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International College of Economics and Finance

Principles of Banking and Finance


Suggested solutions for mock examination Section A
02 November 2013

Question 1

1a. Explain why introduction of financial market can make a consumer better off (15 marks)
1b. Discuss the functions of money and capital markets (10 marks)
1а. Необходимо показать графически оптимальный выбор потребителя без (2б) и с
финансовым рынком (точка касания PPF с кривой полезности (С0; С1) в отсутствии
финансового рынка; и точка касания CML с кривой полезности в присутствии
финансового рынка) и показать, что во втором случае кривая полезности расположена
выше (3б)
Следует указать, что оптимальный объем инвестиций будет одинаковым для всех
потребителей (инвесторов) (3б)
Следует показать разницу в поведении между заемщиками и кредиторами, и указать, как
они достигнут нужного уровня потребления (инвестируют вплоть до точки касания, а
потом, или займут или одолжат недостающую сумму денег) (4б)
Необходимо указать в каких случаях теорема Фишера выполняется: равенство ставки по
займам и привлечениям, возможность заимствования и привлечения без ограничений (3б)
1b. Следует дать определение, какие инструменты обращаются на рынках различного типа
с точки зрения срока и назвать виды инструментов (4б)
Надо сформулировать, что основная функция денежного рынка – обеспечение
ликвидности участников (2б), а рынка капитала – обеспечение возможности привлечения
денежных средств за счет выпуска акций и облигаций на развитие (2б)
Следует сказать, что существует обратная зависимость между доходностью и
ликвидностью инструментов (2б).

Question 2

2a. What is the two-fund separation theorem? What implications does it have for the optimal
portfolio of risky assets held by investors? (15 marks)
2b. Discuss the differences between OTC and exchange-traded markets (10 marks)
2а. Необходимо показать графически выбор инвестора в отсутствии безрискового актива
(определяется точкой касания кривой полезности с множеством эффективных портфелей)
(3б) и в его присутствии (точка касания кривой полезности и CML) и сделать вывод, что
во втором случае он достигает лучшего соотношения относительно доходности и риска
(3б)
Нужно указать, что все инвесторы выбирают один и тот же портфель из множества -
рыночный портфель (2б), а отношение к риску будет определять соотношение между
безрисковым активом и рыночным портфелем (3б)
Необходимо перечислить условия, при которых выполняется two-fund separation theorem:
все инвесторы имеют одинаковые оценки риска и доходности активов (1б),
максимизируют доходность и минимизируют риски (1б), ставки займов и привлечений
равны между собой (1б) и на рынке отсутствуют трансакционные издержки (1б).
2b. Надо сказать, что в первом случае сделки производятся между сторонами
непосредственно, а во втором – в них участвует биржа (4b), что риски на биржевом рынке
ниже (2b), а на рынке OTC хотя риски выше, но это компенсируется меньшей ценой (2b).
В случае приведения примера основных бирж и рынков OTC - +2 балла.

Question 3

3a. Discuss the virtues and limits of diversification of portfolios. What principles are underlying
diversification? (15 marks)
3b. What are the functions of primary and secondary markets? (10 marks)
3а. Основное преимущество диверсификации – снижение рисков инвестирования (2б).
Диверсификация позволяет убрать индивидуальные риски активов, но оставляет
системные или рыночные риски (3б). В основе диверсификации лежит, что доходности
активов не полностью (+1) коррелированы между собой, и риск портфеля в это случае
должен быть меньше средневзвешенного риска активов, которые в него входят (4б).
Студент должен графически и математически показать, что при отрицательной
корреляции (-1) доходности 2 активов риск портфеля может быть снижен до 0 (2б), а
также нарисовать, как при добавлении активов риск портфеля постепенно снижается
вплоть до некой горизонтальной ассимптоты (2б). Если студент сможет показать это
математически (с помощью формул вычисления риска портфеля при N активов, где N –
стремится к бесконечности, а доли активов равны) - +2 балла.
3b. Необходимо показать, что основная функция первичного рынка – обеспечение
возможностей для привлечения средств инвесторами (3б), а вторичного рынка –
обеспечение необходимых условий для функционирования первичного рынка:
определение цены сделок (2б) и ликвидности инструментов после их размещения (2б).
Больший объем торгов совершается на вторичном рынке (1б). Если студент сможет
перечислить основные виды размещений – IPO, SPO, private placement - +2 балла.

