Comments on specific questions

Candidates should answer all THREE questions.

Question 1 [Total: 34 marks]

Consider a market consisting of only two risky stocks, X and Y. The mean and stan-
dard deviation of the returns of each stock is shown in Table 1. The correlation be-
tween the two stocks’ returns is 0.1.

Table 1
Stock Expected Return Standard Deviation
X 0.16 0.30
Y 0.08 0.20

For parts (a) to (c), assume there is no risk-free asset.

(a) Calculate the mean return and standard deviation of a portfolio that is 20% in-
vested in Stock X and 80% in Stock Y. (4 marks)

(b) Determine the combination of X and Y that has the lowest possible return vari-
ance. What is the expected return and standard deviation of this portfolio?
Does this portfolio lie on the efficient frontier? Explain your answer in detail.
(7 marks)

(c) Is Stock Y on the efficient frontier? Explain your answer in detail and illustrate
your argument by sketching a graph. (5 marks)

For parts (d) and (e) assume that a risk-free asset exists and the CAPM assump-
tions hold. The risk-free asset’s return is 2%.

(d) It can be shown that the combination of stocks X and Y where an investor holds
$1.15 in Stock X for each $1 held in Stock Y has the highest attainable Sharpe
ratio. If a risk-averse investor wishes to hold a portfolio with a return stan-
dard deviation no higher than 25%, what weights should they place on Stock
X, Stock Y, and the risk-free asset to maximise expected return? (8 marks)

(e) A client approaches you for advice about a new investment project that has the
same CAPM beta as Stock X and a 99-year lifespan. The project is expected to
deliver a cash flow of $100,000 in exactly one year, after which the annual ex-
pected cash flow will grow by $100,000 each year until it peaks at $5 million at

1
 the end of year 50. Subsequent annual cash flows are then expected to decrease
by $100,000 each year until the final cash flow of $100,000 is paid at the end of
year 99.

(i) What is the appropriate discount rate for the project’s expected cash flows?
Explain your answer in detail. (2 marks)
(ii) What is the most you would advise your client to pay for this investment
today? Explain your answer in detail. (8 marks)

Reading for this question

Subject guide, Chapters 2, 3, 7, and 8

Approaching this question

(a) Expected return:

E [RP ] = wX E [RX ] + (1 − wX )E [RY ]

= (0.2)(0.16) + (0.8)(0.08)
= 9.6%

Standardard deviation:
 2 2 1
σP = wX σX + wY2 σY2 + 2wX wY ρX,Y σX σY 2
1
= (0.22 )(0.32 ) + (0.82 )(0.22 ) + 2(0.2)(0.8)(0.1)(0.3)(0.2) 2

1
= [0.03112] 2
≈ 17.64%

(b) Start with the expression for the variance of the portfolio of X and Y:

σP2 = wX
2 2
σX + (1 − wX )2 σY2 + 2wX (1 − wX )σX,Y

Differentiating w.r.t. wX , setting the first derivative to zero, and solving for wX yields the
variance-minimising weight in X:
0.006
z }| {
∗ −σY2
σX,Y 0.2 − 2
(0.1)(0.3)(0.2)
wX = 2 = ≈ 0.2881
σX − 2σX,Y + σY2 0.32 − 2(0.006) + 0.22
so that:
wY∗ = 1 − wX
∗
≈ 0.7119

2
 The expected return of this portfolio – the Global Minimum Variance Portfolio (GMVP) –
is:
∗
E [RGM V P ] = wX E [RX ] + wY∗ E [RY ]
= (0.2881)(0.16) + (0.7119)(0.08)
≈ 10.31%

The standard deviation of the GMVP is:

 ∗ 2 2 1
σGM V P = (wX ) σX + (wY∗ )2 σY2 + 2wX∗
wY∗ ρX,Y σX σY 2
1
= (0.28812 )(0.32 ) + (0.71192 )(0.22 ) + 2(0.2881)(0.7119)(0.1)(0.3)(0.2) 2

1
= [0.03020] 2
≈ 17.38%

The GMVP is mean-variance efficient. It sits at the vertex of of the portfolio frontier/minimum
variance envelope - there is no other asset with a higher expected return for the same level
of variance/standard deviation.

(c) Since the market comprises only two risky assets, Stocks X and Y must both lie on the
portfolio frontier. However, Stock Y is not efficient - it is strictly dominated by the GMVP,
i.e. GMVP offers a higher expected return with a lower standard deviation than Y. There-
fore, Stock Y must lie on the lower half (i.e. inefficient portion) of the portfolio frontier.

