FORMAL EXAMINATION PERIOD: SESSION 1, JUNE 2016

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1 SEAT NUMBER:. ROOM:... This question paper must be returned. Candidates are not permitted to remove any part of it from the examination room. FAMILY NAME:.... OTHER NAMES: STUDENT NUMBER: FORMAL EXAMINATION PERIOD: SESSION 1, JUNE 2016 Unit Code: AFIN352 Unit Name: Duration of Exam (including reading time if applicable): Total No. of Questions: 28 Total No. of Pages (including this cover sheet): Applied Portfolio Management Three hours plus 10 minutes reading time 15 GENERAL INSTRUCTIONS TO CANDIDATES: Candidates are required to obey all instructions provided by the Final Examination Supervisor and must refrain from communicating in any way with another student once they have entered the final examination venue. Candidates may not write or mark the exam materials in any way during reading time. Candidates may only access authorised materials during this examination. A list of authorised material is available on this cover sheet. If it is alleged you have breached these rules at any time during the examination, the matter may be reported to a University Discipline Committee for determination. EXAMINATION INSTRUCTIONS: 1. This test is comprised of two (2) part questions: Part I comprises 20 multiple-choice questions each worth 2 marks for a total of 40 marks. Part II comprises 8 questions of unequal value for a total of 50 marks. 2. Do not use a separate book for your answers. Write your answers neatly in the space provided on the examination paper (you can do rough working on the back of a page if needed.). Illegible answers will receive zero marks. 3. You must display your student ID card on your table. 4. You must return this test paper at the end of the test. You must not leave the examination room with any part of the paper. 5. You must follow the rules of the test and directions from invigilators. If you fail to follow instructions your paper will be confiscated and you will receive zero marks. 6. If you are caught copying, colluding or otherwise cheating you will be awarded zero marks and the matter will be pursued for disciplinary action at University level AIDS AND MATERIALS PERMITTED/NOT PERMITTED: Dictionaries: No dictionaries permitted Calculators: Non-programmable calculators (no text retrieval capacity) permitted Other: Closed book with specified materials permitted: Students are permitted to bring into the examination room, 1 x A4 page of double-sided, handwritten or typed notes only. Notes are to be collected with the exam paper at the end of the exam.

2 PART I Multiple-Choice Questions (Total: 40 Marks) (Questions 1 to 20 are to be answered on the Multiple Choice Answer Sheet) Question 1. The portfolio manager decides to use the Black-Litterman (B-L) implied model. What could be a reason for this decision to use the B-L model? a) Implementations of minimum-variance portfolio theory produce wildly unrealistic portfolios; b) Historical asset return data produce accurate predictions for future asset returns; c) The B-L model minimises the variance and maximises the Sharpe ratio of the portfolio; d) The B-L model determines the optimal weights based on the assumption that the benchmark can be outperformed; Consider the following Table of sector-level information and use it where required to answer Questions 2 to Question 5: TABLE 1 Benchmark weights Sample μ B-L Implied Returns (Scenario 1) B-L Implied Returns (Scenario 2) COV(Technology, j) VAR(Technology) COV(Utilities, j) VAR(Utilities) PM Expects PM Opinion (δ) Technology 2.71% -0.87% 0.27% 0.96% % A Utilities 11.91% -0.39% 0.31% 1.05% % B Basic Materials 2.56% 0.06% 0.18% 0.77% E(R C ) 0.00% Consumer Serv % 0.30% 0.46% 1.36% E(R D ) 0.00% Telecom 24.69% 1.07% 0.31% 1.05% E(R E ) 0.00% Consumer Goods 10.57% 0.82% 0.27% 0.97% E(R F ) 0.00% Financials 4.53% -0.18% 0.37% 1.17% % 0.00% Industrials 6.17% 0.03% 0.21% 0.84% % 0.00% Oil & Gas 12.80% -0.55% 0.18% 0.77% % 0.00% Other 9.81% 0.75% 0.16% 0.73% % 0.00% A portfolio manager assumes that, in the absence of any additional knowledge or opinions about the market, the current market weights of the benchmark indicate the efficiency weights. She estimates that the expected benchmark return over the next month will be 1%. Question 2. Given the portfolio manager estimates of benchmark return over the next month, what can you say about the implied expected returns of the B-L model as indicated in Table 1? a) The B-L implied returns are consistent with historical estimates; b) Only the implied returns in Scenario 1 of the B-L model are consistent with the anticipated benchmark return; c) Only the implied returns in Scenario 2 of the B-L model are consistent with the anticipated benchmark return; d) Neither Scenario 1 nor Scenario 2 are consistent with the anticipated benchmark return; e) Both Scenario 1 and Scenario 2 are consistent with the anticipated benchmark return. 1

