Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

a) Futures contracts and options on futures contracts can be used to modify risk.

Required:
Identify the fundamental distinction between a futures contract and an option on a futures contract and explain the difference in the manner that futures and options modify portfolio risk.

b) Maendeleo Industries is concerned about interest rates rising. It needs to borrow in the bond market three months hence. The company believes that an option on treasury bond futures is the best hedging device.

i) Should the company buy a put option or a call option? Explain.

ii) Presently, the futures contract trades at Sh.1,000 and 3 month put and call options both involve premiums of 1½ per cent based on this strike price. During the 3 months,
interest rates rise, so that the price on a treasury bond futures contract goes to Sh.950. What
is your gain or loss on the option per Sh.1,000,000 contract?
ANSWER
a) Conceptual differences between Arbitrage Pricing Theory and CAPM.

In APT, return is a function of a set of common factors while in CAPM, return is a function of a market portfolio of risky assets.
APT is a multifactor model that attempts to capture several non-markets influences that cause securities or assets to change in prices. CAPM on the other hand, is a single index model that assume securities or assets change in price because of a common co-movement with one market portfolio of all risky assets.
In application of the theory, the market portfolio or factor required CAPM is specified. In APT, the common factors are not identified.
APT incorporates a number of sensitivity coefficients. These coefficients determine how each independent variable or macro-economic factor affects each asset. Different assets are affected to different degrees or extents common factors.
In CPAM, the only sensitivity factor is beta (Systematic risk).
CAPM is a single period model. APT can be extended to multi-period framework

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