PRELIMINARY EXAM 2010 PROGRAMME(S) : University of London Degree and Diploma Programmes

(Lead College: London School of Economics & Political Science)

SUBJECT DATE DURATION

: : :

23 INVESTMENT MANAGEMENT Monday, 8 March 2010 3 Hours

------------------------------------------------------------------------------------------------------INSTRUCTIONS :

DO NOT TURN OVER THIS QUESTION PAPER UNTIL YOU ARE TOLD TO DO SO.

There are a total of EIGHT (8) questions. Answer only FOUR (4) questions. Each question carries 25 marks.
A handheld calculator may be used when answering questions on this paper but it must not be pre-programmed or able to display graphics, text or algebraic equations. The make and type of machine must be stated clearly on the front cover of the answer book.

Candidates are strongly advised to divide their time accordingly.

Total number of pages: (including this page) 5

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(a) Explain what is meant by a credit default swap and a collateralised debt obligation. What is the financial innovation contained in each? (5 marks) (b) You make a short sales transaction using a margin account with your broker. The stock is currently trading at 5. Assume that at the end of one year it trades at 8, and at the end of two years it trades at 4. The first year dividend is 0.40 per share and the second year dividend is 0.30 per share. The initial margin requirement is 60% and the maintenance margin is 50%. There is no interest on the margin account. You short 500 units of the stock now and buy back the shares after 2 years. What is the return on your investment? (10 marks) 2 (c) Demonstrate that, for standalone portfolios, the M measure and the Sharpe measure provide equivalent rankings. Demonstrate s must be positive for portfolios that have Treynor ratios which exceed the market. Show, using a diagram, that a higher Treynor ratio for portfolio A than for portfolio B does not imply that A > B. (10 marks) (a) With respect to the efficient market hypothesis, explain in what sense weak-form efficiency is weak and strong-form efficiency is strong. (5 marks) (b) The instantaneous return on a portfolio is normally distributed with a mean of (=10%) and a standard deviation, (= 30%). Show how (actual answers are not possible with a standard calculator) you would compute the probability of the fund value falling by 25% over the space of one year. If the target VaR is below this, consider the relative merits of using puts and a cash injection to reduce the VaR. (10 marks) (c) You are given data of three bonds in the table below. Bond A B C Yr1 cash flow 105 6 4 Yr2 cash flow 106 4 Yr3 cash flow 104

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The prices of the three bonds are 95.24, 107.42 and 121.51 respectively. Without calculating spot rates, what is the price of a 3 year zero coupon bond paying 100 in 3 years? Calculate the year 1, 2, and 3 spot rates and check your answer. (10 marks)

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(a) What defines a fund as being exchange traded? How would it differ from an open-end fund? (5 marks) 2 (b) An investor has a utility function E (U ) = where is the expected return 2 2 and is the variance of the investors portfolio, and is the investors risk aversion coefficient. Assume small company stocks on average have a return of 17.74% with standard deviation 39.3% and Treasury bills a return of 3.82% with standard deviation 3.18%. Calculate the degree of risk aversion for the investor. Determine the rankings he would give the portfolios A, B, C and D, in the diagram below, in terms of the utility they provide.

Assume the expected return on the market is 12%, the standard deviation of the market is 25% and the risk free rate is 5%. Faced with the choice, what proportion of his funds would he allocate to the risk free asset and what to the market portfolio, if these were the only choices available? (10 marks) (c) The single index model for stocks A and B is estimated from excess returns with the following results: The standard deviation of market return is 20%. Calculate the standard deviation and idiosyncratic risk of each stock. Calculate the expected return and standard deviation of a portfolio of these two stocks which is designed to have no net exposure to the market. (10 marks) (a) A bull call spread is a speculative position involving the purchase of a call with one exercise price and the sale of a call with a higher exercise price. A bull put spread is a speculative position involving the purchase of a put with one exercise price and the sale of a put with a higher exercise price. Using put-call parity, demonstrate the relationship between these two positions. Assume the lower and higher exercise prices are the same for both positions. (5 marks) (b) A six year 3% coupon bond, with nominal value 100 stands on a yield of 5%. Work out the duration and the convexity of this bond. Using these, work out the price oe which the bond will rise if the yield fell by 1%.

