Faculty of Economics and Business Administration

Exam:

Financial Management 2.2 BK / IBA

Code:

E_BK2_FM / E_IBA2_FM

Examinator:
Co-reader:

Dr. Vincent van Kervel

Arjen Siegmann

Date:

11 dec. 2015

Time:

11.45

Duration:

3 hours

Calculator allowed:

Yes

Graphical calculator
allowed:

Yes

Version A

Number of questions: 40
Type of questions:

multiple choice

Answer in:

English

Remarks:

Credit score:

Grade 6 will be given for 27 correct answers (with reservations)

Grades:

Will be made public Jan. 4, the latest

Inspection:

By appointment with dr. Siegmann (co-reader)

Number of pages:

15 (including this page)

Good luck!
Version A:
B1 t/m B20 = A21 t/m A40
B21 t/m B40 = A1 t/m A20

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38 A
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Chapter 10:
1) Suppose an investment is equally likely to have a 30% return or a -20% return. The standard
deviation (rounded to nearest percentage) on the return for this investment is closest to:
A) 6%
B) 20%
C) 25%
D) 35%
Answer: C
Expected return is 5%. So Var= ((30-5)^2+(-20-5)^2 )/2. Stdev = Sqrt(Var) = 25%
Diff: 2
Section: 10.2 Common Measures of Risk and Return
Skill: Analytical
2) Which of the following statements is FALSE?
A) The standard deviation is the square root of the variance.
B) Because investors dislike only negative resolutions of uncertainty, alternative measures that
focus solely on downside risk have been developed, such as the semi-variance and the expected
tail loss.
C) While the variance and the standard deviation are the most common measures of risk, they do
not differentiate between upside and downside risk.
D) While the variance and the standard deviation both measure the variability of the returns, the
variance is easier to interpret because it is in the same units as the returns themselves.
Answer: D
Explanation: D) While the variance and the standard deviation both measure the variability of
the returns, the standard deviation is easier to interpret because it is in the same units as the
returns themselves.

Consider the following realized returns:

Stock X Stock Y
Realized Realized
Year End Return
Return
2004
20%
-14%
2005
30%
4%
2006
-25%
-58%

2007

56%

34%

3) The sample covariance between Stock X's and Stock Y's returns falls in the range (Hint: use
the formula for calculating the sample covariance from the formula sheet)
A) [-10%, 0%]
B) [0%, 5%]
C) [5%, 10%]
D) [10%, 15%]
Answer: D)
Sample covariance divides by T-1=3 (whereas population covariance divides by T=4).
Average X=20.25%; Average y=-8.5%. Subtract the averages from the realizations. Then
Cov sample = 1/3*(-.25*-5.5+9.75*12.5+-45.25*-49.5+35.75*42.5) = 0.129

4) The sample standard deviation on a portfolio that is made up of 40% X and 60% Y stock falls
in the range:
A) [35%, 40%]
B) [40%, 45%]
C) [45%, 50%]
D) [50%, 55%]
Answer: A) Create returns of the portfolio each period, and take the standard deviation: 36.56%
5) Which of the following statements is FALSE?
A) Because investors are risk averse, they will demand a risk premium to hold unsystematic risk.
B) Over any given period, the risk of holding a stock is that the dividends plus the final stock
price will be higher or lower than expected, which makes the realized return risky.
C) The risk premium for diversifiable risk is zero, so investors are not compensated for holding
firm-specific risk.
D) Because investors can eliminate firm-specific risk "for free" by diversifying their portfolios,
they will not require a reward or risk premium for holding it.
Answer: A
Explanation: A) Because investors are risk averse, they will demand a risk premium to hold
systematic risk.

