UNIVERSITY OF CAPE TOWN

SCHOOL OF ECONOMICS
FINANCIAL ECONOMICS I
HONOURS EXAMINATION
OCTOBER/NOVEMBER 2005
TIME: 3 HOURS
INSTRUCTIONSFORPART1
PartIconsistsofpartsI(A)andI(B)
AnswerthreequestionsfromPartI(A),inoneanswerbook,andall(three)questions
fromPartI(B),inanotheranswerbook
PARTI(A):PORTFOLIOTHEORY&ASSETPRICING[GeoffBrooke]
INSTRUCTIONS:answerthreeofthefollowingfourquestions.
Question1[15marks][UtilityTheory]
(a) The use of Markowitz MeanVariance analysis can be justified by either
assuming that asset returns are normally distributed or by assuming that
investors have quadratic utility. Demonstrate that for an investor with
quadratic utility the utility of wealth can be described by the mean and
varianceofexpectedwealth.(9)
(b) ComparelogarithmicutilityU(W)=ln(W)andquadraticutilityU(W)=W
bW2withspecificreferencetoimpliedattitudestorisk.(6)
Question2[15marks][MeanVariance]
ThestockreturnsforfirmAandfirmBhavethefollowingcharacteristics:
Firm
A
B

Expectedreturn
10%
12%

Thecorrelationbetweenthetwostocksis1.0.

Standarddeviation
8%
20%

(a) Using the definition of portfolio variance, show that a perfectly hedged
portfolio that is 100 shares long and 100 shares short (same company) is
perfectlyriskfree.(5)
(b)Iftherearenorestrictionsonshortsalesorborrowing,whataretheportfolio
weights,expectedreturnandstandarddeviationoftheportfolioofthesetwo
assetswiththelowestrisk(minimumvariance)?(5)
(c) SusanisanexecutiveofficeroffirmA.Underacompanystockpurchaseplan,
shecurrentlyholdsR200,000worthofA'sstock,andthisrepresentshertotal
assets.Thisstockcannotbesold.Susancanpurchaseadditionalamountsof
stockAorstockB,andshecansellstockBshort.Itisillegalforhertosell
stockAshort.HowcanSusaneliminatetheriskinherholding?Bespecific
(givenumbers).(5)
Question3[15marks][CAPM]
(a) TheCAPMcanbederivedwithoutariskfreeasset,usinginsteadtheefficient
portfoliothathaszerocorrelationwiththeMarketportfolio.Demonstratethat
thezerocorrelationportfolioliesonthelowerboundoftheefficientfrontier.
(7)
(b) Giventwoefficientportfolios,AandB,showthatthebetaoftheportfolio
madeupofequalpartsAandBisequalto 1 2 A 1 2 B .(8)

Question4[15marks][FactorModels]
Assumethatatwoindexmodeldescribesreturns,
Ri=ai+bi1I1+bi2I2+ei
andthatthefollowingportfoliosareobserved:
Portfolio
A
B
C

ExpectedReturn
12
13
17

bi1
1.0
1.5
0.5

bi2
1.0
2
3

(a) Findtheplanethatdescribesequilibriumreturns.(8)
(b) Explainhowyouwouldtakeadvantageofthearbitrageopportunitiesthat
wouldexistifacalledportfolioDwiththefollowingpropertieswasobserved.
Rd=15

bD1=2

bD2=0
(7)

PART1(B):CORPORATEFINANCE[EvanGilbert]
INSTRUCTIONS:ANSWERALLQUESTIONS
1.ProjectValuationRealOptionsAnalysis(20)
YouaretheowneroftheMistellBrewingCompanyandyouhavetodecidewhether
ornottoinvestR400minthecreationofaWitblitzproductionfacilitythatwillhavea
twoyearlife.Yourbestguessisthatthevalueoftheprojectcouldevolveasfollows:

Year Zero
Year One
Year Two
750m
Good
Value
today

500m
Bad
R0

Theexpectedpayoffstothemarketportfolio(thealternativeuseofthefirmsfunds)
forthenexttwoyearsaregivenasfollows:
R1.96
R1.40
R1.00

R1.00
R0.714
R0.51

Yourecognisethatyourinvestmentintheplantwillgiveyoutheabilitytomakean
investmentinasimilarplantinYearTwo.ThisinvestmentwillcostyouR500mat
thispointintime.Theriskfreerateis5%p.a.effective.
a. Calculatetheriskneutralprobabilitiesforeachstepoftheproject
b. Whatisthevalueoftheoptiontoexpand?

2.CalculatingWACC(5)
EdconcurrentlyhasaWACCof17%andaD/Eratioof0.4.UsetheHamadamodel
tocalculateitsnewWACCifitchangesitsD/Eratioto0.8.Assumeataxrateof
29%.

3.ImpactofaThreatofBankruptcy(20)
Explainhowthethreatofbankruptcycancreateperverseincentivesforequity
holders.Whobearsthecostsoftheiractions?Givefourspecificexamplesofhowthis
problemmightmanifestitself.

PART2:DERIVATIVES[HaimAbraham]
Time: 1 hours
Answer all questions
All questions carry equal weight
1. A South African company (call it company A) wants to borrow US dollars at a
fixed rate of interest. A US company (call it company B) wants to borrow rands at a
fixed rate of interest. The two companies have been quoted the following rates per
annum,

Company A
Company B

Rands

US dollars

11%
10.6%

7.0%
6.2%

Design a swap that will make each company gain 15 basis points per annum, while a
bank that acts as an intermediary will net 10 basis points per annum.
2. In October 2002 (the present date) a company observes the following prices of iron
(in US cents per kilogram),
Date

October
2002

February
2003

August
2003

Spot

72

69

65

March
2003
Futures
September 2003
futures
March
2004
futures
September 2004
futures

72.3

69.1

72.8

70.2

64.8

70.7

64.3

76.7

64.2

76.5

88.2

February
2004
77

August
2004
88

At the present date the company anticipates that it will buy a million kilograms of iron
in each of February 2003, August 2003, February 2004 and August 2004. The
company decided to hedge its risk by using the futures contracts of the Chicago
Mercantile Exchange, where 1 contract is for a delivery of 25000 kilograms of iron.
The company wants to hedge 80% of its exposure; and the company considers only
contracts with maturities up to 13 months into the future as having sufficient liquidity
to meet its needs.
(a) Devise a hedging strategy for the company.

(b) Based on your strategy in (a) compute the effective prices the company pays
for iron.
3.
(a) A European put and a European call on the same stock have both $20 strike
price and an expiration date in 3 months. The current stock price is $19 and a
$1 dividend is expected in a month. Both options sell for $3. The risk-free
interest rate is 10% per annum. Find an arbitrage opportunity open to a trader.
(b) A bank can borrow and lend money at the same interest rate in the LIBOR
market. The 91-day rate is 10% and the 182-day rate is 10.2% per annum. All
interest rates are expressed with continuous compounding.
What arbitrage opportunities are open to the bank if the Eurodollar futures
price for a contract maturing in 91 days is quoted at 89.5?
4. Assume that a call option has an exercise price equal to the current stock price.
Show diagrammatically the variation of profit and loss with the terminal stock price
for the following portfolios.
(a)
(b)
(c)
(d)

One share and a short position in one call.

Two shares and a short position in one call.
One share a short position in two calls.
One share and a short position in four calls.