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BEE 3016 UNIVERSITY OF EXETER SCHOOL OF BUSINESS AND ECONOMICS MAY/JUNE 2010 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT Duration: THREE HOURS FORMULA BOOKS ARE NOT PERMITTED Answer THREE out of EIGHT questions Calculators permitted 1. (i) Describe what the Capital Asset Pricing Model (CAPM) is intended to explain. [8 marks] (ii) What assumptions does the CAPM make? Which of these assumptions are not made by the Markovitz model of portfolio choice? What is the consequence of the additional assumptions? [8 marks] (iii) What is the security market line? If the CAPM is true, will all securities have observed returns that are on the security market line? Explain your answer. [10 marks] 2. (iv) How can you use CAPM to value a new issue of stock? [7 marks] (i) What is the single index model? [3 marks] (ii) Assume that asset returns are generated by a model for which the market is the single index. The details of the model for three stocks are: Stock Alpha Beta A B C 0.1 -0.2 0.3 1.2 0.75 0.9 e 2 1 1 i The expected return on the market is 12% with a standard deviation of 25%. The risk free rate is 5%. a. Plot the portfolio frontier for stocks A and B. b. Plot the portfolio frontier for stock B and C. c. How would you construct the portfolio frontier for all three stocks? [15 marks] (iii) An investor you are advising has decided to short sell stock A to finance the purchase of stock B. Would you advise for or against this investment? Explain your reasoning. [5 marks] (iv) Are the data in the table consistent with the predictions of the Capital Asset Pricing Model? If not, would this imply rejection of the CAPM or the single index model? [10 marks] [Turn over] 3. i. What is a fixed-interest security? Why are these securities risky? How would you determine the riskiness of a particular fixed income security? [8 marks] ii. Define the “yield to maturity”. Why is this concept used? [4 marks] iii. The table provides information on four bonds. Use this information to determine the yield to maturity on these bonds. What can explain the difference in yields for bonds C and D? Bond A B C D Maturity 1 2 3 3 Coupon 0 10 20 10 Face Value 1000 1000 1000 1000 Price 990 980 960 975 [10 marks] iv. Using the results for bonds A, B, and D calculate the implied spot rates and plot the term structure. Provide an explanation of the term structure. [11 marks] 4. (i) What is an option? Describe the major features of call and put options, and distinguish between European and American options. [6 marks] (ii) Explain the put-call parity relationship. A stock is currently trading at £10. A European call option on that stock which expires in 3 months and has an exercise price of £11 is currently trading at £1. If the (annual) risk-free rate of return is 6%, what is the price of a put option on the stock with the same exercise price and expiry date? [6 marks] (iii) Compute the equilibrium price of a European put option with 6 months until the exercise date if the exercise price is £5.10, the current stock price £5.00, and the stock price at the exercise date may be £5.25 or £4.80. Assume that the annual risk free rate of return is 5%. [7 marks] (iv) Repeat the analysis using £5.25 as the maximum price the stock may reach after 9 months and £4.80 as the minimum price but with the time until exercise divided into (a) two sub-periods; (b) three sub-periods. Explain why your answers differ from that to (iii). Which answer is “best”? [8 marks] (v) How would the answer to (iv) change if the option were American? [6 marks] [Turn over] 5. Discuss how the domestic US housing boom and subsequent bust occurred and how it became the catalyst for the global credit crisis. Your answer should include: a) A description of the factors that contributed to the US housing boom in subprime and, in particular, the development of the originate and distribute banking model. b) How its collapse became the catalyst for the recent global credit crisis. c) Some of the potential reforms which might prevent a re-occurrence of the US housing crisis. [33 marks] 6. Warren Buffett is quoted as saying “When you combine leverage and ignorance you get some pretty interesting results” Discuss the concept of financial leverage. Your answer should include examples of how financial leverage can be achieved, the role that leverage played in the recent financial crisis and examples of organizations that took excessive leverage and the consequence of this. 7. Timothy Sinclair describes the credit rating agencies as “second superpowers”, referring to their importance in investment decisions. Discuss: a) The role of the credit rating agencies. b) The role that the rating agencies played in the credit crisis. c) Suggested reforms to the rating agencies following the crisis. 8. [11 marks] [11 marks] [11 marks] You are a fund manager in charge of a large bank bond fund. You have just been called by an eager salesman from an investment bank telling you about a new issue from a bank that is about to be launched and asking if your fund would like to buy the new bond. Discuss some of the questions you might ask the salesman and the criteria you would use to determine whether the bond has been accurately priced before deciding whether to invest. [33 marks] END OF PAPER