The risk AAA spot rates for maturities 0.

25 years obtained by extrapolation, and

1.25 and 2.25 years were obtained by interpolation,

Mestrado em 0.25 − 0.5

/(0,0.25) = 2% + × (3% − 2%) = 1.5%
Estatística e Gestão de Informação 1 − 0.5
1.25 − 1
1st Season Exam 2021/2022 - Resolution /(0,1.25) = 3% + × (4% − 3%) = 3.25%
2−1
2.25 − 2
/(0,2.25) = 4% + × (5% − 4%) = 4.25%
3−2
CASE 1 Accrued interest, gross prices, and trading decision:
Fixed Income Instruments
Bid Offer
Consider the term structure of spot interest rates for risk AAA (30/360):
Clean price 116.08% 117.08%
Term (tj-years) 0.5 1 2 3 4 5 Accrued interest(*) 9% 9%
r(0,tj) 2% 3% 4% 5% 6% 7% Gross price 125.08% 126.08%
Fair price 125.472% 125.472%
And the existence of the following Treasury and corporate bonds, with annual
Trading decision Do not Sell Do not Buy
coupons and bullet redemption at par: (*)
The accrued interest was calculated using the accrued coupon
multiplied by the coupon nominal rate, &' = 0.75 × 12% = 9%.
Coupon Maturity
Bond Rating Duration Convexity
(30/360) (years) 2. What should be new market clean offer price of the T-Bond if the term
T-bill AAA – 1 1 2 structure suffers an instantaneous multiplicative shock of -150 basis points?
T-Bond AAA 12% 2.25 1.97 6.23
FRN(Y) BB E12M+3% 2 1.07 2.07 Answer:

1. What should be the fair price of the T-Bond? Assuming a market clean price of First, we must estimate the price impact using the duration and convexity
116.08%/117.08%, what should be the trading decision based on your estimated measures.
fair price? 1
Δ%7 = −89: 1 × ; + × < 1 × ;#
2
Answer:
1
T-Bond has the following expected cash flows and maturities: Δ%7! = −1.97 × −0.015 + × 6.23 × (−0.015)# ≈ 0.03025
2

The new market clean price suffers an impact of 3.025%. The post-shock market
value (assuming the offer price) of the bond (P1) should be,

7% = 7! × (1 + Δ%7) = 117.08% × (1 + 0.03025) ≈ 120.622%

12% 12% 112%
!! = + + ≈ 125.472%
[1 + 1.5%]!.#$ [1 + 3.25%]%.#$ [1 + 4.25%]#.#$ I&PM | 2

3. What should be the yield to maturity if you decide to invest in T-Bills (referred CASE 2
in the above table). Assume a market ask price equal to the equilibrium fair price. Stock Valuation
The market consensus is that Unicorn, Plc. has an ROE = 10%, a beta of 1.25, and
Answer: plans to maintain indefinitely its traditional dividend policy which is based on a
payout ratio of 60%. The year-0 earnings were 4€ per share and was just paid.
If we invest in T-Bills and pays the fair price, we get an ytm equal to the spot rate
The coming year’s market return is 10%; The risk-free rate currently offers a 2%
with a maturity of 1 year.
return.
100%
!! = = 97.087% ⟹ ABC = 3% = /(0,3) 1. What is the fair price at which Unicorn’s shares should be traded?
[1 + 0.03]
Answer:
Confirming that the ytm on a pure discount bond should be equal to the spot
rate for the same maturity. Required rate of return (k) on Unicorn,
D = 2% + 1.25 × 8% = 12%
4. What should be the fair price of the FRN(Y) if the current credit spreads (s*)
The annual sustainable rate of growth (g) should be estimated at a level,
between AAA and BB equals to 2% and between AAA and the Money Market is
equal to 0%? Assume that the next coupon is equal to 5.2%. E = FGH × (1 − I) = 10% × (1 − 0.6) = 4%
The expected dividend in year 1 (D1) is,
Answer:
8% = H! × (1 + E) × I = 4 × 1.04 × 0.6 = 2.496 ≈ 2.5
Current credit spread AAA/BB = 3% ¹ 2% Þ this is not a “pure FRN” Finally, the fair price (P0),
8% 2.5
Maturity of the current coupon = 1 year Þ we are on a coupon payment date 7! = = ≈ 31.25
D − E 12% − 4%
We will evaluate a bond with s¹s* in a coupon payment date, with a residual
maturity of 2 years. 2. Based in the results obtained in 1., calculate the present value of growth
opportunities (PVGO). If you are the CFO of Unicorn, do you maintain the actual
Term structure for risk BBB: dividend policy? Justify your answer.
Hint: If you did not solve 2., use a fair price of 30€ and discuss the result.
Term (tj-years) 0.5 1 2 3 4 5
r(0,tj) AAA=MM 2% 3% 4% 5% 6% 7% Answer:
r(0,tj) BB 4% 5% 6% 7% 8% 9% 7! = JK/L − M/LNBℎ + 7PMG

