A00128

Non-Alpha Only

BIRMINGHAM BUSINESS SCHOOL

M.SC. INVESTMENTS

FUND M ANAGEMENT

BANNER CODE: 07 02868

A00128

SUMMER EXAMINATION 2013

3 HOURS

ANSWER 3 QUESTIONS
ATTEMPT AT LEAST ONE QUESTION FROM EACH SECTION
ALL QUESTIONS CARRY EQUAL MARKS

CALCULATORS MAY BE USED IN THIS EXAMINATION PROVIDED THEY ARE NOT CAPABLE OF
BEING USED TO STORE ALPHABETICAL INFORMATION OTHER THAN HEXADECIMAL NUMBERS

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SECTION A

1. The efficient market hypothesis (EMH).. generates considerable (33.3%)

controversy as well as fundamental insights into the price discovery
process. The most enduring critique comes from psychologists and
behavioural economists who argue that is based on counterfactual
assumptions regarding human behaviour, that is, rationality.
(Andrew Lo Efficient Markets Hypothesis The New Palgrave:
Dictionary of Economics, 2Edn. 2007

Critically discuss the above statement in terms of market efficiency and

developments in behavioural finance.

2.

(33.3%)
a. Critically discuss the various methods that can be used to [23 marks]
evaluate the performance of a fund manager.

b. Shulka and Thomas (JEB, 2000) used style analysis to [10 marks]
investigate whether or not mutual funds were being managed in
accordance with their stated objectives. They found that only
46% of 1043 mutual funds they studied were consistent with
funds stated objectives and classification. The other 54% were
misclassified one third seriously so. Over the three years of
their study 57% changed their style and only 27% maintained
their original stated policy.
What is style analysis and how would you replicate their study?
3.

(33.3%)
a. Critically discuss the key drivers of pension fund management.

[8 marks]

b. Black and Litterman propose an approach that overcomes some [8 marks]

of the problems experienced with a simple mean-variance

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optimization (MVO). What are the problems of MVO? Discuss
the key features of the Black and Litterman approach.

c. Compare and contrast value and growth investment strategies. [9 marks]

d. Compare

and

contrast

tactical

and

strategic

investment [8 marks]

strategies.

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SECTION B
4.

(33.3%)
a. You believe that the US stock markets are overheated and due
for a correction. A generally held view by market analysts is that
the market will fall by 10 percent. Based on the above view,
explain with calculations, how you would fully hedge, over the
next three months, a $50 million, diversified portfolio of large US
company stocks using S&P500 stock index futures contracts.
The S&P 500 index stands at 1200. The dividend yield on the
index is 3 % and the three month risk free rate is 1.5 % (all rates
are annualised).

The S&P 500 futures multiplier is $250 per

index point. The beta of the portfolio is 1.25.

i.

What is the result of your hedge based on the fall of 10% in [8 marks]
the S&P index?

ii.

Assume at the end of the three months the S&P 500 index [7 marks]
has only fallen by 5 percent. What is the value of your
portfolio when the hedge matures?

b. Discuss the assumptions underlying your analysis and explain [6 marks]

the performance of the hedged portfolio.

c. Discuss the derivative contracts that might be used to modify the [12 marks]
following:i.

The equity exposure of a 60/40 equity/bond portfolio of US

stocks and bonds.

ii.

The currency exposures of a internationally diversified

portfolio.

iii.

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The duration of a diversified portfolio of US bonds.

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5.

(33.3%)
a. Set up an immunised bond portfolio using the bond information [15 marks]
given below so as to meet the following liabilities: 5m, 7m,
9m and 10m at times 2, 3, 4 and 5 years from now
respectively. The current yield curve can be assumed to be flat
at an interest rate of 5 per cent.
Bond A matures in two years and pays interest of 6 per cent
annually. Bond B pays interest of 5 per cent annually and
matures in six years time.

