ANALYTICAL PROBLEM SET (APS) 4

LECTURES PROFESSOR ROBERT KOSOWSKI

TUTORIALS JOE TAN

This APS is designed to cover the readings for IPM 7 and IPM 8.

SECTION A
BKM Chapter 24 related questions:

Q1.
The difference between an arithmetic average and a geometric average of returns:
a. Increases as the variability of the returns decreases.
b. Decreases as the variability of the returns decreases.
c. Is always negative.
d. Depends on specific returns being averaged, but is not necessarily sensitive to their
variability.

Use the following information for questions 2-4

XYZ stock price and dividend history are as follows:
Year Beginning-Of-Year-Price Dividend Paid at Year-End

1998 $100 $4
1999 120 4
2000 90 4
2001 100 3

An investor buys three shares of XYZ at the beginning of 1998, buys another two shares
at the beginning of 1999, sells one share at the beginning of 2000, and sells all four
remaining shares at the beginning of 2001.
Q2. What is the arithmetic rate of return for the investor? The arithmetic return is closest
to

a. 4.43%
b. 4.87%
c. 5.44%
d. 5.96%

Q3. What is geometric average time-weighted rate of return for the investor? The
geometric return is closest to

a. 3.45%
b. 3.92%
c. 4.12%
d. 4.53%

Q4. What is the dollar-weighted rate of return? (Hint: Carefully prepare a chart of cash
flows for the four dates corresponding to the turns of the year for January 1, 1998, to
January 1, 2001)

a. -1.2503%
b. - 0.4554%
c. - 0.1607%
d. 0.3467%

Use the following information for questions 5-11

Consider the two (excess return) index-model regression results for stocks A and B. The
risk-free rate over the period was 6%, and the market’s 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)
R-square 0.576 0.436
Residual standard deviation, σ(e) 10.3% 19.1%
Standard deviation of excess returns 21.6% 24.9%

Q5. The alpha statistics for Stock A and Stock B respectively are:

a. 1.0% for B and 2% for A

b. 2.0% for B and 1% for A
c. 1.5% for A and 2.5% for B
d. 2.5% for A and 1.5% for B

Q6. The Information Ratio statistics for Stock A and Stock B respectively are:

a. 0.7832% for A and 0.3312% for B

b. 0.4752% for A and 0.8742% for B
c. 0.4907% for A and 0.3373% for B
d. 0.0971% for A and 0.1047% for B

Q7. The Sharpe measures for Stock A and Stock B respectively are:

a. 0.3493% for A and 0.2343% for B

b. 0.4907% for A and 0.3373% for B
c. 0.0971% for A and 0.1047% for B
d. 0.7809% for A and 0.4842% for B

Q8. The Treynor measures for Stock A and Stock B respectively are:
a. 2.394% for A and 9.493% for B
b. 4.907% for A and 3.373% for B
c. 12.030% for A and 7.005% for B
d. 8.833% for A and 10.500% for B

Which stock is the best choice under the following circumstances? This applies to
questions Q9-11.

Q9. This is the only risky asset to be held by the investor.

a. Stock A
b. Stock B

Q10. This stock will be mixed with the rest of the investor’s portfolio, currently composed
solely of holdings in the market index fund.
a. Stock A
b. Stock B

Q11. This is one of many stocks that the investor is analyzing to form an actively managed
stock portfolio.

a. Stock A
b. Stock B

Q12.
A 2-year investment of $2,000 results in a return of $150 at the end of the first year and a
return of $150 at end of the second year, in addition to the return of the original investment.
The internal rate of return on the investment is:

a. 6.4%
b. 7.5%
c. 15.0%
d. None of the above.

Q13.
In measuring the performance of a portfolio the time-weighted rate of return is superior to
the dollar-weighted rate of return because:

a. When the rate of return varies, the time-weighted return is higher.

b. The dollar-weighted return assumes all portfolio deposits are made on Day 1.
c. The dollar-weighted return can only be estimated.
d. The time-weighted return is unaffected by the timing of portfolio contributions and
withdrawals.

Q14.
Pure market timers attempt to maintain a portfolio alpha and a
portfolio beta.

a. Constant; shifting
b. Shifting; zero.
c. Shifting; shifting.
d. Zero; Shifting

Q15. (Value at Risk, see BKM 9th ed, Section 5.7-5.8)

What is the 95 percent 10 day value at risk of a £1 million portfolio whose return has a
standard deviation of 5 percent per year and is assumed to be normally distributed?

