FACULTY OF COMMERCE

DEPARTMENT OF ACCOUNTING AND FINANCE

BACHELOR OF COMMERCE HONOURS DEGREE IN ACCOUNTING AND FINANCE

PART IV FIRST SEMESTER SUPPLEMENTARY EXAMINATION

ADVANCED ASSET PRICING THEORY [COAF 4102]

AUGUST 2024

DURATION: 3 HOURS

INSTRUCTIONS
1. Answer all questions in Section A, and any three questions from Section B.

2. Begin each question on a new page.

3. Show all your workings.

4. Please indicate your study format (Conventional/Block/Parallel) on the cover of your

answer script.

INFORMATION

1. Questions may be answered in any order

2. You may use a scientific calculator.

 SECTION A

(Answer all parts of this question)

QUESTION ONE
1.1. Which of the following would most likely indicate that an investor is subject to an
emotional bias?
A. Regularly basing decisions on only a subset of available information.
B. Reacting spontaneously to a negative earnings announcement by quickly selling a
stock.
C. Remaining invested in a profitable technology stock even though new information
indicates its PE ratio is too high
1.2. Thubelihle has just received new information regarding her investment in Orange, Inc.
The new information appears to conflict with her earlier forecast of what the stock price
should be at this point. Nonetheless, she is unwilling to incorporate the new information
into her forecast and to revise it accordingly. What behavioral trait is Thubelihle
displaying?
A. Conservatism bias.
B. Confirmation bias.
C. Anchoring and adjustment
1.3. Which of the following factors is not included in the Fama French five factor Model?
A. Momentum Factor
B. Sytle Factor
C. Investment Factor
1.4. Consider the Fama-French Factors and the betas for the two portfolios

Factor Risk Portfolio I Portfolio II

Factor
Premiums Sensitivities Sensitivities
RMRF 7.10% 1.2 1
SMB 2.40% - 0.4 0.8
HML −1.3% 0.8 -1.1
The HML factor for Portfolio II is indicative of ______
A. Value bias
B. Growth bias
C. Size bias
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1.5. Colbro Fund uses an aggressive strategy focusing on relatively new, fast-growing
companies in emerging industries. The Colbro Fund is most likely classified as a:
A. Large-cap value fund.
B. Small-cap value fund.
C. Small-cap growth fund
1.6. One year ago, PrinceQuants investments added a new fund—the Baobab Fund to its
existing fund offering. Baobab Fund Invests solely in the equity of companies in oil
production and transportation industries in many countries.
The Baobab Fund can be best described as a fund segmented by:
A. size/style.
B. Geography
C. economic activity.

Consider the diagram below and use it to answer question 1.7 and 1.8

1.7. From the above investment opportunity set, which of the following statements is not
correct?
A. Portfolio D is dominated by portfolio E
B. Portfolio B is not attainable
C. Portfolio C dominates portfolio A

1.8. Amongst the portfolios in the efficient frontier above, portfolio E can be most likely
recommended to an investor who is_____;
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 A. A risk lover.
B. Risk averse.
C. Risk neutral.

1.9. In the Fama-french model, a high P/E ratio is indicative of ;

A. Growth stocks
B. Value stocks
C. Low market capitalization stocks
1.10. Which of the following is correct about limit and market orders.
A. Limit orders have price uncertainity while market orders have execution
uncertainity.
B. Limit orders have execution uncertainity while market orders have price
uncertainity.
C. Limit orders are executed at the best price available wile market orders specify the
execution price
1.11. Luzibo, a Quantitative equity analyst at PrinceQuants investments executes her trades
by buying stocks when they are below their mean-revesion level and selling when they
are above. Her belief is that , over time , the stocks will always revert to their average
value. What type of market anomaly is Luzibo trying to capture?
A. Technical anomaly
B. Fundamental anomaly
C. Calendar anomaly
1.12. Which of the following factors is not part of the Cahart four factor model?
A. Liquidity factor
B. Style factor
C. Momentum
1.13. Given otherwise similar bond characteristics, a manager who is expecting an upward
shift in rates will invest in:
A. a callable bond.
B. a putable bond.
C. an option-free bond.
1.14. A manager positions their portfolio to have a negative overall duration with long
positions in short-term bonds and short positions in long-term bonds. Which of the
following yield curve changes is the manager most likely anticipating?
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 A. Bear flattener.
B. Bear steepener.
C. Bull flattener
1.15. In real options analysis, an option to _____ can be construed as a call option while an
option to _____can be construed as a put option.
A. Abandon, Defer
B. Expand, Defer
C. Defer, Abandon
1.16. Which of the following stock market index construction methodologies can be
interpreted as a portfolio that consists of one share of each constituent company?
A. Equally weighted
B. Market-cap weighted
C. Price weighted

1.17. Which of the following is true about the relationship of a put option value with volatility
and exercise price? A put option value is
A. Positively related to volatility and negatively related to exercise price.
B. Positively related to volatility and positively related to exercise price.
C. Negatively related to volatility and positively related to exercise price.

1.18. The difference between the Cox-Ingersoll-Ross model and the Vasicek Model is that in
the Vasicek Model;
A. volatility does not increase as the level of interest rates increase
B. Interest rates are assumed to be mean reverting
C. There is no randomness in interest rates.

1.19. Which of the following is a necessary characteristic for an equity index to have in order
to use it as a benchmark for a passively managed equity portfolio?
A. Selective.
B. Investable.
C. Flexible.
1.20. A small-cap, high P/E factor-based investment strategy is best classified as:
A. risk oriented.
B. return oriented.
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 C. diversification oriented.

