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IM Sample- Final-EXAM-2020

Investment Management (Trường Đại học Kinh tế Thành phố Hồ Chí Minh)

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SAMPLE FINAL EXAM - Autumn 2020 - ANSWERS

School of Business

Complete your details in this section when instructed by the Exam Supervisor at the start of the exam.
You should also complete your details on any answer booklets provided.

STUDENT SURNAME:

STUDENT FIRST NAME:

STUDENT ID:

EXAM INSTRUCTIONS
Read all the information below and follow any instructions carefully before proceeding.
This exam is printed on both sides of the paper – ensure you answer all the questions.
You may begin writing when instructed by the Exam Supervisor at the start of the exam.
Clearly indicate which question you are answering on any Examination Answer Booklets used.

UNIT NAME: Investment Management

UNIT NUMBER: 200819

NUMBER OF QUESTIONS: 8

VALUE OF QUESTIONS: This is a sample exam

ANSWERING QUESTIONS: This is a sample exam

LECTURER/UNIT COORDINATOR: Lecturer: Mark Thomas

Unit Coordinator: Dr. Gulay Avsar

TIME ALLOWED: 2 hours TOTAL PAGES: 12 <including

coversheet>

RESOURCES ALLOWED
Only the resources listed below are allowed in this exam.
Any calculator which has the primary function of a calculator is allowed. For example, calculators on mobile
phones or similar electronic devices are not allowed.
All notes are allowed

DO NOT TAKE THIS PAPER FROM THE EXAM ROOM

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Answer all questions in the separate answer book

provided.

Question 1 (total of 10 Marks)

The risk free rate is 0.75% and an asset has a sensitivity to the risk factors outlined in the table
below. Using the information provided, answer the following questions.

Factor Market return Size Value

Sensitivity 𝛽 = 0.85 s = -0.65 h = -0.22
Risk premium 9% 2.75% 5.50%

Required

a. An investor isn’t sure which model is appropriate to value stocks and uses both CAPM and
Fama-French to confirm the CAPM

(i) What is the problem with this approach? (1 mark)

(ii) What is the expected return of the stock using CAPM? (1 mark)

(iii) What is the expected return of the stock using Fama-French? (1 mark)

(iv) By how much does the asset’s expected return differ between the two models and
does CAPM overvalue or undervalue the stock? (2 marks)

b. Suppose the above asset is observed in the market trading at a price such that its
expected return was 7.5%. What strategy would you suggest to profit from this situation,
assuming:

(i) The CAPM was the correct pricing model, and explain your reasoning (1 mark)

(ii) The Fama-French three-factor model was the correct pricing model, and explain
your reasoning (1 mark)

c. Discuss the concept of the “efficient frontier” and what it means for investors.
(Max 400 words) (3 marks)

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Question 2 (total of 10 Marks)

The Efficient Markets Hypothesis (EMH) described by Fama (1984) is comprised of three
components; weak form, semi-strong form and strong form efficiency.

Required

a What are the four conditions required for a market to be efficient? (4 marks)

b What is the “joint test problem”? (4 marks)

c What is the “marginal” investor; and why do “informed traders” outperform “uninformed
traders”? (2 marks)

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Question 3 (total of 21 Marks)

Today’s date is 17 March 2021. Consider the following debt securities.

Official Cash Rate: is 0.75%

Bank Bill 1: A bank bill with a face value of $1.25 million, which has 3 days to maturity and is
trading at a yield of 0.72%

Bank Bill 2: A bank bill with a face value of $2.97 million which has 127 days to maturity and
is trading at a yield of 0.87%

Bond 1: A bond with a face value of $0.82million with maturity of 24 March 2027, paying
coupons semi-annually at a rate of 2.15% and trading at a yield of 1.62% p.a.

Bond 2: A bond with a face value of $98.5 million, which matures on 17 October 2027, paying
coupons semi-annually at a rate of 2.35% trading at a yield to maturity of 1.66% p.a.

