MIT Sloan Finance Problems and Solutions Collection Finance Theory I Part 2 Andrew W. Lo and Jiang Wang Fall 2008 (For Course Use Only. All Rights Reserved.)Acknowledgement ‘The problems in this collection are drawn from problem sets and exams used in Finance Theory I at Sloan over the years. They are created by many instructors of the course, including (but not limited to) Utpal Bhattacharya, Leonid Kogan, Gustavo Manso, Stew Myers, Anna Pavlova, Dimitri Vayanos and Jiang Wang,CONTENTS CONTENTS Contents 1 Questions 4 14. Forward and Futures 4 1.5. Options 9 16 Risk & Portfolio Choice 19 17 CAPM 31 18 Capital Budgeting 42 2 Solutions 45 24 Forward and Futures 45 2.5 Options 55 26 & Portfolio Choice 7 2.7 CAPM 90 28 Capital Budgeting 1041 Questions 1.4 Forward and Futures 1. During the summer you had to spend some time with your uncle, who is a wheat farmer. Your uncle, knowing you are studying for an MBA at Sloan, asked your help. He is afraid that the price of wheat will fall, which will have a severe impact on his profits. Thus he asks you to compute the Lyr forward price of wheat. He tells you that its current price is $3.4 per bushel and interest rates are at 1%. However, he also says that it is relatively expensive to store wheat for one year. Assume that this cost, which must be paid upfront, runs at about $0.1 per bushel. What is the lyr forward price of wheat? 2. The Wall Street Journal gives the following futures prices for gold on September 6, 2006 Dec Jun 07_Dec 07 641.80 660.60 678.70 and the spot price of gold is $633.50/oz. Compute the (effective annu- alize) interest rate implied by the futures prices for the corresponding maturities 3. Suppose that in 3 months the cost of a pound of Colombian coffee will be either $1.25 or $2.25. The current price is $1.75 per pound, (a) What are the risks faced by a hotel chain who is a large purchaser of coffee? (b) What are the risks faced by a Colombian coffee farmer? (c) If the delivery price of coffee turns out to be $2.25, should the farmer have forgone entering into a futures contract? Why or why not? 4. Consider a 6-month forward contract (delivers one unit of the security) on a security that is expected to pay a $1 dividend in three months ‘The annual risk-free rate of interest is 5%. The security price is $20. What forward price should the contract stipulate, so that the current value of entering into the contract is zero? 5. Spot and futures price given below. for Gold and the S&P in September 2007 are14 For O7-September _07-December _08-Jw COMEX Gold (S/oz) $693 S706-42 $726.7 CME S&P 500 $1453.55 $1472.4 $1493.7 ‘Table 1: Gold and S&P 500 Prices on September 7, 2007 (a) Use prices for Gold to calculate the effective annualized interest rate for Dec 2007 and June 2008. Assume that the convenience yield for Gold is zero (b) Suppose you are the owner of a small gold mine and would like to fix the revenue generated by your future production. Explain how the futures market enables such hedges. G. Use the same set of information given in the problem above (a) Use S&P 500 future prices to calculate the implied dividend yield on S&P 500. For simplicity, assume you can borrow or deposit moncy at the rates implied by Gold’s futures prices (o) Now suppose you believe that we are headed for a slow-down in economic activity and that the dividend yield will be lower than the value implied in part (a). What June-2008 contracts you would buy or sell to make money, assuming your view is correct? Again, assume you can borrow or deposit money at the rates implied by Gold’s futures prices, 7. The Wall Street Journal gives the following futures prices for erude oil on September 6, 2006: Jun 72.66 Maturity Futures price ($/barrel) and the spot price of oil is $67.50/barrel. Use the interest rates you found in the previous problem. jeld (in effective annual rate) for the market information provided (a) Compute the net conveniene: these maturities. (You can us in the above problem.) (b) Briefly discuss the convenience yield you obtained. 8. The data is the same as in the two problems above, You are running a refinery and need 10 million barrels of oil in three months. (a) How do you use vil futures to hedge the oil price risk? The contract size is 1,000 barrels for futures.1.4 Forward and Futures 1 (b) Suppose that you can also rent a storing facility for 10 million barrels of oi] for three months at an annualized cost of 5% (in terms of the value of oil stored). Describe how you can utilize it to lock into a fixed oil price for your future demand. (c) Which of these two strategies is better? Explain why. 9. The data is the same above. Now suppose instead that you are not in the oil business but can also rent the storage facility at the same cost Can you take advantage of the current market conditions and the rental opportunity? If yes, please explain how (i.e., describe the actions you need to take). If not, briefly explain why. 10. The current price of silver is $13.50 per ounce. The s $0.10 per ounce per year payable quarterly at the beginning of each quarter and the interest rate is 5% APR compounded quarterly (1.25% por quarter) orage costs are (a) Calculate the future price of silver for delivery in nine months ume that silver is held for investment only and that the con- venience yield of holding silver is zero. (b) Suppose the actual price of the futures contract traded in the market is below the price you calculated in part (a). How would you construct a risk-free trading strategy to make money? What if the actual price is higher? To get full credit, say precisely what you will buy or sell, and how much money you will borrow or deposit into a bank account and for how long, 11. A pension plan currently has $50.M in S&P 500 index and $50M in one-year zero-coupon bonds. Assume that the one-year interest rate is 6%. Assume that the current quote on the S&P 500 index is 1, 350, each futures contract is written on 250 units of the index and the dividend yield on the index is approximately 3% per year, i.e., $1,000 invested in the index yields $30 in dividends at the end of the year (a) Suppose you invest $1,350 x 250 in one-year zero-coupon bonds and at the same time enter into a single futures contract on S&P 500 index with one year to maturity. Assume that in one year the index finishes at 1,200. What is the total value of your position? How does this compare with buying 250 units of the index and holding them for a year? Assume that in one year the index finishes at 1,400. Repeat the analysis. (b) If this plan decides to switch to a 70/30 stock/bond mix for a period of one year, how would you implement this strategy using S&P 500 futures? How many contracts with one year to maturity1.4 Forward and Futures 1 would younced? Assume that the index finishes the year at 1, 400, describe the plan's portfolio in one year and one day from now (right after the futures expire). What is the stock/bond mix? 12. Spot price for soybean meal is $152.70 per ton and the 12-month soybean-meal futures is traded at $148.00. The L-year interest rate is 3% (a) What is the net convenience yield on soybean meal for the 12 month period? (b) You need 1,000 tons of soybean meal in 12 months. How would you lock into a price today using the futures contracts? (The size for each soybean-meal futures contract is 100 tons.) 13. The spot price for smoked salmon is $5,000 per ton and its six-month futures price is $4,800. The monthly interest rate is 0025 (.25%). (a) What is the average monthly net convenience yield on smoked salmon for the next six months? (b) If you are a manager of Bread&Circus and need 10 tons of smoked salmon in six months. How can you avoid the risk in the price of smoked salmon over the next six months using futures? jence yield for smoked salmon is your hedging strategy? (c) Suppose that your net con 1.2%. How does this change 14. A wine wholesaler needs 100,000 gallons of Cheap Chardonnay for de- livery in Boston in June 2007. A producer offers to deliver the wine at that time for $500, 000 paid now, in December 2006. The wholesaler can also buy Cheap Chardonnay futures contracts for June 2007. The current futures price is $51,000 for each 10,000 gallon futures contract, ‘The wholesaler is determined to lock in the cost of the 100,000 gallons needed in June. (a) The wholesaler considers the futures contract, but worries that the contract will not lock in her cost, because futures prices may fluctuate widely between now and June. Is her concern justified? Why or why not? (b) Do you recommend that the wholesaler pay the producer now or take a long position in Chardonnay futures? (Additional assump- tions may be needed to answer. Make sure they are reasonable.) Explain briefly.14 16. 17. Forward and Futures 1 . You are a distributor of canola seed and need to make deliveries of 10,000 bushels one month from now. You currently have no canola seed in inventory, The current spot price of canola seed is $7.45 per bushel and the futures price for delivery in one month is $7.65. You would like to hedge the uncertainty about the spot price one month from now (a) If your storage cost is $.15 per bushel (paid at the end of month), what would you do? Suppose that in the short run, your storage cost increases to $.25 (b) Si chat in the sh $.25 per bushel. What would you do? Assume perfect markets: no transaction costs and no constraints. In addition assume that the one-month risk-free interest rate will remain constant over a three-month period. Two futures contracts with two and three months maturity are traded on a financial asset without any intermediate payout. The price for these contracts are Fy = $100 and Fy = $101, respectively. (a) What is the spot price of the underlying asset today? (b) Suppose that a one-month futures contract is trading at price F, = $98. Does this imply an arbitrage opportunity? How would you take advantage of this opportunity? To get full credit, be precise on what you would buy or sell, and how much money you would deposit into a bank account and/or borrow. Assume perfect markets: no transaction costs and no constraints, The one-month risk-free interest rate will remain constant over a six-month period. Two futures contracts are traded on a financial asset without payouts: a three-month (futures price F(t, — 3)) and a six-month (futures price F(t, t + 6)) contract. You can observe that F(t, +3) = $120 and F(t, + 6) = $122. @) wi (b) Suppose that a three-month futures contract is trading at price F(t,t +3) = $119.5. Does this imply an arbitrage opportunity? How would you take advantage of this opportunity? at is the spot price of the underlying asset at time ¢?15 Options 1.5 Options . A stock price is currently $50. It is known that at the end of two months it will be either $53 or $48, The risk-free interest rate is 10% per annum with continuous compounding. What is the value of a two- month European call option with a strike price of $49? 