SECTION B

(Choose any three questions from this section)

QUESTION TWO
a) Suppose that stock returns are affected by two common factors: surprises in inflation and
surprises in GDP growth. A portfolio manager is analyzing the returns on a portfolio of two
stocks ABC and XYZ. R ABC =0.09−1 F INFL +1 F GDP +ε ABC
R XYZ=0.12+ 2 F INFL + 4 FGDP + ε XYZ
One- third of the portfolio is invested in ABC stock, and two- thirds is invested in XYZ stock.

i. Formulate an expression for the return on the portfolio [3 Marks].

ii. State the expected return on the portfolio [2 Marks].
iii. Calculate the return on the portfolio given that the surprises in inflation and GDP
growth are 1% and 0.6%, respectively, assuming that the error terms for ABC and
XYZ both equal 0.5%. [4
Marks]

b) An equity analyst at a pension fund uses the Carhart multifactor model to evaluate Zim
equity portfolios. The active return for the portfolio he manages is 2.0741%.
You are also given the following information on factor return and sensitivities;

Factor Sensitivity

Factor Portfolio Benchmar Factor Return

k

RMRF 0.95 1 5.52%

SMB -1.05 -1 -3.35%

HML 0.40 0.00 5.10%

WML 0.05 0.03 9.63%

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 i. What is thr return from factor tilts
ii.
iii. 63232333333 [ 5 Marks]
iv. What is the return from security selection [2
Marks].
c) A portfolio has two Assets A and B. The standard deviation for Asset A and B are 30% and
20% respectively. Given that the covariance of the two assets is 0.1, compute the weight
of A for the minimum variance portfolio [4
Marks].

QUESTION THREE.
a) Consider a three year 4.25% annual coupon bond puttable at par (100), one year and two
years from now. You are also given the following evolution of interest rates.

Determine the value of the puttable bond using the above information [8
marks].
b) Calculate the forward price three years from now for a $1 par, zero-coupon, two-year bond
given the following spot rates. The two-year spot rate is 4%. The three year spot rate is 5%.
The five-year spot rate is 6%.
[6 Marks]
c) Pinkie wants to value a three-year, 3% annual-pay Treasury bond and she wants to use a pathwise
valuation approach. The interest rate tree (One period Forward rates ) is shown below;

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 0 1 2

3% 5.7883% 10.7383%

3.880% 7.1981%

4.825%

What will be the value of the $100 par option-free bond [6 Marks]

QUESTION FOUR.
a) Suppose that the current stock price is $52 and the risk-free rate is 5%. You have found a
quote for a 3-month put option with an exercise price of $50. The put price is $1.50, but due
to light trading in the call -options, there was not a listed quote for the 3-month, $50 call.
Estimate the price of the 3-month call option using the Put-Call parity relationship.
[3 Marks]
b) The current price of the stock is $30, the risk-free rate is 7%, and the up and down- factors
are 1.333 and 0.75 respectively. Consider a two-period at the money put option that expires
at the end of two years.
i. Determine the hedge ratio at the end of period one for the up factor node(Su) . [2
Marks]
ii. Compute the value of this option using a two-step binomial tree. [5 Marks]
c) Calculate the no-arbitrage forward price for a 100-day forward contract on a stock that is
currently priced at $30.00 and is expected to pay a dividend of $0.40 in 15 days, $0.40 in 85
days, and $0.50 in 175 days. The annual risk-free rate is 5%, and the yield curve is flat.
[4 Marks]
d) Lee uses the Black scholes (BSM) model to value a call option, The current stock price (S) = $
57.03, exercise price (X)= $ 55, risk- free interest rate (r)= 0.22%, volatility (σ)= 32%, and
time to expiration (T) is 3 months. The outputs from the BSM model show that the d1 is
0.31 and d2 is 0.15. The underlying does not pay a dividend.
i. What is the value of this call opition? [4
Marks]
ii. Interpret the meaning of the N(d1) you computed above. [2
Marks]

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QUESTION FIVE
a) Christine Blake is a 35-year old free-lance writer of several successful children’s books. Her
primary source of income is royalty payments. She has accumulated a portfolio with a
current value of $3.6 million. Blake has always self-managed the portfolio and has
confidence in her investment abilities. Blake would like to be able to make independent
decisions when opportunities arise. On several occasions, Blake has found herself holding
positions with sizable losses and she has been reluctant to sell when a security declines.
Because of these losses and the general size of her portfolio, she is seeking professional
help. She is willing to consider higher risk investments if her research identifies an
attractive opportunity. Her current portfolio consists of 15 equity positions of equal dollar
value, diversified across eight industries and four different countries.

i. Explain the term “loss aversion bias” and show how it is displayed by Blake in her
investment decisions.
[ 6 Marks]
ii. Does Blake in constructing her portfolio seem to be affected by disposition effect and/or
home bias? Explain your answer. [6
Marks]

b) Malaba-investco is considering a four year capital project that requires an initial outlay of
€200,000.. Annual after-tax operating cash flows have a 50 percent probability of being
€40,000 for the four years and a 50 percent probability of being €80,000. Salvage value at
project termination is zero. The required rate of return is 10 percent. In one year, after
realizing the first-year cash flow, the company has the option to abandon the project and
receive the salvage value of €150,000.

i. Compute the project NPV assuming no abandonment. [2Marks]

ii. What is the optimal abandonment strategy? Compute the project NPV using that
strategy. [6 Marks]

END OF EXAMINATION PAPER

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Formula Sheet

The Black-Scholes Model formula

S σ2
ln (
K
)+(r + )T
2
d 2 =d 1 −σ √ T
d 1=
σ √T

Stock Simulation

(e μ− σ2 ) t+ σ √ t Z
2

St =S0

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