Required

a Describe the shape of the yield curve. (1 mark)

b What is the fair market price for:

(i) Bank bill 1 (1 marks)

(ii) Bank bill 2 (1 marks)

(iii) Bond 1 (4 marks)

(iv) Bond 2 (4 marks)

c Two hours after you purchase these four securities, stronger than expected employment
data is released to the market and the market reacts by selling off (ie prices fall and yields
rise) in a parallel movement in yields by 0.15% across the entire yield curve and you
liquidate your holdings. How much profit or loss did you generate on each debt security?

(i) Bank bill 1 (1 marks)

(ii) Bank bill 2 (1 marks)

(iii) Bond 1 (4 marks)

(iv) Bond 2 (4 marks)

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Question 4 (total of 17 Marks)

Consider that you have $250,000 to invest equally across four assets and that your analysis of
these four assets provides the information in the two tables below. To 2 decimal places
answer the following questions

Asset A B C D
Price at beginning of the year (in $) 5.72 2.78 11.89 122.38
Expected price at the end of the year (in $) 6.25 2.98 12.73 125.29
Standard deviation 35% 16% 7% 2%

Correlation A B C D
A 1.0 0.7 0.6 -0.3
B 0.7 1.0 0.4 -0.3
C 0.6 0.4 1.0 -0.1
D –0.3 –0.3 –0.1 1.0

Required

a What is the expected return on this portfolio, in percentage terms? (2 marks)

b What is the value of this portfolio after 12 months in dollars and cents? (1 mark)

c What is the standard deviation of this portfolio? (14 marks)

Hint: I suggest you copy the table below into your answer booklet and use it to calculate
your answer – three numbers have been given to you. Note the number in red is a
negative number

Variance table A B C D Portfolio

A 0.00765625
B -0.000060000
C 0.00091875
D
Column totals
Portfolio Variance
Portfolio Standard
Deviation

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Question 5 (A total of 11 Marks)

An investor buys an asset at an initial cost of $1,400,000. The investor believes that at the end
of one year, the asset could have four possible values. These values are $1,225,000,
$1,300,000, $1,750,000 and $2,000,000 with respective probabilities of 15%, 30%, 40% and
15%.

Required

a. What is the expected outcome with respect to the asset’s value? (2 marks)

b. What is the expected return on the asset? (1 mark)

c. What is the expected standard deviation of the return of the asset? (2 marks)

d. What is the coefficient of variation of the asset? (1 mark)

e. What is the fair value of a stock that has just paid a dividend of $12.85, which is expected
to grow indefinitely at 1.25%pa, and that stock has a cost of capital of 8.25%?(1 mark)

f. If the expected future dividend yield of a stock is 4.35% and the stock’s cost of capital is
6.85%, what is its expected growth rate? (1 mark)

g. If a stock with an expected infinite growth rate of 1.95%pa is trading at $142.87, what must
its cost of capital be to justify the assumption of the next dividend being $9.27?
(1 mark)
h. In dollars and cents, what would you pay for a company that generated profits of $1.15 per
share on its 135million shares from which it paid a dividend of $0.84 per share and has
equity capital of $2425million if its cost of capital is 11.25%? (2 marks)

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Question 6 (total of 8 Marks)

Consider the following table which provides a comparison of the returns for a portfolio and its
benchmark. Hint: I suggest you copy and complete this table in your answer booklet to answer
this question. Note: the numbers in red are negative

Year Portfolio Benchmark Portfolio Benchmark Difference Square of the

Return Return Index Index Differences
0 1.00 1.00
1 11.25% 10.75%
2 5.50% 6.75%
3 16.50% 14.50%
4 -3.75% -5.25%
5 8.75% 9.25%
Return
Alpha
Sum
Tracking Error
Information
Ratio

