Sample questions for the Final Exam

1. Explain the Grossman-Stiglitz paradox. How can we resolve it?

Charge for these collected info
2. Outline the “random walk” hypothesis of stock market prices and explain its
significance.
Pt+1=pt+et economics theory future stock prices are not forecastable based on
information available at present time no variable to predict

ordinary investors and experts who want to earn higher return through
forecastable implication cannot beat the market without getting more risk

3. Describe the Efficient Markets hypothesis.(EMH). What are some examples of

predictability of stock market returns that seem to contradict the EMH? Do they prove
that markets are not generally efficient? Do asset bubbles and consequent market
crashes imply that the EMH is wrong?
economics theory future stock prices are not forecastable based on information
available at present time strong hypothesis martingale model
E(pt+1|omegat)=pt
positive serial correlation short run in market returns
Discuss whether large price changes within a short time period can be
reconciled with EMH based on readings assigned during the lecture and
the discussion we had.

Formal description of the EMH as a martingale process and outlining the

implications of that. Examples of asset market anomalies like P/E ratios
(or P/BV ratio being strongly predictive in some time periods or short run
positive auto-correlation in returns and long run negative auto-
correlation. Discuss whether large price changes within a short time
period can be reconciled with EMH based on readings assigned during the
lecture and the discussion we had.

4. Explain why the concavity of the utility function implies that the investor is risk-averse.
Expected utility is lower than utility of expected value. Prefer xbar with 100% instead of
expectd payoff calculated by pa xa and xb with probability of 1-pa

5. Show graphically how the presence or not of a risk free asset affects the shape of the
efficient portfolio frontier. Carefully explain your economic reasoning.
Why is the set of efficient portfolios a straight line? An intuitive argument is as follows. First, construct the
frontier, FF, for risky assets alone, as described in the previous section. Next, plot the rate of return, r0, for
the risk-free asset on the vertical axis of the diagram and connect this with a ray to any point on the
frontier FF. Points along this ray depict the expected return and risk for portfolios comprising the risk-free
 asset and the portfolio of risky assets given by the chosen point on the FF frontier. Lower levels of risk can
be attained (for each level of expected return) by pivoting the ray through r0 to higher and higher points
along FF, until the ray is tangential with FF. No further reduction in risk is feasible (for a given expected
return and the frontier, FF, that is). The set of efficient portfolios for all assets including the risk-free asset
is then the ray formed from this tangency – i.e. the line r0ZE in figure 5.5.

6. Derive and show graphically the efficient portfolio frontier for the case of two risky
assets that are perfectly negatively correlated; i.e. the correlation coefficient is equal to
-1.
推导

7. Consider a world with many risky assets and in which the investor can borrow at a given
interest rate which is different (higher) than the rate at which she can lend. Show the
efficient portfolio frontier graphically. Depict an equilibrium for an investor who chooses
to lend.

8. An investor uses the mean-variance criterion for selecting a portfolio of two risky assets.
Asset 1 has an expected return of 20% and a variance of 4. Asset 2 has an expected
return of 60% and a variance of 36. There is no risk-free asset available.

a) Explain how to construct the efficient portfolio frontier for the cases in which the
correlation coefficient between the returns, ƿ12, is equal to +1 and also when it is equal
to -1.
b) Describe, in general terms, how to construct the portfolio frontier when -1 < ƿ < +1.
(Outline of solution to a) After computing the expected rate of return and the variance of
the portfolio, we find the straight line (on the mean-variance plane) μP = σP/10 for
correlation coefficient equal to 1 and two straight lines = 3/10 ± σP/20 for correlation
coefficient equal to -1. These straight lines constitutes the efficiency frontier. You need to
explain and discuss your answer.
Explain what a portfolio frontier is and how it is generally derived. 2
assets 2 point a b and the curve joing them is portfolio frontier. 只有
asset 1 就在 asset 1.线上的点选择 depend on wealth and preference.
When the correlation coefficient is between 0 and 1, minimizing σP for
each level of feasible μP can trace out the portfolio frontier curve.

9. Show that the portfolio variance tends to zero as the number of assets (n) increases
indefinitely. Assume the asset returns are all uncorrelated with each other. (covariance
= 0 for all pairs of asset returns).
If the asset’s returns are all uncorrelated with each other, then all the covariance terms are
zero and we have to worry only about the variance terms (the diagonal terms). We make
 two simplifying assumptions. First assume that the variance of the asset returns are the
same for all the N assets. Second, assume the investor divides his wealth equally among
the N assets (each asset’s share is thus 1/N), portfolio variance will be equal to Nσ2/N2
(there are n variances and each of them are equal to σ2, and each asset’s share is1/N).
Thus the portfolio variance in this case is equal to σ2/N which tends to zero as the number
of assets N increases indefinitely. For many insurance contracts/situations, it makes sense
to assume zero correlation (for example the probability of a fire accident in a facility).

