b. Calculate the value of the expected return for the risky portfolio based on a 50-50 mixof stocks and bonds. Show your work.

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c. Calculate the value of the expected SD for the risky portfolio for that same 50-50 mix.Show your work.

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d. Consider the complete portfolio of pension fund with a target rate of return of 6%. Willit have more than 0% in each of the three assets? For which asset will it have more than50%? Check the appropriate boxes:

More than 0%? More than 50%?Yes No Yes No

Risk-free asset y yBonds y V* yStocks s Je. Suppose the pension fund could not choose a mix of stocks and bonds, but had tochoose a risky portfolio of either all stocks or all bonds. In terms of the model of portfoliooptimization, which is the better choice, all stocks or all bonds? Explain.

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24. Portfolio Optimization. Consider these expected returns, standard deviationsand correlations for the world bond and stock markets. (Five questions, four pointseach, 20 pts. in all)

Expected ReturnSD

Stocks11%20%

Bonds6%10%

Risk-free asset1%0%

Correlation, p(stocks, bonds) = 0.0

The graph below shows the minimum-variance frontier for different mixes of stocks andbonds based on these assumptions. The diamonds (♦) on the line show the expectedreturn (y-axis) and SD (x-axis) for weights at 10%-point intervals (0% stocks, 10%stocks, 20% stocks, etc.)

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0.050 0.100 0.150 0.200 0.250

a. In the diagram above, (A) mark and label the risk-free rate, (B) draw and label theCapital Allocation Line (CAL), and (C) mark and label the optimal risky portfolio.

10

d. For the fund in the previous question, what is the drawback to using the sameformula if the applicable yield changes by a large amount, say decreasing from5.0% to 4.0%? Would your estimate be an over- or under-estimate of thepercentage change resulting from that decline in yield? Explain.

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e. A 4% coupon treasury will pay semi-annual interest of $2 per $100 face valueon July 15. If the quoted (or clean) price on April 16 (90 days earlier) is $100,what will be its sale (or dirty) price on that date?

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Answer: blO(

f. Consider a two-year bond paying annual coupons of $3 per $100 face value. Ifits current price is $106. what is its yield? Show your work or explain.

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23. Show your work or explain as necessary. (4 pts. each. 24 pts. in all)a. A fifty-year bond with a coupon rate of 5% trades at par or face value. What fraction of itsvalue today is due to the promised return of coupon payments?

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Answer: O. '& o

b. A zero-coupon bond returning $1,000 in ten years currently has a price of 700.What is its yield to maturity?

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c. A fixed-income fund has a duration of 6 years. If the yield applicable to thefund's assets increases from 5.0% to 5.1%, what is the percentage change in thevalue of the fund?

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Answer: ~~,^ ' 'o

22. Which of the following is worth more? (2 pts. each, 10 pts. in all)

Alternative A Alternative BThe

alternativeworthmore:A o r B

A call option on Twitter stock with astrike price of $40

A call option on Twitter stock witha strike price of $45 A

A call option on Twitter stock with astrike price of $45 expiring in March2014

A call option on Twitter stock witha strike price of $45 expiring in July2014 B

A corporate bond paying a 5%coupon on an annual basis (once ayear).

A bond from the same corporationpaying a 5% coupon on a semiannual basis (2.5% twice a year). 5

A ten-year corporate bond with a 5%c o u p o n . y

A ten-year US treasury bond with a5% coupon. \/ A3

A December 2013 call option onTwitter with a strike price of $30when the current price is $40.

A December 2013 put option onTwitter with the same strike price of$30 when the current stock is worth$40. A

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Part II. Answer the following questions.21. Write in the correct answer, A or B. for each question below. (5 at 2 pts. each, 10points)

AorBa. The delta or hedge ratio of a call option is bounded (A) on the interval [0,+ 1] or (B) on the interval [-1,0]. Ab. The SPDR S&P 500 (Symbol SPY) is trading at 123. The January 2013call on SPY with a strike price of 120 is (A) in the money or (B) out of themoney. Ac. The most recently issued Treasury securities are (A) more liquid or (B)less liquid than seasoned issues that have been trading for a while. 3,4? U~ltn~.Xd. Small investors have a tendency to (A) hold on to winners and sell losers(B) sell winners and hold on to losers. 13e. Consider a two-year bond with a face value of $100 and an annual couponof $3. If its yield is 4% it is selling at (A) a premium or (B) a discount. A $

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general level of interest rates increases, what statement about duration is

The duration of high-coupon bonds will increase more than the duration oflow-coupon bonds.The duration of low-coupon bonds will increase more than the duration ofhigh-coupon bonds.

yf The duration of all bonds with the same maturity will increase the same

/df The duration of zero-coupon bonds will not change. /*,'"1fc« < u** r> u^ U^X\15. About which input for the Black-Scholes options pricing model is there the most™^*.

uncertainty?a. The current stock price (So)b. The strike price (X).c) The volatility (a),a. The term to maturity (T).

16. If the correlation between two assets is , it is possible to construct a portfoliowith zero risk.

a. Infiniteb. +1£. zero(3)-'17. The net work of a bank with long-term assets and short-term liabilities will

decline ifa. the general level of interest rates declinesb) the general level of interest rates increases

the yield curve has a positive slope$S the spread between CDs and treasuries narrows.

