fn3023 Exc14

Examiners commentaries 2014

FN3023 Investment management
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201314. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refers to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of this course, and having completed the Essential reading and activities, you should be
able to:
list given types of financial instruments and explain how they work in detail
contrast key characteristics of given financial instruments
briefly recall important historical trends in the innovation of markets, trading and financial
instruments
name key facts related to the historical return and risk of bond and equity markets
relate key facts of the managed fund industry
define market microstructure and evaluate its importance to investors
explain the fundamental drivers of diversification as an investment strategy for investors
aptly define immunisation strategies and highlight their main applications in detail
discuss measures of portfolio risk-adjusted performance in detail and critically analyse the
key challenges in employing them
competently identify established risk management techniques used by individual investors

and corporations.
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Format of the examination paper
The examination paper consists of eight questions of which you have to answer any four. The
questions are a mixture of three types. The first type is a question that asks for a numerical problem
to be solved. The second type of question asks for institutional knowledge, for instance candidates
are asked to explain what instruments are traded in the money market or how a limit order market
works. The third type of question asks for an essay-style answer about a conceptual issue in finance,
for instance what implications the efficient market hypothesis have on investment returns and
factors that may explain why the efficient market hypothesis may not hold in practice.
What are the Examiners looking for?
With numerical questions, it is important that answers and steps are carefully and clearly explained.
A very good answer would specify what knowledge is used. For instance, when the CAPM model is
used as a basis for a cost of capital calculation, it is important that this is outlined in the answer.
When the question asks for an outline of institutional details, an ideal answer is brief and concise,
with a clear emphasis on relevant facts. For instance, if you explain what instruments are traded in
the money market, you need to focus on the distinguishing features of these instruments that
they are fixed income instruments of short maturity, often of large denominations, and issued by the
government, banks or corporations. When the question asks for a critical evaluation of a conceptual
issue, it is important that you address all aspects of the question and structure your argument
carefully so that it is clear to the Examiners what level of understanding you have.
Key steps to improvement
The key test of how much you understand about this subject is whether you can transfer knowledge
about one type of problem in finance to other problems.
The typical pattern that the Examiners find when marking the papers for this course is that
questions that may appear difficult (in the sense they are technically demanding, for instance)
achieve higher scores than questions that may appear to be easy, if the difficult question is closer to
material that candidates have studied beforehand.
In other words, the Examiners find that candidates tend to find it difficult to transfer their
knowledge into new areas. Therefore, problem-solving practice is probably the most valuable
preparation for the examination, and it is important that you attempt to solve problems that go
outside what you encounter in the subject guide.
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Question spotting
Many candidates are disappointed to find that their examination performance is poorer
than they expected. This can be due to a number of different reasons and the Examiners
commentaries suggest ways of addressing common problems and improving your performance.
We want to draw your attention to one particular failing question spotting, that is,
confining your examination preparation to a few question topics which have come up in past
papers for the course. This can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but
you need to be aware that Examiners are free to set questions on any aspect of the syllabus.
This means that you need to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the section of the VLE dedicated
to this course. You should read the syllabus very carefully and ensure that you cover sufficient
material in preparation for the examination.
Examiners will vary the topics and questions from year to year and may well set questions that
have not appeared in past papers every topic on the syllabus is a legitimate examination
target. So although past papers can be helpful in revision, you cannot assume that topics or
specific questions that have come up in past examinations will occur again.
If you rely on a question spotting strategy, it is likely you will find yourself in
difficulties when you sit the examination paper. We strongly advise you not to
adopt this strategy.
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Important note
section.
Comments on specific questions Zone A
Candidates should answer FOUR of the following EIGHT questions. All questions carry equal
marks.
Question 1
(a) Explain what we mean by exchange traded funds. What benefits do these funds
offer to investors?
(7 marks)
Reading for this question
The subject guide has a small section on exchange traded funds in Chapter 2 but candidates are
expected to draw from a broader range of readings from the Essential readings listed in the
beginning of Chapter 2.
Approaching the question
The Examiners were looking for explanations of exchange traded funds and their use
particularly as index tracking funds. This counts for 4 marks. Also, the Examiners were looking
for what kind of benefits these can offer to investors in terms of flexibility of trading and of
diversification at low cost. This counts for 3 marks.
(b) You spread your investment equally in 10 stocks. Each stock has a beta of 1.2,
and idiosyncratic risk (the difference between total variance and systematic
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risk)of 5%. The variance of the market portfolio is 10%. What is the total risk
and the idiosyncratic risk of your portfolio?
(9 marks)

The readings needed to solve this question (which is essentially a technical question) are
given in the section on Diversification: the single index model, in Chapter 6 of the subject
guide.

The variance of the portfolio is equal to the average beta squared times the variance of the
market index plus 1/10 of the variance of the idiosyncratic risk, which means that the total
risk of the portfolio is (1.22)0.10 + (1/10)0.05 = 0.149(14.9%), and consequently the
idiosyncratic risk is 0.005 (0.5%). The Examiners awarded 3 marks for identifying the
market risk component correctly, 3 marks for identifying the idiosyncratic risk component
correctly and 3 marks for making the decomposition correctly.
(c) Stocks have a two-factor structure. Two widely diversified portfolios have the
following data. Portfolio A has average return 10% and factor betas 1.5 and 0.4,
respectively, on the first and second factor. Portfolio B has average return 9%
and factor betas 0.2 and 1.3, respectively, on the first and second factor. The
risk free return is 2%. What are the risk premia for factor one and factor two?
(9 marks)

The readings for this question (which again is a technical question) are covered in the
section called Factor models in Chapter 6 of the subject guide.

The expected return on a portfolio is equal to the risk free return plus a risk adjustment,
which in a two-factor structure is given by two products of factor betas and factor risk
premia. We get, therefore, two equations with two unknowns, the risk premia which we call
m1 and m2 :
0.10 = 0.02 + 1.5m1 + 0.4m2

0.09 = 0.02 + 0.2m1 + 1.3m2 .
This system has solutions m1 = 0.0406 and m2 = 0.0476. The Examiners awarded 3 marks
for identifying the general expression for expected returns in a two-factor structure, and 6
marks for solving the system.
Question 2
(a) Explain what we mean by floating-rate debt. Discuss ways in which these
instruments are helpful to borrowers?
(7 marks)
The readings for this question can be found in Chapter 3, under the section Recent financial
innovations, where you will find a sub-section called Case study 1: Floating rate debt.
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The Examiners were here looking for an explanation of the essential ingredients of a floating rate
debt contract which are a market rate (such as LIBOR) and a contractual coupon rate which is
linked to this rate (for instance LIBOR + 3%), for which they awarded 4 marks. They were also
looking for reasons why these instruments are helpful, which is that they give the borrower a
natural hedge against inflation shocks as inflation can be a large component of the nominal
interest rate (fixed rate debt gets relatively more expensive in low-inflation times and relatively
less expensive in high-inflation times), for which they awarded 3 marks. Also, since LIBOR rate
setting has been under scrutiny recently in the press due to alleged rate fixing by major
US/European banks the Examiners were prepared to award points to candidates who argued
that this was one ofthe potential harmful effects of floating rate debt for borrowers.
(b) A 5-year bond has an annual coupon rate of 5% and yield to maturity of 6%.
What is the duration of the bond?
(9 marks)

The readings for this question can be found in Chapter 7, in a section called Duration.

We can choose a bond with face value 1, face value 100, or face value 1,000. Whichever we
choose we get the same answer. Pick 1,000: The bond is trading below par value because
the coupon rate is lower than the yield to maturity, and the value of the bond is:
1,000 0.05 1,000 0.05 1,000 0.05 1,000
+ 2
+ + 5
+ = 957.876.
(1.06) (1.06) (1.06) (1.06)5
The duration is therefore:

1,000 0.05 1,000 0.05 1,000 0.05 1,000
+2 + + 5 +5 / 957.876
(1.06) (1.06)2 (1.06)5 (1.06)5
= 4.53.
The Examiners awarded 5 marks for working out the price correctly and 4 marks for
working out the duration.
(c) What is the convexity of the bond in part (b)?

(9 marks)

The readings for this question can be found in Chapter 7 of the subject guide, in the section
called Convexity.

