Multiple Choices (2 points each)

Question 1

Characteristics model _______

a. does not allow arbitrage, just like the factor model

b. allows arbitrage
c. implies higher stock return volatility
d. implies lower stock return volatility

Answer: b.

As we discussed in class, APT expected return is the only expected return that avoids
arbitrage. Any other expected return, such as the characteristics model implied
expected return, allows arbitrage.

Question 2

Which of the following statement holds in the history of the US stock market?

a. high market beta stocks tend to outperform the predictions of the CAPM.
b. low market beta stocks tend to outperform the predictions of the CAPM.
c. both high market beta stocks and low market beta stocks tend to outperform
the predictions of the CAPM
d. None of these is correct.

Answer: b.

See class notes.

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Question 3

Consider the multifactor APT with two factors. Stock A has an expected return of
16.4%, a beta of 1.4 on factor 1 and a beta of .8 on factor 2. The risk premium on the
factor 1 portfolio is 3%. The risk-free rate of return is 6%. What is the risk-premium
on factor 2?

a. 15.25%
b. 3%
c. 4%
d. 7.75%
e. 6.89%

Answer: d.

16.4% = 1.4(3%) + .8x + 6%; x = 7.75%.

Question 4

Assume you are allocating your portfolio optimally between the market and two
stocks. If the market Sharpe ratio is 0.4 and the stock 1’s information ratio is −0.3,
and stock 2’s information ratio is 0 (assuming the two stocks’ returns are
uncorrelated). What is the Sharpe ratio of your optimal portfolio?

a. 0.4
b. 0
c. −0.3
d. 0.3
e. 0.5

Answer: e.

Follow the formula in the single index model. The optimal portfolio’s Sharpe ratio is
the square root of market Sharpe ratio squared + the two hedge funds’ information
ratio squared. The answer is 0.5.

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Question 5

Stock XYZ will announce earnings at 11am. You know this will bring big volatility,
though you don’t have any special information about XYZ. XYZ price = $10 at
10:59am.

a. It’s a good idea to bid $9 at 10:59am.

b. It’s a good idea to bid $5 at 10:59am.
c. It’s a good idea to bid $3 at 10:59am.
d. It’s a good idea to bid $1 at 10:59am.
e. All of the above
f. None of the above

Answer: f.

As we discussed, a bid like $1 either won’t execute or will execute when terrible news
come out and price crashes to below $1. Overall, the return is likely negative. Same
for a to e.

Long Question. Fundamental vs sentiment in a long-horizon portfolio (30 points)

Consider a 2-period portfolio optimization problem with t=0,1,2. The utility function
to be maximized is the same as in the class notes. Assume A=4. There are only 2
securities in each period: the 1-period risk-free rate, and a stock. The one-period risk-
free rate = 0 in each period. Assume dividend=0 so the stock return = log(price this
period) – log(price last period).

Solve the following two questions independently of each other.

1. (sentiment changes) At t=0, log(price)=5. At t=1, assume there are two

possibilities: log(price) = 6 or 4, each with 1/2 probability. Irrespective of
what the price at t=1 is, the log(price) at t=2 always has mean=6 and volatility
100% (I.e., the fundamental at t=2 has a fixed mean). What is your optimal
allocation to the stock at t=0? What is the Markowitz allocation at t=0? (FYI,
in this question stock price at t=1 is unrelated to the expected fundamental at
t=2. So you are trading against sentiment-driven price)

2. (fundamental changes) At t=0, log(price)=5. At t=1, assume there are two

possibilities: log(price) = 8 or 4, each with 1/2 probability. If log(price)=8 at
t=1, the log(price) at t=2 has mean=8 and volatility=100%. If log(price)=4 at
t=1, the log(price) at t=2 has mean=4 and volatility=100%. What is your
optimal allocation to the stock at t=0? What is the Markowitz allocation at
t=0? (FYI, in this question the stock price fluctuation at t=1 is driven perfectly
by expected fundamental at t=2)

Answer:

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1. At t=1, the expected return = 0 (if price=6) or 2 (if price=4). The Markowitz
allocation to stock at t=1 is risk premium / (A × variance) = (0-0)/4=0 (if
price=6) or (2-0)/4=0.5 (if price=4). The return between t=1 and 2 of the
optimal portfolio is 0 × 0 = 0 (if price=6) or 0.5 × 2 = 1 (if price=4). The
return of the stock between t=0 and t=1 is 1 (if price=6) or −1 (if price=4).
∗
With these numbers, we can compute that , = −0.5. Therefore,
the Markowitz portfolio at t=0 is − , ∙ 1 = 0, where the return
between t=0 and 1 has a mean = 0 and variance = 1. The optimal
∗
allocation to stock at t=0 is − , ∙1 − , =
0.5

2. At t=1, the expected return = 0 in either state. The optimal allocation to stock
at t=1 is (0-0)/4=0. The return between t=1 and 2 of the optimal portfolio is
∗
always 0 × 0 = 0. , = 0. Therefore, the optimal allocation to stock
∗
at t=0 is − , ∙1 − , = − , ∙
1 , same as the Markowitz portfolio at t=0. From t=0 to t=1, the expected
return = 3 (if price=8) or -1 (if price=4). The expected return from t=0 to t=1
is = 1. The variance = 4. The Markowitz portfolio at t=0 allocates
− , ∙1 = = 0.0625 to the stock (same for the optimal
×
portfolio).