Intermediate Asset Pricing (EBB084A05)

Training exercises (prepare before the tutorials)

Cycle 1

1.1)
HMK Enterprises would like to raise $10 million to invest in capital
expenditures. The company plans to issue five-year bonds with a face value of
$1000 and a coupon rate of 6.5% (annual payments). The following table
summarizes the yield to maturity for five-year (annual-pay) coupon corporate
bonds of various ratings:

a. Assuming the bonds will be rated AA, what will the price of the bonds be?
b. How much total principal amount of these bonds must HMK issue to raise
$10 million today, assuming the bonds are AA rated? (Because HMK
cannot issue a fraction of a bond, assume that all fractions are rounded to
the nearest whole number.)
c. What must the rating of the bonds be for them to sell at par?
d. Suppose that when the bonds are issued, the price of each bond is
$959.54. What is the likely rating of the bonds? Are they junk bonds?

1.2)
Assume there are four default-free bonds with the following prices and future
cash flows:

Do these bonds present an arbitrage opportunity? If so, how would you take
advantage of this opportunity? If not, why not?

Cycle 2

2.1)
Suppose Intels stock has an expected return of 26% and a volatility (i.e.
standard deviation of returns) of 50%, while Coca-Colas has an expected
return of 6% and volatility of 25%. If these two stocks were perfectly
negatively correlated (i.e., their correlation coefficient is 1),
a. Calculate the portfolio weights that remove all risk.
b. If there are no arbitrage opportunities, what is the risk-free rate of interest
in this economy?

2.2)
Stock A has a volatility of 65% and a correlation of 10% with your current
portfolio. Stock B has a volatility of 30% and a correlation of 25% with your
current portfolio. You currently hold both stocks. Which will increase the
volatility of your portfolio: (i) selling a small amount of stock B and investing

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 the proceeds in stock A, or (ii) selling a small amount of stock A and investing
the proceeds in stock B? Explain your answer.

Cycle 3

3.1)
Suppose the risk-free return is 4% and the market portfolio has an expected
return of 10% and a volatility of 16%. Merck & Co. (Ticker: MRK) stock has a
20% volatility and a correlation with the market of 0.06.
a. What is Mercks beta with respect to the market?
b. Under the CAPM assumptions, what is its expected return?

3.2)
Your investment portfolio consists of $15,000 invested in only one stock
Microsoft. Suppose the risk-free rate is 5%, Microsoft stock has an expected
return of 12% and a volatility of 40%, and the market portfolio has an
expected return of 10% and a volatility of 18%. Under the CAPM assumptions,
a. What alternative investment has the lowest possible volatility while having
the same expected return as Microsoft? What is the volatility of this
investment?
b. What investment has the highest possible expected return while having the
same volatility as Microsoft? What is the expected return of this
investment?

Cycle 4

4.1)
The following 2-factor model describes the annual returns on stocks C, D and
E.

= 0.05 + 21 + 22 +

= 0.06 + 11 + 22 +

= 0.05 + 31 + 2.52 +

Both factors and all have expected values of 0, and are assumed to be
uncorrelated to each other. The variances of factor 1 and 2 are 0.0003 and
0.0004, respectively.
a. Assuming that the variance of stock C is 0.0045, calculate the systematic
and the unsystematic risk of this stock (in terms of variances).
b. Calculate the portfolio weights of C, D and the risk-free asset in the
tracking portfolio of stock E.
c. Calculate the risk-free rate, using the outcome of question 4.1b, and
assuming that there are no arbitrage opportunities.
d. Suppose the risk-free rate is 0.02 rather than the answer to question 4.1c,
how would you exploit the resulting arbitrage opportunity?

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Cycle 5

5.1)
Below is an option quote on IBM from the CBOE Web site showing options
expiring in September and October 2012.
a. Which option contract had the most trades today?
b. Which option contract is being held the most overall?
c. Suppose you purchase one option with symbol IBM1222I210-E. How much
will you need to pay your broker for the option (ignoring commissions)?
d. Explain why the last sale price is not always between the bid and ask
prices.
e. Suppose you sell one option with symbol IBM1222I210-E. How much will
you receive for the option (ignoring commissions)?
f. The calls with which strike prices are currently in-the-money? Which puts
are in-the-money?
g. What is the difference between the option with symbol IBM1222I200-E and
the option with symbol IBM1220J200-E?
h. On what date does the option with symbol IBM1222U200-E expire?

5.2)
a) The current price of Natasha Corporation stock is $6. In each of the next two
years, this stock price can either go up by $2.50 or go down by $2. The
stock pays no dividends. The one-year risk-free interest rate is 3% and will
remain constant. Using the Binomial Model and tracking portfolios, calculate
the price of a two-year call option on Natasha stock with a strike price of $7.
Calculate the risk-neutral probabilities and check the resulting call price with
applying risk-neutral valuation.

b) Using the information in 5.2a, use risk-neutral valuation to calculate the

price of a two-year European put option on Natasha stock with a strike price
of $7. Check your answer with the put-call parity.

c) Using the information in 5.2a, use-risk neutral valuation to calculate the

price of a two-year American put option on Natasha stock with a strike price
of $7.
Why should this price be equal to or higher than the price you have
calculated in 5.2b?

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Cycle 6

6.1)
A five-year bond with a yield to maturity of 11% (continuously compounded)
pays an 8% coupon at the end of each year.
a) What is the bonds price?
b) What is the bonds duration?
c) Use the duration to calculate the effect on the bonds price of a 0.2%
decrease in its yield.
d) Recalculate the bonds price on the basis of a 10.8% per annum yield and
verify that the result is in agreement with your answer to 6.1c.
e) Calculate the PV01 of the bond and link the result with your answers on
6.1c and 6.1d.