MTH222R

Timed Online Assignment – January Semester 2021

Foundations of Asset Pricing Models

Monday, 24 May 2021 4:00 pm – 6:30 pm

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Time allowed: 2.5 hours

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INSTRUCTIONS TO STUDENTS:

1. This Timed Online Assignment (TOA) contains FIVE (5) questions and comprises
SEVEN (7) pages (including cover page).

2. You must answer ALL questions.

3. If you have any queries about a question, or believe there is an error in the question,
briefly explain your understanding and assumptions about that question before
attempting it.

4. You MUST submit your answers via Canvas (similar to TMA submission) at the
end time of this TOA (as stated on this cover page). The 15 minutes grace period as
shown on Canvas is strictly meant for technical issues encountered during
submission. Thereafter, you will not be able to submit your answers and you will be
considered as having withdrawn from the course. No appeal will be allowed.

5. You are to include the following particulars in your submission: TOA Course Code,
your Full Name, and SUSS PI Number. Name your submission file as
TOACourseCode_FullName_StudentPI. Use underscore and NOT Space. Example:
TOAXYZ_RaphaelLee_T1923161 (omit D/O, S/O).

6. Your submission should consist of only one file and must not exceed 500MB in size.
The file must be a Microsoft Word file saved in .doc or .docx format. All answers are
to be typed. Flowcharts and graphs may be scanned or photographed and embedded
in the Word file provided it does not exceed the file size limit of 500MB.

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TOA – January Semester 2021
7. For answers which cannot be typed and require to be hand-written, ensure that
question number is clearly stated on each page. All uploaded hand written answers
must be clear, readable and complete. Marks will not be awarded for
un-readable or incomplete images.

8. To prevent plagiarism and collusion, your submission will be reviewed by Turnitin.

The Turnitin report will only be made available to the marker and you will not be
able to view it.

9. The University takes plagiarism and collusion seriously, and your Turnitin report will
be examined thoroughly as part of the marking process.

10. Marks will only be awarded if FULL working is shown.

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TOA – January Semester 2021
Answer all questions. (Total 100 marks)

Question 1

There are two securities, A and B. You can apply the relevant information as shown in
Table Q1.

Return on Return on
State of the economy Probability
Security A Security B
Bear 0.35 6.5% 7.5%
Bull 0.65 14.8% 3.7%

Table Q1

(a) Explain the expected return on each of the two securities by giving the value.
(2 marks)

(b) Explain the standard deviation of the return on each of the two securities by
giving the value.
(4 marks)

(c) Explain the covariance between the returns on the two securities by giving the
value.
(3 marks)

(d) Explain how are the returns of the two securities correlated?
(1 mark)

(e) Suppose John borrowed from his friend 50 shares of security B, which is currently
sold at $60 per share, and sold all shares of the security. He promised his friend
to pay back in a year with the same number of shares of security B. Then he
purchased security A with the proceeds obtained in the sales of security B shares
and the cash of $6,000 he owned. Based on the information, explain what are the
expected return and the standard deviation of the portfolio? How much money
can he expect to receive at the end of the year with the investment?
(10 marks)

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TOA – January Semester 2021
Question 2

There are only three risky assets: Asset 1, 2 and 3 as listed in Table Q2. Assume that the
correlation coefficients of the assets are: 12  0.65, 13  0.15 and 23  0.35.

Asset i Expected rate of return ri Standard deviation i

1 11% 24%
2 14% 37%
3 23% 55%

Table Q2

(a) Solve for the covariance matrix of the three risky assets.
(5 marks)

(b) Solve for the weight vector of the minimum-variance portfolio of the above three
risky assets, and solve for the expected rate of return and the standard deviation
of the portfolio.
(13 marks)

(c) Explain whether you can build a risk-free portfolio with the three risky assets.
(2 marks)

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TOA – January Semester 2021
Question 3

Table Q3 below provides the information of the expected returns, and the standard
deviations of three securities, named A, B and C, as well as that of the market portfolio
and the risk-free asset, respectively.

Security Expected Return Standard Deviation

A 15% 11%
B 26% 16%
C 27% 19%
Market portfolio 20% 12%
Risk-free asset 2% 0%

Table Q3

(a) Outline the concept of Capital Market Line (CML) by writing down its equation.
(2 marks)

(b) Explain if the three securities are efficient.

(5 marks)

(c) You build a portfolio by buying $20,000 of Security C and $10,000 of the Market
portfolio, and borrowing $25,000 at the risk-free rate. Apply CAPM theory to
find the systematic risks and non-systematic risks of the portfolio.
(13 marks)

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TOA – January Semester 2021
Question 4

Table Q4 below gives the information of four assets, A, B, C and D:

Standard Covariance with

Asset Expected Return Deviation the market
i ri i Cov(ri , rM )
A 21.2% 0.02854
B 15.6% 17.5%
C 12.8% 14.5% 0.01053
D 9.7% 10.2%

Table Q4

Assume that CAPM holds and the standard deviation of the market portfolio is 15%.

(a) (i) Identify the risk-free rate.

(ii) Identify the expected rate of return on the market portfolio.

(10 marks)

(b) You invest $9,000 on asset A, $13,000 on asset B and $3,000 on asset C and
$7,000 on asset D.

(i) Explain how much you are expected to receive at the end of one year.
(3 marks)

(ii) Using CAPM, examine the expected amount derived in Question 4(b)(i).
(7 marks)

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TOA – January Semester 2021
Question 5

The risk-free rate is 5%. The expected market rate of return is 17% and the standard
deviation of the market return is 23%. You are evaluating a stock with standard deviation
34% and the covariance with the market 0.06. Now the stock is priced at $78 per share,
and is expected to have pay off $93 in one year time.

(a) Identify the price of the stock predicted by CAPM.

(6 marks)

(b) Solve for the Jensen index of the stock.

(6 marks)

(c) Outline what you should do with the stock.

(2 marks)

(d) Analyse if the stock is efficient.

(6 marks)

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TOA – January Semester 2021