MS Businss onomis MS Intrnational Business onomis

Coursework Financial Market

Student name : Minh Dai Nguyen Student number : 110063077

Student Name : Minh Dai NGUYEN Student Number: 110063077

Question 1

i. R*= 3% The best portfolio is the one that combined with the risk free asset provides the highest return per unit of risk (Rp-R*)/p . pi 5% 6% 8% 13% 18%

Portfolio E(Rpi) 1 2 3 4 5 8% 10% 15% 20% 25%

(Rp-R*)/p 1.00 1.167 1.50 1.30 1.22

Portfolio 3 is the best in the risk-return characteristic.

ii. To earn an expected rate of return of 10% with a standard deviation of 4%, it would require a slope equals to: (Rp-R*)/p = (10% 3%)/4% = 1.75 None of the above portfolios has such a slope, hence it is not possible.

iii. We would want to achieve the desired standard deviation 12% using a combination of the risk free asset and the best portfolio 3. p= w33= 8 w3= 12 >>>> w3=1.5 >>>> wR*= 1- 1.5 = -0.5 We have to borrow a half of our original capital at riskfree rate then invest all capital in portfolio 3. So the expected return: E(RP) = -0.5(3) + 1.5(15) =21% iv. The expected rate of return on a combined portfolio made up of all the above 5

Student Name : Minh Dai NGUYEN Student Number: 110063077

portfolios with an equal weighting given to each portfolio E(RP) = 8(0.2) + 10(0.2)+15(0.2)+20(0.2)+25(0.2) = 15.6 %

Question 2: Correlation ( ) Security A B C D W 0.3 0.2 0.25 0.25 25% 35% 45% 50% A B C D A 1.0 0 0 0 B 0 1.0 0 0 C 0 0 1.0 0 D 0 0 0 1.0

i. Calculate the standard deviation of the market portfolio. AB= AB* A* B = 0 AA= AA* A* A = A2 >>>>> M2 = wA2A2+ wB2B2+ wC2C2+ wD2D2= 367.8 M= 19.2%

ii. R*= 6% E(RM) = 12%

Student Name : Minh Dai NGUYEN Student Number: 110063077

iii. To obtain the expected rate of return of 15% , we invest weight of w in market portfolio, and (1-w) in riskfree assets. (1-w)R* + wE(RM)= 15 (1-w)(6) +w(12) = 15 >>>> 6w=9 >>>> w=1.5 In this case, we need to borrow risk-free assets an amount equally to a halfof our capital then invest all in market portfolio. Then we have a standard deviation is : 1.5*M = 28.8%

Question 3 i.

R*= 5% E(Rx)=12% , X =30% a. To obtain the expected rate of return of 10% , we invest weight of w in risky portfolio, and (1-w) in risk-free assets. (1-w)(5) + w(12)= 10 >>>> 7w=5 >>>> w=0.714 >>> We invest 28.6% our capital in riskfree asset, 71.4% of our capital in risky portfolio. P= 0.714 (30) =21.42% ii. To obtain a standard deviation of 15%, we invest weight of w in risky portfolio, and (1-w) in riskfree assets. P=wX=w(30)= 15% >>>> w=0.5 Invest 50% of our capital in risky portfolio and 50% in risk-free assets.

iii. To obtain an expected return of 20%, we invest weight of w in risky portfolio, and (1-w) in riskfree assets. (1-w)(5) + w(12)= 20 >>>> 7w= 15 >>> w= 2.143 >>>> (1-w) =-1.143 We borrow an amount equally to 1.143 times our capital then invest all in risky portfolio.

Student Name : Minh Dai NGUYEN Student Number: 110063077

Question 4

A Treasury bond with 100 maturity value has a 8 annual coupon and 5 years left to maturity. i. the 5-year yield to maturity in the market is 7%. The current price is given by : P B= + = 104.1

ii. the 5-year yield to maturity in the market is 9%. The current price is given by : P B= + = 96.11

iii. the relationship between yield and the price of the bond is negative. Higher yield to maturity results in the lower price.