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(10 marks) (c) The spreads between two bond yields are identically and independently distributed random variables in successive trading sessions. Demonstrate that, if the spread is above average today it will narrow tomorrow with a probability of 75%. (10 marks) (a) Explain what you understand by a hedge fund. (5 marks) (b) The risk free rate is 3% and the expected return on the market portfolio is 15% with standard deviation 30%. Suppose you have identified an active portfolio with a beta of 1, an expected return of 17% and a standard deviation of specific risk of 40%. What weight does the Treynor-Black model suggest should be attached to this portfolio? Draw a diagram to represent the process of finding the optimal portfolio. Provide accurate labels to represent the expected returns and standard deviations, wherever possible. (10 marks) (c) As a pension fund manager you must make payments of 1,000,000 for each of the next 25 years. The yield curve is currently level at 5%. The pension liabilities have a duration of 14.8 years. You have an asset portfolio of 15 million, equally divided between 3-year zero coupon bonds and 6% perpetuities. Outline the details of an immunization strategy to protect the equity against yield movements. Hint: Infinite sum and the infinite sum for 0 < x < 1. (10 marks) (a) Without using an explicit mathematical model, examine the differences between the Kyle and the Glosten-Milgrom models. (5 marks) (b) You are given the following data on option prices. They are all 9-month options on the same underlying asset which currently trades at 150. The risk free rate is 2.75% (for the 9-month period). Exercise price 140 150 160 Call 22 16 13 Put 9 12 17

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Explain whether you can spot arbitrage opportunities in these prices, and outline the details of potential arbitrage transactions. (10 marks) 1 (c) You have a CARA utility function given by u ( x) = 1 e r ,

where r is the return on an investment, e is the exponential function and is a constant? A gamble becomes available in which there is a 50% chance of receiving 200, and a 50% chance of receiving 50.

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Assuming you have 100 invested and your risk aversion coefficient is 2, derive an expression showing how much you would be prepared to pay to remove the risk. Explain your steps as you proceed. (10 marks) (a) For bonds of the same credit quality and currency, is the yield to maturity always the same? Explain why, or if not, explain why not? (5 marks) (b) Noise traders constitute 1 in 5 traders in the market. For them the asset is worth 130 with probability 50% and 70 with probability 50%. Noise traders buy with probability 40% and sell with probability 60%. Informed traders have perfect knowledge of the asset payoff, and trade accordingly. Work out the bid and ask prices in the first round of trading, using the GlostenMilgrom model. (10 marks) (c) Two well diversified portfolios and one containing idiosyncratic risk are represented by

where f1 and f2 are common 'factor risks' and e represents idiosyncratic risk. Using portfolios i and j, create two pure factor portfolios , where a1 and a2 are constants. and

Determine the as for the two pure factor portfolios. You may assume the risk free interest rate is 5%. Take a position in the pure factor portfolios and in portfolio k so as to immunise it from all factor risk. What return do you expect on your immunised investment? (10 marks) th (a) 6% Treasury 2020 stands on a yield of 4%. It pays interest on Mar 10 and September 10th. Work out the accrued interest on 500,000 nominal of the bond with a settlement date of Tuesday August 3rd, 2010 Work out the simplest expression for the clean price of the bond on September 10th 2010, presuming the yield remains at 4%? (5 marks) (b) Define value at risk. On the basis of a fair coin and fair odds, you accept a bet of 1,000 that the coin will not turn up tails seven times in a row. What is your VaR with 99% confidence? Explain the reason why VaR may be a poor guide in this case for capital to hold in the event of a loss. (10 marks) (c) What theoretical base does behavioural finance provide to support a momentum trading strategy? The return in the previous quarter period was 10%, 7%, 3% and 2%, respectively, for four given stocks. Show how you would implement a momentum strategy. (10 marks)

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