Practice Final Exam II

FM423
Asset Markets

Suitable for all candidates

Instructions to candidates

Time allowed: 3 hours + 10 mins reading time.

The first 10 minutes is a reading period. You may not make notes during the reading
period.

This paper contains four questions, one in Part A (consisting of question 1) and three in
Part B (consisting of questions 2, 3 and 4). Answer all four questions.

Each question carries 25 marks, out of a total of 100. Marks for each part of each question
are indicated.

You may use a calculator (as prescribed in the regulations).

If, at any point, you feel that you require additional information to answer a question, please
feel free to make additional assumptions and state them clearly.

c LSE FM423 Page 1 of 7
Part B
Question 2. (25 points)
(a) (12 marks) Suppose that the current forward and European-call-option prices on nat-
ural gas in sterling per MMBtu are as follows:

Maturity Forward Price Call Price, Strike = 3

6 months 2.2 0.002
one year 2.6 0.030

We have a flat term-structure at 3% per six-month (i.e., $1 today is worth $(1+0.03)

in 6 months, and $(1 + 0.03)2 in a year from today).
(i) (6 marks) Consider a swap agreement where you will receive 1 million MMBtu’s
in six months and 2 million MMBtu’s in one year, all for a fixed price of P per
MMBtu paid at each delivery time. What is the value of P that is consistent with
no arbitrage?
(ii) (6 marks) You wish to enter a contract with the following terms:
∗ In six months you will receive 1 million MMBtu’s of natural gas and in one
year you will receive 2 million MMBtu’s.
∗ The per MMBtu price you will pay will be the spot price at delivery time as
long as the spot price is not more than $3, and you will pay $3 per MMBtu
otherwise.
∗ In addition, you will make a payment P per MMBtu at each delivery time.
There is no time-zero payment. What is the new value of P that is consistent
with no arbitrage?
(b) (5 marks) You are analyzing the returns of the Janus fund and you compare them with
those of the Magellan fund. The Janus fund has an average return of 12%, a standard
deviation of 20%, and a beta of 1.3. The Magellan fund has an average return of 10%,
a standard deviation of 17%, and a beta of 1. The current risk-free interest rate is 2%
and the expected market return is 8%. The market has a standard deviation of 11%.
What are the Sharpe Ratios and the Treynor Ratios of the two mutual funds? What
can you conclude about these funds’ performances? Discuss under what circumstances
we want to use these performance measures.
(c) (5 marks) Using monthly return data over the sample period of January 1980 to De-
cember 2016, you find that a zero-beta long-short strategy that buys firms with positive
earnings surprises and short firms with negative earnings surprises yields positive av-
erage returns. What are the possible interpretations of your findings? List at least
three.

c LSE FM423 Page 2 of 7
 (d) (3 marks) A week in which the stock market has negative returns is followed by a week
of high market volatility. Does this statement violate any forms of market efficiency?
Explain.

c LSE FM423 Page 3 of 7
Question 3. (25 points)

(a) (6 points) Show that early exercise of an American call on a non-dividend paying stock
is never optimal in frictionless markets.

(b) (4 points) Discuss the notion of delta-hedging and its role in the derivation of the
Black-Scholes PDE (a short intuitive explanation will suffice here; do not derive the
PDE).

(c) (5 marks) The sensitivity of the price of a European call option in the Black & Scholes
model to calendar time t (i.e., Theta) is given by the following formula:
 
 −r(T −t)  St σ
Θ = − re KΦ(d2 ) − √ φ(d1 ) ,
2 T −t

where Φ(d) (φ(d)) is the cumulative distribution (probability density) function of a

standard normal, K is the strike price, T the maturity date, and d1,2 depend on all
parameters.
Explain the meaning of each of the two terms in the corresponding square brackets.
What are the signs of the terms for a European call option. Comment on whether you
expect the same signs to hold for European put options.

(d) (10 points) Shares of LSE.com will sell for either 200 or 120 in three months, with
probabilities 0.67 and 0.33 respectively. A European call with an exercise price of 160
sells for 25 today; a European put option with the same exercise price sells for 7. Both
options mature in three months.

(i) (4 points) What is the price of a three-month zero-coupon bond with a face value
of 100?
(ii) (6 points) Calculate the current price of the stock
∗ (3 points) by using risk neutral probabilities;
∗ (3 points) by replicating the stock with a portfolio of the call and the put.

c LSE FM423 Page 4 of 7
Question 4. (25 points)

(i) (12 points) This part is about forward and swap contracts.

