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

list of 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.
interest rates holds, and you hold the three-year zero-coupon bond until
Cov ( IBM , M ) maturity (i.e., the end of Year 4). Calculate the expected price of the three-
0.5= →Cov ( IBM , M year ( 0.5∗(bond
end of Year 1. And √
)=zero-coupon 0.04 )∗( √ 0.16 ))
at the end of Year 1.You will purchase bond at the
you will hold until year 4. Therefore we need to find spot
( √ 0.04 )∗( √0.16 ) rate future rate of that year for 3 year bond. Ie. Need to find f = 1 4

1
( 1.07 )4 3
= 0.04

0.8=
Cov ( GM , M )
( √ 0.04 )∗( √ 0.09 )
→Cov ( GM , M )=(1.03 0.8∗( √0.04 ( −1 = )8.3676% )
∗( √ 0.09 ) ) Since OBECO is a giant “funds of funds” company that resembles a well-diversified
portfolio with the same risk-return profile as that of the market portfolio, we should

1000
use the Treynor ratio to explain whether they should add FULLERTON to their
= 0.048 portfolio. Since the idiosyncratic risk of OBECO has been diversified away, the relevant
Expected price of bond at the end of year 1: = risk we should be interested in is the systematic risk. This is because this ratio will be
Cov ( IBM , M ) ( 1.083676 )3 able to provide OBECO with information relating to how much risk premium is
Beta of IBM = = 0.04/0.04 = 1 // Beta of GM = awarded per unit of market risk. OBECO would not want to add a fund to their

σ2 M $785.78
b). Based on the current yield curve, a risk-free 3-year 10% annual coupon
portfolio which underperforms the market. The Treynor Ratio for FULLERTON is: =

Cov ( GM , M )
bond is issued today (i.e., to mature at the end of Year 3). You buy the
coupon bond at the issuance, and reinvest the coupons until the end of year 2,
[ 1.3−0.1 ]
= 2% (because treynor is adding to an already diversified fund,
= 0.048/0.04=1.2
and resell the bond at the end of Year 2. Assume that the expectations theory
0.6
σ2 M of term structure of interest rates holds.
Calculate the price of the coupon bond at the issuance and the “Realized whereas sharpe ratio is for a whole portfolio) This means for every unit of market risk,
Expected Return IBM = 0.04 + 1(0.14-0.04) = 14% Compound Yield” for the investor over the two-year period. FULLERTON provides 2% risk premium. For a large fund, this is a desirable outcome
Expected Return GM = 0.04 +1.2(0.14-0.04) = 16%
100 100 1100 and would support an argument for adding FULLERTON to the portfolio. Furthermore,
this is a higher result than the Treynor ratio for Brighton (1.7-0.1/1.16 = 1.3793…).
b). Calculate the beta of your portfolio:
Price of Coupon Bond today: + + = During the meeting, Mike proposes that they should also allocate investments to
1.03 1.042 1.06 3
( 200000
500000 )
+1.2 (
200000 100000
50000 ) ( 500000 )
BRIGHTON. He argues the fund manager of BRIGHTON is able to generate superior
β p=1 +0 $1113.12
profits in the future, which is evidenced by the regression output in the table that
BRIGHTON generated strong positive alphas relative to the benchmark during the past
1 five years. He also adds that the large alpha generated by BRIGHTON is a clear
( 1.06 )3
( )
=Suppose
0.88 the spot price of gold is $1,500 per troy ounce today. The futures indication of market inefficiency. However, Jennifer disagrees on Mike’s proposal and
arguments. Based on her knowledge of mutual fund performances and market
c) . Assume
price that
of gold forthe returnincorrelation
delivery between
1 year is $1,530 IBM ounce.
per troy and GMAssume
is 0.40.that the Expected Future rate end of Year 2: 2f3 = −1 =
( 1.04 )2
Calculate the return efficiency, Jennifer believes Mike’s arguments have several flaws and there are caveats
one-year gold futuresstandard
contractdeviation of your
is correctly portfolio:
priced and there are no storage in the regression analysis performed by Mike. Provide two valid reasons to explain why

