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The University of New South Wales School of Banking and Finance

FINS5513 – Security Valuation and Portfolio Selection Final Examination Session 1, 2006 Time Allowed: 2 hours and 30 minutes Reading Time: 10 minutes

This examination contains 24 questions in 2 sections and has 36 total marks: • 20 multiple-choice questions, each carries 1 mark, 20 total marks; • 4 calculation / short answer questions, each question carries 4 marks, 16 total marks; • There are 7 pages to this examination paper, including the title page.

Instructions: 1. Write your name and student number and sign on the top of this page. 2. Attempt all questions. 3. Mark your answer to the multiple-choice questions in pencil on the generalized answer sheet provided. 4. Write your answer to the calculation questions in ink in the booklet provided. ANSWERS MUST BE WRITTTEN IN INK, EXCEPT WHERE THEY ARE EXPRESSLY REQUIRED. PENCILS MAY BE USED ONLY FOR DRAWING, SKETCHING, OR GRAPHICAL WORK. 5. This paper is NOT to be retained by students. 6. You may use your own calculator, but are not allowed to use any other materials.

Part I: Multiple Choice Questions (20 marks, each question is worth one point) Mark clearly the most correct answer to each of the following questions on the multiple choice answer sheet. 1. ABC stock has an expected ROE of 12% per year, expected earnings per share of \$2, and expected dividends of \$1.50 per share. Its market capitalization rate is 10% per year. What are ABC’s expected growth rate and price? a) 8% and \$15.55 respectively. b) 10% and \$22.30 respectively. c) 5% and \$12.32 respectively. d) 3% and \$21.43 respectively. e) None of the above. ANSWER: D Plowback b=\$0.5/\$2 = 25%. g=ROE*b=12%*25%=3%. P=D1/(k-g) = 1.5/(.1-.03)=21.43. 2. Which of the following assumptions does the constant-growth dividend discount model require? (I) Dividends grow at a constant rate. (II) The dividend growth rate continues indefinitely. (III) The required rate of return is less than the dividend growth rate. a) (I) only. b) (III) only. c) (I) and (II) only. d) (I), (II), and (III). e) None of the above. ANSWER: C 3. Which one of the following statements is NOT true for the 2-stage dividend discount model? a) It can accommodate a company’s life cycle effects. b) It is not sensitive to input parameter values. c) It can avoid the difficulties posed by initial growth that is higher than the discount rate. d) It allows the analyst to make use of her expectations regarding when growth might shift from off-trend to a more sustainable level. e) None of the above. ANSWER: B 4. For a callable bond, yield to maturity is a better measure than yield to call when a) yield to maturity is higher than yield to call. b) the issuer has never called its bonds in the past. c) investors expect higher interest rate in the future. d) investors expect lower interest rate in the future. e) None of the above. ANSWER: C 5. A straight bond and a callable bond have the same coupon and maturity. Which of the following statement is true? a) When interest rates are low, the price of the callable bond is higher than that of the straight bond. b) When interest rates are high, the price of the callable bond is higher than that of the straight bond.

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c) When interest rates are high, the price of the straight bond is higher than that of the callable bond. d) When interest rates are low, the price of the straight bond is higher than that of the callable bond. e) None of the above. ANSWER: D

6. You purchased an annual coupon bond 2 years ago that had 4 years remaining to maturity at that time. The coupon rate was 8% and the par value was \$1,000. At the time you purchased the bond, the yield to maturity was 6%. If you sell the bond now and the yield to maturity continues to be 6%, your total rate of return on holding the bond for 2 years would be _________. a) 12.75% b) 10.95% c) 6.00% d) 8.00% e) none of the above ANSWER: A Bond price 2 years ago = 1069.30 Bond price today = 1036.67 Holding period return = HPR = (1036.67-1069.3+80*1.06+80)/1069.3 = 12.75% 7. Bond A is a par value bond with 10 years to maturity and 8% coupon rate. Bond B is a zero-coupon bond with 10 years to maturity and 8% yield-to-maturity. Which bond is more price sensitive to changes in interest rates? a) Bond A because of the higher yield to maturity. b) Bond A because of the longer time to maturity. c) Bond B because of the longer duration. d) Both have the same sensitivity because both have the same YTM. e) None of the above ANSWER: C 8. The price of a par value 10% coupon bond increases by \$30 when the market yield drops by 50 basis points. What is the duration of the bond? a) 6 years. b) 6.6 years. c) 2.7 years. d) 5.15 years. e) None of the above. ANSWER: B Initial price = 1000, dp = 30, y = 10%, dy = -0.5% 30/1000 = -D*(-0.5%)/1.1, D = 6.6 9. Consider a one-year European call option and a one-year European put option on the same stock, both with strike price \$50. If the risk-free rate is 5%, the stock price is \$55, and the put sells for \$5, what should be the price of the call? a) \$7.50 b) \$10.50 c) \$12.50

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a) surrogate hedging. b) cross hedging. c) alternative hedging. d) correlative hedging. e) proxy hedging. ANSWER: B 16. Which of the following is true about profits from futures contracts? a) The person with the long position gets to decide whether to exercise the futures contract and will only do so if there is a profit to be made. b) It is possible for both the holder of the long position and the holder of the short position to earn a profit. c) The clearinghouse makes most of the profit. d) The amount that the holder of the long position gains must equal the amount that the holder of the short position loses. e) Holders of short positions can recognize profits by making delivery early. ANSWER: D 17. Which one of the following statements regarding "basis" is not true? a) the basis is the difference between the futures price and the spot price. b) the basis risk is borne by the hedger. c) a short hedger suffers losses when the basis decreases. d) the basis increases when the futures price increases by more than the spot price. e) none of the above. ANSWER: C

