Kim continually
tells you about the profits she earns on these trades. Given this, you would tend to argue
that the financial markets are at best _____ form efficient.
• A. Weak
• B. Semi-weak
• C. Semi-strong
• D. Strong

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QUESTION 13
• Semi-strong form of market efficiency
• Prices reflect public information, but not
private information Strong
EMH
• So profits can be made when trading on Semi-
strong
private information EMH
All information
• The correct answer is: C
Weak
• More information: Lecture 5 All public information
EMH

Past prices
29
 QUESTION 14
• Suppose Flower Retailer Iggy Tulip's share prices
at the end of the year show the pattern shown in Share Price Iggy Tulip
the graph. Iggy Tulip has paid a steady stream of $80.0
$68.0
constant non-growing dividends and is expected $70.0
$62.0 $65.0
to continue doing so. Assume the market is $60.0 $57.1
efficient. What is Iggy Tulip's expected share y = 4.7923x - 9615.4
$55.0
$50.0
price at the end of 2022? $46.0
$40.0 $38.5 $37.1
A. $65.0
$30.0 $31.0
$28.3
B. $68.0 $23.4
$20.0
C. $74.6 $10.0 $9.0
D. $79.4 $-
2008 2010 2012 2014 2016 2018 2020 2022

30
 QUESTION 14
• Since dividends are assumed constant, Share Price Iggy Tulip
the share price is expected to stay the $80.0
$68.0
same over time. $70.0
$62.0 $65.0
$60.0 $57.1
• Because markets are efficient, the y = 4.7923x - 9615.4
$55.0
$50.0
latest price reflects the most recent $46.0
$40.0 $38.5 $37.1
information, so the share price is $30.0 $31.0
$28.3
expected to stay at that level (it’s a $20.0
$23.4

random walk) $10.0 $9.0

$-
• The correct answer is: A 2008 2010 2012 2014 2016 2018 2020 2022

31
QUESTION 15
• Ice-making company Icesquare’s stock is expected to pay a dividend of 2 USD per share
after 2 months and then again after another 3 months (so payout at 𝑡 + 2 and 𝑡 + 5). The
current stock price is 50 USD, risk-free rate 3% per year, compounded continuously. You
just bought a 6-month forward contract on this stock. What is the forward price for
Icesquare’s stock?
A. $44.85
B. $45.35
C. $46.73
D. $48.74

32
QUESTION 15
• 𝐹0 = 𝑆0 − 𝐼 𝑒 𝑟𝑇
2
−0.03∙12
• 𝑃𝑉 𝐷𝑖𝑣1 = 2 ∙ 𝑒 = 1.990
5
−0.03∙12
• 𝑃𝑉 𝐷𝑖𝑣2 = 2 ∙ 𝑒 = 1.975
6
0.03∙12
• 𝐹0 = 𝑆0 − 𝐼 𝑒 𝑟𝑇 = 50 − 1.990 − 1.975 𝑒 = $46.73
• The correct answer is: C
• More information: Lecture 6

33
QUESTION 16
• Following up on Question 15, three months later, the price of stock became 48 USD, and the risk-
free rate remained the same. What is the value of Icesquare’s contract by then?
• Information from Question 15:
• Ice-making company Icesquare’s stock is expected to pay a dividend of 2 USD per share after 2 months
and then again after another 3 months (so payout at 𝑡 + 2 and 𝑡 + 5). The current stock price is 50 USD,
risk-free rate 3% per year, compounded continuously. You just bought a 6-month forward contract on this
stock. The forward price for Icesquare’s stock was 46.73 USD.
A. -$0.72
B. -$0.37
C. $0.37
D. $0.72

34
QUESTION 16
• 𝐹0 = 𝑆0 − 𝐼 𝑒 𝑟𝑇
2
−0.03∙
• 𝑃𝑉 𝐷𝑖𝑣 = 2 ∙ 𝑒 12 = 1.990
3
0.03∙
• 𝐹0 = 48 − 1.990 𝑒 12 = 46.36
• Long position, so you have a contract to buy at 46.73, while the current forward price is 46.36:
• Loss, so value of 46.36 − 46.73 = −0.374, realized in three months
3
−0.03∙
• PV 𝐿𝑜𝑠𝑠 = −0.374 𝑒 12 = −0.371
• The correct answer is: B
• More information: Lecture 6

35
QUESTION 17
• A currency forward contract specifies all of the following, EXCEPT:
A. The amount of currency to exchange
B. The delivery date on which the exchange will take place
C. The spot exchange rate
D. The currencies to be exchanged

36
QUESTION 17
• You must specify:
• The currencies to be exchanged (underlying asset)
• The amount of currency to exchange (contract size)
• The delivery date on which the exchange will take place (delivery time, location)
• Spot exchange rate is not specified in the contract
• Changes from day to day
• The correct answer is: C
• More information: see slide 18 of Lecture 6

37
QUESTION 18
• Please fill in your name and student number on Mentimeter in the following format:
• Student number, name
• Example: 1234567, Mark Dijkstra
• Please insert your information correctly, especially your student number! This makes
grading easier.

38
QUIZZES
• Don’t forget to take the quiz on Thursday
• 7:00 – 21:00
• Correct answers are shown after 22:00
• Use a decimal point and a comma as thousands separator
• For example: 12,345.67

39