20
Stock X
Stock Y
Expected Return

16
15
GMVP

10
8

0
0 10 20 30

Standard deviation

(d) We are told that the ratio of the weights of X to Y in the Tangency Portfolio (TP) satis-
fies:

TP
wX 1.15 TP
TP
= =⇒ wX = 1.15wYT P
wY 1

3
 TP
And since wX + wYT P = 1 (the TP is fully invested in risky assets), we have:

TP 1.15
wX = ≈ 0.5349
1 + 1.15
1
wYT P = ≈ 0.4651
1 + 1.15

The expected return and standard deviation of the TP are:

TP
E [RT P ] = wX E [RX ] + wYT P E [RY ]
= (0.5349)(0.16) + (0.4651)(0.08)
≈ 12.28%

 TP 2 2 1
σT P = (wX ) σX + (wYT P )2 σY2 + 2wX TP TP
wY ρX,Y σX σY 2
1
= (0.53492 )(0.32 ) + (0.46512 )(0.22 ) + 2(0.5349)(0.4651)(0.1)(0.3)(0.2) 2

1
= [0.0374] 2
≈ 19.34%

In the presence of risk-free borrowing and lending, the Capital Allocation Line (CAL) that
passes through the TP describes the efficient frontier. This optimal CAL represents differ-
ent combinations of the risk-free asset and the TP. The weight in the TP, w, required to
produce an efficient portfolio with standard deviation of 25% satisfies:

0.25
w × σT P = 0.25 =⇒ w= ≈ 1.2929
0.1934

Therefore, the weights of X, Y, and the risk-free asset in this portfolio are:

TP
wX = w × wX ≈ 69.16%
wY = w × wYT P ≈ 60.14%
wrf = 1 − w ≈ −29.29%

The expected return of this portfolio is:

 
E [RT P ] − rf
E [RP ] = wE [RT P ] + (1 − w)rf = rf + 0.25 ≈ 15.29%
|{z} σT P
0.02 | {z }
ST P ≈0.5316

(e) (i) Both the project and Stock X have the same level of systematic risk (same CAPM
beta), hence in a CAPM world, should have the same required return, 16%.

4
(ii) The most the client should be willing to pay is the present value of expected cash
flows (discounted at 16%), which translates into an NPV of zero.
The expected cash flows of the project can be replicated as a portfolio of ordinary
annuities:
• 50-year annuity paying $100,000 per year from t = 1 to t = 50
• 50-year annuity paying $100,000 per year from t = 2 to t = 51
• 50-year annuity paying $100,000 per year from t = 3 to t = 52
• ...
• 50-year annuity paying $100,000 per year from t = 50 to t = 99

Let a 50 denotes the PV of a 50-year ordinary annuity paying $1 per year:

"
1

50 #
1− 1+0.16
a 50 = ≈ 6.246
0.16

Then, the present value of the investment is:

   49
1 1
P V = 100, 000 · a 50 + 100, 000 · a 50 + · · · + 100, 000 · a 50
1 + 0.16 1 + 0.16
 
1 1 1
= 100, 000 · a 50 1 + + + ··· +
1 + 0.16 (1 + 0.16)2 (1 + 0.16)49
 
1 1 1
= 100, 000 · a 50 (1 + 0.16) + + ··· +
1 + 0.16 (1 + 0.16)2 (1 + 0.16)50
| {z }
a 50

2
= 100, 000 (1 + 0.16) a 50
≈ $4, 525, 827.26

5
Question 2 [Total: 33 marks]

Table 2 provides information on the premiums (i.e. market prices) of some call and
put options currently trading in the market. All the options are European, expire
in exactly one year, and are written on the same underlying stock that is not ex-
pected to pay any dividends over the coming year.
Table 2
Type Strike Price Premium
Put $45 $1.293
Call $45 $8.487
Put $50 $2.975
Call $50 $5.413
Put $55 $5.536
Call $55 $3.218

(a) Explain why the premiums on call options in Table 2 decrease as the strike price
increases. (5 marks)

(b) An options strategy involves taking the following four positions: long one put
with a strike price of $45, short one call and one put, both with a strike price of
$50, and long one call with a strike price of $55.

