Part 2: (60 Marks in total)

Answer ALL the questions. Details of calculations are required for Part 2.

Question 3. (20 marks in total)

John Davidson is an investment adviser at Leeds Asset Management plc. He is asked by a client to evaluate various investment opportunities currently available and he has calculated expected returns and standard deviations for five different well-diversified portfolios of risky assets:

Portfolio Expected return

17. Q 7.8%

18. R 10.0%

19. S 4.6%

20. T 11.7%

21. U 6.2%

Standard deviation 10.5% 14.0% 5.0%

18.5% 7.5%

(a) For each portfolio, calculate the risk premium per unit of risk (Sharpe ratio) that you expect to receive. Assume that the risk-free rate is 3.0%. (5 Marks)

(b) Using answers from a, which of these five portfolios is most likely to be the market portfolio and explain why. (200 words maximum) (5 Marks)

(c) If you are only willing to make an investment with a standard deviation of 7.0%, is it possible for you to earn a return of 7.0%? (5 Marks)

(d) What is the minimum level of risk that would be necessary for an investment to earn 7.0%? What is the composition of the portfolio along the Capital Market Line (CML) that will generate that expected return? (5 Marks)

Question 4. (13 Marks in total)

(a) Jade Smith is a foreign exchange trader for a bank in New York. He has $1 million for a short-term money market investment and he faces the following quotes: (Assuming there are 360 days a year)

Spot exchange rate (SFr/$) 3-month forward rate (SFr/$)

1.2810 1.2740

4

US dollar annual interest rate 4.8%

Swiss franc annual interest rate 3.2%

He wonders whether he should invest in US dollars for 90 days or make a covered interest arbitrage (CIA) investment in the swiss franc, and what is the profit/loss if he carries out this investment. (7 Marks)

(b) Using the same values in the table above, Jade decides to seek the full 4.8% return available in the US dollars by not covering his forward dollar receipts an uncovered interest arbitrage (UIA) transaction. What is the maximum expected spot exchange rate (SFr/$) at the end of the 90-day period at which Jade can avoid losing money? (6 Marks)

Question 5. (27 Marks in total)

Consider a semi-annual bond that has a par value of 100, a 15-year maturity, a 5% coupon rate. Monthly interest rate is 0.412%.

(a) Calculate the annualized semi-annual compounding yield. (3 marks)

(b) What is the price of the bond (without calculation)? And explain why you can determine the price of the bond without calculation? (4 marks)

(c) Using answers from (b), calculate the modified duration of this bond. (3 marks)

(d) Using answers from (b) and (c), suppose that the bonds yield to maturity decreases to 3.5%. How much will the bond price increase by applying the duration rule? (5 marks)

(e) Do you agree with the following statement, and explain why? (5 marks) If two bonds have the same duration, then the percentage change in price of the two bonds

will be the same for a given change in interest rates. (f) Discuss the problems with the traditional bond pricing approach by using the yield to

maturity. (300 words Maximum) (7 Marks)