BEAM031
UNIVERSITY OF EXETER
BUSINESS SCHOOL
JANUARY 2010
FINANCIAL INSTRUMENTS
Module Convenor: Dr Ian Tonks
Duration: 1.5 HOURS
Answer THREE out of FIVE questions
Use a separate answer booklet for each section
Approved calculators are permitted.
This is a closed note paper.
QUESTION 1
You are a fund manager managing a £10million portfolio for a UK Trust Fund, and your client has revealed that their investment objective is capital appreciation with minimal risk. You have been instructed by your client to construct an investment portfolio of bonds and equities with no more than five equity securities from the FTSE 100 index.
a) Explain how the price-earnings (P/E) ratio can give an insight into the absolute valuation of equities. What are the advantages and disadvantages of using the P/E ratio to value stocks on a relative basis?
[30 marks]
b) What are the reasons for adopting a top-down approach to the asset allocation decision.
[30 marks]
c) In the context of the current macroeconomic environment, explain the types of sectors and securities you would include in this portfolio, and give reasons for your asset allocation choices.
[40 marks]
(Total 100 marks)
QUESTION 2
a) Azgaz plc has issued a 4% two year bond with a face value of €10,000 and the coupon is payable semi-annually. Currently the term structure is flat and the annual yield to maturity on this bond is 7 per cent
(i) Calculate the price and the duration of this bond.
[20 marks]
(ii) Suppose the annual yield rises to 8%. Show that modified duration can be used to approximate the price change resulting from this change in interest rates.
[20 marks]
(iii) Explain how the assumption of a flat term structure affects duration
[10 marks]
b) The table shows the prices and characteristics of four government bonds
Bond type Price Face Time to
Value maturity
(years) 1-year 3% Bond 100 100 1 2-year 12% Bond 111.33 100 2 2-year 2% Bond 92.72 100 2 3-year zero-coupon 79.38 100 3 Bond
Assume coupons on these bonds are paid annually
(i) From the information in the table, estimate the term structure and the yield curve
[30 marks]
(ii) Plot the shapes of the yield curve and the term structure, and explain how you might use these curves to price a new two-year bond
[10 marks]
(iii) If the expectations theory of the term structure holds, what can you say about the current market expectation of one-year spot rates at the end of the second year?
[10 marks]
(Total 100 marks)
QUESTION 3
Rutania is a small country with a well functioning stock market and is classified as being an emerging market. Over the last few years its economy based on provision of international financial services has witnessed remarkable growth with GDP increasing at 8% per annum. The main stock market index is the RUT20 (being a price-weighted index of the 20 largest listed companies). The following data is available on the index over the last few years 31st 31st 31st 31st 31st Dec Dec Dec Dec Dec 2005 2006 2007 2008 2009 Short term Rutanian government bonds Long term Rutanian government bonds Index Value of RUT20 Earnings on RUT20 companies Return on Equity n/a n/a 112 n/a n/a 2.0% 5.0% 120 3.0% 7.2 13.0% 2.5% 5.0% 130 2.8% 6.5 12.0% 3.0% 5.5% 155 3.0% 8.7 16.0% 3.5% 6.0% 162 2.5% 7.3 14.0% Dividend yield on RUT20 n/a n/a denotes data not available
a) Distinguish between the historic arithmetic and geometric return to equities in Rutania, and explain when the use of each would be appropriate
[20 marks]
b) What has been the historical risk premium on the RUT20? Explain any alternative approaches to assessing the risk premium, and hence compute the required rate of return on the RUT20
[20 marks]
c) Compute two measures of the growth rate of dividends on the RUT10 index
[10 marks]
d) Using the aggregate dividend discount model for the Rutanian
economy, assess whether at 31st December 2009 the RUT20 is over or undervalued
[20 marks]
e) What are the advantages and disadvantages of including an emerging market such as Rutania in a global equity portfolio?
[30 marks]
(Total 100 marks)
QUESTION 4
What is securitization? Examine the role that “securitization” played in the causing the `2008 Credit Crunch’, and examine the effectiveness of the regulatory environment in the Crisis.
(100 marks)
QUESTION 5
a) A “bull call spread” is a portfolio of two options on the same stock, consisting of a long position in a call and short position in another call with a different exercise price, both with the same time to maturity. Draw the net pay-off profile to a “bull call spread” at maturity as a function of the stock price.
[10 marks]
b) When and why would an investor be likely to employ a “bull call spread” strategy?
[20 marks]
c) XYZ plc has both call and put options written on its underlying share price. Currently XYZ’s share price stands at £2.70. A three-month call option with an exercise price of £2.90 has a price of 33 pence. If the risk-free rate of interest is 4 per cent per annum, calculate the price of a three-month put option on this stock with the same exercise price
[20 marks]
d) According to the Black-Scholes formula the value of a call option
depends on five underlying parameters. Identify these parameters and explain how they affect the value of a call option
[50 marks]
(Total 100 marks)
End of exam
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