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Econ 261: Principles of Finance Quiz 2- 40 marks

16 September, 2013

Instructions: 1. Do not turn over the quiz until you are asked to do so.

2. Clearly write your roll number on the Answer Booklet(s).

3. Carefully read all the questions before answering. 4. Your answers must be precise and to the point. Vague and half-baked responses will receive little or no credit. 5. Your graphs must be properly and fully labeled for full credit (if a graph is required by the question) 6. In numerical questions, you are required to show all steps for full credit.

7. There are a total of THREE questions in this quiz and you must attempt all questions for full credit. There is also a short Bonus Question in this Quiz

8. You are allowed 60 minutes for the quiz. You are advised to allocate your time carefully.

Best of Luck!

Question 1: Total 25 Marks You manage a large portfolio of Australian companies, composed of mining and manufacturing stocks. The mining stocks have an expected return of 5% and a standard deviation of 1.2%. The manufacturing stocks have an expected return of 8% and a standard deviation of 4.2%. The correlation coefficient between the two assets is 0.24 a. Derive the variance and return of the combined portfolio(Leave your answer in terms of ws) [4 marks] b. What are the weights in the mining and manufacturing stocks that give the lowest variance of the combined portfolio? What is the return of this portfolio? [8 marks] c. Draw an efficient frontier for the combination of these two assets if the correlation coefficient is (i)-1, (ii) 0 (iii)0.5 or (iv) 1 [4 marks] A risk free asset is now available and yields a modest 2.5%. Assume that the Market Portfolios expected return is 6.5% d. What is the Capital Market Line (CML)? What is the market portfolio and who holds it in their portfolio? [4 marks] e. What are the weights in the two stock types that give the market portfolio? [2 marks] f. What is the slope of the CML? [3 marks] Question 2: Total 15 Marks An Investor has two assets available named X and Y. Asset X has an expected return of 7% and a standard deviation of returns of 4%. Asset Y has an expected return of 12% and standard deviation of return of 6%. a. Assuming the investor places portfolio weight of 0.5 on asset X and 0.5 on asset Y. Assuming that the returns to these assets are perfectly positively correlated, calculate the portfolios expected return and standard deviation of returns. How would your answer change if the correlation coefficient was only 0.5? [7 marks] b. Graphically depict the mean standard deviation frontier implied in part (a) [3 marks] c. What is the two fund separation theorem? What implications does it have for optimal portfolio of risky assets held by investors? How does the Capital Asset Pricing Model (CAPM) address this issue? [5 marks] Bonus Question: Total 3 Marks i. ii. What is the Sharpe Ratio? (Not more than 2 lines) [1 mark] Sharpe Ratio is maximized where the CML is [2 Marks]

For part ii. Do not write more than 10 words