Required

a. Calculate the annualised return of the portfolio and the benchmark (2 marks)

b. Calculate the portfolio alpha (1 mark)

c. Calculate the tracking error of the portfolio (2 marks)

d. Calculate the information ratio of the portfolio (1 mark)

e. If the risk free rate is 3.75%, the return of the market (ie 𝑅𝑚 ) is 9.25%, the value risk premium
is 2.45%, the small cap premium is 1.95%, the momentum premium is 42% and the portfolio’s
exposure to these three factors was -0.25, -0.55, and 0.1, respectively, as a percentage to 2
decimal places determine the amount of Carhardt’s alpha that was produced by the manager
of the portfolio (2 marks)

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Question 7 (total of 7 Marks)

Consider the following after-tax cash flows for three mutually-exclusive projects.

Year Project A Project B Project C

0 -8,000,000 -4,875,000 -14,000,000
1 2,000,000 500,000 3,250,000
2 3,500,000 1,150,000 4,000,000
3 5,750,000 2,175,000 4,240,000
4 4,140,000 4,495,000
5 4,764,000

Clearly, the three projects have different scale (i.e., initial investment), as well as differing
lives. Assume a 12% p.a. discount rate applies to all projects

Required

a. Calculate the NPV for each project. (6 marks)

b. Which project will you accept? Why? (1 mark)

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Question 8 (9 marks)
The board of a company (Firm A) has agreed to pursue a new project and the Chief Financial
Officer (CFO) is directed to organise debt funding of $25 million for the life of the project, which
is 15 years. The CFO speaks with several banks and determines that it may borrow:

• Floating at BBSW + 2.75%pa

• Fixed rate debt at 9.95%pa

A large corporate (Firm B) has launched a takeover bid for a rival firm, that has fallen on hard
times, and the CFO of the suitor company has been directed to raise funds for the takeover,
which is expected to be successful. The CFO meets with the deal team and learns that if the
takeover is successful at the current offer price that the transaction will be cash flow positive
immediately and that funding is required for 15 years. The CFO also has the view that interest
rates are going to decline over that period and therefore prefers raising floating rate debt. The
CFO speaks with their banker and learns that it may borrow:

• Floating at BBSW + 1.05%pa

• Fixed at 7.25%pa

Government debt is trading at 1.05%pa

Both CFO’s happen to approach the same investment bank, you, to explore funding their
requirements via a swap.

You are willing to enter into an intermediated swap with both parties, on the condition that you
make 0.30% from each party of the swap transaction.

Required
Determine the swap strategy that maximises the benefit of the swap for each party, including
your investment bank.

a. Specify the swap cashflows (6 marks)

b. Calculate the borrowing costs and the benefit to each party from entering into the swap.
(3 marks)

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Question 9 (7 marks)
Consider the information for BHP provided in the two tables below and answer the following
questions. (Note: numbers in red are negative)

Balance Sheet $'m 2019 2018

Cash 15,613 15,871
Receivables 3,462 3,096
Inventory 3,840 3,764
Other assets 458 12,399
Total Current Assets 23,373 35,130

Inventory 768 1,141

Financial Assets & Inevestments 1,616 1,179
Plant 68,041 67,182
Intangibles 675 778
Other assets 6,388 6,583
Total Non-Current Assets 77,488 76,863

Total Assets 100,861 111,993

Trade payables 6,717 5,977

Borrowings 1,661 2,736
Other liabilities 3,961 5,276
Total Current Liabilities 12,339 13,989

Debt 23,167 24,069

Other liabilities 13,531 13,265
Total non-current liabilities 36,698 37,334

Total Liabilities 49,037 51,323

Net Assets 51,824 60,670

Issued Capital 2,136 2,238

Reserves 6,869 7,368
Retained earnings 42,819 51,064
Total Equity 51,824 60,670

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P&L $'m 2019 2018

Revenue 44,288 43,129
Other income 393 394
Expenses -28,022 -27,527
EBITDA 16,659 15,996
Depreciation & Amortisation -546 0
EBIT 16,113 15,996
Interest -1,064 -1,245
NPBT 15,049 14,751
Tax -5,864 -9,928
Net Profit After Tax 9,185 4,823

