8006 Exam Dumps : Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

The fair price for the futures contract should be [1000 x ( 1 + (2%-1%)/2)] = 1005. This means the futures contract is 'rich' at 1020. The trader should therefore short the futures contract, and buy the index spot. To buy the spot index, he will incur a borrowing cost of 2%, which will be partly offset by the dividend yield of 1%, and at the end of six months he will owe a net amount of 1005 and hold the index. At the same time the futures contract would expire too, and he would be able to sell at the agreed price of 1020, making a risk free profit of 15.

The underlying asset in a Treasury note futures contract is any long term Treasury note with a maturity of no less than 6.5 years and no more than 10 years. The underlying asset in a treasury bond futures contract is any long term US Treasury bond with a maturity of more than 15 years and not callable within 15 years.

Note the difference betwen what the underlying asset is for treasury bond futures and treasury note futures. In either case, adjustments will be made for the coupon and maturity of the actual bond delivered (the concept of the adjustment of 'cheapest-to-deliver').

Explanation:

The return on an asset is a function of the covariance of the asset's return to the returns of the market portfolio. They do not depend upon the standard deviation of the asset itself. Therefore Choice 'b' is correct and Choice 'c' is incorrect.

The expected returns on an asset are equal to the risk free rate plus the beta times the market risk premium, therefore Choice 'a' is correct.

Portfolios on the efficient frontier will all have a different Sharpe ratio, which is the ratio of excess returns to portfolio volatility.

Choice 'c' is the correct answer (note that the question is asking for an identification of the INCORRECT statement).