(i) Draw the payoff diagram (not a profit-and-loss diagram) for this strategy.
Make sure to label all relevant features of the diagram. (7 marks)
(ii) How much does it cost today to create this strategy? Draw its profit-and-
loss diagram, making sure to label all relevant features of the diagram.
(5 marks)

(c) How can you replicate the payoff of the strategy in part (b) using only call op-
tions and risk-free bonds? Make sure to specify all relevant details of the con-
stituent positions. (6 marks)

(d) Determine the continuously compounded annual risk-free interest rate in this
economy, as implied by your answers to parts (b) and (c). (5 marks)

(e) Assuming the continuously compounded annual risk-free interest rate in the
market is equal to what you calculated in part (d), determine the implied cur-
rent price of the underlying stock. If the actual market price of the stock is
$48, is there an arbitrage opportunity? If yes, detail an arbitrage strategy that
you could implement to exploit the mispricing. (5 marks)

6
Reading for this question

Subject guide, Chapters 4 and 11

Approaching this question

(a) The value of a call is decreasing in the exercise price because, all else equal:

• The payoff/intrinsic value of a call with a lower strike price is always ≥ the payoff on
a call with a higher strike price.
• The lower the strike price, the higher the probability that the call will expire in the
money.

(b) (i) The payoff diagram of the options strategy, known as an Iron Butterfly, is shown be-
low (for the range of underlying stock prices 40 ≤ ST ≤ 60):
Payoff ($)
10
Long put @ 45
Short call @ 50
Short put @ 50
5 Long call @ 55
Iron Butterfly

−5

−10 ST
40 45 50 55 60

(ii) Using the information in Table 2, we know that the net cash flow today from setting
up the Iron Butterfly is:

CF0 = 5.413 + 2.975 − 1.293 − 3.218 = $3.877

The net cash flow is positive, which means we receive $3.877 today (i.e. the strategy
has a negative cost = −$3.877). The profit at maturity is therefore approximately
= Payoff + $3.877. So, shift the payoff diagram up by $3.877.

7
 $
10
Payoff
Profit

5
3.88

0
−1.12

−5

−10 ST
40 45 50 55 60

Aside: strictly speaking, the profit at maturity is = Payoff + $3.877er where $3.877er
is the future value (at maturity) of the $3.877 we obtained today, shown here using
continuous compounding because r is defined later in the question as a continuously
compounded rate.

(c) Note that the Iron Butterfly payoff diagram resembles a (long) Butterfly Spread shifted
down by $5. Therefore, to replicate the Iron Butterfly payoff, we can proceed as follows:

• Long 1 call with strike price $45

• Long 1 call with strike price $55
• Short 2 calls with strike price $50
• Short a risk-free bond with face value of $5 (i.e. borrow the PV of $5)

The call option positions above combine to create a Butterfly spread, while the risk-free
borrowing then shifts the payoff of the Butterfly Spread down by $5.

Payoff ($)
10
Long call @ 45
2 Short calls @ 50
5 Long call @ 55
Borrow PV(5)
Iron Butterfly
0

−5

−10 ST
40 45 50 55 60

8
 All diagonal lines above have a slope of +1 or −1, except for the line corresponding to the
payoff of the 2 short calls, which has a slope of 2 × −1 = −2.

(d) We know that the same Iron Butterfly can be constructed using the method in (b) or (c).
We also know from part (b-ii) that the net cash flow today from implementing the method
in (b) is $3.877. Therefore, by no-arbitrage, this must also be the net cash flow today from
the method in (c):

3.877 = −8.487 + 2 × 5.413 − 3.218 + 5e−r

Solving for r:
 
4.756
r = − ln ≈ 5%
5

(e) From the put-call parity relationship for a non-dividend paying underlying asset, we know
that:
S0 = c0 + PV(X) − p0
where the European call and put are written on the same underlying, have the same strike
price (X) and maturity. Using the put and call options with strike price X = $45 (for
example):
S0 = 8.487 + 45e−0.05 − 1.293 = $49.998 ≈ $50

If the actual market price of the stock is $48, then put-call parity is violated – the stock is
relatively underpriced, its replicating portfolio relatively overpriced. Arbitrage strategy:

• Long stock @ $48

• Short call with strike price X
• Long put with strike prioce X
• Short a 1-year risk-free zero-coupon bond with face value X (i.e. borrow the PV of
X)

This strategy yields an arbitrage profit today of $2 and zero net-payoffs in the future in all
states.