Again it doesnt matter what face value we pick for the bond, as the answer will be the
same either way, so the 1,000 face value chosen in (b) will not affect the answer. The
convexity definition of convexity varies basically a price change in a bond with price P (r)
at a yield to maturity r when the yield changes to r + dr should satisfy the approximation:
dP (r + dr)/P (r) = (D/(1 + r)) dr + C dr2
according to some texts and:
dP (r + dr)/P (r) = (D/(1 + r)) dr + (1/2) C dr2
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according to other texts where D is the duration and C is the convexity. The Examiners
would accept either answer. The first number is given by:

1 1,000 0.05 1,000 0.05
C = 12 +23 +
2 (1.06)3 (1.06)4

1,000 0.05 1,000
+5 6 + 5 6 /957.876
(1.06)7 (1.06)7
= 11.71.
Candidates who got the wrong price in (b) would not be penalised in (c). There were 9
marks for this calculation.
Question 3
(a) Hedge transactions involving the trading of derivatives have zero net present
value, so will never increase the value of the corporation. Discuss this
statement, and explain why hedging of corporate risk nonetheless can add value
to corporations.
(7 marks)
The relevant readings in the subject guide can be found in Chapter 9, in the section called Risk
management for corporations. Candidates may also consult the Further readings listed at the
beginning of Chapter 9, in particular:
Stultz, R. Risk Management and Derivatives. (Mason, Ohio: Thomson South-Western,

2003) [ISBN 9780538861014] which spends a lot of time on this particular issue.
The statement is technically true, as the efficient market hypothesis states that the market price
of financial assets should always reflect the available information so the cost equals the value and
the net present value is zero. The Examiners awarded 3 marks for this observation. However,
corporations create value from hedging indirectly, as hedging can be tax efficient, reduce costs of
financial distress, reduce agency costs and reduce the information cost of financing. In particular,
the firm benefits from avoiding a shortfall of cash flow in certain states which can easily lead to
costs which otherwise would be avoidable. The Examiners awarded 4 marks for the latter part.
(b) A portfolio has a beta of 0.5, and idiosyncratic risk with variance 3%. The
variance of the market portfolio is 10%, and the return on the market portfolio
is 8% on average. The risk free return is 2%. What is the required return on
the portfolio in order that it matches the market portfolio in terms of the
Sharpe ratio?
(9 marks)

The readings for this question are in Chapter 8, in a section called The Sharpe ratio, and
also in Chapter 6, in a section called Estimation issues, where the risk decomposition
between systematic and unsystematic/idiosyncratic risk is dealt with.
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The Sharpe ratio is (Expected return
Risk free return)/Standard Deviation, which for the
market portfolio is (8% 2%)/ 10% = 0.1897. The expected return on the portfolio is r,
and the variance
of the portfolio is (0.5)2 0.10 + 0.03 = 5.5%. Therefore, we need that
(r 0.02)/ 5.5% is greater than 0.1897, which implies that
r 0.02 + ( 0.055)(0.1897) = 0.0645 or 6.45%. The Examiners awarded 5 marks for
deriving an expression for the Sharpe ratio of the portfolio, 2 marks for the Sharpe ratio of
the market, and 2 further marks for finding the cut-off point.
(c) Define absolute and relative risk aversion. In asset allocation situations where
the investors split their investments into a safe and a risky asset, how do
investors with constant absolute risk aversion optimally choose their portfolios
as their wealth changes? What about investors with constant relative risk
aversion?
(9 marks)

The readings can be found in Chapter 6, in a section called Asset allocation over longer time
horizons, and in Appendix 1, in the section called Risk aversion coefficient.

This question assumes that individuals preferences can be expressed as a utility function u
over wealth, x, or u(x). Then we can define risk aversion in terms of the concavity of this
function, specifically the absolute risk aversion coefficient is u00 (x)/u0 (x), and the relative
risk aversion coefficient is the absolute risk aversion coefficient times wealth itself, or
u00 (x)x/u0 (x). Individuals choices in terms of risk taking can be related to these two
concepts, and in particular individuals who have a constant absolute risk aversion will take a
constant amount of risk in their portfolio. For instance, they will invest $1,000 in a risky
assets and hold the rest in a risk-free asset regardless how wealthy they are. In contrast,
individuals with constant relative risk aversion coefficient will hold a constant fraction of
their wealth in the risky assets, for instance, they hold half their wealth in risky and half
their wealth in safe assets regardless of how wealthy they are. The Examiners awarded 3
marks for the definitions of the risk aversion coefficients, 3 marks for the explanation of
risk-taking behaviour with constant absolute risk aversion, and 3 marks for the explanation
of risk taking behaviour with constant relative risk aversion.
Question 4
(a) Explain why asset allocation over longer time horizon can be approached as a
myopic problem when relative risk aversion is independent of wealth.
(7 marks)
The readings are in Chapter 6, in the section called Asset allocation over longer time horizons.
As an investor faces a longer time horizon he/she may not care so much about the risk in the
coming period because this risk may be offset by the risk in the next periods (in some sense, the
investor can by taking a longer time horizon spread the risk over many periods). Myopic
investment behaviour is when the investor even if he/she has a long investment horizon
nonetheless only cares about the risk in the upcoming period when making their portfolio choices.
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The question asks whether this myopic behaviour can be optimal even with longer investment
horizons. There is one condition which ensures that it is when the investor has constant
relative risk aversion because in this case he makes investment choices that are independent of
his wealth. What has happened in previous periods is not relevant, therefore, for his investment
behaviour in the upcoming period. The Examiners awarded 7 marks for this argument.
(b) Consider the situation where a company has a pension liability next year of
1,000, and that the pension liability is expected to grow at a rate of 1% each
year indefinitely. The discount rate for this liability is 5%. You are interested in
immunising the value of the liability from changes in the interest rate. To do
this you can trade a 20-year zero-coupon bond which has 5% yield-to-maturity.
What are the details of your immunisation strategy?
(9 marks)

The readings are in Chapter 7, in the sections called Duration and Immunisation of bond
portfolios. You should also read more generally about the discounting formulas used, for
instance in the Essential readings for Chapter 7 such as:
Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio Theory
and Investment Analysis. (New York; Chichester: John Wiley & Sons,2010) eighth
edition [ISBN 9780470505847] Chapter 18.

The value of your pension liability is the discounted value of a cash flow that grows with 1%
each year, starting at the level of 1,000 next year:
1,000/(0.05 0.01) = 25, 000.
The sum of all discounted products of cash flow and year is:
1,000/1.05 + 1,000(1.01)2 /(1.05)2 + 1,000(1.01)3 /(1.05)3 +

= 1,000/1.05 + 1,000(1.01)/(1.05)2 + 1,000(1.01)2 /(1.05)3 +
+1,000(1.01)/(1.05)2 + 1,000(1.01)2 /(1.05)3 + 1,000(1.01)2 /(1.05)3 +
= 1,000/(0.05 0.01) + (1.01/1.05)1,000/(0.05 0.01) + (1.01/1.05)2 1,000/(0.05 0.01) +
= (1,000/(0.05 0.01))(1 + 1.01/1.05 + (1.01/1.05)2 + ).
If the final bracket is equal to x, then we find that:
x = (1 + 1.01/1.05 + (1.01/1.05)2 + ) = 1 + (1.01/1.05)x
so x = 1/(1 (1.01/1.05)) = 1.05/(0.05 0.01). Therefore, the discounted products of cash

flows and years is 25,000(1.05/(0.05 0.01)) = 625,250, and the duration is 26.25.For each
dollar in liability you need to hold, therefore, 26.25/20 = 1.3125 in the bond to immunise
your pension liability against interest rate risk. This position needs to be rebalanced as the
interest rate changes. The Examiners awarded 3 marks for working out the value of the
liability, 3 marks for working out the duration and a further 3 marks for deriving the
optimal immunisation strategy.
(c) You can buy stocks on margin by borrowing from your broker on a margin
account with 60% initial and maintenance margin. You utilise your margin
accountmaximally. You buy 1,000 shares of a stock valued at 10 per share in
year 0. In year 1 you first receive a dividend of 1 per share, and then you sell
700 of your shares at an ex-dividend price of 11 per share. In year 2 you first
receive another dividend of 1 per share, and then you sell the remaining shares
at an ex-dividend price of 10 per share. What is the 2-year return on your
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capital? Assume the cash proceeds are kept in the margin account with zero
interest rate.
(9 marks)

The relevant readings are in Chapter 2, in the section called Working out the profitability of
margin trades.

