THE AUSTRALIAN NATIONAL UNIVERSITY
SCHOOL OF FINANCE AND APPLIED STATISTICS
Final Examination
FOUNDATIONS OF FINANCE
Study period: 15 minutes
Writing period: 180 minutes
Permitted materials:
Calculator - non-programmable
INSTRUCTIONS:
1. This exam paper comprises a total of 4 pages. Please ensure your paper has the
correct number of pages.
2. The exam includes a total of 6 questions. The questions are of unequal value, with
marks indicated for each question. You must attempt to answer all questions.
3. Do not round calculations until providing your final answer to each question.
Final answers should be rounded to 2 decimal places.
4. Include all workings for each question, as marks will not be awarded for answers
that do not include workings.
5. Ensure you include both your name and student number on your answer book.
6.
Total Marks = 60
The exam counts towards 60% of your grade for the course
Page 2 of 12
Question 1 (6 marks)
Answer BOTH parts of this question:
a) You have just purchased a newly issued 90-day bank-accepted bill with a face
value of $100,000. Given you paid exactly $99,000 for the bill, what was your
annual nominal required rate of return on debt? (3 marks)
b) An oil drilling company’s resources are being depleted and known reserves are
becoming more scarce. As a result, the company’s earnings and dividends are
declining at a rate of 8% each year. If the company just paid a dividend of $5
per share and the required rate of return on equity is 15% per annum, what is
the theoretical price for one share in the company? (3 marks)
Question 2 (9 marks)
After speaking with your friend Tom, who has considerable finance expertise, you
have decided that you want to restructure your share portfolio. At present, you hold a
portfolio worth $40,000 that consists only of ABC shares. The expected return and
standard deviation of these shares are 7% p.a. and 23% p.a. respectively. Tom has
suggested that you should sell your ABC shares, invest some fraction of these funds in
BCD shares and the rest in CDE shares. He claims that a portfolio can be constructed
that has the same expected return as your investment in ABC, but with significantly
less risk. The expected return and standard deviation of BCD shares are 8% p.a. and
18%p.a. respectively. The expected return and standard deviation of CDE shares are
4% p.a. and 3 %p.a. respectively. Given this information and the fact that the
correlation of returns on BCD and CDE shares is 0.55, answer the following
questions:
a) What weights would you need to hold of BCD shares and CDE shares in order
to obtain an expected return equal to that on your portfolio of ABC shares?
(3 marks)
b) What is the standard deviation of a portfolio comprising BCD and CDE shares
in the weights calculated in a). (3 marks)
c) Calculate the minimum variance portfolio weights for a portfolio comprising
stocks BCD and CDE. (3 marks)
Page 3 of 12
Question 3 (8 marks)
You work as an investment advisor for a manufacturing firm. Your boss has just
provided you with details of an investment opportunity available to the company, and
has asked to you evaluate it. Details of the investment’s cash flows are tabulated
below:
Year 0 1 2 3 4 5
E[Cash Flow] -$80,000 $20,000 $20,000 $20,000 $20,000 $30,000
In addition to cash flow information, you have also been provided with the details
below.
The investment opportunity available to the firm is in a different industry to
the firm’s normal operations;
The industry in which the investment opportunity is available is considered
40% less risky than the firm’s industry;
The firm’s beta is 1;
The risk-free rate is 5% p.a; and,
The expected return on the market is 10% p.a.
Given this information, should your firm undertake the investment? What is your
reasoning behind making your recommendation?
Question 4 (9 marks)
Question
Answer ALL parts of this question:
a) You observe that the ASX 200 Index is at a level of 2,900 and that the SPI
futures contract expiring exactly 3 months from today is at a level of 2,915.
Given that the riskless rate of interest is 6.5% p.a., what is the implied dividend
yield on the ASX 200 stock portfolio if no costless arbitrage opportunities exist
in the marketplace? (3 marks)
b) Calculate the theoretical price of a wheat futures contract with 6 months to
expiry given the spot price of wheat is 600 cents per bushel and the risk free
rate and cost of carry are 6% p.a. and 4% p.a. respectively. (3 marks)
c) What are the key differences between forward contracts and futures contracts?
