Financial Economics 2018/19 - MIDTERM EXAM

SOLUTIONS

QUESTIONS 1-10

1. Suppose that 50% of the market portfolio is invested in asset A and the other 50% in asset
B. The table below provides the expected return and volatility of the return of both assets:

A B

Expected return (E(Rj)) 12 13

Volatility or standard deviation (σj) 14 18

The interest rate on the risk-free bond is 5%. The beta of firm A is βA = 2.48 and the beta of
firm B is βB = 1.06.
Using this information, which of the below statements is correct?

a) The expected returns of both firms are not consistent with the assumptions of the
CAPM model.
b) The expected returns of both firms are consistent with the assumptions of the CAPM
model.
c) The assets that compose the market portfolio are undervalued.
d) The market portfolio is not an efficient portfolio in this economy.

We can verify that the CAPM does not hold for A and B

2. Consider an economy with two dates, one period, many risky assets and a risk-free asset
(whose return is 2%). Assume that the CAPM holds. The information about the market
portfolio is the following:

Expected Volatility

Return

7.5% 12.5%

An investor wants to maximize the expected return on her portfolio with a maximum volatility
of 6%. Compute the weight in her portfolio of the risk-free asset.

a) 0.52
b) -0.59
c) 0.12
d) -0.85
 3. The information about the expected return and the volatility (standard deviation of the
return) of assets A and B is given in the following table:

Asset Expected Return Volatility

A 30% 20%

B 20% 15%

The correlation between both assets is -1. Is it possible to build a portfolio with zero risk?

(Hint: there is no short selling restriction)

a) It is impossible to build a zero risk portfolio out of these two assets
b) Yes, by short selling 300% of the investor's wealth of A and investing 400% in B
c) Yes, by investing 42.85% of the investor's wealth in A and 57.15% in B
d) Yes, by investing 150% of the investor's wealth in A and short selling 50% of B

σ2p= ω21 σ21 + ω22 σ22 + 2 ω1 ω2 σ1σ2 ρ12

If ρ12 = -1: σ2p=(ω1 σ1 - ω2 σ2)2, which equals zero if ω1 σ1 - ω2 σ2 = 0

We can verify that 0.4285*0.2-0.5715*0.15 = 0

Note:
• If ρ12 = 1: σ2p=(ω1 σ1 + ω2 σ2)2, which equals zero if ω1 σ1 + ω2 σ2 = 0
• If −1<ρ12 <1: σ2p is always strictly positive, as we saw in class

4. A company will be liquidated within one year. Upon liquidation, each share will pay an
expected total payoff of 10 euros. The covariance of the return of the shares of the company
with the market is 0.08, the variance of the market return is 0.02, the expected market return
is 0.16 and risk-free asset provides an interest rate 0.05. If the assumptions of the CAPM are
true, what is the price of this share today?

a) 6.71
b) 9.82
c) 8.87
d) 7.62

5.- Consider an economy with multiple quoted risky assets, where the risk free interest rate is
2% and where the CAPM conditions are met. The market portfolio has an expected return of
10%. An efficient portfolio has a volatility of 15% with an expected return of 10%. What is the
market volatility?
a) A volatility of σm = 12%
b) A volatility of σm = 15%
c) A volatility of σm = 18.75%
d) None of the above
 From the Capital Market Line, for all efficient portfolios:

E(Rp) = r + ((E(Rm) – r)/ σm ) x σP

0.1 = 0.02 + ((0.1 -0.02)/0.15) x 0.15

6. Suppose assets A and B are the only risky assets in this economy. Betas for assets A and B are
0.8 and 1.2 respectively. Suppose that the CAPM assumptions hold. What is the weight of asset
A in the market portfolio?
a. ωA=0.2
b. ωA=0.6
c. ωA=0.5
d. ωA=0.4

We know the beta of a portfolio is a weighted average of the betas of the assets in the portfolio.
We also know that the market portfolio has a beta of 1. We can check that:

0.5 x 0.8 + 0.5 x 1.2 = 1

7. In a portfolio C, asset A has a weight of 60% and asset B has a weight of 40%. The
information about the expected return and the volatility (standard deviation of the return) of
assets A and B is given in the following table:

Asset Expected Return Volatility

A 25% 20%

B 15% 15%

The covariance between both assets is 0.031 and the rate of return of the risk-free asset is 2% .
What is the expected return and volatility of portfolio C?

