FN2190

Summer 2020 online assessment guidance

FN2190 Asset Pricing and Financial Markets
The assessment will be an open-book take-home online assessment within a 24-
hour window. The requirements for this assessment remain the same as the
originally planned closed-book exam, with an expected time/effort of 3 hours.

Candidates should answer THREE of the following FOUR questions. All questions
carry equal marks.

You should complete your examination using pen and paper. Please use BLACK
ink only.

Handwritten work then needs to be scanned, converted to PDF and then uploaded to
the VLE as ONE individual file including the coversheet. Each scanned sheet
should have your candidate number written clearly at the top. Please do not write
your name anywhere on any sheet.

The paper will be available at 12.00 midday (BST) on Thursday 2 July 2020.

You have until 12.00 midday (BST) on Friday 3 July 2020 to upload your file into
the VLE submission portal. However, you are advised not to leave your submission
to the last minute. We will deduct 5 marks if your submission is up to one hour late,
10 marks if your submission is more than one hour late but less than two hours late
(etc.).

If you think there is any information missing or any error in any question, then you
should indicate this but proceed to answer the question stating any assumptions you
have made.

The assessment has been designed with a duration of 24 hours to provide a more
flexible window in which to complete the assessment and to appropriately test the
course learning outcomes. As an open-book assessment, the expected amount
of effort required to complete all questions and upload your answers during this
window is no more than 3 hours. Organise your time well and avoid working all
night.
You may use any calculator for any appropriate calculations, but you may not use
any computer software to obtain solutions. Credit will only be given if all workings are
shown.

You are assured that there will be no benefit in you going beyond the expected 3
hours of effort. Your assessment has been carefully designed to help you show what
you have learned in the hours allocated.

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This is an open-book assessment and as such you may have access to additional
materials including but not limited to subject guides and any recommended reading.
But the work you submit is expected to be 100% your own. Therefore, unless
instructed otherwise, you must not collaborate or confer with anyone during the
assessment. The University of London will carry out checks to ensure the academic
integrity of your work. Many students that break the University of London’s
assessment regulations did not intend to cheat but did not properly understand the
University of London’s regulations on referencing and plagiarism. The University of
London considers all forms of plagiarism, whether deliberate or otherwise, a very
serious matter and can apply severe penalties that might impact on your award. The
University of London 2019-20 Procedure for the Consideration of Allegations of
Assessment offences is available online at:

https://london.ac.uk/sites/default/files/governance/assessment-offence-procedure-
year-2019-2020.pdf

The University of London’s Rules for Taking Online Timed Assessments have been
included in an update to the University of London General Regulations and are
available at:

https://london.ac.uk/sites/default/files/regulations/progregs-general-2019-2020.pdf

© University of London 2020

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Question 1

You observe that the current three-year discount factor for default-risk free cash
flows is 0.68. Remember, the t-year discount factor is the present value of $1 paid at
time t, i.e. 𝑑𝑑𝑡𝑡 = (1 + 𝑟𝑟𝑡𝑡 )−𝑡𝑡 , where 𝑟𝑟𝑡𝑡 is the t-year spot interest rate (annual
compounding). Assume all bonds have a face value of $100 and that all securities
are default-risk free. All cash flows occur at the end of the year to which they relate.

a) What is the price of a zero-coupon bond maturing in exactly 3 years? (5 marks)

b) Your friend makes the following observation about the above bond: “Since there
is no risk of default and there are no coupons to re-invest, buying the 3-year zero
coupon bond today is a risk-free investment; that is, you are guaranteed to earn
an annual return of 13.72% (i.e. 3-year spot rate)”. Explain why your friend is not
entirely correct and how you would modify the statement to make it correct.
(5 marks)

c) In addition to the bond in (a), you observe the following: a 2-year coupon bond
paying 10% annual coupons with a market price of $97, and two annuities that
are trading at the same market price as each other. The first annuity matures in 3
years and pays annual cash flows of $20, while the second annuity pays annual
cash flows of $28 and matures in 2 years. Using this information:

i. Complete the term structure of interest rates, i.e. determine the one- and
two-year discount factors, d1 and d2, respectively. (6 marks)

ii. Determine the price of the annuities. (2 marks)

d) Assuming annual compounding, determine the implied one-period forward rates

𝑓𝑓2 (i.e. between year 1 and 2) and 𝑓𝑓3 (i.e. between year 2 and 3) in this economy.
What inference can you make about the market’s estimate of the one-year spot
interest rate at 𝑡𝑡 = 1 if the liquidity preference theory is correct? (5 marks)

e) Suppose you decide to purchase a 1-year zero-coupon bond today and also
contract today to re-invest the proceeds from the bond for the following two years
at 16.5% per year. Show that this arrangement presents an arbitrage opportunity.
Demonstrate how you would take advantage of this opportunity. (6 marks)

f) Consider discount factors such that d1 < d2 < d3. Explain why it would be odd to
observe such a situation in a competitive market. (4 marks)

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Question 2

Assume the CAPM holds. Consider three feasible portfolios of stocks X, Y and Z with
the following return characteristics:

Portfolio Expected return Standard deviation

X 7.5% 5%
Y 5% 10%
Z 10% 15%

a) Explain why beta is the appropriate measure of risk in this world. (5 marks)

b) Portfolio Y is known to be uncorrelated with the market. Explain why this property
implies that the risk-free rate in the economy is 5%. (5 marks)

c) It is known that one of the portfolios X, Y, Z lies on the efficient frontier (which
includes the risk-free asset). Which portfolio is efficient? Explain/justify your
answer. (5 marks)

d) An investment manager approaches you and offers you an investment product

with a claimed expected return of 12% and standard deviation of 20%. Should
you accept this investment? Why/why not? If not, show how the manager can
optimally create a portfolio with an identical return volatility to his proposed
portfolio but with a superior expected return. Illustrate your answer graphically,
making sure to label all relevant elements of your picture. (6 marks)

e) Consider an investor who invests $50,000 in a portfolio consisting of X and Z.

