Final Exam Practice Questions Foundations of Finance1Instructions: 120 minutes. Closed book. You are permitted use of a financial calculator andtwo sheets (8½" x 11") of notes. Answer all questions. Each question carries the number ofpoints indicated. Total points is 100. Show all work on the exam paper itself. If you do nothave or can not calculate a number that you need, make an assumption and proceed with therest of the question. No credit will be given for illegible, unsupported or ambiguous answers.Practice Final Exam QuestionsI. [28 points] XYZ Co pays monthly dividends and its current dividend per share is $0.25.XYZ’s dividend per share is expected to grow at the same rate per month indefinitely and itscurrent share price is $20. The riskless rate has always been 0.8% per month and will remainat 0.8%. A market model regression of XYZ’s monthly stock return on the market’s monthlyreturn has a slope coefficient of 1.2. The expected monthly return on the market portfolio is1.3% and its standard deviation is 0.9%. A. Suppose the CAPM holds.1. What is the intercept of the market model regression of XYZ’s monthly stockreturn on the market’s monthly return?2. What is the expected monthly return on XYZ’s equity?3. What is expected dividend growth rate for XYZ?B. Suppose instead that the ICAPM holds and investors care about {E[Rp(t)], σ[Rp(t)],TERM(t)} where TERM(t) is the difference between the yield on a long term bondand the yield on a short term bond at the end of month t. The following informationis available (the table also summarizes some information already presented):iE[Ri(t)] βi,M βi,TERM M 1.3% ? 0.5XYZ ? 1.2 0.7QV 1.1% 0.9 0.2where:βi,M is the slope coefficient from the regression of asset i’s monthly return on themarket portfolio’s monthly return:Ri(t) = αi,M + βi,M RM(t) + ei,M(t); and,βi,TERM is the slope coefficient from the regression of asset i’s monthly return inmonth t on TERM(t) (a time series regression):Ri(t) = αi,TERM + βi,TERM TERM(t) + ei,TERM(t).1. What is βM,M?2. What is the expected return on XYZ?Final Exam Practice Questions Foundations of Finance2-10 -8 -6 -4 -2 0 Payoff ($)10 12 14 16 18 20 22 24 26 Stock Price at Maturity ($)Gross Payoff at Maturity-5 -4 -3 -2 -1 0 Payoff ($)10 12 14 16 18 20 22 24 26 Stock Price at Maturity ($)Gross Payoff at Maturity3. What is the intercept of the market model regression of XYZ’s monthlyreturn on the market’s monthly return (i.e., what is αXYZ,M ?)?4. Is there any reason for not using the constant growth dividend discount modelin this setting?II. [20 points]A. If forward-spot parity holds, what is the one-year forward price of the French Franc,assuming that the current exchange rate is $.20/Franc, the French one-year interestrate is 8% (expressed as an EAR) and the U.S. one-year rate is 6% (also expressedas an EAR)?B. The one-year dividend yield on the S&P is 4%, the current one-year risk-free rate is6% (expressed as an EAR) and the one-year forward price on the S&P index is 460.The dividends are paid at the end of 12 months. 1. If forward-spot parity holds, what is the current level of the S&P index?2. If the current S&P index is 10 points higher than you calculated in theprevious part, describe a risk-free arbitrage and compute the cash flows on it.III. [16 points] Describe a portfolio of puts, calls (with their exercise prices), bonds (with parvalue) and shares of stock that would have the indicated gross payoffs (i.e., terminal value,ignoring the amount paid/received to set up the portfolio). Each put and each call must have1 share of stock as the underlying, be European and expire at the terminal date. The bondsmust be discount bonds which mature at the terminal date. A. B.Final Exam Practice Questions Foundations of Finance3-6 -4 -2 0 2 4 6 8 10 Payoff ($)10 12 14 16 18 20 22 24 26 Stock Price at Maturity ($)Gross Payoff at Maturity-15 -10 -5 0 5 10 Payoff ($)10 12 14 16 18 20 22 24 26 Stock Price at Maturity ($)Gross Payoff at MaturityC. D.IV. [16 points] The common stock of Sternco is currently trading at $40 per share (up from $25at the beginning of the year). Sternco is currently “in play” as a takeover target and is notexpected to pay any dividends for the next 6 months. You believe that if management issuccessful at repelling all offers, the stock will fall significantly, but if they are unsuccessful,the stock will rise. You want to profit from either outcome. The risk-free rate is 10%(continuously compounded annual rate) and a 6-month call option with an exercise price of$40 is selling at $4. A. A dealer offers you a 6-month European put option with an exercise price of $40.What is a fair price for this option?B. Propose a strategy to take advantage of your beliefs that uses one or more of thefollowing instruments: the stock, 6-month call options with an exercise price of $40,6-month European put options with an exercise price of $40 and discount bondsmaturing in 6 months.C. One month ago the firm trying to take over Sternco publicly announced its intentions.This announcement caused Sternco’s stock price to increase and the volatility ofSternco’s stock return to increase. What would have happened to the price ofFinal Exam Practice Questions Foundations of Finance4European calls on Sternco’s stock on the announcement date? V. [5 points] If forward-spot parity holds, what is the current spot price of the English Pound(expressed as U.S. dollars per English pound), assuming that the one year forward rate is$1.80/£, the English one-year interest rate is 7% (expressed as an EAR) and the U.S. one-year rate is 9% (also expressed as an EAR)?SolutionsI.A.1. αXYZ,M = (1- βXYZ,M ) Rf = (1 - 1.2) x 0.8% = -0.16%.2. XYZ lies on the SML:E[RXYZ(t)] = Rf + βXYZ,M {E[RM(t)]- Rf} = 0.8% + 1.2 {1.3% - 0.8%} = 1.4%.3. Use the constant growth DDM:PXYZ(0) = DXYZ(0) [1+g]/{E[RXYZ(t)]-g}20 = 0.25 [1+g]/ {0.014 - g}20 {0.014 - g} = 0.25 [1+g]0.28 - 20g = 0.25 + 0.25gg = 0.03/20.25 = 0.00148 = 0.148% per month.B.1. By definition, βM,M = 1.2. In an ICAPM world, the following holds for any asset i:i: E[Ri(t)] = Rf + βi,M λM + βi,TERM λTERMThus,M: 1.3% = 0.8% + 1 x λM +0.5 x λTERMQV: 1.1% = 0.8% + 0.9 λM +0.2 x λTERMNow M implies λM = {0.5% - 0.5 x λTERM }. Substituting into QV gives0.3% = 0.9 {0.5% - 0.5 x λTERM } + 0.2 x λTERM-0.15% = -0.25 x λTERM which implies λTERM = 0.6% and λM = 0.2%. So finallyXYZ: