FM423 2019
FM423 2019
FM423 2019
FM423
Asset Markets
Instructions to candidates
This paper contains four questions: two in Part A (consisting of questions 1 and 2) and two in Part B
(consisting of questions 3 and 4). Answer all four questions.
Each question is worth 25 marks for an exam total of 100 marks. Marks for each part of each question are
indicated.
If, at any point, you feel that you require additional information to answer a question, please feel free to
make additional assumptions and state them clearly.
Time Allowed Reading Time: 10 minutes. You may not make notes during this time.
Writing Time: 3 hours
You may also use: One sheet of A4 paper containing any information you may find useful
for the exam. Both sides of the paper may be used.
(a) (10 marks) You plan to save for your retirement 20% of your income for the next
20 years starting from the next year. Your income over the next 20 years is constant
and equal to $100K, and the first of the 20 incomes accrues in one year. Today’s rates
are 2% until year 10 and 3% from year 11 onward.
(b) (5 marks) You are given the following information. The current two and three-
year spot rates are 4% and 5% respectively. Furthermore, the two-year forward rate
between year one and three is 4.5%.
(i) (3 marks) Suppose that the expectation hypothesis holds. What one-year spot
rate does the market expect in one year?
(ii) (2 mark ) Suppose the term-structure stays constant over the next year. Consider
one, two, and three-year zero-coupon bonds. Which bond will have the highest
holding one-year return between today and one year from today?
(c) (5 marks) You are in charge of a mutual find that invests in fixed income. Your
current portfolio is valued at $100M and has the modified duration equal to 15. The
term-structure is flat at 5%.
(i) (3 marks) You receive cash inflows of $10M and decide to invest them into 30-
year zero-coupon government bonds. Compute the modified duration of your new
portfolio.
(ii) (2 mark ) Find a portfolio of 10 and 20-year zero-coupon bonds that have the
same value and duration as your new portfolio.
(d) (5 marks) The current prices of two-year and three-year zero-coupon bonds are 95.417
and 92.866. In one year, with probability 1/2 the term-structure will either be flat at 2% or
be flat at 3%. Find the current price of the four-year zero-coupon bond.
market portfolio has an expected rate of return of 10% and a standard deviation of 20%.
The riskless rate is 4%. Idiosyncratic shocks are independent across stocks.
(b) (3 marks) What is the standard deviation of the efficient portfolio that has the same
expected return as portfolio Z?
(c) (5 marks) What is the standard deviation of portfolio Z? (Hint: It would be easiest to
separate the idiosyncratic risk of the portfolio from the systematic risk.)
(d) (5 marks) Suppose stock C just paid a dividend of $1 per share, and this dividend is
expected to grow at a rate of 5% forever. What is the (ex-dividend) price of stock
C today? Suppose the price of stock C next year turns out to be $25. Compute the
return on stock C. Is it consistent with the CAPM?
(e) (6 marks) Draw the efficient frontier, which consists only of stocks A and B, and the
riskless asset. What is the maximum Sharpe ratio that can be achieved by investing
into stocks A and B, and the riskless asset?
(f) (3 marks) If one can only invest in stocks A and B, and the riskless asset, or in stock
C and the riskless asset, which alternative is better?
(a) (6 marks) Show that early exercise of an American call on a non-dividend paying stock
is never optimal in frictionless markets.
(b) (4 marks) Discuss the notion of delta-hedging and its role in the derivation of the
Black-Scholes PDE (a short intuitive explanation will suffice here; do not derive the
PDE).
(c) (5 marks) The sensitivity of the price of a European call option in the Black & Scholes
model to calendar time t (i.e., Theta) is given by the following formula:
−r(T −t) St σ
Θ = − re KΦ(d2 ) − √ φ(d1 ) ,
2 T −t
(d) (10 marks) Shares of LSE.com will sell for either £200 or £120 in three months, with
probabilities 0.67 and 0.33 respectively. A European call with an exercise price of £160
sells for £25 today; a European put option with the same exercise price sells for £7.
Both options mature in three months.
(i) (4 marks) What is the price of a three-month zero-coupon bond with a face value
of £100?
(ii) (6 marks) Calculate the current price of the stock
∗ (3 marks) by using risk neutral probabilities;
∗ (3 marks) by replicating the stock with a portfolio of the call and the put.
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