Chapter 11:
Suppose you have a portfolio where you invest 40% in stock Intel and 60% in stock ATP. The
expected return of ATP is 10%, with a standard deviation of 40%. The expected return of Intel is
15% with a standard deviation of 50%.
6) The correlation between both assets is 0.30. The standard deviation of your portfolio falls in
the range:
A) [0.35, 0.40]
B) [0.40, 0.45]
C) [0.45, 0.50]
D) [0.50, 0.55]

Answer: A
Cov[intel,ATP]= (0.3*0.4*0.5)=0.06
SD(portfolio) =Sqrt(0.4^2*0.4^2+0.6^2*0.5^2+2*0.6*0.4*(0.06) ) = 0.38

7) Which of the following statements is FALSE?

A) Stock returns will tend to move together if they are affect similarly by economic events.
B) Stocks in the same industry tend to have more highly correlated returns than stocks in
different industries.
C) Almost all of the correlations between stocks are negative, illustrating the general tendency of
stocks to move together.
D) With a positive amount invested in each stock, the more the stocks move together and the
higher their covariance or correlation, the more variable the portfolio will be.
Answer: C
Explanation: C) Almost all of the correlations between stocks are positive, illustrating the
general tendency of stocks to move together.

Consider the following covariances between securities:

Duke
Microsoft Wal-Mart
Duke
0.0568
-0.0193
0.0037
Microsoft
-0.0193
0.2420
0.1277
Wal-Mart
0.0037
0.1277
0.1413
8) The variance on a portfolio that is made up of equal investments in Duke Energy and
Microsoft stock is closest to:
A) [0, 0.05]
B) [0.05, 0.10]
C) [0.10, 0.15]
D) [0.15, 0.20]
Answer: B
Explanation: Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2)
= (.50)2(0.0568) + (.50)2(0.2420) + 2(.5)(.5)(-0.0193) = 0.0651

9) Which of the following statements is FALSE?

A) Efficient portfolios can be easily ranked, because investors will choose from among them
those with the highest expected returns.
B) We can rule out inefficient portfolios because they represent inferior investment choices.
C) The volatility of a portfolio depends on the correlation between the securities in the portfolio.
D) Correlation has no effect on the expected return of a portfolio.
Answer A.

Suppose that the risk-free rate is 5% and the market portfolio has an expected return of 10% with
a volatility of 25%. Monsters Inc. has a 35% volatility and a correlation with the market of 0.60.
Assume the CAPM assumptions hold.
10) Monsters' required return falls in the range:
A) [0%, 5%]
B) [5%, 10%]
C) [10%, 15%]
D) [15%, 20%]
Answer: B
Explanation: C) beta = Corr[monster,market] * SD[Monster]/SD[Market]= 0.6*0.35/0.25=0.84.
ri = rf + b(E[RMkt] - rf)
= .05 + .84(.10 - .05) =.092

11) Which of the following statements is FALSE?

A) A short sale is a transaction in which you buy a stock that you do not own and then agree to
sell that stock back in the future.
B) The efficient portfolios are those portfolios offering the lowest possible level of volatility for a
given level of expected return.
C) A positive investment in a security can be referred to as a long position in the security.
D) It is possible to invest a negative amount in a stock or security. This is called a short position.
Answer: A
Explanation: A) A short sale is a transaction in which you sell a stock that you do not own and
then agree to buy that stock back in the future.

Chapter 12:
Use the following table for the next two questions:
Suppose all possible investment opportunities in the world are limited to the four stocks listed in
the table below:
Price per
Number of Shares
Stock
Share
Outstanding (Millions)
Taggart Transcontinental
$15.60
25
Rearden Metal
$13.00
45
Wyatt Oil
$29.25
10
Nielson Motors
$26.25
26
12) The weight on Wyatt Oil stock in the market portfolio is closest to:
A) 15%
B) 20%
C) 25%

