Undergraduate Programs in Economics and Business Administration

Finance I – Endterm Exam

Fall 2019

NAME:
NUMBER:
INSTRUCTIONS:
• You are allowed 120 minutes for this exam plus 15 minutes of tolerance.
• Answer each group in a separate sheet and return the questions statement filled with
your name and number. Only answers in the proper answering sheets will be considered,
meaning that answers in scratch paper will not be considered.
• Please write neatly. Illegible answers will be assumed to be incorrect.
• You can answer the exam in pencil. However, the final answers and final values need to
be written with a pen.
• In order to receive full credit, you must show all your work, including all computations.
• Please round off the final results to three decimal places.
• In the exam the “,” is the thousands separator and the “.” is the decimal separator.
• No questions will be answered during the exam. Any problem with the exam will be
rectified in the same way to all students.
• Good luck!

Volatility of a portfolio with N stocks Minimum variance portfolio with N=2

/ 5// 056/
𝜎"# = ∑( # # ( 0(
')* 𝜔' 𝜎' + ∑'1, 𝜔' 𝜔, 𝜎' 𝜎, 𝜌';, 𝜔*234 = , 𝜔#234 = 1 − 𝜔*234
56 75// 0#56/
/

Capital Market Line Security Market Line

𝐸[𝑟2 ] − 𝑟A
𝐸[𝑟>2? ] = 𝑟A + B C 𝜎>2? 𝑟ED = 𝑟A + 𝛽' G𝐸[𝑟2 ] − 𝑟A H
𝜎2

Price of a European Call (Black&Scholes)

W
TUV [
𝐶 = 𝑆K × 𝑁(𝑑* ) − 𝑃𝑉(𝐾) × 𝑁(𝑑# ) 𝑑* = XY(Z)
+
5√]
, 𝑑# = 𝑑* − 𝜎√𝑇
5√] #

1A
 Section I (4 points) – 25 minutes
In this section for each question you are supposed to choose one of the several available choices. For
each wrong answer you will be deducted 15% of the question points. This section cannot have a final
negative mark, being the minimum zero. Please insert your answer in the proper answering box
below.

1) Select the completely correct answer.

a. Assume that the covariance between two stocks is negative. When the return of one
stock is higher than its own expectation the return of the other stock is always below
its own expectation.
b. Consider that the coefficient of correlation between two stocks is +1. This implies
that when the return of one stock increases by 5pp (pp - percentage points), the
return of the other increases by 5pp (pp – percentage points).
c. The covariance between a stock and itself is +1.
d. Answers b. and c. are correct.
e. None of the above is completely correct.

2) Stocks X and Y expected returns are 20% and 10%. Stock X’s volatility is two-times higher
than stock Y’s volatility. The returns on stocks X and Y are independent. The risk-free rate is
2%.

Select the correct answer.

a. The weight on Y for the minimum variance portfolio between X and Y is 20%.
b. A portfolio that is invested 20% in X and 80% in Y has a zero volatility.
c. Consider a portfolio “P” that is invested 50% in X and 50% in Y. The higher the
stock’s Y volatility, the lower will be the Sharpe Ratio of portfolio P.
d. Consider that you want to create a portfolio W that combines stocks X and Y, which
has an expected return of 12%. If the coefficient of correlation between X and Y
increases, the standard deviation of portfolio W increases.
e. Answers c. and d. are correct.
f. None of the above is completely correct.

3) Select the correct answer.

a. The Sharpe Ratio of a portfolio that combines the riskless asset and portfolio X
always has the same Sharpe Ratio as portfolio X.
b. The CML can give you the expected return of a portfolio that combines three stocks
and has a given standard deviation.
c. The SML only provides equilibrium returns of efficient portfolios.
d. Answers a., b. and c. are correct.
e. None of the above is completely correct.

2A
4) Select the correct answer.
a. Portfolio’s diversification decreases the portfolio’s total risk.
b. Two stock that are in equilibrium and have the same exposure to systematic risk,
should present the same equilibrium expected return.

c. Consider that you created a portfolio with equal weights in 5 stocks. If the
coefficient of correlation for each pair of stocks is +1 you can compute the
portfolio’s standard deviation using the following expression: 𝜎4 = ∑' 𝜔' 𝜎' .
d. Answers b) and c) are correct.
e. None of the above is completely correct.

