Investment Analysis and Portfolio Management

Christmas Worksheet 2008 2009

Question 1.
(i) Define the yield of a bond.
(ii) Four pure discount bonds, all with face values of $1000, and maturities of 1, 2, 3
and 4 years are priced at $980, $970, $960 and $950 respectively. Calculate their
yields.
(iii) An investor looks for a yield to maturity of 8% on her fixed income securities.
What would be the maximum price she should offer for a risk-free bond with a $1000
face value maturing in 3 years paying a coupon of $10 annually with the first payment
due one year from now? What is the maximum price if it is a pure discount bond?
(iv). Three pure discount bonds, all with face values of $1000, and maturities of 1, 2
and 3 years are priced at $930.23, $923.79 and $919.54 respectively. Calculate
a. the 1-year, 2-year and 3-year spot rates
b. the forward rates from years 1-2 and 2-3.
(v) Using the answer to (ii), price a bond that pays a coupon of $40, has a face value
of $1000 and matures in 3 years.
(vi) Using the answer to (iv), plot the term structure. Comment upon its form.
(vii) Does liquidity preference explain the term structure?
Question 2.
(i) Assume there are two risky stocks available. Stock A has an expected return of 5%
and a standard deviation of 6%. Stock B has an expected return of 8% and a standard
deviation of 9%.
a. Assuming the returns on the two stocks are uncorrelated plot the set of efficient
portfolios and mark on the minimum variance portfolio.
b. If all investors are risk averse, will short sales of either stock be observed?
(ii) Now introduce borrowing and lending at a risk-free rate of interest of 2%.
c. Plot the new efficient frontier.
d. Determine the structure of the tangency portfolio.

e. How will an increase in the rate of interest affect the percentage of stock A in the
tangency portfolio?
Question 3.
Assume that returns are generated by a model where the market is the single factor.
The details of the model for three stocks are:
Stock

Beta

ei

Portfolio weight

A
B
C

1.2
0.7
1.0

8
2
3

0.3
0.4
0.3

The expected return on the market is 10% with a standard deviation of 25%. The risk
free rate is 5%.
(i) What is the standard deviation of the return on the portfolio?
(ii) Explain why it is not possible to compute the expected return on the portfolio
using this data. What assumption can you make that will allow you to compute the
expected returns? What are the expected returns under this assumption?
(iii) Discuss the limitations of the market model as a guide to portfolio choice.

Question 4.
(i) Why would a security analyst consider adjusting historical betas?
(ii) Given the betas of a set of stocks, how can they be employed in portfolio
construction?
(iii) Assume there are two stocks, A and B, with A 0.8 and B 1.2 , and
idiosyncratic variations eA 2, eB 4 . If the variance of the return on the market
2
is M
36 , calculate the variance of a portfolio consisting of 120% of stock A.
(iv) What is the variance of the portfolio in (iii) if it is 30% financed by borrowing?
Question 5.
(i) Describe call and put options, making sure that you distinguish between American
and European. Show how a risk-free portfolio can be constructed using these options.
(ii) Describe how the binomial model can be used to price a call option.
(iii) Compute the equilibrium price of a European put option with 1 year until the
exercise date when the exercise price is 3.00, the current stock price 3.00, and the
stock price at the exercise date may be 3.30 or 3.15. Assume that the annual risk
free rate of return is 8%.
Question 6.
Consider two call options. Option 1 has an exercise price of $60 and sells for $5 while
option 2 has an exercise price of $55 and sells for $6. Assuming they have the same
expiration date, calculate the profit from the strategy of issuing two $60 call options
and purchasing one $55 call option. Sketch the level of profit versus the share price at
the expiration date.
Question 7.
a. Using the binomial pricing model calculate the value of a call option on a stock that
currently sells for 50 but may rise to 60 or fall to 45 when there is 1 year to expiry,
the risk free rate of return is 5% and the exercise price is 50.
b. Repeat (i) under the assumption that the year is split into
i. 2 periods
and
ii. 3 periods
but retaining the assumption that the highest price is achieved 60 and the lowest 45.

Question 8.
a. Using the binomial pricing model calculate the value of a put option on a stock that
currently sells for 30 but may rise to 33 or fall to 27 when there is 1 year to expiry,
the risk free rate of return is 5% and the exercise price is 30.
b. Use put-call parity to derive the value of a call option with the details as in (a).
Question 9.
If u = 1.3, d = 1.1 and R = 1.2, find the value of a call option on a stock with current
price P = 100 and exercise price E = 120 for a 4-period tree.
This work will be graded but will not be assessed.
Work to be submitted during lecture 1 next term.