# FINS2624 PORTFOLIO MANAGEMENT

The following equations are provided:U = E(r) – 0.005A?2Ct = StN(d1) – Xe-r(T – t)N(d2)where? ? ? ?? ? ? ?tTddtTr tT XSdt??? ?? ?????? ???? ???1221 ;2 lnSt is the current stock price at time tX is the exercise pricer is the continuously compounded risk free rate per annum? is the standard deviation of returns on the underlying stockT-t denotes the time remaining to maturityAs shared on…Page 2 of 22SECTION A – 70 Multiple-Choice Questions (1 mark each)Mark the answer to each question on the generalised answer sheet provided.Refer to the following table for Questions 1 to 4. The table is extracted from the ReserveBank of Australia website, http://www.rba.gov.au/Statistics/indicative.html, on Monday, 20July 2009.DAILY STATISTICAL RELEASE – Release date: Friday 17 July 2009Indicative Mid Rates of Selected Commonwealth Government Securities (CGS)Treasury Fixed Coupon BondsCoupon Maturity Yield (% p.a.)7.50% Sep 2009 3.0155.25% Aug 2010 3.3155.75% Jun 2011 3.9105.75% Apr 2012 4.4101) For the 5.25% Aug 2010 CGS, the market is demandingA. a higher rate of return now than the time when the bond was issued.B. the same rate of return now as the time when the bond was issued.C. a lower rate of return now than the time when the bond was issued.D. an unfair return from the government.E. insufficient information to tell.2) On Friday, 17 July 2009 the current yield of the 5.25% Aug 2010 CGS isA. smaller than 3.315%B. 3.315%C. larger than 3.315% but smaller than 5.25%D. 5.25%E. larger than 5.25%3) Assuming T+2, on Friday, 17 July 2009 the capital (or adjusted) price of the 5.25% Aug2010 CGS is _______ than the settlement price by $ _______.A. less; 0.540B. less; 0.639C. less; 1.509D. less; 2.262E. None of the above4) Other things being equal, on the basis of T+2, for the 5.25% Aug 2010 CGS, on which ofthe following calendar day will the bond experience a fall in settlement price by anamount that is close to the amount of coupon interest per six-month period?A. Tuesday, 4 Aug 2009B. Wednesday, 5 Aug 2009C. Thursday, 6 Aug 2009D. Friday, 7 Aug 2009E. none of the aboveAs shared on…Page 3 of 22The following information applies to Questions 5 and 6. On Tuesday, 17 November 2009, theyield to maturity of the 5.25% Aug 2010 CGS was 4.150%.5) On the basis of T+2, the settlement price wasA. 99.206B. 100.289C. 100.786D. 102.155E. none of the above6) Had you purchased the 5.25% Aug 2010 CGS on Tuesday, 17 November 2009 and sold iton Friday, 6 August 2010 on the basis of T+2, you would have sold the bond ___ and ___the coupon interest on 15 August 2010.A. cum interest ; not receivedB. cum interest; receivedC. ex interest; not receivedD. ex interest; receivedE. none of the above7) Which of the following attribute of a CGS is set by the government?A. Maturity dateB. Coupon rateC. Yield to maturityD. A and BE. A, B, and C8) Assume annual interest payment. The yields to maturity of a 10% 1-year bond and a12.5% 2-year bond are 5.10% and 6.25% respectively. This term structure implies thatthe spot rate of a two-year bond isA. 6.259%B. 6.312%C. 6.319%D. 6.418%E. insufficient information to solve the problemAs shared on…Page 4 of 22The following term structure of interest rates applies to Questions 9 and 10. Assume thatcoupon interests are paid annually.Coupon rate % pa Time to Maturity YTM % pa10.0 1 year 5.1012.5 2 years 5.258.0 3 years 5.409) According to the expectations hypothesis, investors with an investment horizon of oneyear wouldA. prefer the 3-year bond to the other two bonds as it offers the largest yieldB. prefer the 1-year bond to the other two bonds as its cash flows are certainC. prefer the 1-year bond to the other two bonds as its maturity matches the investmenthorizonD. prefer the 2-year bond to the other two bonds as it offers the largest coupon rateE. none of the above10) The term structure implies that f(1,1), the forward rate of a 1-year bond one year fromnow is:A. 5.42%B. 6.42C. 6.52D. 6.74E. none of the above11) Assume semi-annual interest payment. You purchased and held a five-year bond for oneand a half years. At the time of purchase and sale, the yield is the same as the coupon rateof 10%. If you were able to reinvest all the coupon interests received at 12% per annumcompounded semi-annually, what is the holding period return?A. 10.094%B. 10.188%C. 11.889%D. 13.745%E. insufficient information12) The expectations hypothesis asserts that market expectations of future interest rates areunbiased. This assertion implies that market expectations of future interest ratesA. are always accurateB. can be above or below actual interest ratesC. are always smaller than actual interest rates by the liquidity premiumD. are always larger than actual interest rates by the liquidity premiumE. none of the aboveAs shared on…Page 5 of 2213) Which of the following is correct about the liquidity premium hypothesis?A. Issuers