D) 30%
Explanation: A)
Calculations

Stock
Taggart Transcontinental
Rearden Metal
Wyatt Oil
Nielson Motors
Total

BC
Price per
Share
$15.60
$13.00
$29.25
$26.25

Number of Shares
Outstanding
(Millions)
25
45
10
26

Market
Cap
$390.00
$585.00
$292.50
$682.50
$1950.00

D/1950

Weight
0.2
0.3
0.15
0.35

13) Suppose that you have invested $100,000 invested in the market portfolio and that the stock
price of Taggart Transcontinental suddenly drops to $7.80 per share. Which of the following
trades would you need to make in order to maintain your investment in the market portfolio:
1. Buy approximately 1,140 shares of Taggart Transcontinental
2. Sell approximately 256 shares of Rearden Metal
3. Sell approximately 57 shares of Wyatt Oil
4. Sell approximately 148 shares of Nielson Motors
A) 1 only
B) 2, 3, and 4 only
C) 1, 2, 3, and 4
D) None of the above
Answer: D
Explanation: D) There is no need to rebalance your portfolio. As an investor, you still hold the
market portfolio and therefore there are no trades needed.

14) Which of the following statements is FALSE?

A) One difficulty when trying to estimate beta for a security is that in the CAPM theory the beta
depends on the correlation and volatilities of the security's and market's returns in the future.
B) It is common practice to estimate beta based on the expectations of future correlations and
volatilities.
C) One difficulty when trying to estimate beta for a security is that beta depends on investors
expectations of the correlation and volatilities of the security's and market's returns.
D) Securities that tend to move less than the market have betas below 1.
Answer: B
Explanation: B) Beta is measured using past information.

Consider the following information regarding corporate bonds:

Rating
AAA AA
A
BBB BB
B
CCC
Average Default Rate 0.0% 0.1% 0.2% 0.5% 2.2% 5.5% 12.2%
Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0%
Average Beta 0.05 0.05 0.05 0.10 0.17 0.26 0.31

15) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of
8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%.
Assuming a normal economy the expected return on Rearden Metal's debt is closest to:
A) 0.6%
B) 1.6%
C) 4.6%
D) 6.0%
Answer: D
Explanation: D) rd = ytm - prob(default) loss rate = 8.6% - 5.2%(50%) = 6.00%
Diff: 2
Chapter 13
Assume that the CAPM is a good description of stock price returns. The market expected return
is 8% with 12% volatility and the risk-free rate is 3%. Suddenly macro-economic news arrives.
Because of the news, you change the expected returns of the following stocks according to the
table below:

Stock
Taggart Transcontinental
Rearden Metal
Wyatt Oil
Nielson Motors

Expected
Return after
the news
8%
13%
7%
10%

Volatility
28%
40%
20%
32%

Beta
1.2
1.7
0.8
1.3

16) Which of the following stocks represent buying opportunities?

1. Taggart Transcontinental
2. Rearden Metal
3. Wyatt Oil
4. Nielson Motors
A) 1 only
B) 1 and 2 only
C) 2 and 3 only
D) 2 and 4 only
Answer: D
Explanation: D) i = E[rs] - rf - i(rm - rf), where rf - i(rm - rf) is the CAPM return
Expected
Stock
Return Volatility Beta
Taggart Transcontinental
8%
28%
1.2
Rearden Metal
13%
40%
1.7
Wyatt Oil
7%
20%
0.8
Nielson Motors
10%
32%
1.3

CAPM
Return
9.00%
11.50%
7.00%
9.50%

Alpha
-1.00%
1.50%
0.00%
0.50%

Both Rearden Metal and Nielson Motors represent buying opportunities due to their positive

expected alphas.

17) Which of the following is FALSE regarding individual investor behavior?