Required
a. To 2 decimal places calculate the current ratio for BHP in 2019 (1 mark)

b. In percentage terms and to 2 decimal places calculate the debt to equity ratio for BHP for
2019 (1 mark)

c. Calculate the net profit margin for BHP in 2019 in percentage terms to 2 decimal places
(1 mark)

d. Calculate the return on assets for BHP over 2019 in percentage terms to 2 decimal places
(2 marks)

e. Calculate the return on equity for BHP over 2019 in percentage terms to 2 decimal places
(2 marks)

END OF EXAM PAPER

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Formula Sheet
Terminology
𝑅: 𝑅𝑒𝑡𝑢𝑟𝑛
𝑃𝑛 : 𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑛
𝑃𝑉: 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
𝐹𝑉: 𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑟 𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒
𝑑𝑎𝑦𝑠: 𝑑𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑜𝑟 𝑑𝑎𝑦𝑠 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑠 ℎ𝑒𝑙𝑑
𝑖: 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒, 𝑦𝑖𝑒𝑙𝑑, 𝑜𝑟 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒, 𝑎𝑠 𝑎𝑝𝑝𝑟𝑜𝑝𝑟𝑖𝑎𝑡𝑒
𝐶: 𝐶𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒
𝐶
𝑔: ℎ𝑎𝑙𝑓 𝑦𝑒𝑎𝑟𝑙𝑦 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 ($) 𝑝𝑒𝑟 $100 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 =
2
𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
𝑖: 𝑦𝑖𝑒𝑙𝑑 𝑝𝑒𝑟 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑒𝑥𝑝𝑟𝑒𝑠𝑠𝑒𝑑 𝑎𝑠 𝑎 𝑑𝑒𝑐𝑖𝑚𝑎𝑙: 𝑔𝑒𝑛𝑒𝑟𝑎𝑙𝑙𝑦
2
𝑛: 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤ℎ𝑜𝑙𝑒 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑡ℎ𝑎𝑡 𝑟𝑒𝑚𝑎𝑖𝑛 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
𝑓: 𝑑𝑎𝑦𝑠 𝑓𝑟𝑜𝑚 𝑣𝑎𝑙𝑢𝑎𝑡𝑖𝑜𝑛 𝑑𝑎𝑡𝑒 𝑡𝑜 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑑𝑎𝑡𝑒
𝑑: 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
𝑅𝑓 : 𝑡ℎ𝑒 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒
𝑅𝑚 : 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡
𝑅𝑝 : 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝑅𝐵 : 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘
𝑅𝑖 : 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 𝑖
𝐸(𝑅𝑝 ): 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝜔𝑖 : 𝑤𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 𝑖 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝜌𝑖,𝑚 × 𝜎𝑖 × 𝜎𝑚 𝑐𝑜𝑣𝑖,𝑚
𝛽: 𝑏𝑒𝑡𝑎, 𝛽 = 2
= 2
𝜎𝑚 𝜎𝑚
𝜌𝑎,𝑏 : 𝑐𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 "a" with asset "b"
𝜎𝑖 : 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 i
𝜎𝑗2 : 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 "𝑗"
𝑐𝑜𝑣𝑖,𝑚 : 𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 𝑖 𝑤𝑖𝑡ℎ 𝑎𝑠𝑠𝑒𝑡 𝑚
𝑠: 𝑡ℎ𝑒 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑡𝑜 𝑟𝑖𝑠𝑘 𝑓𝑎𝑐𝑡𝑜𝑟 𝑆𝑚𝐵
ℎ: 𝑡ℎ𝑒 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑡𝑜 𝑟𝑖𝑠𝑘 𝑓𝑎𝑐𝑡𝑜𝑟 𝐻𝑚𝐿
𝑆𝑚𝐵: 𝑡ℎ𝑒 𝑠𝑚𝑎𝑙𝑙 𝑐𝑎𝑝 𝑟𝑖𝑠𝑘 𝑓𝑎𝑐𝑡𝑜𝑟 (𝑝𝑟𝑒𝑚𝑖𝑢𝑚)
𝐻𝑚𝐿: 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑟𝑖𝑠𝑘 𝑓𝑎𝑐𝑡𝑜𝑟 (𝑝𝑟𝑒𝑚𝑖𝑢𝑚)
𝐷1 : 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑟 𝑛𝑒𝑥𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝐷0 : 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑘: 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑎𝑙𝑠𝑜 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑚𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒)
𝑔: 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑅𝑂𝐸: 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
𝐸𝑃𝑆: 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑜𝑛𝑑
𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑎 𝑏𝑜𝑛𝑑:
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑦𝑖𝑒𝑙𝑑
𝐸(𝑟): 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛
𝐶𝐹: 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
𝑛: 𝑦𝑒𝑎𝑟 (𝑛)𝑜𝑟 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛𝑠, 𝑑𝑒𝑝𝑒𝑛𝑑𝑖𝑛𝑔 𝑢𝑝𝑜𝑛 𝑡ℎ𝑒 𝑠𝑖𝑡𝑢𝑎𝑡𝑖𝑜𝑛

