Questions
Section One: Market Efficiency
1. Discuss the implications of the efficient market hypothesis for investment policy as it relates to:
a. technical analysis such as charting
b. fundamental analysis
6 marks
2. Briefly describe two primary roles or responsibilities of portfolio managers in an efficient market
environment.
6 marks
Section Two: Asset Pricing Models
3. Briefly explain whether investors should expect a higher return from holding Portfolio A versus
Portfolio B under the capital asset pricing theory (CAPM).
3 marks
Portfolio A Portfolio B
Systematic Risk
(Beta)
1.5 1.5
Specific Risk High Low
4. Use the information in the table below to answer the following questions.
The following standard deviations and correlations have been obtained for four FTSE 100 companies
on an annualised basis. The standard deviation of the FTSE 100 is 5.5.
Company Standard
deviation
i
Correlation with
the market i,m
Actual Return
Lloyds Banking
Group
12.1 .72 20 percent
Rolls-Royce 14.6 .33 15 percent
Diageo 7.6 .55 19 percent
Glaxo 10.2 .60
10 percent
a. Compute the beta coefficient for each of the four stocks shown in the table.
4 marks
b. Assuming a risk-free rate of 8 percent and an expected return for the market portfolio of 15
percent, compute the expected (required) return using the Capital Asset Pricing Model
(CAPM) for all four stocks shown in the table.
4 marks
c. Plot the actual returns above on the SML for all four stocks and indicate which stocks are
undervalued or overvalued relative to your calculations of the expected returns in the
previous question.
7 marks
Question 4 total marks 15
5. Refer to the data contained in the table below which lists 30 monthly excess returns for two
different actively managed stock portfolios (A and B) and three different common risk factors (1, 2,
and 3). Note: You may find it useful to use Microsoft Excel to calculate your answers.
a. Compute the average monthly return for each portfolio. Annualise the portfolio returns.
Compute the average monthly standard deviation for each portfolio and all three risk factors.
Annualise the standard deviation for the portfolio returns and the risk factors.
7 marks
b. Based on the return and standard deviation calculations for the two portfolios from Part a, is
it clear whether one portfolio outperformed the other over this time period?
3 marks
c. Calculate the correlation coefficients between each pair of the common risk factors (i.e., 1 &
2, 1 & 3, and 2 & 3). In theory, what should be the value of the correlation coefficient
between the common risk factors? Explain why.
5 marks
Question 5 total marks 15
THIS TABLE IS FOR QUESTION 5
PERIOD PORTFOLIO A PORTFOLIO B FACTOR 1 FACTOR 2 FACTOR 3
1 1.08 0.00 0.0001 (1.01) (1.67)
2 7.58 6.62 6.89 0.29 (1.23)
3 5.03 6.01 4.75 (1.45) 1.92
4 1.16 0.36 0.66 0.41 0.22
5 (1.98) (1.58) (2.95) (3.62) 4.29
6 4.26 2.39 2.86 (3.40) (1.54)
7 (0.75) (2.47) (2.72) (4.51) (1.79)
8 (15.49) (15.46) (16.11) (5.92) 5.69
9 6.05 4.06 5.95 0.02 (3.76)
10 7.70 6.75 7.11 (3.36) (2.85)
11 7.76 5.52 5.86 1.36 (3.68)
12 9.62 4.89 5.94 (0.31) (4.95)
13 5.25 2.73 3.47 1.15 (6.16)
14 (3.19) (0.55) (4.15) (5.59) 1.66
15 5.40 2.59 3.32 (3.82) (3.04)
16 2.39 7.26 4.47 2.89 2.80
17 (2.87) 0.10 (2.39) 3.46 3.08
18 6.52 3.66 4.72 3.42 (4.33)
19 (3.37) (0.60) (3.45) 2.01 0.70
20 (1.24) (4.06) (1.35) (1.16) (1.26)
21 (1.48) 0.15 (2.68) 3.23 (3.18)
22 6.01 5.29 5.80 (6.53) (3.19)
23 2.05 2.28 3.20 7.71 (8.09)
24 7.20 7.09 7.83 6.98 (9.05)
25 (4.81) (2.79) (4.43) 4.08 (0.16)
26 1.00 (2.04) 2.55 21.49 (12.03)
27 9.05 5.25 5.13 (16.69) 7.81
28 (4.31) (2.96) (6.24) (7.53) 8.59
29 (3.36) (0.63) (4.27) (5.86) 5.38
30 3.86 1.80 4.67 13.31 (8.78)
Section Three: Bonds
6. Table 1 shows the characteristics of two coupon paying bonds from the same issuer making annual
coupon payments with the same seniority in the event of default and Table 2 displays spot interest
rates. Neither bond’s price is consistent with the spot rates. Using the information in Tables 1 and 2,
recommend either Bond A or Bond B for purchase. Justify your choice.
8 marks
TABLE 1
Bond Characteristics Bond A Bond B
Coupons Annual Annual
Maturity 3 years 3 years
Coupon rate 10% 6%
Yield to maturity 10.65% 10.75%
Price 98.4 88.34
TABLE 2
Spot Interest Rates
Term
Spot Rates
(Zero Coupon)
1 year 5%
2 year 8%
3 year 11%
7. On May 30, 2014, an investor is considering purchasing one of the following newly issued 10-year
AAA corporate bonds shown in the following exhibit. The investor notes that the yield curve is
currently flat.
BOND CHARACTERISTICS
Description Coupon Price Call Feature Call Price
Seminole due May 30, 2024 6.00% 100 Noncallable Not applicable
Carolina due May 30, 2024 6.20% 100 Currently callable 102
a. Contrast the effect on the price of both bonds if yields decline more than 100 basis points.
(No calculation is required).
4 marks
b. State and explain under which interest rate forecasts (rising, stable, declining) the investor
would prefer the Carolina bond over the Seminole bond.
4 marks
c. Explain the difference between the price yield relationship of callable bonds and
noncallable bonds.
4 marks
8. a. What is the aim of the passive bond strategy of immunization? Explain analytically the approach
for an effective immunization strategy. What are the risks of not achieving perfect immunization?
4 marks
b. Consider a £ 1 million face value, 5% annual coupon bond, yielding 9%. It has a maturity of 5 years.
Calculate the bond’s price and its duration.
3 marks
c. Describe how this bond can be used to meet a £ 1,191,960 liability that has the same duration. Show
your calculations.
5 marks
d. Give an example of two industries in which companies are using passive bond strategies to meet
their liabilities.
3 marks
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