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Examiners commentaries 2011

Examiners commentaries 2011


92 Corporate finance Zone A
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201011. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).

Format of the examination paper


Candidates should answer FOUR of the following EIGHT
questions: ONE from Section A, ONE from Section B and TWO
further questions from either section. All questions carry equal
marks.
A list of formulas, extracts from Present Value and Annuity Discount
tables, are given at the end of the paper.
A calculator may be used when answering questions on this paper
and it must comply in all respects with the specification given with
your Admission Notice. The make and type of machine must be
clearly stated on the front cover of the answer book.

Comments on specific questions


Section A
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one from Section B.)
Question 1
a. Derive the risk of a N-asset portfolio in terms of the average variance of
the N assets and the average covariance across all assets. Discuss the
implication(s) of the number of assets (N) in portfolio management and
diversification of risk.
(10 marks)
Reading for the question
Subject guide, pp.2829.
Approaching the question
There are two parts in this question. First we should derive the risk
of a portfolio. Next we should discuss the implications. You should
start off with the general form. The portfolios risk with N-stock of
equal weighting in each stock is defined as:
2

(1) p =

1
N2

i =1

2
i

1
N2

ij

i j

where 2i is the return variance of stock i and ij is the covariance


between returns on stock i and j.
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92 Corporate finance

The summation of all return variance involves N terms while the


summation of all covariances results in N(N1) terms. We can
simplify (1) as
2

(2 ) p =

N 2 N ( N 1)
1 2
1
+
C= + 1 C
2
2
N
N
N
N

where 2i is the average return and C is the average covariance.


As N goes to infinite, (2) can be simplified as
2p = C.
There are a few key implications:
i. As the number of stocks in a portfolio increases, the portfolios risk
tends towards the average covariance.
ii. As long as the stocks are not perfectly correlated, the portfolios risk
decreases as we include more stocks.
iii. In terms of portfolio management, one should try to balance out
(ii) above to the transaction costs of including additional stocks in a
portfolio.
b. Critically assess the validity of the Capital Asset Pricing Model in light of
Rolls critique and other anomalies.
(15 marks)
Reading for the question
Subject guide, pp.3439; BMA, Chapter 8, pp.22227.
Approaching the question
This question aims to test candidates ability to disseminate
ideas gathered from the subject guide and the relevant textbook
materials. The key points that should be clearly discussed are as
follows:
i. The validity of CAPM depends on whether the market portfolio is
mean-variance efficient
ii. The true market portfolio is not observable
iii. Proxies for the market portfolio are often taken from broad-based
equity indices which do not contain all the tradable securities or nonfinancial assets such as real estates, durable goods and even human
capital
iv. This renders the CAPM untestable
v. If the CAPM is untestable, then any empirical evidence as argued by
Roll would be inconclusive about the validity of the CAPM
vi. Other anomalies such as the size effect, book-to-market ratio and P/E
effect seem to suggest that there are risks that are not captured by the
CAPM.
Question 2
a. Explain clearly why it is impossible to successfully takeover a company
according to Grossman and Hart (1980).
(10 marks)
Reading for the question
Subject guide, pp.13940.
Approaching the question
This question was generally well answered. Candidates seem to be
able to memorise the materials from the subject guide. However, a
good answer should be one which reflects candidates understanding
of the arguments put forward by Grossman and Hart (1980).
2

