Principle of Modern Finance Exam Paper

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This is a close-book exam. Section A (Q1) and section B (Q2) are compulsory. You just need to answer one question in section C (Q3, Q4 and Q5). This is a close-book exam. Section A (Q1) and section B (Q2) are compulsory. You just need to answer one question in section C (Q3, Q4 and Q5).

Supplementary Papers Included: Formulae Sheet

Supplementary Papers Included: Formulae Sheet

In marking the papers, the examiner will take into account clarity of exposition and logic of arguments, effective arrangement and presentation and the use of concise and lucid English.

Candidates should ensure that all workings are clearly shown.

MOBILE PHONES MUST BE SWITCHED OFF AND PLACED BEYOND REACH.
THIS IS AN INDIVIDUAL PIECE OF WORK AND ANY FORM OF COLLABORATION OR OTHER FORM OF CHEATING IS REGARDED AS A SERIOUS OFFENCE UNDER THE UNIVERSITY’S ACADEMIC MISCONDUCT PROCEDURES AND COULD HAVE AN EFFECT ON ANY FINAL AWARD CLASSIFICATION.

Section A: Short-Answer Questions - Answer All Questions
Q1
a) According to the Capital Market Theory and Capital Assets Pricing Model, what are the characteristics of the Market Portfolio?(3marks)

b) What does an overvalued asset mean in the context of CAPM, and does such an asset lie above or below the Security Market Line?(3 marks)

c) In a two-asset portfolio, what determines the degree of risk-reduction effect? (2 marks)
d) Sketch and properly label the indifference curve of a highly risk averse individual, and explain what it measures or represents.(4 marks)

e) What is the importance of the indifference curve in Markowitz Portfolio theory?

(2 marks)
f) According the Efficient Market Hypothesis (EMH), why do share prices follow a random walk?(2 marks)

g) What does a fundamental analyst attempt to do, and according to the EMH why would s/he not succeed?(3 marks)

h) What are the implications of semi-strong efficiency for financial managers? (3 marks)
i) What are the differences between a plain vanilla bond and a convertible bond? (3 marks)

j) What are the advantages of a convertible bond to a company?(3 marks)

k) From the formula sheet you have been provided, copy the formula for the constant growth dividend valuation model for ordinary shares, and explain the terms in the model.(3 marks)

l) What are the assumptions behind g = rb?(3 marks)

m) Which group of investors prefer capital gains to dividends and why?(3 marks)

n) If a clientele effect exists, what does it imply for dividend policy?(3 marks)
Total Mark(40 marks)

Section B: Answer All Parts of the Question
Q2 (a)
You have just secured your first job as a financial analyst after successfully completing your postgraduate study. Your first assignment involves demonstrating a thorough grasp of Mean-Variance Analysis and Portfolio Theory, which coincidentally was your most favourite topic in Principles of Modern Finance module. Before your arrival, a more experienced analyst had been working on two projects for a client, and has already estimated the risk and return characteristics of two projects as well as the correlation coefficient between the projects. These are given in the table below:

Project 1Project 2
Expected return 12% 20%
Risk (std dev) 3% 7%

Correlation between the
Project = + 0.1

The client plans to invest 80% of its available funds in Project 1 and 20% in Project 2. Following your employment, the senior analyst has been moved to a new and more challenging task and you have been asked to complete the assignment as indicated below. Required:

(i) To calculate the expected return from the proposed portfolio of Projects 1 & 2. (2 marks)
(ii) To calculate the risk of the portfolio.(4 marks) (iii) To advise on how the client company should invest its funds in order to obtain a zero-risk portfolio...
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