Question 5

i. C=5 , y=0.06 , T=5 (C+M)/(1.06)t tx(C+M)/(1.06)t 4.717 4.45 4.198 3.96 78.462 95.787 4.717 8.9 12.593 15.84 392.31 434.36

t 1 2 3 4 5

C+M 5 5 5 5 105

So the bond is trading at PB= 95.787 The Macaulay duration= 434.36/ 95.787= 4.535 years

ii. the Modified Duration = 4.535/1.06=4.278 years

iii.Since yields are going up from 6% to 6.5% the change in yield is 0.5% or 50 basis

Student Name : Minh Dai NGUYEN Student Number: 110063077

points hence we expect the bond price to fall by: -4.278 x (0.5) = - 2.139 % Hence the new price should be 95.79x [1 0.02139] = 93.74

Question 6:

Bond Category A B C D

Total Market value Macaulay yield (million dollar) 30 80 50 40 duration 1 3 5 10 current 6% 6% 6% 6%

yield expected 5% 5% 5% 5%

Proportion 0.15 0.4 0.25 0.2

i. Macaulay Portfolio duration = 0.15(1)+0.4(3)+0.25(5) +0.2(10)= 4.6 years Modified Duration = Macaulay Portfolio duration / (1+y) =4.6/(1.06) = 4.34 years

ii. With as 1% decrease in yield and modified duration of 4.34 then the portfolio will increase in price by 1%*4.34 =4.34% Hence the $200 million portfolio will be worth $200million(1+4.34%)= $208.68 million.

iii. The strategy is to lengthen the duration of the portfolio. That means to buy long term bonds and decrease the weight of short term bonds. Here, the manager expect the interest rate to fall to 5%, so he hope he will benefit more by holding long term bonds which will rise by largest percentage.

Question 7

It is expected that the AAA bonds rise in price as they is yielding too much over Treasuries (50 >25). On the other hand, the BBB are yielding not much enough so they are expected to rise in price (150<250) . Treasuries might be a bit neutral since

Student Name : Minh Dai NGUYEN Student Number: 110063077

they are yielding not much in relation with the AAA bonds but too much in relation with BBB bonds.

Hence, the strategy is to sell BBB bonds and use the funds to increase the proportion of AAA bonds while keeping the same proportion of Treasury bond. So a suggested portfolio can be Treasuries to remain 30%, BBB bonds lowered to say 20% and AAA bonds raised to say 50%.

Question 8 i. A bond with a call back feature is a type of bond that give the issue the right, but not the obligation, to buy back the bonds from the bond holders at a defined call price. In another word, the bond is cancelled immediately. Compare to a similar bond without call back feature, investor have the benefit of a higher coupon. On the other hand, if the interest rates fall, issuers will be likely to call back the bonds. Hence, investors can only invest at the lower rate. ii. The corporate bond spread is the difference in yield between two bonds that are identical in all aspects except for the credit rate of the issuer. Usually, the bad rating company have higher yield on average than a better rating issuer. In the other words, the spread reflects the additional net yield an investor can earn from a bond with higher risk relative to one with lower risk.

The corporate bond spread is likely to increase in a recession. This is because, bad rating bonds are far less attractive than the good rating bonds in a recession. Investors tend to be more risk-averse and buy good rating bonds and sell bad ones. To be able to survive in a recession, bad rating companies have to attract investors by increase the yield of their bonds. It makes the bond spread increase during the recession.

Question 9 RA = 10%, A = 30% RB = 5%, B = 15%

Student Name : Minh Dai NGUYEN Student Number: 110063077

WA 0.7 0.3

WB 0.3 0.7

AB = 0.5 23.57% 16.9%

AB = 0 21.47% 13.82%

RETURN 8.5% 6.5%

iRi

The return on a portfolio of assets (RP ) is given by :RP = The Standard deviation of the portfolio (P ) is given by: P = (wA2 A2 + wB2 B2 + 2 wA wB A B AB)1/2 When : wA=0.7 , wB=0.3 RP = (0.7*10%) + (0.3*5%) = 8.5%

