Capital Markets Practice Final 1

1 You must submit your exam answers electronically in an Excel file via the Final Exam link under“Assignments”on Canvas.

•    You may only submit one Excel file and nothing else.

•    You are responsible for ensuring you submit the correct file.

•    Please include your name in your Excel file’s name.

1 I MUST SEE YOUR CALCULATIONS FOR YOU TO RECEIVE CREDIT. This means I must see your calculations, not just a number. This includes your programming of Excel’s Solver  function.

1 The exam is open book and notes, as well as your laptop.

1 No questions will be answered during the exam. If you have a problem or an issue during the exam, state so in your answer, make an assumption if necessary and state it in your  answer, and continue with the exam.

1 This is very important. You are to abide by Kellogg’s honor code.

•    I trust that no one will receive assistance from any person. This exam must be completed 100% independently of all people, either directly or indirectly. To do so is a violation of the honor code.

•    Furthermore, you may not assist any other student on this exam. As such, please do not discuss the exam with anyone who has yet to complete it. To do so is a     violation of the honor code.

•    You may not access any email, phone calls, text messages, and such during the exam time. To do so is a violation of the honor code.

•    Do not discuss this exam with anyone until after it is graded. To do so is a violation of the honor code.

Question 1 [70 points]

You are given the following information on a portfolio, Brazil

The first factor is the Fama and French SMB portfolio, the second factor is the Fama and   French HML portfolio and the third factor is the momentum factor, MOM. You are given the following data on the risk-free security and these factor portfolios:

a)  Is Brazil correctly priced? If it is not correctly priced, what should Brazil’s expected return be equal to?

b)  If Brazil is incorrectly priced, is its price too high or too low?

Question 2 [50 points]

You are currently in a personal income tax bracket of 15% and you expect to be in a personal income tax bracket of 22% when you retire in 35 years.

You plan to save in an IRA $150,000of pre-tax income in one lump sum this year and you want to determine if you should put it into a traditional IRA or a ROTH IRA.

The expected return on both IRAs is 8%.

You will withdraw your savings in one lump sum when you retire in 35 years. Which IRA should you select? Prove it.

Question 3 [120 points]

To get credit for this question, I must see all of your calculations.

You have the following information on securities for a hypothetical public company, Bee Corp., and a US government risk-free zero-coupon bond:

•   A put written on Bee's stock, with a strike price of $1,000 and an expiration date exactly 12 months from now, costs $734 today.

•   A call option written on Bee’s stock, also with a strike price of $1,000 and an expiration date exactly 12 months from now, costs $856 today.

•    Bee’s stock is currently trading for $$1,092.87.

•    Bee Corp. has never paid a dividend and is not expected to in the future.

•   At the time you enter the above trades, the price for a US government risk-free one-year zero-coupon bond is $952.38, which has a face value of $1,000.

a)  Create a synthetic risk-free zero-coupon bond using Bee’s stock, call and put options.

i.     What is this synthetic zero-coupon bond’s exact composition?

ii.    What is the total cost of the synthetic zero-coupon bond?

b)  In a single chart, plot the profit diagrams at expiration for:

i.    A long position in the synthetic zero-coupon defined in (a).

ii.   A long position in the actual zero-coupon bond.

c)

i.     What is the risk-free rate derived from the actual zero-coupon bond’s price?

ii.    What is the risk-free rate for the synthetic zero-coupon bond, as determined using the synthetic zero-coupon bond’s cost calculated in Q2aii?

d)

i.     Are the actual and the synthetic zero-coupon bonds correctly priced relative to each other? Why or why not?

ii.    If not, construct an arbitrage portfolio to capture any mispricing. State explicitly the complete composition of the arbitrage portfolio.

iii.   What is the arbitrage portfolio’s profit at expiration?

Question 4 [80 points]

To get credit for this question, I must see all of your calculations.

In this exam’s Excel file, Q5 worksheet, you will find monthly return data for the mutual fund      VISVX, Fama and French’s factors for their five-factor model, the momentum (UMD) factor, and the risk-free return.

a)  Assuming a six-factor factor model holds for the six factors provided, what is fund VISIX’s equilibrium expected return?

b)  What is VISIX’s alpha, the different between VISIX’s historical average and its equilibrium expected return?

c)   If the alpha is non-zero, why do you think that is the case?

d)  Is there a relationship between the alpha of from (b) and the alpha from your factor model regression? If so, how and why?