Cov ( IBM ,GM )=( 0.4∗ ( √ 0.16 )∗( √0.0910.1161%

))
and insurance costs. Also assume that the risk-free rate is compounded
annually and you can borrow and lend money at the risk-free rate. a). What
we should refute Mike’s proposal and arguments. The alpha provided by the regression
analysis are only estimates. There is the possibility for there to be sampling errors
=is0.048
𝞂flat
the theoretical parity price of a two-year gold futures contract, assuming a
yield curve
2 (same interest
2 rates for all maturities)?
p = (W1 * 𝞂 + W2* 𝞂 + 2W1 *W2 * correlation * 𝞂1* 𝞂2)
1/2
or Covariance Price of bond when sold end of year 2:
1100 = $998.95 which reduce the statistical significance of the alpha. Mike proposes, that the alphas is
a ‘clear’ indication of market inefficiency. For the reason mentioned above this cannot
F0p ==S0 (1 + Rf )T
𝞂
1530 = 1500(1 + Rf)
2
1
2
1.1011 certainly be said to be the case. The regression analysis is merely a model. Models are
useful for providing an indication to market performance, however, they are not
√ 0.4 ∗0.16+0.4 ∗0.09+ 2∗0.4∗0.4∗0.048
(1 + Rf) = 1530/1500
1 + Rf = 1.02
Coupon re-investment: perfect. Secondly, there is the caveat of whether the markets are efficient. In a semi-
strong or strong EMH, it should be not be common for abnormal profits to be
=R 23.53%
( 1.04 )2
d)
f = 2%
Let. After
portfolio
reviewing parity
X = theoretical
“irrespective
in part c),
X = 1500(1+0.02)
of your
size is 100
your risk

risk
preference
price
preference,
Assume
troy ounces.
and the
for a two-year
your
Thethat
risk-return
gold
current
you
initial
portfolio
b). Suppose you short 10 one-year gold futures contracts today
optimal
contractinvestor portfolio”. can also
margin
profile of your
futures contract:
2 your investment analyst made a surprising comment that
= $1560.60
is NOT
investby
requited
andthe
in the
the
the market
clearing
First payment invested at 1f2 =
(
(100*1.05009)+100 = $205.01 from coupons
1.03 ) -1 = 5.0097%
consistently made. It is possible that previous five years performance has come down
to luck. Brighton may perform well in the short term, but over a longer investment
horizon the benchmarked performance may not be as relevant.
During the meeting, Harry told Mike that he identified another good-performing fund
NEURIZON. The fund adopts a long-term investment strategy by investing in stocks of
portfolio and make riskless lending and borrowing. Explain
house is $10,000 for your 10 futures contracts. After three months, thewhether you which the prior 5-year cumulative returns were among the bottom 20% of all stocks in
I agree Ending Wealth = 998.95+205.01 = $1203.96
agree
futuresorprice
disagree on thetoanalyst’s
decreases comment,
$1,525 per and why?
troy ounce. Assume that with the not
you did the market. That is, NEURIZON buys these “fallen angels”, which had a prior 5-year
1
analysts comment because there is a way to create a portfolio that is less risky
1203.96 underperformance, and holds them for about 3 years before rebalancing. It turns out that