(3 marks)
Page 4 of 12
Question 5 (12 marks)
Answer ALL parts of this question:
a) What are the differences between an American call option and a European put
option? (3 marks)
b) Suppose that European call and put options on Coca-Cola Amatil with exercise
prices of $10.00 and six months to maturity are selling for $1.25 and $0.75
respectively, that the Coca Cola Amatil stock price is $10 and the riskless rate
of interest is 8% p.a. Does the put-call parity hold in this instance? Indicate
what strategy you would implement in taking advantage of any arbitrage
opportunity and the profit you would earn from your strategy (Note: You are
NOT required to provide a table outlining the initial and terminal values of
your strategy) (5 marks)
c) It is February 23 and you own one contract (over 100 shares) of May-$2.25
Qantas call options. The current Qantas share price is $2.55 and the options
are selling for $0.35. You have now decided to cash out of the position. How
much is your total payoff if you exercise the option? How much will you
receive in total if you sell to close? (4 marks)
Question 6 (16 marks)
Question
Your firm makes a sale to a Japanese customer. The sale price is 100 million Yen
payable on 28 February next year. The forward rate for the end of February is 100
(i.e. 1 Australian Dollar is worth 100 Japanese Yen). Given this information, answer
BOTH the following questions:
a) How can the firm lock in the Australian $1 million sale price? (8 marks)
b) How can the firm take advantage of any decreases in the exchange rate and
also ensure that it receives at least Australian $1 million? (8 marks)
Your answer to both questions should indicate the position you would take as well as
illustrate what will happen if, in February, the Japanese Yen / Australian Dollar
exchange rate turns out to be 150 or 50.
(End of Examination)
Page 5 of 12
SOLUTIONS TO FINAL EXAM QUESTIONS
Question 1 (6 marks)
a) You have just purchased a newly issued 90-day bank-accepted bill with a face
value of $100,000. Given you paid exactly $99,000 for the bill, what was your
annual nominal required rate of return on debt? (3 marks)
We use the pricing formula for a bank accepted bill to calculate the annual
nominal required rate of return:
Solution
b) An oil drilling company’s resources are being depleted and known reserves are
becoming more scarce. As a result, the company’s earnings and dividends are
declining at a rate of 8% each year. If the company just paid a dividend of $5
per share and the required rate of return on equity is 15% per annum, what is
the theoretical price for one share in the company? (3 marks)
Solution
We use the dividend discount model with constant growth to calculate the
theoretical price for one share in the company:
Page 6 of 12
Question 2 (9 marks)
After speaking with your friend Tom, who has considerable finance expertise, you
have decided that you want to restructure your share portfolio. At present, you hold a
portfolio worth $40,000 that consists only of ABC shares. The expected return and
standard deviation of these shares are 7% p.a. and 23% p.a. respectively. Tom has
suggested that you should sell your ABC shares, invest some fraction of these funds in
BCD shares and the rest in CDE shares. He claims that a portfolio can be
constructed that has the same expected return as your investment in ABC, but with
significantly less risk. The expected return and standard deviation of BCD shares are
8% p.a. and 18%p.a. respectively. The expected return and standard deviation of
CDE shares are 4% p.a. and 3 %p.a. respectively. Given this information and the fact
that the correlation of returns on BCD and CDE shares is 0.55, answer the following
questions:
a) What weights would you need to hold of BCD shares and CDE shares in order
to obtain an expected return equal to that on your portfolio of ABC shares?
(3 marks)
Solution
b) What is the standard deviation of a portfolio comprising BCD and CDE shares
in the weights calculated in a). (3 marks)
Solution
Page 7 of 12
c) Calculate the minimum variance portfolio weights for a portfolio comprising
stocks BCD and CDE. (3 marks)
Solution
Question 3 (8 marks)
You work as an investment advisor for a manufacturing firm. Your boss has just
provided you with details of an investment opportunity available to the company, and
has asked to you evaluate it. Details of the investment’s cash flows are tabulated
below:
Year 0 1 2 3 4 5
E[Cash Flow] -$80,000 $20,000 $20,000 $20,000 $20,000 $30,000
In addition to cash flow information, you have also been provided with the details
below.
The investment opportunity available to the firm is in a different industry to
the firm’s normal operations;
The industry in which the investment opportunity is available is considered
40% less risky than the firm’s industry;
The firm’s beta is 1;
The risk-free rate is 5% p.a; and,
The expected return on the market is 10% p.a.
Given this information, should your firm undertake the investment? What is your
reasoning behind making your recommendation?
Solution
Firstly, the beta of the project is equal to 0.6 x 1 = 0.60. Now, using the CAPM, we
can calculate a required rate of return for the NPV evaluation:
Page 8 of 12
Now, using this required rate of return, we can calculate the NPV of the project as:
As the project’s NPV is positive, we accept it as it provides us with a rate of return
greater than we require.
Question 4 (9 marks)
a) You observe that the ASX 200 Index is at a level of 2,900 and that the SPI
futures contract expiring exactly 3 months from today is at a level of 2,915.