First we work out the cash flows related to the underlying position.
Yr 0: the original investment costs 1,000(10) = 10,000 in cash outflow.
Yr 1: Dividend = 1,000(1) = 1,000 in cash inflow; selling shares 700(11) = 7,700 in cash
inflow, a total of 8,700 in cash inflow.
Yr 2: Dividend = 300(1) = 300 in cash inflow; selling shares 300(10) = 3,000 in cash inflow.
The original margin loan is 40% of the total, i.e. a Yr 0 cash inflow of 4,000 from
establishing the loan. In Yr 1 the remaining shares are worth 300(11) = 3,300, so you need
to reduce the loan to 40% of this number, or 1,320, which leads to a cash outflow of 4,000
1,320 = 2,680. Finally, you repay the whole loan in Yr 2, which leads to a cash outflow of
1,320. The net cash flows are, therefore: Yr 0: 10,000 + 4,000 = 6,000; Yr 1: 8,700
2,680 = 6,020; and Yr 2: 3,000 1,320 = 1,680. The profitability can be worked out using
the internal rate of return:
6,000 + 6,020/(1 + IRR) + 1,680/(1 + IRR)2 = 0
which leads to an approximate IRR of 26.4%, or 26.4% return per year. The Examiners
awarded 3 marks for the underlying cash flow derivations; 3 marks for the margin
adjustments to these cash flows and 3 marks for the IRR.
Question 5
(a) Explain what we mean by the term structure of interest rates. Name three
different types of hypotheses explaining the shape of the term structure of
interest rates.
(7 marks)
The readings for this question are in Chapter 7, in a section called The term structure.
The term structure of interest rates is the collection of spot rates of various maturities, reflecting
the varying cost of capital over the various time horizons. The term structure often has a certain
shape, leading to patterns in the future forward rates, which is explained by a number of
hypotheses: the expectation hypothesis which states that the implied forward rates reflect the
markets expectation about the future spot rates; the liquidity preference theory which states
that longer investment horizons imply higher risk to investors and that the longer spot rates are
therefore higher (which leads to a permanent pattern of todays forward rates being higher than
future spot rates); money substitute hypothesis which states that short, dated bonds are
effectively a substitute for cash (which offer zero return) and therefore have low return (which
leads to the same pattern between forward and future spot rates as above); and segmentation
hypothesis which states that the bonds traded in the various maturity classes are serving
different needs for investors, and that te spot rates are not necessarily very related over the
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various maturities. The Examiners awarded 1 mark for the definition of term structure and 6
marks for the explanation of three of the above hypotheses.
(b) The price of a bond is P , and the yield to maturity is r (annually compounded).
You estimate that the current ratio of the change in the bond price, P , over
the change in the yield to maturity, r, is 4.5 times the price of the bond P .
You also recognise that the ratio P/r above is not constant for varying
levels of r and you are trying to work out the numbers for the current yield to
maturity of 5%. If the price of the bond is P = 100, what is the (Macaulay)
duration of the bond? Explain how we can make use of bond duration in
practice.
(9 marks)

The readings for this question are in Chapter 7, in the section called Duration.

The question states that P/r is approximately equal to 4.5P , which implies that
P/P is approximately equal to 4.5r. We also know that P/P is equal to
(Modified duration)r, so the Modified duration, or D/(1 + r), is equal to 4.5. Hence, the
duration is equal to 4.5(1.05). The examiners awarded 2 marks for identifying the first
relationship, 3 marks for identifying the relationship between relative price movements and
interest rate movements and, finally, 2 marks for deriving the duration. The duration is used
in practice to manage balance sheets and in particular as a tool to design
hedge/immunisation strategies to protect the balance sheet from interest rate changes. The
Examiners awarded 2 marks for this explanation.
(c) You are given the following information about a portfolio, denoted A, the
market portfolio, denoted M, and the risk free asset, denoted R.
Portfolio A Market portfolio M Risk free asset R
Expected return 7.3% 8% 2%
Variance 10% 9% 0
Beta 0.88 1 0
Jensens alpha 0.04 0 0
According to the Treynor-Black model, the optimal mix of the A and M
portfolios for variance-averse investors is given by the formula:
A
w= .
A (1 A ) + (ErM rF ) Var
2
(A )
M
In this formula, w is the weight on portfolio A, A is Jensens alpha of portfolio

A, A is the beta of portfolio A, ErM is the expected return on the market
portfolio, rF is the risk free return, Var(A ) is the idiosyncratic risk of portfolio
2
A, and M is the variance of the market portfolio. Work out the optimal weight
w and interpret your answer.
(9 marks)

The readings for this question are in Chapter 6, in the sections called The Treynor-Black
model, and Estimation issues.

Almost all the numbers needed to solve this question are given in the table except the
variance of the idiosyncratic risk term in the final term of the denominator. This variance is
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the difference between the total risk of the active portfolio, which is 10%, and the systematic
risk of the active portfolio, which is (0.88)2 9%. Therefore the optimal weight is:
w = 0.04/(0.04(1 0.88) + (0.08 0.02)(0.10 (0.88)2 (0.09))/0.09) = 1.6.
The Examiners awarded 6 marks for working out the idiosyncratic risk, and 3 marks for
working out the weight. The interpretation is that you should invest 1.6 times your wealth
in the active portfolio and borrow 0.6 times your wealth in the passive portfolio. (However,
there is an unintended mistake in the table, since by the definition of Jensens alpha the
difference between the expected return of the active portfolio, 10%, and the expected return
on a 0.88 beta asset, 0.02 + 0.88(0.09 0.02), is only 2% and not 4%. So Jensens alpha is
possibly overstated in the table, and this would make the weight smaller.)
Question 6
(a) Explain what we mean by the equity premium puzzle. Based on the subject
guide, explain one way to resolve this puzzle.
(7 marks)
The readings for this question are to be found in Chapter 3 of the subject guide, in a section
called The equity premium puzzle.
Asset allocation choices and the difference in return between risky and risk free assets are
intimately linked, and the link is related to the investors preferences or utility functions. If we
roll all investors together to a representative investor and endow this investor with a utility
function we can study the actual holdings of risky versus risk free assets and the actual difference
in average returns, and therefore we can infer what the utility function looks like. In studies
where this has been done the answer is that the implied risk aversion is way too high, which
suggests that the difference in return between safe and risky assets is also way too high, and this
is the equity premium puzzle. The counter argument is that the empirical studies may use
samples that are too short in the sense that they accidentally have chosen periods where the
equity markets have done exceptionally well. Another counter argument is that the empirical
studies may use samples that are too long in the sense that this means they are picking equity
markets that have proven successful and therefore survived for a long period of time. Either
argument can lead to an overstatement of the return on equity markets. The Examiners awarded
4 marks for an explanation of the puzzle and 3 marks for an explanation of one of the two
arguments above.
(b) The Black-Scholes call option formula is C = SN (d1 ) P V (X)N (d2 ), where S
is the current stock price, P V (X) is the present value of the exercise price paid
at the maturity of the option, N () is the cumulative standard normal
distribution function, and d1 and d2 are parameters that depend on S, X, the
risk free interest rate, the volatility of the stock, and the time to maturity.
Suppose S = P V (X) = 100, d1 = 0.1, d2 = 0.1, N (d1 ) = 0.539828, and
N (d2 ) = 0.460172. Use the call formula to derive the expression of a put option
with the same exercise price. What are the call and the put prices?
(9 marks)

The readings for this question are in Chapter 9, in the section called Hedging volatility.
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The formula for a put is from put call parity:
P = C+P V (X)S = SN (d1 )P V (X)N (d2 )+P V (X)S = P V (X)(1N (d2 ))S(1N (d1 )).
Since S = P V (X) = 100, we find that C = 100(N (d1 ) N (d2 )) and:
P = 100(1 N (d2 ) 1 + N (d1 )) = 100(N (d1 ) N (d2 ))
therefore, C = P = 100(0.539829 0.460172) = 7.966. The examiners awarded 3 marks for

the put expression, and 6 marks for the expressions of the put and the call options.
(c) Suppose you buy x call and y put options of the type mentioned in part (b) of
this question. What is the ratio x/y such that the delta of the option portfolio
is zero (i.e. such that the value of the option portfolio does not change for small
changes in the underlying stock price S)? Explain how this portfolio can be
used to hedge against changes in the volatility of the stock.
(9 marks)

The readings for this question are in Chapter 9, in the section called Hedging volatility.

