Econ 363 – Mid Term.

90 Minutes – each question is 25 marks

Question 1
a. Derive the risk on a N-asset portfolio in terms of the average variance of the N assets
and the average covariance across all assets. Discuss the implications of the number
of assets (N) in portfolio management and diversification of risk.
b. Assess the validity of the CAPM.
c. Derive the CPAM equation and explain the difference between SML and CML.
d. Explain the Two-Fund Separation Principle.

Question 2
a. The following three assets exist in the economy:
Rx = 0.2 + 2F1 -F2 = 5%
Ry = 0.16 + 4F1 + 2 F2 = 7%
Rz = 0.1 + 1F1 + F2 = 9%

The % values are the current market returns.

The return on stock M is known to follow the factor model Rm = 0.5 – F1 + 1.5F2. It is
currently traded at the a return of 10%. Find out if there is an arbitrage and what should the
profiteering strategy.

b. Smith’s utility function is U (c0, c1) – ln c0 + ln c1. Smith is endowed with money m0
= 90,000 today and m1 = 500,000 tomorrow. There is perfect capital market for
borrowing and lending at the market rate of interest of 25% per period.
a. Determine the optimal consumption plan for Smith.
b. Smith has an opportunity to invest I0 = 80,000 today to get I1 = 135,000
tomorrow – Should he invest? What will be transaction is he does.
c. If there is no capital market, what will be your answers to b.

Question 3

a. You are valuing a firm that is expected to earn cash flows that grow at 10% for the
first five years and at 5% in perpetuity thereafter. The forecasted cash flow next
period is $100m (which includes the 10% growth) and you estimate a discount rate
of 11%. What is the present value of these cash flows?
b. A company is offering a perpetuity you can purchase for retirement. If the perpetuity
starts 40 years from today and pays $50,000 per year, what is the PV if r = 4%?
c. A loan of $2500 at a rate of 6.5% is to be paid off in ten years, by paying ten equal
installments at the end of every year. How much is each installment?