Given that the riskless rate of interest is 6.5% p.a., what is the implied dividend
yield on the ASX 200 stock portfolio if no costless arbitrage opportunities exist
in the marketplace? (3 marks)
Solution
Using the cost of carry model:
b) Calculate the theoretical price of a wheat futures contract with 6 months to
expiry given the spot price of wheat is 600 cents per bushel and the risk free
rate and cost of carry are 6% p.a. and 4%p.a. respectively. (3 marks)
Solution
Page 9 of 12
c) What are the key differences between forward contracts and futures contracts?
(3 marks)
Solution
The key differences between forwards and futures are:
1. Forwards are tailor made contracts whereas futures are standardised
with respect to asset type, contract size and expiry date;
2. Forwards are traded over the counter whereas futures contracts are
exchange traded; and,
3. Futures are subject to marking to market whereas forwards are not.
Question 5 (12 marks)
a) What are the differences between an American call option and a European put
option? (3 marks)
Solution
An American call option gives the holder the right, exercisable any time over
the life of the option, to buy a pre-specified amount of a specific asset at the
agreed strike price. Conversely, a European put option gives the holder the
right, exercisable only at the option’s expiry date, to sell a pre-specified
amount of a specific asset at the agreed strike price.
b) Suppose that European call and put options on Coca-Cola Amatil with
exercise prices of $10.00 and six months to maturity are selling for $1.25 and
$0.75 respectively, that the Coca Cola Amatil stock price is $10 and the
riskless rate of interest is 8% p.a. Does the put-call parity hold in this
instance? Indicate what strategy you would implement in taking advantage of
any arbitrage opportunity and the profit you would earn from your strategy
(Note: You are NOT required to provide a table outlining the initial and
terminal values of your strategy) (5 marks)
Solution
Substituting the information given into the question into the put-call parity
equation, we can see that the parity does not hold:
$1.25 ≠ $0.75 + $10.00 - $10.00(1.08)-0.5
$1.25 ≠ $1.13
Given this, we know an arbitrage opportunity exists. We can take advantage of
this opportunity by buying the relatively underpriced asset/s and
simultaneously selling the relatively overpriced asset/s. In this instance, this
would involve:
1. Selling the call;
2. Buying the put;
3. Buying the asset; and,
4. Borrowing the present value of the strike price.
Page 10 of 12
c) It is February 23 and you own one contract (over 100 shares) of May-$2.25
Qantas call options. The current Qantas share price is $2.55 and the options
are selling for $0.35. You have now decided to cash out of the position. How
much is your total payoff if you exercise the option? How much will you
receive in total if you sell to close? (4 marks)
Solution
If you exercise the option, your payoff is 100*($2.55-$2.25)=$30. Conversely,
if you sell to close, you receive 100*$0.35 = $35.
Question 6 (16 marks)
Your firm makes a sale to a Japanese customer. The sale price is 100 million Yen
payable on 28 February next year. The forward rate for the end of February is 100 (ie
1 Australian Dollar is worth 100 Japanese Yen). Given this information, answer
BOTH the following questions:
a) How can the firm lock in the Australian $1 million sale price? (8 marks)
Solution
They can achieve this by entering a forward contract to sell the Japanese Yen at
100 (ie to get AUD $1 for every Yen). Then:
1. If the exchange rate turns out to be 150, the yen is worth
100million*(1/150) or AUD $0.67 million in the spot market. However
in the forward market they receive a profit on the forward contract of
100million*(1/100 – 1/150) = AUD$0.33 million. In total, they will
therefore receive AUD $1 million ($0.67 million + $0.33 million).
2. If the exchange rate turns out to be 50, the yen is worth
100million*(1/50) or AUD $2.0 million. However in the forward
market they receive a loss on the forward contract of 100million*(1/100
– 1/50) = AUD$1.0 million. In total, they will therefore receive AUD
$1 million ($2 million - $1 million).
b) How can the firm take advantage of any decreases in the exchange rate and
also ensure that it receives at least Australian $1 million? (8 marks)
Solution
They can achieve this by entering into a long position in Yen put options and
therefore have the sell the yen at 100. Then:
1. If the exchange rate turns out to be 150, the yen is worth
100million*(1/150) or AUD $0.67 million in the spot market.
However in the options market they would exercise the long put
position, therefore receiving a payoff of 100million*(1/100 – 1/150) =
AUD$0.33 million. In total, they will therefore receive AUD $1
million ($0.67 million + $0.33 million).
Page 11 of 12
2. If the exchange rate turns out to be 50, the yen is worth
100million*(1/50) or AUD $2.0 million. They will NOT exercise the
option, as it would lead to a negative payoff. Therefore in total they
would receive AUD $2million.
(End of Examination)
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