Question 1 2 3 4

Answer (Insert only one or leave it blank)

Question 1 2 3 4

Answer (Insert only one or leave it blank) b. e. a. d.

3A
 Section II (7 points) – 40 minutes

Consider the following information:

Equilibrium Price0 Market Price0 DPS1 gDPS

Stock A €1.6 €1.6 €0.1 0
Stock B €2.30 €2.00 €0.2 2%
Stock C €1.00 €1.30 €0.08 4%

SML: E(r' ) = 0.03 + 𝛽' 0.05

Assume that all firms are in steady state (gP = gDPS) and CAPM assumptions are valid. The standard
deviation of the market portfolio is 4%.

a. (1 point) Find the equilibrium expected returns and betas for stocks A, B and C.

Solution:
Using the equilibrium prices, we can get the equilibrium expected returns:
0.1
𝑟Ei = 0 + = 6.25%
1.6
0.2
𝑟Em = 0.02 + = 10.70%
2.3
0.08
𝑟E> = 0.04 + = 12%
1

Next, find the betas using the SML:

0.0625 − 0.03
𝛽i = = 0.65
0.05
0.1070 − 0.03
𝛽m = = 1.54
0.05
0.12 − 0.03
𝛽> = = 1.80
0.05

b. (1 point) Are stocks A, B and C overvalued, undervalued or correctly priced?

Solution:
K.*
𝑟ri = 0 + *.s = 6.25% = 𝑟Ei : is correctly priced.

K.#
𝑟rm = 0.02 + #
= 12% > 𝑟Em = 10.70%: is underpriced.

K.Ku
𝑟r> = 0.04 + *.v
= 10.15% < 𝑟E> = 12%: is underpriced.

Consider also the following covariance matrix:

A B C
A 0.01 0 - 0.001
B - 0.04 0.001
C - - 0.0225

4A
 c. (1 point) Assume only for this question that stocks A, B, C are in equilibrium. Find the
expected return and standard deviation of an equally weighted portfolio in A, B and C.

Solution:
1 1 1
𝐸(𝑟4 ) = x 𝜔' 𝐸(𝑟' ) = × 0.0625 + × 0.1070 + × 0.12 = 9.65%
3 3 3
'
( ( /~•

𝑉𝑎𝑟G𝑟" H = x 𝜔'# 𝜎'# + x 𝜔' 𝜔, 𝑐𝑜𝑣G𝑟' ; 𝑟, H

')* '1,
#
1 1 # 1 # 1 1
= € • × 0.01 + € • × 0.04 + € • × 0.0225 + 2 × × × 0
3 3 3 3 3
1 1 1 1
+ 2 × × × (−0.001) + 2 × × × 0.001 = 0.0081
3 3 3 3
𝜎" = √0.0081 = 8.98%

d. (1.5 points) Assume that you have €120,000. Suppose that you borrow additional €12,000 at
the riskless rate and you invest the total (€132,000) in stock A. Find the expected return,
standard deviation and beta of this portfolio.

Solution:
132,000
𝜔i = = 1.1
120,000
𝜔A = −0.1

𝐸(𝑟4 ) = x 𝜔' 𝐸(𝑟' ) = − 0.1 × 0.03 + 1.1 × 0.0625 = 6.575%

'
( ( /~•

𝑉𝑎𝑟G𝑟" H = x 𝜔'# 𝜎'# + x 𝜔' 𝜔, 𝑐𝑜𝑣G𝑟' ; 𝑟, H = 𝜔i# 𝜎i#

')* '1,

𝜎" = ‚𝜔i# 𝜎i# = 𝜔i 𝜎i = 1.1 × √0.01 = 11%

Using the SML: 0.06575 = 0.03 + 𝛽4 0.05ó𝛽4 = 0.715

e. (1.25 points) Find a portfolio that has the same standard deviation as the portfolio in d. but
presents the highest possible expected return. What can you conclude regarding the portfolio
in d.?

