FM423 2019

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Summer 2019 Exam

FM423
Asset Markets

Suitable for all candidates

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 are supplied with: No additional materials

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.

Calculators: Calculators are allowed in this examination

 LSE ST 2019/FM423 Page 1 of 6


Part A
Question 1. (25 marks)

(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.

(i) (5 marks) Compute the present value of your savings at time 0.


(ii) (5 marks) Suppose that you retire after 20 years and would like to spend equal
amounts for the next 20 years out of your retirement savings (you start spending
one year after you begin retirement). Find the maximum amount that you can
afford to spend. Explain how financial markets can help you guarantee that you
actually get to spend this amount.

(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.

 LSE ST 2019/FM423 Page 2 of 6


Question 2. (25 marks)
Suppose the CAPM holds. An investor holds a portfolio Z of three stocks. The weights
of the portfolio Z and the characteristics of the three stocks are in the table below: The

Stock Beta Std. dev. of idiosyncratic shock Portfolio weight


A 1.25 20% 20%
B 1.25 20% 30%
C 1 10% 50%

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.

(a) (3 marks) What is the expected return of portfolio Z?

(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?

 LSE ST 2019/FM423 Page 3 of 6


Part B
Question 3. (25 marks)
(a) (12 marks) Suppose that the current forward and European-call-option prices on nat-
ural gas in sterling per MMBtu are as follows:

Maturity Forward Price Call Price, Strike = 3


6 months 2.2 0.002
one year 2.6 0.030

We have a flat term-structure at 3% per six-month (i.e., $1 today is worth $(1+0.03)


in 6 months, and $(1 + 0.03)2 in a year from today).
(i) (6 marks) Consider a swap agreement where you will receive 1 million MMBtu’s
in six months and 2 million MMBtu’s in one year, all for a fixed price of P per
MMBtu paid at each delivery time. What is the value of P that is consistent with
no arbitrage?
(ii) (6 marks) You wish to enter a contract with the following terms:
∗ In six months you will receive 1 million MMBtu’s of natural gas and in one
year you will receive 2 million MMBtu’s.
∗ The per MMBtu price you will pay will be the spot price at delivery time as
long as the spot price is not more than $3, and you will pay $3 per MMBtu
otherwise.
∗ In addition, you will make a payment P per MMBtu at each delivery time.
There is no time-zero payment. What is the new value of P that is consistent
with no arbitrage?
(b) (5 marks) You are analyzing the returns of the Janus fund and you compare them with
those of the Magellan fund. The Janus fund has an average return of 12%, a standard
deviation of 20%, and a beta of 1.3. The Magellan fund has an average return of 10%,
a standard deviation of 17%, and a beta of 1. The current risk-free interest rate is 2%
and the expected market return is 8%. The market has a standard deviation of 11%.
What are the Sharpe Ratios and the Treynor Ratios of the two mutual funds? What
can you conclude about these funds’ performances? Discuss under what circumstances
we want to use these performance measures.
(c) (5 marks) Using monthly return data over the sample period of January 1980 to De-
cember 2016, you find that a zero-beta long-short strategy that buys firms with positive
earnings surprises and short firms with negative earnings surprises yields positive av-
erage returns. What are the possible interpretations of your findings? List at least
three.

 LSE ST 2019/FM423 Page 4 of 6


(d) (3 marks) A week in which the stock market has negative returns is followed by a week
of high market volatility. Does this statement violate any forms of market efficiency?
Explain.

Question 4. (25 marks)

(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

where Φ(d) (φ(d)) is the cumulative distribution (probability density) function of a


standard normal, K is the strike price, T the maturity date, and d1,2 depend on all
parameters.
Explain the meaning of each of the two terms in the corresponding square brackets.
What are the signs of the terms for a European call option. Comment on whether you
expect the same signs to hold for European put options.

(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.

 LSE ST 2019/FM423 Page 5 of 6


Useful facts [Note: You may use these facts without proof, unless specifically requested
to prove the fact in question.]
• Geometric Brownian Motion
Let Itô process X satisfy the following equation
dXt = αXt dt + βXt dWt ,
where α and β are known constants, and W is standard Brownian Motion. Then given
the value of the process at time t, Xt , we have for all T > t > 0,
1
XT = Xt exp((α − β 2 )(T − t) + β(WT − Wt )).
2
• Itô’s Lemma
Let X be an Itô process with
dXt = M (t, Xt )dt + Σ(t, Xt )dWt ,
where M (·, ·), Σ(·, ·) are smooth functions, and W is a standard Brownian Motion.
Define a new process Zt = g(Xt , t), where g(·, ·) is also a smooth function. Then,
∂g ∂g 1 ∂ 2g
dZt = dt + dXt + 2
[dXt ]2 ,
∂t ∂x 2 ∂x
or
1
dZt = gt dt + gx dXt + gxx [dXt ]2 .
2
or
1
dZt = [gt + gx M (t, Xt ) + gxx Σ(t, Xt )2 ]dt + gx Σ(t, Xt )dWt
2
• Log-normal variables
Let Z be a normal random variable with mean m and variance s2 , i.e., Z ∼ N (m, s2 ),
then (where a and b are known constants),
1
E[exp(a + bZ)] = exp(a + bm + b2 s2 ).
2
• Put-Call Parity
We have that
CtEU = PtEU + St − PVTt (K),
where CtEU , PtEU are the prices at time t (0 ≤ t < T ) of a European call option and a
European put option, respectively, that expire at time T ; St is the stock price at time
t of a non-dividend paying stock; K is the common strike price of the call and the put,
and the PVTt (·) operator is between t and T .

 LSE ST 2019/FM423 Page 6 of 6

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