Question 4

4a. Discuss the virtues and flaws of CAPM as a tool to evaluate the return on securities (15
marks)
4b. Why do analysts have to pay an attention to a shape and slope of yield curves? (10 marks)

4а. Необходимо сказать, что основное достоинство CAPM, как метода – его простота.
Доходность любого инструмента вычисляется по следующей формуле (приводится
формула) (4б). В равновесии все активы должны находится на SML (она изображается
графически в координатах доходность – бета) (1б). Если фактическая доходность при
заданной бете находится выше уровня, определяемого SML, то инструмент является
недооцененным и его надо покупать (2б), если ниже уровня SML, то – переоцененным, его
надо продавать (2б).
Недостатки CAPM: сложность эмпирического определения рыночного портфеля (2б) и
необходимость выполнения ряда условий: все агенты имеют гомогенные ожидания (1б),
максимизируют доходность и минимизируют риск (1б), могут занимать и одалживать по
безрисковой ставке в неограниченном количестве (1б) и рынок всегда находится в
равновесии (1б).
4б. Аналитики обращают внимание на форму и наклон кривой доходности потому, что
она показывает ожидания рыночных агентов относительно будущего изменения
процентных ставок: долгосрочные ставки процента – это ожидания рынка относительно
краткосрочных ставок процента в будущем (3б). Когда кривая доходности наклонена
вниз, это означает, что рынок ожидает падения ставок в будущем (1б). Это может быть
сигналом относительно ожиданий экономического спада в будущем (2б). Такие оценки
базируются на том, что ставка форвард вычисляется относительно значений ставок спот
на разные сроки (показывается формула для вычисления ставки форвард) (2б). Если
студент приводит еще 2 теории, объясняющие кривые доходности (теория предпочтения
ликвидности и теория сегментации рынка) - +2 балла.
International College of Economics and Finance
Principles of Banking and Finance
Suggested solutions for mock examination Section B
02 November 2013

Question 5

(A) Consider the following two mutually exclusive projects:


Project Co C1 C2 C3 C4
A –15 000 – – – 26 235
B –15 000 5 750 6 613 7 604 –
Assuming the opportunity cost of capital of 15%, what is the NPV of each project and which project
would you choose? (6 points)
The NPV of a project shows the economic profit (or loss) from undertaking it. It takes into account
the time value of money by discounting future cash flows in order to find their today’s equivalent. +1

NPV   DCFt  
n n
CFt
t 0 1  r 
t +1
t 0
Correct calculation is required:
15% Project A Project B
t DF CF DCF CF DCF
0 1,0000 -15 000 -15 000 -15 000 -15 000
1 0,8696 0 0 5 750 5 000
2 0,7561 0 0 6 613 5 000
3 0,6575 0 0 7 604 5 000
4 0,5718 26 235 15 000 0 0
0 0 +2
Decision rule for the NPV method is the following: if a project has a positive NPV, it adds to the
welfare of the investor, and therefore should be accepted. If NPV < 0, it is more profitable to invest
money elsewhere, therefore, undertaking the project will result in a foregone opportunity => such a +1
project should be rejected.
As in our case both NPV(A) = NPV(B) = 0, Project A could as well as B, and investor is indifferent
to invest or not. +1
+6
(B) What is the payback period for the two projects? Explain why payback method might give
contradicting results as compared to the NPV method. Which of these methods of project evaluation
would you base your decision upon and why? (7 marks)
The Payback period shows a time span during which the initial investment is recovered, without +1
taking the time value of money into account. +0.5
For project A the PB period is equal to 4years. +0.5
For project B the PB period is equal to 3years.
According to the PB method, we should choose project B as it has a shorter repayment period (3 < +1
4).
In our case the two methods of project appraisal result in conflicting decisions. The key reason is +0.5
that the PB method doesn’t take into account the cash flows occurring after the initial investment is +0.5
recovered, and project A here has a large cash inflow at the last year of its existence. Another
reason is that PB method ignores the time value of money: if we applied the DPB, we would +1
accept A because the initial investment into is never fully recovered.
The choice of the appropriate method depends on the available input data (whether you have an
estimate of the opportunity cost of capital or not, for example) and on the goal that the investor is +2
pursuing (e.g., whether there are any thresholds on the timing of initial investment recovery or
not). But in general NPV usually gives a more objective assessment of the attractiveness of the
project.
+7
(C) What is the discount rate in the IRR method? In the NPV method? In DPB Method? Discuss the
underlying assumptions and their credibility? (6 marks)
All listed methods – IRR, NPV and DPB method take into account the time value of money by +1
allowing reinvestment of the interim cash flows. But the assumptions about the reinvestment (or
discount) rate under the two approaches differ. +1
NPV assumes that reinvestment is possible at the current market rate of interest. +1
DPB assumes that reinvestment is possible at the current market rate of interest. +1
IRR assumes that you’re always able to find a project as profitable as the current one to reinvest your
intermediate cash flows.
Although NPV and DPB assume the flat term structure of interest rates, its assumptions on +2
reinvestment are more realistic than those of the IRR. In the process of capital budgeting investors
will choose the most profitable projects first, and then put the remaining endowment into less
profitable ones (if you arrange all the projects in a descending order according to their IRRs). This +1
implies that it is very unlikely that the equally profitable projects would still be available throughout
the life of the current project.
+6
(D) ‘Real and financial assets are valued differently, and therefore cannot be compared’. Critically
evaluate. (6 marks)
The approach to the valuation of real and financial assets is very similar: in order to assess the fair
value of an asset we should know the cash flows that the asset is promising to bring, and the +2
opportunity cost of capital (the return on the next-best investment).

