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International Financial Markets ASB 4403-Bangor Business School - Prifysgol Bangor University | 2019 Past paper solutions

Section A

Answer ONE question from Section A, ONE question from Section B, and ONE other question.

You must show all your workings in quantitative answers.

Question 1. Answer ALL parts.

(a) The table presents the October 2018 performance of some major stock market indices and gold.

1. Explain the formula that was used to calculate this returns data. How would the results differ if logarithmic returns had been calculated? [10 marks]
2. What implications do you draw from this table regarding portfolio diversification? What additional information would you collect in order to make more reliable judgements? [20 marks]

Answer:  (Purchase past paper to get the full solution)

i). The formula which was used to calculate this arithmetic return data is £x/n. Just to take the  ignores the compounding effect and order of returns and it is misleading when the investment returns are volatile. For small returns, arithmetic and logarithmic returns will be similar, but, as returns get further away from zero, these two formulations will produce increasingly different answers.

ii). Arithmetic returns aggregate well across portfolios. The arithmetic return for portfolio is simply equal to the weighted average of each constituents\’s arithmetic return. You might want to evaluate a portfolio of investments that might include similar investments (for example, all stocks or all bonds) or a combination of investments (for example, stocks, bonds and real estate). In this instance, you would calculate the mean rate of returns for this portfolio of investments for an individual year or for a number of years.

(b) An investment advisor has selected three equity funds as her current recommendations to a client. The expected returns, standard deviations and correlation coefficients for the three funds are:

The investment advisor has also recommended that the client's decision should involve selecting the optimal equally-weighted portfolio containing two of these three funds (i.e. 50%-50% weights).

1. Calculate the expected risk and return for the following three equally-weighted portfolios: (I) 'UK' and 'European'; (II) 'UK' and 'Asia-Pacific'; (III) 'European' and 'Asia-Pacific.' [30 marks]
2. Explain which one of the three portfolios in part (a) might be the most attractive to the client, and compare the data on the three portfolios with the return and risk of the individual funds. Explain any underlying assumptions that you make. [20 marks]
3. Assuming that this client has not imposed any restrictions on portfolio choice, discuss your views on whether the investment advisor's recommendations are valid and appropriate. [20 marks]

[Total: 100 marks]

Answer:  (Purchase past paper to get the full solution)

i). Calculate the expected risk:

We know that:

= (S.D alpha)² (Weight alpha)² + (S.D European)²(W European)² + (S.D Asia)² (W Asia)² +2 (W alpha)(W European) r *Alpha*European (S.D Alpha) (S.D European) +2 (W European) (W Asia) r *European *Asia (S.D European) (S.D Asia) +2 (W Alpha) (W European) r *Alpha *Asia (S.D Alpha) (S.D Asia)

= (19)²(0.50)² + (26)²(0.50)² +(21)²(0.50)² +2 (0.50)(0.50) 0.34(19)(26) +2(0.50)(0.50) 0.82(26)(21) +2(0.50)(0.50) 0.08(19)(21)

= 120.34 (taking the under root of this figure to find out the standard deviation or risk)

=10.96%

Expected return

= W Alpha * R Alpha + W European * R European + W Asia *R Asia

= 0.50*0.11 + 0.50*0.20 + 0.50*0.14

= 0.055 + 0.1 + 0.07

= 22.5%

ii). One of the three portfolios, the portfolio of UK and Asia pacific is the most attractive one because we know that the concept of high risk and high return. So, this portfolio has high risk and high return and same as low risk and low return. Some of the investors or clients are risk averse and some are aggressive, so the other two portfolios have different risk and return which is not a good portfolio for an investor to invest in it and through diversification, we can reduce the risk of the business and positive correlation also plays an important role to evaluate these portfolios and the correlation is also less than 1 in all portfolios.

iii). If the client has not imposed any restriction on portfolio choice, they he choose any portfolio out of these three portfolios and this is valid advice from advisor’s point of view, because he looks up the portfolio very carefully and managed it and most important to concern about the risk and return of that portfolio. We knew that under the assumption of homogeneous expectations, expected portfolio returns, is a linear function of portfolio risk. In practice, many investors and portfolio managers believe that estimates of security values are correct and market prices are incorrect. Such investors will not use the weights of the market portfolio but will never invest more than the market weights in securities that they believe are undervalued and less than the market weights in securities which they believe are overvalued.

Section B

Answer ONE question from Section A, ONE question from Section B, and ONE other question.

