FINM2003 Mid-Semester Exam Suggested Solutions

Note: These are suggested solutions only. Alternate methods not necessarily detailed here were
allocated marks as appropriate

Question 1

a) Calculate your return over the next year, for each of the scenarios provided in the table, and
the resulting margin. Assume that the only possible source of returns is through stock price
changes. (3 Marks)

Deal with each scenario separately:

10000 x 5.52 = $55,200

The amount borrowed is $25,200. The margin in this case is $30,000 (equity)

If the share price rises to $7.05:

The amount owed at the end of the year is $25,200 x 1.075 = $27,090

The margin is therefore $70,500 - $27,090 = $43,410, and the percent margin is 61.57% (no
margin call)

The rate of return is: (43,410-30,000)/30,000 = 44.7%

If the share price rises to $6.55:

The amount owed at the end of the year is $25,200 x 1.075 = $27,090

The margin is therefore $65,500 - $27,090 = $38,410, and the percent margin is 58.64% (no
margin call)

The rate of return is: (38,410 – 30,000)/30,000 = 28.03%

If the share price remains at 5.52:

The amount owed at the end of the year is $25,200 x 1.075 = $27,090

The margin is therefore $55,200 - $27,090 = $28,110, and the percent margin is 50.92% (no
margin call)

The rate of return is: (28,110 – 30,000)/30,000 = -6.3%

If the share price falls to $4.50:

The amount owed at the end of the year is $25,200 x 1.075 = $27,090

The margin is therefore $45,000 - $27,090 = $17,910, and the percent margin is 39.8% (no
margin call)
 The rate of return is: (17,910 – 30,000)/30,000 = -40.3%

If the share price falls to $4.05:

The amount owed at the end of the year is $25,200 x 1.075 = $27,090

The margin is therefore $40,500 - $27,090 = $13,410, and the percent margin is 33.11% (no
margin call)

The rate of return is: (13,410 – 30,000)/30,000 = -55.3%

b) Recalculate the returns in a), assuming now that Megalo Ltd will pay a cash dividend of 30c
per share, across all scenarios, at the end of the year. (2 Marks)

If the share price rises to $7.05:

(43,410 – 30,000 + 3,000)/30,000 = 54.7%

If the share price rises to $6.55:

(38,410 – 30,000 + 3,000)/30,000 = 38.03%

If the share price remains at 5.52:

(28,110 – 30,000 + 3,000)/30,000 = 3.70%

If the share price falls to $4.50:

(17,910 – 30,000 + 3,000)/30,000 = -30.3%

If the share price falls to $4.05:

(13,410 – 30,000 + 3,000)/30,000 = -45.3%

c) What is your overall expected return? Assume in this part that the company pays a 30c
dividend at the end of the year, across all scenarios. (3 Marks)

= (0.2x0.547) + (0.25x0.3803) + (0.25x0.037) + (0.15x-0.303) + (0.15x-0.453) = 10.03%

d) In words, describe how a margin facility would be used to short sell stocks. (4 Marks)

To have scored high marks for this question, it was expected that you describe both short
selling and the notion of a margin facility. There should be adequate detail in this response,
including the process of short selling (borrow shares, sell them, then ultimately return the
shares to the owner with any dividends paid by the company during this period). Further, you
should explain that a margin facility for short selling effectively acts as security in the event of
a price increase. Unlike the case when buying on margin, i.e. where cash is borrowed to
purchase shares, shares are borrowed in such a scenario. Therefore, in the event of a margin
call, either additional cash must be added to the margin account, or the borrowed shares must
be replaced.
Question 2

a) The index model has been estimated using historical excess return data for stocks A and B,
with the following results:

RA = 0.05 + 0.82RM + eA

RB = 0.01 + 1.25RM + eB

σM = 0.22

σ(eA) = 0.20

σ(eB) = 0.10

i. What is the standard deviation of stocks A and B? (2 marks)

Use the following formula:

𝜎𝑖 = √𝛽𝑖2 𝜎𝑀
2
+ 𝜎 2 (𝑒𝑖 )

𝜎𝐴 = √0.822 0.222 + 0.22 = 0.26934023 or 26.93%

𝜎𝐵 = √1.252 0.222 + 0.12 = 0.292617497 𝑜𝑟 29.26%

ii. To what extent does the market explain the variance of returns, for stocks A and B? (2
marks)

Calculate the R2 for each regression:

𝛽𝑖2 𝜎𝑀
2
𝑅2 =
𝛽𝑖2 𝜎𝑀
2
+ 𝜎 2 (𝑒𝑖 )