9
Question 3 [Total: 33 marks]

Consider the following information on two default-risk free U.S. government bonds,
shown in Table 3. Both bonds have a face value of $100 and pay semi-annual coupons.
All interest rates are expressed as semi-annually compounded Annual Percentage
Rates (APRs).

Table 3
Bond Maturity (years) Coupon rate Yield to maturity (YTM)
A 2 4.25% 4.25%
B 10 9.50% 7.42%

(a) Does Bond A sell at a discount, at par, or at a premium to its face value? Ex-
plain without the aid of any calculations. (5 marks)

(b) Determine the market price of Bond B. (5 marks)

(c) Compute the Macaulay Duration of Bond A. Express your answer in years.
(5 marks)

(d) Using the duration approximation, calculate how much the price of Bond A
will change if its yield to maturity increases by 1 basis point (1 basis point =
0.01%). (5 marks)

(e) You forecast that the yield curve will soon decline at all maturities, but more
at the short-maturity end. Assuming you are unconstrained in your ability to
go long or short in either bond, describe qualitatively how you would invest in
the two bonds today to profit from this scenario, explaining your decision(s) in
detail. (5 marks)

(f ) Suppose, instead, that you are confident the yield curve will become steeper
but are relatively unconcerned about the overall level of interest rates. You
want to construct a portfolio of the two bonds that profits from an increase in
the 10-year yield relative to the 2-year yield but is not affected by equal changes
in the yields of both maturities. Given that the approximate price change of
the 10-year bond in response to a 1 basis point increase in its yield is −$0.0762,
what is the ratio of the number of 2-year bonds to 10-year bonds in your port-
folio? Explain. (8 marks)

10
Reading for this question

Subject guide, Chapters 3, 4, and 5

Approaching this question

(a) Bond A’s coupon rate is equal to its YTM. Therefore, it sells at par.

(b) Bond B pays semi-annual coupons of (0.095/2) × 100 = $4.75.

The effective semi-annual discount rate is 0.0742/2 = 3.71% per half year.
There are 10 × 2 = 20 half-years (i.e. coupon payments) till maturity.
The market price of bond B is:
" #
1 − (1 + 0.0371)−20 100
PB = 4.75 + ≈ $114.50
0.0371 (1 + 0.0371)20

(c) The Macaulay Duration of a bond with fixed cash flows is calculated as:
X PV(Ct )
DM ac = wt · t where wt =
t
P0
The computation of Bond A’s Macaulay Duration is shown in the table below:

t (years) Ct PV(Ct ) wt
0.5 2.125 2.081 0.021
1 2.125 2.037 0.020
1.5 2.125 1.995 0.020
2 102.125 93.887 0.939
P
P0 = 100 wt = 1
P
DM ac = t wt · t ≈ 1.938 years

(d) The approximate change is given by:

∆P ≈ −D∗ · P0 · ∆ytm
where P0 = 100, ∆ytm = 0.0001, and D∗ is Bond A’s Modified Duration, calculated by
discounting its Macaulay Duration by one compounding period:
1.938
D∗ = ≈ 1.898
1 + 0.0425
2
Substituting, we we find:
∆P ≈ −1.898(100)(0.0001) = −$0.01898

11
(e) Since bond prices and yields have a negative relationship, you want to be long at short ma-
turities (Bond A) to take advantage of the fall in yields/increase in price, and possibly long
at long maturities (Bond B), too, given you also expect long rates to fall too.

(f) If we denote the value of the bond portfolio by V , and the number of units of the 2-year
and 10-year bonds by xA and xB , respectively, we want a bond portfolio that’s immunised
against equal changes in the 2- and 10-year yields. Using the duration approximation:
∗ ∗
∆V = xA ∆PA + xB ∆PB ≈ −(xA DA PA + xB DB PB )∆ytm = 0

Therefore, we need to hold quantities of the two bonds in the following ratio:
xA D ∗ PB D∗ PB × 0.0001 0.0762
= − B∗ = − ∗B =− ≈ −4.01
xB DA PA DA PA × ×0.0001 0.01898

If we want to protect ourselves against general movements in yields but profit from steep-
ening – specifically, an increase in the 10-year yield relative to the 2-year yield – we should
go short the 10-year bond (xB < 0) and go long approximately 4 times as many 2-year
bonds (xA > 0).
Intuitively, to immunise your portfolio you need to hold more 2-year bonds than you’re
short 10-year bonds, because the shorter-maturity bond is less sensitive to yield changes.

