Final Exam Asset Management MSc 25 July 2017
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Part 1: Multiple choice questions.
1. The anomalies literature
A. Provides a conclusive rejection of market efficiency.
B. Provides conclusive support of market efficiency
C. Suggests that several strategies would have provided superior returns
D. Provides a conclusive rejection of market efficiency and suggests that several
strategies would have provided superior returns
E. None of the options
The anomalies literature suggests that several strategies would have provided superior
returns.
2. ________ can lead investors to misestimate the true probabilities of possible events or
associated rates of return.
A. Information processing errors
B. Framing errors
C. Mental accounting errors
D. Regret avoidance
Formation processing errors can lead investors to misestimate the true probabilities of
possible events or associated rates of return.
3. The weak form of the efficient market hypothesis contradicts
A. Technical analysis, but supports fundamental analysis as valid
B. Fundamental analysis, but supports technical analysis as valid
C. Both fundamental analysis and technical analysis
D. Technical analysis, but is silent on the possibility of successful fundamental
analysis
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The weak form of the efficient market hypothesis contradicts technical analysis, but is silent
on the possibility of successful fundamental analysis.
4. If the economy is growing, firms with low operating leverage will experience ___
A. Higher increase in profits than firms with high operating leverage
B. Similar increases in profits as firms with high operating leverage
C. Smaller increases in profits than firms with high operating leverage
D. No change in profits
As sales increase, firms with high operating leverage spread these fixed costs of operating
and thus increase profits.
5. Which of the following statement(s) is(are) true?
I The real rate of interest is determined by the supply and demand for funds
II The real rate of interest is determined by the expected rate of inflation
III The real rate of interest can be affected by actions of the Fed
IV The real rate of interest is equal to the nominal interest rate plus the expected
rate of inflation
A. I and II only
B. I and III only
C. III and IV only
D. II and III only
E. I, II, III, and IV only
The expected rate of inflation is a determinant of nominal, not real, interest rates. Real rates
are determined by the supply and demand for funds, which can be affected by the Fed.
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6. You purchase a share of Boeing stocks for $90. One year later, after receiving a dividend
of $3, you sell the stock for $92. What was your holding-period return?
A. 4.44%
B. 2.22%
C. 3.33%
D. 5.56%
E. None of the options
HPR= (92 – 90 + 3) / 90 = 5.56%
7. In the mean-standard deviation graph, the line that connects the risk-free rate and the
optimal risky portfolio, P, is called
A. The security market line.
B. The capital allocation line.
C. The indifference curve.
D. The investor’s utility line.
The capital allocation line (CAL) illustrates the possible combinations of a risk-free assets
and a risky asset available to the investor.
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8. Your client, Bo Regard, holds a complete portfolio that consists of a portfolio or risky
assets (P) and T-Bills. The information below refers to these assets.
E(Rp) 12.00%
Standard deviation of P 7.20%
T-Bill rate 3.60%
Proportion of Complete Portfolio in P 80%
Proportion of Complete Portfolio in T-Bills 20%
Composition of P:
Stock A 40.00%
Stock B 25.00%
Stock C 35.00 %
Total 100.00%
What is the equation of Bo’s capital allocation line?
A. E(rc) = 7.2 + 3.6 x Standard deviation of C
B. E(rc) = 3.6 + 1.167 x Standard deviation of C
C. E(rc) = 3.6 + 12.0 x Standard deviation of C
D. E(rc) = 0.2 + 1.167 x Standard deviation of C
E. E(rc) = 3.6 + 0.857 x Standard deviation of C
The intercept is the risk-free rate (3.60%) and the slope is (12.00% - 3.60%) / 7.20% =
1.167%
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9. Consider an investment opportunity set formed with two securities that are perfectly
negatively correlated. The global minimum variance portfolio has a standard deviation that
is always___
A. Greater than zero
B. Equal to zero
C. Equal to the sum of the securities’ standard deviations
D. Equal to -1
If two securities were perfectly negatively correlated, the weight for the minimum variance
portfolio for those securities could be calculated, and the standard deviation of the resulting
portfolio would be zero.
10. In an index model, the return on a stock in a particular period will be related to__
A. Firm-specific events.
B. Macroeconomic events.
C. The error term.
D. Both firm-specific events and macroeconomic events.
E. Neither firm-specific events and macroeconomic events.
The return on a stock is related to both firm-specific and macroeconomic events.