4.16
!! = 100% + (3% − 2%) × [(1.05)2% + (1.06)2# ] 31.25 = + 7PMG ⟺ 7PMG = 31.25 − 34.67 = −3.42
12%
= 100% + 1.842% = 101.842% The PVGO are negative because the company presents a poor ROE<k, so in this
situation the company is destroying value in its present and future investments.
The actual dividend policy should be revised because, in this situation, the
company should not retain any earnings; the payout ratio should be closed to
100%.

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 CASE 3
Portfolio Management H(W) = HS/1 T − 5 × R1#

The following data are for problems 1 through 3. Consider a market where it is Hint: If you did not solve 1., use a market price of risk equal to 0.9.
only possible to trade two risky assets, A and B, from whom we know the
Answer/Solution:
following information,
We must suggest a portfolio that maximizes the utility of the client. Moreover,
Expected Standard this optimal portfolio must be derived under the GEF restriction.
Correlation
Return Deviation
A 25% 35% 1 -0.4 CXYH(W) = HS/1 T − 5 × R1#
B 12% 15% -0.4 1
Z. B.
The portfolio frontier (opportunity set) equation is known and represented by,
HS/1 T = 5% + 0.95584 × R1
#
R1# = 11.065HS/1 T − 3.325HS/1 T + 0.262
Substituting the restriction on the objective function results in,

1. Assume that the tangency portfolio has a return of 16.126%. Derive the CXYH(W) = 5% + 0.95584 × R1 − 5 × R1#
expression of the global efficient frontier (GEF).
\H(W)
9G<: = 0 ⟹ 0.95584 − 10 × R1 = 0 ⟹ R1∗ ≈ 9.558%
Answer/Solution: \R1
To derive the expression of the GEF we must calculate previously the risk-free
\ # H(W)
rate because we only know the expected return of the tangency portfolio (T). ZG<: < 0 ⟹ −10 < 0
\R1#
Given the expression of the portfolio frontier it is possible to calculate the risk-
free rate in this market, The standard deviation of the suggested optimal portfolio, ^∗ , is approximately
2! − U/4 2 × 0.262 − 3.325 × V5 equal to 9.558%. The expected return, HS/1∗ T, should be equal to,
H(/3 ) = 16.126% = = ⟹ /4 ≈ 5%
U − 2</4 3.325 − 2 × 11.065 × V5
HS/1∗ T = 5% + 0.95584 × 9.558% ≈ 14.136%
Using the portfolio frontier, we get the variance of T.
The composition of the optimal portfolio.
R3# = 11.065(0.16126)# − 3.325(0.16126) + 0.262 ≈ 0.0136
14.136% = N3 × 16.126% + (1 − N3 ) × 5% ⟹ N3 ≈ 0.82 ⟹ N4 ≈ 0.18
⟹ R3 = 11.64%
Client’s Balance Sheet
The GEF equation comes, Tangency 0.82 Equity 1.00
16.126% − 5% A 0.26
HS/1 T = 5% + × R1 = 5% + 0.95584 × R1 B 0.56
11.64%
Riskless 0.18
Total 1.00 Total 1.00

2. Under the conditions of 1., suggest an optimal portfolio, expected return and Note:
standard deviation, to a client that have a utility function of the type,
i) The weights of asset A and B in the tangency portfolio are,
16.126% = '! × 25% + '" × 12% ⟹ '! = 0.3174 ⟹ '" = 0.6826
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ii) The weights of asset A and B in the optimal portfolio corresponds to,
'! = 0.3174 × 0.82 = 0.26 HS/1 T = /4 + `1" aHS/8" T − /4 b + `1# aHS/8# T − /4 b ⟺
'" = 0.6826 × 0.82 = 0.56
H(/9 ) = /4 + `1" × 12% + `1# × 8%
3. Assuming all the CAPM assumptions, classify the following statements as true
or false and explain. 4.1 Verify if these portfolios are in line with the expected return–beta
relationship?
3.1 The beta of a portfolio with an expected return of 0% must be negative?
Answer:
Answer:
Portfolios X and Y are in line with the expected return–beta relationship;
Partially true. In the scope of CAPM assumptions, the security market line
Portfolio Z to be in line with the expected return–beta relationship, must offer
presents the following expression.
an expected return of,
HS/1 T = /4 + `1 × aH(/7 ) − /4 b
HS/1 T = 5% + 2.1 × 12% + 0.9 × 8% = 37.4%
If one assumes a portfolio with an expected return of zero,
Portfolio Z does not follow the risk-return equilibrium.
0% − /4
HS/1 T = 0% = /4 + `1 × aH(/7 ) − /4 b ⟹ `1 ≈
H(/7 ) − /4 4.2 Considering the answer in 4.1 is there an arbitrage opportunity? If so,
describe as detailed as possible the strategy and quantify the result.
This is negative if and only if the riskless rate is 0 < /4 < H(/7 ).
Answer:
3.2 “Portfolios with a standard deviation equal to zero, should offer an expected
Yes, there is an arbitrage opportunity. The profit should be equal to (40% –
rate of return equal to zero”.
37.4%) 2.6%. One must form an arbitrage portfolio selling some proportion of
Answer: portfolios X and Y and buying portfolio Z. To get the proportions of X and Y, we
False. sp = 0 implies E(rp) = rf , which could be zero or not. must solve the following system of equations