Examiners commentaries 2011

Some key points that you might want to discuss would be as follows:
i. The acquired firms value will increase if the takeover is successful. The
gain is z.
ii. The equity of the acquired firm is held by many, small
shareholders.
iii. The acquiring firm pays a premium p and incurs a cost of takeover, c.
iv. Acquiring firm will take over the acquired firm provided that z > p + c.
v. But a minority shareholder will only be willing to sell his/her shares if
p > z; if thats not the case, he/she will wait for the others to sell their
shares and enjoy the free-ride to see his/her equity rise to value at z.
vi. As long as none of the minority shareholders perceive themselves to
be pivotal, everyone will free-ride on the improvement of the value
offered by the acquiring firm.
vii. Given that, the bid will fail.
b. Outline the arguments for the agency cost on debt. Explain how the use of
convertible bonds might mitigate the agency conflict between equity-holders
and debt-holders in financially distressed firms with high debt to equity ratios.
(15 marks)
Reading for the question
Subject guide, pp.11218.
Approaching the question
Key points:
i. The agency costs on debt arise in two folds:
a. The value of debt decreases due to sub-optimal managerial decision
b. Debt-holders impose more measures on corporate governance
structure and restrictive clauses in the debt covenants to safeguard
their interests.
ii. These costs rise as more debts are issued
iii. If corporate managers are not looking after the debt-holders interests,
then there might be cases when a firm might be over-investing in risky
projects in the expense of debt-holders, under-investing when small
but safe NPV projects are passed, and swapping for more risky projects
once a loan is obtained
iv. Convertible bonds might help mitigate these problems when the debtholders perceive that their interests are not being protected and risks
are being shifted from the shareholders to them.
Question 3
a. Explain clearly the 3 main conditions for debt to work effectively as a signal
of a firms value.
(9 marks)
Reading for the question
Subject guide, pp.11920.
Approaching the question
Many candidates simply reproduced the material from the subject guide
without clearly identifying and explaining those three key conditions.
The subject guide outlines the Ross model (1977) but what you need is to
understand how those equations in the model work. In general, there are
three key conditions:
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92 Corporate finance

i. The market is adhering to the semi-strong form efficient but not strong
form. A firms true value is therefore not observable.
ii. Good quality firms have high future cash flows and low quality firms
do not. Good firms can issue relatively high percentages of debt and
still comfortably service the high interest payments.
iii. The penalty for the managers of a low quality firm to lie about its value
by issuing temporarily high levels of debt would need to outweigh the
benefit that those managers might derive from the short-term rise in
the firms value.
b. Critically assess the empirical evidence for the semi-strong form of market
efficiency.
(10 marks)
Reading for the question
Subject guide, pp.8183.
Approaching the question
To tackle this question, you should highlight the key points relating to the
testing of semi-strong form efficient markets. Some of the key points can
be summarised as follows:
i. The test for semi-strong form efficiency is about how fast and accurate
information from an event can be incorporated into prices.
ii. Identify a sample of firms for a particular event.
iii. Measure the ex ante expected return of each firm.
iv. Construct the average abnormal return by comparing the actual
average return to the average expected return.
v. The cumulative abnormal returns before and after the event is then
examined.
To improve the quality of the answer, you should provide a discussion
on the empirical evidence. For example, Asquith and Mullins (1983)
suggested that information incorporated within 510 minutes and share
prices moved up on unexpected dividend announcements. It seems to
suggest that such a market is adhering to the semi-strong form efficiency.
However, Ball and Brown (1968) argued that unexpected earnings may
not be fully incorporated in stock prices. This seems to suggest that
empirical evidence for or against market efficiency might be period
specific and methodology dependence.
c. Explain why Net Present Value is a better investment appraisal technique
than Internal Rate of Return.
(6 marks)
Reading for the question
Subject guide, pp.1819; BMA, Chapter 5, pp.13743.
Approaching the question
This part was generally quite well answered. The key points that should
be discussed are:
i. IRR does not account for the size or magnitude of the project. It is not
a good tool to rank projects.
ii. Cost of capital may vary over time but IRR assumes that any spare cash
can be re-invested at the same rate. This might not be realistic.
iii. IRR is not additive and therefore the total IRR of all projects need
to be re-computed. NPV has an additive property and therefore the
combined effect can be determined easily.

Examiners commentaries 2011

Question 4
a. Explain, with the aid of a diagram, why a firms dividend policy is independent
from its investment policy in a perfect and complete market. You should
include a discussion of the Fishers Separation Theorem in your answer.
(10 marks)
Reading for the question
Subject guide, pp.914.
Approaching the question
In a perfect and complete capital market where there is no transaction cost
and information is widely available to everyone, it is argued that a firms
investing, financing and dividend decisions are not interlinked. This can be
illustrated in the following diagram.

