Investments

Spring 2012

Proposed Solutions
Exercise 1 (20%)
a) Weak (historical data), semi strong (public information) and
strong (all, including insider information).
b) Not consistent with the semi strong or strong form of the efficient
market hypothesis.
Exercise 2 (30%)
a) Using the prices of the dierent ZCBs we can compute the dierent
yields as follows:
100
1 = 2%
98, 04

1/2
100
=
1 = 2, 2%
95, 74

1/3
100
=
1 = 2, 8%
92, 05

1/4
100
=
1 = 3, 4%
87, 48

y1 =
y2
y3
y4

Hence, the yield curve looks like

b) According to the Expectations hypothesis one should interest rates

to rise in the future. However, if one believes there is a liquidity
premium one can believe that future interest rates will be same,
higher or even lower than current ones - it all depends of what one
thinks about the liquidity premium.
c) The price of this coupon bond is $100 (given that the bond was
issued at par). Therefore:

100 =

c 100 100(1 + c)
+
, c = 2, 198%
1, 02
1, 0222

d) In order to immunize the bond portfolio to any paralled shifts of

the yield curve, we need to construct a portfolio with duration equal
to 0. Let w denote the weight of the 3-year ZCB. Given that the
duration of any ZCB is equal to the ZCB maturity, we determine w
as follows:

w3 + (1

w)4 = 0 , w = 4

Thus, to invest $100.000 in a portfolio composed of 3-year and 4-year

ZCBs, we need to buy $400.000 of the 3-year ZCBs and sell $300.000
of the 4-year ZCBs.
e) To construct a loan that will start at the end of year 1 and will be
paid at the end of year 3 I need to buy 1-year ZCBs and sell 3-year
ZCBs.
f) Let f1,3 denote the annual forward rate between year 1 and year 3.
f1,3 can be determined as follows:

1 + f1,3 =
f1,3 =

"

(1 + y3 )3
(1 + y1 )

#1/2

(1 + 2, 8%)3
1 + 2%

1/2

1 = 3, 202%

Exercise 3 (25%)
a) We can use put-call parity to price WCD stock as follows:

S = C
S = 57, 1

P + P V (X)
3, 654 +

40
= NOK 88
1, 053

b) The current price of each WCD share is NOK 95. The price of the
stock implied by the put-call parity is NOK 88. Thus, there is an
arbitrage opportunity. To exploit this opportunity we buy low and sell
high. This implies buying the put-call parity constructed stock and
selling the existing stock in the market. To be specific, one needs to:

Position Instrument
Cash Flow
Buy
Call
- NOK 57,1
Sell
Put
+ NOK 3,654
Buy
Bond
- NOK 34,554
Sell
Stock
+NOK 95
Portfolio
+ NOK 7

c) To determine the price of this option we need to determine the

cash flows at each node. To do so, one needs to realize that:
In year 1, if the stock WBD goes up to NOK 90, this means
that the stock goes up by 20%, which triggers the first exotic
feature of the option - the buyer has to exercise the option in
year 1 and hell receive NOK 15 (NOK 90 - NOK 75). Note
that in this case, the option does not reach year 2, so the
upper branch is year 2 is irrelevant.
In year 1, if the stock WBD goes down to NOK 60, this means
that the stock goes down by 20%, which triggers the second
exotic feature of the option - the call option becomes an
European put option with strike price of NOK 68. This means
that in year 2, the option is not exercised if the stock price
goes up to NOK 72, and is exercised with a gain of NOK 20
(NOK 68 - NOK 48) if the stock price goes down to NOK 48.

Hence, the dynamics of this derivative can be expressed as follows:

The next step is to apply the binomial model to price the put:
Cu Cd
0 20
5
! =
=
S u Sd
72 48
6
5
20 48
C d Sd
6
B =
!B=
= 57, 143
1 + rf
1 + 5%
5
P ut =
60 + 57, 143 = NOK 7, 143
6
=

The final step is to price the original call:

Cu Cd
15 7, 143
! =
= 0, 2619
S u Sd
90 60
C d Sd
7, 143 60 0, 2619
B =
!B=
=
1 + rf
1 + 5%
Call = 0, 2619 75 8, 163 = NOK 11, 48
=

Exercise 4 (25%)
a) The return of a portfolio is
rp = y
r + (1

y)rf = y(
r

r f ) + rf ,

so from standard rules of statistics

E[rp ] = y(E[r]

rf ) + rf ,

8, 163

and
2
p

Var(rp ) =

= y2

b)

1
2
The Sharpe ratio of this portfolio is, using the answers in a),
yI =

SI =

E[rp ]

rf

1
(E[r]
2

rf ) + r f

rf

1
2

E[r]

rf

i.e., identical to the Sharpe ratio for the risky asset.

c) The investor solves

1
A
2

max E[rp ]
y

2
p

Again, using a), this problem is equivalently stated as

1 2 2
max y(E[r] rf ) + rf
Ay
.
y
2
Setting the first order condition equal to zero yields
E[r]

rf

or
y =

Ay

E[r]
A

rf
2

= 0,
.

d) Now,
E[r] rf
.
A 2
The Sharpe ratio of this portfolio is
E[rp ] rf
y (E[r] rf ) + rf
Sy =
=
y
p
y =

rf

E[r]

rf

also the same Sharpe ratio as for the risky asset (as well as the
portfolio in question b).
e) The Sharpe ratio of all risky portfolios (y 6= 0), as described in the
text, is equal to the Sharpe ratio of the risky asset. This can be
proved by a similar derivation as in d) (or b)). Observe that any asset
fraction y cancels from this derivation.