Investments

Midterm Exam – Fall 2018

Professor Martijn Boons

Professor Emanuele Rizzo

October 20 (11.15 - 12.45)

This exam consists of 12 Multiple Choice (MC) questions and 1 open question. Each MC
question is worth 1.25 points; the Open question is worth a total of 5 points. For the MC
questions, write your solution in the MC solution sheet provided below (on page 2). For the
open question, provide your answer in the space provided below each sub-question. Any
writing outside the provided space will not be graded! Thus, be extra careful when writing
your solution.

This is a close-book exam, but a formula sheet is provided on the last page (11) of the exam.
Only one-line (financial) calculators are permitted. We suggest you to round all intermediate
calculations to the 3rd decimal (e.g., 0.1235 = 0.124). Good luck!
Name: _________________________________ Number (on Student Card): _____________

In the table below, you can provide your answers to the multiple choice questions. Don’t
forget to write your name and student number at the top of this page!

Question # Your answer

10

11

12

2
Name: _________________________________ Number (on Student Card): _____________

Multiple choice questions

For multiple choice questions 1 and 2, use the following data:

Exp. Ret. St. Dev.

Stock X 8% 15%
Stock Z 12% 25% Corr(X, Z) = 0.3
Risk-free rate, 𝑟𝐹 5%

1. What is the Sharpe ratio of the Tangency portfolio of Stocks X and Z?

A. The Sharpe ratio of the Tangency Portfolio equals 0.305.
B. The Sharpe ratio of the Tangency Portfolio equals 0.355.
C. The Sharpe ratio of the Tangency Portfolio is lower than 0.275.
D. The Sharpe ratio of the Tangency Portfolio is above 0.400.

2. For what risk aversion level A is a 100% investment in the Tangency portfolio optimal
for an investor with mean-variance utility?
A. The risk aversion level is A=5.311.
B. The risk aversion level is A=2.432.
C. The risk aversion level is A=1.817.
D. The risk aversion level is A=1.645.

For multiple choice questions 3 and 4, use the following data:

Exp. Ret. St. Dev.

Market 10% 15%
Risk-free rate, 𝑟𝐹 5%

3. What is the expected return of the optimal portfolio (i.e., the portfolio on the Capital
Market Line) with a standard deviation of 12%?
A. The expected return is 8%.
B. The expected return is 9%.
C. The expected return is 6%.
D. The expected return is 7%.

3
Name: _________________________________ Number (on Student Card): _____________

4. What is the beta of the optimal portfolio (i.e., the portfolio on the Capital Market Line)
with an expected return of 7.5%?
A. The beta is 0.3.
B. The beta is 0.5.
C. The beta is 0.7.
D. The beta is 0.75.

5. It is December 31 and you and your partner are celebrating your 25th birthday today.
During all the festivities, you decide it is about time to think about how to guarantee a
bright, financially secure future together. Your plan is to buy a seaside retirement home
on your 50th birthday that will cost you €300.000. Moreover, to provide for the both of
you, you plan to buy a standard retirement annuity on your 65th birthday, that pays
€12000 at the end of every year. This annuity will last for 30 years, so that you will
receive the last payment on your 95th birthday. Suppose that you, instead of depositing
the required amount of money in a savings account today, decide to deposit a growing
amount every year. The first deposit in the savings account, equal to ‘FD’, takes place on
your 26th birthday (and the last deposit on your 50th birthday). Because you expect your
annual salary to grow by 3% per year, you also assume your annual deposit will grow by
3%. How much should ‘FD’ be to pay for both the house and the pension annuity from
these savings? The EAR is 12%.
A. The first deposit FD should be < 2000.
B. The first deposit FD should be 2000 ≤ FD ≤ 2500.
C. FD = 2817.
D. FD = 2623.