of long-term bond offer investors a higher than expected return to minimiseuncertainty in the costs of refinancing.B. Household lenders demand a liquidity premium as they prefer to lend for a term thatis longer than the maturity of the bondC. We add liquidity premium to forward rates to arrive at market expectation of futureinterest ratesD. A and CE. A, B and C14) According to the liquidity premium hypothesis, which of following has the largestliquidity premium? f(n,t) denotes the forward rate of a n-period bond in t periods’ time.A. f(10,5)B. f(10,2)C. f(5,2)D. f(2,5)E. insufficient information to tell15) The duration of a coupon bond is positively related to the bond’sA. time to maturity.B. yield to maturity.C. coupon rate.D. B and CE. A, B, and C16) Suppose you forecast that there will be a downward and parallel shift in the yield curve inthe near future. You are holding an equally weighted portfolio in the following bondseries now:6.50% May 2013, 6.25% Apr 2015, 6.00% Feb 2017Should the forecast come true, you would increase the portfolio value the most in theshort-run by liquidating investment in the _____ series and investing the money in the______ series now.A. 6.50% May 2013, 6.00% Feb 2017B. 6.25% Apr 2015, 6.00% Feb 2017C. 6.00% Feb 2017, 6.50% May 2013D. 6.00% Feb 2017, 6.25% Apr 2015E. Insufficient information17) Which of the following is free from price and income risks?A. Buy and hold a CGS with six months or less to maturityB. Buy a 6.25% Apr 2015 CGS and the beginning of this session and sell the bond at theend of this sessionC. Buy a 5-year zero coupon bond and hold the bond for 2 yearsD. A and CE. None of the aboveAs shared on…Page 6 of 2218) Other things being equal, the duration of a zero coupon bondA. does not change over timeB. is inversely related to the bond’s yield to maturityC. increases as the bond approaches the expiration dateD. is independent of the bond’s yield to maturityE. none of the above19) Duration is defined as the weighted average time to recover the cost of a bond investment.The weight allocated to each future cash flow isA. computed by dividing the cash flow received by the cost of investment.B. computed by dividing the present value of the cash flow received by the present valueof all future cash flows.C. the time when the cash flow is received.D. computed by dividing the time when the cash flow is received by the maturity of thebond.E. none of the above20) You are currently holding a portfolio that consists of (a) $2000 cash and (b) one 10-yearzero coupon bond with a face value of $1000 and 12% yield to maturity. The Macaulayduration of the portfolio isA. 1.3866B. 2.4356C. 2.7826D. 3.9171E. none of the above21) Which of the following bond is the most price sensitive to interest rate movements?A. A bond with short term to maturity and high coupon rateB. A bond with short term to maturity and low coupon rateC. A bond with long term to maturity and low coupon rateD. A bond with long term to maturity and high coupon rateE. None of the above22) Income risk is related toA. the uncertain amount of interest earned from reinvesting the coupon interests receivedfrom a bond investmentB. the uncertain capital gain/loss arising from a bond investmentC. the uncertain proceeds of sale when a bond is sold before the maturity dateD. B and CE. A, B, and CAs shared on…Page 7 of 2223) The Macaulay duration equation can be obtained by differentiating the present value ofthe cash flows of a coupon bond with respect toA. The coupon rateB. The discount rateC. The number of periods to maturityD. Income and price risksE. The weights of the cash flows24) According to the mean-variance criterion, which of the following combination dominatesall others?A. E(R) = 0.15; Variance = 0.20B. E(R) = 0.10; Variance = 0.20C. E(R) = 0.10; Variance = 0.25D. E(R) = 0.15; Variance = 0.25E. None of the above25) The standard deviation of returns of a portfolio of risky assets is determined byA. the allocation of funds to the constituent assets of the portfolio.B. the correlation coefficients among the constituent assets of the portfolio.C. the standard deviations of returns of the constituent assets of the portfolio.D. B and CE. A, B, and C26)In the absence of a risk free asset, which of the following ranking rule is needed to locatethe optimal portfolio of risky assets?A. The portfolio with the largest utility is preferred.B. The portfolio with the largest reward to variability ratio is preferred.C. For a given level of expected return, the portfolio with the lowest level of risk ispreferred.D. For a given level of risk, the portfolio with the largest expected return is preferred..E. None of the above27) The standard deviation of return on ABC and XYZ are 0.1 and 0.4 respectively. Thecorrelation coefficient between the two assets is 0.6. The standard deviation of return ofan equally weighted portfolio of the two