2. A stock price is currently $80. It is known that at the end of four months it will be either $75 or $85. The risk-free interest rate is 5% per annum with continuous compounding. What is the value of a four- month European put option with a strike price of $80? 3. Today's price of three traded call options on BackBay.com, all expiring in one month, axe as follows trike Price Option Prie $50 $7} 60 $3 7 $1} You are considering buying a “butterfly spread” consisting of the fol- lowing positions: * Buy 1 call at strike prive of $50 # Sell (write) 2 calls at strike price of $60 Buy 1 call at strike price of $70. (a) Plot the payoff of your total position for different values of the stock price on the maturity date (b) What is the dollar investment required to establish the spread? (c) For what stock prices on the maturity date will you be making an overall profit? 4. You are given the following prices: Security Maturity (years) Strike Pri JEK stock - - 4 Put on JEK stock 1 50 3 Put on JEK stock 1 68 Call on JEK 1 so? Call on JEK 1 60 ? Tbill (FV=100) 1 - 91 What is the price of the two call options?1.5 Option 10 (a) Here are the payoff diagrams of some popular trading strategies using just put and call options with same maturities. How would you replicate them? Identifyfigthe number and strikes of call or put options that have to be bought or sold in order to generate these payoffs. (All angles are 45 degrees!) 4 @ ¢ Bek Price & Bek Price © Figure 1: Payoff Diagrams (b) Now suppose for institutional reasons, you are short on volatility in this market, ie. you will lose money if the market becomes volatile. For example you can imagine that your are an investment bank working on a few major M&A deals which may fall apart if the market goes down too much or goes up too much. In either case, you will lose money if the market becomes volatile. Explain which if any of the above three payoffs would work well to hedge your exposure. What is the cost of this hedge to you? 6. A bullerfly spread is a combination of option positions that involve three strike prices. To create a butterfly spread, a trader purchases an option with a low strike price and an option with a high strike price and sells two options with an intermediate strike price. For this problem,15 Options assume that the intermediate strike price is halfway between the low and the high strike prices and that the options are European. Denote the intermediate strike price by X, the low strike price by X — a, and the high strike price by X + a, a > 0. (a) Graph the payoff diagrams at maturity of the butterfly spread in which the underlying options are call options. Holding the intermediate strike price fixed, what happens to the payoffs as the low and high strike price converge to the intermediate price? (b) Suppose that a trader purchases a butterfly spread (using call options) for which the intermediate strike price equals to tod stock price, Based only on this trade, what is the trader's view of the future direction of the market? 7. IBM shares are now tra rates is flat at 5% at $80.00. The term structure of interest (a) Plot the terminal payoff from a European put option on 1 share of IBM with a exercise price of $85 and a maturity of 3 months (not including the price of the option). (b) Suppose that you purchase the put option at $4.00 from the mar ket. Specify the ranges of IBM share price at the options maturity date for which you will be making a net profit 8. Suppose that after a recent news about the economy, IBM share price remains the same, but the prices of its options shot up. How is this possible? 9. You are given the following information. Use this information to de- termine the unknown prices ‘Table 2: Stock, Options, and T-bill prices soutiry Maturity (years) Strike _Price($) 401 Stock - - $100 Put on 401 Stock 1 sso $3 Put on 401 Stock 1 360 $5 Calle on 401 Stock 1 $50 $57.50 Calle on 401 Stock 1 360 ? Thill(FV=100) 1 - 2 10. Joseph Jones, a manager at Computer Science, Inc. (CSI), received 1,000 shares of company stock as part of his compensation package. ‘The stock currently sells at $40 at share. Joseph would like to defer selling the stock until the next tax year. In January, however, he will u1. 12. 12 Option need to sell all his holdings to provide for a down payment on his new house. Joseph is worried about the price risk involved in keeping his shares. At current prices, he would receive $40,000 for the stock. If the value of his stock holdings falls below $35,000, his ability to come up with the necessary down payment would be jeopardized. On the other hand, if the to $45,000, he would be able to maintain a small cash reserve even after making the down payment Joseph considers three investment strategies: stock value rise Ais to write January call options on the CSI shares with, strike price $45, There calls are currently selling for $3 each. (b) Strategy B is to buy January put options on CSI with strike price $35. These options also sell for $3 each. (c) Strategy C is to establish a zero-cost collar by writing the January calls and buying the January puts. Evaluation each of these strategies with respect to Joseph's investment goals. What are the advan and disadvantages of each? Which would you recommend? You write a call option with strike $50 and buy a call with strike $60. The options are on the same stock and have the same maturity date One of the calls sells for $3; the other sells for $9. (Assume zero interest rate.) (a) Draw the payoff graph for this strategy at the option maturity date. (b) Draw the profit graph for this strategy. (c) What is the break-even point for this stratgy? Are you bullish or bearish on the stock? Consider an inereasingly popular deposit contract with payoffs linked to the performance on the S&P 500 Index on the U.S. stock market For every dollar invested in the contract, the rate of return in one year is equal to 60% of the realized rate of return of the S&P 500 Index during this year if this rate of return is positive; otherwise, you get your money back. In essence, you are protected from the downside tisk of the S&P 500 Index, while you are still able to participate in the upside potential of the stock market. The one year riskloss interest rate is 10%. For simplicity, assume that the stocks in the index do not pay dividends (a) Draw a graph for the payoff one year from now for a one dollar investment in the contract with the horizontal axis being the re-1.5 Option alized rate of return on the S&P 500 Index. Also write down the payoff symbolically. (b) Show that the payoff one year from now for a one dollar investment in this contract is the payoff to a portfolio of a default-free bond European call option on the S&P 500 Index. (c) Suppose that the rates of return on the S&P 500 Index can take two possible values one year from now, 20% and -20% with prob- abilities 60% and 40%, respectively. Do you make money or lose money investing in this contract? If so, how much? and a 13. What is a lower bound for the price of 3-month call option on a non- dividend-paying stock when the stock price is $50, the strike price is $45, and the 3-month risk-free interest rate is 8%? Explain brief 14. Draw position (payoff) diagrams for each of the following trades. Each put or call option is written on 100 shares of the same stock and has the same G-month maturity. The current stock price is $50 per share. (a) Buy 100 shares, buy a put with an exercise price of $40, sell a call with an exercise price of $60. (b) Same as (a), except that you borrow $4902. The semi-annual interest rate is 2%, so you will have to repay $4902 x 1.02 = $5000 after six months (c) Buy a put and a call with exercise price of $50, sell a put with exercise price of $40, sell a call with an exercise price of $60. 15. Explain how you could generate the same payoffs as in part a of last question without purchasing any shares, 16. Incffable Corporations stock price is currently $100. At the end of 3 months it will be either $110 or $90.91. The risk-free interest rate is 2% per annum. What is the value of a 3-month European call option with a strike price of $100? Calculate your answer to this problem using (a) replication. (b) the risk-neutral method. 17. State whether the following statements are true or false. In each case, provide a brief explanation. (a) Ina risk averse world, the binomial model states that, other things being equal, the greater the probability of an up movement in the stock price, the lower the value of a European put option. 