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Investment Management Exam Questions

Section A

Section A
Answer ONE question from Section A, ONE question from Section B, and ONE other question.
You must show all of your workings in quantitative answers. You may include scanned images of your own diagrams and calculations within your Word document.


Question 1. Answer ALL parts.
(a) Consider the following series of stock prices for Arwel plc. The stock did not pay dividends.

£0.80 £0.70 £0.80 £1.05 £0.95 Use this data as a focus to explain the features of simple (arithmetic) and logarithmic returns. [20 marks]


(b) Complete the empty cells in this table and interpret your results. Currency pair 1 st May rate 1 st June rate Monthly simple return Monthly logarithmic return EUR:JPY 129.55 122.84 JPY:EUR [10 marks]


(c) Using diagrams and examples, explain the concept of ‘Dominance’ in the context of portfolio theory and the capital asset pricing model (CAPM); [20 marks]


(d) Explain the differences between an ‘efficient portfolio’ and an ‘efficient market’. [20 marks]


(e) Consider the following two funds:
Fund Expected return Standard deviation of returns UK Growth 15% 24% North American Value 7% 16% The returns on the two funds are perfectly negatively correlated (i.e. correlation coefficient of -1).
(i) Calculate the proportions (weightings) that would be needed in each fund in order to generate a portfolio with a standard deviation of zero. What is the expected return of that portfolio? [10 marks]
(ii) Calculate the expected returns and standard deviations of three other portfolios with weightings of your choice. Present a graph of your results. [20 marks]


Question 2. Answer ALL parts.
(a) Discuss, with examples, the rapidly increasing attention placed on Environmental, Social and Governance (ESG) factors within the investment management industry. [15 marks]


(b) At times of financial market stress or crisis, investors typically engage in ‘flight to quality’ and/or ‘flight to safety’.
(i) Using examples, explain these terms; [10 marks]
(ii) Discuss how ‘flight to safety’ can be interpreted within the context of the Capital Market Line (CML) of the CAPM. [15 marks]
(iii) Explain the limits to diversification at times of economic or financial crisis. [10 marks]


(c) The following information is available for three of the many stocks in the equity market and for the market index

(i) This market is currently in equilibrium according to the CAPM. Calculate the beta values for each of the three stocks and interpret the values. [10 marks]
(ii) Calculate whether the three stocks plot on the CML. What conclusions do you draw from this? [15 marks]
(iii) A new stock (Elwyn plc) is introduced to this market. On its introduction, it has an expected return of 18% and a beta value of 1.45. Comment on the likely outcome of this situation. [10 marks]


(d) Discuss the potential reasons why initial public offerings (IPOs) are typically underpriced. [15 marks]


Question 3. Answer ALL parts.
(a) Explain the similarities and differences between the capital market line (CML) and security market line (SML) of the CAPM. [25 marks]


(b) “The expected return is inversely related to the current price.” Use a graph and a numerical example to interpret this statement. [15 marks]


(c) Consider European-style call and put options on an underlying stock which have an exercise price (X) of £60.
(i) Assuming the stock prices at maturity (ST) listed in the first column of the table below, calculate the payoffs from buying/writing the call/put options to complete the cells in the table. Assume that each option premium equals £0.2 X. [20 marks]

(ii) Use the table of results to explain the terms ‘at-the-money’, ‘in-the-money’ and ‘out-of-themoney’. [10 marks]


(d) The ‘UK Match’ index-tracking fund is considered to be a suitable proxy for the ‘market portfolio’ of the CAPM. This fund has an expected return of 7.5% for the next year, and shares in the fund are currently priced at £80.
Ffion plc has an estimated CAPM Beta value of 1.6 and its shares may be purchased for £80. This stock has an expected return of 14% for the next year. A one-year risk-free asset may be purchased at £12 and offers a 1% return for the next year.
(i) Devise a strategy to exploit the mispricing of Ffion plc and illustrate the cash flows arising from this strategy. [25 marks]
(ii) Assuming a different scenario, with Ffion plc correctly priced according to the CAPM, discuss the potential return from your strategy in part (i). [5 marks]


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