FN2190

BSc DEGREES AND GRADUATE DIPLOMAS IN ECONOMICS, MANAGEMENT,

FINANCE AND THE SOCIAL SCIENCES, THE DIPLOMA IN ECONOMICS AND
SOCIAL SCIENCES AND THE CERTIFICATE IN EDUCATION IN SOCIAL
SCIENCES

Summer 2022 Online Assessment Instructions

FN2190 Asset pricing and financial markets

Friday 13 May 2022: 09:00 - 13:00 (BST)

The assessment will be a closed-book take-home online assessment within

a 4-hour window. The expected time/effort to answer all questions is 3 hours.

Candidates should answer THREE of the following FOUR questions. All

questions carry equal marks.

You should complete this paper using pen and paper. Please use BLACK INK
only.

Handwritten work then needs to be scanned, converted to PDF and then

uploaded to the exam platform as ONE individual file. Please ensure that your
candidate number is written clearly at the top of each page included in the scan.
Please do not write your name anywhere on your submission.
Workings should be submitted for all questions requiring calculations. Any
necessary assumptions introduced in answering a question are to be stated.

You may use any calculator for any appropriate calculations, but you may not
use any computer software to obtain solutions. Credit will only be given if all
workings are shown.

You have until 13:00 (BST) on Friday 13 May 2022 to submit your answers.
However, you are advised not to leave your submission to the last minute in order to
allow sufficient time to submit your work.

If you think there is any information missing or any error in any question, then
you should indicate this but proceed to answer the question stating any
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The assessment has been designed with a duration of 4 hours to provide a more
flexible window in which to complete the assessment. As a closed-book exam, the
expected amount of effort required to complete all questions is no more than 3
hours. Organise your time well. You are assured that in terms of answering all

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

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 FN2190

FN2190 Asset Pricing and Financial Markets

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

Please find questions on the following page.

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Question 1

Assume that the CAPM holds. Consider a stock market that consists of only two risky
securities, Stock 1 and Stock 2, with the following expected returns (µ) and standard
deviations of returns (σ): µ1 = 0.25, σ1 = 0.20; µ2 = 0.15, σ2 = 0.10. Table 1 shows the
expected returns and standard deviations for six assets, A to F (the entries for asset A
are left intentionally blank). These assets are portfolios consisting of the risk-free asset,
Stock 1, and Stock 2 in varying quantities (which may be positive, negative, or zero).

Table 1

Asset Expected return Standard deviation

A
B 0.06000 0
C 0.18620 0.11405
D 0.23000 0.16900
E 0.16096 0.09124
F 0.17000 0.10276

(a) Asset D has zero investment in the risk-free asset. Determine the portfolio weights
of Stock 1 and Stock 2 in asset D. (3 marks)

(b) What is the correlation between the returns of Stock 1 and Stock 2? (3 marks)

(c) Asset A is the minimum variance portfolio formed from Stocks 1 and 2 only.

i. Show that the weight of Stock 2 in asset A is given by:

σ12 − σ1,2
𝑤𝑤2 =
σ12 − 2σ1,2 + σ22

where σ1,2 denotes the covariance between Stocks 1 and 2. (4 marks)

ii. Complete the entries for asset A in Table 1. (3 marks)

(d) One of the assets in Table 1 is the market portfolio. Identify the market portfolio,
clearly explaining/justifying your choice. (6 marks)

(e) Show how you can construct an efficient portfolio with the same expected return as
Stock 1 but a lower volatility, illustrating your argument by sketching a graph.
Assuming you intend to borrow/lend $10,000 risk-free to create this portfolio, how
many dollars would need to be invested in each stock? (8 marks)

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(f) Determine the CAPM beta of the portfolio you constructed in (e). Given your
answers to the rest of this question, if we observe a rational investor holding 100%
of his wealth in Stock 1, what can we conclude about financial constraints faced by
the investor? (6 marks)

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Question 2

(a) Consider a two-period consumption model consisting of now, t = 0, and next year,
t = 1. There are two investors, Investor A who is patient and wants to wait and
consume the maximum amount possible at t = 1, and Investor B who is impatient
and wants to consume the maximum amount possible now. Both investors have an
income of $200,000 today and no income at t = 1. Both investors have access to a
real investment opportunity costing $200,000 now and returning a guaranteed
$215,000 at t = 1. They also have access to risk-free borrowing and lending at an
annual rate of 10%. Explain the investment decisions taken by each investor (both
real and financial) and the resultant cash flows and consumption, including a brief
discussion of the optimality of the net present value (NPV) rule. (7 marks)

(b) You have just purchased a house in Sydney for $2 million, using your own savings
to make a down payment equal to 20% of the house’s value, with the remainder
financed via a 25-year mortgage. The mortgage has fixed monthly payments, with
the first payment due in exactly one month. The stated annual interest rate on the
loan is 6% with monthly compounding. How much of the loan principal will you repay
in the first year of the loan, expressed as a percentage of your total annual
mortgage payment. Will this percentage increase, decrease, or stay the same in
subsequent years? Explain. (6 marks)

(c) The term structure of interest rates is flat with all spot rates equal to 10%. Consider
the following bonds:

• Bond A: a ten-year 10% coupon bond with a face value of $100.

• Bond B: a four-year zero coupon bond with a face value of $100.
• Bond C: a four-year 5% coupon bond with a face value of $100.