0.822 0.222
𝑅𝐴2 = 0.822 0.222 +0.22 = 0.448611714

1.252 0.222
𝑅𝐵2 = 1.252 0.222 +0.12 = 0.883211678

iii. What is the covariance between the returns on stocks A and B? (2 marks)

2
𝐶𝑜𝑣(𝑟𝐴 , 𝑟𝐵 ) = 𝛽𝐴 𝛽𝐵 𝜎𝑀

𝐶𝑜𝑣(𝑟𝐴 , 𝑟𝐵 ) = 0.82 × 1.25 × 222 = 496.10

 iv. What is the covariance between each stock and the market index? (2 marks)

𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑀 )
𝛽𝑖 = 2
𝜎𝑀

Rearrange and solve for the numerator:

2
𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑀 ) = 𝛽𝑖 𝜎𝑀

Stock A:
2
𝐶𝑜𝑣(𝑟𝐴 , 𝑟𝑀 ) = 𝛽𝐴 𝜎𝑀 = 396.88

Stock B:
2
𝐶𝑜𝑣(𝑟𝐵 , 𝑟𝑀 ) = 𝛽𝐵 𝜎𝑀 = 605

b) What is the difference between the Capital Market Line (CML) and the Security Characteristic
Line (SCL)? With the aid of diagrams, describe what each line represents and the meaning of
their intercepts and slopes. (6 marks)
Question 3

You have constructed a portfolio consisting of two stocks, A and B. Stock A has an expected return of
15%, and a standard deviation of 32%, and Stock B has an expected return of 9%, and a standard
deviation of 21%. The correlation between the two stocks is 0.15, and the T-bill rate is 4.5%.

a) You decide to form a risky portfolio consisting of 65% Stock A, and 35% Stock B. Calculate the
expected return, reward-to-volatility ratio, and standard deviation of your risky portfolio. (3 marks)

Expected return:

E(rp) = 0.65(0.15) + 0.35(0.09) = 0.129 or 12.9%

Standard deviation:

σp = (w2A σ2A + w2B σ2B + 2wAwBρσAσB)1/2

σp = (0.6520.322 + 0.3520.212+2×0.65×0.35×0.15×0.32×0.21)1/2 = 0.230765 or 23.0765%

Reward to volatility:
𝐸(𝑟) − 𝑟𝑓
𝜎
0.129−0.045
=
0.230765

= 0.364
b) Assume you have a client who is happy with the composition of your risky portfolio in part (a), but
is comfortable with a standard deviation of only 15%. What would be the weighting in Assets A and
B, and T-bills, and the expected return, of this client’s complete portfolio? (3 Marks)

Use the expression σC = yσp, set σC = 15 and solve for y:

0.15 = 0.230765y

y = 0.650040085 (risky portfolio)

1-y = 0.3499599 (T-bills)

Therefore the weightings are:

Asset A (0.650040085×0.65) 0.422529

Asset B (0.650040085×0.35) 0.227514029
T-bills 0.3499599

The expected return of this portfolio is:

E(rp) = 0.422525 (0.15) + 0.227514 (0.09) + 0.34996 (0.045) = 0.0996 or 9.96%

c) Recalculate (b), but instead assume that your client exhibits a coefficient of risk aversion of 4 as an
indicator of risk tolerance, rather than the 15% standard deviation. (3 Marks)

Assuming a risk tolerance of 4:

𝐸(𝑅𝑝 ) − 𝑟𝑓
𝑦∗ =
𝐴𝜎𝑝2
0.129 − 0.045
𝑦∗ = = 0.39435121
4(0.230765)2
Therefore the weightings are:

Asset A (0.39435121×0.65) 0.256328286

Asset B (0.39435121×0.35) 0.13022923
T-bills (1 – 0.39435121) 0.60564879

The expected return of this portfolio is:

E(rp) = 0.2563 (0.15) + 0.138023 (0.09) + 0.605649 (0.045) = 0.078125 or 7.813%

d) Calculate the composition of the minimum variance portfolio consisting of stocks A and B, and its
reward-to-volatility ratio. (3 Marks)

 B2  Cov (rA ,rB ) 0.32 2  0.01006

wMin(B) =   0.7307
 A2   B2  2Cov (rA ,rB ) 0.212  0.32 2  2(0.01006 )
The weightings for assets A and B are:

Asset A 0.2693
Asset B 0.7307

Reward to volatility:

E(rp) = 0.2693 (0.15) + 0.7307 (0.09) + 0.605649 (0.045) = 0.106158 or 10.62%

σp = (0.269320.322 + 0.730720.212+2×0.2693×0.7303×0.15×0.32×0.21)1/2 = 0.1869206

Therefore:
𝐸(𝑟) − 𝑟𝑓 0.106158 − 0.045
= = 0.32718705
𝜎 0.1869206