+1
You can determine the value of the real project by calculating its NPV:
+1
For financial assets you can basically do the same, just slightly altered:
where P0 is the equivalent of your initial investment (the price that you’ve paid at the purchase).
The only problem that arises with valuing, for example, stocks, is that they do not have a definite
maturity. But under certain assumptions (constant or zero growth of dividends after a certain period
+1
of time) the formula can be altered in the following way (GGM): where g is the
rate of dividend growth.
Good student premium: if you recall the Intertemporal consumption choice model, you should
remember that the optimal investment decision (under the Fisher Separation theorem) was
determined exactly by comparison of the returns on real and financial assets. +1

+6

Question 6
Assume that XYZ intends to expand its business, which requires raising additional funding.
(A) Discuss options the company has. (6 points)
To raise additional funds company has 3 main options: it could take a loan, issue bond or equity
instruments.
One of the simplest ways is taking loan. Loans are popular among small companies, that could not +2
afford issuing bonds and who is not ready for an IPO. Loan is relatively expensive way of financing,
as it is indirect financing and bank required a premium that adds to required return of depositor.
Sometimes collateral is required tom lower rate for the loan.

2nd way of raising funds is bond placement. Bond is liability of the company to pay coupons to
investors and principal upon maturity. To receive favorable interest rates, the company should be +2
well-known and has stable cash flows. It is way of direct financing. Bonds as well as loans do not
give its holders any voting rights.
3rd way of financing is issuing equity via IPO or SPO. On the one hand equity is a contribution in the
company, that will be never repaid, but on the other hand it dilutes the capital 9formaer stakeholders
after SPO could have less voting power, and claim smaller share of total profit etc.). And, like bonds
equity is issued only by mature companies, as there are lots of requirements like financial statements +2
disclosure, good level of corporate governance. And the underwriting also has huge fixed costs, so
the size of the company and IPO should be sufficiently large.
+6
Assume that the company decided to issue additional bonds – as its competitors did (see the table below?
Assume that competitors have the same level of risk and leverage):
(B) Please derive yield curve and explain it shape using relevant concepts (stylized facts). (6 points)
The main assumption under the pricing of zero-coupon bond is that price today is equal to present
value of all future cash flows, discounted back at appropriate discount rate. So we could find implied +1
spot rates for listed maturities.

The yield curve is downward sloping, that could be explained by expectations theory – if we expect
than in 1 year rates will be lower, then today we would be ready to made investment with annual rate +1
lower, that 1Y spot (reinvestment in 1Y would be unprofitable, so now we are happy with lower 2Y
interest rate). The same logic applies to 3Y.