a) 21.0% and 13.4%

b) 21.0% and 18.1%
c) 18.0% and 20.2%
d) None of the above is correct

8. Consider an economy with a risk-free bond (asset 0) and two risky shares (assets 1 and 2). The
return of the risk-free asset (the interest rate) is r = 5%. The properties of the returns of the
risky assets (in %) are resumed in the next table:
Volatility or standard
deviation (σj)

Asset 1 4.81

Asset 2 23.32
Correlation between these returns = Corr(R1, R2) = ρ12 = 0. We assume that CAPM holds. The
market portfolio invests 70% in asset 1 and 30% in asset 2. Compute the betas of the 3 assets.

β0 β1 β2

a) 0.00 0.769 2.406

b) 1.00 0.269 2.406

c) 0.00 0.269 2.706

d) 0.00 0.70 0.30

The risk-free asset has a zero beta. The market portfolio’s beta is one and is a weighted
average of the betas of the assets in the portfolio. It can be verified that:

0.7*0.269+0.3*2.706 = 1

9. Consider an economy with one safe asset and one risky asset. The safe asset is a zero
coupon bond maturing in 1 year with a nominal of 100 euro and a price of 95.24 euro. The
risky asset is a stock with a price today of 90.91 euro, and whose value in t=1 is a random
variable with mean 100 euro and standard deviation 9.09euro. What is the Sharpe ratio of the
risky efficient portfolios?

a) 0.500
b) 0.623
c) 0.757
d) 0.412

The risk-free interest rate is the return of the bond:

r = (100-95.24)/95.24 = 0.05

The return of the risk asset is:

R = (P1 – P0 )/ P0 =P1 / P0 – 1

The expected return is therefore:

E(R) =E( P1 )/ P0 – 1 = 100 /90.91 -1 = 0.1

The standard deviation is:

σ(R) = σ ( P1 )/ P0 = 9.09 /90.91 = 0.1

The Sharpe ratio of the risky asset is:

(E(R) –r )/ σ(R) = (0.1-0.05)/0.1 = 0.5

Since there is only one risky asset in this economy, all efficient portfolios are combinations of
the risk-free asset with the risky asset and their Sharpe ratios are equal to the Sharpe ratio of
the risky asset.

10. Consider an economy with one period and two dates (t=0, t=1), a bond (asset 0) and two
risky assets (assets 1 and 2). The risk-free rate paid by the bond (interest rate) is r=5%. The risky
asset returns and characteristics are given in the table below:

Volatility (σj) Expected return E(Rj)

Asset 1 12.82 13.07

Asset 2 14.06 12.35

Correlation between risky asset returns = Corr(R1, R2) = ρ12 = 0

Which of the following portfolios is the tangency portfolio?

a) Portfolio A: 57% in Asset 1, 43% in Asset 2

b) Portfolio B: 68% in Asset 1, 32% in Asset 2

c) Portfolio C: 31% in Asset 1, 69% in Asset 2

d) Portfolio D: 14% in Asset 1, 86% in Asset 2

It can be verified that Portfolio A has the highest Sharpe Ratio

QUESTIONS 11-15

11) Consider the CAPM. The expected return on the market is 18%. The expected return on a
stock with a beta of 1.2 is 20%. What is the risk-free rate?
a) 2%
b) 6%
c) 8%
d) 12%
12) Which of the following correctly describes a repurchase agreement?

a) The sale of a security with a commitment to repurchase the same security at a specified

future date and a designated price.

b) The sale of a security with a commitment to repurchase the same security at a future date
left unspecified, at a designated price.

c) The purchase of a security with a commitment to purchase more of the same security at a
specified future date.

d) None of the above is correct

13) You are optimistic about Telecom stock. The current market price is $50 per share, and you
have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an
interest rate of 8% per year and invest $10,000 in the stock. What will be your rate of return if
the price of Telecom stock goes up by 10% during the next year?

a) 10%
b) 15%
c) 18%
d) 12%

Rp = ω RTEL + (1- ω) r

ω = 10000/ 5000 = 2

Rp = 2 x 0.1 + (-1) x 0.08 = 0.12

14) Portfolios on the ________ have the ________ Sharpe ratio.

a) capital market line; lowest

b) capital market line; highest

c) security market line; lowest

d) security market line; highest

15) The value of a derivative security

a) depends on the value of the related security.

b) is impossible to calculate.

c) is unrelated to the value of the related security.

d) has been enhanced due to the recent misuse and negative publicity regarding these
instruments.

