HEC Lausanne

Exam Solutions
Session/year : Winter 2022

Title of the course : Investments

Professor : Amit Goyal
Date of the exam : 19.01.2022
Duration of the exam : 2.5 hours
# pages of this document : 15 pages

To be completed :
Last and first name :

Student number :

Place number :

Procedures :
Documentation : Closed book (formula sheet provided at the end).
Calculator : Non programmable.

This exam contains 5 multiple choice problems and 5

problems. The total number of points is 100. Please
answer the multiple choice problems in the question
sheet itself. Ambiguous marking or choosing more than
one option will get no credit. Points for problems are
awarded for correctness of the answer and the clarity
Instructions : of the reasoning as well as the steps leading to the an-
swer. Correct answers arrived at through false logic will
not be awarded full points. If you feel that you need
to make additional assumptions, please do so and state
your assumptions clearly. The questions are in no par-
ticular order, so do not assume that the later questions
are more difficult than the earlier questions.
Pen : Pens (ink) only are authorized.

Reserved for grading

Participation Course work Exam Final grade

Grade: Grade: Grade: /100 Grade: /6

1
HEC Lausanne

Question 1 (20 Points) [Fixed Income]

Consider the following table with features of three different coupon bonds (each bond has
a face value of $100):

Bond Maturity (years) Annual Coupon Price

Bond 1 1 10% 106.56
Bond 2 2 8% 106.20
Bond 3 3 8% 106.45

a) Find the 1-year, the 2-year, and the 3-year zero-coupon rates from the above table. (6
points)
b) Consider another bond with the following features (face value $100):

Bond Maturity (years) Annual Coupon Price

Bond 4 3 9% 109.01

Is Bond 4 priced fairly? (2 points)

c) Assume now, that the 1-year zero coupon bond and the 2-year zero coupon bond
shown in the table above exist in the economy but the 3-year zero-coupon bond does
not exist. At the same time, the spot rates are the same as those found in part a) of
this exercise. Under this situation, does there exist an arbitrage opportunity? If so,
please lay out the exact strategy and the potential arbitrage profit. Is this arbitrage
strategy unique? (12 points)

SOLUTION
a) The 1-year zero-coupon rate denoted by R(0, 1), verifies:
110
= 106.56,
1 + R(0, 1)
which implies:
110
R(0, 1) = − 1 = 3.228%.
106.56
The 2-year zero-coupon rate denoted by R(0, 2), verifies:
8 108
+ = 106.20,
1 + 3.228% (1 + R(0, 2))2
which implies:
!1/2
108
R(0, 2) = 8 = 4.738%.
106.20 − 1+3.228%

The 3-year zero-coupon rate denoted by R(0, 3), verifies:

8 8 108
+ + = 106.45,
1 + 3.228% (1 + 4.738%)2 (1 + R(0, 3))3

2
HEC Lausanne

which implies:
!1/3
108
R(0, 3) = 8 8 = 5.718%.
106.45 − 1+3.228%
− (1+4.738%)2

b) The price P of Bond 4 using the zero-coupon curve is given by the following formula:
9 9 109
P = + 2
+ = 109.177.
1 + 3.228% (1 + 4.738%) (1 + 5.718%)3

c) First of all, we need to create the three-year zero coupon bond using the other available
bonds:

Cash Flow in Year

1 2 3
Bond 3 ($100 Face Value) 8 8 108
Less: 1-year zero ($8 Face Value) −8
Less: 2-year zero ($8 Face Value) −8
3-year zero ($108 Face Value) 0 0 108

By the Law of One Price:

Price(3-year zero) =
Price(3-year coupon bond) − Price(1-year zero) − Price(2-year zero)
8 8
= 106.45 − 1.03228 − (1.04738) 2 = $91.41.

