University of the Western Cape

Faculty of Economic and Management Sciences

School of Business and Finance

INVESTMENT ANALYSIS (MAN 308)

2014 Semester Test 2

Lecturer: Mr. Wayne Small and Adv. Joyce Williams

Time: 2 Hours

Marks: 76

Instructions to Candidates:

1. Answer ALL parts of the question.

2. Section A: Complete using MCQ pink sheets
3. Section B: Complete in booklet.

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SECTION A [15]

1. Which of the following statements about Standard IV (B) Duty to Employers (Additional
Compensation Arrangements) is TRUE? Members:
A. Are prohibited from undertaking independent practice in compensation with their employer.
B. Must obtain their employer’s written consent to engage in independent consulting work.
C. Are prohibited from making preparation to go into competitive business before terminating their
employment.
D. Must only inform their employer about the plan to engage in independent consulting work.

2. According to Standard I(A) Knowledge of the Law, in the event of conflict, Members and
Candidate must:
A. Adhere to the less strict securities laws
B. Comply with the more strict law, rule or regulation.
C. If the applicable law is less strict members must adhere to the applicable law.
D. Adhere only to the Code and Standard.
-
3. Mr. Sam became involved in illegal and unethical activities. In terms of the Members
Fundamental Responsibilities, Members must:
A. Determine the legality of the activity.
B. Dissociate themselves from the illegal or unethical activity and
C. Urge his/her firm to attempt to persuade any perpetrator to stop
D. A,B AND C

4. According to Standard I(C) Misrepresentation, Members and Candidates shall not make any
statements, orally or in writing, that misrepresent:-
A. The services that they or their firm are capable of performing.
B. Their qualifications or the qualifications of their firm.
C. The member’s academic and professional credentials.
D. A, B and C.

5. Sue is a partner in the firm of Kate and Ken, a small firm only offering investment advisory
services. She assures a prospective client her firm can perform all the financial and investment
services the client need.
A. Sue has violated Standard I(D) Misconduct.
B. Sue has violated Standard I(A) Knowledge of the law
C. Sue did not violate any Standards.
D. Sue has violated Standard I(C) Misrepresentation.

6. Betty is a analyst in the corporate financial department of an investment services firm. Her
presentation to a potential new client includes the promise that her firm will provide full
favorable research coverage of the potential client.
A. Betty may agree to provide research coverage without any promise.
B. Betty firm’s recommendation must be straightforward, transparent.

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C. Betty has violated Standard I (B) because her presentation includes a promised to provide
favorable research coverage.
D. Betty did not violate any Standard because it was only a presentation.

7. Standard 1(C) – Misrepresentation:- prohibits members and candidates from guaranteeing

specific returns on investments that are inherently volatile.
Indicate which statement violates this Standard.
A. Some investment products have guarantees built in to the structure of the product itself.
B. Ken provides his client with information on investment products that has guarantees built in to
the structure of the product for which his firm has agreed to cover the loss.
C. Ben advised his client that he cannot provide any guarantees for which the client will earn 15%
on equities this year.
D. Clint guaranteed his client that they will earn 15% on equities this year.

8. Thabo heads the research department of a brokerage firm. Thabo has supervisory
responsibilities and delegates some of his supervisory duties to his subordinate. Which
statement best describes his responsibilities based on the Standard of Professional Conduct.
A. Thabo is not responsible for those duties that he has delegated to his subordinates.
B. The CFA Institute Standards prevent Thabo from delegating his supervisory duties to
subordinates.
C. Thabo retains supervisory responsibility for all his subordinates despite his delegation of some
duties.
D. Thabo’s supervisory responsibilities only apply to analysts with the CFA designation.

9. Standard IV (A): Loyalty does not preclude members or candidates from entering into an
independent business while employed. Members and candidates who plan to engage in
independent practices for compensation must :-
A. Notify the employer
B. Describe the type of services members will render
C. Advise the expected duration of the services and compensation.
D. A,B and C

10. A company report of profits that is posted on the internet and distributed widely via a press
release. If John used this information and discussed this information only with a selected group
of investors. Indicate which statement is True
A. John has violated Standard II(A) “Nonpublic” information.
B. John did not violate Standard II(A) “Nonpublic” information.
C. John has violated Standard II(B) “Market Manipulation”.
D. John did not violate any of the Standards.

11. Member’s who, reside in a country with less strict securities and regulations than the Codes and
Standards (LS) and do business in a country with more strict securities and regulations than the
Code and Standard (MS), must:

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 A. Adhere to the Code of Standards only.
B. Adhere to the laws in a country with less strict laws.
C. Adhere to the applicable laws.
D. Adhere to the more strict securities and regulations.

