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

This question requires us to use the CAPM.

Recall that according to CAPM the expected return on an asset = The risk free rate + β x Market risk premium.

Using the beta and expected return of security A, we can determine the market risk premium to be (8% - 3%)/1.2 = 4.1667%. The excess return is the return over the risk free rate, and for security B, this is nothing but the beta multiplied by the market risk premium. Therefore the correct answer is 4.1667% x 1.5 = 6.25%. Note that this is the 'excess return', and not the total return. (Total return will include the risk free rate).

A covered call is an attempt to earn premium income by selling calls while protecting against the downside by holding long the underlying. In case prices rise, the holder of the covered call can give away the held underlying. In case prices fall or stay below the strike price of the sold call, the holder of the covered call gets to keep the premium.

The holder of the covered call will suffer a loss if the price of the underlying declines due to the long position held in the underlying. However, these losses will be partly offset by the premiums earned on the calls sold.

Choice 'd' does not represent a correct statement as in the event of a rise in the price of the underlying the holder of the covered call will lose any upside, but will not have unlimited losses. In the event of a decline in stock prices, his losses will be equal to the loss on the underlying, minus the premium earned.

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.