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11. In your opinion is that a security has an expected rate of return of 0.11. It has a beta of
1.5. The risk-free rate is 0.05 and the market expected rate of return is 0.09. According to
CAPM, this security is
A. Underpriced
B. Overpriced
C. Fairly priced
D. Cannot be determined from data provided
11% = 5% + 1.5(9%-5%) = 11.0% therefore, the security is fairly priced.
12. A company paid a dividend last year of $1.75. The expected ROE for next year is 14.5%.
An appropriate required return on the stock is 10%. If the firm has a plowback ratio of 75%,
the dividend in the coming year should be
A. $1.80
B. $2.12
C. $1.77
D. $1.94
g= 0.145 x 0.75 = 10.875%; $1.75(1.10875) = $1.94
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13. Floating-rate bonds are designed to ___ while convertible bonds are designed to ___.
A. Minimize the holders’ interest rate risk; give the investor the ability to share in the
price appreciation of the company’s stock
B. Maximize the holders’ interest rate risk; give the investor the ability to share in the
price appreciation of the company’s stock
Floating-rate bonds allow the investor to earn a rate of interest income ties to current
interest rates, thus negating one of the major disadvantages of fixed income investments.
Convertible bonds allow the investor to benefit from the appreciation of the stock price,
either by converting to stock or holding the bond, which will increase in price as the stock
prices increases.
14. If the value of a bond is lower than the value of the sum of its parts (STRIPPED cash
flows) you could __
A. Profit by buying the stripped cash flows and reconstituting the bond.
B. Not profit by buying the stripped cash flows and reconstituting the bond.
C. Profit by buying the bond and creating STRIPS.
D. Not profit by buying the stripped cash flows and reconstituting the bond and profit
by buying the bond and creating STRIPS.
E. None of the options.
Buying and stripping the bond would be profitable so answer D is correct.
15. Which of the following bonds has the longest duration?
A. An 8-year maturity, 0% coupon bond
B. An 8-year maturity, 5% coupon bond
C. A 10-year maturity, 5% coupon bond
D. A 10-year maturity, 0% coupon bond
E. Cannot tell from the information given
The longer the maturity and the lower the coupon, the greater the duration.
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Part 2: Definitions.
16. Weak-form Efficient Market Hypothesis:
The weak-form EMH asserts that stock prices reflect all available historical and technical
information. This implies that predictability of returns is not possible. Consequently,
technical analysis, which is the search for recurrent predictable patterns in stock prices, is
fruitless.
17. Country Risk Analysis:
investigating the country-specific macro-economic and political factors that can influence
asset performance. One typically looks at the soundness of fiscal and monetary policies,
economic growth prospects, the Balance of Payments structure and currency strength, the
external debt of the country foreign exchange reserves in relation to imports and short-term
debt, and the extent to which the political situation is supportive.
18. Sharpe ratio:
A reward-to-volatility measure, widely used to evaluate the performance of investments
and investment managers. It measures the trade-off between risk and reward via comparing
the risk premium of an investment to the standard deviation of the excess return in the
same investment. In portfolio management analysis, the Sharpe Ratio is equal to the slope
of the Capital Allocation Line.
19. Passive investment strategy:
An asset management approach that avoids any direct or indirect security analysis, but
rather relies on investing in pre-defined baskets of securities, for example by index-tracking
or mutual funds. Passive strategies can be highly efficient because they are relatively low-
cost. They can be applied to equity portfolios, fixed income investments, money market
assets, or combination of these asset classes.
20. Security Market Line:
A graphical depiction of the expected return-beta relationship; the x-axis is beta and the y-
axis is expected return. The slope of the SML, is determined by the risk premium of the
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market portfolio, E(rm) - rf; the intercept if the y-axis is rf. the SML shows individual asset risk
premiums as a function of asset risk. It is valid for both efficient portfolios and individual
assets. In market equilibrium, all securities must lie on the SML.
21. Bond convexity:
A non-linear (curved) inverse relationship between changes in bond yield and changes in
bond price. Non-callable bonds typically have positive convexity, meaning that the
downward slope is steeper for yield decreases than for yield increases; a desirable feature
for investors. Callable bonds or mortgage-backed securities often display negative convexity
due to (embedded) call optionality, a non-desirable feature for investors.
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Part 3: Calculations.
22.