12
Comments on specific questions

Candidates should answer all THREE questions.

Question 1 [Total: 33 marks]

Consider the following information on two default-risk free U.S. government bonds,
shown in Table 1. Both bonds have a face value of $100 and pay semi-annual coupons.
All interest rates are expressed as semi-annually compounded Annual Percentage
Rates (APRs).
Table 1
Bond Maturity (years) Coupon rate Yield to maturity (YTM)
A 2 5.46% 5.46%
B 10 7.32% 8.84%

(a) Does Bond B sell at a discount, at par, or at a premium to its face value? Ex-
plain without the aid of any calculations. (5 marks)

(b) Determine the market price of Bond B. (5 marks)

(c) Compute the Macaulay Duration of Bond A. Express your answer in years.
(5 marks)

(d) Using the duration approximation, calculate how much the price of Bond A
will change if its yield to maturity decreases by 1 basis point (1 basis point =
0.01%). (5 marks)

(e) You forecast that the yield curve will soon rise at all maturities, but more at
the short-maturity end. Assuming you are unconstrained in your ability to go
long or short in either bond, describe qualitatively how you would invest in the
two bonds today to profit from this scenario, explaining your decision(s) in de-
tail. (5 marks)

(f ) Suppose, instead, that you are confident the yield curve will become steeper
but are relatively unconcerned about the overall level of interest rates. You
want to construct a portfolio of the two bonds that profits from an increase in
the 10-year yield relative to the 2-year yield but is not affected by equal changes
in the yields of both maturities. Given that the approximate price change of
the 10-year bond in response to a 1 basis point increase in its yield is −$0.0612,
what is the ratio of the number of 2-year bonds to 10-year bonds in your port-
folio? Explain. (8 marks)

1
Reading for this question

Subject guide, Chapters 3, 4, and 5

Approaching this question

(a) Bond B’s coupon rate is less than its YTM. Therefore, it sells at a discount.

(b) Bond B pays semi-annual coupons of (0.0732/2) × 100 = $3.66.

The effective semi-annual discount rate is 0.0884/2 = 4.42% per half year.
There are 10 × 2 = 20 half-years (i.e. coupon payments) till maturity.
The market price of bond B is:
" #
1 − (1 + 0.0442)−20 100
PB = 3.66 + ≈ $90.05
0.0442 (1 + 0.0442)20

(c) The Macaulay Duration of a bond with fixed cash flows is calculated as:
X PV(Ct )
DM ac = wt · t where wt =
t
P0
The computation of Bond A’s Macaulay Duration is shown in the table below:

t (years) Ct PV(Ct ) wt
0.5 2.73 2.657 0.027
1 2.73 2.587 0.026
1.5 2.73 2.518 0.025
2 102.73 92.238 0.922
P
P0 = 100 wt = 1
P
DM ac = t wt · t ≈ 1.922 years

(d) The approximate change is given by:

∆P ≈ −D∗ · P0 · ∆ytm
where P0 = 100, ∆ytm = −0.0001, and D∗ is Bond A’s Modified Duration, calculated by
discounting its Macaulay Duration by one compounding period:
1.922
D∗ = ≈ 1.871
1 + 0.0546
2
Substituting, we we find:
∆P ≈ −1.871(100)(−0.0001) = +$0.01871

2
 (e) Since bond prices and yields have a negative relationship, you want to be short at short
maturities (Bond A) to take advantage of the rise in yields/fall in prices, and possibly
short at long maturities (Bond B), too, given you also expect long rates to rise too.

(f) If we denote the value of the bond portfolio by V , and the number of units of the 2-year
and 10-year bonds by xA and xB , respectively, we want a bond portfolio that’s immunised
against equal changes in the 2- and 10-year yields. Using the duration approximation:
∗ ∗
∆V = xA ∆PA + xB ∆PB ≈ −(xA DA PA + xB DB PB )∆ytm = 0

Therefore, we need to hold quantities of the two bonds in the following ratio:
xA D ∗ PB D∗ PB × 0.0001 0.0612
= − B∗ = − B∗ =− ≈ −3.27
xB DA PA DA PA × 0.0001 0.01871
If we want to protect ourselves against general movements in yields but profit from steep-
ening – specifically, an increase in the 10-year yield relative to the 2-year yield – we should
go short the 10-year bond (xB < 0) and go long approximately 3.3 times as many 2-year
bonds (xA > 0).
Intuitively, to immunise your portfolio you need to hold more 2-year bonds than you’re
short 10-year bonds, because the shorter-maturity bond is less sensitive to yield changes.

