SSE Riga written examination in Financial Economics

Monday, 26 March 2018, Time: 9.00 – 12.30

Place: SSE Riga premises

EXAM RULES

1. Answer each problem on a separate sheet of paper. Do not, for example, start writing
your solution to problem 2 on the same sheet of paper on which you finished writing your
solution to problem 1. If you fail to observe this rule, parts of your written solutions will not
get graded and you will receive no points for them.

2. Write your student ID on each sheet of paper. Paper is distributed by SSE Riga - other sheets
of paper are not allowed. Sheets of paper that do not contain your ID may not be graded and
you will not receive points for those answers.

3. Your answers should be explained and well reasoned. State all formulas explicitly and show
all calculations on the paper (including interpolation procedure when determining the
probabilities from the Standard Normal distribution table). A significant number of points
will be deducted for not showing all calculations.

4. Record your answers using at least three significant figures (e.g., $493,000; 0.00284; 2.78).
Where relevant, express answers as percentages rather than fractions (i.e., 1.23% instead of
0.0123). For intermediate steps in the calculation, maintain maximum precision to avoid
rounding errors.

5. You may only use calculators supplied by SSE Riga.

6. Write clearly using legible handwriting. Answer all questions using English language.

7. The maximum score for the examination is 200 points; a total of 100 points is required to
pass, 140 for pass with merit, and 160 points for the grade of excellence.

8. ADDITIONAL RULES FOR THOSE STUDENTS USING DIGIEXAM:

a) Problems 1-4 are to be written on paper only and Problems 5-7 are to be written in
DigiExam only. If you fail to observe this rule, parts of your solutions will not get
graded and you will receive no points for them.

b) DigiExam Technical requirements and procedures are specified in the SSE Riga
Examination Rules (see point 10). The procedures specify what will happen in case of
technical problems with DigiExam. In case of technical problems, students will not be
compensated for lost time.

c) Submit your DigiExam only at the end of the exam time (12:30), or if you leave the
exam early, then only immediately before handing in your exam papers to the
invigilator and leaving. Exam invigilators record the time at which students leave the
exam, and the DigiExam system records the time at which the exam is submitted. If you
submit the DigiExam and do not leave the exam immediately afterwards, you will
receive a failing grade for the exam.

Good luck!
Problem 1 (30 points)
Assume that CAPM holds and the stock market consists of two stocks: Absolute Business
Leaders Venture, known as ABLV, and Business Intelligence Bureau, known as BIB. There is
uncertainty in the market with three possible states with the following probabilities and stock
returns for ABLV:
Recession (p=0.4) Normal (p=0.5) Boom (p=0.1)
Returns -2.00% 6.20% 22.01%

a) Calculate the expected return and standard deviation of returns for ABLV stock. (4p)

b) BIB stock has double the expected return as ABLV, but also double the standard deviation
of returns. The correlation between ABLV and BIB stock returns is zero. Calculate the
weights in each stock that would minimize your total risk. What is the return and standard
deviation of this portfolio? (6p)

c) Now assume there is a risk-free asset with a rate of return 1%. What should you do to
reduce portfolio risk while keeping the same return as in portfolio b)? What is the
standard deviation of the new portfolio? Depict portfolios b) and c) graphically. (10p)

d) Estimate the market risk premium. (3p)

e) Estimate the (equity) betas of ABLV and BIB. (2p)

f) Now assume the market portfolio consists of many stocks with the same expected return
as in d). You have spotted stock WB with the (equity) beta of 2 and your fundamental
analysis reveals that the expected return on this stock is 10%. What inference can you
draw from this information? Explain! (If you have not calculated part d), assume that the
market risk premium is 6%) (3p)

g) Define and interpret the Appraisal ratio (aka Information ratio). (2p)

