BFF5040 S1 2016 Tutorial Questions (3).docx

BFF5040 Tutorial Questions Question based on week 1 topic due in week 2T1Q1 You are attempting to formulate an investment strategy. On the one hand, you think there is great upward potential in the stock market and would like to participate in the upward move if it materializes. However, you are not able to afford substantial stock market losses and so cannot run the risk of a stock market collapse, which you think is also a possibility. Your investment adviser suggests a protective put position: Buy both shares in a market index stock fund and put options on those shares with 3-month expiration and exercise price of $780. The stock index fund is currently selling for $900. However, your uncle suggests you instead buy a 3-month call option on the index fund with exercise price $840 and buy 3-month T-bills with face value $840.a. On the same graph, draw the payoffs to each of these strategies as a function of the stock fund value in 3 months. (Hint: Think of the options as being on one “share” of the stock index fund, with the current price of each share of the fund equal to $900.)b. Which portfolio must require a greater initial outlay to establish? (Hint: Does either portfolio provide a final payout that is always at least as great as the payoff of the other portfolio?)c. Suppose the market prices of the securities are as follows:Stock fund $900T-bill (face value $840) $810Call (exercise price $840) $120Put (exercise price $780) $ 6Make a table of the profits realized for each portfolio for the following values of the stock price in 3 months: ST = $700, $840, $900, $960.Graph the profits to each portfolio as a function of ST on a single graph.d. Which strategy is riskier? Which should have a higher beta?e. Explain why the data for the securities given in part (c) do not violate the put-call parity relationship.T1Q2 a. Which type of order is often used together with short sales (sales of securities you dont own but have borrowed from your broker) to limit potential losses from the short position? i. Limit ordersii. Price-contingent ordersiii. Stop-loss ordersiv. Stop-buy ordersv. Market ordersb. Consider the following limit-order book for a share of stock of a specialist. The last trade in the stock occurred at a price of $50.Limit Buy OrdersLimit Sell OrdersPriceSharesPriceShares49.7550050.2510049.5080051.5010049.2550054.7530049.0020058.2510048.50600i. If a market buy order for 100 shares comes in, at what price will it be filled?ii. At what price would the next market buy order be filled?iii. If you were a security dealer, would you want to increase or decrease your inventory of this stock?T1Q3 a. De Trader opens a brokerage account and purchases 300 shares of Internet Dreams at $40 per share. She borrows $4,000 from her broker to help pay for the purchase. The interest rate on the loan is 8%.i. What is the margin in Des account when she first purchases the stock?ii. If the share price falls to $30 per share by the end of the year, what is the remaining margin in her account? If the maintenance margin requirement is 30%, will she receive a margin call?iii. What is the rate of return on her investment?b. Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams from the previous problem. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share.i. What is the remaining margin in the account?ii. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?iii. What is the rate of return on the investment? T1Q4 (Review key equations BKM 10 Chapter 5 page 162)Suppose your expectations regarding the stock price are as follows:State of the marketProbabilityEnding PriceHPRBoom0.3514044.5%Normal growth0.3011014%Recession0.3580-16.5%Compute the mean and standard deviation of the HPR on stocksT1Q5 a. Investment management is far more tractable when rates of return can be well approximated by the normal distribution because:i. The normal distribution is symmetricii. The normal distribution belongs to a special family of distributions characterised as “stable”iii. Scenario analysis is greatly simplifiediv. Statistical dependence of returns across securities can be summarized in a straightforward fashionv. All of the aboveb. Which of the following statement is correct?i. When the distribution of returns is positively skewed, the standard deviation underestimates riskii. When the distribution of returns is negatively skewed, the standard deviation underestimates riskiii. When a distribution is “skewed to the right”, its skewness measure is negativeiv. When a distribution is “skewed to the right”, its skewness measure is positivev. (i) and (iii) are correctvi. (ii) and (iv) are correctc. Which of the following statement is incorrect?i. Kurtosis concerns the likelihood of extreme values on either side of the mean at the expense of a smaller likelihood of moderate deviationsi. Kurtosis measures the degree of fat tailsii. Standard deviation will overestimate the likelihood of extreme events when the tails of a distribution are fatiii. Kurtosis of a normal distribution is defined as zero, and any kurtosis above zero is a sign of fatter tails.Question based on week 2 topics due in week 3T2Q1 Suppose the rate of return on short-term government securities (perceived to be risk-free) is about 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 12%. According to the capital asset pricing model:a. What is the expected rate of return on the market portfolio?b. What would be the expected rate of return on a stock with a beta of 0?c. Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 dividends next year and you expect it to sell then for $41. The stock risk has been evaluated at beta = -0.5. Is the stock overpriced or under-priced?T2Q2 Suppose a market expected return of 10% and a riskless rate of 6%. Assume the CAPM.a) A stock has correlation of 0.8 with the stock market, standard deviation of 30%, and the market standard deviation is 20%. Compute the stocks expected return.b) Assume both borrowing and lending are possible at the riskless rate. Show how an investor can achieve a portfolio with 1.0 beta byi. only taking positions in a riskless security and a portfolio with beta 0.8;ii. only taking positions in a riskless security and a portfolio with beta 1.5.c) A stock has an expected return of 4%. Compute the beta of the security and argue for or against holding a position in the security.T2Q3Assume an arbitrary two-factor APT model. The riskless rate is 4%. The expected return on a risk factor, namely Q, is 10%, and the expected return on another risk factor, R, is 12%. a) Compute the expected return of portfolio S, which has a factor beta of 0.5 on Q and 0.75 on R.b) If portfolio S had an expected return of 12%, construct an arbitrage strategy which has no exposure to either risk factor but guarantees you a profit. State the assumptions required.T2Q4 A security analyst is in the process of measuring the cost of capital of XYZ shares. He has collected the following monthly data for the period from 2000-2005 (60 months):rit = 60 observations of the returns on the XYZ shares over the 60-month period (one each month)rMt = 60 observations of the returns on the S&P 500 index over the sample period (one each month)rft = 60 observations of the risk-free rate (one each month)The CAPM equation is estimated through the following regression:rit-rft=ai+birMt-rft+eitThe result of the regression is presented as follow:Where Intercept = ai , MRP = rMt - rft , eit = error terma. Read and interpret the meaning of the above regression outcome: What is the value of adjusted R-square and what does the figure tell us about the overall fit of the regression model? Comment on the statistical significance of the Intercept and MRP Interpret the meaning of the coefficient of the variable MRPb. Sample averages of the three variables are as followed: rM= 0.49% , rf= 0.44% per month. Calculate the expected excess return for XYZ share using the CAPM equation estimated above.T2Q5The expected return-beta relationship represented in CAPM is tested through a two-stage procedure: first-pass and second-pass regression. Carefully read BKM 10 Chapter 13 p415 417 and answer the following questions: a. State the first pass regression. What are the inputs and outputs of the first-pass regression?b. State the second pass regression. What are the inputs and outputs of the second-pass regression?c. If the empirical SML is too flat, how accurate is CAPM in predicting the performance of high- or low- beta stocks? d. What is the implication of a coefficient on 2 being positive and statistically significant?e. What are the limitations of this approach?T2Q6Identify and briefly discuss three criticisms of beta as used in the capital asset pricing model (CAPM)T2Q7Amihud (2002) Amihud, Y. (2002). Illiquidity and stock returns: cross-section and time-series effects.Journal of financial markets,5(1), 31-56. has developed an asset pricing model that accounts for liquidity risks. a. In what ways liquidity potentially affect stock returns in your view?b. Name three types of liquidity risks? How are they measured? How would these liquidity risks incorporated into CAPM?Question based on week 3 topics due in week 4T3Q1Richard Roll, in an article on using the capital asset pricing model (CAPM) to evaluate portfolio performance, indicated that it may not be possible to evaluate portfolio management ability if there is an error in the benchmark used.a. In evaluating portfolio performance, describe the general procedure, with emphasis on the benchmark employed.b. Explain what Roll meant by the benchmark error and identify the specific problem with this benchmark.c. Draw a graph that shows how a portfolio that has been judged as superior relative to a “measured” security market line (SML) can be inferior relative to the “true” SML.d. Assume that you are informed that a given portfolio manager has been evaluated as superior when compared to the Dow Jones Industrial Average, the S&P 500, and the NYSE Composite Index. Explain whether this consensus would make you feel more comfortable regarding the portfolio managers true ability.e. Although conceding the possible problem with benchmark errors as set forth by Roll, some contend this does not mean the CAPM is incorrect, but only that there is a measurement problem when implementing the theory. Others contend that because of benchmark errors the whole technique should be scrapped. Take and defend one of these positions.T3Q2 Bart Campbell, CFA, is a portfolio manager who has recently met with a prospective client, Jane Black. After conducting a survey market line (SML) performance analysis using the Dow Jones Industrial Average as her market proxy, Black claims that her portfolio has experienced superior performance. Campbell uses the capital asset pricing model as an investment performance measure and finds that Blacks portfolio plots below the SML. Campbell concludes that Blacks apparent superior performance is a function of an incorrectly specified market proxy, not superior investment management. Justify Campbells conclusion by addressing the likely effects of an incorrectly specified market proxy on both beta and the slope of the SML.T3Q3 Carefully read BKM10 Chapter 13, section 13.3 regarding Fama-French three factor model and answer the following questions:a. What are the risk factors incorporated in the Fama and French