AB = 0.5 ; P = ((0.720.32) + (0.320.152)+ 2 (0.7)(0.3)(0.3)(0.15)(0.5))1/2 = 23.57% AB = 0; P = ((0.720.32) + (0.320.152))1/2 = (0.0461)1/2 = 21.47% When : wA=0.3, wB=0.7 RP = (0.3*10%) + (0.7*5%) = 6.5% AB = 0.5 ; P = ((0.320.32) + (0.720.152)+ 2 (0.3)(0.7)(0.3)(0.15)(0.5))1/2 =16.9% AB = 0; P = ((0.320.32) + (0.720.152))1/2 = (0.0191) 1/2 = 13.82%

Question 10

Security A B C

Proportion invested 0.4 0.3 0.3

Beta 0.8 1.2 2.0

Expected 1 year return 12% 18% 24%

We have beta of the portfolio : P =

= 0.4(0.8) + 0.3(1.2) + 0.3(2.0) = 1.28

E(Rp) = R* + P [E(RM) - R*] = 8% + 1.28(15% - 8%) = 16.96% RP = 0.4 (12%) + 0.3 (18%) + 0.3(24%) = 17.4% Based on CAPM, E(RABC) < RABC , the portfolio returns less than the CAPM expected , hence the portfolio is undervalued.

Question 11

Student Name : Minh Dai NGUYEN Student Number: 110063077

Correlation ( ) Security A B C D W 0.267 0.267 0.133 0.333 10% 15% 20% 30% A B C D A 1.0 0 0 0 B 0 1.0 0 0 C 0 0 1.0 0 D 0 0 0 1.0

i. Market portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market. So this market portfolio have 4 securities A,B,C,D with weights : 0.267 ; 0.267 ; 0.133 ; 0.333, respectively. We have correlation coefficient AB, AC, BC ,ij = 0 >>> M2= wi2i2 = 0.013 M = 0.114 = 11.4%

ii. R* = 5% ERM = 15% The equation for the CML is given by: E(RP) = R* + ( ERM R*) = 5% + (10%) = 5% + 0.877%* p

The equation for the securities market line is given by SML = R(Ep) = R* + ( E(RM)- R*)= 5% + (10%) iii. We would like to have E(RP) of 12%. E(RP) = 5%+ 0.877%* p = 12% p= 7.98% = p/ M = 0.7 wP= 0.7 w*=0.3 We invest 70% our capital in market portfolio and 30% in risk-free assets.

Question 12

Student Name : Minh Dai NGUYEN Student Number: 110063077

Do= 20pence G1,2,3=15% G4,5= 8% G6= 5% R=10% i. The fair value price of the share is given by

PE = + =572.7 pence x

ii. The fair value of the share at the end of year 5 is given by P5= x = 462.62 pence

Question 13 r= 8% We use this formula : E(RE) = (1+D/E)p (D/E)r

Dept/equity Ratio 0.4 1 2.2

Expected Rate of Return on Equity 0.0% -3.2% -8.0% -17.6% 5.0% 3.8% 2.0% -1.6% 10.0% 10.8% 12.0% 14.4% 15.0% 17.8% 22.0% 30.4%

We can conclude that the return on equity is much more variable when the company has a high level of primary gearing than when it has a low level of primary gearing.

Question 14 i. R*= 5% The best portfolio is the one that combined with the risk free asset provides yields the highest return per unit of risk (Ri-R*)/p .

Student Name : Minh Dai NGUYEN Student Number: 110063077

Portfolio 1 2 3 4 5

E(Ri) 10% 12% 15% 18% 25%

i 5% 6% 8% 14% 18%

(Rp-R*)/p 1.000 1.167 1.250 0.929 1.111

Portfolio 3 is the best in the risk-return characteristic.

ii. We would want to achieve the desired expected rate of return of 15% with a standard deviation of 6% using a combination of the risk free asset and the best portfolio 3. To earn an expected rate of return of 15% with a standard deviation of 6%, it requires: (Rp-R*)/p = (15% 5%)/6% = 1.67 None of portfolio have that slope (portfolio 3 is 1.25) , thus this is not possible.

