Question 1. Answer all parts of the question.

I. The following table shows a market where there are only three assets, and in the next time

period, one of three possible outcomes will occur.

State

Probability

E(r)

City

Lama

Wool

Excellent

0.3

16%

1.5%

25%

James

Alp

Delta

Good

0.5

(b) Calculate and interpret the returns correlation for each pair of assets.

13%

1.5%

18%

(a) Calculate and interpret the expected return and standard deviation for each asset.

(11 marks)

(5 marks)

E(r)

16.4%

9.25%

12%

12%

II. The table presents the annual expected returns and standard deviations for three portfolios

and for the market index:

Asset

Poor

0.2

6%

1.5%

4%

Standard deviation

19.25%

11.30%

13.125%

13.75%

Market index

The risk-free rate of interest is 1%. This stock market is in equilibrium according to the

capital asset pricing model (CAPM).

(a) Calculate and interpret the beta value of each of these three portfolios. (5 marks)

(b) Do these three portfolios lie on the Capital Market Line and what do you conclude

from this?

(7 marks)

(c) Two new assets, Nick and Roll, are introduced to this market at prices which imply

expected returns of 9% and 16%, respectively. The expected beta values are 0.9 and 1.25,

respectively. Do Nick and Roll lie on the Security Market Line and what do you conclude

from this?

(8 Marks)

III. Critically analyse the advantages and disadvantages of direct/individual investment in

stock and bonds versus investment in Mutual funds.

(14 marks)

[Total 50 marks]

Page 3 of 5/nQuestion 2. Answer all parts of the question.

I. Consider the following three bonds:

Bond N

£1,000

8%

Bond S

£1,000

5%

Bond T

£1,000

Par Value

Coupon

Zero

Time to Maturity

7 years

Required Yield

5%

(a) Calculate and interpret the present values of each bond.

(b) Calculate and interpret the Macaulay Duration for each bond.

4 years

5%

5 years

5%

(11 marks)

(7 marks)

(c) If required yield increases from 5% to 6%, discuss the action that a bond portfolio

manager should take in this situation.

(3 marks)

II. You are considering a new project that costs £2000m and you have estimated the

following cash flows: Year 1: £300m; Year 2: £400m; Year 3: £1400m. If the discount rate is

9%, do you recommend the project?

(4 marks)

III. Discuss, providing examples, the similarities and differences between Active versus

Passive investment strategies, and then explain the roles or responsibilities of portfolio

managers in an efficient market environment.

(25 marks)

[Total 50 marks]

Question 3. Answer all parts of the question.

I. Discuss, providing insights from relevant literature, the main characteristics of external

credit rating agencies and the key roles of credit ratings in financial markets. (25 marks)

II. Discuss, providing examples, the motivation for hedging, speculation and arbitrage in

financial markets.

(25 marks)

[Total 50 marks]

Page 4 of 5/nQuestion 3. Answer all parts of the question.

L. Discuss, providing insights from relevant literature, the main characteristics of external

credit rating agencies and the key roles of credit ratings in financial markets. (25 marks)

II. Discuss, providing examples, the motivation for hedging, speculation and arbitrage in

financial markets.

(25 marks)

[Total 50 marks]

Page 4 of 5/nQuestion 4. Answer all parts of the question.

L. Consider the following information about Kaplan and Morris for one-time period:

Expected return Standard Deviation

16%

24%

Stock

Kaplan

Morris

18%

26%

You invest 40% of your fund in Kaplan and 60% in Morris.

(a) Calculate and interpret the expected return of your portfolio.

(3 marks)

(b) Calculate the standard deviation of returns on your portfolio, and interpret your

results, for the following two different scenarios:

(10 marks)

i. the correlation coefficient between the returns for Kaplan and Morris is +0.55'.

ii. the correlation coefficient between the returns for Kaplan and Morris is *-0.80.

II. Suppose you have a portfolio of Koll and Nell with a beta of 1.6 and 0.7, respectively. If

you put 60% of your money in Koll, 35% in Nell and 5% in the risk-free asset, calculate and

interpret the beta of your portfolio.

(4 marks)

III. An investor wishes to:

(1) have a shareholding in only one company, Jax, with a beta of 1.25, and

(ii) have a portfolio with a beta value of one.

What is your advice as to how the investor can achieve these twin objectives?

(4 marks)

IV. The share price of Carl is currently £250 and the last dividend was £5. The analyst is

predicting a dividend growth rate of 6% and the required rate of return is 8%. According to

the Gordon Growth model, is Carl's stock fairly priced?

(4 marks)

V. Analyse, providing examples, the steps involved in the process of portfolio investment.

(25 Marks)

[Total 50 marks]

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