W1

B
Individual 1
y1

C1*
A

C0*

y0

Individual 2

W0

C0

Suppose a firm is operating in a two-period environment (period 0 and


period 1) with an initial cash flow of Y0. It has the opportunity to invest in
two types of investments. The first type of project relates to investments
which require an initial investment outlay, CFi,0 and deliver CFi,1 in the
next period for each investment i. Thereafter it is referred to as production
investment projects. The second type of investment is essentially financial
which allows the firm to borrow and lend an unlimited amount at an
interest rate of r. In this case, if a firm borrows (or lends) W0 in period 0, it
will pay back with interest (or receive with interest) W1 = W0(1 + r).
Investing decision
What should the firm do in terms of its investments?
A firm will logically rank and invest in production investment projects
in descending order of their profitability (Ri for each i). A production
opportunity frontier can be obtained (such as the curve Y0Y1). A firm will
invest up to the point where the marginal investment i* yields a return that
equals to the return from the capital market (i.e. interest rate r). The total
investment outlays, the amount represented by C0Y0, is the sum CFi,0 for all
i (i = 1 to i*). Once the investment plan is fixed, the firm will have C*0 in
period 0 remaining and a cash return of C*1 in period 1.
Dividend policy
In this setting, how much should the firm give out as dividend to its
shareholders in each period? The answer is simple. It should give out C0 and
C1 in period 0 and 1 respectively. However, would shareholders be satisfied
with these amounts in each period? Suppose we have two individual
shareholders 1 and 2. Each of them has their unique utility function of
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92 Corporate finance

consumption in each period. This can be represented by the indifferent


curves in the diagram above. For individual 1, he prefers to consume less
in period 0 and more in period 1. Given the current firms dividend policy,
how would he be satisfied? There are two ways to achieve it.
The firm will pay C0,a and invest any excess cash flow (i.e. C*0 C0,a ) at
r in period 0 and give out C*1 + (C*0 C0,a)(1 + r). Mathematically, it can
be proved that it is equal to C1,a. Therefore the firm will pay the exact
dividend in each period to individual 1.
Alternatively, the firm pays C*0 to individual 1 and he can invest any
excess cash flow after his consumption in period 0 in the financial
investment earning a return of r and receive the same combined cash flow
of C1,a.
This reasoning applies to any individual shareholders with any unique
utility functions. Take Individual 2 as an example. Her consumption
pattern does not match the firms dividend payout. Similarly, there are two
ways we can satisfy her consumption pattern.
The firm will borrow C0,b C*0 at r in period 0 and pay out C0,b to
individual 2. In period 1, the firm will pay out C*1 (C0,b C*0)(1 + r).
Mathematically, it can be proved that it is equal to C1,b. Therefore the firm
will pay the exact dividend in each period to individual 2.
Alternatively, the firm pays C*0 to individual 2 and she borrows any
shortfall to make up to her consumption C0,b in period 0. In period 1, she
will receive C*1 less the loan and interest she takes out in period 0. This
will leave her with a net amount exactly equal to C1,a.
The above argument indicates that financial managers do not need to
consider shareholders consumption patterns when fixing the investment
plan or the dividend policy. The easiest way is to maximise the firms
cash flows and distribute the spare cash flows as dividends. Shareholders
will use the capital markets to facilitate their consumption patterns
accordingly.
Financing decision
In the beginning, we assume that the firm has an initial cash flow of
Y0 and requires a total investment outlay of C0Y0. If any part of Y0 is
not contributed by shareholders, the firms dividend in period 1 will
be reduced by the fund raised from borrowing (at a cost of r) and the
interest. However, shareholders can offset this shortfall of dividend in
period 1 by investing the fund not contributed in the firm in the capital
market and earn a return exactly equal to r.
The above argument illustrates the Fisher separation in which the
investing, financing and dividend decisions are all unrelated. However,
if the capital market is imperfect, such external funding is restricted; this
might break the Fisher separation. For example, to increase investment, a
firm might need to raise extra borrowing. If borrowing is restricted, then
the firm will have to reduce the dividend payout. This might affect the
shareholders consumption and hence investment plan and dividend policy
become intertwined.
Candidates need to explain the key concepts above. A good answer
should highlight why a firm can simply maximise its value by
investing in NPV projects and shareholders can use the capital
markets to facilitate their consumptions regardless of what the firm
pays out as dividends.