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Formulas
(𝑃2 − 𝑃1 )
Return: 𝑅 =
𝑃1
𝑃2 −𝑃1 𝑑𝑎𝑦𝑠
Simple annualised return: 𝑅 = [( ) × ] × 100%
𝑃1 365
1
𝑃 𝑛
Annualised return: 𝑅 = (𝑃2 ) −1
1
𝐹𝑉
Bank Bill Formula: 𝑃𝑉 = 𝑖 𝑑𝑎𝑦𝑠
(1+( × ))
100 365
𝑓
1−𝑣 𝑛
RBA Bond Formula (per $100 face value of the bond): 𝑃 = 𝑣 𝑑 (𝑔 (1 + ( )) + 100𝑣 𝑛 )
𝑖
1
Where:𝑣 = 1+𝑖 to 8 decimal places
Capital Asset Pricing Model: 𝑅𝑝 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 )
Fama-French three factor model: 𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽 [(𝑅𝑚 ) – 𝑅𝑓 ] + 𝑠(𝑆𝑚𝐵) + ℎ(𝐻𝑚𝐿)
Expected return of the portfolio: 𝐸(𝑅𝑝 ) = ∑ 𝜔𝑖 𝑅𝑖
Portfolio variance: 𝜎𝑝 2 = ∑ ∑ 𝜔𝑖 𝜔𝑗 𝜎𝑖 𝜎𝑗 𝜌𝑖,𝑗
Standard deviation of a portfolio: 𝜎𝑝 = √𝜎𝑝2
Expected return of a portfolio where there is a probability of different outcomes:
𝐸(𝑅𝑃 ) = ∑ 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦𝑖 × 𝑉𝑎𝑙𝑢𝑒𝑖

Standard deviation of a portfolio where there is a probability of different outcomes:

2
𝜎 = √∑ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦𝑖 × (𝑅𝑖 − 𝐸(𝑅𝑝 ))

𝜎
Coefficient of variation: 𝐶𝑂𝑉 =
𝐸(𝑅𝑝 )
1 𝐷 𝐷0 ×(1+𝑔)
Dividend Discount Model: 𝑃𝑉 = (𝑘−𝑔) = (𝑘−𝑔)
Plowback ratio: 𝑃𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 + 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 100%
Growth rate of dividends: 𝑔 = 𝑅𝑂𝐸 × 𝑝𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑟𝑎𝑡𝑖𝑜
Price earnings ratio: 𝑃⁄𝐸 =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒
𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑝𝑟𝑜𝑓𝑖𝑡𝑠
Return on equity: 𝑅𝑂𝐸 =
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑃𝑛
Continuous Compunded Return: 𝑅𝑡 = 𝑙𝑛 (𝑃 )
𝑛−1

