FIE400E 2016 Spring Solutions

NORGES HANDELSHØYSKOLE
Examination Spring 2016
Code: FIE 400 E Title: Investments
Exercise 1
Grading suggestion:
a) 4 points b) 3 points c) 2 points d) 2 points e) 3 points f) 3 points g) 4 points h) 4 points
a)
7.500 15.000 25.000 60.000
Fair price= 1+2%
+ (1+2,2%)2
+ (1+2,4%)3
+ (1+2,6%)4
= 99.142, 594 NOK
The product is not fairly priced because the bank is demanding 100.000 NOK. To obtain the
cash-flows promised by the bank, we only need an investment of 99.142,594 NOK in ZCBs.
b)
Not likely, because although we can buy the “cheap” portfolio of ZCBs, shorting the “expensive”
bank’s product would be unfeasible.
c)
2-y ZCBs: 150.000 NOK 3-y ZCBs: 150.000 NOK 4-y ZCBs: -200.000 NOK
d)
2-y ZCBs: 150.000 × (1 + 2.2%)2 = 156.672, 6 NOK
3-y ZCBs: 150.000 × (1 + 2.4%)3 = 161.061, 274 NOK
4-y ZCBs: −200.000 × (1 + 2.6%)4 = −221.625, 352 NOK
e)
150.000 150.000 −200.000
Duration = 100.000
×2+ 100.000
×3+ 100.000
× 4 = −0, 5 years
f)
Ignoring the time effect of one day, the portfolio remains unchanged since it does not have have
1-y ZCBs.
g)
The goal is to immunize the overall portfolio, so we need portfolio’s duration equal to zero:
w × −0.5 + (1 − w) × 1 = 0 ⇔ ⇔ w = 2/3
The old portfolio has a weight of 2/3, while the 1-y ZCBs has a weight of 1/3.
h)
I prefer the portfolio in c) because it has a negative duration. Hence, if I expect yields to rise, the
price of that portfolio will increase, while the portfolio in g) will remain unchanged.
1
2
Exercise 2
Grading suggestion:
a) 3 points b) 5 points c) 5 points d) 8 points e) 4 points
a)
The Sharpe ratio of the market is simply the slope of the CML: 0,5.
b)
I cannot say anything about the pricing of securities A and B because the CML cannot price
individual securities. For that I need the securities’ betas, which are not provided.
c)
As in part b), I cannot say anything about the pricing of stock C. However, I can test if stock C
rejects CAPM by computing its Sharpe ratio: SC = 15%−3%18%
= 2/3 > 0, 5 — CAPM cannot hold in
this world because the market does not yield the highest Sharpe ratio.
d)
0 −0,2% 0 0,7% 0,5%
Step 1: wA = 9%2
= −0, 247 wB = 14%2
= 0, 357 wC0 = 10%2
= 0, 5
−0,247 0,357 0,5
Step 2: wA = −0,247+0,357+0,5
= −0, 405 wB = 0,61
= 0, 585 wC = 0,61
= 0, 820
Step 3: αAct = −0, 405 × (−0, 2%) + 0, 585 × 0, 7% + 0, 82 × 0, 5% = 0, 9%
Step 4: σe2Act = (−0, 405)2 × 0, 092 + 0, 5852 × 0, 142 + 0, 822 × 0, 12 = 0, 015

0,9%
0
Step 5: wAct = / 9%
0,015 0.182
= 0, 216
Step 6: βAct = −0, 405 × 0, 9 + 0, 585 × 1, 2 + 0, 82 × 1, 3 = 1, 404

0,216
Step 7: wAct = 1+(1−1,404)×0,216
= 0, 237
Step 8: wM arket = 1 − 0, 237 = 0, 763
Investment:
• 76.300 NOK in the market;
• -9.598,5 NOK (100.000 × 0, 237 × −0, 405) in security A;
• 13.864,5 NOK in security B;
• 19.434 NOK in security C.
e)
Step 9: E[r] = (0, 237 × 0, 9%) + (0, 763 + 0, 237 × 1, 404) × 9% = 10, 075%
Step 10: σ 2 = (0, 763 + 0, 237 × 1, 404)2 × 0, 182 + 0, 2372 × 0, 015 = 0, 0397
10.075%
S=√ 0,0397
= 0, 506
3
Exercise 3
Grading suggestion:
a) 3 points b) 7 points c) 5 points d) 10 points
a)
5
50 = rXY Z
⇔ rXY Z = 10%
b)
N ew 4,50 1
PXY Z = 10%−g × (1+10%)5
N ew
To increase shareholder value: PXY Z > 50 ⇒ g > 4, 41%
c)
3% = ROE × 50% ⇔ ROE = 6%
ROE should be higher than 8,82% ( 4,41%
50%
).
d)
N ew 9×50% 1+8% 5 1 9×(1+8%)4 ×(1+4%)×50% 1
PXY Z = 10%−8%
× [1 − ( 1+10% ) ]× (1+10%)5
+ 10%−4%
× (1+10%)10
= $53, 160
Exercise 4
Grading suggestion:
a) 17 points b) 8 points
1) At year 1, if prices go up:
• Pear Inc. goes up by 149,510−115,220