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 Problem 2 (30 points)
The following bonds are trading in the market:
Maturity Coupon Coupon payment Face Value YTM
(p.a.) frequency (per year)
B1 1 year 2.50% 1 $ 1000 2.50% p.a. effective annual rate
B2 2 years 10.0% 1 $ 1000 3.50% p.a. effective annual rate
B3 3 years 5.00% 2 $ 1000 4.00% p.a. effective annual rate
B4 4 years 0 0 $ 1000 5.00% p.a. effective annual rate

a)
i) Calculate the prices of the four bonds.
ii) Assuming the term structure of interest rates is flat over the first year, how much is
bond B2 expected to cost after 3 months?
iii) You expect interest rates to fall in the near future. How could you make the most of
your expectations with the given bonds?
iv) Calculate the 1 and 2, and 4-year spot rates, as well as the forward rates 1 𝑓2 and 2 𝑓4
expressed as p.a. effective annual rates.
v) Do you expect the percentage change in the price of bond B4 to be smaller/larger/the
same over the coming year (from 𝑡 = 0 to 𝑡 = 1) compared to the second year (from
𝑡 = 1 to 𝑡 = 2)? Explain your reasoning.
vi) Suppose Sweatbank allows you to borrow/lend $10 million in one year’s time for a
period of one year at a rate of 5.00% p.a.. How could you make an arbitrage profit if
you can also borrow/lend from/to Crybank at the spot rates in part (iv)? (20p)

b) Bad news emerges indicating that bond B4 might not return the promised face value. Based
on historic defaults, it is likely that if bond B4 defaults the borrower will repay only 80% of
the face value and the estimated probability of default is 20%. Investors now require a 2%
risk premium above the previous yield of 5.00% p.a..
i) Calculate the new price of the bond B4 and its promised yield.
ii) How could a risk-averse investor protect themselves from such changes in the market?
iii) Why might CDS spreads give a more pure measure of default risk than bond yields?
(5p)

c) ABCLV, a financial services provider to the laundromat industry, is being liquidated and you
have been tasked with valuing an existing interest rate swap that must be terminated. Under
the terms of the swap, ABCLV must pay a floating rate of WASHBOR every 6 months on a
notional amount of €100 million. In return, ABCLV receives a fixed rate of 6% p.a. with
semi-annual compounding. The swap has a remaining life of 9 months and cash flows are
exchanged every 6 months. The 3-month and 9-month continuously compounding rates are
4.00% and 4.50% p.a., respectively. 3 months ago WASHBOR was 3.5% p.a. with semi-
annual compounding. Calculate the value of the swap for ABCLV? (5p)

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Problem 3 (30 points)
Company A is a listed company with 200 million shares, paying a corporate tax of 15% annually.
To keep investors happy, they pay out 75% of earnings as dividends each year. They rebalance
their capital structure to keep a fixed debt-to-equity ratio of 1.5 (reinvesting the proceeds of new
debt) and they pay the risk free rate of 8% p.a. on their debt. Analysts forecast the company’s
earnings to be $85.0 million at the end of the year (𝑡 = 1) and around 5.60% of the stock’s value
is estimated to be due to the value of growth opportunities. The company’s shares are currently
valued at $3.75.
a) Calculate:
(i) The market value of the company’s equity;
(ii) The value of the whole enterprise;
(iii) The current amount of debt as valued by the market;
(iv) The analysts’ appraisal of the value of growth opportunities;
(v) The required return on equity;
(vi) The growth rate;
(vii) The company’s business risk (required return on assets);
(viii) The present value of tax shields;
(ix) The company’s value if it had no debt;
(x) The weighted average cost of capital;
(xi) The firm’s forecast free cash flow at the end of the year. (10p)

b) The company’s shareholders believe that the company’s management is misusing the
company’s resources, so after external advice which estimated the present value of agency
costs as $80 million, have decided to increase the company’s debt levels. The company will
issue $500 million worth of new debt and buy back shares at a 20% premium to the current
price, and all debt (new and old) will be rolled over in perpetuity. The increase in debt is
expected to cut the present value of agency costs in half. However, there is now a non-
negligible default probability of 20%, with the present value of bankruptcy costs estimated
around $300 million and the company now pays 10% p.a. on their debt.
(i) Are the shareholders right in saying that the issue of new debt will increase the
enterprise value? Compute the change in enterprise value and the new enterprise
value?
(ii) Calculate the percentage change in shareholder wealth for the shareholders that do
not participate in the buyback?
(iii) What premium would make the shareholders indifferent between selling their
shares in the repurchase and not?
(iv) List three reasons why an investor in real life might not be indifferent between
buybacks, capital gains, and dividends. (13p)

c) The comany’s management have other ideas – instead of increasing leverage, they have
decided to acquire a private company in the same industry at a price of $110 million. The
acquisition is expected to increase Company A’s free cash flow by $7 million p.a. starting
from the first year (𝑡 = 1) and this additional FCF is expected to grow at a rate of 5% p.a.