iii. We would want to achieve the desired standard deviation 12% using a combination of the risk free asset and the best portfolio 3. p= w33= 12 >>>> w3=1.5 >>>> wR*= 1- 1.5 = -0.5 We have to borrow a half of our original capital at riskfree rate then invest all in portfolio 3. E(RP) = -0.5(5) + 1.5(15) =20% iv. Because we weight 5 portfolio equally, so we have each portfolio weights 20% E(Rp) = 0.2(10)+0.2(12)+0.2(15)+0.2(18)+0.2(25)= 16% We have the variance of the portfolio is given by: =

Because we dont know the relationship between these five portfolios, we cant not calculate the exact variance and standard deviation of the portfolio. In case of no relationship, the covariance between different portfolios is zero, we have: = (w1 )2 + (w2 )2 + (w3 )2 = 25.8 ; = 5.1%

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Student Name : Minh Dai NGUYEN Student Number: 110063077

If there is relationship between portfolio, it is difficult to tell where the standard deviation of the combined portfolio is higher than portfolio 3. However, increase the number of securities is usually a good way to reduce the risk.

Question 15

(i) The sale implies that the party selling the contract will borrow 1 million for 3 months from September 2013 at 100-94.5= 5.5% annual rate of interest.

(ii) . If you think 3-month interest rates in September 2013 will be 6.5% you will sell the contract at 94.5 hoping that it will expire at 93.5 (100-6.5) if so you take advantage of 100 ticks at $25 per tick or $2500.

(iii) If the Corporate Treasurer wishes to borrow 1 million and hedge the risk, it will sell the contract. The Corporate Treasurer may think the interest rates rise to 6.5% in September 2012, so that it will have to borrow 1 million at 6.5% for 3 months and pay the interest $16250. But if the treasurer buys the interest rate futures at 94.5 it would go to 93.5 so the treasurer get profit of $2500 from the future contracts, and borrow 1 million and pay the interest of $16250. In this case, the interest the treasure have to pay is only 16250-2500= $13750.

Question 16

The December 2013 FTSE 100 stock index futures contract is reading 6500 while the cash index is reading 6300. The futures contract is worth 10 per point.

i. the FTSE futures contract is at a forward premium because the future index now exceed the cash index ( 6500> 6300) , the annualized cost of finance exceed the expected dividend yield

ii. If the index falls to 5300 then the approximate value of the portfolio will fall to:

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Student Name : Minh Dai NGUYEN Student Number: 110063077

* 30 million = 25,240,00 , a potential loss of 4,760,000 So we need to sell (short) the futures contracts whose price is 6500, which will expire at 5300 (since cash = futures on expiry) this will make 1200 points (at 10 per point) or 12,000 per contract. So 4.760,000 /12,000 = 396.6 contracts. So the fund manager needs to sell 397 futures contracts to hedge.

iii. By buying the future contracts at 6500 which will read at 7000 by expiration. We will make 500 point or 5000 per contract bought. However, the risk we face is that the market falls to say 5000, we will lose 1500 points or 15000 per contract.

Question 17

i. Call premium C is given by C = SN(d1) Xe-rTN(d2)

SN(d1) : the expected value of the underlying security upon expiration Xe-rTN(d2) : the expected present value of the strike price on expiration

S: spot price $50 X: exercise price $55 r : riskfree interest: 10% T : time to muture : 3 months (0.25 year) : annualised standard deviation 0.6

d1=

( )

( ) (

= -0.0844

d2= d1 - =-0.38

N(d1) = 0.46812 N(d2)= 0.352

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Student Name : Minh Dai NGUYEN Student Number: 110063077

>> C = SN(d1) Xe-rTN(d2) = 50(0.46812) 55(0.352)(2.718)-0.1*0.25 = $4.52 Call premium C is $4.34

ii. Using the Put-call parity we can have the put premium as given: P= C-S+Xe-rT =4.52 - 50+ 55(2.718)-0.1*0.25 = $8.165