Examiners commentaries 2011

b. Using the arguments for the signalling and tax clientele effects of dividends,
to what extent would you conclude that dividend policy is relevant to
corporate value?
(15 marks)
Reading for the question
Subject guide, pp.12932.
Approaching the question
This question requires candidates to carefully explain the signalling
effect and the tax effect of dividend policy. A good answer should
provide a balanced view on how a change of dividend policy might
affect a firms value based on these two theories.
Some of the key points which might be discussed are as follows:
i. Discuss the stylised facts of dividend by Lintner (1958).
a. Some kind of target payout ratio
b. No change to dividend payout unless it is sustainable
c. Short term increase in earnings does not necessarily prompt
managers to increase payout.
ii. Market is not consistent with the strong form and the quality of a firm
is not observable; and hence dividend may serve as a signal.
iii. Unexpected rise in dividend may indicate that a firm has a better
ability to generate future cash flows. Its value will rise accordingly. On
the other hand, an unexpected dividend cut may signal the financial
problem a firm is facing. Share price may fall as a result.
iv. Tax shareholders pay different marginal tax rates on dividend income
and capital gain. Therefore those who have a higher tax rate on capital
gain would prefer firms to pay a higher dividend while those who pay
a lower capital gain tax will prefer the firms to pay a lower dividend.
v. However, the tax clientele effect will disappear in equilibrium. The no
arbitrage ensures that any difference in value of firms with different
payout ratios will disappear.

Section B
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one from Section A.)
Question 5
a. Tiger plc has the following projects:
Projects
A
B
C
D

Initial Investment,
NPV (after tax),
100,000
10,000
150,000
25,000
75,000
5,000
50,000
6,000

The company has only 250,000 available at year 0. There is no other


investment opportunity for the firm with any spare cash which is not
invested in the above 4 projects.
i. Assume that all projects above are infinitely divisible. Explain, with supporting
calculations, which projects the company should choose to maximise its
value? What is the optimal NPV of the investment plan? (3 marks)
[For the full question, please refer to the examination paper.]

92 Corporate finance

Reading for the question


BMA, Chapter 5, pp.14347.
Approaching the question
To tackle this problem, one should first calculate the profitability
index (defined as NPV/initial investment) for each project.
Projects
A
B
C
D

Initial Investment,
100,000
150,000
75,000
50,000

NPV (after tax),


10,000
25,000
5,000
6,000

PI
1.10
1.17
1.07
1.12

Ranking
3
1
4
2

If investments are infinitely divisible, then we should invest in B, D and


half of A, i.e.:
Total NPV = 25,000 + 6,000 + 0.5 10,000 = 36,000.
If investments are not infinitely divisible, then we should invest in B and
A, i.e. Total NPV = 35,000.
b. CM Ltd has been presented with the following project:
A new machine for 100,000 is required at the beginning of the first year. The
machine will last for 4 years and thereafter can be disposed of for 20,000.
The companys policy is to depreciate this type of machine over its economic
life on a straight-line basis.
The demand for the product CF depends on the states of the economy in the
future. In the good state, CM Ltd expects to sell 12,000 units per year for the
next 4 years. If the economy is bad, sales will fall to 8,000 units per year. Each
state of the economy has an equal probability to materialise.
[For the full question, please refer to the examination paper.]
A suggested solution to part (i) is given below:
Year
0
Machine

(100,000)

Revenue

4
20,000

300,000

300,000

300,000

300,000

(250,000)

(262,500)

(275,625)

(289,406)

50,000

37,500

24,375

30,594

(7,500)

(5,625)

(3,094)

3,478

(100,000)

42,500

31,875

21,281

34,072

DF

0.909

0.826

0.751

0.683

PV

(100,000)

38,633

26,329

15,982

23,271

50,000

37,500

24,375

30,594

(25,000)

(18,750)

(14,063)

(42,188)

25,000

18,750

10,313

(11,594)

7,500

5,625

3,094

(3,478)

Costs
NCF before tax

(100,000)

Tax
NCF after tax

NPV
NCF = Taxable profit
Capital allowances
Taxable profit after CA
Tax (@30%)

4,215

There are a few things which are worth noting:


i. If the demand is dependent on the states of the economy (like in this
question), you are expected to consider ONLY the expected demand in
the numerical analysis (unless it is stated otherwise in the question).