131.5 Option (b) By observing the prices of call and put options on a stock, one can recover an estimate of the expected stock return. (c) An investor would like to purchase a Buropean call option on an underlying stock index with a strike price of 210 and a time to ma- turity of 3 months, but this option is not actively traded. However, two otherwise identical call options are traded with strike prices of 200 and 220 respectively, hence the investor can replicate a call with a strike price of 210 by holding a static position in the two traded calls. () In a binomial world, if a stock is more likely to go up in price than ‘to go down, an increase in volatility would increase the price of a call option and reduce the price of a put option. Note that a static position is a position that is chosen initially and not rebalanced through time Draw a diagram showing an investor's profit and loss with the terminal stock price for a portfolio consisting of: 18. (a) One share of stock and a short position in one call option (b) Two shares of stock and a short position in one call option (c) One share of stock and a short position in two call options (d) One share of stock and a short position in four call options You should take into account the cost from purchasing the stock and revenue from selling the calls. For simplicity ignore discounting when combining these costs and revenues with the terminal payoff of the portfolio, For simplicity also assume that the current stock price is equal to the strike price, K, of the call. Denote the current call price by c, and the terminal stock price by Sr. 19. Stock XYZ is worth § = $80 today. Every 6 months the stock price goes either up by u = 1.3 or down by d = 0.8. The riskless rate is 6% APR with semiannual compounding. The stock pays no dividends. (a) Compute the price of a European call with a maturity of 1 year and a strike price of X = $95. (b) Compute the price of an American call w and a strike price of X = $95. a maturit (c) Compute the price of a European put with a maturity of 1 year and a strike price of X = $95 20. In August 1998 the Bank of Thailand was reported as offering to foreign investors in troubled banks the opportunity to resell their shares back to the central bank within a period of five years for the original purchase 415 Options price. “This is to guarantee that at least they will not lose any of the money they plan to invest,” said the Deputy Governor. (The Wall Street Journal Burope, August 6, 1998, p.20.) Suppose that(a) the standard deviation of Thai bank shares was about 50 percent a year, (b) the interest rate on teh Thai baht was 15%, and (c) the banks were not expected to pay a dividend in this five-year period. How much was this option worth? Assume an investment of 100 million baht. 21. Shares of ePet.com are traded at $60. In six months, share price could either be $66 or $54 with probability 0.6 and 0.4, respectively. The current 6-month risk-free rate is 6%. What is the price of a European put on 100 ePet shares with a strike price of $64 per share? Would your answer be different if the option is American? 22. Consider again ePet. You want to use ePet shares and the risk-free bond to replicate a payoff in six months that equals the square of ePet's share price. That is, when ePet price goes up to $66, you have a payoff of 66? = $4, 356 and when the price goes down to $64, you have a payoff of 54? = $2,916. Describe the strategy that gives these payoffs. What is the present value of these payofl 23. The price of the stock of NewWorld Chemicals Company is $80. The standard deviation of NewWorld’s stock returns is 50%. The 1-year interest rate is 6%, (a) What should be the price of a call on one share of NewWorld with a maturity of 1 year and strike price of $85? Use the Black-Scholes formula. (b) What should be the price of a put on one share of NewWorld with the same maturity and strike price? 24. You are asked to price some options on ABC stock. ABC's stock price can go up by 15 percent every year, or down by 5 percent. Both out- comes are equally likely. The risk free interest rate is 5 percent per year for the next two years, and the current stock price of ABC is $100. (a) Find the risk neutral probabilities (b) What is the price of a European Call option on ABC, with strike 100 and maturity 2 years? (c) Describe the strategy to replicate the payoff of the call using the stock and the risk-free bond.15 Options (a) What is the price of an American option with the same charac- teristics? 25. You are asked to price some options on KYC stock. KYC’s stock price by 15 percent every year, or down by 10 percent. Both out- can go up comes are equally likely. ‘The risk stock price of KYC is 100 1 rate is 5 percent, and the current (a) Price a European Put option on KYC with maturity of 2 years and a strike price of 100. (b) Price an American Put option on KYC with the same character istics. Is the price different? Why or why not? 26. IBM is currently trading at $90.29 per share. You believe that IBM will have an expected return of 7% with volatility of 26.1% per year, while annual interest rates are at 0.95%. What is the price of an European put on IBM with a strike price of $90 and maturity of 1 year? 27. Shares of Ontel will sell for either $150 or $80 three months 1 with probabilities 0.60 and 0.40, respectively. A European call with an exercise price of $100 sells for $25 today, and an identical put sells for $8. Both options mature in three months. What is a price of a three-month zero-coupon bond with a face of $1007 28. 401.com’s stock is trading at $100 per share, The stock price will either go up or go down by 25% in cach of the next two years. The annual interest rate is 3% (a) Determine the price of a two-year European call option with the strike price X — $110. (b) Determine the price of a two-year European put option with the strike price X = $110. (c) Verify that the put-call parity holds (a) Determine the price of a two-year American put option with the strike price X = $110. (c) What is the replicating portfolio (at every node of the tree) for the American put option with the strike price X = $110? 29. For this problem assume that the risk-free rate of interest for one year loans is 5%. Google stock is selling today for $500 a share. Assume that in one year Google will cither be worth $600 a share or $475 a 161.5 Option U share and that Google will pay no dividends for at least two years A call option with an exercise price of $550 and one year to go until expiration is available for Google stock. What is the value of this call option? 30. A particular stock follows the price movement below sa $29 24 325. $28 $23 s21 today t-month months Figure 2: Stock Price Movement (a) For this part, suppose the interest rate is fixed at 1% per month. What is the price of a put option with maturity two months, and strike of $26 ? (b) Again, suppose the interest rate is fixed at 1% per month. What is the price of an exotic derivative that in 2-months has a pay off that is a function of the maximum price of the stock during the two month period given by max($ — $25, 0) where 5 = max S; oat and t is measured in months. 31. Intel stock is trading at $120 per share, and the company will not pay any dividends over the next year. Consider an Intel European call option and a European put option, both having an exercise price of 7 08, Andrew W: Ls and Jane WaneOption U 32. 33. 18 $124 and both maturing in exactly one year. The simple (annualized) interest rate for borrowing and lending between now and one year from now is 3% for each 6 month period (6.09% per year) Assume that there are no arbitrage opportunities. Is there enough information to determine which option has the higher market value? If so, which option, the call or the put, has higher market value? Caleulate the price of a three-month European put option a non-dividend paying stock with a strike price of $50 when the current stock price is $50, the risk free rate is 10% per annum, and the volatility is 30% per annum. What difference does it make to your calculations if a dividend of $1.50 is expected in two months? Assume that the assumptions made to derive the Black-Scholes formula are valid. It is possible to buy three-month call options and three-month put options on stock X. Both have an exercise price of $60 and both are worth $10. Is a six-month call with an exercise price of $60 more or less valuable than a similar six-month put?1.6 Risk & Portfolio Choice 1 1.6 Risk & Portfolio Choice 1. True or false or “it depends”? (a) Briefly explain or qualify your answer: diversification can reduce risk only when asset returns are negatively correlated. (b) If the returns on all risky assets in the world were uncorrelated with each other, the expected return of each risky asset should be the same, 2. True or false or "it depends”? Optimal portfolios should exclude indi- vidual assets whose expected return and risk (measured by its standard deviation) are dominated by other available assets, 3. Is the following statement true or false? Explain. As more securities are added to a portfolio, total risk would typically be expected to fall at a decreasing rate. 4. You need to invest $10M in two assets: a risk-free asset with an ex- pected return of 5% and a risky asset with an expected return of 12% and a standard deviation of 40%. You face a cap of 30% on the port- folio’s standard deviation (the “risk budget”). What is the maximum expected return you can achieve on your portfolio? 5. Are the following statements true, false or uncertain? Briefly explain your answer (a) Diversification over a large number of assets completely eliminates risk. (b) Dive (c) A stock with high standard deviation may contribute less to port- folio risk than a stock with lower standard deviation. ification works only when asset returns are uncorrelated, (a) Diversification reduces the expected return on the portfolio as its risk decreases. 