3 Question 3. What is the portfolio manager (PM) opinion (δ) about the Technology sector (missing value (A) in Table 1) and the Utilities sectors (missing value (B) in Table 1) over the next month? a) [δ A = 0.26; δ B =0.23]; b) [δ A = 0.95; δ B =0.97]; c) [δ A = 0.14; δ B =0.23]; d) [δ A = 0.26; δ B =0.14]; Question 4. If the standard deviation of the benchmark portfolio is equal to 5.26% and the risk free rate is 0.40%, what is the value of the normalizing factor (N F ) used to derive the B-L implied returns? a) N F = 3.423; b) N F = 2.751; c) N F = 1.155; d) N F = 0.003; e) None of the above; Question 5: The capital market line (CML) is shown in the graph below. The standard deviation per annum is denoted by σσ and the expected return per annum is denoted by μμ. Assume that markets are efficient, the CAPM is true, and all assets are fairly priced. Which of the statements below is NOT correct? a) Asset A s beta is 1.4; b) Asset B s beta is 0.5; c) Asset A s total variance is 0.16, systematic variance is 0.04 and idiosyncratic variance is 0.12; d) Asset B s total variance is 0.01, systematic variance is 0.01 and idiosyncratic variance is 0; 2

4 Consider the following Table of security- and portfolio-level information and use it where required to answer Questions 6 to 9: Table 2 Securities' Standard Deviation (σ) Portfolio A Portfolio B Portfolio C Weights Weights Weights Security 1 30% Secuirty 2 25% Security 3 20% Security 4 15% Security 5 10% Portfolio Variance Question 6. Compute the diversification ratio (DR) for each of the portfolios A, B, and C indicated in Table 2. Which of the following is correct? a) DR A = 3.41; DR B = 1.82; DR C = 2.67 b) DR A = 1.63; DR B = 0.88; DR C = 1.96 c) DR A = 3.41; DR B = 1.82; DR C = 1.08 d) DR A = 1.63; DR B = 1.88; DR C = 1.08 e) None of the above; Question 7. Which of the following statements is true? a) All stocks included in the Most Diversified Portfolio (MDP) have perfect correlation with it; b) Any stock that is not included in the MDP is less correlated to the MDP than any of the stocks included in it; c) All stocks included in the MDP have the same correlation with it; d) The MDP minimises the diversification ratio; e) None of the above; Question 8. When does the Most Diversified Portfolio (MDP) approach to asset allocation provide the same tangency portfolio solution obtained by maximising the Sharpe ratio of the portfolio? a) When the MDP is located on the Capital Allocation Line (CAL); b) When the MDP minimises the diversification ratio (DR); c) When the MDP is located on the efficient frontier of risky assets; d) If the idiosyncratic volatility of the MDP is eliminated through diversification; Question 9. Given the diversification ratios (DR) obtained in Question 6, how do you identify then the Most Diversified Portfolio (MDP)? a) The MDP is the portfolio that minimises the diversification ratio ; b) The MDP is the portfolio that has a diversification ratio of zero; c) The MDP is the portfolio that maximises the diversification ratio; d) The MDP is the portfolio that maximises the Sharpe ratio; 3

5 Question 10. Why do we use the risk-free rate when computing the price of forward or futures contracts? a) Because we price these contracts assuming that investors are well diversified; b) Because we price these contracts assuming that investors are risk averse; c) Because we price these contracts assuming that investors can hedge any systematic risk; d) Because investor risk preference have no effect on the value of these contracts; Question 11. In the Black-Litterman asset allocation model, how can a portfolio manager account for the degree of confidence in her own opinions about asset class returns? a) She can simply rely on market expectations of asset class returns; b) She can estimate the portfolio weights based on her own opinions about asset class returns; c) She can rely on mean-variance optimisation to derive portfolio proportions; d) She can form a portfolio based on a convex combination of the market weights and the opinion-adjusted weights; Question 12. From the perspective of an investors, what is a desirable attribute of a portfolio manager s performance? a) The ability to derive above-average returns for any level of portfolio risk; b) The ability to outperform the benchmark while maximising the tracking error; c) The ability to outperform the benchmark irrespective of management fees; d) The ability to derive above-average net-of-fees returns for a given risk class; e) All of the above. Question 13. Please identify one performance measure that accounts for downside risk: a) The Value-at-Risk of the portfolio; b) The ratio between the return of the portfolio in excess of a threshold and the semi-deviation of portfolio returns; c) The downside performance volatility; d) The ratio between fund active return and its standard deviation; Question 14. What is a limitation of the Grinblatt and Titman (1993) holdingsbased performance measure? a) It relies on fund portfolio holdings that can be easily manipulated by the portfolio manager; b) It does not account for the portfolio manager s security selection ability; c) It requires at least three reporting periods to calculate fund performance; d) It does not control directly for differences in either risk or investment style of the portfolio; 4

