ECN226 Capital Markets 1 – 2016 Past Paper Questions and Answers

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Discounted prices compared to all other websites
ECN226 Capital Markets 1 – 2016
Questions and Answers

Question 1




This is the most commonly used utility function, and it represents the utility “score” assigned to each
portfolio. Investors choose the portfolio with the highest utility score. Here, E[r] is the expected
return on the asst or portfolio, σ is the standard deviation of returns and A is the degree of risk
aversion. The higher A is, the more the investor dislikes risk.

The value of A which makes this investor indifferent between the risky portfolio and the risk-free
asset is the value of A which equates the utility gained from both of these options:
𝐴
0.06 = 0.15 − (0.15)
2
𝐴 0.09
= = 4
2 (0.15)
𝐴 =8




Question 2




The rate of return, or holding-period return, can be calculated as:
𝐸𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 + 𝐶𝑃
𝑃𝐻𝑅 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
The beginning price can be calculated as follows:

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1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 = 𝐹
(1 + 𝑦)
1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 = 1000 = 385.54
(1 + 0.1)
And similarly,
1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 = 1000 = 390.92
(1 + 0.11)
The holding-period return is then:
390.92 − 385.54 + 0
𝑃𝐻𝑅 = = 0.014
385.54


Question 3




Since the stock’s beta is equal to 1.2, its expected rate of return is:

6 + 1.2(16 − 6) = 18%
This simply states that the expected rate of return of the asset is equal to the risk-free rate plus the
excess return multiplied by the stock’s beta.

We can use the following formula to calculate the price after one year:
𝐷𝐼𝑉 + 𝑃 − 𝑃
𝐸[𝑟] =
𝑃
6 + 𝑃 − 75
0.18 =
75
Rearranging,

𝑃 = 82.5