(4 points for creating the three-year zero coupon bond)

Now, that we have created our own 3-year zero coupon bond, using the existing bonds,
we can use all three zero coupon bonds to determine the arbitrage profit. We have
already observed from the previous exercise that the bond is underpriced since the
current observed market value is equal to $109.01, but the fair value is equal to $109.18.
Thus, we already know that we need to go long in Bond 4 and short in all other zero
coupon bonds. This, plus the fact that we need to make all future cash-flows equal to
zero helps us to set up the following system of equations:

0 = y × 9 + x1 × 100 + x2 × 0 + x3 × 0
0 = y × 9 + x1 × 0 + x2 × 100 + x3 × 0
0 = y × 109 + x1 × 0 + x2 × 0 + x3 × 108.

Accordingly, we have that:

100 100 108
y=− x1 = − x2 = − x3 .
9 9 109

As a result, the arbitrage profit is given via going long in one Bond 4 (-109.01) and
short 9/100 1-year zero coupon bonds (+8.72), short 9/100 2-year zero coupon bonds
(+8.20) and short 109/108 3-year zero coupon bonds with face value $108 (+92.26).
Thus, we have exactly replicated exactly one Bond 4 and thus, the arbitrage price is

3
HEC Lausanne

given by the difference between the observed and the fair price:

Arbitrage = −109.01 + 8.72 + 8.20 + 92.26 = $0.17. (6 points for finding the arbitrage)

No, the arbitrage strategy is not unique. As long as the relative relationship from
zero coupon bonds to Bond 4 is respected the arbitrage can be scaled to obtain and
arbitrage of k × $0.17 (2 points).

4
HEC Lausanne

Question 2 (20 Points) [Portfolios]

Suppose the entire securities market consists of a riskless asset, F, together with only 4
stocks: V, W, X, and Y. There are 200 million shares of each of V and W outstanding,
and 500 million shares of each of X and Y outstanding. Assume that the price of stock
X is equal to the price of stock Y. The graph below illustrates the location of F and
of the 4 stocks. Also shown is the minimum variance frontier for investing in V, W, X,
and Y, the mean-variance efficient portfolio (denoted by T) of these 4 stocks, the capital
allocation line through F and T, and two portfolios A and B on this capital allocation
line. Furthermore, portfolio D is a portfolio of V, W, X, and Y. Assume that portfolio T
is the market portfolio of the 4 stocks (i.e., the market portfolio of risky assets).

a) If you could invest in F and only one of the 4 stocks, which stock would you choose
(Hint: it might help to support he explanation graphically)? (8 points)
b) Which of the portfolios A, B, and D can you be sure involves borrowing/short sales of
some asset (i.e. a negative portfolio share for one or more assets)? (8 points)
c) If you hold an efficient portfolio and you own 300 shares of stock X, how many shares
of stock Y do you own? (4 points)

SOLUTION

a) X, since it would lead to the steepest capital allocation line. (In other words, the line
joining X and F, which corresponds to portfolios of X and F, gives a higher expected

5
HEC Lausanne

return for any return standard deviation than the lines joining F with V, W or Y). See
graph below with these lines added. (4 points)
b) B involves a negative portfolio share for the riskless asset F (1 point). D must involve
a negative portfolio share for one or more of the 4 stocks since its expected return is
higher than that of all 4 stocks (3 points).
c) 300 shares of stock Y. Optimal portfolios are combinations of F and T, and T equals
the market portfolio of stocks. Since the market value of X and Y is the same, and
since the price of X and Y is the same, any investment in T must involve equal holdings
of X and Y. (2 points)

6
HEC Lausanne

Question 3 (15 Points) [CAPM]

Your current portfolio consists of three assets, the common stock of Netscape and Wal-
Mart combined with an investment in the riskless asset. You know the following about
the stocks (ρi,j denotes the correlation between asset i and asset j):

Netscape Wal-Mart
E(rstock ) 0.148 0.130
2
σstock 0.64 0.25
ρstock,M 0.30 0.40

Further, the expected return of the market portfolio (M) is equal to E(rM ) = 0.13 and
2
σM = 0.04. Finally, the risk-free return is equal to rf = 0.04.