6. Are the following statements true or false? Give brief but precise ex- planations for your ans vers, (a) Stock A has expected return 10% ai and stock B has expected return 12% and stand: Then, no investor will buy stock A. d standard deviation 15%, d deviation 13% (b) Diversification means that the equally weighted portfolio is opti- mal. 7. Which statement about portfolio diversification is correct? 191.6 Risk & Portfolio Choice JESTION (a) Proper diversification can reduce or eliminate systematic risk (b) Diversification reduces the portfolio’s expected return because it reduces the portfolio’s total risk (c) As more securities are added to a portfolio, total risk would typi- cally he expected to fall at a decreasing rate. (a) The risk-reducing benefits of diversification do not occur mean- ingfully until at least 30 individual securities are included in the portfolio, 8. Which of the following portfolios can not be on the Markowitz efficient frontier? Explain briefiy. Portfolio | Expected Return | Standard Deviation | Q 10% 15% R 10.5% 16.5% 8 11.5% 18.5% T 12.5% 20% 9. You have decided to invest all your wealth in two mutual funds: A and B. Their returns and risks are as follows the mean returns are 74 = 15% and 7p = 11% © the covariance matrix is ra [Te ra | 04 | 025 rp | 025 | 032 You want your total portfolio to yield a return of 12%, What pro- portions of your wealth should you invest in A and B? What is the standard deviation of the return on your portfolio? 10. There are only two securities (A and B, no risk free asset) in the market, 20 Expected returns and standard deviations are as follows: Soomity [Expected retum | standard Deviation Stock A [25% 20% Stock B [15% 25% (a) The correlation between stocks A and B is 0.8. Compute the expected return and standard deviation of a portfolio that has 0% of A, 10% of A, 20% of A, ete, until 100% of A. Plot the portfolio frontier formed by these portfolios.1.6 Risk & Portfolio Choice JESTION (b) Repeat the previous question, assuming that the correlation is 0.8. (c) Explain intuitively why the portfolio frontier is different in the two cases. 11. Stock A and B have th Mowing characteristics: EQ) | AY] 8% [20% B | 3% | 40% ‘Their correlation is 0. The risk-free interest rate is 2% (a) Consider a portfolio, P, with 90% in stock A and 10% in the risk: free asset. What is the mean and standard deviation of portfolio P's return? (b) Consider another portfolio, Q, which consists of 80% of stock A and 20% of stock B. What is the mean and stand: deviation of portfolio Q’s return? (c) You need to choose a portfolio to invest all your wealth in, Be- tween portfolio P and Q, which one is better? Explain why. that stock A dominates risk), explain why you e tock B (A has the same mean but er include stock B in your portfolio. 12. You can form a portfolio of two assets, A and B, whose returns have the following characteristics: Stock | E[R] Standard Deviation Correlation A | 0.10 0.20 B | 0.15 0.40 05 If you demand an expected return of 12%, what are the portfolio weights? What is the portfolio’s standard deviation? 13. Your have decided to invest all your wealth in two mutual funds: A and B. Their returns are characterized as follows’ the mean returns are 74 = 20% and fy = 15% © the covariance matrix is TA Te ra | 0.8600 | 0.0840 rs | 0.0840 | 0.1225 211.6 14. 15. 16. 22, Risk & Portfolio Choice JESTION You want your total portfolio to yield a return of 18%. What proportion of your wealth should you invest in fund A and B? What is the standard deviation of the return on your portfolio? In addition to the fund A and B in the previous question, now you decide to include fund C to your portfolio. Its expected return is Fc 10%. The covariance matrix of the three funds is TA Te ro Fa | 0.8600 | 0.0840 | 0.1050 rx | 0.0840 | 0.1225 | 0.0700 re | 0.1050 | 0.0700 | 0.0625 Your portfolio now consists of fund A, B and C. You would like to have an expected return of 16% on your portfolio and a minimum risk (measured by standard deviation of the return). What portfolio should you hold? What is the return standard deviation of your portfolio? (Hint: You would need to use Excel Solver or some other optimization software to solve the optimal portfolio.) You can only invest in two securities: ABC and XYZ. The correlation between the returns of ABC and XYZ is 0.2. Expected returns and standard deviations are as follows Security | E[R]_o(R) ABC [20% 20% XY 15% 25% a) It seems that ABC dominates XYZ in that it has a higher expected return and lower standard deviation, Would anyone ever invest in XYZ? Why? b) What is the expected return and standard deviation of a portfo- lio that invests 60% in ABC and 40% in XYZ? ©) Suppose instead that you want your portfolio to have an expected return of 19.5%. What portfolio weights do you select now? What is the standard deviation of this portfolio? You have the same data as the previous question. In addition, you have a risk-free security with a guaranteed return of 5%. The tangency portfolio has an expected return of ?? and standard deviation of ?? (a) What weights are placed on ABC folio? nd XYZ in the tangency port-1.6 Risk & Portfolio Choice JESTIONS (b) What portfolio weights will you choose for the risk-free asset and the tangency portfolio to get an expected return of 19.5%. (c) Compare this portfolio with the one you obtained in (c) of the previous question. Comment. 17. Calculate the expected return and standard deviation of a portfolio of stocks A, B and C. Assume an equal investment in each stock. Correlations Expected Return | Standard Deviation P= x 11% 30% 10] 3 [as B 14.5% 45% 3 | 10 | 45 c 9% 30% 15 | 45 | 1.0 18. Your employer offers two funds for your pension plan, a money market fund and an S&P 500 index fund. The money market fund holds 3 month Treasury bills, which currently offer a 3% safe return per year The S&P 500 index fund offers an expected return of 10% per year with a standard deviation of 20% (a) You want to achieve an expected return of 8% per year for your portfolio. What should be the composition of your portfolio? What is the standard deviation of its returns? (b) Now your employer adds an emerging-market fund to the two ex isting funds. The emerging-market fund offers an expected return of 10% per year, the same as the S&P 500 index fund, but with a standard deviation of 30%, higher than the S&P 500 index fund. Would you consider including the emerging-market fund as part of your portfolio? Explain (c) The correlation between the S&P 500 index fund and the emerging- market fund is zero. Consider portfolio A, which consists of 80% in the S&P index fund and 20% in the emerging-market fund Calculate portfolio A’s expected return and standard deviation. (@) If you mix portfolio A with the money-market fund to achi expected return of 8%, is it better than the portfolio in part (a) of this question? Explain 19. You are given data on the following stocks: VIR) > Price Mkt. Cap 0.0837 0.0325 S50 SI05M 0.1225 0.0420 $30 © $40M. - 0.0900 $27 S75M 23,1.6 Risk & Portfolio Choice JESTION a) Compute the expected return and variance of an equally weighted portfolio (i.e. weights of 1/3 on each of the stocks) Consider alternative portfolios formed using assets A, B, and C. For instance, a value-weighted portfolio places weights on each assets in proportion to their market capitalizations. The S&P500 index is an ex- ample of a value-weighted portfolio. A. price-weighted portfolio places weights in proportion to prices. The Dow Jones is an example of a price-weighted portfolio. b) What are the expected returns and variance of a valuc-weighted portfolio. ©) What are the expected returns and variance of a price-weighted portfolio. 20. Your current portfolio consists of three assets, the common stock of IBM and GM combined with an investment in the riskless asset. You know the following about the stocks (p,; denotes the correlation be- tween asset i and asset j, and M denotes the market portfolio) Prone = 0-60 Pars.sr = 0.80 0.0900 oy = 0.0 Chast You also have the following data about the market portfolio M and the riskless asset F Fy S013 re =0.04 02, = 0.04 Suppose that individuals can borrow and lend at ry and that the Capi- tal Asset Pricing Model (CAPM) describes expected retums on assets You have $200,000 invested in IBM, $200,000 invested in GM, and $100,000 invested in the riskless asset, (a) What are the expected rates of retun on IBM stock and GM stock? (b) Assume that the correlation between IBM and GM, prex.cus i 0.40. What is the variance of your portfolio? What is its beta, Bye? (c) Suppose that you can also invest in the market portfolio. Find an efficient portfolio that has the same standard deviation as your portfolio, but has the highest expected rate of return possible What is the expected rate of return on this portfolio? 241.6 Risk & Portfolio Choice JESTIONS 21. There are three assets, A, B and C, where A is the market portfolio and C is the risk-free asset. The return on the market has a mean of 12% and a standard deviation of 20%. The risk-free assct yields a return of 4%. Asset B is a risky asset whose return has a standard deviation of 40% and a market beta of 1, Assume that the CAPM holds. (a) Compute the expected return of asset B and its covariances with asset A (the market portfolio) and asset C’ (the risk-free asset), respectively (b) Consider a portfolio of the two risky assets, A and B, with weight w in asset A (the market portfolio) and 1 —w in asset B. Compute the expected return and return standard deviation of the portfolio with w being 0, 1/2, and 1, respectively, and enter them into the following table: Portfolio weight w 0 1/2 1 Expected return Standard deviation van you rank the three portfe (a) Consider a portfolio with equal weights in asset B and C (the risk- free asset). Denote this portfolio as asset D. Compute the return standard deviation and expected return of asset D. jos in the question above? Explain (e) Consider a portfolio of asset A (the market portfolio) and C. Find the portfolio weight such that its return standard deviation is the same as that of asset D in Question (a). What is the expected retum of this portfolio? (f) What can you say about the mean-variance efficiency of asset A, B and C (ce,, are they efficient portfolios)? Explain (2) Construct an efficient portfolio from the assets A, B and C with an expected return of 10%. 