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 thereafter. Company A intends to finance the acquisition so that its debt-to-equity ratio
remains at 1.5 and will continue to maintain this ratio in future years. Assume any debt
issued in the acquisition has the same cost as the current debt (8% p.a.).
(i) What is the NPV of the acquisition? Should shareholders support the deal?
(ii) How much debt and how much equity must be issued to finance the acquisition?
(iii) What is the expected Company A stock price reaction (percentage change) when
the deal is announced to the market? (7p)

Problem 4 (35 points)

Juris Inc. is a local company with a focus on the Spanish market. Its current stock price is $75,
simple 10-month risk-free rate is 2% (not annualized), and historical annual volatility of stock
returns is 60%.

a) Using the Black-Merton-Scholes model calculate the value of an at-the-money European

call option on Juris stock with 10 months to maturity. The stock is expected to pay a $6
dividend in 5 months. (8p)

b) Due to the recent events in Catalonia, some believe that the price of Juris stock will
decrease. An investor targeting bearish stocks wants to buy an at-the-money put option
on Juris stock with 10 months to maturity; however, the market has dried up and the only
at-the-money put options left are priced at $18.
(i) Using a two-step binomial model, how could the investor replicate an at-the-
money European put option on Juris stock with 10 months to maturity and $6
dividend payment in 5 months? Calculate the hedge ratio and the risk-free
position (B) at each node of the two-step binomial tree. (9p)
(ii) Calculate the value of the replicating portfolio in the initial node. (2p)
(iii) Should the investor create the replicating portfolio or buy the option that is
available on the market? (1p)

c) Now assume that your in-depth analysis reveals that the volatility of Juris stock returns is
going to increase. Show the payoff diagrams of two options’ strategies that would allow
exploiting this prediction. Explain how to create these strategies and how do they differ.
(6p)

An SSE Riga graduate has decided to launch a farming business. The initial investment required
for a farm is €10 million, while the present value of future cash flows is €9 million. If the farm is
launched now, the graduate has 2 years left to convert the farm into an organic one and receive
EU subsidies. Organic operations require an investment of €3 million and they are expected to
generate additional €5 million (in the present value terms), including the subsidies. The expected
annual volatility of the cash flows is 20% and the continuously compounded annual risk-free rate
is 2%.

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 d) How would you define the opportunity to introduce organic operations in options
language? Draw a payoff diagram, name the axes and indicate all the critical values. (3p)

e) Use Black-Merton-Scholes model to calculate the value of the opportunity to introduce

organic operations. What is the net present value of the business with and without this
opportunity? Would you invest in the business? Why/why not? (6p)

The Black-Merton-Scholes formula for a European call option:

c  S  N (d1 )  E  e  rt  N (d 2 )

 
ln S


 r
E 
2 
t
d1   2 
 t
d 2  d1   t
Appendix: The Cumulative Distribution of a Standardized Normal Random Variable.

Problem 5 (25 points)

a) Caballero, Farhi, & Gourinchas in the paper “The Safe Assets Shortage Conundrum” predict
that the shortage of safe assets is likely to persist in the near future.
(i) Explain what is considered a “safe asset” and what are the main characteristics of
such assets? (4p)
(ii) What is the reason for the shortage of safe assets in the world? Explain by providing
the main constraints of safe asset producers. Discuss the impact of the recent
financial crisis of 2007-2008 on the supply of and demand for safe assets. (6p)