Examiners commentaries 2011

ii. Non cash items should not be included in the NPV calculations. You
should also clearly mention why those non cash items should be
excluded from the analysis.
iii. Capital allowance must be calculated in accordance with the rule given
in the question.
Year
0
Written down value

100,000

Capital allowance

75,000

56,250

42,188

25,000

18,750

14,063

42,188

Part (ii) requires candidates to re-work the NPV if the project is to defer by
one year.
Year
0

Machine

NCF before tax

360,000

360,000

(330,750)

(347,288)

45,000

29,250

32,713

(6,000)

(3,150)

7,061

(100,000)

39,000

26,100

39,774

0.909

0.826

0.751

0.683

(90,900)

32,214

19,601

27,165

Tax
1

PV
(11,919)

NCF = Taxable profit


Capital allowances
Taxable profit after CA
Tax
Written down value
Capital allowances

20,000
360,000

(100,000)

NCF after tax

(315,000)

costs

NPV

(100,000)

Revenue

DF

100,000

45,000

29,250

32,713

(25,000)

(18,750)

(56,250)

20,000

10,500

(23,538)

6,000

3,150

(7,061)

75,000

56,250

25,000

18,750

56,250

Assumptions:
i. We assume that the machine will be purchased in one years time if the
project is to be deferred. The resale value remains the same by the end
of year 4.
ii. The annual cost will still rise at 10% per annum.
iii. The firm will only (potentially) engage in this project if the good state
of the economy is realised.
Since there is a 50% chance that the good state of the economy will
realise, the expected NPV of deferring the project until year 2 is 5,960
(0.5 11,919). The deferment is not advantageous.

92 Corporate finance

Question 6
a. The last 5 years returns on Vjay plc and on the broad market index are as
follows:
Year

Vjay, %

Market, %

2010

2009

2008

10

2007

13

10

2006

14

15

If the risk free rate is expected to be 3% per annum in the foreseeable future,
estimate Vjays beta using the covariance method and its expected return
according to the Capital Asset Pricing Model (CAPM).
(10 marks)
Reading for the question
BMA, Chapter 7, pp.20205 (especially Table 7.7).
Approaching the question
This is a straightforward textbook type question.
I

II

III

IV

VI

VII

Vjays rtn, %

Markets rtn, %

I - mean

II - mean

III2

IV2

III x IV

2010
2009
2008
2007
2006

2
0
10
13
14

5
2
7
10
15

Sum
Mean
Variance
Covariance
Standard deviation
Beta = Cov/Var(M)
Expected return

35
7

25
5

Year

9
7
3
6
7

10
7
2
5
10

81
49
9
36
49

100
49
4
25
100

90
49
6
30
70

224

278

245

56

69.5
61.25

7.48
61.25/69.5

0.88
4.76

b. Suppose the returns on Stocks x, y and z are determined by the following


two-factor model:

rx = 0.2 + 2 F1 F2 = 5%
ry = 0.16 + 4 F1 + 2 F2 = 7%
rz = 0.1 + 1F1 + F2 = 9%
i. Determine the portfolio weights you need to place on x, y and z in order
to replicate the portfolio returns on F1 and F2 respectively.
(10 marks)
Reading for the question
Subject guide, pp.4850.
Approaching the question
Let w1, w2, and w3 be the weights in x, y and z respectively.
Forming the first factor loading, we have:
1. w1 + w2 + w3 = 1
2. 2w1 + 4w2 + w3 = 1
10

8.34

Examiners commentaries 2011

3. w1 + 2w2 + w3 = 0
We can either solve the three equations simultaneously using a matrix or
solve each pair of equations at a time.
(2) (3) => 3w1 + 2w2 = 1
(2) (1) => w1 + 3w2 = 1
=> w2 = 2/7
=> w1 = 11/7
=> w3 = 9/7
Forming the second factor loading, we have
1. w1 + w2 + w3 = 1
2. 2w1 + 4w2 + w3 = 0
3. w1 + 2w2 + w3 = 1
=> w2 = 1/7
=> w1 = 3/7
=> w3 = 2/7
ii. The return on Stock M is known to follow the factor model below rm = 0.5
F1 + 1.5F2. It is currently traded with a return of 10%. Explain if any arbitrage
opportunity arises in this case.
(5 marks)
F1 = 0.43r1 + 0.417r2 + 0.194r3 = 0.43 5 +0.417 7 + 0.194 9 = 2.515
F2 = 0.333r1 + 0.667r3 = 0.333 5 + 0.667 9 = 4.338
rm = 0.5 F1 +1.5F2 = 0.5 2.515 + 1.5 4.338 = 4.492
Since the return based on the factor model is well below the
observed return (10%), an arbitrage opportunity seems to exist.
However, if the factor representation is not a true model, then such
a price difference might not be reconciled.
Question 7
Blue Shark plc, a quoted company in the UK, is considering a takeover of Black
Seal Ltd. Both companies are 100% equity financed. The following information is
available for these two companies:
Blue Shark
Number of shares

Black Seal

10,000,000

1,000,000

10

Not available

0.8

Share price
Dividend per share (latest)
You discover the following additional information:

i. Black Seal Ltd. has been paying a constant dividend for the last 5 years to its
shareholders.
ii. The Directors of Black Seal have been using a discount rate of 15% to
appraise its projects.
iii. It is believed that if the takeover is successful, Black Seals dividend per
share will grow at 10% per year.
[For the full question, please refer to the Examination paper.]
Reading for the question
BMA, Chapter 31, pp.82933.

