MIE 375 Financial Engineering Final Exam. Dec.21, 2010 Instructions: Closed book and notes. You are allowed two sides of a 3 by 5 inch note card, Show all work. Problem 4 (8 points) - ‘Suppose that you own both a lake and a boat. You plan to profit by fishing from the lake. Each season you decide either to fish or not to fish. If you do not fish, the population of the lake will double by the start of the next season. If you do fish, you will extract 70% of the fish that were in the lake at the beginning of the séason, then the fish population at the start of the next season will be the same as at the start of the current season, The initial fish population is 10 tons. Your profit is a one dollar per ton. The interest rate is constant at 33%. You have three seasons to fish. What are the optimal fishing decisions and what is the associated present value of the fish from this optimal strategy? Problem 2 (8 points) ‘Suppose the following three bonds afe traded in the market. (CF, = cash flow after year é) bond | CF: [CF2 [CFs [yum ‘A_|100[ 100 | 4100 | 4% B_ |200]500| 500 [3.5% Cc |s00[o [200 [3% Construct a 0-coupon bond with a maturity of 3 years. Problem 3 (8 points) ‘Suppose that a bank receives the following liability schedule year |year2 |year3 12,000 | 18,000 | 20,000 year, 18,000 at the end of the second year, and 20,000 at the end of the third year. The bank wishes to use the three bonds below to form a portfolio today to hold until all bonds have matured and that will generate the required cash to meet the liabilities. All bonds have face value of a 100 and the coupons are annual (with one coupon per year). For example, one unit of Bond 2 costs 99 now and the holder will receive 3.5 after 1 year and then 3.5 plus the face value of 100 at the end of the second year. i.e. the bank needs to pay 12,000 at the end of the firstBond 1 [2 [3 Price 102 | 99 [98 ‘Coupon 5 [35/35 Maturity year|+ [2 [3 f Formulate an optimization model that can be used to find the lowest cost bond portfolio consisting of bonds 1,2, and 3 above that will meet the liabilities. In your model you wish to allow carry over of money to future periods [i.e. you may generate more cash than needed to meet a liability] (the money should be carried over at the appropriate forward rate). (Note: you must write out the detailed model showing all coefficients and variables in all constraints and objective function in expanded form (no summations!), explain all decision variables. DO NOT WRITE A GENERAL MODEL, Do not solve the model.) Problem 4 (25 points, 5 points) Suppose that are only two risky securities in the market (A and B, there is no risk free asset). The correlation between retums A and B is -0.4. Expected retums and standard deviations are as follows: security | expected retum | standard deviation A 20% 20% B 15% 25% (a) (6 points) What is the expected return and standard deviation of a portfolio that + invests 65% in A and 35% in B. (b) (10 points) Construct the portfolio of A and B with minimum risk (assume that short selling is allowed). What is the expected retum and standard deviation of this portfolio? ; (0) (6 points) Now introduce a riskless asset with rate 3%. Formulate the MVO portfolio model for these three assets (A,B, and risk free) but with the goal of maximizing expected return subject to the variance of the portfolio being fixed at a constant level (and of course subject to the budget constraint). Assume short selling is allowed. (d) (10°points) Solve the model in (c) to obtain the optimal portfolio of A,B, and the risk free asset and state what the ratio of investment is between B and A. (€) (6 points) What is the optimal portfolio (of the model in (c)) if you want a return of 20%? Problem 5 (10 points, 2.5 points each)In Merriland there are only two securities A and B whose properties are given in the following table: # shares outstanding | price per share | expected retum | sd of retum A | 100 $1.50 15% 15% B | 150 $2.00 12% 9% The correlation coefficient between the retums of A and Bis pas = There is also a risk free asset and Merriland is a world in which the capital asset pricing model (CAPM) holds. (a) What is the expected retum of the market portfolio? (b) What is the standard deviation of the market portfolio? (©) What is the beta of security A? (d) What is the risk-free rate in Merriland? Problem 6 (APT) (13 points) PART 1 State True of False (5 points, 1 point each) {a) The APT factors cannot reflect diversifiable risks. (b) The market rate of retum cannot be an APT factor. (©) Each APT factor must have a positive risk premium associated with it; otherwise the model is inconsistent. (d) There is no theory that specifically identifies the APT factors. (e) The APT model could be true but not very useful, for example, if the relevant factors change unpredicatably. PART 2 (8 points, 4 points each) Suppose that there are only two pervasive economics factors. Stocks X,Y, and Z have the following sensitivities to these two factos: Stock [fi [fi xX__[4.75 |.25 ¥-_- [-4.00[2.00 Z__ [2.00 [1.00 ‘Assume that the expected risk premium is 4 % on factor 1 and 8% on factor 2. Treasury bills offer zero risk premium. (a) According to APT, what is the risk premium on each of the three stocks. (b) Suppose you buy $200 of X, $50 of Y, and sell $150 of Z. What is the sensitivityof your portfolio to each of the two factors? What is the expected risk premium? Problem 7 (12 points, 4 points each) ‘Suppose that you have. a bond portfolio currently worth $10,000,000 and you are worried about interest rate changes over the next 6 months. You are considering using Treasury bond futures (maturity 6 months) to protect the portfolio against changing in value over the next 6 months (a) Would you buy or sell futures here? (b) Explanation of your choice in (a) (you need only justify qualitatively) (hint: Consider the two cases of interest rate going up and down.) (©) Suppose that the duration of the portfolio is 6.8 years and that the current futures unit price for a treasury bond is $93-2. where the underlying treasury bond has a yield of 8.8% and the duration is 9.2 years. Also, each futures contract delivers $100,000 in face value of the bonds (so in this case the futures price on a single contract is $93,062.50). How many contracts do you involve? Problem 8 (16 points) (a) (4 points) You are given the following prices: ‘security Maturity (years) | Strike Price K | Current Price ($) JK stock E ale 94 . Put on JK stock 1 80 5 Call on JK 1 80 Mm Bond w/face val=100 | 4 7 a What is the price of the call option? (b) (8 points) Find the price of a European put option on an underlying asset whose current price is $50 for the case when K=$50 (i.e. strike price is $50) where there are 3 time periods, and the stock price will go up next period by a factor of 1.5 or go down with factor .5, there are no dividends, and the lending/borrowing rate is 10%. (©) (4 points) The lending/borrowing rate can be set equivalent to the risk-free rate in binomial option pricing model or in any valid method for option pricing that can use a replicating portfolio argument. Why would this be valid? (A response longer than 4 sentences will result in a loss of ALL the marks for this problem!)