22. Assume that an investor must put all of her money in the following four stocks. Correlations xpected Return | Standard Deviation }>—° Fee x i% 25% To, 3 [a5] 4 B 14.5% 35% 3 10] .45] 2 c 9% 30% 15 | 45 | 1.0 | .25 D 11.5% 32% 2 |.25 | 1.0JESTION 1.6 Risk & Portfolio Choice (a) What is the expected return and standard duration of an equally weighted portfolio of the four stocks? (b) Calculate the mean-variance efficient portfolios that can be con- structed from the four stocks. (Hint: use Excel Solver) (c) Assume the investor can borrow or lend at a 5% risk-free rate What is the best portfolio of the four stocks? 23. Assets X, Y, and Z have the following characteristics: [Asset [ Exp. Ri Std. Dev. (6) x 15% 20% LY 10% Cz 10% ‘Correlation Consider the portfolio frontier of the three assets, Without solving for the portfolio weights, answer the following questions: (a) The frontier portfolio with mean 12% has higher weight on iy ii Z (b) The frontier portfolio with mean 9% has higher weight on ii, Z Explain the intuition £ 24, Consider a sample of 1000 randomly selected stocks, and assume for simplicity that cach stock has a standard deviation of 35%. The corre- lation coefficient between each pair of stocks is 3. What is the standard deviation of an equal-weighted portfolio of 10 stocks? 100 stocks? 1000 stocks? 25. Assume that you can borrow and lend at a riskless rate of 5% and that the tangency portfolio of risky assets has an expected return of 13% and a standard deviation of return of 16%. 261.6 26. 27. 28. JESTION Risk & Portfolio Choice (a) What is the highest level of expected return that can be obtained if you are willing to take on a standard deviation of returns that is at most equal to 24%? Answer and explain below. (b) What is the fraction of your wealth (in percent) invested in the riskless asset in the portfolio you found in part (a) (the mean- variance efficient portfolio with a standard deviation of 24%)? What is the fraction invested in the tangency portfolio of risky assets? For this problem assume that it is possible to borrow and lend risklessly at arate of 4%. Also assume that the expected return on the tangency (Le., the optimal) portfolio composed only of risky assets is 13% with a standard deviation of 18%. Below we list 6 pairs of expected return and standard deviation combinations. For each pair determine whether or not the pair is feasible, If it is feasible, then there is at least one investment that can be made using risky assets and riskless borrowing or lending that produces this level of expected return and standard deviation. Then, if the pair is feasible, determine whether it is efficient or not. It is efficient if the expected return is the highest level that can be obtained for the associated level of standard deviation. Pair Standard Deviation Expected Return a 20.00% 24.75% b 12.00% 18.00% © 30.00% 19.00% a 60.00% 50.00% e 10.00% 4.00% f 45.00% 56.50% Parmacheenee Belle’s entire common stock portfolio ($500,000) is al- lotted to an index fund tracking the Standard & Poors 500 index. The expected rate of retum on the index is 9.5% and the standard deviation is 18% pe ar. The one-year risk-free rate is 2.0%. Now Ms. Belle receives a strongly favorable security analyst's report on Mycronics Corp. The analyst projects a return of 25%. Myroncis has a high volatility (40% annual standard deviation) but its correlation coefficient with the S&P 500 is only .3. Assume the return in the analyst's report is an unbiased forecast. Should Ms. Belle sell part of her index fund holdings and invest in Myronies? If so, how much? Note: Ms. Belle can also lend or borrow at the 2.0% risk-free rate. Samantha Darling’s entire common stock portfolio ($100,000) is allot- ted to an index fund tracking the Standard & Poors 500 index. The1.6 Risk & Portfolio Choice 1 expected rate of return on the index is 12% and the standard deviation is 16% per year. The one-year risk-free rate is 5.5%. Now Samantha receives a strongly favorable security analyst's report on e.Coli Corp. The analyst projects a return for e.Coli of 25%. e.Coli has a high volatility (50% annual standard deviation) but its correlation coefficient with the S&P 500 is only .4 Assume the analyst's report is accurate. Should Samantha sell part of Note: her index fund holdings and invest in e.Coli? If so, now much? Samantha can also lend or borrow at the 5.5% risk-free rate. 29. You are a salesman/investment advisor working for a major investment bank. Whenever clionts contact you with money to invest, your job is to help them find an appropriate mutual fund to invest in given their financial position. The available investments are: BIR|_o(R) A [10% 15% B | 20% 45% © | 20% 55% Assume throughout this problem that you only recommend one of the three funds to your clients (possibly a different recommendation for different clients though). a) Would you recommend investment C to someone who comes to you with all his investment funds? Explain. b) Which investment would you recommend to Keith Richards, the really, really old rock star from the Rolling Stones? Assume he invests all his wealth in your particular recommendation, ©) Might your answer to b) change if Keith invests only half his wealth in your particular recommendation? If so, under what circumstances? 30. Sarah runs an investment consulting business offering advice to clients on portfolio choices, using what she has learned in 15.401. Her analysis shows that the efficient frontier of risky assets can be obtained by mix- ing two portfolios, a portfolio of "large cap” stocks (L) and a portfolio of "small cap” stocks ($). In addition, she can also invest in riskless T-Bills (F) For a very risk-averse retiree, Sarah has recommended the following portfolio: 70% in P, 20% in L and 10% in §, For a young, less risk- averse executive, however, Sarah recommends only 10% in F and the 281.6 Risk & Portfolio Choice rest in the two risky portfolios Assume that Sarah has chosen the optimal portfolios for both the old retiree and the young executive. What are the weights for the young executive on the “large cap” and ”small cap” portfolios, respectively? (Hint: The tangent portfolio should a combination of portfolios L and 8.) 31. Which of the following common stock portfolios is best for a conserva- tive, risk-averse investor? Explain briefly. Expected | Expected | Standard Deviation Return_| Risk Premium of Return Portfolio A | 19% 13% 20% Portfolio B | 16% 10% 16% Portfolio C | 13% 7%. 12.5% Note: the risk premium is calculated by subtracting a 6% Treasury from the expected rate of return. The investor can also buy ‘Treasury bills. Dill rat 32. Suppose the overall stock market is divided in four assct classes: large- cap growth stocks (LGR, 40% of the market), large-cap income stocks (LING, 35% of the market), small-cap growth stocks (SMGR, 15% of the market) and small-cap income stocks (SMINC, 10% of the market) Forecasted returns, standard deviations (o) and correlation coefficients for these asset classes are given on the table below. You can borrow or lend at the risk-free interest rate of 5%. You have $1 million to invest in some combination of the four asset classes. (You can buy index funds or exchange traded portfolios tracking the assct classes.) LGR LINC) SMGR = SMINC % of market 0.40 0.35 0.15 0.10 7 0.1438 0.1092 0.1329 0.0931 o 028 0.20 0.30 0.22 Correlations: LGR LINC SMGR = SMINC LGR. 1 065 0.70 0.30 LINC 065 1 0400.55 SMGR 070 040 1 0.45 SMINC 030 0.55 «04511.6 Risk & Portfolio Choice 1 (a) What are the expected rate of return and standard deviation of the market portfolio? What is the market's Sharpe ratio (the ratio of expected risk premium to standard deviation)? (b) Can you improve the portfolio's Sharpe ratio by investing more in any of the asset classes? (Hint: Analyze a two-asset portfolio, with the market as one asset and a particular asset class as the other If you sell some of the market portfolio and put the proceeds in that assct class, you end up over-weighting the asset class.) 3031 . You are a consultant to a large manufacturing corporation that CAPM CAPM . What is the beta of a portfolio with E(r,) = 18%, if ry = 6% and Er) = 14%? con- sidering a project with the following net after-tax cash flows (in millions of dollars) Years from Now __AfterTax Cash Flow 0 = 1-10 15 The project's beta is 1.8. Assuming that ry = 8% and E(ry) = 16%, what is the net present value of the project? What is the highest possible beta estimate for the project before its NPV becomes negative? Are the following true or false? (a) Stocks with a beta of zero offer an expected rate of return of zero. (b) The CAPM implies that investors require a higher return to hold highly volatile securities, (c) You can construct a portfolio with a beta of 0.75 by investing 0.75 of the investment budget in bills and the remainder in the market portfolio. |. Assume that the risk-free rate of interest is 6% and the expected rate of return on the market is 16%. A share of stock sells for $50 today. It will pay a dividend of $6 per share at the end of the year. Its beta is 1.2. What do investors expect the stock to sell for at the end of the year? Assume that the risk-free rate of interest is 6% and the expected rate of return on the market is 16%. A stock has an expected rate of return of 4%. What is its beta? Why would anyone consider buying this risky asset which provides an expected return less than the risk-free rate? . In 1997 the rate of return on short-term government securities (per- ceived to be risk-free) was about 5%. Suppose the expected rate of return required by the market for a portfolio with a beta measure of 1 is 12%. According to the capital asset pricing model (security market line). (a) What is the expected rate of return on the market portfolio? (b) What would be the expected rate of retumn on a stock with 3 = 0?1 L 32. 