A) Individual investors fail to diversify their portfolios adequately.
B) A vast majority of individual investors hold fewer than 10 stocks in their portfolio.
C) Employees tend to underinvest in their company's own stock.
D) Individual investors who trade more actively tend to perform worse.
Answer: C, individuals tend to overinvest

Assume that the economy has three types of people: 20% are fad followers, 75% are passive
investors holding the market portfolio, and 5% are informed traders. The portfolio consisting of
all informed traders has a beta of 1.4 and an expected return of 16%. The market has an expected
return of 10% and the risk-free rate is 4%.
18) The alpha for the informed investors is closest to:
A) -2.4%
B) -0.9%
C) 0.0%
D) 3.6%
Answer: D
Explanation: D) i = E[rs] - rf - i(rm - rf) = 16% - 4% - 1.4(10% - 4%) = 3.6%
19) In practice we use proxies for the true market portfolio. Which of the following investments
is NOT represented by such proxies:
A) Human capital
B) Stocks
C) Bonds
D) Precious metals
Answer: A
20) Which of the following statements is FALSE?
A) An investment with a positive CAPM alpha contains a systematic risk other than the market
portfolio.
B) We might be using the wrong proxy portfolio when we calculate alphas.
C) If the CAPM correctly computes the risk premium, an investment opportunity with a positive
alpha is a positive NPV investment opportunity.
D) If the CAPM correctly computes the risk premium, investors should flock to invest in positive
alpha stocks.
Answer A: No, the investment may simply be mispriced.

21) Which of the following statements is FALSE?

A) A portfolio that costs nothing to construct is called a self-financing portfolio.

B) In general, a self-financing portfolio is any portfolio with portfolio weights that sum to one
rather than zero.
C) We can construct a self-financing portfolio by going long some stocks, and going short other
stocks for the same dollar value.
D) The market portfolio is not a self-financing portfolio, because the portfolio weights sum to
one.
Answer B); self financing portfolio weights sum to 0.
Chapter 20:
22) Using options to place a bet on the direction in which you believe the market is likely to
move is called:
A) speculation.
B) hedging.
C) Straddle.
D) Butterfly.
Answer: A

23) With which option portfolio can you obtain the following payoff:
25
20
15
10
5
0
0

10

20

30

40

50

60

A) A long put, a short call and two long calls.

B) A long put, a long call and a short call.
C) A short put, a long call and a long put.
D) A short put, a short call and a long put.
Answer B, long put at 20, long call at 20 and short call at 30.

24) You are looking at quoted option prices on the CBOE (Chicago Options Board Exchange).
Can one of the American options have a negative time-value?
A) Yes, for puts and calls.
B) Yes, but only for puts.
C) No, because arbitrage would be possible.

D) Yes, but only if dividends are paid.

Answer C: With negative time value, you can buy the option and exercise immediately with a
profit.
25) Luther Industries is currently trading for $27 per share. The stock pays no dividends. A oneyear European put option on Luther with a strike price of $30 is currently trading for $2.60. If
the risk-free interest rate is 6% per year, then the price of a one-year European call option on
Luther with a strike price of $30 will lie in the interval:
A) [1$, 2$]
B) [2$, 3$]
C) [3$, 4$]
D) [4$, 5$]
Answer: A
Explanation: A) C = P + S - PV(K) - PV(Div)
C = $2.60 + $27 -

- $0 = $1.2981

26) You have calculated the price of a call option using the put-call parity, and find that your
price is $1 higher than the price currently traded in the market. With which position can you earn
a riskless arbitrage?
A) Go long in the call, short the underlying stock and save money on the bank.
B) Go short in the call, long in the underlying stock and borrow money from the bank.
C) Go long in the call, long the underlying stock and save money on the bank.
D) Go short in the call, short in the underlying stock and borrow money from the bank.
Answer: A. The option is traded at a too low (cheap) price. Thus, you go long (buy) the option.
Now you want to hedge this position with the replicating portfolio to make a riskless profit. That
is, you want to short the replicating portfolio. A call option is replicated by a long stock position
and borrowing money. To short the replication portfolio, you go short in the stock and save
money.
27) Which of the following statements is FALSE?
A) An American call on a non-dividend-paying stock has the same price as its European
counterpart.
B) The price of any call option on a non-dividend-paying stock always exceeds its intrinsic value.
C) For dividend paying stocks, it is never optimal to exercise a call option early.
D) If present value of the dividend payment is large enough, the time value of a European call
option can be negative, implying that its price could be less than its intrinsic value.
Answer: C
Explanation: C) It is never optimal to exercise a call option on a non-dividend-paying stock
earlyyou are always better off just selling the option.
Chapter 21
The current price of KD Industries stock is $290. In the next year the stock price will either go
up by 10% or go down by 15%. KD pays no dividends. The one year risk-free rate is 3% and
will remain constant.