Consider a portfolio of x units of calls and y units of puts, which have the value:
xC + yP = x(SN (d1 ) P V (X)N (d2 )) + y(P V (X)(1 N (d2 )) S(1 N (d1 )).
If we wish to immunise this portfolio against small movements in the price of the stock S,
we use:
dxC + yP/dS = xN (d1 ) y(1 N (d1 )) = 0
which implies:
x/y = (1 N (d1 ))/N (d1 ) = 0.85
so that for each unit of puts you buy 0.85 units of calls. The value of this portfolio will not
respond to small changes in the stock price but will respond to small changes in the other
parameters determining the option prices, most notably the volatility parameter. When the
volatility goes up, the value of the options also go up, therefore the value of this portfolio
will go up. Buying this portfolio will deliver a cash flow if there is an increase in the
volatility, and selling this portfolio will deliver a cash flow if there is a reduction in the
volatility, and it can be used therefore to hedge against volatility changes. The Examiners
awarded 3 marks for a correct expression of the value of the portfolio, 3 marks for the
optimal x/y ratio and 3 marks for the explanation.
Question 7
(a) Explain how you can use the single index model to estimate the
variance-covariance matrix of stocks. Why is this method useful in practice?
(7 marks)
The readings for this question are in Chapter 6, in the section called Estimation issues.
13
The single index model assumes that the return on stock i can be written on the form
ri = ai + bi rM + ei , so that the covariance between two stocks:
cov(ri , rj ) = cov(ai + bi rM + ei , aj + bj rM + ej )
= cov(bi rM + ei , bj rM + ej )
= cov(bi rM , bj rM ) + cov(bi rM , ej ) + cov(ei , bj rM ) + cov(ei , ej )
= cov(bi rM , bj rM )
= bi bj cov(rM , rM )
= bi bj var(rM ).
The b parameters are the beta coefficients of the stock, so the covariance of two stocks can be
linked directly to the beta coefficients of the stocks, which hold because the single index model
assumes that all idiosyncratic risk of a stock is uncorrelated with all other risk. This model is
useful in practice because it reduces the number of estimations that need to be made by a large
fraction, and it guarantees that the variance-covariance matrix is constructed in such a way that
the variance of all portfolios is positive. If there are missing observations then it is possible that
the covariance estimate is such that the variance of certain portfolios becomes negative. The
Examiners awarded 4 marks for the outline of the method and 3 marks for the explanation of the
usefulness of the method.
(b) A bond is quoted with a price of 100.20 per 100 face value. The coupon of 3.2%
of face value is paid once a year, and it is 45 days since the last coupon payment.
If you were to trade this bond, what price do you expect to pay for the bond?
(9 marks)

The readings for this question are in Chapter 2, in the section called Bond market
instruments.

The quoted price is equal to the dirty price minus accrued interest. The price you pay is the
dirty price, which can be deduced once you know the accrued interest. The accrued interest
is the coupon payment, in this case 3.2, times the number of days since the last coupon
payment, which is 45, divided by the number of days between coupon payments, which in
this case is 365 since the coupon is paid annually. Accrued interest is therefore 3.2(45/365)
= 0.395, and the dirty price is 100.595. The Examiners awarded 3 marks for working out
accrued interest, and 6 marks for formulating and working out the dirty price.
(c) The expected return on the market index is 8%, with standard deviation 0.3,
and the risk free return is 2%. You consider holding a portfolio that has at most
standard deviation 0.2, subject to the constraint that the portfolio earns an M 2
measure of 2%. What Sharpe ratio is required to meet your investment
objective?
(9 marks)

The readings for this question are in Chapter 8, in the sections called The Sharpe ratio and
More portfolio performance measures.

The M 2 measure is given as:
M 2 = (1 x)rF + xr rM = x(r rF ) (rM rF ) = 0.02
14
subject to the constraint that x = StdDev(rM )/StdDev(r). Substituting the expression for x
into the expression for M 2 above, we find that:
((r rF )/StdDev(r))/((rM rF )/StdDev(rM )) (rM rF ) = 0.02
or Sharpe(r)/Sharpe(rM ) = 0.02 + (rM rF ) = 0.08. Therefore, Sharpe(r) = 0.08

Sharpe(rM ) = 0.08 (0.06/0.3). Using the constraint that StdDev(r) is at most 0.2, we find
that r must be equal to 0.02 + 0.08 (0.06/0.3)StdDev(r) but the right-hand side is smaller
than 0.02 + 0.08 (0.06/0.3) 0.2. The Examiners awarded 3 marks for working out the
expression for M 2 , 3 marks for working out the optimal weight in the M 2 measure and 3
marks for finding the expression for the expected return on the portfolio as a function of the
standard deviation.
Question 8
(a) The information ratio for a portfolio is defined as Jensens alpha divided by the
unsystematic (idiosyncratic) risk of the portfolio. Explain how this ratio works,
and discuss its usefulness for investors.
(7 marks)
The readings for this question are in Chapter 8, in the section called More portfolio performance
measures.
When investors are fully diversified and take small positions in a portfolio, they dont care about
the idiosyncratic risk of the new portfolio since the incremental variance of the new position
depends only on the covariance between the new portfolio and the already diversified portfolio
(i.e. the systematic risk of the portfolio). Therefore, the information ratio is useful for investors
who do not hold fully diversified portfolios. In this case the investor is interested in the cost of
holding a portfolio which delivers a benefit in terms of superior systematic risk. The information
ratio, which is the ratio of Jensens alpha (the measure of superior systematic risk) divided by
the idiosyncratic risk, measures the benefit to cost ratio of this calculation. Where this ratio is
high, the investor knows that the cost of holding it is small relative to the benefits it delivers.
The Examiners awarded 4 marks for the explanation of the information ratio, and 3 marks for
pointing out the usefulness of this ratio.
(b) In Rolls model described in the subject guide we consider a dealer market for
an asset that has the fundamental price at time t of mt , which changes in
response to the arrival of new information, mt = mt1 + ut , where ut represents
new information at time t. The transaction price at time t at which trade takes
place is pt = mt + qt c, where qt is equal to +1 or 1 and c is a constant. Roll
argues that Cov(pt , pt1 ) = c2 , where pt is the price change at time t
(= pt pt1 ). Explain the relationship between the transaction price and the
fundamental price of the asset. Derive Rolls covariance term and explain what
additional assumptions are needed as you go along. How can we interpret this
result?
(9 marks)

The readings for this question are in Chapter 5, in the section called Bid-ask bounce: the
Roll model.
15

Rolls model assumes that the transaction price is equal to the fundamental price
plus/minus a half-spread c, depending on whether the investor is buying or selling,
respectively. The transaction prices will, therefore, tend to bounce up and down with the
buy/sell decision of the investors, in addition to the market changes in the fundamental
price. The covariance of successive price movements is, therefore:
cov(pt+1 pt , pt pt1 ) = cov((mt+1 mt ) + (cqt+1 cqt ), (mt mt1 ) + (cqt cqt1 ))

= cov((mt+1 mt ), (mt mt1 )) + cov((mt+1 mt ), (cqt cqt1 ))
+cov((cqt+1 cqt ), (mt mt1 )) + cov((cqt+1 cqt ), (cqt cqt1 ))
= 0 + 0 + 0 + cov(cqt+1 , cqt ) cov(cqt+1 , cqt1 )
cov(cqt , cqt ) + cov(cqt , cqt1 )
= c2 var(qt ).
Since var(qt ) = 1, the covariance of successive price movements is c2 . Therefore, the

half-spread c equals minus the square root of the covariance in successive price movements.
The Examiners awarded 3 marks for the derivations, 3 marks for outlining what
independence assumptions are needed and 3 marks for the interpretation/intuition of the
result.
(c) You are given the following information about 1-year put and call prices for an
asset that is currently trading at a price of 100.
Exercise price 90 Exercise price 100 Exercise price 110
Call 34.4 29.5 24.6
Put 22.6 27.5 32.5
Are there arbitrage opportunities in this market? If so, demonstrate how they
could be exploited.
(9 marks)

The readings for this question are in Chapter 9, in the section called Portfolio insurance
with calls.