10. What are the main predictions of the Capital Asset Pricing Model (CAPM)? Discuss the
role and significance of the assumptions needed to obtain the prediction.
 Prediction 1 violate if homogenous belief not exist.
mean variance not exist

significance off CAPM

 CAPM solves three most important issues in investment simultaneously:
 Where to invest? Invest in the market portfolio and risk-free asset.
 How to value an asset? Estimate the beta of this asset and
discount all the future cash flows generated by this asset using a
discount rate given by CAPM.
 How to evaluate investment performance? Adjust the performance by beta.

11. Assume that over some time period, a security market line was estimated. The results
are shown below:

Ri = 0.06 + 0.19i

Assume that over the same period, two mutual funds had the following results:

Fund A: Actual Return = 10%  = 0.8

Fund B: Actual Return = 15%  = 1.2

What can be said about fund performance?

12. Assume that the following assets are correctly priced according to the security market
line (SML). Derive the SML. What is the expected return of an asset with a beta of 2?

R1= 6% 1= 0.5

R2= 12% 2= 1.5

13. The following information is provided for a stock market

j J
Asset 1 6.6% 0.4
Asset 2 9.8% 1.2
Asset 3 12.2% 1.8
Notation: j is expected return for asset j and J is beta-coefficient for Asset j, j = 1, 2, 3.

a) In the context of the Capital Asset Pricing Model (CAPM), define the ‘beta-coefficient’,
βj, corresponding to asset j. Discuss how assets’ beta-coefficients should be interpreted
and explain how their values can be obtained in practice.

b) Assuming that a risk-free asset is available, explain and interpret the Security Market
Line (SML) in the context of the CAPM. Construct the SML from the given information
and interpret the values of its coefficients.

c) Now suppose a risk-free asset is not available, although the other assumptions of the
CAPM remain valid. How should the SML be constructed and interpreted in this case?

d) You are informed that a fourth asset, with β4 = 0.8, is available. Recent observations
reveal that its average rate of return is 7.0%. What inferences, if any, would you draw
from this information?

-SML depicts
Figure 1: The Security Market Line, SML
Hence it must follow that: μM = 0.09 and r0 = 0.05. Thus, in this example the market
price of risk is 4%. Hence the SML is:
μj = 0.05 + 0.04_j .
(Check that the data for asset 3 also satisfy the SML.)
(c) Now suppose a risk-free asset is not available, although the other assumptions of the
CAPM remain valid. How should the SML be constructed and interpreted in this case?
Answer:
The formal analysis is the same as for the previous part, except that now the intercept
of the SML is interpreted as the expected rate of return on a zero beta portfolio (i.e., a
portfolio for which the beta-coefficient is zero). Formally:
μj = ! + (μM − !)_j ,
where ! denotes the expected rate of return on a zero beta portfolio. Essentially, the only
difference is that the risk-free rate of return is replaced with !. (Answers should include
a brief interpretation of the ! in terms of the Black version of the CAPM — check your
lecture notes on this.)
(d) You are informed that a fourth asset, with _4 = 0.8, is available. Recent observations
reveal that its average rate of return is 7.0%. What inferences, if any, would you draw
from this information?
Answer: The CAPM predicts that the expected rate of return on the fourth asset is:
0.082 = 0.05 + 0.04 Å~ 0.8.
But the observed average rate is 7.0% < 8.2%. Hence, the fourth asset is overpriced.
This evidence could be indicative either that the market is in disequilibrium or that the
CAPM is not a good representation of the market.

14. Suppose that there are two states and three assets with the following returns and
prices:
 Assets
A B C
State 1 5 4 4.5
State 2 4 0 6
Price 1.5 1 ?

a) Find the equilibrium price of Asset C.

b) Find 𝛿, 𝜋, 𝑞1 𝑎𝑛𝑑 𝑞2.
c) Compare your results from those obtained in the example discussed during the
lecture.

15. Discuss the role of the arbitrage principle in the determination of asset prices.
Define what is meant by the “arbitrage principle” – the fact that in market equilibrium,
arbitrage opportunities must be ruled out.
Observed market prices reflect the absence of arbitrage opportunity
Exits an investor who prefers more wealth and for whom an optimal portfolio can be
constructed
There exist positive state price
Risk neutral valuation relationship

Define arbitrage opportunities and explain why they must be ruled out in equilibrium.
Law of one price
V(x, k)>0 arbitrage principle=market equilibrium
Note that there are very few assumptions required for the arbitrage principle to work.
Some investors need to prefer more wealth to less.
“No arbitrage” also implies the existence of state prices and the risk-neutral valuation
relationship which are important concepts in asset pricing. (In the real world, they are
used mostly for pricing options/derivatives). No proofs necessary, just need to state and
discuss the ideas.