∑(𝑅𝑃 −𝑅𝐵 )2
Portfolio Tracking Error: 𝜎(𝑇𝐸) = √
𝑛
(𝑅𝑃 −𝑅𝐵 )
Information Ratio: 𝐼𝑅 =
2
√∑(𝑅𝑃 −𝑅𝐵 )
𝑛
𝐶𝐹
Net Present Value: 𝑁𝑃𝑉 = ∑ (1+𝑖)𝑛
Carhardt’s alpha: 𝛼 = 𝑅𝑝 − {𝑅𝑓 + 𝛽 [(𝑅𝑚 )– 𝑅𝑓 ] + 𝑠(𝑆𝑚𝐵) + ℎ(𝐻𝑚𝐿) + 𝑢(𝑈𝑚𝐷)}
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑡𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 =
𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑅𝑒𝑣𝑒𝑛𝑢𝑒

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𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦

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Solutions
Question 1
a Using equation 9.8, which can be expressed as 𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽 [(𝑅𝑚) – 𝑅𝑓] + 𝑠(𝑆𝑀𝐵) + ℎ(𝐻𝑀𝐿),
the expected return under
a. Fama-French is an extension of CAPM, incorporating two additional risk factors. Further more,
under Fama-French beta becomes unity. Hence both methods will yield very different results
which are not comparable
b. Using the CAPM (see the case study on page 283), which can be expressed as 𝐸(𝑅𝑖 ) = 𝑅𝑓 +
𝛽 [(𝑅𝑚) – 𝑅𝑓], the expected return can be calculated as E(R) = 0.0776 or 7.76%. (1)
c. Under Fama-French the return can be calculated as E(R) = 0.0600 or 6.00%. (1)
d. Therefore, the CAPM overestimates the expected return under Fama-French by 1.76% (2)

b If the asset was observed in the market to be trading with a return of 7.5%, then the market is out of
equilibrium under both models. High(er) expected return means low(er) price. Low(er) expected return
means high(er) price.

(i) Under CAPM, the lower expected return than the model suggests the price of the asset is higher
than predicted by the CAPM model, thus the appropriate strategy is to SELL SHORT the asset. (1)
(ii) Under FF, the higherr expected return suggest the price of the asset is lower than predicted by
the FF model, thus the appropriate strategy is to BUY the asset. (1)

c The efficient frontier is constructed by plotting the risk (measured in terms of standard deviation) against
the return (measured in terms of %) for portfolios of various asset allocations. On the efficient frontier lies
those portfolio asset allocations with the maximum return for any level of risk. All other portfolio asset
allocations result in inefficient portfolios, ie they do not provide portfolios with the maximum level of
return for a given level of risk. The efficient portfolio is important for investors because they should seek
to contruct portfolios that lie on the efficient frontier (3)

Question 2
a Efficient Market Hypothesis:
(i) Information must be freely available
(ii) There are no transaction costs or taxes
(iii) There are no restrictions on trading
(iv) Investors interpret the information accurately
b The joint test problem:
(i) To test for market efficiency requires a benchmark to test the subject against. (1)
(ii) For the market to be inefficient, the subject of the test must outperform the benchmark reliably.
(1)
(iii) The problem though is the determination of the benchmark model as all benchmarks have their
problems (1)
(iv) Thus any test for market efficiency also is a test for the suitability of the benchmark model (1)

c The marginal investor is the person who is willing to jump across the bid/ask spread and therefore is the
person who sets the price for the asset. Informed investors transact upon fundamental analysis of securities
through which they are able to determine the quantum and direction of a stock’s mispricing to capitalise
upon this mispricing whereas uninformed investors trade on rumour, historical information, and other
spurious reasons. Hence informed investors who are trading on insight would be expected to outperform
uninformed investors; which is observed in the markets and studies. (2)

