CIC2004 Investment Management

Extra practice/revision questions and answer to calculation questions from mid-

term test

Topics: Short sell, margin call calculation

1) An investor buys $8,000 worth of a stock priced at $40 per share using 50% initial margin.
The broker charges 6% on the margin loan and requires a 30% maintenance margin. In 1 year
the investor has interest payable and gets a margin call. At the time of the margin call the
stock's price must have been less than __________.

Answer:
At the time of purchases:
Stock $ 8,000 Loan 4,000
Equity 4,000
Total Assets $ 8,000 TL + E 8,000

After one year:

Stock 200 × P Loan $ 4,000
Interest $ 240
payable
Equity 200 × P−4,000−240
Total Assets 200 × P TL + E 200 × P

Margin Call when stock price drops below $30.29.

2) You purchased 200 shares of ABC common stock on margin at $50 per share. Assume the
initial margin is 50% and the maintenance margin is 30%. You will get a margin call if the
stock drops below __________. (Assume the stock pays no dividends, and ignore interest on
the margin loan.)

Solve for P:
P = $35.71
3) You invest $1,000 in a complete portfolio. The complete portfolio is composed of a risky
asset with an expected rate of return of 16% and a standard deviation of 20% and a Treasury
bill with a rate of return of 6%. __________ of your complete portfolio should be invested in
the risky portfolio if you want your complete portfolio to have a standard deviation of 9%.

Answer:

4) You have $500,000 available to invest. The risk-free rate, as well as your borrowing rate, is
8%. The return on the risky portfolio is 16%. If you wish to earn a 22% return, you should
__________.
A) borrow $125,000
B) invest $125,000 in the risk-free asset
C) invest $375,000 in the risk-free asset
D) borrow $375,000
Answer:

Invest 1.75 × $500,000 = $875,000 in the risky asset by borrowing $375,000 at the risk-free
rate.

5) An investor buys $16,000 worth of a stock priced at $20 per share using 60% initial margin.
The broker charges 8% on the margin loan and requires a 35% maintenance margin. The
stock pays a $.50-per-share dividend in 1 year, and then the stock is sold at $23 per share.
What was the investor's rate of return?

Value of stock in 1 year: ($23 ÷ $20) × $16,000 = $ 18,400

Dividends received ($16,000 ÷ 20) × $0.50 = $ 400

Interest due (1 − 60%) × $16,000 × $ (512)

0.08 =
Loan payoff (1 − 60%) × $16,000 = $ (6,400)
Ending account balance $ 11,888
6) You sell short 300 shares of Microsoft that are currently selling at $30 per share. You post the
50% margin required on the short sale. If you earn no interest on the funds in your margin
account, what will be your rate of return after 1 year if Microsoft is selling at $27? (Ignore
any dividends.)

7) You sell short 200 shares of Doggie Treats Incorporated that are currently selling at $25 per
share. You post the 50% margin required on the short sale. If your broker requires a 30%
maintenance margin, at what stock price will you get a margin call? (You earn no interest on
the funds in your margin account, and the firm does not pay any dividends.)

Account at the time of the short sale:

Cash from SS $ 5,000.00 Liability $ 5,000.00
Cash for Equity $ 2,500.00 Equity $ 2,500.00
Total Assets $ 7,500.00 TL+E $ 7,500.00
Account as prices change:
Cash from SS $ 5,000.00 Liability $ 200P
Cash for Equity $ 2,500.00 Equity $ 7,500−200P
Total Assets $ 7,500.00 TL+E $ 7,500.00

Margin Call when stock price drops below $28.85

Topics: Equity Valuation, CAPM, Multi-factor model, Arbitrage strategy

8) Caribou Gold Mining Corporation is expected to pay a dividend of $4 in the upcoming year.
Dividends are expected to decline at the rate of 3% per year. The risk-free rate of return is
5%, and the expected return on the market portfolio is 13%. The stock of Caribou Gold
Mining Corporation has a beta of 0.5. Using the CAPM, the return you should require on the
stock is __________.

Ans:
9) Interior Airline is expected to pay a dividend of $3 in the upcoming year. Dividends are
expected to grow at the rate of 10% per year. The risk-free rate of return is 4%, and the
expected return on the market portfolio is 13%. The stock of Interior Airline has a beta of 1.4.
Using the constant-growth DDM, the intrinsic value of the stock is __________.

10) Transportation stocks currently provide an expected rate of return of 15%. TTT, a large
transportation company, will pay a year-end dividend of $3 per share. If the stock is selling at
$60 per share, what must be the market's expectation of the constant-growth rate of TTT
dividends?