11) The standard deviation of the market portfolio is 30%. Stock A has a beta of 1

and a residual standard deviation (firm-specific risk) of 30%. What is the standard deviation of
the asset’s return according to the single-index model?

a) 42.42%
b) 36.21%
c) 28.43%
d) 18%

σ2p= β2M σ2M + σ2ε = 0.32 + 0.32 = 0.18

σp = 0.4242

12) The Sharpe ratio of any portfolio on the efficient frontier is

a) the same

b) higher than the Sharpe ratio of any individual asset

c) always positive

d) all of the above

13) You short-sell 200 shares of Rock Creek Fly Fishing Co., now selling for $50 per share. If you
want to limit your loss to $2,500, you should repurchase the shares and close the position at
________.

a) $37.50

b) $62.50

c) $56.25

d) $59.75

Profit of Short Sale = 200 x ( 50 - P1 ) = -2500 -> P1 = 62.5

14) The weak form of the Efficient Market Hypothesis states that ________ must be reflected
in the current stock price.

a) all past information, including security price and volume data

b) all publicly available information

c) all information, including inside information

d) all costless information

15) In forming a portfolio of two risky assets, what must be true of the correlation

coefficient between their returns if there are to be gains from diversification?

a) It must be negative

b) It must be -1

c) It must be strictly less than 1

d) There are always gains from diversification, regardless of the correlation coefficient

11) The standard deviation of the market portfolio is 20%. Stock A has a beta of 1.5

and a residual standard deviation (firm-specific risk )of 30%. What is the standard deviation of
the asset’s return according to the single-index model?

a) 42.42%
b) 36.21%
c) 28.43%
d) 18%

σ2p= β2M σ2M + σ2ε = 1.52 x 0.22 + 0.32 = 0.18

σp = 0.4242

12) Adding additional risky assets to the investment opportunity set will generally move the
efficient frontier ________ and to the ________.

a) up; right

b) up; left

c) down; right

d) down; left
13) The semistrong form of the Efficient Market Hypothesis states that ________ must be
reflected in the current stock price.

a) all security price and volume data

b) all publicly available information

c) all information, including inside information

d) all costless information

14) A fixed-income security pays

a) a fixed level of income for the life of the owner.

b) a fixed stream of income or a stream of income that is determined according to a specified

formula for the life of the security.

c) a variable level of income for owners on a fixed income.

d) a fixed or variable income stream at the option of the owner.

15) You sell short 300 shares of common stock at $30 per share. If the initial margin is 50% of
the sale revenues, you must put up a margin of ________.

a) $4,500

b) $6,000

c) $9,000

d) $10,000

Sales Revenues = 300 x 30 = 9000

Margin = .5 x 9000 = 4500

11) When adding a risky asset to a portfolio of many risky assets, which property of the asset
has a larger impact on the risk of the portfolio:

a) the asset’s standard deviation

b) the asset’s covariance with the other assets in the portfolio
c) the asset’s expected return
d) the asset’s variance
12) An investment project has a .7 probability of delivering a return of 100% and a .3 probability
of a return of -50% in a year. What is the standard deviation of the return on this investment?

a) 47.25%
b) 52.32%
c) 55%
d) 68.73%

E(R) = 0.7 x 1 +0.3 x (-0.5) = 0.55 = 55%

σ2 = 0.7 x (1 – 0.55)2 + 0.3 x (-0.5-0.55)2 = 0.4725

σ =0.6873 = 68.73%

13) You short-sell 200 shares of Tuckerton Trading Co., now selling for $50 per share. What is
your maximum possible loss?

a) $50

b) $150

c) $10,000

d) unlimited

14) Risk that can be eliminated through diversification is called ________ risk.

a) unique
b) firm-specific
c) white noise risk
d) all of these options

15) Suppose an investor is considering one of two investments that are identical in terms of
expected payoffs but different in terms of risk. If the CAPM holds, he can expect to ________.
a) earn no more than the Treasury-bill rate on either security.
b) pay less for the security that has higher beta.
c) pay less for the security that has lower beta.
d) earn more if interest rates are lower.