A. What are E(rx,y) expected return for stock X and stock Y?
Probability 0.3 0.5 0.2
X -20% 18% 50%
Y -10% 20% 10%
E(rx) = [0.3 x (-20%)] + [0.5 x 18%] + [0.2 x 50%] = 13%
E(ry) =[ 0.3 x (-10%)] + [0.5 x 20%] + [0.2 x 10%] = 9%
B. What are the standard deviations of the expected returns?
sx2= [0.3 x (-20 - 13)2] + [0.5 x (18 - 13)2] + [0.2 x (50 – 13)2] = 326.7 + 12.5 + 273.8 = 613
sx = 24.76%
sy2= [0.3 x (-10 - 9)2] + [0.5 x (20 - 9)2] + [0.2 x (10 – 9)2] =
sy= 13.00%
23. Suppose your client decides to invest in your portfolio.
A. What would be the proportion of Stock Y. So that the overall portfolio will have an
expected rate of return of 18%
E(rc) = rf + y x [E(rp) – rf] = 2% + y * (20% - 2%) = 2% + 18% x y
If the expected return of the portfolio should be 18%, then 18% = 2% + 18% x y
Y= (0.18 – 0.02) / 0.18 = 0.8889
Therefore, to have a portfolio with an expected rate of return equal to 18%, the client must
invest 88.89% of his total funds in the risky portfolio
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B. What would be the amount invested in T-bills?
100% - 88.89% = 11.11 in T-Bills.
24. Missing question????
25. Missing question????
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Part 4: Long answer questions.
26. Discuss how the investor can use the separation theorem and utility theorem to
produce an efficient portfolio suitable for the investor’s level of risk tolerance.
One can identify the optimum risky portfolio as the portfolio at the point of tangency
between a ray extending from the risk-free rate and the efficient frontier of risky securities.
Below the point of tangency on this ray from the risk-free rate, the efficient portfolios
consist of both the optimum risky portfolio and risk-free investments (T-Bills); above the
point of tangency, the efficient portfolios consist of the optimum risky portfolio purchased
on margin. If the investor’s indifference curve, which reflects the investor’s preferences
regarding risk and return, is superimposed on the ray from the risk-free rate, the resulting
point of tangency represents the appropriate combination of the optimum risky portfolio
and either risk-free assets or margin buying for that investor. Thus, the separation theorem
separates the investing and financing decisions. That is, all investors will invest in the same
optimal risky portfolio and adjust the risk level of the portfolio by either lending (investing in
U.S. Treasuries, i.e., lending to the U.S. government) or borrowing (buying risky securities on
margin).
Feedback: The purpose of this question is to ascertain whether the student understand the
basic principles of the utility theory, the optimal risky portfolio, and the separation theorem,
these concepts relate to constructing the ideal portfolio for a particular investor.
27. Discuss duration. Include in your discussion what duration measures, how duration
relates to maturity, what variables affect duration, and how duration is used as a portfolio
management tool (include some of the problems associated with the use of duration as a
portfolio management tool).
Duration is a measure of the time it takes to recoup one’s investment in a bond, assuming
that one purchased the bond for $1,000. Duration is shorter than term to maturity on
coupon bonds as cash flows are received prior to maturity. Duration equals term to maturity
for zero-coupon bonds, as no cash flows are received prior to maturity. Duration measures
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the price sensitivity of a bond with respect to interest-rate changes. The longer the maturity
of the bond, the lower the coupon rate of the bond, and the lower the yield to maturity of
the bond, the greater the duration. Interest-rate risk consists of two components: price risk
and reinvestment risk. These two risk components move in opposite direction; if duration
equals horizon date, the two types of risk exactly offset each other, resulting in zero net-
interest-rate risk. This portfolio management strategy is immunization. Some of the
problems associated with this strategy are: the portfolio is protected against one interest-
rate change only; thus, once interest rates change, the portfolio must be rebalanced to
maintain immunization; duration assumes a horizontal yield curve (not the shape most
commonly observed); duration also assumes that any shifts in the yield curve are parallel
(resulting in a continued horizontal yield curve); in addition, the portfolio manager may
have trouble locating acceptable bonds that produce immunized portfolios; finally, both
duration and horizon dates change with the mere passage of time, but not in a lockstep
fashion, thus rebalancing is required. Although immunization is considered a passive bond
portfolio management strategy, considerable rebalancing must occur, as indicated above.
The portfolio manager must consider the trade-offs between the transaction costs and not
being perfectly immunized at all times.
Feedback: The rationale for the question is to be certain that the student thoroughly
understands duration, how duration is used as a portfolio management tool, and the
deficiencies of duration as a portfolio management tool.
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