assets isA. 23.35%B. 28.28%C. 28.72%D. 29.15%E. none of the aboveAs shared on…Page 8 of 2228) Risk averse investorsA. never take riskB. rank investments according to expected return onlyC. always demand a premium above the risk free asset for risky investmentsD. always have a negative degree of risk aversionE. None of the above29) Given the portfolios lying on the capital allocation line, an investor should choose theportfolio thatA. maximises his/her expected returnB. minimises his/her riskC. maximises the reward to variability ratioD. maximises his/her expected utilityE. none of the above30) In the presence of a risk free asset, which of the following ranking rule is needed to locatethe optimal portfolio of risky assets?A. For a given level of expected return, the portfolio with the lowest level of risk ispreferred.B. The portfolio with the largest reward to variability ratio is preferred.C. The portfolio with the largest utility is preferred.D. B and C.E. A, B, and C.31) If the borrowing rate is higher than the lending rate, which of the following is correct?A. Portfolios lying on the capital allocation line may have different reward to variabilityratios.B. Investors with different degrees of risk aversion will always choose the same portfolioof risky assets.C. The capital allocation line is a straight line.D. Two of the aboveE. None of the aboveInformation for Questions 32 and 33:Imagine that there are only two efficient portfolios of risky assets, EP1 and EP2. EP1 offers10% expected return and 4% risk. EP2 offers 16% expected return and 6% risk. An investorhas $100 to invest and can borrow or lend risk-free at 4%.32) Calculate the minimum level of return required by the investor if he can tolerate 20% risk.A. 44%B. 46%C. 48%D. 54%E. None of the aboveAs shared on…Page 9 of 2233) In order to achieve a 64% return, the best way is to:A. borrow $400 at the risk-free rate and invest $500 in EP2.B. borrow $500 at the risk-free rate and invest $600 in EP1.C. borrow $1000 at the risk-free rate and invest $1100 in EP1.D. borrow $900 at the risk-free rate and invest $1000 in EP1.E. None of the above34) The beta of CBA is 0.8. The expected return on the market is 15% and the risk free rateis 5%. CBA is currently priced at $25. If the market predicts that CBA will pay adividend of $0.50 at the end of this year when its price will end up at $30, CBA is lyingA. above the capital market lineB. below the capital market lineC. above the security market lineD. below the security market lineE. none of the above35) As diversification increases, the total variance of a portfolio approachesA. 0.B. 1.C. systematic risk.D. unsystematic risk.E. none of the above36) The single index model may be applied toA. conduct an event study.B. evaluate funds performance.C. estimate beta.D. A and CE. A, B and C37) The difference between the actual excess return of a stock and that predicted by theSingle Index Model (SIM) is known asA. alpha, the intercept.B. beta, the slope.C. e, the residual return.D. the risk premium.E. none of the aboveAs shared on…Page 10 of 2238) In the context of the single index model, random and independent firm specific news areresponsible for the observation ofA. a non-zero alpha coefficient.B. a non-zero beta coefficient.C. non-zero residual returns.D. A and CE. A, B, and C39) The single index model ______.A. is the empirical version of the capital asset pricing modelB. studies the relationship between expected return and systematic riskC. studies the relationship between excess stock returns and excess market index returnsD. A and CE. B and C40)Based on the outputs of the single index model regression, a stock is said to have anabnormal return ifA. the intercept is significantly different from 0.B. the slope coefficient is significantly different from 0.C. the average residual return is significantly different from 0.D. A and CE. A, B and C41) Which of the following is correct about R2, one of the outputs from the Single IndexModel regression?A. It shows the proportion of unsystematic risk of the stock relative to its total risk.B. The square root of R2 is the correlation coefficient between the excess returns of thestock and the market.C. R2 is the square of excess return.D. A and BE. A, B, and C42) Which of the following is indicative of an inefficient market?A. Deviation of market prices from the fundamentals over an extended periodB. Predictable returns that are based on dividend yieldsC. Predictable returns that are based on past returnsD. A and BE. A, B and C43) Which of the following strategy is shown to produce positive abnormal returns?A. Invest in stocks at the top end of the return scale (where return is measured over thepast year) for a period of 3 to 6 monthsB. Invest in spinoffs and their parents for a period of 3 yearsC. Invest in initial public or seasoned equity offerings for a period of 5 yearsD. A and