Summer Assessment 2020

Assessment paper and instructions to candidates:

2019/20 syllabus only – not suitable for resit

This paper contains 4 questions: 2 questions in Section A and 2 questions in Section

If at any point in this examination you feel that anything is unclear, please make any
additional assumptions that you feel are necessary and state them clearly.

Precision, clarity, and legibility will all be valued and rewarded in grading.

Specify the question numbers that you answered in the boxes provided on the
coversheet for submission.

Instructions on how to scan and upload your answers can be found on the course
Moodle page. It is your responsibility to ensure that your answers are legible,
including the scanned versions of your answers.

Time Allowed: You have a 24-hour window to complete and submit your assignment.
The exam was written with the intention that it should take 3 hours 30 minutes for
students to complete. We recommend that you spend 15 minutes reading the exam
paper before you begin writing your answers.

Permitted materials: This is an open-book, open-notes exam.

Calculators: Calculators are permitted in this assessment.

LSE ST2020/FM213 Page 1 of 3

a) Bonds A and B are both risk-free government bonds and have two years to maturity. Bond A has a
coupon rate of 5% and bond B has a coupon rate of 8%. The price of Bond A is £1,001.40 and the
price of Bond B is £1,058.02. Bond C, which is also a risk-free government bond, has three years to
maturity, a coupon rate of 4% and a price of £924.45. All bonds pay their coupons annually and
each has a face value of £1,000.
i. What is the term structure of spot rates for maturities of 1, 2 and 3 years in this setting?
Comment on and interpret its shape. [6 marks]
ii. A three-year corporate bond has a yield to maturity of 7%. The price of £1000 worth of face
value of the bond is £947.51. What is its coupon rate? [3 marks]
iii. What is the price of a risk-free government bond with the same coupon rate, face value and
maturity as the corporate bond in (ii)? [3 marks]
iv. Compare the prices of the bonds discussed in (ii) and (iii) and give some intuition to explain
which is larger. Proceed to explain which of the two bonds will have the greater yield to
maturity and why. [3 marks]

b) You are trying to price a one period at-the-money put option on a (non-dividend paying) asset. The
current underlying price is $65 and at the end of the period the price will either fall to $50 or rise to
$90. The risk-free interest rate for one period is 2%.
i. What is the no-arbitrage price of the put option? Explain each of the steps in your pricing
analysis as you perform them. [6 marks]
ii. What is the delta on the put and what is the interpretation of that figure? [4 marks]

Question 2 [25 marks]

a) You are considering having a new kitchen fitted in your home. The cost of the new kitchen is
£15,000 to be paid immediately. You borrow all of this amount from a bank that is willing to give you
a five year loan. Payments will be quarterly (with the first payment one quarter from now) and the
stated annual interest rate, with quarterly compounding, is 4%. What will be the quarterly repayment
that you have to make to the bank? Exactly one year into the loan you inherit some money and
decide to use it to pay off the loan. How much will it cost you to do so? [5 marks]

b) What does it mean to describe a random variable as a fair game? Describe how the fair game
concept can be employed in the definition of an informationally efficient market. Describe any
limitations of the application of this concept to the efficient markets case. [5 marks]

c) The one year interest rate in Australia is currently 0.5% while that in the US is currently 1.5%. The
spot exchange rate is currently 0.6506 US Dollars per Australian Dollar. Compute the no-arbitrage
one-year forward exchange rate, explaining each of the steps in your derivation. Devise an arbitrage
strategy that will deliver you a profit if the one-year forward rate in the market is 0.6700 US dollars
per Australian dollar and compute the profit. [5 marks]

d) The risk-free interest rate is 2% (per annum). The market portfolio has an annual mean return of
14% and annual return standard deviation of 26%.
i) Investor A wishes to invest in stock Y, as she likes its high expected return of 18%. The stock
has a return standard deviation of 40%. Construct the investor a portfolio which has the same
expected return but lower risk, telling her what weights to employ and what risk she should
face. [4 marks]
ii) Investor B is rather cautious and is planning on investing in stock Z as it has return standard
deviation of 20%, even though it only has an expected return of 7%. Recommend to this
investor a different portfolio that hits the same target for standard deviation but delivers a
greater expected return. Explicitly set out the weights of the portfolio and the return that one
would expect. [4 marks]
iii) Write down and interpret the CAPM equation that holds in this setting. [2 marks]
Ó LSE ST 2020/FM213 Page 2 of 3
Question 3 [25 marks]

Denote today by year 0. Happy Oil is currently expected to pay a total dividend of $1 million in exactly one
year’s time (year 1), after which the total dividend is expected to grow at an annual rate of 5%, forever.
However, the company’s CFO has heard that the value of a share depends on the flow of dividends, and
therefore announces that the year 1 dividend will be increased to $2 million and that the extra cash needed
for the additional dividend will be financed by issuing new equity at year 1. After that, the total dividend each
year will be as previously forecasted, that is, $1.05 million in year 2, increasing by 5% in each subsequent
year. Currently, the firm has 2 million shares outstanding. The total market value of these shares is $20
million prior to the announcement of the new dividend policy.

a) Suppose the newly issued shares are issued at the cum-dividend price in year 1. What is the issue
price and how many shares will the firm need to issue? [7 marks]

b) Calculate the total dividend paid out to the old shareholders in each year, starting from year 1? What
is the total payoff to old shareholders at year 0 after the firm announces the dividend increase? [5
marks]

c) Suppose the newly issued shares are issued at the ex-dividend price in year 1. Repeat parts a. and
b. [8 marks]

d) Compare parts b. and c. Is old shareholders’ payoff different? Why? [5 marks]

Question 4 [25 marks]

Your firm has assets in place with value A which can be between 6 million and 12 million and is expected to
stay constant in years 1 and 2. You know the value of A, but outside investors do not. In addition, your firm
has 1 million of excess cash and the opportunity to invest 11 million in year 2 in a project that subsequently
yields 13 million in year 3. Therefore, your firm needs to raise additional funds of 10 million in order to invest
and realize the project’s NPV. Your firm can repurchase (buy) or issue (sell) shares in years 1 and 2 before
making the potential investment. Your objective is to maximize the firm value in year 3. You currently have 1
million shares outstanding. Assume no time discount.
a) Assume that you can only issue shares in year 2, but cannot trade shares in year 1. Would you issue
shares at a price of 8 if the value of your firm’s existing assets A = 12 million? What if A = 6 million?
[7 marks]
b) Now assume that you can only repurchase shares in year 1, but cannot trade shares in year 2. Would
you repurchase shares at a price of 10 if your firm’s existing assets A = 12 million? What if A = 6
million? (Hint: you will not be able to issue equity for investment. Share repurchases reduce the firm’s
total number of shares) [7 marks]
c) Finally, suppose you can repurchase shares at a price of 10 in year 1, as in part b). Subsequently,
you can then issue equity at a price of 9 to finance the entire 11 million investment in year 2, should
you still wish to pursue the project. If you directly issue equity for investment without a prior
repurchase, the issue price is 8, same as in part a). What is the optimal choice for the firm if A = 12
million? What if A = 6 million? (Hint: there are four potential actions: repurchase and then issue, only
repurchase, direct issue, and doing nothing.) [7 marks]
d) Compare the firm’s decision to repurchase equity when A = 6 million in part b) and part c). Is there a
difference, and why? [4 marks]

Ó LSE ST 2020/FM213 Page 3 of 3