Solution:
Portfolio X: rf + Market portfolio
( ( /~•

𝑉𝑎𝑟(𝑟ƒ ) = x 𝜔'# 𝜎'# # #

+ x 𝜔' 𝜔, 𝑐𝑜𝑣G𝑟' ; 𝑟, H = 𝜔2 𝜎2
')* '1,

# #
𝜎ƒ = ‚𝜔2 𝜎2 = 𝜔2 𝜎2
𝜎ƒ = 𝜔2 𝜎2 ó0.11 = 𝜔2 0.04ó𝜔2 = 2.75
𝜔A = 1 − 2.75 = −1.75

5A
𝐸(𝑟ƒ ) = 𝜔A 𝑟A + 𝜔2 𝐸(𝑟2 )ó 𝐸(𝑟ƒ ) = −1.75 × 0.03 + 2.75 × 0.08 = 16.75%

The expected return on portfolio X is higher than the portfolio in question d., even though they have
the same risk. This means that the portfolio in d. is not efficient.

f. (1.25 points) Assume only for this question that you can only combine the riskless asset with
stock A, stock B or stock C, and all these stocks are in equilibrium. Also, consider that you
cannot have short positions in the riskless asset. What is the most efficient portfolio that has
an expected return of 10.70%? Compute its standard deviation and beta.
(Note: no graph required)

Solution:
First check all Sharpe Ratios:
𝐸 (𝑟i ) − 𝑟A 0.0625 − 0.03
𝑆𝑅i = = = 0.325
𝜎i 0.1
𝐸 (𝑟m ) − 𝑟A 0.1070 − 0.03
𝑆𝑅m = = = 0.38
𝜎m 0.2
𝐸(𝑟> ) − 𝑟A 0.12 − 0.03
𝑆𝑅> = = = 0.6
𝜎> 0.15

For this portfolio you should combine the riskless asset and stock C:
𝐸(𝑟4 ) = 𝜔A 𝑟A + 𝜔> 𝐸(𝑟> )ó 𝐸(𝑟4 ) = 𝑟A + 𝜔> …𝐸(𝑟> ) − 𝑟A †ó0.1070 = 0.03 + 𝜔> (0.12 − 0.03)ó
𝜔> = 85.56%
𝜔A = 1 − 0.8556 = 14.44%
( ( /~•

𝑉𝑎𝑟G𝑟" H = x 𝜔'# 𝜎'# + x 𝜔' 𝜔, 𝑐𝑜𝑣G𝑟' ; 𝑟, H = 𝜔># 𝜎>#

')* '1,

𝜎" = ‚𝜔># 𝜎># = 𝜔> 𝜎> = 0.8556 × √0.0225 = 12.83%

𝛽" = x 𝜔' 𝛽' = 0.1444 × 0 + 0.8556 × 1.8 = 1.54

'

6A
 Section III (3.5 points) – 25 minutes

Suppose that the only securities available for trading are calls and puts (with any strike price, but the
same maturity T) on a stock, and zero-coupon bonds paying $1 at T.
Payoff

40

20

10 20 30 40 ST

Suppose that you are interested in replicating the payoff shown above.

a. (1.5 points) What portfolio of only puts (maturity T, any strike) will give you the desired
payoff? Please note that you are required to present a table to justify your answer.

Solution:
Portfolio [0 ; 10] [10 ; 20] [20 ; 30] [30 ; 40] [40 ; +∞)
2 Long Put (k=40) 80 - 2ST 80 - 2ST 80 - 2ST 80 - 2ST 0
2 Short Put (k=30) 2ST - 60 2ST - 60 2ST - 60 0 0
2 Long Put (k=20) 40 - 2ST 40 - 2ST 0 0 0
2 Short Put (k=10) 2ST - 20 0 0 0 0
Payoff 40 60 - 2ST 20 80 - 2ST 0

b. (2 points) What portfolio of calls, puts (maturity T, any strike) and/or stock and/or bonds
will give you the desired payoff? You need to use at least one call and one put. Using
risk-free bonds and the stock is optional. Please note that you are required to present a table
to justify your answer.

Solution:

Portfolio [0 ; 10] [10 ; 20] [20 ; 30] [30 ; 40] [40 ; +∞)
4 Long Put (k=10) 40 - 4ST 0 0 0 0
4 Long S 4ST 4ST 4ST 4ST 4ST
6 Short Call (k=10) 0 60 - 6ST 60 - 6ST 60 - 6ST 60 - 6ST
2 Long Call (k=20) 0 0 2ST - 40 2ST - 40 2ST - 40
2 Short Call (k=30) 0 0 0 60 - 2ST 60 - 2ST
2 Long Call (k=40) 0 0 0 0 2ST - 80
Payoff 40 60 - 2ST 20 80 - 2ST 0