$10,000 of that investment was funded with risk-free borrowing. The expected
return of the investor’s portfolio is 9.375%.

i. Calculate the dollar amounts invested in each of X and Z. (4 marks)

ii. If the correlation between X and Z is 2/3, what is the standard deviation of
the investor’s portfolio? (2 marks)

f) Show that any portfolio on the Capital Market Line (CML) with a positive weight in
the market portfolio is perfectly correlated with the market portfolio. Interpret this
result. (6 marks)

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Question 3

Assume all options are European, and that the underlying asset is a non-dividend
paying stock, unless otherwise specified.

(a) A ‘protective put’ strategy involves buying both a put option on a stock and the
underlying stock itself.

i. Draw a payoff diagram (not a profit-and-loss diagram) for a protective

put strategy. Make sure to label all relevant parts of the diagram. Why
do you think this strategy has its name? (5 marks)

ii. Using put-call parity, explain why the payoff of a protective put
resembles the shape of the payoff of a call option. (5 marks)

(b) You observe two call options, A and B, with the same exercise price, written
on the same underlying asset. Option A matures in one year, while B matures
in 18 months. Which option has the higher value? Explain. (5 marks)

(c) The value of a European put option must satisfy the following restriction:

𝑝𝑝0 ≥ 𝑋𝑋𝑒𝑒 −𝑟𝑟𝑟𝑟 − 𝑆𝑆0

where 𝑝𝑝0 is the current put price, 𝑆𝑆0 is the current price of the underlying
stock, 𝑋𝑋 is the exercise price, 𝑟𝑟 > 0 is the annualised continuously
compounded risk-free rate, and 𝑇𝑇 is the time till expiration. Prove by
contradiction that the above arbitrage restriction must hold, i.e. show that if
the condition does not hold, there is an arbitrage opportunity. (4 marks)

(d) It is also known that the value of a European put cannot be greater than the
present value of its exercise price, i.e. 𝑝𝑝0 ≤ 𝑋𝑋𝑒𝑒 −𝑟𝑟𝑟𝑟 . This restriction, along with
the one in (c), suggests that the price of a European put can fall below its
exercise value prior to maturity. When is this situation likely to arise? Give an
intuitive explanation as to why its value is below its exercise value in such
circumstances. (4 marks)

(e) Stock K currently sells for $120. After one year, its price will either increase by
10% or fall by 10%. The annual risk-free interest rate is 5%.

i. Calculate the current value of an at-the-money European call option on

stock K maturing in one year. (5 marks)

ii. Now assume that the volatility of Stock K increases so that if the stock
price increases, it will still increase by 10% but if it falls, it will fall by
more than 10%. Everything else including the expiration date, current
stock price, exercise price, and interest rate stays the same. Show
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 mathematically that the current value of the call option is higher than
the value you calculated in part (i). (5 marks)
Question 4

(a) The table below lists some partial information about a firm. Assume that the
number of shares outstanding stays constant forever.
Year
0 1 2 3 4
Book equity per share 100 132.25
Earnings per share (EPS) 21.325
Return on equity (ROE) 0.20 0.20 0.15 0.15
Payout ratio 0.25 0.25 0.50 0.50
Dividends per share 5
Dividend growth rate - 0.075

i. Fill in the missing values in the table from years 1 to 4. (6 marks)

ii. Assume that after year 4, the company maintains its ROE and payout
ratio at year 4 levels. The cost of capital is 12.5%. What is the fair price
of the company’s stock today (i.e. at t = 0)? (3 marks)

iii. Suppose the company announces today that it expects any new
investments made in or subsequent to year 4 to only earn the cost of
capital. The values you calculated in part (i) will be unaffected by this
announcement. By how much will the share price change today after
the announcement? (4 marks)

(b) Consider the following statement: “For markets to be informationally efficient,

all investors must be rational”. Is this statement true? Why/why not? (you will
be marked on the justification(s) provided). (4 marks)

(c) Companies sometimes try to match the duration of their assets and liabilities.
Explain how you think this approach may be useful in protecting net worth
from interest rate risk (net worth = A – L, the difference between the market
value of assets and liabilities). When is this approach likely to prove less
effective? Why? (5 marks)

(d) Assume that the CAPM holds. Consider two firms X and Y, and the risk-free
asset, with the following return characteristics:

𝝈𝝈𝟐𝟐𝒊𝒊 𝒄𝒄𝒄𝒄𝒄𝒄(𝒓𝒓𝒊𝒊 , 𝒓𝒓𝒎𝒎𝒎𝒎𝒎𝒎 ) 𝑬𝑬(𝒓𝒓𝒊𝒊 )

X 225 200 7.5
Y 1600 600
rf 0 5
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 What is the expected return of stock Y? (5 marks)

(e) Exactly one year ago, you entered into a forward agreement to purchase one
unit of a commodity for $F in exactly T years from now. The current price of
the commodity in the spot market is $S. The risk-free continuously
compounded interest rate in the market is currently r per year. There are no
convenience yields or storage costs associated with holding the commodity.
Using a replicating portfolio approach, show that the current value of your
forward agreement, f, is:
𝑓𝑓 = 𝑆𝑆 − 𝐹𝐹𝑒𝑒 −𝑟𝑟𝑟𝑟
(6 marks)

END OF PAPER

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