Question 2 [Total: 34 marks]

Consider a market consisting of only two risky stocks, X and Y. The mean and stan-
dard deviation of the returns of each stock is shown in Table 2. The correlation be-
tween the two stocks’ returns is 0.2.

Table 2
Stock Expected Return Standard Deviation
X 0.25 0.25
Y 0.10 0.20

For parts (a) to (c), assume there is no risk-free asset.

(a) Calculate the mean return and standard deviation of a portfolio that is 20% in-
vested in Stock X and 80% in Stock Y. (4 marks)

(b) Determine the combination of X and Y that has the lowest possible return vari-
ance. What is the expected return and standard deviation of this portfolio?
Does this portfolio lie on the efficient frontier? Explain your answer in detail.
(7 marks)

3
(c) Is Stock X on the efficient frontier? Explain your answer in detail and illustrate
your argument by sketching a graph. (5 marks)

For parts (d) and (e) assume that a risk-free asset exists and the CAPM assump-
tions hold. The risk-free asset’s return is 3%.

(d) It can be shown that the combination of stocks X and Y where an investor holds
$3.72 in Stock X for each $1 held in Stock Y has the highest attainable Sharpe
ratio. If a risk-averse investor wishes to hold a portfolio with a return stan-
dard deviation no higher than 15%, what weights should they place on Stock
X, Stock Y, and the risk-free asset to maximise expected return? (8 marks)

(e) A client approaches you for advice about a new investment project that has the
same CAPM beta as Stock X and a 59-year lifespan. The project is expected
to deliver a cash flow of $50,000 in exactly one year, after which the annual ex-
pected cash flow will grow by $50,000 each year until it peaks at $1.5 million at
the end of year 30. Subsequent annual cash flows are then expected to decrease
by $50,000 each year until the final cash flow of $50,000 is paid at the end of
year 59.
(i) What is the appropriate discount rate for the project’s expected cash flows?
Explain your answer in detail. (2 marks)
(ii) What is the most you would advise your client to pay for this investment
today? Explain your answer in detail. (8 marks)

Reading for this question

Subject guide, Chapters 2, 3, 7, and 8

Approaching this question

(a) Expected return:
E [RP ] = wX E [RX ] + (1 − wX )E [RY ]
= (0.2)(0.25) + (0.8)(0.10)
= 13%
Standardard deviation:
 2 2 1
σP = wX σX + wY2 σY2 + 2wX wY ρX,Y σX σY 2
1
= (0.22 )(0.252 ) + (0.82 )(0.22 ) + 2(0.2)(0.8)(0.2)(0.25)(0.2) 2

1
= [0.0313] 2
≈ 17.69%

4
(b) Start with the expression for the variance of the portfolio of X and Y:

σP2 = wX
2 2
σX + (1 − wX )2 σY2 + 2wX (1 − wX )σX,Y

Differentiating w.r.t. wX , setting the first derivative to zero, and solving for wX yields the
variance-minimising weight in X:
0.01
z }| {
2 2
∗ σ − σX,Y 0.2 − (0.2)(0.25)(0.2)
wX = 2 Y = ≈ 0.3636
σX − 2σX,Y + σY2 0.252 − 2(0.01) + 0.22
so that:
wY∗ = 1 − wX
∗
≈ 0.6364

The expected return of this portfolio – the Global Minimum Variance Portfolio (GMVP) –
is:
∗
E [RGM V P ] = wX E [RX ] + wY∗ E [RY ]
= (0.3636)(0.25) + (0.6364)(0.10)
≈ 15.45%

The standard deviation of the GMVP is:

 ∗ 2 2 1
σGM V P = (wX ) σX + (wY∗ )2 σY2 + 2wX
∗
wY∗ ρX,Y σX σY 2
1
= (0.36362 )(0.252 ) + (0.63642 )(0.22 ) + 2(0.3636)(0.6364)(0.2)(0.25)(0.2) 2

1
= [0.0291] 2
≈ 17.06%

The GMVP is mean-variance efficient. It sits at the vertex of of the portfolio frontier/minimum
variance envelope - there is no other asset with a higher expected return for the same level
of variance/standard deviation.

