# Consider a bond

Section A:

Consider a bond with a par value of £1,000, a coupon rate of 8%, a maturity of 20 years and one coupon instalment per year. The market interest rate is currently 10%. Suppose you buy the bond today with the view to sell it in a year’s time. What would be your return on the bond if interest rate were to rise to 15% in a year’s time?

(10 marks)

Consider two assets: Unicorn stock and Mermaid stock. Unicorn stock either provides a rate of return of 30% or -20%, with equal probability. Mermaid stock either provides a return of 15% or -5%, with equal probability. You decide to hold a portfolio by investing half of your money in Unicorn stock and the other half in Mermaid stock. If Unicorn stock and Mermaid stock’s returns are independent of each other, what will be the expected return and standard deviation of your portfolio? Assume the risk-free interest rate is 3%. Do you think you have made a rational choice by holding the portfolio?

(10 marks)

Consider the stock of Aviva PLC. The beta of the stock is 1.25. The earnings per share (EPS) in the coming year is 55p. The expected Return on Equity (ROE) is 11%. The expected return on the market portfolio is 9%. The risk-free rate is 5%. The dividend pay-out ratio is 50%. What is the fair price of Aviva stock?

(10 marks)

Consider a US export firm expecting to receive £2 million in 3 months. It is estimated that its profit will fall by \$15,000 for every \$0.01 depreciation of £. Each £/\$ futures contract calls for delivery of £62,500. How could the firm fully hedge against the exchange rate risk? Should it buy or sell the £/\$ futures contract? How many contracts should be bought or sold?

(10 marks)

Section B:

During the Covid-19 crisis of 2020, the UK government has increased borrowing dramatically, yet the interest rate on 10-year UK Treasury bond fell from 0.63% in February to 0.21% in July. Explain the rationale behind this phenomenon using the asset market approach.

(30 marks)

If a country becomes more productive than another country, its currency should always appreciate against the other’s currency”. Is this statement true or false? Explain your reasoning with reference to the theory of exchange rate determination and international monetary system including gold standard, fixed exchange rate regime and floating exchange rate regime.

(30 marks)

Capital Asset Pricing Model (CAPM) is the theory that underpins asset pricing. Discuss the assumptions and implications of CAPM and the applications of CAPM.

(30 marks)

In a September 2009 article in the New York Times Magazine, the Nobel Laureate Paul Krugman wrote that “in short, the belief in efficient financial markets blinded many, if not most, economists to the emergence of the biggest financial bubble in history”. Evaluate the Efficient Market Hypothesis (EMH) using evidence. Explain whether you agree with Krugman’s analysis that the financial crisis of 2007-9 invalidated the EMH.

(30 marks)