28) Using the binomial pricing model, the calculated price of a one-year call option on KD stock
with a strike price of $290 is closest to:
A) $4
B) $8
C) $16
D) $20
Answer: D)
Price is 20.28. Stock up is 1.1*290=319. Stock down is 0.85*290=246.5.
Delta=
B=

=(29-0)/(319-246.5)=0.4.
=(0-0.4*246.5)/1.03=-95.72. C=D*S+B=0.4*290-95.72=20.28

29) Which of the following statements is FALSE?

A) If you take the option price quoted in the market as an input and solve for the volatility you
will have an estimate of a stock's volatility known as the implied volatility.
B) The Black-Scholes formula can be used to price American or European call options on nondividend-paying stocks.
C) We need to know the expected return on the stock to calculate the option price in the BlackScholes Option Pricing Model.
D) We can use the Black-Scholes formula to compute the price of a European put option on a
non-dividend-paying stock by using the put-call parity formula.
Answer: C
Explanation: C) We do not need to know the expected return on the stock to calculate the option
price in the Black-Scholes Option Pricing Model.
30) You are looking at a very deep out-the-money call option. The term N(d1) in the BlackScholes model is:
A) close to zero
B) is negative
C) is close to one
D) None of the above
Answer: A call option always have a positive delta. However, if its far out-of-the-money, the
delta gets smaller, and goes towards zero.
Chapter 22:
31) Which of the following statements on the option to delay is FALSE?
A) One way to see why you sometimes choose not to invest in a positive-NPV project is to think
about the decision of when to invest as a choice between two mutually exclusive projects: (1)
invest today or (2) wait.
B) You invest today only when the NPV of investing today exceeds the value of the option of
waiting, which from option pricing theory we know to be always positive.
C) When you do not have the option to wait, it is optimal to invest in any positive-NPV project.
D) If there is a lot of uncertainty, the benefit of waiting is diminished.

Explanation: D) If there is a lot of uncertainty, the benefit of waiting is increased.

Suppose you are considering to invest in a project that costs $1mln. With probability 50% the
project is successful and will generate a cashflow of $100,000 yearly. Otherwise, the project fails
and yields nothing. After one year, the project has an option to grow: for an additional investment
of $1 mln the size of the cashflows of the project double to $200,000 per year. The discount rate
is 6%.
32) The value of the project, including the option to expand, falls in the range:
A) [-200,000$, 0]
B) [0, 100,000$]
C) [100,000$, 200,000$]
D) [200,000$, 300,000$]
Answer C: NPV of project without option: -1,000,000+50%*100,000/0.06=-$167,000.
Clearly, we use the option to expand only if the project is successful (50%), which we know after
1 year:
=0.5*1/1.06*(-1,000,000+100,000/0.06)=$315,000
Combined, the project + option yields -167+315=$148,000
33) The major principles to remember when considering real options include all of the following
EXCEPT:
A) out-of-the-money real options have value.
B) in-the-money real options need to be exercised immediately.
C) waiting is valuable.
D) create value by exploiting real options.
Answer: B
Section: 22.7 Key Insights from Real
Chapter 30
A company is considering to buy a one-year insurance policy against hurricane damage for a
price of $2 mln. The damage in case of a hurricane is $100 mln. The interest rate is 5%.
34) What is the probability of a hurricane, assuming the insurance is priced actuarially fair?
A) 1.9%
B) 2.0%
C) 2.1%
D) 2.2%
Answer B: We know that P(loss) * 100 / 1.05 = 2 mln. So, P(loss) is 2 / (100/1.05)=2.1%
35) Which types of costs are relevant to an insurance company when selling insurance?
A) Issuance costs and managerial incentives
B) The costs of moral hazard and adverse selection
C) Distress costs and moral hazard
D) The costs of tax rate fluctuations and debt capacity
Answer B
36) In reality market imperfections exist that can raise the cost of insurance above the actuarially