b) Currently, the structured finance market is undergoing a revival. For example, China’s asset-
backed securities (ABS) market saw tremendous growth of 64% in 2017. CDOs/CLOs have
also witness growth since the financial crisis of 2007-2008. In the following, you may draw
on any of the readings and material covered in lectures.
(i) Explain how the process of manufacturing structured finance products such as CDOs
works. (3p)
(ii) Could securitization be one of the possible solutions to the shortage of safe assets?
Explain why/why not mentioning some advantages and drawbacks. (3p)
(iii) What is the nature of the risk in such products? What mistakes have been made by
credit rating agencies in assessing and rating the risk? (4p)

c) Why might technology companies hold large cash balances on their balance sheets and have
low dividend payouts? Relate the reasons to various assumptions of Modigliani and Miller’s
“perfect capital markets”. You may draw on any of the readings and material covered in
lectures. (5p)

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Problem 6 (25 points)

a) Long-Term Capital Management (often referred to as LTCM) was a large hedge fund, led by
Nobel Prize-winning economists and renowned Wall Street traders, which collapsed in 1998
(see the graph below).

Value of $1 invested in LTCM vs. S&P 500 (March 1994 - October 1998).
Retrieved from Vixandmore.blogpost.com

(i) One of the differences in the regulation of hedge funds and mutual funds is the
mandatory disclosure condition. Why do some hedge funds choose not to disclose their
trades, and what are the costs and risks behind it? How is the hedge fund client selection
different from that of the mutual funds? (“Hedge Funds: Past, Present, and Future.”)
(5p)
(ii) Even though it is usually reasonable to assume that the law of one price holds in financial
markets, there are different factors, such as noise trader risk, that might become an
obstacle for arbitrageurs. What is meant by the “noise trader risk”? How has it
contributed to the fall of the fund? (“Anomalies: The Law of One Price in Financial
Markets.”) (5p)
(iii) The fall of the LTCM in 1998 lead to a bailout agreement among 16 financial
institutions. Please discuss the motivation of the Federal Reserve behind such a decision.
(“Deciphering the Liquidity and Credit Crunch 2007-2008”) (5p)

b) One of the examples of anomalies discussed in “Anomalies: The Law of One Price in
Financial Markets” is corporate spinoffs. How does a “spinoff” work? Why and how can
corporate spinoffs affect the stub value of the parent company? Please use two examples from
the reading. (5p)

c) Cooper, Gulen and Ovtchininkov (2009) document positive correlation between political
contributions and earnings. However, this real economic effect is not immediately impounded
into returns. What are the explanations behind abnormal positive returns that firms
successfully engaging into political contributions experience? (5p)

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Problem 7 (25 points)
a) A young firm, Morten Ltd., buys stone sculptures of the great economist Keynes. It has a big
supplier, Krugman Ltd., which has recently located its costly production facility in the
neighborhood to supply unique edition of the sculptures exclusively for Morten. The
relationship between the two firms will be mutually beneficial if firms retain good relations
with each other. Morten is planning to do an IPO and considers increasing the number of
antitakeover defenses. Why would this be a beneficial decision for Morten? Name two
examples of anti-takeover defenses and explain them. (“The Bonding Hypothesis of Takeover
Defenses: Evidence from IPO firms.”) (5p)

b) Please explain how a “stakeholder view” in civil law countries leads to a higher corporate
social responsibility (CSR) rating. (“On the Foundations of Corporate Social
Responsibility.”) (5p)

c) The Economist (February 10, 2018): “Active managers have become more active, making
bigger bets on individual stocks. This makes their portfolios less like the index”. Please
explain how a shift from “closet indexing” to a more concentrated ownership encourages
active funds to engage into stewardship activities in their portfolio companies. Based on your
argumentation, are active funds becoming more or less risky? Why? (“The Agency Problems
of Institutional Investors.”) (5p)

d) Why might widely held corporations suffer from a lack of shareholder activism? What are
proxy advisors and how could proxy advisors potentially solve the problem? What conflict of
interest can the proxy advisors frequently have? (5p)

e) This question refers to your trading experience in StockTrak. Briefly describe the decision
process behind one of your (or your colleague’s) trades with options. What are the main
benefits and risks related to options trading? (5p)