All coupons are paid annually. Using the bond duration concept, explain which bond
will experience a smaller percentage price change if the term structure shifts
upwards by 100 basis points (i.e. to 11%). (5 marks)

(d) Comment on the validity of the following statement: “According to the CAPM, an in-
the-money put option on a zero beta stock should have an expected return equal to
the risk-free rate”. (5 marks)

(e) Suppose that in any given year, there is a 50% chance that a mutual fund will
outperform the market simply by chance. If there are N mutual funds, what is the
smallest number N such that the probability of observing at least one out of these N
funds outperform the market for 10 consecutive years by chance exceeds 99%?
Noting that there are around 8,000 mutual funds in the US, comment on the
implication(s) of your answer for empirical tests of efficient markets. (5 marks)

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(f) Consider a forward contract to deliver, in two years’ time, a two-year coupon bond
with a face value of $100 and a coupon rate of 10%. The forward price 𝐹𝐹 will be paid
in year 2 while the bond payments occur in years 3 and 4. The current term
structure of interest rates is given by: 𝑟𝑟1 = 6%, 𝑟𝑟2 = 5%, 𝑟𝑟3 = 4.5%, and 𝑟𝑟4 = 4%.
Using a replicating portfolio approach, find the no-arbitrage forward price, 𝐹𝐹.
(5 marks)

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Question 3

Consider the following information in Table 2, on three default-risk free bonds with
annual coupon payments and face value of $1,000.

Table 2

Bond Coupon rate (%) Time to maturity (years) Yield to maturity (%)
A 4 1 5
B 6.5 2 6
C 8 3 8

(a) Determine the prices of bonds A, B and C. (3 marks)

(b) Determine the current term structure of spot interest rates and briefly comment on
the shape of the term structure. (5 marks)

(c) Demonstrate how you can use bonds A, B and C to replicate a 3-year zero coupon
bond with a face value of $1,000. (6 marks)

(d) If the 3-year zero coupon bond in (c) has a market price of $780, show how you can
earn an arbitrage profit. Make sure to clearly detail the arbitrage strategy. (6 marks)

(e) Assume you can buy and sell zero coupon bonds (face value $1,000) of any
maturity and that all bonds are trading at their no-arbitrage price implied by the term
structure calculated in (b). An investor expects to receive a cash inflow of $5 million
in one year’s time, which she then plans to lend out immediately. The term of the
loan will be two years, with fixed coupon interest paid to the investor at the end of
each year, along with the repayment of the entire principal amount at the maturity of
the loan. Explain how the investor could arrange this loan today and “lock in” the
interest rate on the loan, stating exactly how many units of the required bonds need
to be long/short and the resultant cash flows. What should the interest rate on this
loan be? (8 marks)

(f) Instead of paying fixed coupons, suppose Bond C pays a floating rate of coupon
interest, whereby its coupon rate varies positively with the general level of interest
rates. All else being the same, would Bond C’s modified duration be higher, lower,
or the same as its fixed-interest counterpart? Explain your answer (you do not need
to do any calculations). (5 marks)

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Question 4

(a) Consider the following two strategies:

• Strategy 1: short one call option with strike price 𝑋𝑋 + 2𝑎𝑎, short one call option
with strike price 𝑋𝑋 − 2𝑎𝑎, and long two call options with strike price 𝑋𝑋.
• Strategy 2: long two put options with strike price 𝑋𝑋, short one put option with
strike price 𝑋𝑋 − 2𝑎𝑎, and short one put option with strike price 𝑋𝑋 + 2𝑎𝑎.

Both strategies are based on the same underlying non-dividend paying stock and all
options are European and have the same maturity date, 𝑇𝑇. Both 𝑋𝑋 and 𝑎𝑎 are positive
constants, 𝑋𝑋 − 2𝑎𝑎 > 0, and the stock price today is equal to 𝑋𝑋.

i. Which strategy has the higher cost to implement today? You must use a
payoff table at maturity to comprehensively justify your answer, stating any
assumptions. (9 marks)

ii. Why would a trader use these strategies? (2 marks)

(b) Comment on the validity of the following statement: “The risk-neutral pricing
approach makes no assumptions about the nature of investors’ risk preferences”.
(3 marks)

(c) Consider a two-period binomial model (t = 0, 1, 2), with a risky non-dividend paying
stock, BHP, which is currently trading for $4. In each period, the stock can go up by
20% or down by 5%. The risk-free interest rate for the second period (i.e., between t
= 1 and t = 2) is 2%. An at-the-money European put option on BHP with maturity
date t = 2 is currently trading at $0.20715.

i. What is the implied risk-free interest rate for the first period in this economy?
(6 marks)

ii. Using the replicating portfolio method, determine the value today of a
European call option on BHP stock with maturity date t = 2 and exercise price
of $3.85. (6 marks)

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 iii. Consider a new European option in the market which is path-dependent, with
underlying stock BHP. The new option has the following payoff function at the
maturity date t = 2:

𝑚𝑚𝑚𝑚𝑚𝑚�𝑆𝑆𝑎𝑎𝑎𝑎𝑎𝑎 − 𝑋𝑋, 0�

where 𝑋𝑋 = $3.85 is the exercise price of the option and 𝑆𝑆𝑎𝑎𝑎𝑎𝑎𝑎 is BHP’s
average stock price during the life of the option i.e., the arithmetic average of
the stock price BHP realises on the path from t = 0 to t = 2. Explain intuitively
whether you expect this new option to have a value today that is higher,
equal, or lower than the option in part (ii)? What is the value today of this
option? (7 marks)

END OF PAPER

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