Mock Exam

FM300
Corporate Finance, Investments, and Financial Markets

Suitable for all candidates

Instructions to candidates Time allowed: 3 hours This paper consists of two sections containing three questions each. Answer EXACTLY TWO questions from section I, and EXACTLY TWO questions from section II. All questions will be given equal weight (25%).

You may also use:

Electronic calculator (as prescribed in the examinations regulations).

Section A
1. (a) (5 marks) An investor who puts $10,000 in T-bills and $20,000 in the market portfolio will have a beta of 2.0. Is this statement true or false? Explain. (b) (8 marks) Assume that: the market portfolio is a 60-40 combination of stocks and bonds; the standard deviations of the returns on stocks and bonds are 20% and 10%; the correlation between the returns on stocks and bonds is 0.25; the Sharpe ratio of the market portfolio is 0.40. Under the CAPM, what are the expected returns on stocks and bonds, in excess of the risk-free rate? (c) (6 marks) Investors expect the market return in the coming year to be 12%. The Treasury bill rate is 4%. Procter & Gambles (PG) stock has a beta of 0.50. The market value of its outstanding equity is $100 million. Calculate your estimate of the expected return on PG stock. If the market return in the coming year actually turns out to be 10%, what is your best guess of the return that will be earned by PG stock? Suppose now that PG wins a major lawsuit during the year. The settlement is $5 million. PGs stock return during the year is 10%. Assume that the magnitude of the settlement is the only unexpected firm-specific news during the year. What is your estimate of the settlement that the market previously expected PG to receive from the lawsuit? Continue to assume that the market return in the year is 10%. Carefully explain your reasoning in the framework of the market efficiency tests based on event studies. (d) (6 marks) The following table represents the main result of the paper The interaction of value and momentum strategies by C. Asness, Financial Analyst Journal, 1997. It reports monthly percentage returns of 25 portfolios, sorted on 5 Book-to-Market groups (from low B/M to high B/M) and 5 past returns groups (from losers to winners). All t-statistics (not reported in this table) are greater than 2. Is there evidence of an interaction between momentum and value strategies? Can higher profits be obtained by taking both past returns and B/M into account? Explain. Low B/M 1 - loser 2 3 4 5 - winner Return of winner-loser 0.03 0.61 0.52 0.99 1.50 1.47 2 0.49 0.59 0.93 0.97 1.44 0.95 3 0.80 0.90 0.80 1.17 1.49 0.69 4 0.83 1.25 1.19 1.45 1.60 0.76 High B/M 1 1.35 1.44 1.68 1.62 0.62 Return of high-low BM 0.97 0.74 0.92 0.69 0.13

2. (a) (i) (6 marks) What is momentum? Describe in detail how momentum strategies are implemented. Why can momentum portfolios be called hedge portfolios? (ii) (6 marks) Discuss one rational explanation and one behavioral explanation for the profitability of momentum strategies. (b) (5 marks) Consider the following two excess return index-model regression results for stocks A and B. The risk-free rate over the period was 6%, and the markets average return was 14%. Performance is measured using an index model regression on excess returns. Stock A Stock B Index Model Regression Estimates 1% + 1.2(rM-rf) 2% + 0.8(rM-rf) Residual Standard Deviation 10.3% 19.1% Standard Deviation of Excess Return 21.6% 24.9% For each stock, calculate Jensens alpha, the appraisal ratio, the Sharpe measure, and the Treynor measure. Discuss which stock is the best choice under the following circumstances: This is the only risky asset to be held by the investor. This stock will be mixed with the rest of the investors portfolio, currently composed solely of holdings in the market index fund. This is one of many stocks that the investor is analyzing to form an actively managed stock portfolio. (c) (8 marks) A global equity manager is assigned to select stocks from a universe of large stocks throughout the world. The manager will be evaluated by comparing his returns to the return of the MSCI World Market Portfolio, but he is free to hold stocks from various countries in whatever proportions he finds desirable. Results for a given month are contained in the following table: Country U.K. Japan U.S. Germany Weight in MSCI index 0.15 0.30 0.45 0.10 Managers Weight 0.30 0.10 0.40 0.20 Managers return in country x 20% 15% 10% 5% Return of index for country x 12% 15% 14% 12%

Calculate the total value added of all the managers decisions this period, and distinguish between the value added by the managers country allocation decisions and the value added by the managers stock selection ability within countries. Explain why it is important to distinguish between stock picking ability and asset allocation ability in performance attribution.

3. (a) You are advising the owner of a Spanish trading company that has just signed a contract for a sale in the U.S. The revenue of $ 50 million is due in three months. The owner believes that the dollar is overvalued, and is worried about potential losses from the sale. The current spot exchange rate between the dollar and the Euro is

S[USD/EUR]=0.900. The three-month Euro-dollar interest rate is 2% per annum, and the three-month Euro-Euro interest rate is 3% per annum. (i) (5 marks) Suppose you advise the owner of the trading company to use a forward contract to hedge the risk he faces. What theory do you use to calculate the forward rate? How many Euros will the owner of the company receive in three months? Can investors trust the theory you just used for your calculations? Explain. (ii) (5 marks) A trader working at a hedge fund has speculated by doing a carry trade: he has borrowed USD at the Euro-dollar rate for three months to invest them in the higher yielding Euro-deposits for the same period of time. His forecast of the exchange rate in three months is EtS[USD/EUR]t+3 = 0.850. If he takes a USD 100 million position, how much money does he expect to make? What risk is he compensated for? If he believed in the theory of Uncovered Interest Parity, what would be his forecast of the spot exchange rate in three months? Can investors trust this theory? (b) (5 marks) You are a U.S. investor considering the purchase of one of the following securities. Assume that the currency risk of the Canadian government bond will be hedged, and the 6-month discount on Canadian dollar forward contracts is 0.75% versus the U.S. dollar. Bond U.S. Canadian Maturity 6 months 6 months Coupon 6.50% 7.50% Price 100 100

Calculate the expected price change required in the Canadian government bond which would result in the two bonds having equal returns in U.S. dollars over a 6-month horizon. Assume that the yield on the U.S. bond is expected to remain unchanged. (c) (10 marks) You are a U.S. investor who is considering investments in the French (stocks A and B) and Swiss (stocks C and D) stock markets. The world market risk premium is 6%. The currency risk premium on the Swiss franc is 1.25%, and the currency risk premium on the euro is 2%. The interest rate on one-year risk-free bonds is 3.75% in the U.S. In addition, you are provided with the following information: Stock W SFr A 1 1 -0.25 B 0.90 0.80 0.75 C 1 -0.25 1.0 D 1.5 -1.0 -0.5

Calculate the expected return for each of the stocks (the U.S. dollar is the base currency). Explain the differences in the expected returns of the four stocks in terms of W, , and SFr. Carefully explain your arguments.

Note: section II will be distributed at the end of Lent term. (So you should allocate 90 minutes to this mock exam.)