+2

Market segmentation theory, which states that interest rates for different maturities are defined in
+1
separate markets (i.e. factors that influence players of ST market will not affect LT part of yield
curve)
Liquidity preference theory states that investors require additional premium id they lock up liquidity
+1
for a long g time. We could say that in required return for 3Y part of yield is attributable to the
premium because of lack of liquidity (i.e. in case if investors did not require premium, than required
return for 3Y would be even lower).
+6
(C) What should be the annual coupon for the company’s bond with 3 years till maturity, if XYZ wants it
to be traded on par today (3 points)
The price of a bond is defined on the assumption, that the fair amount of money one is willing to +0.5
spend on the bond is exactly the sum of present values of future cash flows:
+0.5

In order for this bond to be priced at par the coupon rate should be 7.22%. It is wrong to find any +2
averages from the rates, since cash flows are not similar for each year (principal is paid at the end,
but interim payments consist of coupons).
+3
XYZ changed its mind and decided to issue additional shares. The best possible proxy is S&P 500.
Standard deviation of S&P 500 returns is 0.07857; expected return is 12% whereas risk free rate is 4%.
The covariance of S&P 500 and XYZ is 0.00321 and standard deviation of XYZ stock return is 0.56.
(D) Please advise what should be the expected return of such stock. Explain your reasoning. (6 points)
To understand what is required rate of return for the stock we need first to define the level of its +1
systematic risk (because of diversification we require premium only for systematic risk, that could +1
not be eliminated).
The measure of systematic risk is defined under CAPM framework as beta coefficient:
( ; ) +2
=
So beta is equal 0.00321/(0.07857)^2=0.52 (defensive stock, that is less risky than tangency
portfolio)
So we require the rate equal to Rf + beta*(Rm-Rf). 4% + 0.52*(12%-4%)=8.2% (out of required +2
return almost a half is attributable to the systematic risk premium).
+6
(E) Assume now that investment community treats such expansion as additional risk for the company. As
a result beta for the stock doubles. What is the required return in this case? Comment on your result (4
points)
Now stock has more systematic risk, new beta is equal to 2*0.52=1.04 +1
The stock becomes very aggressive; it is more risky than the tangency portfolio. So investors would +1
require to double the risk premium for systematic risk:
So we require the rate equal to Rf + beta*(Rm - Rf). 4% + 1.04*(12%-4%) = 12.3% (out of required
return almost two third half is attributable to the systematic risk premium). +2
+4

Question 7
(A) Compute the Variance of Market portfolio and discuss which stock(s) are riskiest for diversified
Under the assumption (*) that the market consists of 3 instruments and those instruments forms +2
investor’s portfolio the correct formulas should be stated:
βp = βm = 1
βp=0,3*βA +0,5*βB + 0,2*βC +1
COVim
i 

2

Thus,  m  0,3 * 520  0,5 * 400  0,2 * 660  488


m
2
+2

What stock(s) are riskiest for diversified investor?

Students are requested to compare stock’s β.


Under CAPM: E Ri   Rf  i * ( E Rm)  Rf 
Beta-sensitivity of the return is an individual security to the market return. E Ri  increase linearly +0,5
with βi.
COVAm
А   1,0656

2 +0,5
m

COVBm
B   0,82
 +0,5
2
m

COVCm
C   1,35
 +0,5
2
m

Summing up, Stock A almost mimic the market, Stock B is a conservative company stock, and
Stock C is an aggressive company stock. +2

+9
(B) What is expected return for each stock? What is the expected return on tangency portfolio?
Stock A: (27 – 25 + 1)/25 = 12% +1,5

Stock B: (45 – 40 + 2)/40 = 17,5% +1,5

Stock C: (17 – 15 + 0,5)/15 = 16,6% +1,5


The main conclusion of CAPM: in the equilibrium the tangent portfolio of risky assets must be the
market portfolio. Thus, E RTP   0,3 *12%  0,5 *17,5%  0,2 *16,6%  15,67%. Assumption +1,5
(*) is used.
+6
(C) Compute the required return for each stock, comment briefly
CAPM is assumed to be used.

Stock A: 0,08 + 1,0656*(0,1567 – 0,08) = 16,17% +1

Stock B: 0,08 + 0,82*(0,1567 – 0,08) = 14,29% +1

Stock C: 0,08 + 1,35*(0,1567 – 0,08) = 18,35% +1

+3

The appropriate trading/investment strategy is:


- Short sell Stock A and Stock C since they are overvalued;
- Buy Stock B since it is undervalued. +2

Graphical analysis:
E (R) C

A +3
B

+5
(D) Please describe your investment (trading) strategy that is based on results received in (B) and (C)
(E) What advantages has CAPM framework, comment its main drawbacks/applicability limitations
Advantages of CAPM: +1
- rather simple calculations and applications;
- the concept by the majority of professionals