• The famous Black-Scholes model is also actually an application of the arbitrage principle.
(although we didn’t discuss this and you are not required to mention it, but you can
now!).
• Arbitrage principle also plays a role in APT (Arbitrage Pricing Theory). We use the “no
arbitrage” principle to convert factor models into the APT framework where each assets
rate of return can be modeled as a function of the factor risk premium and factor
loadings.
• NPV relationship is important in Finance and we can appeal to arbitrage to see why it
must hold.
• Thus the arbitrage principle has wide applicability in Finance.

16. Provide a formal definition of an arbitrage portfolio and an arbitrage opportunity. What
are state prices and how are they related to the idea of RNVR (risk-neutral valuation
relationship)?
 17. Discuss the CAPM and APT as alternative approaches to asset price valuation. What are
the major strengths and limitations of each approach?
Comparison of CAPM and APT
1. Both can be used as asset pricing models. In fact, both models are still being used by
business analysts and financial market practitioners. There are other models of asset pricing, but
these two are certainly most popular in the real world.
2. APT requires fewer assumptions than CAPM – why does that matter?
Market portfolio still efficient if these assumptions holds?
APT is not a complete theory of asset pricing – it is more a way of “operationalizing”
(implementing or testing) an asset pricing model if you have one. It lacks adequate theoretical
foundation because (a-priori) we don’t know which factors to include in our model. Selection of
factors is based on guess/economic intuition which is unsatisfactory
4. From the point of view of a practitioner, APT can often be more useful than CAPM.
(Why?). The predictions of APT can be used to develop investment strategies. capm beta
Overestimate cost of return apt as long as factor model performs good which factor
maximize portfolio return. may Only work in a particular data sample and time period
because of no theoretical basic.
5. Empirical record of APT is also much better than CAPM – it can fit the data much better.
But is this the result of data mining?
6. Normally distributed extreme

18. The paragraph below is a quote from the article “The Capital Asset Pricing Model:
Theory and Evidence”, by Fama and French (Journal of Economic Perspectives, Summer
2004).

“The attraction of the CAPM is that it offers powerful and intuitively pleasing
predictions about how to measure risk and the relation between expected return
and risk. Unfortunately, the empirical record of the model is poor—poor enough
to invalidate the way it is used in applications. The CAPM’s empirical problems may
reflect theoretical failings, the result of many simplifying assumptions. But they may
also be caused by difficulties in implementing valid tests of the model”.

Do you agree with the arguments of the authors? Why or why not? Discuss the
empirical evidence for/against the Capital Asset Pricing Model (CAPM).

19. Why is it sometimes claimed that stock prices are “too volatile” to be compatible with
asset market efficiency?
Shiller first establishes that the variance of the actual stock price (the price that we
observe in the market) has to be less than the variance of the theoretical equilibrium
price. The theoretical equilibrium price is the one that would have prevailed if investors
had perfect foresight. The theoretical equilibrium price is equal to the market price plus
an error. It is as if the market tries to guess (forecast) the theoretical equilibrium price,
but since people don't have perfect foresight there is inevitably a forecast error.
 Therefore the theoretical equilibrium price is equal to the market price plus the forecast
error.
• Next we make the reasonable assumption that the forecast error is random and is
uncorrelated with the actual market price or any economic/financial variable. (and the
variance of the forecast error is positive). Based on this Shiller is able to conclude that
the variance of the actual market price should be less than that of theoretical
equilibrium price. This, therefore puts an upper bound on what the variance of the stock
market prices should be - if it is higher than that, we can say that stocks are "too
volatile”. Now we need to define the theoretical equilibrium price. (Unlike the market
price, we don't directly observe it). Shiller uses the NPV approach to define it. The price
of an asset should be equal to its net present value, if not, there is an arbitrage
opportunity. If the price is cheaper than the asset's actual value, then people will rush to
buy the asset and the price will go up and vice versa. The value of an asset should be the
future income stream generated by your ownership of this asset discounted to the
present time by an appropriate discount rate that reflects the riskiness of the cash
flows/income generated by this asset.
• In the textbook, there is a discussion of the NPV approach and how Shiller uses it to
calculate the theoretical equilibrium price. He finds that contrary to what one would
expect, the variance of the observed market price is considerably higher than the
theoretical equilibrium price, and this leads to his conclusion.
• Next you need to discuss/evaluate Shiller’s claim. Three types of critism