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Economics and finance

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32 views

Cat 1&2

Economics and finance

Uploaded by

codewithdhanian
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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KENYATTA UNIVERSITY

UNIVERSITY EXAMINATIONS 2024/2025


FIRST SEMESTER EXAMINATION FOR THE DEGREE OF
BACHELOR OF ECONOMICS AND FINANCE
EAE 414: THEORY OF FINANCE
CAT ONE, TWO & THREE

17th November, 2024 Time: 2 hours

Instructions

1. Answer ALL the questions.

2. Strictly attempt the CATs in Groups of Five

3. Pick the CAT answer booklets from your respective class reps

4. The group leader shall be responsible of submitting the CAT during the exam

Question 1

Consider an individual who lives in a two states world with complete and perfect capital
markets in a one period framework. His beginning of the period consumption is C0 and
is numeraire, his wealth at the beginning of the period is w0 =[ KES50,
] 000[ while that
] of
date 1 is zero. The ] of the two securities in this market h1 h2 are 0.6 0.4 and
[ prices
1 0
their payoffs are
0 1

(a) What are the state prices in this market? State the reason for your answer.
(b) If the individual is myopic, state his one period budget constraint given that con-
sumption and security purchases exhaust his date 0 wealth
(c) If this individual’s entire period utility function is given by U (C0 , h1 , h2 ) = lnC0 +
1
3
lnh1 + 23 lnh2 . Find his trading strategy at the beginning of the period and his
consumption strategy
(d) What is the risk free rate in this market?

[15 marks]

1
Question 2

Table 1 shows the returns of security X (x) and Y (y).

Table 1: The returns of security X and Y

xi yi
-1.408 -3
17.258 15
3.777 2
22.443 20
7.925 6

Given that the states are equally likely you are required to:

(a) Test whether diversification is possible


(b) Find the optimal holdings of security X and Y that will guarantee minimum risk
(c) Find and interpret the covariance between portfolio A which is 75% in x and the
minimum variance portfolio in 2(b) above.
[15 marks]

Question 3

Suppose a stock now sells at So = KES100, it’s price will either increase by a factor of
u = 1.20 to KES120 ( u stands for up) or fall by a factor of d = .9 to KES90 ( d stands
for down) by year-end. Consider a call option written on the stock with a strike price of
KES110 and a time expiration of one year, if the risk free rate is 10% find

(a) The replicating portfolio for the call option


(b) The price of the call option
(c) Does the price of the call option guarantee elimination of arbitrage? If yes/no why?
[15 marks]

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