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University of Cape Town School of Economics ECO4053Z Financial Economics I EXAM 2007
University of Cape Town School of Economics ECO4053Z Financial Economics I EXAM 2007
School of Economics
ECO4053Z Financial Economics I
EXAM 2007
PART I: SHAKILL HASSAN
Time: 1 hours
This part consists of two questions
Although they may seem challenging, they are both bookwork, so stay calm
This section is closed book of course
Answer both questions
Explain and motivate all steps very clearly
Purely mathematical answers with no explanation will be severely penalised (and will
not exceed half the available marks)
Question 1: Mean-Variance Analysis
Consider a setting with N risky assets and no risk-free asset. Show that any portfolio
on the mean-variance efficient frontier can be obtained as a combination of any pair
of efficient portfolios. Comment with regard to optimal portfolio choice. Explain all
steps clearly.
Hints: recall the optimisation programme that identifies one portfolio on the frontier.
Suppose this programme is solved for two portfolios, offering distinct rates of
expected return. Now show that any other portfolio on the frontier, associated with
any other rate of expected return, can be obtained as a combination of the two
identified portfolios. (This is the two-fund theorem.)
Question 2: Equilibrium Asset Pricing
Derive the standard Capital Asset Pricing Model. State all assumptions; explain all
steps clearly.
Good luck.
Question 5
Consider the following table,
Bond principal
(R)
Time to maturity
(years)
Annual coupon
(payable yearly)
Bond price
(R)
100
100
100
100
1/2
1
3/2
2
0
0
6.2
8
98
95
101
104
(i)
(ii)
Question 6
(a) When you buy a call with a strike price K2 and exercise date T2 and sell a call
with a strike price K1 and exercise date T1 (T2 > T1), the outcome is a diagonal spread.
Show diagrammatically the profit of the diagonal spread when (i) K 2 > K1 and when
(ii) K2 < K1.
(b) The two-month interest rates in the US and South Africa are 3% and 8% per
annum (continuously compounded), respectively. The spot price of the US$ is R0.65.
The futures price of a contract deliverable in 2 months is R0.66. what arbitrage
opportunities does this create?
(c) Show on a diagram the variation of profit and loss with the terminal stock price
for the two portfolios below,
(i)
(ii)