FINM2411

FINAL EXAM SOLUTION

SEMESTER 1, 2020

QUESTION 1 [2 MARKS]

True or False:
Under the CAPM, investors require a rate of return that is proportional to the volatility of
each asset.

False: Required return depends on beta, not volatility. The correlation between stock and
market returns is an important element of beta, and volatility is entirely a firm-specific
characteristic. For example, a stock with high volatility but very low correlation will have
a low required return.

QUESTION 2 [2 MARKS]

True or False:
The simple average of all equity betas in a market must equal exactly 1, by construction.

False: It is the weighted average that must equal 1, where the weights are the market
values of each asset.

QUESTION 3 [2 MARKS]

True or False:
All assets and portfolios that plot on the Capital Market Line have returns that are
perfectly positively corelated with the market portfolio.

True: Such assets and portfolios have no firm-specific or diversifiable risk. Such assets or
portfolios are, or behave in the same way, as a combination of the risk-free asset and the
market portfolio. Consequently, the only source of variation is from movements in the
returns of the market portfolio.

QUESTION 4 [2 MARKS]

True or False:
A firm that operates in rural areas, and is more exposed to bushfire risk, will have a
higher beta than an otherwise identical firm that operates in a major city.

False: The occurrence of bushfires is unrelated to whether the broad economy is

performing well or poorly. This is more of a firm-specific risk than a market-driven
systematic risk.

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QUESTION 5 [2 MARKS]

True or False:
Under the CAPM, no asset or portfolio has a higher Sharpe ratio than the market
portfolio.

True: The market portfolio is the tangency portfolio under the CAPM.

QUESTION 6 [2 MARKS]

True or False:
Under the CAPM, it is possible for an asset to have a negative beta, but a positive
expected return.

True: A stock with a small negative beta will have a positive expected return if the
magnitude of the product of beta and market risk premium is less than the risk-free rate.

QUESTION 7 [2 MARKS]

True or False:
Under the CAPM, it is possible for the market portfolio to include a short position in one
or more assets.

False: This would imply that the aggregate demand for the stock is negative in which
case it would be a stock that nobody owns. That can’t occur in equilibrium.

QUESTION 8 [2 MARKS]

True or False:
Under the CAPM, risk-averse investors will try to avoid volatile stocks and only invest in
stocks with a low volatility.

False: Under the CAPM, investors hold a diversified market portfolio that consists of all
sorts of stocks.

QUESTION 9 [2 MARKS]

True or False:
Under the CAPM, investors with high wealth and low risk aversion have more impact on
stock prices than do investors with low wealth and high risk aversion.

True: Investors with high wealth and low risk aversion will invest relatively more into
risky assets. Consequently, their trading will have a larger impact on market clearing
prices.

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QUESTION 10 [2 MARKS]

True or False:
Under the CAPM, the only way an individual stock could plot on the CML is if it happens
to have exactly the same expected return and standard deviation as the market
portfolio.

True: Every other point in the opportunity set is strictly below the CML.

QUESTION 11 [10 MARKS]

Consider a CAPM economy in which there are four risky assets and a risk-free asset as
follows:

Expected Standard Market

Asset
return deviation capitalisation
A 9% 15% 100
B 10% 20% 200
C 11% 25% 200
D 14% 30% 100
Risk-free 4% 0% 100

If that investor wants an expected return of 8%, how much will be invested in the risk-
free asset?

The total market capitalisation of risky assets is:

100+200+200+100=600.
The expected return on the market portfolio is computed as:

100 200 200 100

E [ rm ] = ×9 % + ×10 % + ×11 %+ × 14 %=10.83 % .
600 600 600 600
The optimal way of obtaining the 8% expected return is by investing in some proportion
in the risk-free asset and the market portfolio, so we need to solve for w f ∈¿:

8 %=wf × 4 % + ( 1−w f ) ×10.83 % ,

where w f =41.46 % .

QUESTION 12 [10 MARKS]

Information about Asset A and the Market Portfolio is set out below:

Asset/Portfolio Expecte Standard

d return deviatio

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 n
A 28%
Market Portfolio 11% 10%
Risk-free asset 4% 0%

The correlation between Asset A and the Market Portfolio is 0.3.

