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Investment Analysis

josh
April 14, 2020 0 Comment

Final exam paper

BUS329, S1/TJD 2020

(1) (a) How would you evaluate the informational role of financial market during the recent COVID-19 pandemic around the globe? (6 Marks)

Because of COVID-19

Circuit breaker

Cities Shutting down

The informational role: stock prices reflect the collective assessment of investors regarding firms’ current performance and future prospects. If the investors believe that a firm is performing better than other firms and the expected return on firm’s stock is higher, they will purchase the stocks of that firm. Demand for that firm’s stock will rise. The firm can raise more capital at this higher price and make more feasible investments. In this way capital flows to the productive firms. In other words, financial markets channel funds to the most efficient use.

· Economy downturn

· Stock Price = Firms current performance/valuation

· Investors will look at the best prospect and invest in a company

· Negative of pandemic

· Companies affected by the pandemic will

(1) (b) Can you transfer/defer your today’s consumption into the future? Explain the mechanism of how this can be done (4 marks)

YES

Consumption timing: Financial markets help consumers to defer their consumption. If the consumers decide to consume more at future, they will save more now and invest in financial assets, which they can liquidate in future and consume. Thus consumers can shift their consumption over the course of their lifetime. That is, they can plan their consumption so as to give the highest level of satisfaction.

Use securities to store wealth and transfer consumption to the future

(2) (a) Stock market around the world is affected by COVID-19 pandemic. As an experienced investor you decide to take the advantage of it. Currently the stock of ABC Ltd. is selling for $40 per share, which was trading at $45 one week earlier and you are certain that the price will fall further. To take the advantage of this downward price momentum you sell short 1000 share of ABC Ltd at the current market price. You want to make $5000 profit from this short selling. You place an order with your broker to purchase the shares at a certain price to cover the position. What type of order did you place with your broker and at what price? Explain why. (5 marks)

· Find the 4 types of options order

· Price will be (Formula) to find what price the share need to drop to achieve 5k profit

· Definition of the order you used and mechanism of the order

(2) (b) Continue from 2(a) above. You borrowed 1000 shares of ABC Ltd from your broker and sell short. Initial margin is 50%. Your broker informs you that a margin call will be issued if your equity falls below $13,500. How much can the price of ABC Ltd rise before you get a margin call? What is the maintenance margin in your account? (3 + 2 = 5 marks)

Known

(3) (a) “Capital allocation line (CAL) must always be a straight line” – Is this statement true? Explain with examples (5 marks)

(3) (b) Can the proportion of optimal investment in risky portfolio (in a portfolio of one risk-free asset and one risky portfolio) be different for different investors? Explain with examples. (5 marks)

· TEXTBOOK 6.4 PAGE 178

· Yes

· Explain what happens when you insert Risk free asset in to a portfolio

· Giving an example of formula

· Option 2) Lecture 4 Slide 13

· Need to explain the formula on how to create a complete formula using one risk-free asset and one risky asset (y= proportion of risky portfolio, p) (1-y = proportion of risk free asset invested, f) Depends on the investors risk adversity

· Explain the risk adverse

(4) (a) There are two tasks in portfolio choice problem: (i) determination of the optimal risky portfolio and (ii) capital allocation. These two tasks are independent, or one is separate from the other. Explain why. (5 marks)

(4) (b) Suppose that the expected return and standard deviation of stock A are 10% and 5% respectively, while the expected return and standard deviation of stock B are 15% and 10% respectively. Returns of stock A and B are perfectly negatively correlated. Also suppose that it is possible to borrow at the risk-free rate. What must be the value of the risk-free rate? (5 marks)

(5) (a) As a result of the current COVID-19 pandemic, stock markets around the globe have become volatile. As an investor you perceive that the markets are going to experience significant movements in the near future; however, you are not sure about the direction of such movements. The markets may go up or go down. In such uncertain circumstances, what type of option strategy would you recommend to follow? Explain why. (3 marks)

(5) (b) The common stock of the ABC Corporation has been trading in a narrow range, around $50 per share for months, and you believe it is going to stay in that range for the next three months. The price of a 3-month put option with an exercise price of $50 is $4.

(i) if the risk-free rate is 10% per year, what must be the price of a 3-month call option on ABC stock at an exercise price of $50 if it is at the money? (Assume put-call parity holds and the stock pays no dividend). (2 marks)

(ii) What would be a simple option strategy using a put and call to exploit your conviction about the stock price’s future movements? Explain clearly. (3 marks) (iii) How far can the stock price move in either direction before you lose money? (2 marks)

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