UNIVERSITY OF CAPE TOWN

SCHOOL OF ECONOMICS
ECO4053Z
FINANCIAL ECONOMICS
EXAMINATION NOVEMBER 2006

Part I Shakill Hassan

TIME: 1 HOURS

Instructions:
Answer all questions.
Mathematical or numerical answers must be accompanied by clear explanations
All questions carry equal weight.
This is a closed-book exam.
Question 1 [Portfolio Theory]
a) Consider an investment set with only three securities, two risky and one risk-free. The
risk-free rate is 10%. The expected returns and standard deviations of the risky
securities are as follows:

Security 1
Security 2

Expected return
10%
4%

Standard deviation
5%
2%

What is the optimal investment for a mean-variance optimiser? Why?

b) Consider an investment set with N-risky securities and one risk-free asset. Assume
the Capital Market Line is upward sloping. Argue, with the aid of a diagram or
mathematically, that a risk-averse mean-variance optimising investor will never
optimally invest all her wealth in the risk-free asset, irrespective of her degree of risk
aversion. State all/any assumptions. Is there a contradiction between your answer and
the answer to (a) above? Why or why not? [Hint: It may help to think of conditions
for optimal portfolio choice, and the shape of indifference curves in expected return
deviation space.]
Question 2 [Asset Pricing]
a) Suppose the return on any asset can be described exactly by a linear two-factor model.
Use an arbitrage argument to obtain a common ratio (of a scaled excess return), with the
natural interpretation of the market price of risk, and hence obtain an arbitrage-free
asset pricing equation. (Explain all steps, clearly.)
b) Show that we can associate different assets CAPM-betas with differences in the assets
(APT-) factor loadings. Comment (with particular attention to the implications for
understanding systematic risk).

Question 3[Corporate Finance]

An entrepreneur is faced with the choice of two mutually exclusive investment projects.
Both cost 100. At the end of the investment period, project A pays 150 in the good state of
the economy, and 75 in the bad state. Project B pays 175 in the good state, and 50 in the
bad state. There is a 40% (respectively, 60%) probability that the economy will be in the
good (respectively, bad) state. The entrepreneur has no other productive assets. There are
no taxes or direct bankruptcy costs, investors behave as if they were risk-neutral, and the
risk-free rate of interest is zero.
a) Which investment project will the entrepreneur choose if it is financed exclusively by
equity capital? [State any assumptions.]
b) Assume the entrepreneur is able to borrow 75 by issuing a one period bond with a
face value of 75, to be repaid at the end of the investment period. Which investment
will the entrepreneur choose?
c) What is the maximum amount a sophisticated bond investor (or lender) will be
prepared to pay (or lend) for the entrepreneurs bond with face value (promised
repayment) of 75? Why?
d) Give a brief options-theoretic explanation of the agency cost of debt faced by the
entrepreneur.
e) Can the use of convertible bonds mitigate the problem? How or why not?

UNIVERSITY OF CAPE TOWN

SCHOOL OF ECONOMICS
ECO4053Z
FINANCIAL ECONOMICS
EXAMINATION NOVEMBER 2006

Part II Haim Abraham

TIME: 1 HOURS

All questions carry equal weight

Answer all questions
Question 4
Company A and company B can borrow in the currency markets under the following terms,

Fixed rate $
Floating rate

Company A

Company B

Treasuries+0.6%
LIBOR+0.15%

Treasuries+1.8%
LIBOR+1.6%

The spot exchange rate is 1.5$=1. Company A and company B enter into a 2-year swap
agreement via a financial intermediary. The notional principal is 100 million. Assume that
the yield on treasuries is 7% in each year. The LIBOR is 5% in the first year and 5 % in the
second year. Assume that company A takes 60% of the total gain from the swap, company B
takes 24% and the financial institution takes 16%.
Conclude the swap transaction.
Question 5
The prices of bonds are as follows,
Principal (R)
100
100
100
100
(i)
(ii)
(iii)

Time to maturity
(years)

1
1
2

Annual coupon (R) Bond price (R)

payable yearly
0
98
0
95
6.2
101
8.0
104

Calculate the zero rates of 6 and 12 months maturities.

Calculate the forward rates for the periods, 6 months to 12 months, and 12
months to 18 months.
Estimate the price of a 2-year bond providing a yearly coupon of 7% per
annum.

Question 6
A stock price is currently R30. Each month for the next two months it is expected to increase
by 8% or reduce by 10%. The risk-free interest rate is 5%.
(i)

Use a two-step tree to calculate the value of a derivative that pays off
max [(30 S T ) 2 ,0] , where ST is the stock price in two months?
If the derivative in (i) is American-style, should it be exercised early?

(ii)
Question 7

(a) Construct a table showing the payoff from a bull spread when puts with strike
prices K 1 and K 2 ( K 2 K 1 ) are used.
(b) What is the result if the strike price of the put is higher than the strike price of
the call in a strangle?