11) The two-factor model on a stock provides a risk premium for exposure to market risk of 9%,
a risk premium for exposure to interest rate risk of −1.3%, and a risk-free rate of 3.5%. The
beta for exposure to market risk is 1, and the beta for exposure to interest rate risk is also 1.
What is the expected return on the stock?

= 0.035 + 1 × (−0.013) + 1 × 0.09 = 0.112 = 11.2%

12) Given the following relationships for three stocks (D, E, and F) and two common risk factors
(x1 and x2). Assume x1 = 6% and x2= 3% , calculate the expected prices of each stock for the
next year. Assume that all three stocks currently sell for $40 and will not pay a dividend in
the next year.
E(RD)=0.5 x1 + 0.7x2
E(RE)=0.2 x1 + 0.5x2
E(RF)=1.3 x1 + 1.0 x2

Answer:

Stock D: E(RD)=0.5(0.06) + 0.7(0.03) = 0.051 = 5.1%

Expected Price = 40 x (1 + 0.051) = $42.04

Stock E: E(RE)=0.2(0.06) + 0.5(0.03) = 0.027 = 2.7%

Expected Price = 40 x (1 + 0.027) = $41.08

Stock F: E(RF)=1.3(0.06) + 1.0(0.03) = 0.108 = 10.8%

Expected Price = 40 x (1 + 0.108) = $44.32
13) Suppose that you know that next year the prices for Stocks X, Y, and Z will actually be
$40.00, $29.75, and $31.00 respectively. All stocks currently sell for $30 each. The expected
prices are as follows:

E(RX)=(0.6)z1 + (0.5)z2
E(RY)=(0.4)z1 + (0.3)z2
E(RZ)=(1.0)z1+(0.9)z2

Where z1=5% and z2=3%

You may assume that you can use the proceeds from any necessary short sale.

a) Create a riskless arbitrage investment strategy to take advantage of these mispriced

securities.
b) Calculate the net investment and the net risk exposure of the arbitrage strategy.

Answer:

Step 1: Calculate expected returns and expected prices

Expected prices:
Stock X: $30 x 1.045 = $31.35
Stock Y: $30 x 1.029 = $30.87
Stock Z: $30 x 1.077 = $32.31

Step 2: Identify the mispricing of the stocks

• Stock X: Expected Price = $31.35, Actual Price = $40.00

• Stock Y: Expected Price = $30.87, Actual Price = $29.75
• Stock Z: Expected Price = $32.31, Actual Price = $31.00

Mispricing Analysis:

• Stock X is overpriced at $40.00 (expected price is $31.35).

• Stock Y is underpriced at $29.75 (expected price is $30.87).
• Stock Z is underpriced at $31.00 (expected price is $32.31).
 Step 3: Create the arbitrage strategy

To take advantage of the mispricing, we will:

• Short Stock X (because it is overpriced).

• Buy Stock Y and Buy Stock Z (because they are underpriced).

Step 4: Calculate the Net Investment

• Net Investment for Stock X (Short Position): You are shorting Stock X at $40.00.
Therefore, you receive $40.00 for selling it.
• Net Investment for Stock Y (Long Position): You are buying Stock Y at $29.75. So, you
invest $29.75 in Stock Y.
• Net Investment for Stock Z (Long Position): You are buying Stock Z at $31.00. So, you
invest $31.00 in Stock Z.

Net Investment = Proceeds from short sale of Stock X − (Investment in Stock Y + Investment in Stock Z)

Net Investment = 40.00 − (29.75+31.00) = 40.00 − 60.75= −$20.75

So, the net investment is -$20.75, meaning you receive $20.75 upfront.

Step 5: Calculate the Profit at the End of the Year

At the end of the year, we expect the stock prices to converge to the expected values.
Here's how your positions will perform:

1. Short Stock X:
o You sold Stock X at $40.00 and will buy it back at $31.35 (expected price).
o Profit from short sale = $40.00 - $31.35 = $8.50.
2. Long Stock Y:
o You bought Stock Y at $29.75 and will sell it at $30.87 (expected price).
o Profit from Stock Y = $30.87 - $29.75 = $1.12.
3. Long Stock Z:
o You bought Stock Z at $31.00 and will sell it at $32.31 (expected price).
o Profit from Stock Z = $32.31 - $31.00 = $1.31.

Total Profit = $8.50 + $1.12 + $1.31 = $10.93

Topics: Bond duration

14) A bond currently sells for $1,050, which gives it a yield to maturity of 6%. Suppose that if
the yield increases by 25 basis points, the price of the bond falls to $1,025. What is the
modified duration of this bond?