1
4. Suppose that there are two independent economic factors, F1 and F2. The risk- 2.1 = 1.5N: + 2.4(1 − N: ) ⎧N: =
⎪ 3
free rate is 5%, and all stocks have independent firm-specific risk components. c ⟹ XhI
Portfolios X, Y and Z are both well-diversified with the following characteristics: 0.9 = 2.1N: + 0.3(1 − N: ) ⎨ 2
⎪N; =
⎩ 3
Beta on Beta on Expected
Portfolio The characteristics of the arbitrage portfolio are as follows,
F1 F2 Return
X 1.5 2.1 39.8% Beta Beta
Portfolio weight E(R)
on F1 on F2
Y 2.4 0.3 36.2%
X -1/3 -0.5 -0.7 -13.27%
Z 2.1 0.9 40.0% Y -2/3 -1.6 -0.2 -24.13%
Z 1 2.1 0.9 +40.00%
In this economy the regression equation is of the type:
Total 0 0 0 +2.6%

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 CASE 4 3. An at-the-money put maturing in 6 months is traded by €1.6. The homologous
Derivatives call option is traded by €3.1. The underlying asset is currently traded by €42. The
1. In futures contracts, the value of margins is set by the exchange or clearing annualized riskless rate is 10% (9.531% in continuous terms).
house, as the applicable. What factors may underlie the setting of initial margin 3.1 Verify if the option prices are in line with the put-call parity relationship.
levels?
Answer:
Answer: The put-call parity establishes that a portfolio composed by an european put and
(Pedagogical answer, Hull, J. 10th ed., p. 31). Minimum levels for the initial and the underlying asset must have the same value of a portfolio composed by an
maintenance margin are set by the exchange clearing house. Individual brokers european call and a cash position equal to the present value of the strike price.
may require greater margins from their clients than the minimum levels specified Furthermore, because the options are at-the-money, S = X = 42.
by the exchange clearing house. Minimum margin levels are determined by the 42
variability of the price of the underlying asset and are revised when necessary. 1.6 + 42 > 3.1 + ⟹ 43.6 > 43.1
6
The higher the variability, the higher the margin levels. l1 + 0.1 × m
12
Margin requirements may depend on the objectives of the trader. Day trades The prices are not in line with the put-call parity relationship.
and spread transactions often give rise to lower margin requirements than do
hedge transactions. In a day trade the trader announces to the broker an intent 3.2 According with your previous answer, is there an arbitrage opportunity? If
to close out the position in the same day. In a spread transaction the trader so, propose an arbitrage strategy and quantify the result.
simultaneously buys (i.e., takes a long position in) a contract on an asset for one
maturity month and sells (i.e., takes a short position in) a contract on the same Answer:
asset for another maturity month. Yes, there is an arbitrage opportunity. We must sell a put and the underlying
asset and buy a call and make a deposit by remaining amount to let the initial
cash flow equal to zero.
2. Bank Alfa intends to speculate about a rise in the 6-month interbank rate Moment 0:
within 6 months. Bank Zetha offers to bank Alfa a FRA 6´12 with a rate of 4%. Sell a put option 1.6
If the interbank interest rate at the FRA term equals to 6%, Bank Alfa should (Short) Sell the asset 42
receive or pay the FRA result? Explain your answer. Buy a call option -3.1
Answer: Deposit -40.5

To implement the speculative strategy (higher future rates), bank Alfa should Total 0
assume a long position (buyer) in the FRA. Moment 0.5:
Buy the asset -42
(6% − 4%)
9FU<=> = ×j >0 Receive the deposit +42.525 = 40.5 × l1 + 10% × %#m
?
(1 + 6% × 6/12)
Total +0.525
Bank Alfa must receive the FRA result from bank Zetha.

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