Put-call parity makes it possible to make risk-free investments out of investments in the
stock, the call on the stock and the put on the stock, when the exercise price is the same for
both options. This is done by the relationship P V (x) = S + P C, which for the thee cases
above yields P V (90) = 100 + 22.6 34.4; P V (100) = 100 + 27.5 29.5; and
P V (110) = 100 + 32.5 25.6. All three have implied risk free rates the first one 2.041%;
the second 2.041%; and the third one 1.946%. Therefore, you can invest in either of the two
first and borrow in the last one to make a small profit. The Examiners awarded the
application of the put-call parity 6 marks, and the outline of an arbitrage position of the
type above 3 marks.
16

Important note
section.
Comments on specific questions Zone B
Candidates should answer FOUR of the following EIGHT questions. All questions carry equal
marks.
Question 1
(a) Explain the difference between exchange trading and over-the-counter (OTC)
trading of securities. Discuss the relative benefits for investors of the two forms
of trading.
(7 marks)
The readings for this question are in Chapter 2 of the subject guide, in the section called
Exchange trading and over-the-counter (OTC) trading.
Exchange trading takes place in a centralised market where buyers and sellers orders are
aggregated and matched (possibly with the help of a market maker but most modern markets are
fully electronic markets that match limit orders). Over-the-counter (OTC) trading takes place in
a decentralised market where buyers and sellers approach a dealer who is the counterparty. The
dealers may trade between each other or with other buyers and sellers to net out their positions.
The benefits of investors who trade in exchanges is that they will get the best deal from their
counterparty without an intermediary taking a cut, and they will trade a standardised asset
where there is normally high liquidity. The benefits of investors who trade in OTC markets is
that they can request specialised products where there otherwise is little liquidity. The
17
Examiners awarded 4 marks for the explanation of the two market structures, and 3 marks for
the outline of the relative benefits.
(b) Suppose a competitive risk neutral market maker clears the market by offering
bid and ask quotes at which she is willing to trade one share of a stock. Traders
are either uninformed noise traders who are as willing to buy a share as sell a
share of the stock, or informed traders who know exactly the value of stock and
who consequently buy when the value is high and sell if the value is low. The
ratio of informed to uninformed traders is 1 to 5. The value of the stock is 110
if it is high and 90 if it is low, and both are seen as equally likely by the market
maker. Work out the market makers bid and ask quotes in the first round of
trading.
(9 marks)

The readings for this question ae in Chapter 5, in the section called GlostenMilgrom.

This is a GlostenMilgrom style question, where the traders trade fixed units and the only
problem is to outline the bid-ask price setting by the market maker. A competitive market
maker works out the probability of high value conditional in the event that the trader wants
to buy the asset, or alternatively wants to sell the asset. The first is:
P (Buy | Hi) P (Hi)

P (Hi | Buy) =
P (Buy | Hi) P (Hi) + P (Buy | Lo) P (Lo)
and the second:
P (Sell | Hi) P (Hi)

P (Hi | Sell) =
(P (Sell | Hi) P (Hi) + P (Sell | Lo) P (Lo)).
The probability of insiders trading is 1/6, and they buy when the value is Hi and sell when
the value is Lo, so:
(5/6) 0.5 0.5

P (Hi | Sell) = = 0.417
((5/6) 0.5 0.5 + ((5/6) 0.5 + (1/6)) 0.5)
and:
((5/6) 0.5 + (1/6)) 0.5
P (Hi | Buy) = = 0.583.
(((5/6) 0.5 + (1/6)) 0.5 + (5/6) 0.5 0.5)
Conditional on a Buy transaction the Ask price is therefore
0.583(110) + (1 0.583)(90) = 101.66, and conditional on a sell transaction the bid price is:
0.417(110) + (1 0.417)(90) = 998.34.
The Examiners awarded 5 marks for a demonstration of the conditional probabilities and 4
marks for working out the prices.
(c) You seek to implement a return based trading strategy to exploit potential
momentum effects in the stock market. The following table shows the most
recent 3-month returns on 5 stocks in which you seek to trade.
Stock A B C D E
3-month return 5% 3% 1% 2% 8%
18
Based on these data, work out a set of weights for your portfolio such that you
commit no capital to your position.
(9 marks)

The readings for this question are in Chapter 4 in the section called Return based trading
strategies.

An equally weighted index has return:
(1/5) (5% + 3% + (1%) + (2%) + 8%) = 2.6%
so the weigths are proportional to the vector:
(5 2.6, 3 2.6, 1 2.6, 2 2.6, 8 2.6) = (2.4, 0.4, 3.6, 4.6, 5.4)
so for instance if you trade 100 times the vector, your position is going to have 240 invested
in A, 40 invested in B, 360 invested in C, 460 invested in D, and 540 invested in E. The
total value of your investment is 240 + 40 360 460 + 540 = 0, and that will be true for
any factor multiplied by the vector above. The Examiners awarded 2 marks for working out
the return on the index, 5 marks for deriving the fundamental weight-vector and 2 marks for
demonstrating that your position will commit zero capital.
Question 2
(a) Explain what we mean by floating-rate debt. Discuss ways in which these
instruments are helpful to borrowers.
(7 marks)
The readings for this question can be found in Chapter 3, under the section Recent financial
innovations, where you will find a sub-section called Case study 1: Floating rate debt.
Here the Examiners were looking for an explanation of the essential ingredients of a floating rate
debt contract which are a market rate (such as LIBOR) and a contractual coupon rate which is
linked to this rate (for instance LIBOR + 3%), for which they awarded 4 marks. They were also
looking for reasons why these instruments are helpful, which is that they give the borrower a
natural hedge against inflation shocks as inflation can be a large component of the nominal
interest rate (fixed rate debt gets relatively more expensive in low-inflation times and relatively
less expensive in high-inflation times), for which they awarded 3 marks. Also, since LIBOR rate
setting has been under scrutiny recently in the press due to alleged rate fixing by major
US/European banks the Examiners were prepared to award points to candidates who argued this
as a potential harmful effects of floating rate debt for borrowers.
(b) A 5-year bond has annual coupon rate of 5% and yield to maturity 6%. What is
the duration of the bond?
(9 marks)
19

The readings for this question can be found in Chapter 7, in a section called Duration.

We can choose a bond with face value 1, face value 100, or face value 1,000, whichever we
choose we get the same answer. Pick 1,000: the bond is trading below par value because the
coupon rate is lower than the yield to maturity, and the value of the bond is:
1,000 0.05 1,000 0.05 1,000 0.05 1,000
+ 2
+ + 5
+ = 957.876.
(1.06) (1.06) (1.06) (1.06)5
The duration is therefore:

1,000 0.05/(1.06) + 2 1,000 0.05/(1.06)2 + + 5 1,000 0.05/(1.06)5 + 5 1,000/(1.06)5
957.876
= 4.53.
The Examiners awarded 5 marks for working out the price correctly and 4 marks for
working out the duration.
(c) What is the convexity of the bond in part (b)?

(9 marks)

The readings for this question can be found in Chapter 7 of the subject guide, in the section
called Convexity.

Again it doesnt matter what face value we pick for the bond, as the answer will be the
same either way, so the 1,000 face value chosen in (b) will not affect the answer. The
convexity definition of convexity varies basically a price change in a bond with price P (r)
at a yield to maturity r when the yield changes to r + dr should satisfy the approximation:
dP (r + dr)/P (r) = (D/(1 + r)) dr + C dr2
according to some texts and:
dP (r + dr)/P (r) = (D/(1 + r)) dr + (1/2) C dr2
according to other texts where D is the duration and C is the convexity. The Examiners
would accept either answer. The first number is given by:
C = (1/2) (1 2 1,000 0.05/(1.06)3 + 2 3 1,000 0.05/(1.06)4