6. Which of the following two portfolios provides the largest expected return for a buy-and-
hold investor with a 10-year horizon? Portfolio A has an annual (arithmetic average)
expected return of 10% and a standard deviation of 25%. Portfolio B has an annual
(geometric average) expected return of 7.5% and a standard deviation of 10%. (The
correct answer is based on the closest approximation possible using the data provided
above.)

4
Name: _________________________________ Number (on Student Card): _____________

A. Portfolio A, with an expected 10-year buy-and-hold return of 159.4% vs 115.9% for

Portfolio B.
B. Portfolio A, with an expected 10-year buy-and-hold return of 159.4% vs 106.1% for
Portfolio B.
C. Portfolio B, with an expected 10-year buy-and-hold return of 106.1% vs 94.4% for
Portfolio A.
D. Portfolio A, with an expected 10-year buy-and-hold return of 100% vs 75% for
Portfolio B.

For multiple choice questions 7 and 8, use the following data and assume the CAPM holds:

Exp. Ret. St. Dev. Beta

Stock A 15% 22% 1.3
Stock B 10% 14% 0.8

7. What is the risk free rate and the expected return on the market portfolio?
A. 𝐸(𝑟𝑀 ) = 11% and 𝑟𝐹 = 4%.
B. 𝐸(𝑟𝑀 )= 12% and 𝑟𝐹 = 2%.
C. 𝐸(𝑟𝑀 )= 13.5% and 𝑟𝐹 = 2.5%.
D. 𝐸(𝑟𝑀 )= 15% and 𝑟𝐹 = 5%.

8. Estimate the correlation coefficient between stock A and B using a CAPM single-factor
model. Assume that the volatility of the market portfolio is 12%.
A. Corr(A,B) = 0.365.
B. Corr(A,B) = 0.398.
C. Corr(A,B) = 0.486.
D. Corr(A,B) = 0.521.

9. Assume a portfolio manager purchased one share exactly one year ago at €90, and sold it
today at €97. Exactly half a year ago the stock paid a dividend of €5. The beta of the
stock is 1.2, the risk-free rate of return is 5% and the realized market return over the year
is 11.8%. Which of the following statements about the manager’s alpha is incorrect?

5
Name: _________________________________ Number (on Student Card): _____________

A. The alpha is 31 basis points or 0.31%, assuming the dividend was reinvested at the
risk-free rate of 5%.
B. The alpha is 49 basis points or 0.49%, assuming the dividend was reinvested at the
market return of 11.8%.
C. The alpha is 17 basis points or 0.17%, assuming the dividend was not reinvested.
D. The alpha is positive, independent of how the manager may have reinvested the
dividends.

10. Stocks with high CAPM beta typically are:

A. Counter-cyclical stocks and stocks with low financial leverage
B. Stocks of companies selling non-discretionary products or services
C. Cyclical stocks and stocks with high debt/equity ratio
D. Stocks operating in industries with low sensitivity to the business cycle

11. Suppose you run a first-stage (time-series) CAPM regression for N stocks in a sample of
historical returns: 𝑟𝑖,𝑡 − 𝑟𝐹,𝑡 = 𝛼𝑖 + 𝛽𝑖,𝑀 (𝑟𝑀,𝑡 − 𝑟𝐹,𝑡 ) + 𝜀𝑖,𝑡 . With this regression you
2
estimate market beta (𝛽𝑖,𝑀 ) and idiosyncratic variance (𝜎𝜀,𝑖 ) for each stock i=1,..,N, where
2
𝜎𝜀,𝑖 is the variance of the residuals from each first-stage regression. What are the testable
hypotheses in the following second-stage (cross-sectional) regression that serve to test
whether the CAPM correctly describes cross-sectional variation in expected returns:

2
𝐸(𝑟𝑖,𝑡 − 𝑟𝐹,𝑡 ) = 𝜆0 + 𝜆1 𝛽𝑖,𝑀 + 𝜆2 𝜎𝜀,𝑖 + 𝑢𝑖 ?