7A
 Section IV (5.5 points) – 30 minutes
Part I (3 points)
The current stock price of OldGears is €20. Assume that each semester OldGears’s stock price can
increase by €3 or decrease by €5. Consider also a risk-free rate (APR) of 6% semi-annual
compounded.

a. (1.25 points) Compute the value of a European Put on OldGears’s stock with a strike price
of €15 and 1-year left to maturity. Use the replicating portfolio technique.
(Show all computations)

Solution:
A 6%
𝑟‡ = = 3%
2

Evolution of Underlying Asset European Put (k = 15)

26 0
23 18 PutU 0
20 Put0
15 18 PutD 0
10 5

𝑃𝑢𝑡Š = 0

PutD:
0 = 18∆ + 𝐵 × 1.03 ∆= −0.625
‹ ó‹
5 = 10∆ + 𝐵 × 1.03 𝐵 = 10.922
𝑃𝑢𝑡Ž = 15 × (−0.625) + 10.922 = 1.547

Put0:
0 = 23∆ + 𝐵 × 1.03 ∆= −0.193
‹ ó‹
1.547 = 15∆ + 𝐵 × 1.03 𝐵 = 4.319
𝑃𝑢𝑡K = 20 × (−0.193) + 4.319 = 0.451

b. (1.75 points) Compute the value of an American Put on OldGears’s stock with a strike price
of €15 and 1-year left to maturity. Use the replicating portfolio technique. What can you
conclude when comparing this value to the one in question a.?
(Show all computations)

Solution:
American Put (k = 15)

0
PutU 0
Put0
PutD 0
5

8A
 𝑃𝑢𝑡Š = 𝑚𝑎𝑥{15 − 23 = −8; 0} = 0

PutD:
0 = 18∆ + 𝐵 × 1.03 ∆= −0.625
‹ ó‹
5 = 10∆ + 𝐵 × 1.03 𝐵 = 10.922

𝑃𝑢𝑡Ž = 𝑚𝑎𝑥{15 − 15 = 0; 15 × (−0.625) + 10.922 = 1.547} = 1.547

Put0:
0 = 23∆ + 𝐵 × 1.03 ∆= −0.193
‹ ó‹
1.547 = 15∆ + 𝐵 × 1.03 𝐵 = 4.319

𝑃𝑢𝑡K = 𝑚𝑎𝑥{15 − 20 = −5; 20 × (−0.193) + 4.319 = 0.451} = 0.451

The value is exactly the same as in question a. because investors never want to exercise before
the expiration date. Remember that the value of an American option is always ³ than the value of
an equivalent European option.

Part II (2.5 points)

Company Y stock is currently trade at €25. Company Y is expected to pay a dividend of €4 next
quarter. The expected implied volatility of company Y’s stock is 20% per year and the annual
continuous risk-free rate is 4%.

a. (1.5 points) Compute the price of a European Call option over company Y stock with a strike
of €32 and 21 months left to the expiration date (maturity).
(Show all Computations)

Solution:
25 − 4𝑒 0K.K–×K.#—
ln € • 0.2√1.75
32𝑒 0K.K–×*.˜—
𝑑* = + = −1.188
0.2√1.75 2
𝑑# = −1.188 − 0.2√1.75 = −1.453
𝑁(𝑑* ) = 𝑁(−1.188) = 0.117
𝑁(𝑑# ) = 𝑁(−1.453) = 0.073

𝐶𝑎𝑙𝑙K = (25 − 4𝑒 0K.K–×K.#— ) × 0.117 − 32𝑒 0K.K–×*.˜— × 0.073 = 0.287

b. (1 point) Assume only for this question that a European Call on Firm Y’s stock, with a strike
price of €32 and 21 months left to maturity is €1.2. Explain what should be done to exploit
this arbitrage opportunity. (Show all computations)

Solution:
Find the value of a Put option based on the price in the option in question a.:
𝑃𝑢𝑡K = 𝐶𝑎𝑙𝑙K − 𝑆K + 𝑃𝑉(𝐷𝑃𝑆) + 𝑃𝑉(𝐾) = 0.287 − (25 − 4𝑒 0K.K–×K.#— ) + 32𝑒 0K.K–×*.˜— = 9.084

9A
Strategy:
t=0
Sell Call 1.2
Buy Put -9.084
Buy S0 -25
Borrow the PV(DPS) +3.960
Borrow the PV(K) +29.837
Payoff 0.913

10A
11A