BE. A, B and CAs shared on…Page 11 of 2244) Which of the following is correct about an event study?A. it may be used to test whether the market is semi-strong form efficientB. it measures the relationship between an event that affects securities and the return ofthose securitiesC. it may be used to assess the speed and timing of stock price reaction to a firm specificeventD. A and CE. A, B and C45) Researchers have found that most of the small firm effect occursA. randomlyB. in JanuaryC. in DecemberD. during the spring monthsE. during the summer months46) Which form of market efficiency do the chartists not believe in?A. weak formB. semi-strong formC. strong formD. all of the aboveE. none of the above47) Proponents of the efficient market hypothesis think technical analystsA. should focus on relative strengths.B. should focus on resistance levels.C. should focus on momentum strategies.D. A, B and CE. are wasting their time.48)In a semi-strong efficient market,A. security prices react quickly to new informationB. investors are unable to use fundamental analysis to consistently earn abnormal returnsC. investors can never earn an abnormal returnD. A and BE. A, B, and C49) Which of the following would provide evidence against the semi-strong form of theefficient market hypothesis?A. Observing a post-announcement drift in cumulated average residualsB. Past losers, stocks with the worst 3- to 5-year past return, turn out to be future winnersC. Low price earnings ratio stocks tend to have positive abnormal returnsD. A and CE. A, B and CAs shared on…Page 12 of 2250) Which of the following is used to explain the underperformance of actively managedfunds relative to the index funds?A. Brokerage costB. Bid-ask spreadC. Market impact costD. A and BE. A, B and CConsider the following portfolios for Questions 51 and 52. All values are annualised and therisk-free rate is 10%. Portfolio AveragereturnStandard deviationof returnsResidual standarddeviationBeta A 20% 30% 4.00% 0.8 B 18% 10% 1.25% 1.0 C 23% 20% 1.20% 1.2 All Ords 20% 16% 151) The Treynor index of portfolio B isA. -0.02B. 0.08C. 0.80D. 6.4E. none of the above52) The appraisal ratio of portfolio C isA. 0.8333B. 2.1667C. 10.83D. 19.17E. none of the aboveAs shared on…Page 13 of 22Consider the following portfolios for Questions 53 and 54. All values are annualised andinvestors can borrow and lend at a risk-free rate of 5%.Portfolio AveragereturnStandard deviationof returnsBeta Residual standarddeviationA 10% 0.16 0.65 0.01B 12% 0.53 0.75 0.50C 22% 0.63 2.50 0.10All Ordinaries index 7% 0.2553) Which of the above portfolios has the highest abnormal return?A. Fund AB. Fund BC. Fund CD. All Ordinaries indexE. The abnormal returns for all of the funds is zero54) An investor plans to invest all the spare money in a managed fund. The investor does nothave any other investment. Which fund should the investor choose?A. Fund AB. Fund BC. Fund CD. Indifferent between A and CE. Indifferent between B and C55) If a stock’s price is S0 at time zero and S1 one period later, then the continuouslycompounded return on the stock, r, is given byA. 1 + r = ln(S1/S0)B. r = ln(S1/S0)C. r =S SS1 00?D. 1 + r = e S S 1 0 /E. none of the above56) Tracy won $10,000 from the Channel 7 game show “Deal or No Deal”. She already has a$50,000 investment in an index fund. Tracy wishes to invest the windfall in an activeportfolio managed by either Macquarie Bank or Platinum Asset Management, the mostappropriate performance index to evaluate the two active portfolios is theA. Jensen alphaB. Sharpe indexC. Treynor indexD. appraisal ratioE. diversification indexAs shared on…Page 14 of 2257) When a superannuation fund is large and has many managers, the ___________ istypically used in practice to evaluate individual managers.A. diversification indexB. Sharpe indexC. Treynor indexD. appraisal ratioE. none of the above58) Suppose two portfolios have the same average return, the same beta, but portfolio A has ahigher standard deviation of returns than portfolio B. According to the Treynor index, theperformance of portfolio A __________.A. is better than the performance of portfolio BB. is the same as the performance of portfolio BC. is poorer than the performance of portfolio BD. cannot be measured as there is no data on the alpha of the portfolioE. none of the above59) Traders may use options alone or together with the underlying stock to benefit fromA. no or immaterial change in the value of the underlying stockB. persistent upward or downward movements in the value of the underlying stockC. volatility movements in the underlying stockD. B and CE. A, B and C60) Which of the following scenario violates the assumptions of the Black Scholes model?A. Stock returns have fat tailsB. Stock movements follow a jump-diffusion processC. Time-varying volatilityD. A and CE. A, B and C61) If you write a put option written on a