A. 𝜆0 = 0; 𝜆1 = 𝐸(𝑟𝑀,𝑡 − 𝑟𝐹,𝑡 ); 𝜆2 = 0.
B. 𝜆0 = 0; 𝜆1 = 𝐸(𝑟𝑀,𝑡 ); 𝜆2 = 0.
C. 𝜆0 = 𝛼𝑖 ; 𝜆1 = 𝐸(𝑟𝑀,𝑡 − 𝑟𝐹,𝑡 ); 𝜆2 < 0.
D. 𝜆0 = 0; 𝜆1 = 𝐸(𝑟𝑀,𝑡 ); 𝜆2 < 0.

12. Security A has a beta of 1.0 and an expected return of 12%. Security B has a beta of 0.75
and an expected return of 11%. The risk-free rate is 5%. All else equal between the two
stocks, which of the following is true?

6
Name: _________________________________ Number (on Student Card): _____________

A. There is an arbitrage opportunity. The investor can make a profit by buying B and
financing 0.75 of the purchase by short selling A and the rest by borrowing at the risk-
free rate.
B. There is an arbitrage opportunity. The investor can make a profit by selling B and
investing 0.75 of the proceeds in A and the rest in the risk-free asset.
C. There is an arbitrage opportunity. The investor can make a profit by buying B and
financing 0.50 of the purchase by short selling A and the rest by borrowing at the risk-
free rate.
D. There is no arbitrage opportunity. All assets are fairly priced.

7
Name: _________________________________ Number (on Student Card): _____________

On the following pages, you find the open questions and the space to provide your
answers. Any writing outside the provided space will not be graded. Write your name at
the top of each page.

Open question (5 points)

Note: Each subquestion A to F is worth 1 point. We will not take into account for the
grading the subquestion for which you score the worst.

This question is about a two-factor APT model, where the first factor is assumed to be the
excess market return, formally written as:

𝑒 𝑒 𝑒
𝑟𝑖,𝑡 = 𝛽𝑖,𝑀 𝑟𝑀,𝑡 + 𝛽𝑖,𝐹2 𝑟𝐹2,𝑡 + 𝜀𝑖,𝑡 (Model (1))

A. The CAPM is a single-factor model, where market beta explains all variation in
expected returns. The APT is a multi-factor asset pricing model that adds additional
factors next to the market. Describe briefly (i) what failure of the CAPM brought
about the search for additional factors and (ii) what is the theoretical motivation to
include these additional factors.
i)

ii)

8
Name: _________________________________ Number (on Student Card): _____________

B. Discuss what is the relation between the tangency portfolio and the two factors in the
APT Model (1)? To do so, also sketch a graph in expected return/standard deviation
space.
Discussion:

𝐸(𝑟)

For the remainder of this open question, use the following data:

Exp. Excess St. Dev. Beta(MKT)= 𝛽𝑖,𝑀 Beta(F2)= 𝛽𝑖,𝐹2 Corr(𝑟𝐴,𝑡 , 𝑟𝐵,𝑡 )
Ret.
Portfolio A 10% 18% 1.2 0.1 0.5
Portfolio B 4% 15% 0.8 0.3
MKT=F1 7% 12% 1 0
F2 5% 10% 0 1

C. Does the two-factor APT model predict the returns of portfolios A and B correctly? If
A and/or B are mispriced, carefully document which portfolio is underpriced and/or
overpriced.
A)

B)

9
Name: _________________________________ Number (on Student Card): _____________

D. Construct a portfolio that has no factor exposure (so that its beta with respect to both
MKT and F2 is zero) and a positive two-factor alpha, i.e., a positive abnormal
expected excess return relative to the APT Model (1). The strategy must invest a total
of 1$ and takes positions in the two portfolios (A and B), the market and the risk-free
asset.