Assume that individuals can borrow and lend at the risk-free rate and that all investors
hold efficient portfolios (In other words, the market portfolio is the tangent portfolio).
You have $200,000 invested in Netscape, $200,000 invested in Wal-Mart, and $100,000
invested in the riskless asset.

a) Assume that the correlation between Netscape and Wal-Mart, ρNetscape,Wal-Marts , is 0.10.
What is the variance of your portfolio? (2 points)
b) Find an efficient portfolio that has the same expected return as your current portfo-
lio, but the lowest standard deviation possible. What is the standard deviation and
variance of this portfolio? (4 points)
c) Find an efficient portfolio that has the same standard deviation as your current port-
folio, but the highest expected return possible. What is the expected return of this
portfolio? (4 points)
d) Discuss the differences between the capital market line (CML) and the security market
line (SML). (5 points)

SOLUTION

a) We will use the formula for the variance of a portfolio of three assets and then simplify;
since all the covariances and the variance term involving the risk-free asset are zero:

σP2
= x2N etscape σN
2 2 2 2 2
etscape + xW alM art σW alM art + xf σf +
+ 2xN etscape xW alM art × ρN etscape,W alM art × σN etscape × σW alM art
+ 2xN etscape xf × σN etscape,f + 2xW alM art xf × σW alM art,f
= 0.42 × 0.64 + 0.42 × 0.25 + 0 + 2 × 0.4 × 0.4 × 0.1 × 0.8 × 0.5 + 0 + 0
= 0.1552.

Thus, the standard deviation is equal to σP = 39.396%.

7
HEC Lausanne

b) The expected return of the current portfolio is:

E(rP ) = xN etscape E(rN etscape ) + xW alM art E(rW alM art ) + xf E(rf )
= 0.4 × 0.148 + 0.4 × 0.13 + 0.2 × 0.04
= 0.1192.

The efficient portfolio, call it ep1, has an expected return of 0.1192. Since the portfolio
is made up of the market and the riskless asset, E(rep1 = xm E(rm ) + xf E(rf ). Thus,
0.1192 = xm × 0.13 + (1 − xm ) × 0.04 and xm = 88%. Variance of the portfolio
2
σep1 = x2m σm
2
= 0.882 ×0.04 = 0.0310. Standard deviation of the portfolio σep1 = 17.6%.
c) This efficient portfolio, call it ep2, has a standard deviation of 39.395%. Since the
portfolio is made up of the market and the riskless asset, σep2 = xm σm . Thus,
39.395% = xm × 20% and xm = 197% and so xf = −97%. The expected return
on this portfolio is:

E(rep2 ) = xm E(rm ) + xf E(rf )

= 1.97 × 0.13 − 0.97 × 0.04
= 21.73%.

d) The capital market line measures the excess return (return of the portfolio over the
risk-free return) per unit of total risk, as measured by standard deviation. The CML
applies to efficient portfolios only. The security market line measures the excess returns
of a portfolio or a security per unit of systematic risk (beta). The SML applies to
individual securities and to all portfolios (whether efficiently diversified or not). Thus,
the SML has much general applications than the CML and is more broadly used. The
SML is frequently used to evaluate the performance of portfolio managers.

8
HEC Lausanne

Question 4 (15 Points) [Currencies]

a) The table given below exhibits the current exchange rates between the US-dollar,
the Euro and the Swiss Franc. Using the information provided in the table, please
complete the table by determining the missing exchange rates (note: full mark will
only be awarded if the calculations are explicitly stated) (6 points):

1 USD 1 EUR 1 CHF

USD 1.00 1.25
EUR 1.00
CHF 1.15 1.00

b) Assume that you observe the one-year forward exchange rate to be $0.90/CHF (mean-
ing 1 CHF = 0.9 USD). Further, the one-year interest rate is equal to 5% in Switzerland
and 10% in the US. Using the spot exchange rates (CHF/USD) found in the previous
exercise (part a), determine whether the covered interest rate parity (CIP) holds in
the given setup (2 points).
c) Is there an arbitrage opportunity? If so, lay out a detailed strategy of how to exploit the
arbitrage. Assume that you are an investor based in Switzerland that has a maximum
borrowing capacity of CHF 1,000,000 that can be used for trading. Finally, show
the size of the maximum possible arbitrage profit (if you think there is an arbitrage
opportunity (7 points).