(c) Since the market comprises only two risky assets, Stocks X and Y must both lie on the
portfolio frontier - no other asset offers the same expected return. Since stock X’s expected
return is higher than the GMVP’s expected return, X must lie on the upper half (i.e. effi-
cient portion) of the portfolio frontier. Therefore, Stock X lies on efficient frontier.

5
 30
Stock X
25 Stock Y

Expected Return
GMVP
20

10

0
0 5 10 15 20 25

Standard deviation

(d) We are told that the ratio of the weights of X to Y in the Tangency Portfolio (TP) satis-
fies:
TP
wX 3.72 TP
TP
= =⇒ wX = 3.72wYT P
wY 1
TP
And since wX + wYT P = 1 (the TP is fully invested in risky assets), we have:
TP 3.72
wX = ≈ 0.7881
1 + 3.72
1
wYT P = ≈ 0.2119
1 + 3.72
The expected return and standard deviation of the TP are:
TP
E [RT P ] = wX E [RX ] + wYT P E [RY ]
= (0.7881)(0.25) + (0.2119)(0.10)
≈ 21.82%

 TP 2 2 1
σT P = (wX ) σX + (wYT P )2 σY2 + 2wXTP TP
wY ρX,Y σX σY 2
1
= (0.78812 )(0.252 ) + (0.21192 )(0.22 ) + 2(0.7881)(0.2119)(0.2)(0.25)(0.2) 2

1
= [0.0440] 2
≈ 20.97%

In the presence of risk-free borrowing and lending, the Capital Allocation Line (CAL) that
passes through the TP describes the efficient frontier. This optimal CAL represents differ-
ent combinations of the risk-free asset and the TP. The weight in the TP, w, required to
produce an efficient portfolio with standard deviation of 15% satisfies:
0.15
w × σT P = 0.15 =⇒ w= ≈ 0.7154
0.2097
6
 Therefore, the weights of X, Y, and the risk-free asset in this portfolio are:
TP
wX = w × wX ≈ 56.39%
wY = w × wYT P ≈ 15.16%
wrf = 1 − w ≈ 28.46%

The expected return of this portfolio is:

 
E [RT P ] − rf
E [RP ] = wE [RT P ] + (1 − w)rf = rf + 0.15 ≈ 16.47%
|{z} σT P
0.03 | {z }
ST P ≈0.8977

(e) (i) Both the project and Stock X have the same level of systematic risk (same CAPM
beta), hence in a CAPM world, should have the same required return, 25%.
(ii) The most the client should be willing to pay is the present value of expected cash
flows (discounted at 25%), which translates into an NPV of zero.
The expected cash flows of the project can be replicated as a portfolio of ordinary
annuities:
• 30-year annuity paying $50,000 per year from t = 1 to t = 30
• 30-year annuity paying $50,000 per year from t = 2 to t = 31
• 30-year annuity paying $50,000 per year from t = 3 to t = 32
• ...
• 30-year annuity paying $50,000 per year from t = 30 to t = 59
Let a 30 denotes the present value of a 30-year ordinary annuity paying $1 per year:
"
1

30 #
1 − 1+0.25
a 30 = ≈ 3.995
0.25
Then, the present value of the investment is:
   29
1 1
P V = 50, 000 · a 30 + 50, 000 · a 30 + · · · + 50, 000 · a 30
1 + 0.25 1 + 0.25
 
1 1 1
= 50, 000 · a 30 1 + + + ··· +
1 + 0.25 (1 + 0.25)2 (1 + 0.25)29
 
1 1 1
= 50, 000 · a 30 (1 + 0.25) + + ··· +
1 + 0.25 (1 + 0.25)2 (1 + 0.25)30
| {z }
a 30

2
= 50, 000 (1 + 0.25) a 30
≈ $997, 525.65

7
Question 3 [Total: 33 marks]

Table 3 provides information on the premiums (i.e. market prices) of some call and
put options currently trading in the market. All the options are European, expire
in exactly one year, and are written on the same underlying stock that is not ex-
pected to pay any dividends over the coming year.
Table 3
Type Strike Price Premium
Put $90 $4.024
Call $90 $17.553
Put $100 $7.916
Call $100 $11.837
Put $110 $13.322
Call $110 $7.635

(a) Explain why the premiums on put options in Table 3 increase as the strike price
increases. (5 marks)

(b) An options strategy involves taking the following four positions: long one put
with a strike price of $90, short one call and one put, both with a strike price of
$100, and long one call with a strike price of $110.

