L.S.E.

FM423-Michaelmas Term 2022

Summative In-Class Assignment

Instructions:

1. Time available: 90 minutes + 10 minutes reading time. No writing is permitted during

2. If you arrive late, your end time will be the same time as all other students.

3. Answer all questions in the answer booklet provided. If you require additional space,
please request another answer booklet.

4. Please write ONLY your Candidate Number on your assignment. Any attempt to
identify yourself will result in an automatic fail.

5. This is an individual assessment. You must not communicate with any other student
for the duration of the assessment and the work you submit must be entirely your own.

6. If at any point, you feel that anything is unclear, please make any additional assump-
tions, state them clearly, and proceed with your answers. Any academic questions will
not be answered during the ICA.

7. You may use a calculator as prescribed in the examination regulations.

8. The assignment consists of two questions. Please explain clearly all the steps in your
solution. This will help us give you partial credit if your final answer is incorrect.

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Q1. (Fixed income, 50 marks total)

(a) (20 marks total) You are given the following information about three bonds:

Bond Maturity Annual Coupon Rate YTM

A 2 3% 3.96%

B 2 0% 4%

C 3 5% 5%

i. (10 marks) Find the price of bonds A, B, and C.

ii. (10 marks) Find today’s term structure.

(b) (15 marks total) You have the following information about today’s spot rates:
r1 = 1%, r3 = 2%, and r4 = 3%.
i. (5 marks) What forward rates can you compute based on the available infor-
mation?

ii. (5 marks) Suppose the Expectations hypothesis holds. What can you say
about the expected spot rates one year from now? Be as precise as possible.

iii. (5 marks) Suppose a dealer offers you to transact at the following two forward
rates: 2 f1 = 2% and 2 f2 = 3.5%. Is there an arbitrage opportunity? If so,
explain what trades using 1, 3, and 4-year zero-coupon bonds, and the two
forward rates above you need to make to take advantage of it; be as precise
as possible.

(c) (10 marks total) The current term structure is flat and is equal to 4%.
i. (5 marks) You do not have a view about the future level of the term structure,
but you think that it will steepen in the future. Suppose you can trade 2 and
10-year zero-coupon bonds. Describe how you should structure your trade;
be as precise as possible.

ii. (5 marks) Consider two portfolios. The first portfolio consists of 10 units of
10-year zero-coupon bonds and 10 units of 20-year zero-coupon bonds. The
second portfolio consists of 20 units of 15-year zero-coupon bonds. Which
portfolio is more sensitive to the interest rate movements?

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(d) (5 marks) You have the following information about today’s forward rates: 1 f1 =
2%, 2 f1 = 2.5%, and 3 f1 = 3%. Consider a forward 2-year interest rate swap that
starts at time 2. (In this contract, you agree today to receive a fixed rate, K,
and pay future floating rates 2 r1 and 3 r1 in years 3 and 4, respectively). Find the
the swap rate (the value of K that makes the value of the forward swap contract
equal to zero today).

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Q2. (Stocks, 50 marks total)

(a) (10 marks) You are given the following information. The current price of stock
A is 100. The stock is expected to pay a dividend of $5 per share next year. The
market beta of the stock is 1.2, the riskfree rate is 4%, and the expected return
on the market portfolio is 9%. What is the expected ex-dividend price of stock A
in one year from now? Assume that the CAPM holds.

(b) (20 marks total) Consider two portfolios A and B in a CAPM economy. The
expected return on portfolio A is E(RA ) = 13% and the expected return on
portfolio B is E(RB ) = 6%. The CAPM beta of portfolio A is βA = 2 and of
portfolio B is βB = 0.6. The standard deviation of the market portfolio is 20%.
i. (5 marks) Suppose A and B are correctly priced according to the CAPM.
Derive and plot the security market line and label the intercept and market
risk premium.

ii. (5 marks) Suppose you have $1 million. You can only invest in A and B but
your final portfolio needs to have a beta of 3.4. What should you do?

iii. (5 marks) Suppose there is a portfolio C with the expected return equal to
E(RC ) = 9% and the standard deviation of the idiosyncratic component of
its return is 30%. What is the standard deviation of portfolio C’s return?

iv. (5 marks) What can you say about the standard deviation of portfolio A’s
return? Be as precise as possible.

(c) (10 marks) Suppose you can only invest in stocks Y and Z. Y and Z have the
expected returns and standard deviations given in the table below:
Stock Expected return (%) Standard deviation (%)
Z 15 20
Y 35 40
The correlation between the returns of the two securities is 0.25. Which of the
following portfolios cannot be optimal? Explain your answer.
i. 100% Z
ii. 75% Z; 25% Y
iii. 50% Z; 50% Y
iv. 25% Z; 75% Y
v. 100% Y

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(d) (10 marks total) You look at all stocks traded today in the market. You estimate
their expected returns, variances, and covariances using sample averages, sample
variances, and sample covariances, and construct the tangent portfolio, R∗ , based
on these estimates.
i. (5 marks) What can you say about the relationship between the tangent
portfolio and the market portfolio?

ii. (5 marks) Suppose you run the following regressions

Ri − Rf = αi + βi (R∗ − Rf ) + εi .

What can you say about αi in these regressions?