three factor models? How are they measured?b. Why do we not subtract the risk-free rate from SMB or HML? Why do we subtract the risk-free rate from Rm ?c. Subsequent to Fama and Frenchs (1993) finding, several academics have made effort in interpreting the size and value effect. Their studies can be classified into two strands of literature: risk-based interpretation and behavioural based interpretation. List and briefly explain some studies under each strand. d. Cahart (1997) incorporated a forth factor so called “momentum” into the Fama-French model. Define “momentum” and describe how it is measured.e. Suppose I sort some stocks by some characteristics to find new anomalies:Beta0.840.890.930.981.041.091.121.19Returns0.450.620.80.991.161.451.481.72Is there evidence to support the finding of a new anomaly with respect to the CAPM?T3Q4InterceptMRPSMBHML0.440190.793760.05243-0.11812-0.14881.1116-0.1197-0.3328The above are coefficients estimates obtained by running the Fama-French three factor model on two different assets. One of the assets is a portfolio of stocks from the consumer goods industry, and another is a portfolio of stocks from the tech industry. Deduce which portfolio is which, given your knowledge of the differing characteristics of the two industries. T3Q5Suppose you find, as research indicates, that in the cross-section regression of the CCAPM, the coefficients of factor loadings on the Fama-French model are significant predictors of average return factors (in addition to consumption beta). How would you explain this phenomenon?T3Q6The following is an excerpt of a table replicated from The cross section of expected stock returns (Journal of Finance, Fama and French(1992). Interpret the table and explain the manifestation of the value effect and how this contradicts the CAPM (note relevant section of the table)Questions based on week 4 topics due in week 5T4Q1 The Generic Genetic (GG) Corporation pays no cash dividends currently and is not expected to for the next 3 years. Its latest EPS was $10, all of which was reinvested in the company. The firms expected ROE for the next 3 years is 15% per year, during which time it is expected to reinvest all of its earnings. Starting in year 4, the firms ROE on new investments is expected to fall to 12%, and the plowback ratio is 1/2, which it will continue to do forever after. The risk-free rate is 5%, the expected market return is 8%, and the stock of GG has a beta coefficient of 1.4. A competitor in the market trades with a price-earnings (PE) ratio of 16 in the market.a. What is the intrinsic value of a share of GG stock based on DDM?b. Do you think it is important to use multistage dividend discount model to value a firm? in what circumstances? and does it have any limitations, eg. compared to FCFE model?c. If a stock is underpriced, what is the relationship between market capitalization rate and its expected rate of return?d. What is the relative valuation of GG based on the PE ratio?e. Comment on the differences in the estimated value of GG if any and the merits of each method of valuation.f. Assuming the company is the target of a hostile takeover and the acquirer is offering to pay $165 for a share in GG. On the basis of your two calculations to value the firm should you accept the offer giving reasons for your recommendation?T4Q2.Abbey Naylor, CFA, has been directed to determine the value of Sundancis stock using Free Cash Flow to Equity (FCFE) model. Naylor believes that Sundancis FCFE will grow at 25% for 2 years and 10% thereafter. Capital expenditures, depreciation, and working capital are expected to increase proportionately with FCFE.a. Calculate the amount of FCFE per share for the year 2011, using data from Table 18A (BKM 10th edition, Chapter 18, page 628)b. Calculate the current value of a share based on the two-stage FCFE model. c. Describe one limitation of the two-stage DDM model that is addressed by using the two-stage FCFE modelDescribe one limitation of the two-stage DDM model that is not addressed by using the two-stage FCFE modelT4Q3Suppose you have made the following assessment for Company XYZ for four years:20X120X220X320X4EBITDA*8095110120Depreciation and amortization20222528Pre tax operating profit60738592Capital investment12303020* EBITDA = Earnings before interest, taxes, depreciation and amortization.The estimates are for the end of the next 4 years and the estimates for year 4 are expected to remain constant for subsequent years. The amounts are in millions of dollars.Additional information: Company XYZ has $400,000,000 of debt Company XYZ has 1,000,000 shares outstanding. For this kind of investment opportunity, the firm considers that its weighted average cost of capital defined as: to be 7.40% The corporate tax rate is 40 percent.Required:a. Calculate the value of Company XYZ in millions of dollars. b. Calculate the intrinsic value of a share in Company XYZT4Q4.Twenty years after the original Fama-French model, Fama and French (2013) have proposed a new, five-factor model, incorporating two additional factors, RMW and CMA. RMW (robust-minus-weak) is the difference in returns between a portfolio of firms with robust and weak profitability; CMA (conservative-minus-aggressive) is the difference in returns between a portfolio of firms with conservative (i.e. low) and aggressive (i.e. high) investment.Recall the constant growth dividend discount model:P0=E11-br-gThe economic intuition behind why HML, CMA and RMW are risk “premiums” can be derived easily from the above fundamental valuation formula. Explain how.Questions based on week 5 topics (no submission is required in week 6)T5Q1. Investors expect the market rate of return