11

92 Corporate finance

Approaching the question


Cash consideration
Cost of acquisition = 15,000,000
Net cost = 15,000,000 5,666,667 = 9,666,667
Gain = 17,600,000 10,666,667 = 12,266,667
Net gain = 12,266,667 9,666,667 = 2,600,000
Share exchange
Value of the combined company = 100,000,000 + 17,600,000 =
117,600,000
New share price = 117.6m/11m = 10.69
Cost of acquisition = 10.69 1m = 10,690,909
Net cost = 10,690,909 5,333,333 = 5,357,576
Gain = 12,266,667 (same as the cash consideration)
Net gain = 12,266,667 5,357,576 = 6,909,091
The advantages and disadvantages of cash and share exchange in M&A
can be summarised as follows:
Cash

Acquired

Acquiring

Advantages

Shareholders will receive a certain


cash flow when they sell their
shares to the acquiring firm. It
implies that they will obtain a
certain return on their investment

Acquiring firms shareholders


will have full control over the
combined operation.

Disadvantages

The receipt of cash is deemed


to a disposal of shares which
will attract capital gains tax and
shareholders will lose ownership

There is a liquidity
implication. Acquiring firm
needs to raise sufficient cash
flows for the acquisition.

Advantages

The acquired firms shareholders


will maintain some form of
ownership in the combined
operation.

There is no cash outflow in


this type of acquisition.

Disadvantages

The return on investment from


the combined operation might be
uncertain.

Acquired firms shareholders


need to share ownership with
the shareholders from the
acquiring firm.

Share exchange

Question 8
a. Mojito plcs share price, S, can either go up to SH or down to SL in the next
period. Derive the price of a call option written on S in terms of a position in
the stock and a risk free asset.
(7 marks)
b. Mojito plcs shares are currently traded at 10 each. Its share price is
expected to go up to 13 or down to 8 in three months time. The effective
interest rate for the next three months is 2%. What is the price of a call
option on Mojitos share with an exercise price of 10?
(5 marks)
c. Explain clearly why the price of a call option does not depend on the
investors risk preference and the probabilities of the future states of the
economy. Determine the risk neutral probabilities of the two states of the
economy in (b).
(13 marks)
12

Examiners commentaries 2011

Reading for the question


Subject guide, pp.6063.
Approaching the question
a. Derive the option price.
Form a portfolio with a% in S and b in risk-free asset. This portfolio
mimicks the payoff of a call option:
CH = aSH + b(1 + rf)
CL = aSL + b(1 + rf).
Solving the two equations we have:
a = CH CL / SH SL
b = SLCH SHCL / (1 + rf)(SL SH)
The value of a call, C = aS + b.
b. Given the information in the question, we can determine that:
CH = 3
CL = 0
SH = 13
SL = 8.
Substituting into the two equations in (a) we have:
a = (3 0)/(13 8) = 3/5 = 0.6
b = (8 3 13 0) / (1.02 5) = 4.706
The value of the call, C = 0.6 10 4.706 = 1.294.
c. If SH = uS (u percentage of S) and SL = dS (d percentage of S), then:
a = (CH CL)/(u d)S
b = (uCL dCH)/(u d)R
C = aS + b = (CH CL)/(u d)+ (uCL dCH)/(u d)R.
= [pCH + (1p)CL]/R where p=(R d)/(u d), the risk neutral probability.
Using the information in (b), R = 1.02; d = 0.8; u = 1.3, p = 1.02 0.8 / 1.3
0.8 = 0.44.
Information about the probability and risk are already priced in the
underlying asset. Therefore the option prices which derived their values
from the underlying assets would reflect this information. To see this, we
can express the current stock price as the probability weighted average
of future prices of the two states:
S = qSH (1 q)SL / 1 + rf
q = R d / u d.

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