Capital Markets Practice Final 3

Question 1 [70 points]

Answer the following questions true, false, or uncertain. Briefly explain your answer.

a)   The results of Fama and French’s research indicate that financial markets are not efficient.

b)   You think the likelihood of interest rates being pushed up by the Federal Reserve is high, you feel strongly the stock market will fall because of this. To take advantage of your prediction you could invest heavily in a portfolio of call options.

c)    A typical behavioral bias is that many investors sell their investments that are losing money too quickly, not waiting enough time for the investments to rebound.

d)   If your risk aversion coefficient is 10, the market’s expected return is 15% with a standard deviation of 20%, and the risk-free rate is 5%, then your optimal portfolio is to invest 60% of your wealth in    the market portfolio and the remainder in the risk-free asset.

e)    If you hold a portfolio of long stocks, which you do not want to liquidate and you wish to hedge out all possible stock movements, one possible hedging strategy is to buy puts and write calls on the     same stock, along with some level of borrowing or lending.

f)    According the CAPM, the small firm effect is an anomaly.

g)   The affect heuristic causes some investors to be too rationale in their investment choices, causing them to spend too much time thinking about their investment choices and therefore losing out on some money-making choices.

Question 2 [65 points]

I must see most of your own calculations for this question for you to receive credit.

Assume a two-factor model holds, with a value factor and a momentum factor.

In this exam’s data and template file for Q2 you will find return data for four mutual and two factor portfolios, Value and Momentum.

a)   Calculate the equilibrium expected returns for each of these funds. Estimate the factor regressions using excess returns.

b)   Calculate the alpha for each of these funds, the difference between the historical average and the equilibrium expected return. You use gross returns for these calculations.

c)    Compare and explain the differences between (a) and (b).

Question 3 [100 points]

You have the following information on securities for a hypothetical public company NET Corp.

•    A put written on NET's stock, with a strike price of $120 and an expiration date exactly 24 months from now, costs $2 today.

•    A call option written on NET’s stock, also with a strike price of $120 and an expiration date exactly

24 months from now, costs $3 today.

•    NET’s stock is currently trading for $100.

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

•   The one-year risk-free rate for zero-coupon bonds of all maturities is 3%.

a)   Create a synthetic NET Corp. stock using zero-coupon bonds and the above options. What is the synthetic stock exactly composed of, be specific?

b)   Given the upfront prices of the options, the stock, and the risk-free return, are all these securities correctly priced relative to each other? Prove it.

c)    Chart the profit diagrams at expiration for (i) a long position in the synthetic stock defined in (a) and (ii) a long of the actual stock. Plot these two profit diagrams in the same chart.

d)   If the securities are mispriced relative to each other form an arbitrage portfolio to capture the mispricing. State exactly what the arbitrage portfolio is, its arbitrage profit, and prove that the arbitrage portfolio is riskless.

e)    Plot the profit diagram for the arbitrage portfolio.

Question 4 [50 points]

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

For your planning purposes, you want to figure out the effect of taxes on one of your personal investment strategies (not a retirement account).

•    You were paid a pre-tax bonus of $215,000.

•    You will invest as much of this bonus as possible.

•    You are currently in a personal income tax bracket with a 28% tax rate and a long-term capital gains rate of 20%, and you expect to be in these brackets for at least a year.

•    You will initially invest your money in a stock for one year less a day at a 12% pre-tax rate of return.

•   Then you will transfer your investment money into a mutual for 20 years at a 15% pre-tax rate of return.

•    At the end of this 20 years, you will withdrawal your complete investment from this mutual fund, at which time you will be in the 15% income tax bracket and 10% in long-term capital gains rate.

•    Next you will invest the total amount of your investment dollars into another stock for a year less a day. Your income brackets ill not change.

•   This new stock investment will earn a 30% pre-tax return.

•    At the end of this final year, you will withdrawal your total accumulated invested amount.

•    None of the above investments pay dividends.

What amount of money will you have, after-tax, after all these investments?