The duration of bond B is 5.329

Comment on any reservations you might have about the

immunisation approach you have used.
b. Suppose the market rate of interest rises to 6 per cent [13marks]
immediately after the first liability payment has been made. ( the
duration of the original 6 year bond will now have four years to
maturity, a market value of 96.53 and a duration of 3.72
years).Does the bond portfolio still meet Redingtons conditions?

c. Explain the difference between the Macaulay duration and key [5 marks]
rate durations. And also their uses?

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6.

(33.3%)
a. Jane Smith, a UK fund manager, has 10 million which she plans [11 marks]
to invest in US equities. The current spot market bid ask
exchange rates are $1.50/ and $1.51/ respectively. At the end
of a year Jane will sell the US stocks for an expected
$16.5million and return the money to the UK. Assume that at the
end of the year the spot market bid ask exchange rates of
$1.47/ and $1.48/ respectively.
What will be the total return on her US investment? Provide a
breakdown of her total return in terms of a currency return and a
US stock market return.

b. Suppose at the end of 6 months Jane is concerned that the US [8 marks]

dollar might depreciate as a result of concerns that the US
market may not recover as quickly as she previously thought as
a result of political problems relating to the US budget. Her boss
suggests she should hedge $10 million of her exposure to US
dollars by using a 6 month forward contract to exchange the
dollars at an exchange rate of $1.50/. The remaining US dollars
will be exchanged in the spot market.
What now would be the return on her investment and the
breakdown of returns in terms of currency and stock market
returns if the spot market bid-ask market exchange rates at the
end of the year are $1.52/ and 1.53/ respectively?

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c. Suppose, instead of using a forward contract to hedge $10 [8 marks]

million US dollars Jane buys an over-the-counter, six month,
European style currency option to exchange the dollars at an
exercise price of $1.50/.

The option premiums quoted by the

bank she deals with are, for a call option is 2 percent and for a
put is 3 per cent of the $10 million. Assume at the time she
purchased the option the exchange rate was $1.50/ (ignore bid
ask spread). All remaining US dollars will be exchanged in the
spot market.
Which currency option should she purchase and what would the
amount of sterling she would return to the UK at the end of the
year if the spot exchange rates are as given in (c) above? What
is the breakdown of her returns in terms of market and currency?
You may ignore the time value of money.

d. Suppose Kate also manages a portfolio of UK equities and [6 marks]

European equities in addition to her US investment. Discuss the
potential diversification benefits she might obtain under both
normal and crisis market conditions.

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7.

(33.3%)
a. Alexis, a hedge fund manager, has undertaken an equity neutral
strategy involving two stocks from the same industry, which will
be unwound at the end of three months. Stock X is currently
trading at $25/share which she estimates to have a fair value of
$28. A dividend of $0.50/share is expected shortly. Stock Y is
currently trading at $56 and is estimated to have a fair value of
$54. A dividend of $0.75/share is expected. She borrows and
then sells 4000 shares of stock Y and uses the proceeds to buy
stock X both at their current market prices. Assume Alexis has
the funds to meet a 30 percent margin at an interest rate of 4
percent that is required on the short sale.
Assume at the end of the three months both stocks are trading at
the fair values she estimated.

(i) What is the return to her strategy if she incurs transaction [9marks]
costs of $1000?

(ii) Discuss the risks associated with the above strategy.

[4 marks]

b. Suppose you manage a 2.5m portfolio which believe has a

positive alpha (), and further, that the stock market is about to
fall. Over the next month return on your portfolio, Rp, can be
described by the following equation:
Rp = Rf + (Rm Rf) + +
The residual risk is defined by . Assume = 1.2, = 0.015, Rf =
0.01

(a one month rate, not annualised)

The FTSE100 index is 6250 and for simplicity you may assume
no dividends are paid during the month. The FTSE stock index
futures contract has a multiplier of 10 per index point.

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i.

What is the hedged value of your portfolio?

[10 marks]

ii.

Discuss the risks in the above strategy.

[4 marks]

c. Explain how two of the following hedge fund strategies are [6 marks]
implemented and how the risks of the strategy might be
managed.
i.

Distressed securities

ii.

Merger arbitrage

iii.

Global macro

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End of Exam