(a) (2 points) Consider a two-year forward contract delivering a two-year coupon

bond with a face value of $100 and coupon rate of 20%. More specifically, the
forward price F will be paid in year 2 while the bond payments occur in years 3
and 4. The term structure is given by r0,1 =3%, r0,2 =4%, r0,3 =4.5%, r0,4 =5%.
Find the forward price F .
(b) (3 points) Suppose, one year later the term structure becomes r0,1 =2%, r0,2 =3%,
r0,3 =3.5%, r0,4 =4%. What is the new value of the contract with forward price as
in part (a)?
(c) (2 points) Consider a 4-year interest rate swap that each year exchanges fixed
payments at rate k to the cash flows of a floating rate note with spot annual
interest rate rt−1,t . The term structure is given by r0,1 =3%, r0,2 =4%, r0,3 =4.5%,
r0,4 =5%. Find the fixed rate k.
(d) (3 points) Suppose, one year later the term structure becomes r0,1 =2%, r0,2 =3%,
r0,3 =3.5%, r0,4 =4%. The notional amount is $100. What is the value of the
interest rate swap in part (c) at t =1 (after the first cash flow is exchanged) to
the party receiving the fixed leg of this contract?
(e) (2 points) Prove covered-interest-parity (CIP). [Note: Make sure every step in
your proof is justified.]

(ii) (13 points) Historically, the dividend-price (d/p) ratio of the overall stock market in
any year is able to forecast movements in the stock market over the next few years;
e.g., a low d/p ratio is typically followed by poor returns in the stock market.

(a) (2 points) The “rational finance” camp, i.e., those who believe that prices are set
by rational investors, argues that the return pattern is driven by investors chang-
ing their perception of future stock market risk. Explain how such a mechanism
could, in principle, generate the return pattern mentioned above.
(b) (3 points) The “behavioural finance” camp, i.e., those who believe that prices
are set in part by irrational investors, argues that the return pattern mentioned
above is due to investors’ sometimes exhibiting irrational exuberance or irrational
pessimism. Explain how such a mechanism could, in principle, generate the return
pattern mentioned above.
(c) (2 points) Describe the distinctions among the three forms of market efficiency.
Which form of market efficiency is violated by the behavioural story in part (b)?
(d) (3 points) Suppose that the d/p ratio on the overall stock market falls, so that
we forecast low returns on the stock market going forward. If we believe the
”behavioural finance” explanation for the return pattern mentioned above, given

c LSE FM423 Page 5 of 7
 in part (b), should we now lower our allocation to stocks, raise it, or leave it
unchanged? Explain.
(e) (3 points) Suppose that you are interested in figuring out which of the two mech-
anisms in (a) and (b) is really driving the return pattern mentioned above. What
analysis might you do to figure this out, i.e., to decide in favour of one or the
other mechanism? [Hint: Based on the rational story, how would you expect the
market risk to vary over time?]

c LSE FM423 Page 6 of 7
 Useful facts [Note: You may use these facts without proof, unless specifically requested
to prove the fact in question.]
• Geometric Brownian Motion
Let Itô process X satisfy the following equation
dXt = αXt dt + βXt dWt ,
where α and β are known constants, and W is standard Brownian Motion. Then given
the value of the process at time t, Xt , we have for all T > t > 0,
  
1 2
XT = Xt exp α − β (T − t) + β(WT − Wt ) .
2
• Itô’s Lemma
Let X be an Itô process with
dXt = M (t, Xt )dt + Σ(t, Xt )dWt ,
where M (·, ·), Σ(·, ·) are smooth functions, and W is a standard Brownian Motion.
Define a new process Zt = g(Xt , t), where g(·, ·) is also a smooth function. Then,
∂g ∂g 1 ∂ 2g
dZt = dt + dXt + [dXt ]2 ,
∂t ∂x 2 ∂x2
or
1
dZt = gt dt + gx dXt + gxx [dXt ]2 .
2
or
 
1 2
dZt = gt + gx M (t, Xt ) + gxx Σ(t, Xt ) dt + gx Σ(t, Xt )dWt
2
• Log-normal variables
Let Z be a normal random variable with mean m and variance s2 , i.e., Z ∼ N (m, s2 ),
then (where a and b are known constants),
 
1 2 2
E[exp(a + bZ)] = exp a + bm + b s .
2
• Put-Call Parity
We have that
CtEU = PtEU + St − PVTt (K),
where CtEU , PtEU are the prices at time t (0 ≤ t < T ) of a European call option and a
European put option, respectively, that expire at time T ; St is the stock price at time
t of a non-dividend paying stock; K is the common strike price of the call and the put,
and the PVTt (·) operator is between t and T .

c LSE FM423 Page 7 of 7