FINANCE II Exercise set 3. Attention:

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1 FINANCE II Exercise set 3 Attention: In addition to this set of problems, two other problems are chosen from the textbook. A discussion problem, number 15 from chapter 20, where you are supposed to solve the problem before the class and be prepared to participate in discussions. The other problem is number 12 from chapter 22. These problems are not multiple-choices. 1. Given an optimal risky portfolio with expected return of 14% and standard deviation of 22% and a risk free rate of 6%, what is the slope of the best feasible CAL? A B C D E The market portfolio has a beta of A. 0. B. 1. C. -1. D E The risk-free rate and the expected market rate of return are 0.06 and 0.12, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on security X with a beta of 1.2 is equal to. A B C D E

2 4. (CFA problem) The portfolio manager John Wilson is evaluating the expected performance of two common stocks, Furhman Labs Inc. and Garten Testing Inc. He has gathered the following information: The risk-free rate is 5 %. The expected return on the market portfolio is 11.5 %. The beta of Furhman stock is 1.5. The beta of Garten stock is 0.8. Based on his own analysis, Wilson s forecasts of the returns on the two stocks are % for Furhman stock and % for Garten stock. Calculate the expected rate of return according to the CAPM for both stocks. Indicate whether each stock is undervalued, fairly valued or overvalued in relation to the CAPM model. 5. Given the following two stocks A and B If the expected market rate of return is 0.09 and the risk-free rate is 0.05, which security would be considered the better buy and why? (Tip: compare to the expected rate of return of the CAPM) A. A because it offers an expected excess return of 1.2%. B. B because it offers an expected excess return of 1.8%. C. A because it offers an expected excess return of 2.2%. D. B because it offers an expected return of 14%. E. B because it has a higher beta. 6. According to the CAPM, the risk premium an investor expects to receive on any stock or portfolio increases: A. directly with alpha. B. inversely with alpha. C. directly with beta. D. inversely with beta. E. in proportion to its standard deviation. 7. You invest $200 in security A with a beta of 1.4 and $800 in security B with a beta of 0.3. The beta of the resulting portfolio is A B C D E (CFA problem) An analyst wants to evaluate portfolio BC, consisting entirely of U.S. common stocks, using both the Treynor and Sharpe measures of portfolio performance. The following table provides the average annual rate of return for portfolio BC, the market portfolio (as measured by the S&P 500), and U.S. Treasury bills during the past 8 years:

3 Average Annual Rate of Return Standard deviation of Return Beta Portfolio BC 10% 18% 0.60 S&P % 13% 1.00 T-bills 6% 0 0 a. Calculate the Treynor and Sharpe measures for both portfolio BC and the S&P 500. Briefly explain whether portfolio BC underperformed, equaled, or outperformed the S&P 500 on a risk-adjusted basis using both the Treynor measure and the Sharpe measure. b. On the basis of the performance of portfolio BC relative to the S&P 500 calculated in part (a), briefly explain the reason for the conflicting results when using the Treynor measure versus the Sharpe measure. c. Can you, based on the difference in Treynor measure between portfolio BC and S&P 500 say whether portfolio BC has a positive, negative or zero Jensen measure? Compute the Jensen measure of portfolio BC to verify. 9. You want to evaluate three mutual funds using the Jensen measure for performance evaluation. The risk-free return during the sample period is 6%, and the average return on the market portfolio is 18%. The average returns, standard deviations, and betas for the three funds are given below. The fund with the highest Jensen measure is. A. Fund A B. Fund B C. Fund C D. Funds A and B are tied for highest E. Funds A and C are tied for highest 10. Suppose you purchase one share of the stock of Volatile Engineering Corporation at the beginning of year 1 for $36. At the end of year 1, you receive a $2 dividend, and buy one more share for $30. At the end of year 2, you receive total dividends of $4 (i.e., $2 for each share), and sell the shares for $36.45 each. The time-weighted return on your investment is. A % B. 4.08% C. 6.74% D % E %

4 11. Suppose you own two stocks, A and B. In year 1, stock A earns a 2% return and stock B earns a 9% return. In year 2, stock A earns an 18% return and stock B earns an 11% return. Which stock has the higher geometric average return? A. Stock A B. Stock B C. The two stocks have the same geometric average return D. At least three periods are needed to calculate the geometric average return 12. The straightforward generalization of the simple CAPM to international stocks is problematic because. A. inflation risk perceptions by different investors in different countries will differ as consumption baskets differ B. investors in different countries view exchange rate risk from the perspective of different domestic currencies C. taxes, transaction costs and capital barriers across countries make it difficult for investor to hold a world index portfolio D. All of these are correct. 13. The yield on a 1-year bill in the U. K. is 8% and the present exchange rate is 1 pound = U. S. $1.60. If you expect the exchange rate to be 1 pound = U. S. $1.50 a year from now, the return a U. S. investor can expect to earn by investing in U. K. bills is A. -6.7% B. 0% C. 8% D. 1.25% 14. Suppose the 1-year risk-free rate of return in the U. S. is 5%. The current exchange rate is 1 pound = U.S. $1.60. The 1-year forward rate is 1 pound = $1.57. What is the minimum yield on a 1-year risk-free security in Britain that would induce a U. S. investor to invest in the British security? A. 2.44% B. 2.50% C. 7.00% D. 7.62%

5 15. You are a U. S. investor who purchased British securities for 2,000 pounds one year ago when the British pound cost $1.50. No dividends were paid on the British securities in the past year. Your total return based on U. S. dollars was if the value of the securities is now 2,400 pounds and the pound is worth $1.60. A. 16.7% B. 20.0% C. 28.0% D. 40.0% 16. Consider an at-the-money European put option on Apple Inc. with one month left to maturity. Apple Inc. Currently trades at $110, the put option currently trades at $2 and the interest rate is zero. a) If Apple Inc. at maturity date trades at $100. What is the payoff of your portfolio? b) If Apple Inc. at maturity date trades at $100. What is the profit of your portfolio? 17. Consider the following multifactor (APT) model of security returns for a particular stock. Factor Factor Beta Factor Risk Premium Inflation 1.0 9% Industrial production % Oil prices 0.2 8% If T-bills currently offer an 8% yield, find the expected rate of return on this stock if the market views the stock as fairly priced.

For each of the questions 1-6, check one of the response alternatives A, B, C, D, E with a cross in the table below:

November 2016 Page 1 of (6) Multiple Choice Questions (3 points per question) For each of the questions 1-6, check one of the response alternatives A, B, C, D, E with a cross in the table below: Question