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