+ + 5 6 1,000 0.05/(1.06)7 + 5 6 1,000/(1.06)7 )/957.876
= 11.71.
The candidates who got the wrong price in (b) would not be penalised in (c). There were 9
marks for this calculation.
Question 3
(a) Explain the difference between hedging using put-option protection and
Value-at-Risk (VaR). Discuss the relative advantages and disadvantages of the
two hedge-strategies.
(7 marks)
20
The readings for this question are in Chapter 9, in the section called Put protection vs. VaR.
A put-option protected hedge strategy will, if it works the way it is intended, have payoffs in the
states where the value of the underlying asset is low. If these events are correlated with your
hedging events, then it delivers a targeted hedge. A value-at-risk strategy delivers a cash cushion
in all states, so it provides unnecessary capital in the states of nature where there is no hedging
need. The trade-off is between a targeted hedge, which may be expensive in illiquid markets and
also fail to deliver the hedge effect if the correlation between the hedging need and the
underlying asset is not sufficiently high, and a non-targeted hedge, which will deliver in all states
of nature. The Examiners awarded 4 marks for an explanation of the different types of hedge
strategies and 3 marks for an outline of the various benefits.
(b) A portfolio has a value V that follows a geometric Brownian motion with drift
parameter (instantaneous return) m = 0.10 and diffusion parameter (volatility)
= 0.2, which implies that the log return of the portfolio value from time t to
time T , ln VT ln Vt , is normally distributed with mean (m 2 /2)(T t) and
variance 2 (T t). What is the 1%, 20-day VaR of the portfolio? Hint: If X is
a normally distributed random variable with mean M and variance S 2 , then
Z = (X M )/S is a standard normally distributed random variable with mean
0 and variance 1 with probability Prob(Z 2.33) = N (2.33) = 0.01.
(9 marks)

The readings for this question are in Chapter 9, in the section called Put protection vs VaR.

If x is a normal random variable, then (x E(x))/StdDev(x) is a standard normal random
variable with mean 0 and variance 1. Therefore, if the return y on the portfolio above is
normal with mean (m 2 /2)(T t) and variance 2 (T t), the transformed return
z = (y (m 2 /2)(T t))/( T t) is normal with mean 0 and variance 1. The
than 2.33 is N (2.33) = 0.01, means that the probability that
probability that z is less
(y (m 2 /2)(T t))/( T t) is less than
2.33 is also 1%. This condition reduces to y
being less than (m 2 /2)(T t) 2.33 T t, or y being less than:
p
(0.10 0.22/2)(20/365) 2.33(0.2) 20/365 = 0.105.
Therefore, the 1% 20-day VaR of the portfolio is 10.5% of the portfolios value.
The Examiners awarded 3 marks for transforming the problem into standard normal form,
and 3 marks for applying the relationship with the standard normal distribution function
N (z), and finally 3 marks for working out the VaR number.
(c) Consider the portfolio in part (b), and assume that the risk free rate
(continuously compounded) is 2%. The costs of a 20-day European call and put
options on the portfolio with exercise price 1,000 are, respectively, 17.766 and
16.671 per 1,000 capital invested at time t (i.e. assuming Vt = 1,000). Create a
put-protected portfolio which over a 20-day period will not end up at a
value below its current levels Vt .
(9 marks)
21

The readings for this question are in Chapter 9, in the section called Portfolio insurance
with calls.

We can work out this problem on the basis of 1,000 capital invested. Take the present value
of this cash flow at maturity:
P V (1,000) = 1,000 exp(0.02(20/365)) = 998.90
which means that if you invest 998.90 risk free you will have 1,000 in 20 days time. Since
you have invested 1,000, you will have 1.095 left to purchase call options with exercise price
1,000. Since one call costs 17.766 you purchase only 1.095/17.766 units of the call.
Therefore, your portfolio consists of 998.90 invested risk free and 0.06 units of a 20-day call
option with exercise price 1,000. Since each call is equivalent to a put plus 1,000 worth of
the index minus PV(1,000) invested risk free, you can transform the 0.06 Calls to 0.06 Puts
plus 0.06(1,000) invested in the index less 0.06(998.90) invested risk free. Therefore, your
position now consists of (1 0.06)998.90 = 998.84 invested risk free; 0.06(1,000) = 60
invested in the index; and 0.06(16.671) = 1.000 invested in puts with exercise price 1,000.
The Examiners awarded 5 marks for identifying the first position involving calls, and a
further 4 marks for transforming it into a portfolio involving puts.
Question 4
(a) Explain the Treynor-Black model outlined in the subject guide.

(7 marks)
Chapter 6 of the subject guide.
This model explains an approach to taking advantage of the knowledge of a portfolio which lies
above the capital market line (i.e. the portfolio has superior Sharpe ratio relative to the market
portfolio). The approach consists of mixing the new portfolio (the active portfolio) with the
market portfolio (the passive portfolio) in such a way that the Sharpe ratio of the mixture
portfolio is maximal. An illustration of this problem and a formula for the weights of the optimal
mixture portfolio are given in the subject guide. The problem is only an approximate solution to
the problem, as the new information should actually lead to a recalculation of the entire portfolio
frontier, which leads to the identification of a new tangency portfolio.
(b) A competitive risk neutral market maker clears the market for trading in an
asset. There are two traders, an uninformed noise trader and an informed
trader who has perfect information about the true value of the asset, which is
110 or 90. The market maker thinks the two prices are equally likely. The
uninformed trader buys one unit or sells one unit of the asset with equal
probability. The market maker observes the aggregate orders from the two
traders and clears the market. Work out the optimal trading strategy and the
expected profits for the informed trader.
(9 marks)
22

The readings for this question are in Chapter 5, in the section called Discrete version of the
Kyle model.

This is a Kyle-style question. We need to work out the optimal trading strategy by the
informed trader as well as the optimal price setting strategy by the market maker. The
market maker observes the aggregate order flow, the sum of uninformed and informed
trading, so if the informed trader trades in any other quantities than the uninformed traders
the market maker can infer the informed traders trading. Therefore, the informed trader
buys one unit if the price is 110, and sells one unit if the price is 90. Since either is
probability half and half, the aggregate order flow is therefore either 2 or 0 if the price is
110, or 0 or 2 if the price is 90. The market maker cannot infer the price if the aggregate
order flow is 0, and sets a market clearing price of 100 in this case. Therefore the insiders
profits is 0.5(110 100) + 0.5(110 110) = 5 if the price is 110, and
0.5(100 90) + 0.5 (90 90) = 5 if the price is 90, so the expected trading profits of the
insider is 5, and the expected profits of the market maker is 0. The Examiners awarded 3
marks for outlining the price setting strategy of the market maker, 3 marks for the insiders
optimal trading strategy and 3 marks for the insiders expected profits.
(c) You find that the auto-covariance in price-changes (measured transaction by

transaction) is -0.02. What do you expect is the spread between the bid and ask
prices in this market (measured in dollars and not in percentages)?
(9 marks)

The readings for this question are in Chapter 5, in the section called Bid-ask bounce: the
Roll model.

We know that if c is the half-spread, then the following relationship holds:
p
c = cov(pt , pt1 ).
Since cov(, ) = 0.02, we find that c = 0.14, so the spread is 0.28 in dollar terms. The
relationship between c and the covariance of successive price changes was awarded 5 marks
by the Examiners, and working out the correct spread was awarded 4 marks.
Question 5
(a) Hedge transactions involving the trading of derivatives have zero net present
value, so will never increase the value of the corporation. Discuss this
statement, and explain why hedging of corporate risk nonetheless can add value
to corporations.
(7 marks)
The readings in the subject guide can be found in Chapter 9, in the section called Risk
management for corporations, but you may also consult the Further readings listed in the
beginning of Chapter 9, in particular:
Stultz, R. Risk Management and Derivatives. (Mason, Ohio: Thomson South-Western,

2003) [ISBN 9780538861014] which spends a lot of time on this particular issue.
23
The statement is technically true, as the efficient market hypothesis states that the market price
of financial assets should always reflect the available information so the cost equals the value and
the net present value is zero. The Examiners awarded 3 marks for this observation. However,
corporations create value from hedging indirectly, as hedging can be tax efficient, reduce costs of
financial distress, reduce agency costs and reduce the information cost of financing. In particular,
the firm benefits from avoiding a shortfall of cash flow in certain states which can easily lead to
costs which otherwise would be avoidable. The Examiners awarded 4 marks for the latter part.
(b) A portfolio has a beta of 0.5, and idiosyncratic risk with variance 3%. The
variance of the market portfolio is 10%, and the return on the market portfolio
is 8% on average. The risk free return is 2%. What is the required return on
the portfolio in order that it matches the market portfolio in terms of the
Sharpe ratio?
(9 marks)

The readings for this question are in Chapter 8, in a section called The Sharpe ratio, and
also in Chapter 6, in a section called Estimation issues, where the risk decomposition
between systematic and unsystematic/idiosyncratic risk is dealt with.

