SINGLE ASSET
Suppose treasuries yield = 5%
Returns for an equity investment over a period of 1 year are as per the given table
Calculate expected return per year
Probability Return Expected Return E(R^2) {E(R^2)-[E(R)]^2} sqrt{E(R^2)-[E(R)]^2}
0.05 50% 0.025 0.0125 0.0025
0.25 30% 0.075 0.0225 0.0225 18.974% RISK
0.4 10% 0.04 0.004 0.004
0.25 -10% -0.025 0.0025 0.0025
0.05 -30% -0.015 0.0045 0.0045
10% 3.60%
Standard Deviation sqrt{E(R^2)-[E(R)]^2}
COMBINING RISKY INVESTMENTS
Expected return of investment 1= E(R1) or Mu1
Expected return of investment 2= E(R2) or Mu2
Proportion of w1 invested in investment 1 and w2=1-w1 invested in investment 2
sigma 1 and sigma 2 are std dev of the two investments
Rho is the coefficient of correlation between the two investments
Expected return of the portfolio (MUp) = w1mu1+w2mu2
Std dev of the portfolio (sigma p) = sqrt[(w1)^2*(sigma1)^2 + (w2)^2*(sigma2)^2 + 2(rho)(w1)(w2)(sigma1)(sigma2)]
QUESTION
mu1 = 10%
mu2 = 15%
sigma1 = 16%
sigma2 = 24%
rho = 20%
Calculate return and std dev of the portfolio with the following weights
w1 w2 MUp Sigmap
0 1 15% 0.0576 24%
0.2 0.8 14% 0.040346 20%
0.4 0.6 13% 0.028518 17%
0.6 0.4 12% 0.022118 15%
0.8 0.2 11% 0.021146 15%
1 0 10% 0.0256 16%
o)(w1)(w2)(sigma1)(sigma2)]
R = alpha + (beta)Rm + e
Rm = systematic risk (non-diversifiable)
e = non-systematic risk (diversifiable)
alpha = extra return on a portfolio in excess of that predicted by capm
E(Rp) = Rf + beta(Rm-Rf)
alpha = Rp-Rf-beta(Rm-Rf)
beta = rho*sigma/sigma m
rho = correlation bw return from investment and return from market portfolio
sigma = std dev of return from investment
sigma m = std dev of return from market portfolio
QUESTION
beta = 0.6
Rf = 4%
Find expected return
Rm = 20% 10% -10%
E(R) = 13.60% 7.60% -4.40%
QUESTION
beta = 0.8
Rf = 5%
Rm = 7%
Rp = 9%
alpha = 2.4%
QUESTION
Bank sold a European call option on 100000 shares for 300,000 of a non-dividend paying stock
Stock price 49
Strike price 50
Rf 5%
sigma 20%
T 20 weeks
Value of the call option?
QUESTION
1 year european call option
Spot price 50
Strike price 55
Company sells 1000000 call options at 6000000
Probability of the stock price after 1 year
25% chance of 79
60% chance of 60
15% chance of 30
Rf 5%
Valuation? How much profit can be booked?
0.25 79 19.75 60.25-strike price = 5.25
0.6 60 36
0.15 30 4.5 5.25/1+Rf = 5 million
60.25
But the company sold it for 6 million so the profit is 1 million
Scenario Analysis? In the worst case, how much will this transaction cost the company?
Scenario analysis will consider price rising to 79 with a prob of 25%
Cost to the seller = 79-strike price = 24
Present value = 24/1+Rf = 22.85714
Inworst case scenario, the transaction will cost the company 22.85-6 = 16.85714
For 1 million options, 16.85714 million
Valuing a Forward Contract
Payoff = St -K St is stock price at t
K is delivery price
Expected payoff in a risk-neutral world = Soe^rT-K
Present value of expected payoff = So-Ke^-rT
QUESTION
Price of non dividend paying stock = 30