E. Decompose the variance of Portfolio A into variance coming from factor exposure
and idiosyncratic variance. Using this decomposition, calculate the R2 in a time-series
regression of Portfolio A's excess returns on the two factors.

F. What is the 95%-Value at Risk for an investment of 1 million Euros in an equal-

weighted portfolio of A and B? You may assume the returns of the portfolio are
normally distributed.

10
Name: _________________________________ Number (on Student Card): _____________

Formula Sheet

• The present value of a growing annuity with first payment equal to C, discount rate k,
growth rate g and maturity N:
𝐶 1+𝑔 𝑁
PV(GA) = 𝑘−𝑔 ∗ (1 − (1+𝑘 ) )

• Converting an Annual Percentage Rate (APR) with compounding interval m (e.g. m=2
for semi-annual) to an Effective Annual Rate (EAR):
𝐴𝑃𝑅
𝐸𝐴𝑅 = (1 + 𝑚 )𝑚 − 1

• Converting the realization R of a normal random variable (with mean 𝜇 and standard
deviation 𝜎) to a standard normal distribution:
𝑅−𝜇
𝑧=
𝜎
• Recall the following cumulative probabilities for standard normal variables: P(z≤-
2.33)=1%; P(z≤-1.65)=5%; and, P(z≤-1.28)=10%.
𝐴
• Mean-variance utility over a random return 𝑟: 𝑈 = 𝐸[𝑟] − 2 × 𝑉𝑎𝑟[𝑟]
• Minimum-variance portfolio of two risky assets D and E, weight in D:
σE2 − σ𝐷𝐸
𝑤𝐷𝑀𝑉 =
σD2 + σE2 − 2σ𝐷𝐸

• Tangency portfolio of two risky assets D and E, weight in D:

𝜇𝐷𝑒 σE2 − 𝜇𝐸𝑒 𝜎𝐷𝐸

𝑤𝐷𝑇 = 𝑒 2
𝜇𝐷 σE + 𝜇𝐸𝑒 σD2−(𝜇𝐷𝑒 + 𝜇𝐸𝑒 )𝜎𝐷𝐸

• Variance of a portfolio of N assets:

σ2𝑝 =𝑉𝑎𝑟(∑𝑁 𝑁 2 2 𝑁
𝑖=1 𝑤𝑖 𝑟𝑖 )=∑𝑖=1 𝑤𝑖 σ𝑖 + ∑𝑖=1 ∑𝑗≠𝑖 𝑤𝑖 𝑤𝑗 σ𝑖 σ𝑗 𝜌𝑖𝑗 , or

in matrix notation σ2𝑝 = 𝑤𝑝 ′𝛺𝑤𝑝 , where 𝑤𝑝 is an N-vector of weights and 𝛺 an NxN

variance-covariance matrix.
• APT: when returns are generated by the K-factor model (with the market as the first
factor)
𝑒 𝑒 𝑒
𝑟𝑖,𝑡 = 𝛽𝑖,𝑀 𝑟𝑀,𝑡 + ⋯ + 𝛽𝑖,𝐾 𝑟𝐾,𝑡 + 𝜀𝑖,𝑡 ,
with 𝜀𝑖,𝑡 uncorrelated across i, we have
𝑒 𝑒 𝑒
𝐸(𝑟𝑖,𝑡 ) = 𝛽𝑖,𝑀 𝐸(𝑟𝑀,𝑡 ) + ⋯ + 𝛽𝑖,𝐾 𝐸(𝑟𝐾,𝑡 )
𝑒
𝑉𝑎𝑟(𝑟𝑖,𝑡 )= 𝛽𝑖 ′𝛴𝑓 𝛽𝑖 + 𝑉𝑎𝑟(𝜀𝑖,𝑡 ),
with 𝛽𝑖 = (𝛽𝑖,𝑀 , … , 𝛽𝑖,𝐾 )′ and 𝛴𝑓 is the variance-covariance matrix of the factors.

11