The Sharpe ratio is (Expected return
Risk free return)/Standard Deviation, which for the
market portfolio is (8% 2%)/ 10% = 0.1897. The expected return on the portfolio is r,
and the variance
of the portfolio is (0.5)2 0.10 + 0.03 = 5.5%. Therefore, we need that
(r 0.02)/ 5.5% is greater than 0.1897, which implies that
r 0.02 + ( 0.055)(0.1897) = 0.0645 or 6.45%. The Examiners awarded 5 marks for
deriving an expression for the Sharpe ratio of the portfolio, 2 marks for the Sharpe ratio of
the market and 2 further marks for finding the cut-off point.
(c) Define absolute and relative risk aversion. In asset allocation situations where
the investors split their investments into a safe and a risky asset, how do
investors with constant absolute risk aversion optimally choose their portfolios
as their wealth changes? What about investors with constant relative risk
aversion?
(9 marks)

The readings for this question can be found in Chapter 6, in a section called Asset allocation
over longer time horizons, and in Appendix 1, in the section called Risk aversion coefficient.

This question assumes that individuals preferences can be expressed as a utility function u
over wealth, x, or u(x). Then we can define risk aversion in terms of the concavity of this
function, specifically the absolute risk aversion coefficient is u00 (x)/u0 (x), and the relative
risk aversion coefficient is the absolute risk aversion coefficient times wealth itself, or
u00 (x)x/u0 (x). Individuals choices in terms of risk taking can be related to these two
concepts, and in particular individuals who have a constant absolute risk aversion will take a
constant amount of risk in their portfolio, for instance they will invest $1,000 in risky assets
and hold the rest in a risk-free asset regardless of how wealthy they are. In contrast,
individuals with a constant relative risk aversion coefficient will hold a constant fraction of
their wealth in the risky assets, for instance, they hold half their wealth in risky and half
their wealth in safe assets regardless of how wealthy they are. The Examiners awarded 3
24
marks for the definitions of the risk aversion coefficients, 3 marks for the explanation of
risk-taking behaviour with constant absolute risk aversion and 3 marks for the explanation
of risk taking behaviour with constant relative risk aversion.
Question 6
(a) Explain what we mean by the term structure of interest rates. Name three
different types of hypotheses explaining the shape of the term structure of
interest rates.
(7 marks)
The readings for this question are in Chapter 7, in a section called The term structure.
The term structure of interest rates is the collection of spot rates of various maturities, reflecting
the varying cost of capital over the various time horizons. The term structure oftenhas a certain
shape, leading to patterns in the future forward rates, which is explained by a number of
hypotheses: the expectation hypothesis which states that the implied forward rates reflect the
markets expectation about the future spot rates; the liquidity preference theory which states
that longer investment horizons imply higher risk to investors and that the longer spot rates are
therefore higher (which leads to a permanent pattern of todays forward rates being higher than
future spot rates); money substitute hypothesis which states that short dated bonds are
effectively a substitute for cash (which offer zero return) and therefore have low return (which
leads to the same pattern between forward and future spot rates as above); and segmentation
hypothesis which states that the bonds traded in the various maturity classes are serving
different needs for investors, and that the spot rates are not necessarily very related over the
various maturities. The Examiners awarded 1 mark for the definition of term structure and 6
marks for the explanation of three of the above hypotheses.
(b) The price of a bond is P , and the yield to maturity is r. You estimate that the
current ratio of the change in the bond price, P , over the change in the yield
to maturity, r, is 4.5 times the price of the bond P . You also recognise that
the ratio P/r above is not constant for varying levels of r and you are trying
to work out the numbers for the current yield to maturity of 5%. If the price of
the bond is P = 100, what is the (Macaulay) duration of the bond? Explain
how we can make use of bond duration in practice.
(9 marks)

The readings for this question are in Chapter 7, in the section called Duration.

The question states that P/r is approximately equal to 4.5P , which implies that
P/P is approximately equal to 4.5r. We also know that P/P is equal to
(Modified duration)r, so the Modified duration, or D/(1 + r), is equal to 4.5. Hence, the
duration is equal to 4.5(1.05). The Examiners awarded 2 marks for identifying the first
relationship, 3 marks for identifying the relationship between relative price movements and
interest rate movements and, finally, 2 marks for deriving the duration. The duration is used
in practice to manage balance sheets and in particular as a tool to design
hedge/immunisation strategies to protect the balance sheet from interest rate changes. The
Examiners awarded 2 marks for this explanation.
25
(c) You are given the following information about a portfolio, denoted A, the
market portfolio, denoted M, and the risk free asset, denoted R.
Portfolio A Market portfolio M Risk free asset R
Expected return 7.3% 8% 2%
Variance 10% 9% 0
Beta 0.88 1 0
Jensens alpha 0.04 0 0
According to the Treynor-Black model, the optimal mix of the A and M
portfolios for variance-averse investors is given by the formula
A
w= .
A (1 A ) + (ErM rF ) Var
2
(A )
M
In this formula, w is the weight on portfolio A, A is Jensens alpha of portfolio

A, A is the beta of portfolio A, ErM is the expected return on the market
portfolio, rF is the risk free return, Var(A ) is the idiosyncratic risk of portfolio
2
A, and M is the variance of the market portfolio. Work out the optimal weight
w.
(9 marks)

The readings for this question are in Chapter 6, in the sections called The Treynor-Black
model, and the section called Estimation issues.

Almost all the numbers needed to solve this question are given in the table, except the
variance of the idiosyncratic risk term in the final term of the denominator. This variance is
the difference between the total risk of the active portfolio, which is 10%, and the systematic
risk of the active portfolio, which is (0.88)2 9%. Therefore the optimal weight is:
w = 0.04/(0.04(1 0.88) + (0.08 0.02)(0.10 ((0.88)2 (0.09))/0.09) = 1.6.
The Examiners awarded 6 marks for working out the idiosyncratic risk, and 3 marks for
working out the weight. The interpretation is that you should invest 1.6 times your wealth
in the active portfolio and borrow 0.6 times your wealth in the passive portfolio. (However,
there is an unintended mistake in the table, since by the definition of Jensens alpha the
difference between the expected return of the active portfolio, 10%, and the expected return
on a 0.88 beta asset, 0.02 + 0.88(0.09 0.02), is only 2% and not 4%. So Jensens alpha is
possibly overstated in the table, and this would make the weight smaller.)
Question 7
(a) Explain what we mean by collateralised debt/loan obligations. It has been

claimed that these instruments played a role in undermining banks lending
operations in the period leading up to the financial crisis in 2007 explain the
argument behind this assertion.
(7 marks)
The readings for this question are in Chapter 3, in the section Recent financial innovation, and
specifically in the sub-section called Case study 7: Collateralised debt/loan obligations.
26
Collateralised debt obligations are assets which are backed by the cash flow of loans or bonds. It
is often easier to sell claims on large bond/loan portfolios as collateralised debt obligations than
to sell the individual bonds/loans directly, therefore the use of these instruments has become a
way of offloading old loans from the banks balance sheet so that the bank can release capital for
new lending. The reason these instruments got a bad name in the run-up to the financial crisis is
that they were thought to encourage banks to lend to bad borrowers and then to sell the loans off
to investors who did not realise the loans were bad, which created a large amount of bad debt in
many Western economies. The incentives to screen borrowers for credit quality are reduced if the
bank knows that the loans can simply be packaged into a series of collateralised debt obligations.
The Examiners awarded 4 marks for the explanation of what these instruments are, and 3 marks
for the argument they could encourage bad lending practices.
(b) An investor has mean-variance preferences which can be expressed as the

function U (, 2 ) = (/2) 2 , where is the expected return on the
investors portfolios, 2 is the variance of the investors portfolio, and > 0 is a
parameter describing the investors variance aversion. Derive the optimal
portfolio for the investor when all investors have mean-variance preferences and
there exists a risk free asset. Also derive the critical value of which
determines the cut-off point between investors who are net lenders and net
borrowers of the risk free asset.
(9 marks)

The readings for this question are in Chapter 6, in the section called CARA utility and
normal returns.