Question 2. Answer ALL parts.

a. Explain the relevance of 'risk aversion' and 'efficient portfolios' for the capital market line (CML) of the capital asset pricing model (CAPM). [15 marks]

b. Using diagrams, explain the similarities and differences between the CML and the security market line (SML).[15 marks]

c. This table presents the annual expected returns and standard deviations for three stocks and for the market index. The risk free interest rate is 2%

1. This stock market is in CAMP equilibrium. Explain the implications of this statement for proceeding with any quantitative analysis.[5 marks]
2. Calculate the Beta values for each of these three stocks and interpret your results.[20 marks]
3. Identify whether the stocks plot on the CML, and explain what you conclude from this.[20 marks]
4. A new stock, Willow plc, is introduced to the market and is under-priced according to the SML. Explain why this is plausible and what you would expect to happen.[10 marks]

 d). Classify the following scenarios according to systematic and unsystematic risk:

1. A petroleum company reveals a discovery of new oil reserves.
2. A company unexpectedly wins a large government contract.
3. A large company's chief executive unexpectedly announces her resignation.

State your assumptions and explain your reasoning.[15 marks]

[Total: 100 marks]

Question 3. Answer ALL parts.

a. An investor obtains the following Beta values for a set of companies. This is based on the capital asset pricing model (CAPM).

The risk free asset (Rf) offers a 2% return.

1. A global equity index has been used to estimate the above Beta values. Briefly explain how this estimation might be conducted.[15 marks]
2. Calculate the Beta values for the following potential portfolios (based on £ amounts): One: Aron plc (£300), Carw NV (£650), Evon JSC (£800) and Hyppia SpA (£250). Two: Brynie SA (£2,200), Deiva AG(£700), Ghia LLC (£500) and £,1600 in Rf.[20 marks]
3. How might the investor achieve twin objectives of having a shareholding in only one company (Fled SA de CV) whilst at the same time having a portfolio with the same Beta value as the 'market portfolio' of the CAPM? [10 marks]
4. If the investor anticipates a sharp recession over the next year, explain how they could use information on Beta values to inform their buy and sell decisions of these stocks. [10 marks]
5. Evon JSC and Fled SA de CV are emerging market companies. What additional factors would you consider prior to investing in these companies' stocks? [10 marks]

b. The 'UK Infinity' index-tracking fund is considered to be a proxy for the 'market portfolio' of the CAPM. This fund has an expected return of 12% for the next year, and shares in the fund are currently priced at E30.

Jeremy plc has an estimated CAPM Beta value of 1.7 and its shares may be purchased for 330. This stock has an expected return of 24% for the next year.

A one-year risk-free asset may be purchased at e10.50 and offers a 3% return for the next year.

1. Using a diagram, explain why Jeremy plc is mispriced according to the CAPM.[10 marks]
2. Devise a strategy to exploit the mispricing, and illustrate the cash flows arising from this strategy.[20 marks]
3. If Jeremy plc was correctly priced according to the CAPM, what is the potential return from your strategy in part (ii)?[5 marks]

Question 4, Answer ALL parts.

a. Explain the relative merits of using an exchange-traded derivative contract versus using an over-the-counter derivative contract. [40 marks]

b. Explain the key characteristics of trading in the foreign exchange market, according to the BIS (Bank for International Settlements) surveys.[30 marks]

c. A fund manager recently made the following statements: "Company profits are mostly in line with expectations. Unemployment and inflation are low in many developed countries. Investors are concerned with global trade disputes. Global growth is slowing and interest rate rises are expected in the near future."

Explain how this statement can relate to the characteristics of 'factor models' of asset pricing and explain the main features of one model of this type.

[30 marks]

[Total: 100 marks]

Question 5. Answer ALL parts.

(a)

Forward buyer: S_I - F

Call option buyer: Max (S_I - X, 0)

Put option buyer: Max (X - S_I, 0)

Using diagrams and examples, explain the above three statements and identify the key differences among them.

[40 marks]

(b) Using the case of forward contracts, explain the relevance of arbitrage (or 'no arbitrage') in derivatives pricing.

[30 marks]

(c) Using a numerical example, illustrate the use of stock index futures for hedging an underlying equity portfolio.

[30 marks]

[Total: 100 marks]

Question 6. Answer ALL parts.

(a) A legendary international investor recently announced that he will advise his widow to invest 90% of his wealth in a fund which tracks the W&P500 index. Critically analyse the potential theoretical and empirical justifications for this viewpoint.

[40 marks]

(b) Critically analyse three examples of international stock market anomalies.

[30 marks]

(c) Discuss the potential implications of each of the following hypothetical scenarios in the context of informational efficiency. State any assumptions that you make and comment on what further details you would seek in practice.

1. A leading US-based technical analyst claims that there will always be opportunities for her trading strategies to succeed because of her belief in 'the paradox of efficient markets.'
2. Mrs Wise has generated a vast wealth from trading international equities and bonds. Recently, she announced on a television show that she used a secret system for asset allocation, which is now revealed in her new book.
3. A European consumer organisation published a research study which concluded that 85% of European Actively-managed mutual funds had failed to consistently outperform the market average over a five year period. [30 marks]

[Total: 100 marks]

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Last updated: Oct 03, 2019 02:40 PM