18. You bought one S&P 500 futures contract at 1,000. The contract is currently trading at 925. The futures margin is 5% of the contract. What is your rate of return on the contract? a) -5% b) -7.5% c) -150% d) -162% e) none of the above. ANSWER: C Assuming the contract multiplier/size is M, margin deposit on one contract is 5%*1000*M. The rate of return is (925-1000)*M/(5%*1000*M) = -150% 19. You would like to take a position in the S&P500 stock index, but have decided to use market-index futures contracts and T-bills rather than actually purchasing the index. Your strategy will duplicate the payoff you would receive if you held the index and your goal is to time the market. If you want to minimize transactions costs and you are bullish, you should a) sell futures contracts and buy T-bills and shift back and forth between them as you expect the market to turn up or down. b) sell futures contracts and T-bills and shift back and forth between them as you expect the market to turn up or down. c) buy futures contracts and T-bills and shift back and forth between them as you expect the market to turn up or down.

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d) buy and hold futures contracts and shift in and out of T-bills as you expect the market to turn up or down. e) buy and hold T-bills and shift in and out of futures contracts as you expect the market to turn up or down. ANSWER: E 20. Assume that the risk-free rates in U.S. and Germany are 4% and 3% respectively. The current spot exchange rate is 1.67DM/\$. If the futures market price is 1.63 DM/\$, how could you arbitrage? a) Borrow German Marks in Germany, convert them to dollars, lend the proceeds in the United States and enter futures positions to purchase German Marks at the current futures price. b) Borrow U. S dollars in the United States, convert them to German Marks, lend the proceeds in Germany and enter futures positions to sell German Marks at the current futures price. c) Borrow U. S. dollars in the United States and invest them in the U. S. and enter futures positions to purchase German Marks at the current futures price. d) Borrow German Marks in Germany and invest them there, then convert back to U. S. dollars at the spot price. e) There is no arbitrage opportunity. ANSWER: B Futures price = 1.654DM/\$ by interest rate parity. Current DM futures at 1.63DM/\$ is too high. Short futures and long spot.

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Part II: Short-Answer Questions (16 marks) Answer all 4 questions in the exam booklet. Each question is worth 4 marks. All parts to each question have the same weight. You must show your work to each part of every question.

21. (a) Explain why a collateralized loan is similar to a covered call option. (b) Explain the difference between short-selling a stock, selling a futures contract on the stock, and entering a forward contract to sell the stock. ANSWER: (a) page 723 of BKM (b) Selling futures and forwards are essentially the same, except futures are standardized contracts with lower transaction costs and greater liquidity. Both have little immediate cash flow implications, although futures requires a small amount of liquid assets for margin account. Short-selling a stock generates immediate cash inflow, although investors often face restrictions on short-selling and the proceeds may not be available for re-investment until the short position is covered. 22. BHP spot price is \$60. Call options on BHP with 3 months to maturity and strike price \$60 are selling at an implied volatility of 30%. The risk-free rate is 4%. You believe the true volatility is 32%. (a) How do you trade on your belief without taking on exposure to stock risk? How many shares of stocks will you hold for each option contract purchased or sold? (b) Suppose that 3-month put options with a strike of \$60 are selling at an implied volatility of 34%. Construct a delta-neutral portfolio of calls and puts that will profit when the option prices come back into alignment. ANSWER: a) Using a volatility of 32% and time to maturity T = .25 years, the hedge ratio for BHP is N(d1) = .5567. Because you believe the calls are underpriced (selling at too low implied volatility), you will buy calls and short .5567 shares for each call that you buy. b) Using the "true" volatility of σ = .32, the call delta is .5567 and the put delta is .5567 – 1 = –.4433. Therefore buy .5567/.4433 = 1.256 puts for each call purchased. For every \$1 spot price change, call price increases \$0.5567 and put price decreases \$0.4433. The delta-neutral portfolio has a profit of \$0.1134.

23. Bond A is a zero-coupon bond with 10% yield to maturity. Bond B pays \$50 coupons annually with a yield to maturity 12%. Both bonds have \$1000 par value and 10 years to maturity. (a) Calculate the market prices of A and B; (b) Calculate the duration of A and B; (c) Suppose you buy one bond of A and one bond of B. What is the duration of the portfolio? ANSWER: (a) PA = 1000/1.1 =385.54, PB=
10

∑ 1.12
50
t =1

10

t

+

1000 = 604.48 1.1210

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(b) DA=10, DB= (

∑ t 1.12
50
t =1

10

t

+ 10 ×

1000 ) / 604.48 = 7.47 1.1210

(c) DP=10*385.54/(385.54+604.48)+7.47*604.48/(385.54+604.48) = 8.45 24. A fund manager plans to buy \$6 million of 3-year bonds in three months. At current yields the bonds would have a modified duration of 2.5 years. The T-note futures contract is selling at par value and has a modified duration of 7.5 years. Assuming constant basis, should the fund take a long or short position in futures? How many futures contracts are needed? Each futures contract has a face value of \$100,000. ANSWER: The hedge is against falling interest rate therefore rising bond price in 3 months. Need to take a long position in futures. Assuming constant basis, the exposure in spot is 6,000,000*2.5, the exposure in futures with N contracts is 100,000*N*7.5. Matching exposure implies 100,000*N*7.5 = 6,000,000*2.5, thus N = 20 contracts.

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