(i) Draw the payoff diagram (not a profit-and-loss diagram) for this strategy.
Make sure to label all relevant features of the diagram. (7 marks)
(ii) How much does it cost today to create this strategy? Draw its profit-and-
loss diagram, making sure to label all relevant features of the diagram.
(5 marks)

(c) How can you replicate the payoff of the strategy in part (b) using only put op-
tions and risk-free bonds? Make sure to specify all relevant details of the con-
stituent positions. (6 marks)

(d) Determine the continuously compounded annual risk-free interest rate in this
economy, as implied by your answers to parts (b) and (c). (5 marks)

(e) Assuming the continuously compounded annual risk-free interest rate in the
market is equal to what you calculated in part (d), determine the implied cur-
rent price of the underlying stock. If the actual market price of the stock is
$102, is there an arbitrage opportunity? If yes, detail an arbitrage strategy that
you could implement to exploit the mispricing. (5 marks)

8
Reading for this question

Subject guide, Chapters 4 and 11

Approaching this question

(a) The value of a put is increasing in its exercise price because, all else equal:

• The payoff/intrinsic value of a put with a higher strike price is always ≥ the payoff on
a put with a lower strike price.
• The higher the strike price, the higher the probability that the put will expire in the
money

(b) (i) The payoff diagram of the options strategy, known as an Iron Butterfly, is shown be-
low (for the range of underlying stock prices 80 ≤ ST ≤ 120):
Payoff ($)
20
Long put @ 90
15 Short call @ 100
Short put @ 100
10 Long call @ 110
Iron Butterfly
5

0
−5

−10

−15

−20 ST
80 90 100 110 120

(ii) Using the information in Table 3, we know that the net cash flow today from setting
up the Iron Butterfly is:

CF0 = 7.916 + 11.837 − 4.024 − 7.635 = $8.094

The net cash flow is positive, which means we receive $8.094 today (i.e. the strategy
has a negative cost = −$8.094). The profit at maturity is therefore approximately
= Payoff + $8.094. So, shift the payoff diagram up by $8.094.

9
 $
20
Payoff
Profit

10
8.09

0
−1.91

−10

−20 ST
80 90 100 110 120

Aside: strictly speaking, the profit at maturity is = Payoff + $8.094er where $3.877er
is the future value (at maturity) of the $8.094 we obtained today, shown here using
continuous compounding because r is defined later in the question as a continuously
compounded rate.

(c) Note that the Iron Butterfly payoff diagram resembles a (long) Butterfly Spread shifted
down by $10. Therefore, to replicate the Iron Butterfly payoff, we can proceed as follows:

• Long 1 put with strike price $90

• Long 1 put with strike price $110
• Short 2 puts with strike price $100
• Short a risk-free bond with face value of $10 (i.e. borrow the PV of $10)

The put option positions above combine to create a Butterfly spread, while the risk-free
borrowing then shifts the payoff of the Butterfly Spread down by $10.

Payoff ($)
20
Long put @ 90
2 Short puts @ 100
10 Long put @ 110
Borrow PV(10)
Iron Butterfly
0

−10

−20 ST
80 90 100 110 120

10
 All diagonal lines above have a slope of +1 or −1, except for the line corresponding to the
payoff of the 2 short puts, which has a slope of 2 × 1 = 2.

(d) We know that the same Iron Butterfly can be constructed using the method in (b) or (c).
We also know from part (b-ii) that the net cash flow today from implementing the method
in (b) is $8.094. Therefore, by no-arbitrage, this must also be the net cash flow today from
the method in (c):

8.094 = −4.024 + 2 × 7.916 − 13.322 + 10e−r

Solving for r:
 
9.608
r = − ln ≈ 4%
10

(e) From the put-call parity relationship for a non-dividend paying underlying asset, we know
that:
S0 = c0 + PV(X) − p0
where the European call and put are written on the same underlying, have the same strike
price (X) and maturity. Using the put and call options with strike price X = $90 (for
example):
S0 = 17.553 + 90e−0.04 − 4.024 = $100.001 ≈ $100

If the actual market price of the stock is $102, then put-call parity is violated – the stock
is relatively overpriced, its replicating portfolio relatively underpriced. Arbitrage strategy:

• Short the stock @ $102

• Buy a call with strike price X
• Short a put with strike prioce X
• Buy a 1-year risk-free zero-coupon bond with face value X (i.e. lend the PV of X)

This strategy yields an arbitrage profit today of $2 and zero net-payoffs in the future in all
states.

11