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ffi or ECONOMICS eruo

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Summer 2017 examination

FM423
Asset Markets

Suitable for all candidates

I nstructions to cand idate.s

This paper contains six questions, three in Part A (consisting of questions 1, 2, and 3) and three in Part B
(consisting of questions 4, 5, and 6).

Answer two questions from Part A and two questions from Part B for a total of þg¡ questions.

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

Please indicate clearly in your answer sheet which four questions you answered'

lf, 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.

Time Allowed - Reading Time: 10 minutes. You may not make notes during this time
Writing Time: 3 hours

You are supplied with: No additional materials.

You may also use: No additional materials.

Galculators: Catcutators are atlowed in this examination

@ LSE ST 20171FM423
Page 1 of 9
 Part A
Question 1. (25 marks) You are given the following ihformation:

Bond Coupon Rate Maturity (years Price

A 0% 1 98.039
B 5% 2 101.980
C 5To 3 t00.228
D 7% oo 16.302

Coupon payments are annual, interest rates are annual, and par values are 100

(u) (¡ marks) Determine the one-, two- and three-year spot rates

(b) (3 marks) Consider an interest-rate swap in which fixed rate is exchanged for floating,
and which has three-year maturity and annual payments. What is the swap rate?

(.) (¡ marks) Suppose that a dealer offers you the opportunity to borrow or lend for two
years starting one year from no-w, at the rate of 6% guaranteed today. Show that there
is an arbitrage. What trading strategy would you use to perform the arbitrage?

(d) (5 rnarks) Suppose that rates are determined according to the expectations hypothesis,
what will be the one-year spot rate in two years? What will be the two-year return
from investing in bond C? Express this as an annualized return. Assume that coupons
are reinvested at the prevailing spot rates.

(") (2 n¡arks) Find YTM of perpetuity D

(f) (5 marks) Suppose that the term-structure starting from year four is flat. Find the
term-structure of interest rates.

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Question 2. (25 marks) Consider three portfolios of stocks, A, B, and C, which have
the following annual expected returns and standard deviations: Elr¡]:70% and oe:20T0,
Elrsl:15o/o and op:25%, E[r"1:14% and oc:2270. The annually compounded riskless rate
is r:5Y0.

(") (2 mørks) It is known that one of the portfolios A, B, C lies on the effi.cient frontier
(which includeç the riskless asset). \Mhich portfolio is efficient?

(b) (3 marks) Consider a conservative investor who wants to invest in a new portfolio P
by the portfolios A,
allocating her wealth between the riskless asset and only one of
B, or C. The investor wants her new portfolio to have a standard deviation op:I\Yo.
What is the highest expected return that the investor can obtain?

(") (g marks) It is known that portfolio C is a combination of portfolios A and B, i.e.

rc : wr¡ * (1 - w)rB. What is the weight ø? What is the correlation between
portfolios A and B returns?

(d) (5 marks) Consider an investor who borrows 10,000 and uses her own 20,000 to invest
20,000 in portfolio A and 10,000 in portfolio B. What is the expected return on the
investor's portfolio? What is the standard deviation of the investor's portfolio?

(") (3 marlcs) Is portfolio C the tangency portfolio? Why or why not?

(f) (2 marks) \Ã/hat is diversification, and what are the limits to diversification? What
types of risk can be diversified awa¡ and what types cannot?

(g) (ø marks) Explain why the increase in portfolio variance when you add a small amount
of a stock to your portfolio is largely determined by the stock's covariance with your
portfolio.

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Question 3.
(25 marks) Cheetah, a UK automobile company, has just paid an annual
dividend of 2. Dividends are expected to grow at 3% per year forever. The riskfree rate is
2Yo and the market risk premium ís 4Yo. The beta of Cheetah is 1.2.

(u) (0 marks) At what prices does the stock of Cheetah trade today?

(b) (6 marks) Investors learn about the recession and expect the dividends of Cheetah to
grow at lVo over the next two years. They expect the recession to end after two years,
and the 3% growth rate to resume. How does today's price of Cheetah change in light
of this new information?

(") (Z marks) What is the stock's return between just before the information in part (b)
is learned and just after?

(d) (6 marks) Suppose that in addition to the infoimation in part (b) investors iearn that
the market risk premium during the two years of the recession will be 6%. How does
today's price of Cheetah change in light of this new information?

(") (¡ marks) Suppose that you don't like.volatility in dividend growth of Cheetah. There-
fore, you look at another company called NeverletYouDown (NLYD). NLYD has an
expected dividend of 1 in perpetuity and is currently traded at 50. What can you say
about the beta of NLYD? Continue to assume that the recession wiil last two years
and that during the recession the market risk premium will be 6%.

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Part B
Question 4. (25 marks)
(a) (9 marks) Consider the following two-factor model for the returns of three well-diversified
assets (i.e., with no idiosyncratic risk):

r¡: -0.025*h*Iz,
rs : 0.075- It*Iz,
rç : 0.I-21\+412.
(i) (6 mørks) Compute the expected return of the factor replicating portfolios and
the risk-free rate for this economy. What is the expected return to portfolio D
that has exposures minus 6 to factor 1 and minus 2 to factor 2 (D is also well-
diversified).
(ii) (3 marks) Assume that the standard deviation of factor L is 2% and the standard
deviation of factor 2 is 4%. What is the standard deviation of portfolio D? Make
sure you justify each step in this calculation. What is the Sharpe Ratio of portfolio
D?