The first step is to argue that when investors have mean-variance preferences, they will
always choose portfolios that consist of the risk-free asset and the tangency/market portfolio
(2-fund separation). Therefore, the optimal portfolio can be expressed as:
xrM + (1 x)rF = rF + x(rM rF )
for some x, where rF is the risk free return and rM is the return on the tangency/market
portfolio. Next, the variance of this portfolio is equal to x2 M
2 2
, where M is the variance of
the tangency/market portfolio. Therefore, the investors are maximising:
rF + x(rM rF ) (/2)x2 M
2
with respect to x. The first order condition is when the derivative is zero, or
2 2 2
(rM rF ) = xM , or x = (1/)(rM rF )/M . When x = 1 then = (rM rF )/M .
When is greater than this value, x is less than 1 and the investor is a net lender since his
weight 1 x is positive. When is less than this value, x is greater than 1 and the investor
is a net lender since 1 x is negative. The Examiners awarded 3 marks for the observation
that we get 2-fund separation, 3 marks for the derivation of the optimal x, and 3 marks for
the net lending/borrowing cut-off point.
(c) In the subject guide there is a discussion about the difficulties of measuring the
performance of hedge funds. The following table is an extract from this
material, and shows the actual performance data on a hedge fund against the
S&P 500 index.
S&P 500 Hedge Fund
Monthly mean return 1.4% 3.6%
Monthly standard deviation 3.6% 5.8%
Annual Sharpe ratio 1.39 2.15
27
Explain what the numbers in the table mean. Explain how the hedge fund
achieved these numbers, and why the real performance of the hedge fund may
not be as high as the numbers indicate.
(9 marks)

The readings for this section are in Chapter 4, in the section called Performance of hedge
funds.

The first step is to explain the numbers in the table, which is that the hedge fund appears
to achieve a greater Sharpe ratio than the market portfolio. This is evidence that the hedge
fund is doing extremely well, since the excess return per unit of risk is nearly twice what it
is for the market portfolio. The problem with this is that there are hidden risks in the hedge
funds portfolio, which arises from the practice that many hedge funds are involved with
which is to sell deep out of the money put options. These options will generate a profit
through the sale price, and they will very rarely be exercised because they are deep out of
the money. Therefore, the hedge fund will generate a monthly return which appears stable.
However, the fact that the options are very rarely exercised does not mean that the risk is
not there, only that the risk is not easily reflected in the hedge funds returns. The
Examiners awarded 3 marks for explaining the numbers in the table, 3 marks for explaining
how the practice of selling deep out of the money options can generate the numbers in the
table and 3 marks for the fact that the problem is a bias in the calculation of the Sharpe
ratio from the hidden risk of these options.
Question 8
(a) Explain how you can use the single index model to estimate the
variance-covariance matrix of stocks. Why is this method useful in practice?
(7 marks)
The readings for this question are in Chapter 6, in the section called Estimation issues.
The single index model assumes that the return on stock i can be written on the form
ri = ai + bi rM + ei , so that the covariance between two stocks:
cov(ri , rj ) = cov(ai + bi rM + ei , aj + bj rM + ej )
= cov(bi rM + ei , bj rM + ej )
= cov(bi rM , bj rM ) + cov(bi rM , ej ) + cov(ei , bj rM ) + cov(ei , ej )
= cov(bi rM , bj rM )
= bi bj cov(rM , rM )
= bi bj var(rM ).
The b parameters are the beta coefficients of the stock, so the covariance of two stocks can be
linked directly to the beta coefficients of the stocks, which hold because the single index model
assumes that all idiosyncratic risk of a stock is uncorrelated with all other risk. This model is
useful in practice because it reduces the number of estimations that need to be made by a large
fraction, and it guarantees that the variance-covariance matrix is constructed in such a way that
the variance of all portfolios is positive. If there are missing observations then it is possible that
28
the covariance estimate is such that the variance of certain portfolios becomes negative. The
Examiners awarded 4 marks for the outline of the method and 3 marks for the explanation of the
usefulness of the method.
(b) A bond is quoted with a price of 100.20 per 100 face value. The coupon of 3.2%
of face value is paid once a year, and it is 45 days since the last coupon payment.
If you were to trade this bond, what price do you expect to pay for the bond?
(9 marks)

The readings for this question are in Chapter 2, in the section called Bond market
instruments.

The quoted price is equal to the dirty price minus accrued interest. The price you pay is the
dirty price, which can be deduced once you know the accrued interest. The accrued interest
is the coupon payment, in this case 3.2, times the number of days since the last coupon
payment, which is 45, divided by the number of days between coupon payments, which in
this case is 365 since the coupon is paid annually. Accrued interest is therefore 3.2(45/365)
= 0.395, and the dirty price is 100.595. The Examiners awarded 3 marks for working out
accrued interest, and 6 marks for formulating and working out the dirty price.
(c) The expected return on the market index is 8%, with standard deviation 0.3,
and the risk-free return is 2%. You consider holding a portfolio that has at most
standard deviation 0.2, subject to the constraint that the portfolio earns an M 2
measure of 2%. What expected return is required to meet your investment
objective if the portfolio has maximum risk?
(9 marks)

The readings for this question are in Chapter 8, in the sections called The Sharpe ratio and
More portfolio performance measures.

The M 2 measure is given as:
M 2 = (1 x)rF + xr rM = x(r rF ) (rM rF ) = 0.02
subject to the constraint that x = StdDev(rM )/StdDev(r). Substituting the expression for x
into the expression for M 2 above, we find that:
((r rF )/StdDev(r))/((rM rF )/StdDev(rM )) (rM rF ) = 0.02
or Sharpe(r)/Sharpe(rM ) = 0.02 + (rM rF ) = 0.08. Therefore:
Sharpe(r) = 0.08Sharpe(rM ) = 0.08(0.06/0.3).
Using the constraint that StdDev(r) is at most 0.2, we find that r must be equal to
0.02 + 0.08(0.06/0.3)StdDev(r) but the right-hand side is smaller than
0.02 + 0.08(0.06/0.3)0.2. The Examiners awarded 3 marks for working out the expression for
M 2 , 3 marks for working out the optimal weight in the M 2 measure and 3 marks for finding
the expression for the expected return on the portfolio as a function of the standard
deviation.
29

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Examiners commentaries 2014

Examiners commentaries 2014

Information about the subject guide

contrast key characteristics of given financial instruments

relate key facts of the managed fund industry

define market microstructure and evaluate its importance to investors

explain the fundamental drivers of diversification as an investment strategy for investors

competently identify established risk management techniques used by individual investors

Format of the examination paper

What are the Examiners looking for?

Key steps to improvement

Examiners commentaries 2014

Information about the subject guide

Comments on specific questions Zone A

Reading for this question

Approaching the question

Reading for this question

Approaching the question

Reading for this question

Approaching the question

0.10 = 0.02 + 1.5m1 + 0.4m2

Reading for this question

Approaching the question

Reading for this question

Approaching the question

The duration is therefore:

(c) What is the convexity of the bond in part (b)?

Reading for this question

Approaching the question

dP (r + dr)/P (r) = (D/(1 + r)) dr + C dr2

according to some texts and:

dP (r + dr)/P (r) = (D/(1 + r)) dr + (1/2) C dr2

Reading for this question

Stultz, R. Risk Management and Derivatives. (Mason, Ohio: Thomson South-Western,

Approaching the question

Reading for this question

Approaching the question

Reading for this question

Approaching the question

Reading for this question

Approaching the question

Reading for this question

Approaching the question

1,000/(0.05 0.01) = 25, 000.

1,000/1.05 + 1,000(1.01)2 /(1.05)2 + 1,000(1.01)3 /(1.05)3 +

If the final bracket is equal to x, then we find that:

x = (1 + 1.01/1.05 + (1.01/1.05)2 + ) = 1 + (1.01/1.05)x

so x = 1/(1 (1.01/1.05)) = 1.05/(0.05 0.01). Therefore, the discounted products of cash

Reading for this question

Approaching the question

6,000 + 6,020/(1 + IRR) + 1,680/(1 + IRR)2 = 0

Reading for this question

Approaching the question

Reading for this question

Approaching the question

In this formula, w is the weight on portfolio A, A is Jensens alpha of portfolio

Reading for this question

Approaching the question

w = 0.04/(0.04(1 0.88) + (0.08 0.02)(0.10 (0.88)2 (0.09))/0.09) = 1.6.

Reading for this question

Approaching the question

Reading for this question

Approaching the question