18. Using "adjusted beta" (ADJ BETA = 0.67*BETA + 0.33) rather than estimated"raw beta" (BETA) makes sense if

a. Estimated betas are biased toward zerob. Estimated betas are biased toward one

(oy Estimated betas exhibit regression toward the mean; -. d. The estimated beta is less than zero or greater than two. &{(aM* r^o L Ln9j Which of the following instruments has a region of "negative convexity"? r^*v fc**^

a. A ten-year US treasury with a coupon of 3%s b. A straight or "bullet" corporate bond with a coupon of 5%

/ ^pr A callable corporate bond with a coupon of 7%^—" d. A zero-coupon bond constructed from the principal-only portion of a US

treasury.20. If you wrote call options on 100 shares of Twitter, which of the following actions

would provide a hedge against your liability as the option writer?a. Selling short shares of Twitter

£b^ Buying shares of Twitterc. Buying a put option on 100 shares with the strike price equal to the current

stock priced. Selling a put option on 100 shares with a strike price equal to the current

stock price.5

a.

0 If the yield curve is flat, then according to the liquidity preference theory of theterm structure of interest rates, market participants expect future short-term ratesto be

a. Higher than today's short-term ratesb. Equal to today's short-term rates

(c) Lower than today's short-term ratesif Zero.

8. If a stock has a large estimated alpha over the last three years, according to the CAPM,then

it is riskyit is safeit has a high expected returnadjusting for market movements, it did better than the market.

iTch statement about beta is true?a. High beta stocks have high alphas.b. High beta stocks have high correlations with the market.

/c.yA beta can be equal to zero.^ti: None of these statements is true.

(nfl Consider the stock price series Pt (t = 1,.. .n,), where Pt represents the price atend of period t. This series does not follow a random walk if

? SSW" p" p" pli - o *ww w w «wb. Corr(Pt+r Pt, Pt- Pt-i) - 0jef If the stock's beta is greater than one Cfr*Y***Jl If the stock's beta is less than one

11. The actual, realized return for a portfolio of high-yield (or "junk") bonds dependson

a. the price originally paid for the bondsb. the fraction of bonds that defaultc. the recovery rate in the event of default

/cy all of the above./12j For a bond paying a coupon C with a yield of r, the expression ]jjj^

equal toa

is( l+r) '

C / ( l + r ) ~ A C ~ u rX , c - o + r r r c/ C t " C " »

13. Consider a bond with a maturity of five years, a face value of $1,000 and anannual coupon rate of 2%, and a yield to maturity of 4%. The quoted price of thebond will

a. decrease on average over the next five yearsJk" be the same five years from now as it is today

y^T^ncrease on average over the next five years Cu/Aaa J V^tfVxl ^ e ^ e q u a l $ 1 0 0 0 / ( 6 % - 4 % ) . ™ ' r

Part I. Multiple Choice. Four points each, twenty questions. Use the answer sheet to fillin the correct letter for the questions that follow. (Twenty questions, 2 points each, 40points in all)

K-X ^. . . . < ">W.

The risk that cannot eliminated by building diversified portfolios is calleda. Market riskb. Systematic risk

Non-diversifiable riskAll of the above,number of assets in a portfolio increases, the number of correlations

for portfolio optimization k> £alf*o v~v«l*l.-L,Declines

b." Increases linearly (in constant proportion to the number of assets)f c/Jhcreases exponentially

d. Goes to zeroWhich statement represents an inference that is not valid?

If the stock market is efficient, then stock prices follow a random walk.If the stock market is efficient, then the autocorrelation of monthly returnswill be zero.

c. If the stock market is not efficient, it may still be hard to make money in> ^ 7 \ t h e s t o c k m a r k e t . f \ r \

\sC~$*^ stock prices follow a random walk, then the stock market is efficient. I *5r tvK.jffl Consider the results of an event study of target firm returns around merger

'̂ ^announcements. Which result would contradict the "efficient marketshypothesis"?

a. Target firm stock prices increase 5% in the five days leading up to the^ - ^ a n n o u n c e m e n t . f a U t i * « ^ « r , W o k , S y / . W t *

? (Jsff Target firm stock prices decrease 5% in the five days after the P^-WulL *■ ef^i.v a n n o u n c e m e n t . '/̂ 5?STarget firm stock prices decline 5% in the twelve to six months ahead of

^—""the announcement.d. Target firm stock prices are unchanged on average after the

announcement.With a rising yield curve, which bond has the highest yield to maturity?

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A five-year treasury with a 3% couponA five-year treasury with a 6% coupon .

ten-year treasury with a 3% coupon (fyUrVT"M- lofruyf-p^ 1 r^i at e n - y e a r t r e a s u r y w i t h a 6 % c o u p o n °

of the same set of bonds has the shortest duration?A five-year treasury with a 3% coupon*) uA five-year treasury with a 6% couponA ten-year treasury with a 3% couponA ten-year treasury with a 6% coupon

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i r - t lUniversity of KansasSchool of Business

FIN 410Investment Theory and Applications

Instructor: G. Bittlingmayer Fall 2013

EXAM II

Name

1.2.3.

4.

5.

j ! m j > mV- Student ID 7J^M>°lO

(PLEASE PRINT - LEGIBLY)

Student ID <7/>\3c\i'}

Place all books, notebooks and other materials not authorized on the floor.Formulas appear at the end of this exam. You may detach the formula sheets.You may use a calculator. Use of a calculator to store formulas or otherinformation will be viewed as a violation of the honor code.Do all your work on the exam. Clear demonstrations of how you arrived at youranswer make it easier to award partial credit.Be sure to write your name in the space above and sign the honor pledge belowbefore handing in your exam.

University of Kansas, School of Business, Honor Pledge:

On my honor, I have neither given nor received any unauthorized aid on thisexam. Nor am I aware of anyone giving or receiving unauthorized aid.

This exam has a total of 125 points.