(b) (16 rnarks) Give brief answers to the following questions:

(Ð (/, marks) What are the advantages of the APT relative to the CAPM? What are
the main drawbacks of the APT?
(1i) (/r marks) What empirical regularity in the equity markets do we refer to as
momentum? Describe key implementation issues that arise when designing an
institutional product exploiting this empirical regularity?
(iii) (l marks) Using monthly return data over the sample period from January 1980
to Decemb er 2016, you find a zero-beta long-short US equity strategy which yields
positive average returns. What are the possible interpretations of your findings?
List at least three.
(i") (4 marks) A week where the stock market is volatile is likely to be followed by
another volatile week, Does this statement violate any forms of market efficiency?
Explain.

Page 5 of 9
Question 5. (25 rnarks) The price today of LSE.com stock is 50. After the first six months,
the price will either increase by 20 percent (with probability Il2) or decrease by 20 percent
(with probability 712). Over the next six-month period, the stock price will again either
increase by 20 percent (with probability 215) or decrease by 20 percent (with probability
3/5). The stock will not pay any dividends over the next year. The six-month interest rate
is 5 percent (for both six-month periods). In answering the following questions, assume that
there are no arbitrage opportunities.

6) Q marks)
Calculate the price today of a one-year European put option on this stock which has
a strike price of 50.

(b) (8 marks)
Calculate the price today of a one-year American put option on this stock which has
a strike price of 50.

(c) (10 rnarks)

An Asian option is an option whose payoff depends on the average value of the stock
price over the life of the option. (Early exercise of the option is not allowed.) One
example is a fixed-strike Asian call option, whose payoff at maturity is mar(A- X,0),
where .4 is the âverage value of the stock price and X is the strike price. Calculate
the value today of a one-year fixed-strike Asian call option on this stock with a strike
price of 45 (include toda;r's stock price when you calculate the average price over the
year).

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Question 6. (25 marks)

(u) (¡ marks) Discuss the notion of delta-hedging and its role in the derivation of the
Black-Scholes PDE (a short intuitive explanation will suffice here; do not derive the
PDE).

(b) (5 marks)The sensitivity of the price of a European Call option in the Black & Scholes
modei to calendar time ú (i.e., Theta) is given by the following formula:

Sto
o : - lre-,Q-t) yço(dz)l - 6@ù
2r/T - t
where Õ (d) is the cumuiative distribution (probability density) function of a standard
normal, K is the strike price, ? the maturity date, and d1,2 depend on all parameters.
Explain the meaning of each of the two terms in the corresponding square brackets.
What are the signs of the terms for a European Call option. Comment on whether you
expect the same signs to hold for European Put options.

(") (5 marks) Using ltô's Lemma, compute the dynamics for the logarithm of the stock
price, i.e., d(tog,Sr) in the Black-Scholes model where the stocks follows a geometric
Brownian motion. What sort of process is the logarithm of the stock price?

(d) (5 mørlcs)Consideraputwith K:l06and? -t-1 yearremaininguntilmaturity,

and suppose that ,S : 100, o : 20To per year, and ra : 6yo (annual interest rate,
annually compounded). What is the Black-scholes price? A table with values for the
cumulative distribution function (cdf) for the standard normal is attached. To use the
table, round all inputs to the normal cdf to the closest hundredths. Thus, for example,
if calculating e(d1) where ú: L.LL , you should calculate e(1.11) : 0.8665.
(.) (¡ marks) Consider an option whose payoff at maturitv (time T) is equal to a constant
Vt lf. Kt I Sr I Kz, ãconstant Vs Lf. Ksl Sr < Ka, andzero otherwise' K1, K2,
K3, and Ka ate positive constants with K1 1 Kz 1 Ks 1 K+. Use the risk-neutral
valuation method to calculate the no-arbitrage price of this option at t 17 (write
your ans\/er in terms of Õ(d1) and/or A@ù from the Black-Scholes equation, which
you may use without proof, though you must explain why you use those Black-Scholes
components).

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 Standard Normal Cumulative Probability Table

Cumulative probabilíties for NEGATIVE z-values are shown in the following table:

z .03 0.07
-3.4 0.0003 0.0003 0.0003 0.0002
.3.3 0.0005 0.0005 0.0005 0.0004 0.0004 0.0004 0.0004 0.0004 0.0004 0.0003
-3.2 0.0007 0.0007 0.0006 0.0006 0.0006 0.0006 0.0006 0.0005 0.0005 0.0005
-3.1 0.0010 0.0009 0.0009 0.0009 0.0008 0.0008 0.0008 0.0008 0.0007 0.0007
-3.0 0.0013 0.0013 0.0013 0.0012 0.0012 0,0011 0.0011 0.0011 0.00't0 0.0010

-2.9 0.0019 0.0018 0.0018 0.00'17 0.0016 0.0016 0.00'15 0.0015 0.0014 0.0014
-2.8 0.0026 0.0025 o.0024 0.0023 0.0023 0.0022 0.0021 0.0021 0.0020 0.0019
.2.7 0.0035 0.0034 0.0033 0.0032 0.0031 0.0030 0.0029 0.0028 0.0027 0.0026
-2.6 o.0047 0.0045 0.0044 0.0043 0.0041 0,0040 0.0039 0.0038 0.0037 0.0036
-2.5 0.0062 0.0060 0.0059 0.0057 0.0055 0.0054 0.0052 0.0051 0.0049 0.0048

-2.4 0.0082 0.0080 0.0078 0.0075 0.0073 0.0071 0.0069 0.0068 0.0066 0.0064
-2.3 0.0107 0.0104 0.0102 0.0099 0.0096 0.0094 0.0091 0-0089 0.0087 0.0084
-2.2 0.0139 0.0136 0.0132 0.0129 0.0125 0.0122 0.01 19 0.0116 0.01 '13 0.01 10
-2.1 0.0179 0.0174 0.4170 0.0166 0.0162 0.0158 0.0154 0.0150 0.0146 0.0143
-2.0 0.0228 0.0222 0.0217 0.0212 0.0207 0.0202 0.0197 0.0192 0.0188 0.0183

-1 I 0.0287 0.0281 0.4274 0.0268 0.0262 0.0256 0.0250 0.0244 0.0239 0.0233
-1 I 0.0359 0.0351 0.0344 0.0336 0.0329 0.0322 0.0314 0.0307 0.0301 0,0294
-1 7 o.0446 0.0436 0-0427 0.0418 0.0409 0.0401 0.0392 0.0384 0.0375 0.0367
-1 6 0.0548 0.0537 0.0526 0.0516 0.0505 0.0495 0.0485 0.0475 0.0465 0.0455
-1 5 0.0668 0.0655 0.0643 0.0630 0.0618 0.0606 0.0594 0.0582 0.o571 0.0559

-'t.4 0.0808 0.0793 0.0778 0.0764 0.0749 0.0735 0.0721 0.0708 0.0694 0.0681
-1.3 0.0968 0.0951 0.0934 0.0918 0.0901 0.0885 0.0869 0.0853 0.0838 0.0823
-1.2 0.1151 0.1131 0.1112 0.1093 0.1075 0.1056 0.1 038 0.1020 0.1 003 0.0985
-1.1 0.1 357 0.1 335 0.1314 0.1292 0.1271 0.1251 0.1230 0.1210 0.1 190 0.'1170
-1.0 0-1587 0.1562 0.1539 0.1515 0.1492 0.1469 0.1446 0.1423 0.1401 0.1379

-0.9 0.1841 4
0.1 81 0.1788 0.1762 0.1736 0.1711 0.1685 0.1660 0.1635 0.1 61 1

-0.8 0.2119 0.2090 0.2061 0.2033 0.2005 0.1977 0.1949 0.1922 0.1894 0.1 867
-0.7 0.2420 0.2389 0.2358 0.2327 0.2296 0.2266 0.2236 0.2206 0.2177 0.2148
-0.6 0.2743 0.2709 0.2676 0.2643 0.2611 0.2578 0.2546 0.2514 0.2483 0.2451
-0.5 0.3085 0.3050 0.3015 0.2981 0.2946 0.2912 0.2877 0.2843 0.2810 0.2776

-0.4 0.3446 0.3409 0.3372 0.3336 0.3300 0.3264 0.3228 0.3192 0.3156 0.3121
'0.3 0.382'l 0.3783 0.3745 0.3707 0.3669 0.3632 0.3594 0.3557 0.3520 0.3483
-0,2 0.4207 0.4168 0.4129 0.4090 0.4052 0.40'13 0.3974 0.3936 0.3897 0.3859
-0.1 0.4602 0.4562 0.4522 0.4483 0.4443 0.4404 0.4364 0.4325 0.4286 0.4247
0.0 0.5000 0.4960 0.4920 0.4880 0.4840 0.4801 0.4761 0.4721 0.4681 0.4641

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 Standard Normal Gumulative Probability Table

Cumulative probabilities for POSITIVE z-values are shown in the following table:

0.06
60 0.5199
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.587'l 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879

0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 4.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389

1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.89M 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9'162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319

1.5 0.9332 0.9345 0.93s7 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
r.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767

2.0 0.9772 0.97V8 0:9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.98r7
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936

2.5 0.9938 0.9940 0.994'l 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2,7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986

3.0 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
3.1 0.9990 0.9991 0.9991 0.9991 0.9992 0.9992 0.9992 0.9992 0.9993 0.9993
3.2 0.9993 0.9993 0.9994 0.9994 0.9994 0.9994 0.9994 0.9995 0.9995 0.9995
3.3 0.9995 0.9995 0.9995 0.9996 0.9996 0.9996 0.9996 0.9996 0.9996 0.9997
3.4 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9998

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