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Question 3
a The yield curve is normally sloped (1)

b Pricing

𝐹𝑉
(i) Bank bill 1: 𝑃𝑉 = 𝑖 𝑑𝑎𝑦𝑠 , thus, P=$1,249,926.03 (1)
(1+( × ))
100 365
(ii) Bank bill 2: P=2,961,036.58 (1)

(iii) Bond 1: f=7, d=181, i=0.0081, v=0.99196508, n=12, g=1.075, f/d=0.03867403, Price/$100
face=$104.061, Price=$853,300.20(2)

(iv) Bond 2: f=31, d=182, i=0.0083, v=0.99176832, n=13, g=1.175, f/d=0.17032967, price/$100 face =
$105.262, P=$103,683,070.00 (2)

c Profit: falling prices means rising yields

𝐹𝑉
(i) Bank bill 1: 𝑃𝑉 = 𝑖 𝑑𝑎𝑦𝑠
, thus, P=$1,249,910.6, thus the profit or loss is 1249910.62—
(1+( × ))
100 365
1249926.03 = -$15.41 (ie a LOSS) (2)

(ii) Bank bill 2: P=$2,959,496.62, thus the profit is 2959496.62-2961036.58=-$1,539.95 (ie LOSS) (2)

(iii) Bond 1: f=7 d=181, i=0.00885, v=0.99122764, n=12, g=1.075, f/d=0.03867403, price/$100
face=$103.194, thus P=$846,190.80; Profit = 846190.80-853300.20=-7,109.40 (LOSS)

(iv) Bond 2: f=31, d=182, i=0.00905, v=0.99103117, n=13, g=1.175, f/d=0.17032967, price/$100face =
$104.312, Price=$102,747,320.00, profit or loss = 102747320.00-103683070.00=-935,750.00 (ie
LOSS)

Question 4
a The return of the portfolio is the weighted sum of the return of the assets. From the table below the return of the
portfolio is 6.48% (3)

A B C D Total
P1 ($) 5.72 2.78 11.89 122.38
P2 ($) 6.25 2.98 12.73 125.29
R (%) 9.27% 7.19% 7.06% 2.38%
Weight (%) 25% 25% 25% 25%
E(Rp) 2.32% 1.80% 1.77% 0.59% 6.48%
PV $ 250,000
FV $ 266,200.00

b FV = PV x (1+Rp) = $266,200.00 (1)

c Standard deviation = SQRT(∑ ∑ 𝝈𝝈𝝎𝝎𝝆) (14) = (12) for table (1) for vaiance (1) for standard deviation
Variance table A B C D Portfolio
A 0.00765625 0.00245000 0.00091875 -0.00013125
B 0.00245000 0.00160000 0.00028000 -0.00006000
C 0.00091875 0.00028000 0.00030625 -0.00000875
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D -0.00013125 -0.00006000 -0.00000875 0.00002500

Column totals 0.01089375 0.00427000 0.00149625 -0.00017500
Portfolio 0.016485000
Variance
Portfolio 12.84%
Standard
Deviation

Question 5
a $1,573,750: weighted sum of the probabilities (2)
b 12.41%: (P2/P1)-1 (1)
c 20.25%: sqrt of the weighted sum of the squares of the differences of returns: 20.25% (2)
d 1.63: Coefficient of variation = stdev/E(r) (1)
The next questions are based upon Gordon Dividend Growth Model
𝐷1 𝐷0 × (1 + 𝑔)
𝑃𝑉 = =
(𝑘 − 𝑔 ) (𝑘 − 𝑔 )
e D0=$12.85, g=1.25%, k=8.25%, P=$185.87 (1)
f D1/P=4.35%, k=6.85%, g=2.50% (1)
g D1=$9.27, g=1.95%, P=$142.87, k=8.44% (1)
h Payout=73.04%, ploughback=26.96%, ROE=6.40%, g=1.73%, P=$8.97