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Appendix: List of references
1. ASSET PRICING

Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014, Wisdom of Crowds: The Value of
Stock Opinions Transmitted Through Social Media

DeLong, J. Bradford, and Konstantin Magin, 2009, The U.S. Equity Return Premium: Past, Present, and
Future

Fama, Eugene F. and Kenneth R. French, 2004, The Capital Asset Pricing Model: Theory and Evidence

Fama, Eugene F., 2014, Two Pillars of Asset Pricing

Thaler, Richard, 2016, Behavioral Economics: Past, Present, and Future

2. DERIVATIVE ASSET PRICING

Lamont, Owen A. and Richard H. Thaler, 2003, Anomalies: The Law of One Price in Financial Markets

Ritter, Jay R., 2008, Forensic Finance

Stulz, Rene M., 2004, Should We Fear Derivatives?

Stulz, Rene M., 2007, Hedge Funds: Past, Present, and Future

3. ASPECTS OF THE FINANCIAL SYSTEM

Böhme, Rainer, Nicolas Christin, Benjamin Edelman, and Tyler Moore, 2015, Bitcoin: Economics,
Technology, and Governance

Brunnermeier, Markus K., 2009, Deciphering the Liquidity and Credit Crunch 2007–2008

Kirilenko, Andrei A. and Andrew W. Lo, 2013, Moore’s Law versus Murply’s Law: Algorithmic Trading and
Its Discontents

La Porta, Rafael, Florencio Lopez-De-Silanes and Andrei Shleifer, 2008, The Economic Consequences of
Legal Origins

Zingales, Luigi, 2017, Towards a Political Theory of the Firm

4. CORPORATE GOVERNANCE

Bebchuk, Lucian A., Alma Cohen, and Scott Hirst, 2017, The Agency Problems of Institutional
Investors

Cooper, Michael J., Huseyin Gulen, and Alexei V. Ovtchinnikov, 2010, Corporate Political Relations
and Stock Returns

Dimson, Elroy, Oğuzhan Karakaş, and Xi Li, 2015, Active Ownership

Dyck, Alexander and Luigi Zingales, 2004, Private Benefits of Control: An International Comparison

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Glaeser, Edward, Simon Johnson and Andrei Shleifer, 2001, Coase Versus the Coasians

Gompers, Paul A., Joy L. Ishii, and Andrew Metrick, 2010, Extreme Governance: An Analysis of Dual-
Class Companies in the United States

Johnson, William C., Jonathan M. Karpoff, Sangho Yi, 2015, The Bonding Hypothesis of Takeover
Defenses: Evidence from IPO firms

Liang, Hao and Luc Renneboog, 2017, On the Foundations of Corporate Social Responsibility

McCahery, Joseph A., Sautner, Z., Starks L.T., 2016, Behind the Scenes: The Corporate Governance
Preferences of Institutional Investors

Shleifer, Andrei and Robert Vishny, 1997, A Survey of Corporate Governance

5. BONDS, CREDIT DERIVATIVES, FUTURES AND INTEREST RATES

Holmstrom, Bengt, 2015, Understanding the role of debt in the financial system

Caballero, Ricardo, Emmanuel Fahri, and Pierre-Olivier Gourinchas, 2017, The safe assets shortage
conundrum

Coval, Joshua D., Jakub Jurek, and Erik Stafford, 2009, The economics of structured finance

Stulz, Rene M., 2010, Credit default swaps and the credit crisis

6. CORPORATE FINANCE

Becker, Bo, and Per Stromberg, 2012, Fiduciary duties and equity-debtholder conflicts

DeAngelo, Harry, Linda DeAngelo, and Douglas J. Skinner, 2008, Corporate payout policy

Dong, Ming, David Hirshleifer, and Siew Teoh, 2012, Overvalued equity and financing decisions

Kahle, Kathleen, and Rene Stulz, 2017, Is the US public corporation in trouble?

Kaplan, Steven N., and Per Stromberg, 2009, Leveraged buyouts and private equity

Myers, Stewart C., 2001, Capital structure

Parsons, Christopher, and Sheridan Titman, 2008, Empirical capital structure: A review

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