12. Which of the following statements regarding “Disclosure of Referral Fees” are TRUE? The
disclosure of any benefit received from referrals of customers and clients will help the client to:-
A. Determine the fair fee for services.
B. Evaluate the full cost of the services
C. Evaluate possible partiality shown in the recommendation of services.
D. B AND C

13. Kitty, CFA, decided to change her recommendation on Black & White from “buy to sell”. The
following morning she emails the amendment to all her clients with the known interest in ABC
Co. Later that afternoon one of her customers calls in an order to buy 5000 shares of ABC Co.
According to the Standard of Professional Conduct, which action should Kitty take?
A. Do not accept the order because it runs against his recommendation.
B. Accept the order because she has complied with the Standard – Fair Dealing.
C. Do not accept the order until the client had time to read the new report.
D. Advise her customer of the change in her recommendation before accepting the order.

14. Standard IV(A) does not preclude members and candidates from entering into an independent
business while still employed, members and candidates who plan to engage in independent
practice for compensation must :
A. Must provide notification to their employer.
B. Must describe the type of service the member will render.
C. Notify the employer of the expected duration and compensation for the service.
D. A, B, C and must receive consent from their employer.

15. Which of the following is not a violation of Standard I(C) Plagiarism:

A. Using charts and graphs stating their sources
B. Using articles without acknowledgment.
C. Copying proprietary computerized spreadsheets without seeking authorization of their creators.
D. Citing specific quotations supposedly attributable to “leading analysts” without specific
reference.

SECTION B [61]

Question 1 (11)

An option premium consists of two components, the intrinsic value (IV) and time value (TV).
Graphically illustrate a call option valuation function. Label all relevant points. In addition, discuss
the implications and relevancy of the call option value curve in terms of out-of-the-money, at-the-
money and in-the-money.

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Answer

5 points for graph

Option Value

Value of Call Option (C)

TV IV

(Payoff to LC if expires now)

S0

Out-of-the-Money In-the-Money

(S0 < X) (S0 > X)

Implications and relevancy of value function (6 points)

The value curve shows that when a stock price is very low, option is nearly worthless. This is
because there is almost no chance that the option will be exercised. The call is out-of-the-money.
When the stock price is very high, the option value approaches adjusted intrinsic value. In the mid-
range, where the option is approximately at the money, the option curve diverges from the straight
line corresponding to adjusted intrinsic value. This is because the exercise might have negligible
payoff (or negative), the volatility of value of option is high in this region. The option is, therefore,
highest at the money. A call increases in value with the stock price. The slope is greatest when the
option is deep in-the-money. In this case, the option will be exercised. This will result in the option
value increasing in price one-for-one with the stock price.

 TV is essentially a “volatility value, and therefore TV is highest when the option is

“at-the-money.
 TV decreases when moving closer to expiration.
 At expiration, C = IV (i.e. ST – X or 0).

Question 2 (6)

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A portfolio of 7 000 shares held long requires 9 500 call options on the same share held short to
result in a perfect hedge. Estimate the following: (6)

a) hedge ratio for this operation;

b) call option delta;
c) put option delta

Answer

Shares 7000
Call
options 9500
1.35714
a) HR 3
0.73684
b) Call option delta 2
c) Put option delta -0.26316

Question 3 (14)

Today is 1 September 2014. Use a 2-step approach based on the binomial option pricing model to
determine the fair values of a call option (X = R415) on a SASOL shares. The share price of SASOL is
currently R410, and is expected to move up by 17%, or down by 11% every six months. The current
South African Short Term T-bill rate is 8% p.a.

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Answer:

Up 17%
Down 11% Period 0 1 2
Rf 8% Binomial tree for Sasol Shares (underlying asset)
Xp 415 0 6 12
561.2
5
(1+Rfpp)^
2 108% 479.70
426.9
therefore 4% 410 3
and
P 0.53 364.90
324.7
Q 0.47 6

Period 0 1 2
Binomial tree for Sasol Call
0 6.00 12.00
146.2
5

80.31
43.90 11.93

6.12
0

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Question 4 (34)

Provide a discussion on the nature and identities of option “Greeks”. Include in your answer a
discussion on their signs for call and put options respectively.

1. Delta (1) - sensitivity of option value to changes in underlying asset price (2).
* delta of call: between 0 and +1 (1)
* delta of put: between -1 and 0 (1)
* delta = 0.5 for at-the-money options (call and put). (1)
* “delta neutral portfolio” (1) :gain/loss of the portfolio completely offset by loss/gain
of the options undertaken. (1)

* delta hedge (1) requires continuous adjustments as underlying asset price (1) and
time (1) change to keep the portfolio delta neutral (1).

2. Gamma (1) - sensitivity of delta to changes in underlying asset price. (2)

* a hedger applies delta hedge would like Gamma to be as small as possible to reduce
the frequency of the hedging adjustments. (2)
* call and put both have +ve gamma (i.e. increase in stock price will increase both call
delta and put delta) (2)

3. Vega (1) - sensitivity of option value to changes in underlying asset volatility. (2)
* call and put both have +ve vega. (2)
* vega is highest for at-the-money options. (1)

4. Theta (1) - sensitivity of option value to time decay. (1)

* call and put both have –ve theta (1) (i.e. time decay reduces the value of both call
and put options) (1)
* theta is lowest (most negative) for at-the-money options. (1)

5. Rho (1) - sensitivity of option value to changes in risk-free rate. (2)

* rho is +ve for call option and –ve for put option. (2)