Question 18 I can buy 50,000 of $1.9/1 future price, so that I will receive 50,000 in a years time. If the spot rate is $2.1 in a years time i can then sell the 50,000 for $105,000 and make a profit of 105000-50000*1.9= $10000. However, the risk is that if the rate fall to $1.70/1 in a years time I would lose $10,000 or 5882.33 Alternatively I could pay a call premium of 50,000*$0.08 = $4,000 for the right to buy sterling at $1.90/1 in a years time. If sterling is $2.1/1 in a years time I will exercise the right to buy 100,000 at $1.90/1 in a years time then sell it for $2.1/1 to get $10,000. With the $4,000 premium, the net profit is $6,000 or 2857. However, if the rate falls to $1.8/1 in a years time I will not exercise the option and lose the premium of $4,000 or 2352.9. There is both pros and cons of futures and options. Future profits and losses are symmetric whereas option loss is limited. Hence, if I want to restrict the loss, I can consider options. However, in certain rate, I can consider futures for a higher potential return.

Question 19 i. Th appropriate futurs pri is givn by the equation: F= Whr: F is th futurs pri, S is th spot hang rate ($1.90/1) rus is th intrst rat on th US dollar, 5% ruk is th intrst rat on th pound, 7% is th numbr of days of duration of th ontrat, 180 days
( )

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Student Name : Minh Dai NGUYEN Student Number: 110063077

t is the number of day into the contract, 120 days. T-t is the number of days remaining to delivery of the contract, 60 days. So we have : F= $1.9/1 * = $1.894/1

ii. The appropriate arbitrage model for the pricing of the future index is given by the equation below: = Where +[ ( )* ]

is the stock index future price at time t with a settlement date T, is the price of cash stock index at time t, 6300 is the annualized cost of finance for the period between t and T , 6% is the expected average dividend yield on the stocks that make up the cash index during the holding period, 1.5%

So we have

= 6300 + [6300* (0.06-0.015)*145/365]= 6412.6

The appropriate arbitrage model for the pricing of the future index is 6412.6

Question 20

The pricing of interest rate future contracts is based on arbitrage conditions. In particular the price of a future interest rate contract is determined by the so-called forward/forward rate, given by : Z% = [( Where Z% is the interest rate implicit in the futures contract is the interest rate on the distant forward/forward period, 5% is the interest rate on the near forward/ forward period, 5.5% is the number of days remaining to the distant forward/forward period, 182 is the number of days remaining to the near forward/ forward period, 91 -1] *

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Student Name : Minh Dai NGUYEN Student Number: 110063077

Z% =( Z% = 0.0444 or 4.44%

-1) *

So we have the appropriate 3 months ahead future price is 100-4.44= 95.56

Suppose that a trader invest $1 million for 6 months at 5%, which means that they receive 1,000,000*[1+(0.05)*(6/12)]= $1,025,000 at the end of six months. Alternatively, he could invest money for 3 months at 5.5% which means he would receive 1,000,000*[1+(0.055)*(3/12)]= $1,013,750 in 3 months time

He could then lend the money by selling a future contract at 4.44% for three months so that the $1,013,750 becomes 1,013,750*[(1+ (0.0444)*(3/12)]= $1,025,000 , which is identical to leaving the funds on deposit for 6 months

If three months ahead future price were different, say below the forward/forward rate at 95.56 then it would pay arbitrageurs to borrow long and lend short by buying a future contract to guarantee the future interest rate of 5%. By borrowing $1,000,000 at 5% for 6 months the arbitrageur would have to repay $ 1025000

At the same time he could lend money for three months at 5.5% so would receive $1013750 and also buy a three months future contract at 94 so he could earn 6% and so would receive 1,013,750*1.015= $1028956

The guaranteed profit is $3956.25 and such an arbitrage opportunity would mean there would be excess demand for the futures contract until the price bid up to 95.56 However, if price were above the forward/forward rate, for example at 97,then it would pay an arbitrageur to lend long and borrow short by selling a future contract to guarantee the future rate of 5%

By lending at 5% for 6 months the arbitrageur receive $ 1025000. By borrowing $1000 000 at 5.5% for 3 months the arbitrageur would have to repay $1 013 750