The value at risk would be closest to

a. £ 100
b. £ 5000
c. £ 10000
d. £ 50000
SECTION B

Chapter 17-18 related questions:

Q1.
The common stock of the PUTT corporation has been trading in a narrow range for the
past month, and you are convinced it is going to break far out of that range in the next 3
months. You do not know whether it will go up or down, however. The current price of the
stock is $100 per share, and the price of a 3-month call option at an exercise price of $100
is $10.
If the risk-free interest rate is 10% per year, what must be the price of a 3-month put option
on PUTT stock at an exercise price of $100? (The stock pays no dividends.)
a. 6.44
b. 7.65
c. 7.95
d. 8.95

Q2.
As a follow-up to the previous question: What would be a simple options strategy to exploit
your conviction about the stock price's future movements? How far would it have to move
in either direction for you to make a profit on your initial investment?

a. $17.08
b. $18.08
c. $20.00
d. $21.04

Q3.
The common stock of the CALL corporation has been trading in a narrow range around
$50 per share for months, and you believe it is going to stay in that range for the next 3
months. The price of a 3-month put option with an exercise price of $50 is $4.
If the risk-free interest rate is 10% per year, what must be the price of a 3-month call option
on CALL stock at an exercise price of $50 if it is at the month? (The stock pays no
dividends).
a. 4.83
b. 4.95
c. 5.18
d. 5.28

Q4.
As a follow up to the previous question: What would be a simple options strategy using a
put and a call to exploit your conviction about the stock price's future movement? How far
can the stock price move in either direction before you lose money?
a. 8.01
b. 9.18
c. 9.40
d. 9.98

Q5.
As a follow up to the previous question: How can you create a position involving a put, a
call and a riskless lending that would have the same payoff structure as the stock at
expiration? What is the net cost of establishing that position now?
a. 50
b. 55
c. 60
d. 65

Q6.

(see BKM 8th ed, ch 20) Consider the following options portfolio. You write a February
expiration call option on IBM with exercise price 105. You write a February IBM put option
with exercise price 100.
Graph the payoff of this portfolio at option expiration as a function of IBM's stock price at
that time. What will be the profit/loss on this position if IBM is selling at 103 on the option
expiration date? (Use the Wall Street Journal listing from Figure 20.1 to answer this
question)

a. 7.93
b. 7.40
c. 6.93
d. 8.32
Q7.
We will derive a two-state put option value in this problem. Data: S0=100; X=110;
1+r=1.10; Expiration: 1yr. The possibilities for ST are 130 and 80.

Show that the range of S is 50, whereas that of P is 30 across the two states. WHat is the
hedge ratio of the put?

a. -3/5
b. -4/5
c. -3/6
d. -5/6

Q8.
As a follow up to the previous question: Form a portfolio of three stares of stock and five
puts. What is the (non-random) payoff of this portfolio? What is the present value of the
portfolio? The present value of the portfolio is

a. 209.1
b. 310.4
c. 354.5
d. 370.3

Q9.
As a follow up to the previous question: Given that the stock currently is selling at 100,
solve for the value of the put.
a. 10.61
b. 10.91
c. 11. 85
d. 12.46
Q10.
You are attempting to value a call option with an exercise price of $100 and 1 year to
expiration. The underlying stock pays no dividends, its current price is $100, and you
believe it has a 50% change of increasing to $120 and a 50% change of decreasing to
$80. The risk-free rate of interest is 10%. Calculate the call option's value using the two-
state stock price model.
The hedge ratio should be
a. 1/2
b. 2/3
c. 4/5
d. 5/6

Q11.
As a follow up to the previous exercise. The value of the call should be
a. 12.0
b. 13.6
c. 14.5
d. 15.9

Q12.

Suresh Singh, CFA, is analyzing a convertible bond. The price of the underlying common
stock is 40$ and the conversion rate is 22. The market price of the convertible bond is
1050$. Compute the bond's conversion value. The conversion value is
a. 820
b.870
c. 860
d. 880
Q13.
As a follow up to the previous question, compute the market conversion price. The market
conversion price is
a. 47.73
b. 47.93
c. 48.85
d. 49.32