Capital Markets Practice Final 2

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 WORK 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]

Use the data that are in this exam’s Data Excel file Q1 worksheet for this question.

•    In this worksheet there are monthly return data for the period from 2013:12 through 2018:11 for three mutual funds.

•    In this worksheet you will also find the return data for the Fama-French five factors for the same period, the excess return on the market, SMB, HML, RMW and CMA, as well as the risk-free asset.

a)  Estimate and report the factor sensitivities to the five Fama-French factors for the three mutual funds. Highlight those coefficients that are significant. I must see your own calculations.

b)  Calculate the Fama-French five-factor model equilibrium expected returns for the three mutual funds. I must see your own calculations.

c)  Why are the Fama-French equilibrium expected returns from (c) different than historical averages you calculated for part (a)? Be specific.

d)  What is the rationale for using equilibrium expected returns as inputs to the Markowitz calculations, rather than historical averages as in (a)?

Question 2 [35 points]

There are two types of IRAs (investment retirement accounts) in the US: traditional IRA and ROTH IRAs. In this question you are to determine which IRA yields a better after-tax return, traditional IRAs or ROTH IRAs?

•    Investments in traditional IRAs are not taxed upon investment. The investments are pre-tax income which is then invested and taxed at the personal income tax rate upon withdrawal.

•    Investments in ROTH IRAs are taxed as ordinary income before the investment is made. The investments are after-tax income, but income is not taxed upon withdrawal.

Using the following assumptions, which IRA will yield the larger after-tax dollar amount in 25 years? Show all your calculations.

•    Both the traditional and ROTH IRAs earn an investment return of 4%.

•   You are in the highest US tax bracket.

•    For both IRAs, you will invest a lump sum equivalent to $5,000 of pre-tax income.

•   The initial investment you deposit into the IRAs will be invested in the IRA for 25 years, at which time you will be over 60 and retired, and you will withdrawal the complete amount you have in your IRA all at one time.

Question 3 [40 points]

You may not cut and paste your answer from another worksheet, I must see all your own calculations.

You have the following information on securities for a hypothetical public company, Water Corp., and a risk-free asset:

•   A put written on Water's stock, with a strike price of $220 and an expiration date exactly 12 months from now, costs $1.75 today.

•   A call option written on Water’s stock, also with a strike price of $220 and an expiration date exactly 12 months from now, costs $6.59 today.

•    Water’s stock is currently trading for $220.

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

•   The risk-free return on one-year zero-coupon bonds is 2.25%.

a)   Create a synthetic Water Corp. one-year call option with a strike price of $220 using    Water’s stock and put option plus borrowing or lending with the one-year zero-coupon bond.

i.     What is this synthetic call option’s exact composition?

ii.    What is the potential profit or loss from this borrowing or lending position at expiration?

b)  Chart the profit diagrams at expiration for

i.    A long position in the synthetic call option defined in (a).

ii.   A long position in the actual call option. Plot the two profit diagrams, (i) and (ii), in separate charts.

iii.  Are the above two charts the same? Prove it by plotting the difference between the synthetic call’s profits and the actual call’s profits (at expiration).

Question 4 [25 points]

Answer the following true, false or uncertain and explain why.

a)  Investment decisions are straight forward.

b)  The media is an unbiased source of investment advice.

c)  When we bucket are investment choices it simplifies and optimizes our investment choices.