SOLUTION

a) The exchange rates are given by (1.5 points per correct exchange rate):

1 USD 1 EUR 1 CHF

USD 1.00 1.25 0.87
EUR 0.80 1.00 0.70
CHF 1.15 1.44 1.00

One possible intuitive calculation:

• Given that 1 USD = 1.15 CHF. Divide both sides by 1.15, you get (1/1.15) USD
= 1 CHF which means 1 CHF = 0.87 USD.
• Given that 1 EUR = 1.25 USD. Divide both sides by 1.25, you get (1/1.25) EUR
= 1 USD which means 1 USD = 0.80 EUR.
• We have found that 1 CHF= 0.87 USD and 1 USD=0.80 EUR. Then, 1 CHF =
0.87 USD = (0.87*0.8) EUR = 0.7 EUR.
• We have found that 1 CHF= 0.7 EUR. Divide both sides by 0.7, you get (1/0.7)
CHF = 1 EUR which means 1 EUR = 1.43 CHF.

9
HEC Lausanne

b) No-arbitrage forward rate implied by CIP:

1 + I$ 1.10
F =S× = 0.87 × = 0.9114.
1 + ICHF 1.05
Thus, the CIP does not hold in this case (2 points).
c) There is an arbitrage opportunity since the CIP does not hold - as seen in the previous
exercise. Thus, to exploit the arbitrage opportunity we need to apply the following
strategy:
1) Borrow 1,000,000 CHF at a rate of 5%.
2) Exchange 1,000,000 CHF to 870,000 USD at the spot market.
3) Invest the 870,000 USD at 10%; get 957,000 USD at maturity.
4) In order to hedge the exchange rate risk, sell forwards with a value of 957,000 USD
to obtain 1,063,333.33 CHF.
5) Finally, repay the 1,050,000 for the credit taken including the interest rates.
6) Pocket an arbitrage of 13,333.33 CHF.
(2 points for the first item and one for each of the other items).

10
HEC Lausanne

Question 5 (15 Points) [Commodities]

You purchased the following futures contract today at the settlement price listed in the
Wolves Street Journal. Answer the questions below regarding the contract.

Olive Oil (CBT) 50,000 lbs.; cents per lb.

Lifetime
Open High Low Close Change High Low Open Interest
January 15.28 15.33 15.25 15.29 −0.02 20.35 15.25 7,441

a) Using the table below, determine the margin requirement, if you have deposited 1529
at the initiation of the contract? (2 points)
b) Enter the missing information into the table using the necessary information given.
Show your calculations. (10 points)

Day Futures Profit/Loss Total value Mark-to-market

price per lb. of contract settlement
0 n.a. 7,645 n.a.
1 $0.1527
2 7,700
3 285

c) Briefly explain what convenience yield is. (3 points)

SOLUTION
a) The margin requirement can be calculated as: 1,529/7,645 = 20%.
b) The following calculations are required to find the missing information in the table:

t=0: futures price = total value of contract/contract size = 7,645/50,000 = $0.1529

t=1: total value of contract = futures price×contract size = 0.1527×50,000 = 7,635
mark-to-market = 7,635 − 7,645 = −10
P/L per lb. = −10/contract size = −0.0002
t=2: futures price = total value of contract/contract size = 7,700/50,000 = $0.1540
mark-to-market = 7,700 − 7,635 = 65
P/L per lb. = 65/contract size = 0.0013
t=3: total value of contract = 7,700 + 285 = 7,985
P/L per lb. = 285/contract size = 0.0057
futures price = total value of contract/contract size = 7,985/50,000 = $0.1597

Thus, the completed table is the following:

Day Futures Profit/Loss Total value Mark-to-market

price per lb. of contract settlement
0 $0.1529 n.a. 7,645 n.a.
1 $0.1527 −0.0002 7,635 −10
2 $0.1540 0.0013 7,700 65
3 $0.1597 0.0057 7,985 285

11
HEC Lausanne

c) A convenience yield is the benefit or premium associated with holding an underlying

product or physical good, rather than the associated derivative (futures) contract. Can
be viewed as the number that restores the equality between futures price and spot
price plus cost of carry. Reflects market’s expectations concerning future availability
of commodity; Greater the possibility that shortages will occur, higher the convenience
yield.

