FINANCE 634

Spring 1998 Exam 2

Part 2

1. You have estimated the following subjective distributions of returns for the assets shown for the coming year in three possible states of the economy.

	A	B	T-Bills
Bad (Prob = .35)	5%	3%	6%
Normal (Prob = .45)	15%	7%	6%
Good (Prob = .20)	25%	18%	6%

Asset A is a well-diversified portfolio composed of 100 stocks. Asset B is a portfolio of a few risky investments.

a. Complete the following table: [15 Pts. -5 Points for each wrong or absent answer -- Zero minimum]

	A	B	T-Bills
Expected Return
Std Dev of Return
Correlation with Asset A	-----
Correlation with T-Bills			-----
Beta Coefficient

b. Suppose you want to form a portfolio from any or all of the assets listed above such that your expected return is 25%. According to portfolio theory, describe the best (most rational) method of constructing such a portfolio and justify (in words) your strategy based on the underlying theory.

[5] Wt in A: _________ Wt. in B: ___________ Wt. in T-Bills: __________

c. Suppose you want to form a portfolio from any or all of the assets listed above such that your portfolio has half as much systematic risk as the average stock. What would be the rational composition of your portfolio?

[4] Wt in A: _________ Wt. in B: ___________ Wt. in T-Bills: __________

d. Suppose you plan to invest $20,000 in asset A and $50,000 in Asset B. You also intend to invest $30,000 in Treasury Bills. What will be the expected return, standard deviation, and beta coefficient of your position? Show your work?

[4]

2. Suppose that the current risk-free rate is 5.5%, the stock market has had a 25% annualized rate of return this year, and the Beta for MegaBucks common stock is 1.25. If you put $10,000 in this stock now, how much will your investment be worth one year from now? Justify your answer with references to portfolio theory. [4]

3. Suppose the required return on General Motors common stock was 13% one year ago but it is 16% today. Using what you know about portfolio theory, beta, and the SML, list and briefly explain all of the factors that could account for this change. [4]

4. Honest Abe Investment Advisors, PLLC, uses fundamental analysis of information contained in financial statements with sophisticated computer programs that also track price and volume data to produce investment recommendations for its clients. So far this year, its clients have earned a 28% return while the S&P 500 Index has made about 15%. Given what you know about the Efficient Markets Hypothesis, what is the maximum level of market efficiency (weak form, semi-strong form, or strong form) that would be consistent with the ability to produce this performance. Justify your answer in words. Please be brief. [4]

Answers:

E(R) of A = 13.5%

E(R) of B = 7.8%

E(R) of T = 6.0%

SD of A = .0726

SD of B = 0.0540

SD of T = 0.0

Corr(A,B) = .9485

Corr of anything else = 0

Beta of A = 1.0

Beta of B = .705

b. Wt(A) = 2.55 Wt(B) = 0 Wt(T) = -1.55

c. Wt(A) = 0.5 Wt(B) = 0 Wt(T) = 0.5

d. E(R) = 8.4%; SD = 4.10%; Beta = .5526

2. You can't say. E(Rm) is given for the past, not future. Even if you had the right E(Rm), you still couldn't know what the investment would be worth in one year. This could only be estimated.

3. Increase in the riskfree rate, increase in risk aversion, increase in Beta (any or all).

4. Strong-form is consistent. Beating the market for a short time is in no way evidence against market efficiency.

Extra Credit: Points as marked. No partial credit.

How do you think the position of the SML has changed since summer? How has this change affected the cost of capital for the average US company? Justify your answer with appropriate arguments based on recent events and portfolio theory. [3

The derivations of the Capital Market Line and the Security Market Line assumed that investors can borrow and lend at the same rate - the risk free rate. In reality, we can lend at the risk free rate but we must borrow at a higher rate. How does this fact affect the CML and SML and the investment decisions that we can make using these models? [3]

Draw the yield curve as it would appear today, using the current (close) rate for T-Bills and the current (close) rate for long-term government bonds. [3]