Answer:

Change in Price = – (Modified Duration ´ Change in YTM) ´ Price

D
= − 1+ y ´ Δy ´ P

Given the current bond price is $1,050, yield to maturity is 6%, and the increase in YTM
and new price, we can calculate D:

D
$1,025 – $1,050 = – ´ 0.0025 ´ $1,050 Þ D = 10.0952
1+ 0.06

D 10.0952
Modified Duration = D* = = = 9.5238
1+ y 1.06
15) A nine-year bond paying coupons annually has a yield of 10% and a duration of 7.194 years.
If a bond’s yield changes by 50 basis points, what is the percentage change in the bond’s
price?
Answer:

The percentage change in the bond price is:

DP Dy 0.0050
= – DuraCon ´ = -7.194 ´ = -0.0327 or a 3.27% decline
P 1+ y 1.10

16) You are managing a portfolio of $2 million. Your target duration is 12 years, and you can
choose from two bonds:

1. A zero-coupon bond with a maturity of 7 years and a yield of 6%.

2. A perpetuity (a bond that pays a fixed annual payment forever) with a yield of 6%.

Calculate the weightage of the zero-coupon bond and the perpetuity that you will hold in your
portfolio in order to achieve your target duration of 12 years.

Answer:

For a zero-coupon bond, its duration is equal to its maturity. Since the maturity of this bond is 7
years, the duration of the zero-coupon bond is 7 years.
The formula for the duration of a perpetuity is:

So, the duration of the perpetuity is 17.67 years.

The portfolio duration is a weighted average of the durations of the two bonds:

Solve for w1, w1 = 0.532

So, the weight of the zero-coupon bond is approximately 0.532 or 53.2%.

w2, weight of the perpetuity:

w2 = 1− w1 = 1−0.532 = 0.468

So, the weight of the perpetuity is approximately 0.468 or 46.8%.

To achieve a portfolio duration of 12 years, we will hold:

• 53.2% in the zero-coupon bond (7 years maturity).

• 46.8% in the perpetuity (6% yield).

This allocation will give the target duration of 12 years.

Topics: Portfolio performance

17) Consider the following historical performance data for two different portfolios, the Standard
and Poor’s 500, and the 90-day T-bill.

a. Calculate the Fama overall performance measure for both funds.

b. What is the return to risk for both funds?
c. For both funds, compute the measures of (1) selectivity, (2) diversification, and (3) net
selectivity.
d. Explain the meaning of the net selectivity measure and how it helps you evaluate investor
performance. Which fund had the best performance?
2
R = the manager’s level of diversification, =1 (completely diversified), <1.0 (Incomplete
diversification)

(a) Overall Performance= Excess Return (ER)= Rp - Rf

OP of Fund 1 (Excess Return for fund 1) = 26.4% - 6.2% = 20.2%

OP of Fund 2, (Excess Return for fund 2) = 13.22% - 6.2% = 7.02%

(b) Return from Risk = β (Rm – Rf)

Return from risk for Fund 1 = 1.351 (15.71 – 6.2) = 12.85%

Return from risk for Fund 2 = 0.905 (15.71 – 6.2) = 8.61%

(c)

(1) Gross Selectivity return (Investment skill) = Excess Return – Return from risk

SelectivityFund 1 = 20.2% - 12.85% = 7.35%

SelectivityFund 2 = 7.02% - 8.61% = -1.59%

(2) To measure diversification:

Diversification = RRR – E(R),

where RRR = Rf + RTR (Rm – Rf) and

Ratio of total risk, RTR = σ1/ σm [i.e. standard deviation of portfolio / standard deviation of
market]

RTRFund1 = 20.67/13.25 = 1.56

RTRFund2 = 14.20/13.25 = 1.07

Return from total risk, RRR = Rf + RTR (Rm – Rf)

RRRFund1 = 6.2% + 1.56 (15.71 – 6.2) = 21.04%

RRRFund2 = 6.2% + 1.07 (15.71 – 6.2)= 16.38%

Return to Systematic risk, E(R) = 6.2% + 1.351 (15.71 – 6.2) = 19.05% (CAPM)

Return to Systematic risk, E(R) = 6.2% + 0.905 (15.71 – 6.2) = 14.81% (CAPM)

Therefore, Diversification = RRR – [E(R)]

DiversificationFund 1 = 21.04% - 19.05% = 1.99%

DiversificationFund 2 = 16.38% - 14.81% = 1.57%

(3) Net Selectivity = Selectivity return – Diversification

Net Selectivity Fund 1 = Selectivity return – Diversification

= 7.35% - 1.99% = 5.36%

Net Selectivity Fund 2 = -1.59% - 1.57% = -3.16%

(d) Net selectivity is the selectivity skill of a manager, meaning how much of the risk premium
comes from ability to select stock.

Although not fully diversified - Fund 1’s performance outperformed Fund 2.