7_CAPM (c) Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 dividends next year and you expect it to sell then for $41. The stock risk has been evaluated by 3 = ~.5. Is the stock overpriced or underpriced? 7. True or False? (a) CAPM says that all risky assets must have positive risk premium. (b) The expected return on an investment with a beta of 2.0 is twice as high as the expected return on the market. (c) Ifa stock lies below the security market line, it is under valued. 8. If we regress the stocks’ average risk premium (return minus the risk- free rate) on their betas, what should be the slope and the intercept according to the CAPM? 9. If we regress a stock’s risk premium on the risk premium of the market portfolio, what should be the slope and the intercept according to the CAPM? 0. The risk-free rate is 5%, the expected return on the market portfolio is 14%, and the standard deviation of the return on the market portfolio is 25%. Consider a portfolio with expected return of 16% and assume that it is on the efficient frontier (a) What is the bota of this portfolio? (b) What is the standard deviation of its return? (c) What is its correlation with the market return? 1. Your future father-in-law is 60 years old. He shows you his portfolio: Holdings $ 50,000 S&P 500 Index Fund 100,000 Analog Devices Inc. 200,000 He asks you to forecast how nmch the portfolio will be worth in 5 years when he retires. The risk-free rate is 6% per year, the average return on the market portfolio is 12%, the beta of the S&P index is 1.0, and the beta of Analog Devices is 1.5. (a) What is the expected rate of return on the portfolio, assuming the CAPM holds? (b) What is the forecasted portfolio value after 5 years?12. 13. 14. 16. 33 . Five CAPM (c) Your future father-in-law is not impressed with this CAPM “the- ory” since his portfolio has done much better than your forecasted return over the past five years, What would you say about that? Integral Industries, Inc. (III) has three subsidiaries, A, B, and C. You are negotiating to buy subsidiary C. Subsidiary A tribute to 40% of II's market value and have betas of 0.8 and 1.4, respectively. The company as a whole has a beta of 1.0. What is the beta of subsidiary C? Ifyou end up buying it, what would be C's oppor- 1% and the market nd B each con tunity cost of capital? The current risk-free rat risk premium is 6% Stock 1 and 2 have the same beta of 0.8, But stock 1's return has a standard deviation of 40% and stock 2 has a standard deviation of 60%. How would you compare the risk of these two stocks? Which one do you think should have the higher expected returns? Explain briefly. Stock A has a beta of 0.6 and stock B has a beta of 1.2. They both have a return standard deviation of 40% and the market portfolio has a return standard deviation of 25%. What fractions of the total variances of the two stocks’ returns are market risks? cars of monthly risk premiums give the following statistics for Ampersand Electric common stock (risk premium — rate of return - risk-free rate) © eis 0.4% per month, with a standard error of 1.2% © 3 is 1.2, with a standard error of 0.27 © Ris 0.30 © ois 7.2% per month. (a) What does a measure? What role does it play in the CAPM? Does a positive a indicate a higher-than-normal expected return? (o) What docs R? measure? Would a higher R? increase your confi- dence in the estimated 8? Briefly explain your answers. Consider three stocks: Q, R and S. Beta | STD (annual) [ Forecast for Nov 2008 Dividend | Stock Price | Q | 0.45 35% $0.50 $45 | R/ 145 40% 0 375 | S [0.20 10% $1.00 320__|17. 18. 34 CAPM Use a risk-free rate of 2.0% and an expected market return of 9.5%. The market's standard deviation is 18%. Assume that the next dividend will be paid after one year, at t = 1 (a) According to the CAPM, what is the expected rate of retum of each stock? (b) What should today’s price be for each stock, assuming the CAPM is correct? Assume the Fama-French 3-factor APT holds with the factor risk pre- miums given in BM Table 8.5, p. 209. What are the expected rates of return for stocks Q, R and $ in the previous question? The factor sensitivities are Osize | Prook—to—market Q 0.05) 0.14 R 0.33 0.22 s 121 061 It is November, 2007. The following variance-covariance matrix, for the market (S&P 500) and stocks T and U, is based on monthly data from November 2002 to October 2007. Assume T and U are included in the S&P 500, The betas for T and U are T = 0.727 and U = 0.75. S&P5O0[_T w SEP500 | 0.0256 [0.0186 [0.0192 T 0.0186 [0.1225 | 0.0262 U 0.0192 [0.0262 [0.0900 Average monthly risk premiums from 2002 to 2007 were: S&P5O0 : 1.0% T : 0.6% U1l% Assume the CAPM is correct, and that the expected future market risk premium is 0.6% per month. ‘The risk-free interest rate is 0.3% per month, (a) What were the alpha’s for stocks T and U over the last 60 months? (b) What are the expected future rates of return for T and U?7_CAPM (c) What are the optimal portfolio weights for the S&P 500, T and U? Explain. 19. CML and SML: Using the properties of the capital market line (CML) and the security market line (SML), determine which of the following scenarios are consistent or inconsistent with the CAPM. Ex- plain your answers, Let A and B denote arbitrary securities while F and M represent the riskless asset and the market portfolio respectively. (a) Scenario I Security | BIR] A [20% 08 B 15% 12 (b) Scenario I: o(R) 30% 30% (c) Scenario IIT: Security x F M (a) Scenario IV; Security | BIR] 9 A 20% =1.5 F 5% 0 M | 15% LO (c) Scenario V: 15% 1.0 20. ‘True/False/Depends Questions: Please include brief explanations in your responses: (a) The average retum on stocks in the US over the past 30 years has been 12% annually. You find two portfolios, one with an expected return of 14% and another with an expected return of 19%. This contradicts the CAPM.1.7 CAPM 1 QUESTIONS (b) All portfolios on the SML have no idiosyncratic risk. 21. Calculating Beta (Part Two): Consider two securities, A and B, along with the market portfolio M. Their variance-covariance matrix is: Security| A VIR] ! A [0.0900 0.0420 0.0525 B = 0.1225 0.0437 M - - 0.0625 (a) Calculate the beta of each stock. (b) Which stock has the highest expected return? 22. Are the following statements true or false? Give brief but precise ex- planations for your answers. (a) Stock A has expected return 10% and standard deviation 15%, and stock B has expected return 12% and standard deviation 13%. Then, no investor will buy stock A. (b) Diversication means that the equally weighted portfolio is opti- mal. (c) The CAPM predicts that the expected return on the market port- folio is always greater than the return on the riskless asset. (d) The CAPM predicts that a security with a beta of zero o@ers zero expected return, (e) The CAPM predicts that all investors hold the same portfolio of risky assets (f) The CAPM predicts that investors demand higher expected rates of return from stocks that have a high (positive) sensitivity to Suctuations in the stock market. (g) An investor who puts $10000 in T-bills and $20000 in the market portfolio will have a beta of 2.0. 23. Security B has a price of $50 and a beta of 0.8. The risk-free rate is 3% and the market risk premium is 4%. (a) According to the CAPM, what return do investors expect on the security?30. 31, CAPM ‘True or False, Briefly explain. (a) The capital asset pricing model assumes that all investors have the same information and are willing to hold the market portfolio, (b) Over the long run, average returns on low-beta stocks have been less than predicted by the capital asset pricing model. Suppose that the actual rate of return on the S&P 500 index from December 17, 2001 (today) to December 17, 2002 (12 months hence) is 9.0%, including dividends paid by companies in the index. You are given the following information about the performance of mutual funds X, Y and Z, Each mutual fund invests only in common stocks, Fund (manager) Rate of return Alpha (SE) __Beta (SE)_R? X (Gladys Friday) 9.8% 48% (10%) 1.05 (05) 92 Y (Gene Pool) 9.0% 65% (3.0%) 1.10 (.07) 88 Z (Hugh Betcha) 134% +.50% (3.1%) 1.60 (.09) 65 Alphas and betas are estimated from 52 weekly returns from December 2001 to December 2002. Returns and alphas are given above as annual percentage retums, SE means standard error. The start-of-year risk- free rate is 2.5% Based on these statistics, what can you say about the investment strat- egy and performance of cach of the three managers? Explain, Consider risk as well as return before answering, . Your company offers three funds to its employees for their pensions: a money-market fund, an S&P 500 index fund and a new-economy equity fund. You need to form a portfolio from these funds for your own pension investments The money-market fund is invested in 3-month Treasury bills, now with a risk-free return of 1.5% per annum. The index fund gives a premium of 8% and a standard deviation of 20% per annum. ‘The new-economy fund’s return can be described by the following equation: re rp = at Bry — Te) + ee where r; and rag are the fund and market returns, rp is the risk-free return, @ is a constant, and e, is the part of the fund’s returns not explained by the market. The performance of the fund over the last 60 months gives7_CAPM 0.0 12 ea ce © R? = 0.75 (proportion of the va plained by the market return) ance of the fund’s return ex- (a) Compute the expected return of the new-economy fund using CAPM. Use reasonable estimates for the market return and the risk-free return. (b) If CAPM holds, what is the optimal portfolio to achieve an ex- pected return of 8% per annum. (c) If instead, the estimate of a is 0.0050 (0.5% per month) with a standard error of 0.0015. Without doing any calculations, discuss how this may affect your portfolio. 