He would then borrow the equivalent money for three months by selling the future at 97) at 3% so having to repay $1.013750 + 1 013 750 * 0.03* 0.25 = $1 021 353

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Student Name : Minh Dai NGUYEN Student Number: 110063077

This means he receive $1025000 and pat out only $1021353, guaranteeing a profit of $3647. Such an arbitrage opportunity would mean there would be excess selling of the future contract until the price fell to 95.56

Question 21 i. I could buy the put premium at say, a strike of 400 pence for 350. If the share price decrease to 300 pence, as I expected, I can make profit of 650 (400-300-

35=65pence per share). Even of the share increase to 500, I will not exercise the option; therefore, my loss is restricted to the premium paid of 350

ii. The strategy is to buy the put premium contract at strike of 400 for 350. If the price falls to 300 pence, as I forecasted, I lost 900 because of the fall in value of 1000 shares. However, the put premium will partially offset it by making a profit of 650. So the lost is only 900-650= 250. If the price rises to 500 pence, then 1000 shares now worth 5000, or an increase of 1100 in value. However, I loss 350 from the put premium. So the net increase is 1000-350= 650.

Question 22 i. We have :
Call In-the-money At-the-money Out-of-the-money Current price above exercise price Current price equals exercise price Current price below exercise price Put Current price below exercise price Current price equals exercise price Current price above exercise price

The currently price is 290 pence. Call premium exercise prices are 300 and 330 pence, higher than current price. Hence, they are out-of-the-money.

Call premium exercise prices are 300 and 330, higher than current price . Therefore, 16

Student Name : Minh Dai NGUYEN Student Number: 110063077

in-the-money put premium are Put strike 300 pence April (20) June (35) September 45 and Put strike 330 pence April (45) June (50) September (60)

ii. The time value = option premium intrinsic value The Call option: At strike of 300 and 350, the call option is out of the money, therefore , there is no intrinsic value. The time value of the option is the option premium. The call option with the lowest time value is April 20 strike at 330 pence, which is 20 pence. The Put option: The intrinsic value for strike at 300 pence is 300-290=10 pence The intrinsic value for strike at 330 pence is 330-290=40 pence The lowest time value for strike at 300 pence is April 20, which is 20-10=10 The lowest time value for strike at 330 pence is April 20, which is 45-40=5 Therefore, the lowest time value is Put April 20 strike at 330, which is 5 pence.

iii. There is no intrinsic value in call options. The intrinsic value of put option is 10 pence for strike at 300 pence and 40 pence for strike at 330 pence. Therefore, the highest intrinsic value is put options strike at 330 pence April (45), June (50) and September (60) iv. Because I expect the price increases to 450 pence, my strategy is to buy the call option strike at 300 pence with call premium 30 pence. If I am correct, it expires at 450, I will make profit at 120 pence per share (450 300 30) or 1200 in total.

Question 23

Volatility measures risk/uncertainty of the underlying stock price of an option. There are two types of volatility, namely historical volatility and implied volatility. The difference between historical volatility and implied volatility is given below.

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Student Name : Minh Dai NGUYEN Student Number: 110063077

historical volatility Historical Volatility is a measure of price fluctuation over the recent time. Historical volatility uses historical (daily, weekly, monthly, quarterly, and yearly) price data to measure the volatility. Could be proved defective as the past data is not necessarily a good guide to the future Usually fails to pick up the

historical volatility The volatility implicit in the current option price. Implied volatility take the current price of option and finding volatility that, when plugged into the option pricing formula, gives the current market price of the option. Taking into account expected

fluctuation of the stock price, such as earning announcement, other

important news.

possibility of large discrete shifts

The use of volatility hint the volatility arbitrage, a type of statistical arbitrage that takes advantage of differences between the implied volatility of the option, and a forecast of future realized volatility of the option's underlier. In volatility arbitrage, volatility rather than price is used as the unit of relative measure, i.e. traders will attempt to buy a low volatility option and sell it when the volatility is high.

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