According to the CAPM, what is the expected return of Asset A?

First compute the beta of Asset A:

ρ A , M σ A 0.3 ×0.28
β A= = =0.84 .
σM 0.1

The CAPM can then be used to estimate the expected return:

E [ r A ] =r f + β A × MRP=4 % +0.83 ( 11%−4 % )=9.9 % .

QUESTION 13 [20 MARKS]

Consider a CAPM economy that contains three risky assets with the information set out
in the table below.

Expecte Standard
Asset
d return deviation
A 10% 20%
B 12% 25%
C 14% 30%
Risk-free 5% 0%

and with correlation matrix:

A B C
A
B 0.3
C 0.2 0.4

What is the market risk premium in this economy?

The calculations in the attached spreadsheet show that the expected return on the
market portfolio is 11.9%. Consequently, the MRP is 6.9%.

What is the standard deviation of the market portfolio?

The calculations in the attached spreadsheet show that the standard deviation of the
market portfolio is 18.1%.

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What is the beta of Asset B?

The beta can be deduced from the CAPM:

E [ r B ] =r f + β B × MRP
12 %=5 %+ β B × 6.9 % ,

in which case β B =1.02.

Consider an investor who currently owns only Asset B because that investor is targeting
a 12% return. What proportion of the standard deviation that the investor is currently
bearing would be eliminated if the investor were to target that same 12% return in the
optimal way?

The optimal investment would be a combination of the risk-free asset and the market
portfolio. The proportion of the standard deviation of Asset B that is market-related is
given by the correlation between B and the market. That correlation can be derived from
the beta:

ρB , M σ B
βB=
σM
ρB , M × 0.25
1.02= .
0.181

in which case ρ B , M =0.74 . Thus, 26% of the current standard deviation can be eliminated
by investing in the optimal manner.

QUESTION 14 [10 MARKS]

You have compiled the following information for four comparator firms:

Comparato
Raw equity beta Leverage
r
A 0.93 20%
B 0.60 32%
C 1.14 30%
D 0.67 31%

What is the mean estimate of betas re-levered to 40%?

First compute the asset beta estimates by multiplying by the proportion of equity finance
for each firm. Then re-lever by dividing by 0.6, being the target equity proportion:

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 Comparato Raw equity Asset Re-levered
Leverage
r beta beta equity beta
A 0.93 20% 0.74 1.24
B 0.60 32% 0.41 0.68
C 1.14 30% 0.80 1.33
D 0.67 31% 0.46 0.77
Mean 1.005

QUESTION 15 [10 MARKS]

Consider an investor with CRRA utility with risk-aversion parameter 3 and 100 units of
wealth. The investor has been convinced to invest 50 units of wealth in a risky
investment that is equally likely to gain 31% or lose -23% over the course of the year.
The remaining 50 units is invested in a government bond yielding 6% over the course of
the year. The investor now regrets making the risky investment. What is the maximum
amount the investor would be willing to pay to be released from the risky investment so
they can invest their entire wealth in the risk-free asset?

First note that the investor’s total wealth in the ‘up’ state will be:

W up=50 ( 1.06 )+50 ( 1.31 )=118.5 ,

and the investor’s utility in that state will be:

1−γ 1−3
W 118.5
U up = = =−3.56 × 10−5 .
1−γ 1−3

Similarly, the investor’s total wealth in the ‘down’ state will be:

W down =50 (1.06 )+ 50 ( 0.77 )=91.5 ,

and the investor’s utility in that state will be:

1−3
91.5 −5
U down = =−5.97 × 10 .
1−3

Consequently, the investor’s expected utility is:

E [ U ] =0.5 ×−3.56 ×10 + 0.5 ×−5.97 ×10 =−4.77 × 10 .

−5 −5 −5

Next, we can find the certainty equivalent by solving:

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 −5 W 1−3
−4.77× 10 = ,
1−3

where W=102.421. That is, the investor would be indifferent between their current
position and having 102.421 units of wealth at the end of the year for sure.
The present value of that sum (which could be invested in the risk-free asset now) is:

102.421
=96.624 .
1.06

Thus, the investor would be willing to give up 3.376 units of wealth (100-96.624) today.