33. Two mutual fund managers are being evaluated for their performance in the last ten years. One of them, Mr. Hare, has achieved an eyc-popping 34% annual average return; the other, Ms. Tortoise, has obtained a modest 12% annual average return, On closer examination of their portfolios, it is found that Mr. Hare always bet on risky Argentinian stocks (whose beta is 4), whereas Ms. Tortoise always invested in conservative technology firms like IBM (whose b is (a) If the risk-free return was 3% every year and the expected mar- ket return was 11% every year, who should get the higher bonus? Why? (Credit only if reasoning is correct.) (b) If the risk-free return was 7% every year and the expected market, return was 13% every year, who should get the higher bonus? Why? (Credit only if reasoning is correct) 34. True or false. Explain briefly By the CAPM, stocks with the same beta have the same variance. 35. True or false. Explain briefly If CAPM holds, @ should be zero for all assets. 36. Does the CAPM provide a good explanation of past av return? How would you (briefly) summarize the evidenes 37. True or false. Explain brie 407_CAPM (a) The Sharpe ratio equals average return divided by standard devi- ation of return (b) The average beta of all the assets in the market is 1 38. Assume that you can borrow and lend at a riskless rate of 5% and that the tangency portfolio of risky assets has an expected return of 13% and a standard deviation of return of 16%. (a) What is the highest level of expected return that can be obtained if you are willing to take on a standard deviation of returns that is at most equal to 24%? Answer and explain below. (b) What is the fraction of your wealth (in percent) invested in the riskless asset in the portfolio you found in part (a) (the mean- variance efficient portfolio with a standard deviation of 24%)? What is the fraction invested in the tangency portfolio of risky assets? 4118 Capital Budgeting 1.8 Capital Budgeting 1. Table A gives investments, NPVs, IRRs and the first three y 42 flow for several capital investment projects. Each project’s cash flows continue for several more years, longer for some projects than others. The cost of capital is 12% for all projects. Table A (figures in millions) Project | Invest in 2000] Cy | C2 |] Cs [NPV] IRR A 100 20 | 20] 20} 57 | 178 B 200 0 | 20} 40} 64 | 145 c 50 20 | 20] 20} 41 | 37.8 D 75 -10} 10] 30] 0 | 12 E 30 0} 5 | 7 ul F 10 3f4]s 30.2 Projects A and B are mutually exclusive - your firm can take only one ‘The projects are discrete - you cannot make partial investments in any project. (a) Suppose the firm rejects all projects with payback periods greater than 3 years, What is the NPV from following this policy? (b) A manager defends the decisions in part a as a way to avoid taking on risky projects. Does this defense make sense? (c) Which project would you choose, A or B? (d) Suppose that the firm now identifies a new project AA with ex- actly the same cash flows, NPV and IRR as project A. Does the opportunity to invest in AA change your answer to part c? (c) Suppose the firm has only $200 million to invest - a fixed capital constraint. Which projects would you undertake? (Ignore pro: AA) (£) Now the firm negotiates a line of credit that allows it to borrow up to $100 million at 8%. Would access to additional debt capital at a cost of 8% change your answers to questions c, d or c? Explain each answer briefly. You own three oil wells in Vidalia, Texas. They are expected to produce 7,000 barrels next year in total, but production is declining by 6 percent every year after that. Fortunately, you have a contract fixing the selling price at $15 per barrel for the next 12 years. What is the present value of the revenues from the well during the remaining life of the contri Assume a discount rate of 8 percent.18 4B Capital Budgeting . Your company’s CFO has budgeted $18 million for capital expenditures during 2000 by your division. Unfortunately the division has good opportunities to invest much more than $18 million, The cost of capital is 12%. Project | Investment im 2000 | NPV] IRR Q 10.5 55 | 15 R 20 05 | 18 s 6.0 2.5 | 25 T 15 2.0 | 30 U 15 10 | 26 v 3.0 10 | 20 Assume the $18 million budget can not be increased. Which projects should be undertaken? © DEF Corporation is trying to decide whether to undertake an expansion of its production facilities. The expansion will cost $8.5 million, to be paid immediately. After tax cash flows generated by the expansion are projected to be $1 million next year, and will be growing indefinitely with inflation at 2.5% per year. Assume that the CAPM holds, the beta of DEF assets is 1.2, the riskless rate is 5% per year (and the yield curve is flat at this rate) and that the expected return on the market portfolio is 12%. Should DEF undertake the expansion? You have developed the technology to use gold to produce high capacity The technology has cost $ 5 million to develop. You need $30 million of initial capital investment to start production. Sales of the switch sales will be $20 million per year for the next 5 years and then drop to zero. The main cost of production is gold. Bach year, you need 20,000 ounces of gold. Gold is currently selling for $250 per ounce. Your supplier thinks that the gold price will appreciated at 5% per year for the next 5 years. The cost of capital is 10% for the fiber- optics business. The tax rate is 35%. The capital investment can be depreciated linearly over the next 5 years. (a) Calculate the after-tax cash flows of the project, (b) Should you take the project? . Your company considers a now investment project, which lasts for three years. The project requires a purchase of a new machine, which costs $600,000. This initial investment can be depreciated to zero over the next three years according to a straight line depreciation rule. The machine has no salvage value at the end. Operating revenue is projected to be $400,000 per year. Operating costs for raw materials are $100,00018 Capital Budgeting 1 per year. The above data is summarized in the following table (in thousands of dollars) Capital expenditure [ 600 Depreciation 200 | 200 | 200 ‘Operating revenue 00 | 400 [400 ‘Operating cost, Too [100 [1007 ‘The corporate tax rate is 30% and the risk-adjusted discount rate is 10%. (a) Compute after-tax cash flows every year: (b) Should we take the project and why’ (c) Suppose that you need to purchase an inventory of raw materials now (year 0) instead of year by year in the next three years. This will require an initial expense of $300,000 in inventory, which will then be depleted, by equal amount every year in the next three years. How would your answers to the above questions chang: 7. Halliburton is considering for a two-year project. The project requires an initial capital expenditure of $100 million (in year 0), which can be depreciated linearly to zero in the next two years. It generates a revenue of $80 million and a cost of $25 million per year for the next two years (year 1 and 2). The tax rate for Halliburton is 30% (a) Compute the net after-tax cash flows of the project. (b) The cash flows of this project are risk-free. The market gives the following interest rates: (years) 1 spot interest rate (%) | 4.00 Should Halliburton take this project? Explain. 442 Solutions 2.4 Forward and Futures 1. Use simple arbitrage argument. To deliver one bushel of wheat in a year, you can buy it today for $3.4 per bushel and store it for one sar. The cost of storage is $0.1 per bushel. So the total cost if $3.5 per bushel in today’s dollar. Project this forward one year using the interest rate of 4% give the price of $3.5 x (1 + 4%) = $3.64 for 1-year forward contract 2, We assume that the forward price is equal to (or very close) to the futures price. The forward price is given by: Hr = So(1 +r)" Re-arreng this basic formulat to get Hy\ (ER) - Applying this formula, we get the effetice annualized interest rates: © October: roc = (635.60/633.50)!? — 1 = 0.0405 © December: rec = (641.80/633.50)" — 1 = 0.0534 # June, 2007: ryun.or = (660.60/633.50)!2/9 — 1 = 0.0574 December, 2007: rpec, (678.70/633.50)'7 — 1 0567 3. (a) On one hand, the hotel chain faces the risk that the price at which it purchases coffee will rise. On the other hand, the hotel chain can pass along these costs to the consumers of the coffee, so it is not clear to what extent the hotel chain will be affected by an increase in coffee pr ‘The hotel chain's ability to pass along rising costs to its customers is a type of a natural hedge. A company’s failure to recognize its natural hedges can lead to “hedges” that actually increase risk (c.g., a hotel chain that locks in its costs by buying forward coffee might be at a competitive disadvantage if coffee prices fall) (b) ‘The coffee farmer has no natural hedge and is at risk if the price of coffee falls. The coffee farmer may wish to sell forward coffee (c) When entering the contract, the coffee farmer presumably under- stood the risk that a hedge may lock in a lower selling price if coffee prices rise above the futures price. The fact that the farmer lost the upside while protecting the downside docs not indicate that there were “losses” or that the farmer was wrong.24 For 46 4, 6. (a) (b) (a) Assume the Yield Curve is flat at 5% Price of forward = $20 * (1+ 5%)* — $1 = (1+5%)?5 = $19.482 The second terms takes into account that you don’t receive the $1 dividend if you enter into the futures today, ‘The price of futures contract is related to the spot price by the following equation: F=S(1 40)" For 7-Dec contract we have: $706.42 7.97% $693 (1+ r2-months) /* > 73-monthe Similarly, for the 8Jun contract we have: $726.7 = $693 (1+ ro-montns)* > Po-months = 6.54% Since you are the owner of a gold mine, you are naturally long gold in the future. In order to eliminate the uncertainty regarding the price you will be able to sell your product at, you can enter into a futures contract to be able to sell your production at a price that can be fixed today. For example, based on the information given here, you can enter into a contract to sell your December 2007 production at the price of $706.42 /oz and your June 2008 production at $726.7 /oz For a financial asset with a dividend the spot price and the futures price are related as: Fasler—y)? 