115,220
= 29, 76%;
120−100
• Xevron goes up by only 100 = 20%;
• Pear Inc. is dropped out of the basket;
• You still hold an American call;
• X = 100+120
2
= 110.
• Exercising the option at this stage yields a payoff of $10.
• if at year 2 Xevron goes up:
– You still hold a call;
– X = 100+120+144
3
= 121, 333;
– Zu = 22, 667.
• if at year 2 Xevron goes down:
– Since Xevron dropped by more than 15% (-20%), you now hold a put;
– X = 100+120+96
3
= 105, 333;
– Zd = 9, 333.
• Computing the value of the European option (using ∆ and B formulas) yields 16,348;
• it is not optimal to exercise early.
4
At year 1, if prices go down:

• Pear Inc. goes down by 78,431−115,220
115,220
= −31, 93%;
80−100
• Xevron goes down by only 100 = −20%;
• Xevron is dropped out of the basket;
• Since Pear Inc. dropped by more than 15%, you now hold a put;
• X = 115,22+78,341
2
= 96, 823.
• Exercising the option at this stage yields a payoff of $18,395.
• if at year 2 Pear Inc. goes up:
– Since Pear Inc. goes up by more than 15% (59,38%), you now hold a call;
– X = 115,22+78,431+125
3 = 106, 217;
– Zu = 18, 783.
• if at year 2 Pear Inc. goes down:
– You still hold a put;
– X = 115,220+78,431+25
3
= 72, 884;
– Zd = 47, 884.
• Computing the value of the European option (using ∆ and B formulas) yields 31,254;
• it is not optimal to exercise early.
At year 0:
• You hold an American Call;
• Zu = 16, 348;
• Zd = 31, 254.
• Computing the value of the option (using ∆ and B formulas) yields 22,593;
Auxiliar calculations for ∆ and B (Using risk-free asset and Pear Inc. for the replicating portfolio):
t=1 year, Up state
∆ = 22,667−9,333
175−125
= 0, 267 B = 9,333−125×0,267
1+2%
= −23, 571
Z1,U p = 0, 267 × 149, 51 − 23, 571 = 16, 348
t=1 year, Down state
∆ = 18,783−47,884
125−25
= −0, 291 B = 47,884−25×(−0,291)
1+2%
= 54, 077
Z1,Down = −0, 291 × 78, 431 − 54, 077 = 31, 254
t=0
16,348−31,254
∆ = 149,51−78,431 = −0, 210 B = 31,254−78,431×(−0,21)
1+2%
= 46, 789
Z0 = −021 × 115, 22 + 46, 789 = 22, 593
2)
From put-call parity:
S = C(X = 50) − P (X = 50) + P VBond (F V = 50)
However, we do not have C(X = 50), but we know that C(X = 50) > C(X = 60). Moreover,
plugging in C(X = 60) in our put-call formula:
50
8 − 7, 0196 + 1+2% = $50 = Stock price
Hence, with C(X = 50)
50
C(X = 50) − 7, 0196 + 1+2% > $50 ⇒ Arbitrage opportunity!
To exploit this arbitrage, I:
• Buy stock ABC in the market: pay $50;
• Sell C(X = 50): receive more than $8;
• Buy P (X = 50): pay $7,0196;
• Short risk-free bonds with face value of 50: receive $49,0196;
• Profit: Difference between C(X = 50) and C(X = 60).

FIE400E 2016 Spring Solutions

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NORGES HANDELSHØYSKOLE

Examination Spring 2016

Code: FIE 400 E Title: Investments

Step 3: αAct = −0, 405 × (−0, 2%) + 0, 585 × 0, 7% + 0, 82 × 0, 5% = 0, 9%

Step 4: σe2Act = (−0, 405)2 × 0, 092 + 0, 5852 × 0, 142 + 0, 822 × 0, 12 = 0, 015

Step 6: βAct = −0, 405 × 0, 9 + 0, 585 × 1, 2 + 0, 82 × 1, 3 = 1, 404

Step 8: wM arket = 1 − 0, 237 = 0, 763

1) At year 1, if prices go up:

• Pear Inc. goes up by 149,510−115,220

At year 1, if prices go down:

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