Finance 600

Modules 3 & 4 Assignment

Due: March 11, 2017 (11:59 PM Eastern Time)

This is an individual assignment. To receive full credit, you must EXPLAIN your answers and/or
show supporting calculations. There are 8 questions and 26.5 points on this assignment (100% =
25 points).

1. (6 Points) Stock X and Stock Z both have an expected return of 12%. The standard
deviation of the expected return is 10% for Stock X and 14% for Stock Z. Assume that
the correlation between these two stocks is +0.3.

A. IfyouMUSTholdoneofthesetwostocksinisolation,whichonewouldyou
select,andwhy?

Sincethereturnsforbothstocksaresame,IwillchooseStockX,whichhaslesserStandard
deviationonexpectedreturns(10%)

B. Whatistheexpectedreturnandthestandarddeviationofaportfoliothatincludes
50%StockXand50%StockZ?

ExpectedReturn=0.5*(12%)+0.5*(12%)=12%
StdDev=[(0.5*10%2)+(0.5*14%2)+(2*0.5*0.5*0.3*10%2*14%2)]1/2=12.17%

C. IfyoumustholdatwostockportfolioconsistingonlyofStockXandStockZ,
whatistheoptimalpercentage(between0%and100%)oftheportfoliotoputin
StockX?StockZ?

Since,forStockX,theriskislesserthanwhilethereturnsareexactlysameasthatofStockZ.It
makessensetoinvestcompleteportfolioinStockX.So.X=100%,Z=0%

D. Candiversificationproducebenefitsifthecorrelationbetweentwostocksis
greaterthanzero?Explainwhytheanswerisyes,usingyouranswerstopartsB
andC.
Diversificationwillmakesense(whenthecorrelationbetween2stocksispositive),onlyifthe2
stocksofferdifferentexpectedreturns.Then,thediversificationwillleadtoaportfolioofthese
twostockswithhigherreturnsandlowerstandarddeviationincomparisontosinglestocks.
However,inourcase,thestocksoffersamereturnbutonehashigherstandarddeviationthanthe
other.Insuchcase,diversifyingintheotherstockmakesnosense.

E. Whyisitlikely(inreality)thatthecorrelationbetweenthereturnsofferedby
moststockswillbepositive?
Moststocksarecorrelatedpositivelywiththestockindexreturns.Sotheymove
intandemwiththemarketnewsandidiosyncraticrisksarepricedinbybeta
ofthestocks.Soingeneral,stocksshowpositivecorrelationwitheachother
aswell.
 2. (4.5 Points) Briefly (four sentences or less) explain why each of the following italicized
statements is true, false, or uncertain.

A. Stock X and Stock Z both sell for $25, and neither company pays a dividend.
Stock X has a Beta of 0.75 while Stock Z has a Beta of 1.25. If the market
increases by 10% over the next year, it is likely (but not certain) that the price of
Stock Z will be greater than the price of Stock X in one year.

TRUE
Since the beta of Z is 1.25, it will move 1.25 times the market movement, while X will move 0.75
times. If market goes up, Z will go up by 1.25 times more.

B. If the market is semi-strong form efficient, it is very difficult for market participants
to identify firms that will have superior operating performance (e.g., sales growth
and profit margins) in the future.

FALSE
Operating performance can be adjudged by the fundamental factors in the firm and its business
which is publicly available as it is semi-strong efficient market. Only information that is not
openly available to public can lead abnormal returns.

C. Assume that Stock X and Stock Z both sell for $25, and neither company pays a
dividend. Stock X has a Beta of 0.75 while Stock Z has a Beta of 1.25. There
exists a call option with an exercise price of $25 on each individual stock; these
options expire in six months

Incomplete Q

3. (3 Points) Assume that a stock is priced at $50 and pays an annual dividend of $2 per
share.

A. Assume that an investor purchases the stock paying 100% cash. After one year, the
investor sells the stock for $65.25 per share (after collecting the dividend). The
percentage return on this investment was _____.

Annual Return = (65.25+2-50) / 50 = 34.5%

B. Assume that an investor purchases the stock on margin, paying $25 per share and
borrowing the remainder from the brokerage firm (ignore interest on the margin
 loan). After one year, the investor sells the stock for $65.25 per share (after
collecting the dividend). The percentage return on this investment was ____.

Annual Return = (65.25 + 2 25 (amount to be paid back to broker) ) = 42.25

Percentage return = 42.25 / 25 = 169%

C. Should you advise your clients to purchase stocks on margin, or pay cash?

Advice to client will depend upon the Risk Averseness of the client. Paying all cash will be less
risky and subsequently generate lesser returns.
However, buying on margin, will leverage the portfolio of the investor and generate higher
returns. But in the event of stock prices going down, there is a risk of larger disproportionate
losses due to the leverage.

4. (3 Points) An investor holds a portfolio of low-grade, long-term corporate bonds. The

investor fears that interest rates might increase in the future, and wishes to hedge against
this risk (rather than selling the bonds now).

A. Can this risk be hedged using standardized futures contacts? If so, how?

The investor can buy Put Option on the corporate bond, which will hedge her portfolio against the
price drop of the underlying.

B. Will your hedging strategy in Part A eliminate all risk? Why or why not?

It will not totally eliminate the risk, as movements in the stock might not completely be inversely
correlated, as buying put will come at a cost.

5. (2 Points) You have taken a stock option position that gives you a high probability of
earning a fixed profit, and a small probability of losing an unlimited amount of money.
What position have you taken? Explain briefly.

In the given scenario, I am Long Put on the underlying stock. As, for a put buyer, gains are
limited to (strike price put premium) while losses are unlimited.

6. (2 Points) The stock price of XYZ Co. is currently $40. There exists both a put and a
call option on this stock, and both options expire 6 months from now. If the exercise
price for each option is $40, and if the market is efficient, will the options have the same
premium? Why or why not?
If the markets are efficient, every investor in the market place knows which way the stock is
going to move in the future as all the information is available to everyone. Thus, no one would
bet against the market as all the information that could affect the stock is known to everyone. So
the call premiums on stocks which are supposed to go up (due to internal and external factors)
will be higher than the put premiums and vice versa.

7. (2 Points) An investor named Lohan sold one T-Bond futures contract when the quoted
price was 93-25. When the position was closed out, the price of the T-Bond futures
contract was 94-12.

A. Did interest rates increase or decrease? How do you know?

Quoted price = 93 + 25/32 = 93.78125

Closing Price = 94.375

Since the T bonds are on discount basis, the interest rates decreased (as the price increased)

B. What was Lohans profit or loss from this contract (ignoring transaction costs)?
Profit = 94.375 93.78125 = 0.59375 per futures contract

8. (4 Points) A put option has an exercise price of $40 and the call premium is $5. The
current market price of the underlying stock is $38.

A. Is the option in the money or out of the money?

Assuming call premium means option premium

The option is out of the money (40-38-5 = -3)

B. What is the intrinsic value of the option? The time value?

Intrinsic Value = 40-38 = 2

Time Value = 5-2 = 3

C. What is the break-even stock price on the options expiration date?

Breakeven stock price = 40-5 = 35

D. If you purchase this option, what is your maximum possible gain?

Maximum gain = 40-5 = 35 (when the underlying stock price become zero)