12
HEC Lausanne

Multiple Choice Questions (MCQ) [3 points each]

MCQ1: According to the Capital Asset Pricing Model (CAPM), which one of the following
statements is false?
a) The expected rate of return on a security increases in direct proportion to a decrease
in the risk-free rate.
b) The expected rate of return on a security increases as its beta increases.
c) A fairly priced security has an alpha of zero.
d) In equilibrium, all securities lie on the security market line.
e) All of these are correct.

a) The statement that the expected rate of return on a security increases in direct pro-
portion to a decrease in the risk-free rate is false.

MCQ2: a relationship between expected return and risk.

a) APT stipulates
b) CAPM stipulates
c) Both CAPM and APT stipulate
d) Neither CAPM nor APT stipulate
e) No pricing model has found

c) Both models attempt to explain asset pricing based on risk/return relationships.

MCQ3: Which of the following is not true?

a) Holding other things constant, the duration of a bond increases with time to maturity.
b) Given time to maturity, the duration of a zero-coupon decreases with yield to maturity.
c) Given time to maturity and yield to maturity, the duration of a bond is higher when
the coupon rate is lower.
d) Duration is a better measure of price sensitivity to interest rate changes than is time
to maturity.
e) All of these are correct.

b) The duration of a zero-coupon bond is equal to time to maturity, and is independent

of yield to maturity.

13
HEC Lausanne

MCQ4: Markets would be inefficient if irrational investors and actions

if arbitragers were .
a) existed; unlimited
b) did not exist; unlimited
c) existed; limited
d) did not exist; limited
e) None of these is correct.

c) Markets would be inefficient if irrational investors existed and actions if arbitragers

were limited.

MCQ5: In a two-security minimum variance portfolio where the correlation between

securities is greater than −1.

a) the security with the higher standard deviation will be weighted more heavily.
b) the security with the higher standard deviation will be weighted less heavily.
c) the two securities will be equally weighted.
d) the risk will be zero.
e) the return will be zero.

b) The security with the higher standard deviation will be weighted less heavily to produce
minimum variance. The return will not be zero; the risk will not be zero unless the
correlation coefficient is −1.

14
HEC Lausanne

Formula Sheet
PT
• Bond Price = C/(1 + Rt )t + F/(1 + RT )T
t=1
p p
• Forward rate FT →T +N = n (1 + RT +N )T +N /(1 + RT )T − 1 = n BT /BT +N − 1

• Duration = 1/P × Tt=1 t × CFt /Y t

P

• Convexity = 1/[P × Y 2 ] × Tt=1 (t2 + t) × CFt /Y t

P

• % change in price = ∆P/P ≈ −Modified Duration × ∆y + 0.5 × Convexity × ∆y 2

• Portfolio mean = w1 µ1 + w2 µ2
• Portfolio variance = w12 σ12 + w22 σ22 + 2w1 w2 σ12
• Optimal allocation: wp = (µ − Rf )/(γσ 2 ) for utility U = µ − 0.5γσ 2
• Minimum variance portfolio: w1mvp = (σ22 − σ12 )/(σ12 + σ22 − 2σ12 )
• Tangency portfolio: w1T = (µe1 σ22 − µe2 σ12 )/(µe1 σ22 + µe2 σ12 − (µe1 + µe2 )σ12 )
• CAPM: E(Ri ) = Rf + βi × [E(RM ) − Rf ]
• APT: E(Ri − Rf ) = βi1 λ1 + βi2 λ2 + ... + βiK λK
• Risk decomposition: Rit − Rf t = αi + βi Ft + eit ⇐⇒ σi2 = βi2 σF2 + σei
2

• Sharpe ratio = (µ − Rf )/σ

• Jensen’s alpha = R̄ − [R̄f + β(R̄M − R̄f )]
• Hedge ratio h∗ = cov(∆P, ∆F )/var(∆F )
• Futures price F0,T = P0 (1 + R)T − D + S − C = P0 + Carry cost − Convenience Yield

15