Question 6

Year Portfolio Benchmark Portfolio Benchmark Difference Square of the

Return Return Index Index Differences
0 1.00 1.00
1 11.25% 10.75% 1.1125 1.1075 0.50% 0.000025
2 5.50% 6.75% 1.1737 1.1823 -1.25% 0.00015625
3 16.50% 14.50% 1.3673 1.3537 2.00% 0.0004
4 -3.75% -5.25% 1.3161 1.2826 1.50% 0.000225
5 8.75% 9.25% 1.4312 1.4013 -0.50% 0.000025
Return 7.43% 6.98%
Alpha 0.45%
Sum 0.00083125
Tracking Error 1.29%
Information Ratio 0.35

a Return portfolio= 7.43% (1), Return benchmark = 6.98% (1)

b Portfolio alpha = portfolio-benchmark=7.43-6.98=0.45%pa (1)
c Portfolio tracking error = 1.29%pa (2)
d Information ratio = alpha/TE=0.45/1.29=0.35 (1)
e Carhardt alpha = -4.33% (2)

Question 7
A:NPV=2000000/1.12+3500000/1.12^2+5750000/1.12^3-8,000,000=668,629.28 (2)
B:NPV=500000/1.12+~~~+4140000/1.12^4-4875000=667,368.41 (2)
C:NPV=3250000/1.12+~~~+4764000/1.12^5-14000000=668,384.78 (2)
Project A is preferred as it has the highest NPV (1)
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Year A B C A flows B flows C flows

discounted discounted discounted
0 -8,000,000 -4,875,000 -14,000,000 -8,000,000.00 -4,875,000.00 -14,000,000.00
1 2,000,000 500,000 3,250,000 1,785,714.29 446,428.57 2,901,785.71
2 3,500,000 1,150,000 4,000,000 2,790,178.57 916,772.96 3,188,775.51
3 5,750,000 2,175,000 4,240,000 4,092,736.42 1,548,122.04 3,017,948.25
4 4,140,000 4,495,000 2,631,044.84 2,856,653.76
5 4,764,000 2,703,221.54

Question 8
To maximise the benefit to both parties, each swap must occur at the midpoint of the differences.
• Midpoint of fixed rates is 8.60
• Midpoint of floating rates is BBSW+1.90
The recommendation is for Firm A to:

• Borrow in the floating market at BBSW + 2.75%pa

• Enter into a swap transaction with the investment bank where Firm A will:
– Pay fixed at a rate of 8.75%pa
– Receive floating at BBSW + 1.75%pa
The recommendation is for Firm B to:
• Borrow in the fixed market at 7.25%pa
• Enter into a swap transaction with the investment bank where Firm B will:
– Pay floating at BBSW + 2.05%pa
– Receive fixed at 8.45%pa
The investment bank, therefore, will:
• From Firm A:
– Receive fixed at 8.75%pa
– Pay floating at BBSW + 1.75%
• From Firm B:
– Receive floating at BBSW + 2.05%
– Pay fixed at 8.45%pa
Thus,
• Firm A will: (2)
– Borrow floating at BBSW + 2.75%pa
– Receive floating at BBSW + 1.75%pa
– Pay fixed at 8.75%pa
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– For a net payment of fixed at 9.75%pa, which is a benefit of 0.20%

• Firm B will: (2)
– Borrow fixed at 7.25%pa
– Receive fixed at 8.45%pa
– Pay floating BBSW + 2.05%pa
– For a net payment of floating at BBSW + 0.85%pa, which is a 0.20%pa improvement on what it would
borrow floating if it went into the market
• The investment bank will: (1)
– Profit by 0.30%pa on the fixed leg
– Profit by 0.30%pa on the floating leg
– Enjoy a total profit of 0.60%pa

Question 9
a. Current ratio = 23,373/12,339 = 1.89 (1)
b. Debt/Equity=49,037/51,824 = 94.62% (1)
c. Net Profit Margin= 9,185/44,288=20.74% (1)
d. Return on Assets = 9,185/{(100,861+111,993)/2}=8.63% (2)
e. Return on Equity=9,185/{(51,824+60,670)/2}=16.33% (2)

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