6 Question 15. What is the traditional objective of attribution analysis in portfolio performance evaluation? a) In a team-managed portfolio, attribution analysis attempts to identify the fund manager who is responsible for the overall portfolio performance; b) It attempts to distinguish between market timing and security selection as the source of the portfolio s overall performance; c) It attempts to identify the asset class that contributed the most to the overall portfolio performance; d) It attempts to identify the market segment that contributed the most to the overall portfolio performance; Question 16. What does a call option s delta measure? a) It is defined as the rate of change of the value of the portfolio with respect to the volatility of the underlying asset; b) It is defined as the rate of change of the option price with respect to the passage of time; c) It is defined as the rate of change of the portfolio delta with respect to the price of the underlying asset; d) It is defined as the rate of change of the value of the portfolio with respect to the interest rate; Question 17. Please identify a common characteristic of hedge fund products? a) Hedge fund investments are far less liquid than mutual funds or closed-end funds; b) There are no limitations on when and how often investment capital can be contributed to or withdrawn from a hedge fund; c) They tend to be more correlated with traditional asset class investments; d) Hedge fund managers usually receive only a compensation expressed as a percentage of assets under management; e) All of the above. Question 18. Assume that mutual funds outperform their benchmarks by about 1.5%, on average, after accounting for transaction costs but before considering management fees. What can you say about the mutual fund industry? a) The industry creates value for mutual fund investors; b) Mutual fund managers have significant security selection skills; c) Mutual fund managers have significant market timing skills; d) Mutual fund managers are able to deliver persistent performance to their investors; 5

7 Question 19. What does the notion of Black Swan refer to? a) It refers to high impact, high frequency events that completely reinforce the applicability of conventional frameworks for the pricing of derivatives and the management of risk; b) It refers to high impact, high frequency events that completely undermine the applicability of conventional frameworks for the pricing of derivatives and the management of risk; c) It refers to high impact, low frequency events that completely undermine the applicability of conventional frameworks for the pricing of derivatives and the management of risk; d) It refers to the idea that derivative pricing models appear to be objective and preference free; Question 20. What particular features of hedge funds may render them susceptible to black swan-type risks? a) The convex-like compensation structure of hedge funds could induce excessive risk taking; b) High transparency of portfolio holdings expose hedge funds to the risk of front-running and extreme events; c) The existence of many restrictions on the types of trades undertaken by hedge funds can jeopardise their performance; d) Hedge fund strategies tend to make bets on a series of high frequency and high impact events; e) All of the above. 6

8 PART II Essay Questions (Total: 50 Marks) (Questions 21 to 28 are to be answered directly on to this examination paper) Question 21 (10 marks): What would happen to market efficiency if all investors attempted to follow a passive strategy? Please explain briefly but clearly your argument. 7

9 Question 22 (5 marks): Suppose that we see significant negative abnormal returns (declining CARs) in the days following a merger announcement date for stock XYZ. Please explain carefully whether this case represents a violation of efficient markets. 8

10 Question 23 (5 marks): Investors and academic researchers have long searched for outperforming mutual fund managers. This search however seems quite elusive due to the presence of high noise in fund performance. Barras, Scaillet and Wermers (2010) refer to this issue as false discoveries in mutual fund performance. Explain briefly but clearly how noise in performance could impair investors ability to discriminate good from bad performing managers. 9

11 Question 24 (5 marks): Please describe what are the main investment strategies or investment objectives adopted by hedge fund vehicles. 10

12 Consider the following Table of information summarising the average performance of three mutual funds (Fund A, Fund B and Fund C) over the past 5 years. Please answer questions (25) to (27) with reference to the following information as required. Average Return Standard Deviation of Returns Correlation with Market Fund A 18% 35% Fund B 16% 35% Fund C 20% 35% Market Index 14% 21% Risk-free rate 2% 0% Question 25 (5 marks): Please describe the advantages and disadvantages of using the Sharpe ratio, Treynor ratio and Jensen s alpha when assessing fund performance. 11

13 Question 26 (5 marks): Compute the Sharpe ratio and the Treynor ratio for Fund A, Fund B, Fund C, and the Market Index. 12

14 Question 27 (5 marks): Rank the performance of the funds based on the Sharpe ratio and the Treynor ratio. Are the two performance rankings consistent? If not, explain the most likely reason for this difference. 13

15 Question 28 (10 marks): Please describe briefly but clearly the main issues with assessing the coefficient of risk aversion in the mean-variance asset-allocation framework? 14