stock, which of the following is true?A. You may close off the position by buying another put option written on a differentstockB. The final payoff is unlimited.C. You gain the right to sell the underlying shares on or before the expiration date at thepredetermined exercise price.D. B and CE. None of the above62) A European put option with six months to maturity has a strike price of $35. Theunderlying stock, which does not pay dividends, now sells for $34. The put premium is$1.58. The time value of the put option isA. zeroB. $0.58C. $1.00D. $1.58E. $35.58As shared on…Page 15 of 22Information for Questions 63 to 65:Today the share price of CBA is $23. You write one CBA Sep $22.75 call at a premium of$0.60, buy two CBA Sep $23 calls at a premium of $0.45 for each option, and write one CBASep $23.25 call at a premium of $0.32. Assume the size of one contract is one share of theunderlying asset.63) What is the position value today?A. -$0.25B. -$0.02C. $0.02D. $0.25E. None of the above64) If the share price of CBA rises to $24.00 on the expiration date, the position value on theexpiration date isA. $0.00B. $0.20C. $0.25D. $0.50E. none of the above65) If the share price of CBA rises to $24.00 on the expiration date, the profit/loss on theexpiration date isA. -$0.02B. $0.02C. $0.25D. $0.27E. None of the above66) The put-call parity equation for European options is derived by constructing twoportfolios in such a way that their values at the common option expiration date are equaland the assumption that one can borrow and lend at the same risk free rate, r. Oneportfolio, P1, consists of a long stock and a long put (with a strike price of $X and timeremaining to maturity T). The second portfolio, P2, consists ofA. a long call with a strike price of Xe-rT and an investment of Xe-rT in the risk free asset.B. a long call with a strike price of X and an investment of X in the risk free asset.C. a long call with a strike price of X and an investment of Xe-rT in the risk free asset.D. a long call with a strike price of Xe-rT and an investment of X in the risk free asset.E. none of the aboveAs shared on…Page 16 of 2267) A collar strategy containsA. a short out-of-the-money put, a long out-of-the-money call, and a long position in theunderlying asset.B. a long out-of-the-money put, a short out-of-the-money call, and a long position in theunderlying asset.C. a long out-of-the-money put, a long out-of-the-money call, and a short position in theunderlying asset.D. a long out-of-the-money put, a short out-of-the-money call, and a short position in theunderlying asset.E. none of the above68) If ABC’s standard deviation of monthly continuously compounded returns is 1.2%. Itsannualised standard deviation of continuously compounded returns isA. 4.16%B. 13.15%C. 14.40%D. 37.95%E. None of the aboveThe following payoff diagram refers to the Questions 69 and 70. 069) You can achieve the payoff in the above diagram by using the following combination ofoptions:A. buy a call with X = 50, sell a call with X = 60.B. sell a call with X = 50, sell a call with X = 60.C. sell a put with X = 50, sell a call with X = 60.D. sell a put with X = 50, buy a call with X = 60.E. buy a put with X = 50, buy a call with X = 60.70) Which of the following is true?A. The diagram suggests that the maximum payoff on the option expiration date is $0.B. The diagram suggests that the loss on the option expiration date may be unlimited.C. The position that corresponds to the diagram must generate a positive cash flow whenthe position is established.D. A and B.E. A, B and C.50 60 STPayoffAs shared on…Page 17 of 22SECTION B – 4 Short-Answer Questions (Total = 30 marks)Print your name and student number below. Write the answers in the space providedunderneath the questions.Surname: ______________________Given names: ___________________Student ID number: ______________QUESTION 1 – Term Structure of Interest Rates Total = 2 marksThe following questions are written in the context of the liquidity premium hypothesis.i) Denote f(3,5) as the forward rate of a three-year bond in five years’ time inferred from theterm structure of interest rates today. LP(3,5) is the corresponding liquidity premium.How do you obtain today’s market expectation of the yield of a 3-year bond in five years’time using f(3,5) and LP(3,5)? (1 mark)E[r(3,5)] = _____________________________________ii) Investor should demand (a) more or (b) less liquidity premium than LP(3,5) for investingin a 6-year bond for 5 years. (1 mark)My choice is _________________ .As shared on…Page 18 of 22QUESTION 2 – Portfolio Theory Total = 10 marksAssume that short-selling is banned, there are six risky assets to consider, and investors canlend and borrow risk free at 4.75% p.a. (rfL) and 6.00% p.a. (rfB), respectively. We haveidentified two optimal portfolios of risky assets, ORPL and ORPB, for those who may lendand borrow at the