UMAD5X-15-3 Investment Management

Question 1

(a) A share in IM will pay a dividend of £1.20 and has a current market price greater than £20. You also know that the expected return on the share is 8%.

(i) Using DDM Model explain why this means that the dividend cannot be constant at £1.20 per share. (5 marks)

(ii) You then discover that the dividend paid by IM will increase by 4% each year. Calculate the intrinsic value of a share in IM. (3 marks)

(iii) If the dividend growth changed from 4% to 2% what would happen to the intrinsic value of the share in IM? (2 marks)

(b) It is now Dec 2020 and AJW Limited has just paid a dividend of £1.00. Dividends will increase by 6% for the next four years and then the growth rate will reduce to 2%.

The risk-free rate is 1%, the expected market return is 7% and the beta of AJW Limited according to Bloomberg is 1.2

(i) Calculate the expected return on a share in AJW Limited (3 marks)

(ii) Calculate the intrinsic value of a share in AJW Limited (12 marks)

Total 25 marks

Question 2

(a) The share price and dividend history in pence for IMW are as follows. Dividends are paid on 31 December in each year.

What are the arithmetic and geometric average time-weighted rates of return for the investor? (8 marks)

(b) The table below shows the expected return and risk (standard deviation) for eight shares.

(i) Use the concept of Efficient Frontier to identify four shares that you would select for the optimal portfolio. Explain why you have chosen each one and why the remaining shares were excluded. Draw the efficient frontier portfolio on a suitable diagram. (12 marks)

(ii) Calculate the Sharpe ratio for each of the eight shares with a 2% risk-free rate and identify the highest and lowest value. (5 marks)

Total 25 marks

Question 3

(a) The following table provides the expected return and standard deviation of returns (risk) for two funds managed by Arlo Securities. The risk-free rate from investing in a government bond is currently 2%.

You have a new client who wishes to invest 50% of his money in the risk-free rate and 50% in one of the Arlo funds.

(i) Calculate the expected return and risk for combining Arlo Global with the government bond and Arlo Small Firms with the same government bond. (8 marks)

(ii) This client then indicates he would definitely prefer to invest at least 50% of his money in the Arlo Global fund and requires an expected return of 6%. What proportion of his money does he invest in the risk-free government bond and what is the standard deviation of this portfolio? (6 marks)

(iii) A different client then asks if he could combine the Arlo Small Firms fund with the risk-free bond and reduce the risk of this combined portfolio to 12%. Calculate the proportion of his money to invest in Arlo Small Firms and the expected return of this portfolio. (4 marks)

(b) This week you meet Alice who has no previous knowledge of investment but has recently inherited £200,000 after the death of an elderly relative. Explain to her the key differences between active and passive investment funds and comment on their performance in light of their returns. (7 marks)

Total: 25 marks

Question 4

You wish to compare the performance of two investment advisers. One produced a return of 15% and the other a 12% return. However, the beta of the first adviser was 1.5 while that of the second was 1.2.

(a) Can you tell from this data which of the advisers was a better selector of individual shares? (5 marks)

(b) If the risk-free rate were 1% and the market return during the period were 7%, which adviser would be the better share selector? (10 marks)

(c) Why would all investors hold the market portfolio in the CAPM? In your answer, you should refer to the assumptions of the CAPM. (10 marks)

Total: 25 marks

Question 5

(a) Details of two £ sterling bonds with par value of £100 issued by the same company and paying annual interest are provided below.

(i) What is the current price of Bond B? (5 marks)

(ii) What is the duration of Bond A? (5 marks)

(iii) Explain why the coupon rates on the two bonds are different (2 marks)

(iiii)How would the price of Bond B change if the Yield to Maturity (YTM) decreased from 6% to 5%? (3 marks)

(b) The share price of Deep Sleep has been very close to £60 for a year and you think this will not change in the next few months. The price of a three-month put option with exercise price £60 is £6 and a call option for the same expiry date and exercise price sells for £10.

(i) Define a simple strategy using a put and a call to produce a profit if your view on the future share price is correct. (4 marks)

(ii) What is the maximum profit that can be made with this strategy? (2 marks)

(iii) Show the profit or loss from this strategy if the share price of Deep Sleep in three months’ time is between £20 and £90. (4 marks)

Total: 25 marks

Question 6

(a) You believe the share price of Fickle (currently £20 per share) could move substantially in reaction to a court decision that is expected in three months’ time. If the court ruling was in favour of the company, its share price would rise to £24 per share. On the other hand, if the ruling was against the company, its share price could fall to £16. You own no shares in Fickle but hope to acquire a call option with a payoff of £4 if the outcome of the court decision turns out to be favourable.

Using the binomial option model, how much is the call option worth if the current risk-free rate is 2% a year (9 marks)

(b) In each of the following scenarios, briefly explain whether the option will be more or less expensive than your answer in part (a) above:

(i) You wish to have a payoff of £5 per share by changing the strike price of the option. (2 marks)

(ii) Fickle share price is only £14 if the court rules against the firm? (2 marks)

(iii) The court ruling is brought forward in time? (2 marks)

(c) Describe how the following financial activities may be viewed as transacting an option.

(i) Buying shares in a company with assets of £A and debts of £D (5 marks)

(ii) Making a loan worth £B to the company. (5 marks)

Total: 25 marks

Question 7

The table below provides forecast data prepared in March 2020 for a UK based company included in the FTSE 100 Index

The consensus view from Bloomberg is that the growth for the shares is 10.0% while the long-term growth for the UK economy is considered to be 3.0%.

(a) If the beta of the company is 1.6, the risk-free rate is 1% and the market risk premium is 6% calculate the intrinsic value of a share using the multistage growth version of the DDM model. (10 marks)

(b) Explain why the growth rate estimate from Bloomberg is unrealistic and inappropriate for the DDM model and use the data in the table above to produce an alternative estimate. (7 marks)

(c) Explain why the Treasury yield curve can have the two different shapes shown below. Identify the likely reasons underlying the two different shapes of yield curve and the information conveyed by the yield curve with regard to the future level of short rates and the state of the economy. (8 marks)

Total: 25 marks