( )
replenish the margin and there was no margin calls over the three months.
and offers a higher return than this portfolio. The expected return of this
What is the balance in your margin account in three months? Realized compound Yield = 2 – 1 = 0.040002 = 4% NEURIZON’s investment strategy works well for its fund investors. Not only for
portfolio is 12.8% (2/5*0.14+2/5*0.16+1/5*0.04). As seen from c, the 𝞂 of NEURIZON, other funds adopting NEURIZON’s investment strategy also performs
Contract with leverage, means you own 100*10 = 1000 troy ounces
the portfolio is 23.53%. We can notice that the expected return of the market
When you short a position, you profit when the value of the position 1113.12 well for their investors. On average, these NEURIZON-type funds have earned superior
portfolio is 14% and has 𝞂 of 20% (0.04^1/2). An investment into the market _____________________________________________________________ cumulative abnormal returns over and above the CAPM for decades. Please interpret
decreases. The price of the future fell from 1530 to 1525. Meaning we
portfolio is therefore better than an investment of our weighted our portfolio whether the superior performance of NEURIZON’s investment strategy is a violation of
receive $5 profit per troy ounce we hold. Inflow from short position = 1000 A risk-free 3-year 10% annual coupon bond is scheduled to be issued at the
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 the Efficient Market Hypothesis or not. The superior performance of NEURIZON’s
*(1530-1525) = $5000
the coupon bond at the issuance, (at the end of Year 1), reinvest the coupons investment strategy is a violation of the Efficient Market Hypothesis. This is because in
Therefore, Balance in margin account = 10000 + 5000 = $15000
until the end of Year 3, and resell the bond at the end of Year 3. Assume that an efficient market, prices should be an accurate information of information relating to
c). The price of 1-year index futures contract for S&P 500 is 3,000, while the
the expectations theory of term structure of interest rates holds. Required: the security. The possibility to consistently make abnormal returns from historic
current S&P 500 index value is 2,952. It is also known that the dividend yield
Calculate i) the expected price of the bond at the end of Year 1, ii) the information over the ex-ante expected return is a direct contradiction of the EMH.
on S&P 500 is 1% per year compounded annually. Assume you can borrow
expected total cash flow for the investor at the end of Year 3, and iii) Although there may be some anomalies to the EMH that can be explained, the fact
and lend money at the riskless rate of 2% per year compound annually. Also,
“Realized Compound Yield” for the investor over the two-year period - from that other funds have adopted the same approach and receive the same result is more
you can buy and short sell the S&P 500 index now.
the end of Year 1 to the end of proof against the EMH. The Weak form EMH would suggest that no abnormal returns
Design an arbitrage strategy and show that the strategy has a zero cost with
Year 3. can be achieved by studying past price and volume movements. NEURIZON’s strategy
a sure profit at the end of Year 1. F0 = 2952(1+0.02-0.01)1 = $2981.66 The 2
1f2 = 1.05 /1.03-1 violates this notion as they make consistent profits from past prices. Since weak EMH
current futures price for one year is $3000, since 3000>2981.66, we can say = 7.04% is a subset of strong and semi-strong EMH, all of EMH forms are violated.
that the futures contract is overpriced. There is an opportunity for arbitrage. 3
1f3 = (1.07 /1.03)
1/2

We should short the futures contract, long the underlying asset (S&P 500 – 1 = 9.06%
contract) and borrow proceeds. Initial Cash flow: Short Futures (0), long the 4
1f4 = (1.06 /1.03)
1/3
– 1 = 7.02%
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 + Under the expectations theory, expected future spot rates are equal to the
29.52 = $17.89 arbitrage profit. corresponding forward rates. Assuming a par value of $1,000:
Price at the end of Year 1 = 100/1.0704 + 100/1.0906 2 + 1100/1.0702 3 =
1074.944838
Reinvested coupons: 100×(1.09062/1.0704)+100 = 211.115 (or calculate 2f3)
Price of the bond: 1100×1.09062/1.07023 = 1067.383677 (or calculate 3f4)
The expected total Year 3 cash flow = 1278.498689
RCY = (1278.498689/1074.944838)1/2 – 1 = 9.06
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):

36 0.32
D =
1
ln ( )(
36
+ 0.03−0+
2
∗1 = 0.25 )
0.3∗√ 1
N(-d1) = 0.4013, // N(d1) = 1 - 0.4013 = 0.5987
D2 = D1 – 0.3*
√1 = -0.05 // N(d2) = 0.4801

0
C0 = 36∗e ∗N ( d 1 )−36∗e−0.03∗1∗N ( d 2 )
=(36*1*0.5987)-(36* −0.03∗1 *0.4801)
e
= 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 + 36
e−0.03∗1 – 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