respective risk free rate of interest. Composition of the optimal portfolio of risky assets Risk return combination RA1 RA2 RA3 RA4 RA5 RA6 E(RP) ?PORPL 0.0285 0.9715 0.0000 0.0000 0.0000 0.0000 58.62% 28.23%ORPB 0.0182 0.9818 0.0000 0.0000 0.0000 0.0000 58.87% 28.36%i) An investor knows that he will neither borrow money to invest nor put all his money in aportfolio of risky assets. State the underlying linear programming problem that theinvestor needs to solve in order to find out the best allocation of his capital. (4 marks)The investor needs to find __________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________that ____________________________________________________________________________________________________________________________________________________________________________________________________________________subject to the constraint(s) __________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________As shared on…Page 19 of 22ii) Another investor knows that she will neither lend nor borrow money at the above risk freerates. Compute the range of degree of risk aversion of the investor. Report the answer to 4decimals. (4 marks)________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________iii) A third investor who has $1,000.00 finds it optimal to borrow an additional $4,000.00 toinvest. Compute the expected return and risk of the consequent allocation. Report theanswer in percentage value and to 2 decimals, e.g., 1.23%. (2 marks)________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________As shared on…Page 20 of 22QUESTION 3 Total = 10 marksInformation for parts (i) to (vii) – Suppose the current market price of a European call option,c0, is $3.00. The option has six months to maturity and the strike price, X, is $35. The currentprice of the underlying stock, S0, which does not pay dividends, is $34. The continuouslycompounded risk free rate, r, is 6% per annum and the stock volatility, ?, is 25% per annum.Based on the above information, d1 = 0.0941, d2 = -0.0827, N(d1) is 0.5375 and N(d2) is0.4671. Assume that there are no transactions costs, investors can borrow and lend at the riskfree rate, and the option contract size is one share per option.i) Is the call option in, at, or out of the money? (1 mark)The call option is _________________________.ii) Write down the equation for the intrinsic value of a call option. Apply the equation tocompute the intrinsic value of the call option. (1 mark)________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________iii) According to the Black Scholes option pricing model, the theoretical value of the calloption is $2.41. Hence the market has a) overpriced or b) underpriced the option. (1 mark)My choice is ___________________________.iv) The probability that the call option will finish in the money is __________. (1 mark)v) The hedge ratio of the call option is _____________ . (1 mark)vi) Given the hedge ratio of the call option and the current mispricing situation, tell us thetransactions that you may execute today to earn a risk-free arbitrage profit. (3 marks)________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________As shared on…Page 21 of 22________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________vii)Suppose you enter into a covered call position at the current market prices. If the stockprice goes up to $40 on the expiry date of the option and the call is exercised, describeyour obligation on the option maturity date, i.e., the consequent flow of fund and stockfrom your point of view. (2 marks)________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________As shared on…Page 22 of 22QUESTION 4 – CAPM Total = 8 marksSymbols and equations are accepted for part (iii) only.i) Among the many applications of the CAPM, what is the most important piece ofinvestment advice that has been adopted and embraced by the funds managementindustry? (1 mark)The most important piece of investment advice is _______________________________________________________________________________________________________________________________________________________________________________.ii) Investors may also apply the CAPM to measure and price risk. What are the twoyardsticks to measure risk? (For example, we may use inch and centimeter to measurelength.) (3 marks)We may use _________________________________________________________ and_______________________________________________ to measure risk.iii) How much return should investors expect for each unit of risk as specified by the answersin part (ii)? (2 marks)Investors should expect for each unit of risk as specified by the 1st expression in (ii)______________________________________________________________________.Investors should expect for each unit of risk as specified by the 2nd expression in (ii)______________________________________________________________________.iv)