Main disadvantage of CAPM (Poll critique) is that market portfolio does not exist. +1

Good Student premia


Limitations of CAPM are its assumptions that are not consistent with reality:
- the ability to lend and borrow infinite sums of money at the risk-free rate +0.25
- investors maximize their utility only on the basis of expected portfolio returns and return +0.25
standard deviation;
- markets are perfect and frictionless +0.25
- investors have homogeneous beliefs regarding future returns +0.25

BONUS: Roll Critique (the unobservability of the market portfolio makes CAPM untestable =>
various proxies are used
Empirical evidence suggests that stocks returns are related to 3 characteristics:
–Size of the firm (can be measured by market capitalization) +0.75
–Firm’s perspectives (can be measured by market-to-book ratio) +0.75
–Past performance (average stock’s return over the past six months) +0.75

+2
Question 8

(A) Consider 2-year bond with semi-annual payments. Coupon rate is 12%. What is the fair price of the bond,
if the YTM is 16% and the yield curve is flat? Will it be selling at a discount of with premium to the
principle? (6 points)
To price the bond we have to discount the future cash flows it promises to bring. The cash flows are
determined by the coupon rate (12% of par in our case), while flat yield curve implies that we can +1
apply the same rate to discount future cash flows (16%).
The formula for pricing the bond with annual coupon payments is the following:
c

   
P0 2N
2  1 , where c is the coupon rate, r is the YTM, N is number of years till +1
FV t 1 1  r t 1  r 2 N
2 2
maturity.

+1

+2

This bond’s fair price is thus 0.93376 of par => it is trading at discount to the principle
+1
+6
(B) ‘The existence of premium or discount is determined by the relative value of coupon rate as compared
to the YTM’ Critically evaluate. (8 points)
The statement that a bond is traded at a discount implies that its current price is below the face value
+1
of the bond. A premium implies a reverse situation: current price is above the face value.
It could be easily demonstrated that a bond with c = YTM should be traded at par (i.e., without a
discount or premium). You can think of such bond as a bank account: if you deposit $100 with the
bank at 10% p. a., the face value (what you get at the expiry) is $100, as well as its PV (what you +2
put in now).
Suppose the price of the bond rises (remember that coupon payments are fixed). As a result, the
YTM decreases, becoming less than the coupon rate. Therefore, whenever c > YTM the bond is +2
traded at a premium.
Alternatively, if the price of the bond falls, given fixed coupon payments, the YTM should increase.
Therefore, whenever c < YTM the bond is traded at a discount. The easiest example here is a zero +3
coupon bond: it’s always traded at a discount as 0 = c < YTM, whatever the YTM is.
+8
(C) What would your strategy be if the bond is currently traded at 110%? (5 points)
If the bond is currently traded at 110%, it is overpriced: 110% < 93.376%. +0.5
Therefore, we sell it short/issue the bond with same characteristics (assumption regarding short
sales required) as it is expensive, and invest in alternative instrument with YTM of 16%. +2
Our strategy should be sell/issue the bond. +1.5
As the demand for it is likely to decrease/supply to increase (due to our actions), its price will drop
all the way to its fair level (93.376%).
As a result, we can either capture capital gain by borrowing and selling the bond and buying it
+1
back as soon as it reaches the fair price, or hold alternative instrument till its maturity as well as
the initial bond, that we issued (factually we attract money at 12% and invested in 16%) p. a.
+5
(D) What would the price of the bond in (A) be if the coupons were paid on an annual basis? Compare it
to the answer in (A) and explain the difference (6 points)
If coupons are paid annually, we should recalculate the price of the bond according to the formula:
+0.5
+1

+1
This bond’s fair price if thus 0.93579 of par => it is trading at larger discount to the principle
(discount = 100% – 93.58% = 6.42%). +1
The price of a bond with annual coupons is smaller than of the one with semi-annual coupons
(93.38 < 93.58).
This appears because of two effects – as cash flow in semiannual bond appear earlier in the year, +1.5
that bond is more valuable for investor so the higher price is justified. On the other hand due to
bank-based approach when we have semiannual discounting we have an economic mistake – as
annual rates are higher (1+r/2)^2 > (1+r). As the most of the value of conventional bond comes
from principal, that is repaid at maturity higher discount rate that is applied to it in case of +1
semiannual rate results in lower price of semiannual bond as compared to annual one, though in
economic logic it should be higher.
+6