fair price and offset some of these benefits. These insurance market imperfections include all of
the following EXCEPT:
A) adverse selection.
B) agency costs.
C) administrative and overhead costs.
D) taxation of insurance payments.
Answer: D
37) Which of the following statements is FALSE?
A) Not all insurable risks have a beta of zero. Some risks, such as hurricanes and earthquakes,
create losses of tens of billions of dollars and may be difficult to diversify completely.
B) When a firm buys insurance, it transfers the risk of a loss to an insurance company. The
insurance company charges an upfront premium to take on that risk.
C) Insurance for large natural disasters is generally a positive beta asset: when disaster strikes,
the insurance company loses and the market portfolio is low.
D) Because insurance provides cash to the firm to offset particular losses, it can reduce the firm's
need for external capital and thus reduce issuance costs.
Answer: C
Explanation: C) Owning insurance is a negative-beta asset. For the insurance company it is a
positive beta investment because they sell it (ie, go short).

You are a risk manager for Security First Trust Savings and Loan (SFTSL). SFTSL's balance
sheet is as follows (in millions of dollars):
Assets
Cash reserve
Auto loans
Mortgages
Total assets

20
30
40
90

Liabilities
Checking & Savings
Certificates of Deposit
Long-term financing
Total Liabilities
Owners Equity
Total

30
25
30
85
5
90

The duration of the auto loans is four years and the duration of the mortgages is ten years. Both
cash reserves and checking and savings have zero duration. The CDs have a duration of three
years and the long-term financing has a twelve year duration.
38) The duration of SFTSL's equity is closest to:
A) 7 years
B) 9 years
C) 11 years
D) 13 years
Answer: A
Explanation:
Dassets = 2/9 0(cash) + 3/9 4(auto) + 4/9 10(mortgage) = 5.33 years

Dliabilities = 300/850 0(checking) + 25/85 3(CDs) + 30/85 12 (Long Term) = 5.22 years.
A=90, L=85.
A
L
Dequity = Dassets-liabilities =
DA DL = 7.2 years
AL
AL
You are a Chinese investor who is trying to calculate the present value of $5 million cash inflow
that will occur one year in the future. The spot exchange rate is S = 1.8839/$ and the forward
rate is F1 = 1.8862/$. The appropriate yen discount rate for this cash flow is 5.32% and the
appropriate $ discount rate is 5.24%.
39) The present value of the $5 million cash inflow computed by first converting into yen and
then discounting is closest to:
A) $8,950,495
B) $8,954,615
C) $8,943,695
D) $8,961,420
Answer: B
Explanation: B) FV = $5 million 1.8862/$ = 9,431,000
PV = 9,431,000 /1.0532 = 8,954,615, answer B)
40) Which of the following statements is FALSE?
A) U.S. tax policy requires U.S. corporations to pay taxes on their foreign income at the same
rate as profits earned in the United States.
B) The home government gets an opportunity to tax the income from a foreign project to the
domestic firm.
C) The general international arrangement prevailing with respect to taxation of corporate profits
is that the home country gets the first opportunity to tax income.
D) The home government must establish a tax policy specifying its treatment of foreign income
and foreign taxes paid on that income.
Answer: C
Explanation: C) The general international arrangement prevailing with respect to taxation of
corporate profits is that the host country gets the first opportunity to tax income produced within
its borders.