0) Rearranging this equation you get pier (2) You have to be careful the use the relevant interest rates, 13—months oF T5-monehs, Calculated in the pervious problem for this question, For 7-Dec contract we have: Ys-months = 1 + 0.0797 ‘or 8-Jun contract we have: ays ) = 2.87% the = 0654 Yo-menths = 1 + 0.0654 (is2.4 Forward and Futures 2 SOLL (b) You can sce that in equation 1, the divided yield appears with negative sign, ie. a decrease in dividend yield will causes the price of a futures contract to increase. Hence, if you helieve that the dividend yield in the next 9 months will be lower than 2.84%, it implied that you believe the future is priced too "cheaply", ie. you think the replicating portfolio for the futures contract would cost more than the price this contract is traded for in the market. To take advantage of that, you must enter into a contract. to be able to buy the S&P index in June 2008. As a general rule, you always try to buy the asset that appears to be under priced according to your model or you view in this case, You also need to take appropriate positions in the S&P index in the spot market to hedge your exposure to S&P index. Since you are long the future, the appropriate position you need to take is to sell S&P index (compare this with question one, the logie is the same). But since you don't own the S&P index you need to borrow this to sell it, ie. you will take a short position in S&P. Let’s assume that you borrow the S&P index from a mutual fund to sell in the market. for $1453.55 today. You will deposite this money into a bank for 9 months which will grow to $1524.23. As time progresses, you need to pay the equivalent amount of divided paid by the stocks in the S&P index to the mutual fund that lent you the index. If your view is current, the total dividend you have to pay out is less than $1524.23-$1453.55=$30.53 and you will end up being positive - remember you need to buy back the S&P index in 9 months to return it to the mutual fund that lent you the index initially but you can do this at the price of $1453.55 which you agreed upon initially. In short, you have a positive exposure, ie you make money, if your view is correct about slow down in the rate of dividend yield 7. Recall futures pricing formula: (1 + re = Or)” Rearrange this to get: where ry is the annualized interest rate and gp is the annualized con- venience yield over the time horizon indicated by T. Apply this to the market data’ # October: Jou = 1+ 0.0405 — (67.50/67.50)"? = 0.040524 For 9. 4B 2 SOLUTIO d and Futures s © December: pee =1 4 0.0534 — (69.60/67.50)* = —0.0769 © June, 2007: Gsunor = 1 + 0.0575 — (72.66/67.50)7/* 0.0458, © December, 2007: Gpeqor = 1 + 0.0566 — (73.49/67.50)/15 = —0.0137 (a) You can go long 10,000,000/1,000=10,000 future contract with December maturity. You then get a lock in price of $69.60 per barrel. (b) You should buy oil in the spot market and store it until December The total cost will be 67.50 x (1 + 5% + 5.34%)? = $69.18. here we assumed the rent of 5% is compounded monthly and you should also include the time value of money. For simplicity, we have assumed the rent payment are paid upfront. (c) You should follow option b because the cost as calculated above is slightly less than the current market price of $69.60 for these contracts. In fact, you should do even more than hedging and try to eliminate this arbitrage. You can do this because you have access to cheaper storage facility than what is priced into the future prices through the convenience yield (5% vs. 7.69%) but the difference is small. We already eluded to this answer above. Here is what you should to precisely. ice of $69.60 * Borrow $68.70 at the rate of 5.34% for 3-month. This will grow to exactly $69.60 in 3-months. © Sell future contract as th # Use $67.50 of the above money to buy oil in the spot market # Pay $67.50 x (1 +5%)!/4 — $67.50 = $0.83 of the storage cost up- front (again depending on how the rent is quouted, compounded, and paid this calculation may change) © Pocket the difference today, ie. take the arbitrage profit of $68.70- 10.37. # In December, take deliver the oil, get $69.60 and pay back your debt. P2.4 Forward and Futures 2 SOLL () Here is the arbitrage argument of why this has to be the market price. This is basically the same argument that you have seen in class. Suppose you enter into a contract to sell silver in 9-months at price F. The fair price F must be equal to the cost of replicating portfolio, or otherwise there is an arbitrage opportunity. We will discuss the case that there is a mispricing and a strategy to take advantage of that in part b. Here is how the replicating portfolio will be constructed. ‘To replicate the future contract you would borrow money today ($13.50 to buy an ounce of silver), buy silver and store that for 9 months. Note that your initial net cash flow is zero. You will have to also pay storage fees once every quarter. By the end of 9 months, you will owe 13.50 (1+ %88)* = 14.013 due to your initial borrowing and, in addition, you will owe % (1+ 29)? + 23 (1 + 208)? +24 (1 + 208)" — 0.077 due to the storage fees that you have had to pay. On the other hand, you own an ounce of silver which you can sell at agreed price of F. In order to have the net cash flow zero at maturity, F must be equal to the total money you owe. Putting all these together you get that F must be equal to the value given above in order to have no arbitrage. If the actual futures price is below $14.09 you would like to take advantage of this mispricing by buying the futures contract, Le. entering into the contract to buy Silver in 9 months. This is also sometimes referred to as “taking a long position in the futures contract”. You can then use the reverse of the above replication argument to synthesize a short position in the future to offset. your long position. Alternatively, if the price is above, you would enter in a short position in the futures contract, ie. agree to sell Silver in 9-months at a level above $14.09, and use the above replication strategy to replicate a long position in the future. The main idea here is that the cost of the replicating strategy is $14.09. Hence if you can buy the future at lower price or sell at higher, you should do that and use the replication strategy to offset your position. This way you will eliminate all your risk and make risk-free or arbitrage money. The argument works exactly the same way, with signs reversed, in both case. We consider both cases below. For concreteness, let’s assume you can sell the contract at $14.30, which is higher that the fair price you calculated in part a. To take advantage of this, you would do the following: i. Enter into a contract to sell Silver in 9 months at $14.30 ii, Borrow $13.50 now and buy an ounce of silver. You will have to borrow this money for 9 months.24 For uu. 50 (a) iii, Store the silver, which will cost you $0.10 per quarter - mean- ing you would have to take additional loans from the bank every quarter to pay for this cost. iv. By the end of 9-months, you will owe the total of $14.09 - see part a to understand where this number is coming from. v. Sell your ounce of Silver at the price $14.30, ie the price that was agreed upon at time zero vi. Use $14.09 to pay your debt and pocket the $0.21 on money The argument if the price was below $14.09 is exactly reversed Again, For concreteness let's assume the price is $13.90. You would enter into a contact to buy silver in 9 months at th You would short sell silver today, ic. borrow silver to sell it for $13.50 today, and deposite the money into a bank for 9 months A potentially confusing concept here in this case is understanding what happens to the storage cost. Since you have borrowed the silver to short sell, the person who you borrowed the silver from would owe you the storage cost - think that he would h, pay the cost to someone else to store the Silver for him which he must now pay you in this case. You would deposite the storage cost you receive every quarter into your bank account as well. By the end of 9 months, you will have $14.09 in the bank. Use $13.90 to buy silver and return that to the person who lent you silver The difference, $0.19 in this case, is the risk free arbitrage money you have made. price. had to First, we calculate the total investment in TBills for one year $1350 x 250 = $337, 500. Second, lets list everything given in the problem: S(t) = $1350, S(T) = $1, 200 or $1,400, rp = 0.06, D = 0.03, and, finally, each future contract has 250 units of the index. Using formula (23) from Lecture 2 we can calculate the index futures price F (t,T) = S(t)x(1 + r)—D = $1350x (14+6%) -$1350%3% = $1390.5, Where D denotes the value of future dividends at the end of 1 year Tables below present results for the required position: buy Bills and one futures contract on S&P. Transaction yoff at T = 12 months, S| Buy TBills $337, 500 x (1+ Long Futures _$250 x (1200 ~ 1390.5) N 31,200 (7) Z) = $387, 751 347625 Index 250 x ($1200 + $1350 x 0.03) = $310, 125