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Financial RiskFinancial

Risk Management
Problem Set 2
Dr Frederic Schweikhard Hilary Term 2015
Dr Zoe Tsesmelidakis Problem Set 2
Problem Set 5
Financial Management Financial Analysis

Note: Remember to label all important elements in your graphs, particularly the axes,

Homework Exercises

I. CAPM and Investment Decisions

Securities A and B are priced in line with the CAPM and exhibit the following return
A 8% 0.4 6%
B 16% 1.2

(a) Determine the beta and the expected return of the market portfolio M as well as the
risk-free rate.
(b) Give the equations for the capital market line and the security market line.
(c) Calculate the standard deviation M of the market portfolio under the assumption
that the covariance between A and M is 0.00225.
(d) Sketch the relationship between expected return and systematic risk in this market.
Do not forget to label the axes and other elements properly.
(e) Considering to the table below, are stocks D and E fairly priced, underpriced, or
overpriced? First determine the cost of capital implied by the Dividend Discount
Model. In a second step, compare this rate to the expected return predicted by the
CAPM. What would be the consequence of any mis-pricing you find?

Stock Current price (P0 ) Current dividend (D0 ) Dividend growth rate (g)
D 100 4 0% -0.2
E 21 2 5% 1.6

II. CAPM and Cost of Capital Modigliani-Miller Revisited

Conglo Corporation is a conglomerate. Through its three divisions, Conglo maintains

business operations in the following sectors:
Division/Sector Proportion of Conglo (in terms of firm value)
Food 50%
Electronics 30%
Chemistry 20%

The management would like to estimate the total cost of capital rA of the three divisions
individually. To this end, it has identified three competitors of comparable business risk
as the Conglo divisions. However, the financial risk of the competitors diers.
Firm Equity beta ( E) Debt ratio (D/(D + E))
Tesco (Food) 0.8 0.3
Samsung (Electronics) 1.6 0.2
BASF (Chemistry) 1.2 0.4

(a) Estimate the unlevered (or asset) beta for all three Conglo divisions based on their
competitors. Assume that debt is risk-free, i.e., D = 0.

(b) Conglos debt ratio (calculated as debt divided by total assets) is 0.4. What is your
estimate of Conglos levered (or equity) beta?
Hint: Use the proportions from the upper table to calculate Conglos unlevered beta
as the weighted average.

Assume that the expected market return is 15%, the riskless rate is 7%, and that the
capital market is perfect.

(c) Calculate Conglos equity cost of capital.

(d) Estimate the total cost of capital of Conglo.

Hint: This can be achieved in two ways. Either by (i) the WACC formula or (ii) the
CAPM equation in connection with unlevered betas. You can verify that your result
is consistent with both approaches.

III. Hedging with Futures

A gold-mining company is concerned about volatility in its revenues. Assume gold sells
currently (t0 ) for $800 an ounce, but the price is extremely volatile and could fall as
low as $700 or rise as high as $1,000 in the next year. The company will bring 1,000
ounces to the market next year (t1 ). Risk-free investments yield 5% p.a. and interest is
compounded continuously.

(a) Calculate the theoretical per-ounce price of a futures contract of gold maturing in t1 .

(b) Suppose gold futures traded in the market are fairly priced and you find one that
actually matures in one year. One futures contract applies to 100 ounces of gold.
Describe the position the company would need to enter to hedge against price fluc-
tuations (i.e., how many units, long or short position...?). Draw a per-ounce payo
graph of the position.

(c) Make a table comprising (i) the revenue from the sale of the gold without any hedge,
(ii) the payo from the futures position, (iii) the total proceeds combining (i) and (ii)
in each state of the world. What rate of return is the company earning on its gold
given the hedge?

IV. Put-Call Parity

A European call with a remaining life of 6 months and a strike price of 30 EUR trades at
2 EUR. The underlying stock is worth 29 EUR and a dividend of 0.50 EUR is expected
after two and five months. The term structure is flat and the risk-free rate is 10% p.a.
Assume continuous compounding. At what price should a European put with the same
strike price, underlying, and maturity trade?

V. Option Valuation with Binomial Trees

Consider a stock S whose price process is defined as follows: In any period, its price
increases by 10% with probability p = 0.7 and it decreases by 20% with probability
1 p = 0.3. The initial stock price is S0 = 100 and the risk-free asset yields 5% per
period. Assume interest is compounded once per period.

(a) Draw a binomial tree for the three-period case (i.e., with 4 points in time from t0 to
t3 ) and indicate the price evolution of the stock in each node. What is the probability
of realization of each end node? What is the expected stock price in t3 from todays

(b) Calculate the risk-neutral probability for one upward movement.

(c) Indicate the payos associated with following European options in the nodes of the
tree as well as their fair value in t0 .
Hint: Value each option by first calculating its expected payo using risk-neutral
probabilities and then discounting it using the risk-free rate.

(i) European call, Long position, Maturity T =3, Strike X=100

(ii) European call, Short position, T =3, X=100
(iii) European put, Long position, T =3, X=100

(d) Draw a new tree and repeat the previous exercise for the following American options.
Hint: Here, you must compare in each node whether it is optimal for an investor to
exercise early or keep (or sell, which is equivalent) the option.

(i) American call, Long position, T =3, X=100
(ii) American put, Long position, T =3, X=100

(e) Use the European calls above to build a straddle. What is an investor betting on
by holding a long position in such an option strategy? Give the value of the straddle.
At maturity, how far must the stock have moved for the investor to realize a profit,
i.e., a positive net payo? Draw a graph of the straddle payo and net payo.
Hint: The net payo is the sum of the options payos minus the option premiums.

Self-Study Exercises

VI. Option Price Determinants

In which direction does the price of a call option move in response to the following
changes, other things equal? Explain why.

(i) Stock price increases.

(ii) Volatility of the stock price increases.

(iii) Time passes, so the options expiration date comes closer.