Finance 3300 - Exam 2 Name _________________________________
Formulas Two risky assets E(Rp) = w1 R1 + w2 R2 p2 = w12 12 + w22 22 + 2w1w2 12 12 ; note to find p, take s !are root of p2 "ne risk#free and "ne Risky $sset E(Rp ) = Rf + p%(Rm#Rf)&2' E(Rp) = w1 Rf + w2 Rm w1 + w2 = 1 w(ere w1 is ) in risk#free asset and w2 is ) in risky asset* p = w2 2 +$,-. E(Rp) = r f + /(Rm#rf) i2 = 0%Ri # E(Ri)'2&(n#1) i,m = 01%Ri # E(Ri)'%Rm # E(Rm)'2&n#1 / = (i,m 3 i)&m or / = i,m & m2 im = im&im 2 or r#s !are = E4p5ained 6ar*&Tota5 6ar* = (/ i2 3 m2)&i2 -!5tip5e +(oi7e 8se t(e fo55owin9 for t(e ne4t : !estions ;o! are 5ookin9 at two risky assets, t(e e4pe7ted ret!rns, standard de<iations, and 7orre5ation =etween t(e two assets are 9i<en =e5ow. E(R$) = >), ?tandard de<iation = 12)* E(R@) = 12), ?tandard de<iation = 1A)* +orre5ation =etween t(e two assets is 1*B* 1* Cf yo! p!t DB) of yo!r wea5t( in asset $ and t(e ot(er DB) in asset @, w(at is t(e e4pe7ted ret!rn of yo!r portfo5ioE $* 1A) @* F*D) +* 1B*D) G* D*H) 2* Cf yo! p!t DB) of yo!r wea5t( in asset $ and t(e ot(er DB) in asset @, w(at is t(e standard de<iation of yo!r portfo5ioE $* Ireater t(an 1A) @* Ireater t(an 12) =!t 5ess t(an 1A) +* Jess t(an 12) :* $* @* +* G* $55 e5se e !a5, if t(e 7orre5ation =etween t(e two assets =e7ame s5i9(t5y ne9ati<e, t(e standard de<iation of t(e portfo5io wo!5d =e Kero* t(e standard de<iation of t(e portfo5io wo!5d =e !naffe7ted* t(e standard de<iation of t(e portfo5io wo!5d rise* t(e standard de<iation of t(e portfo5io wo!5d fa55*
H* $n in<estor de<e5ops a portfo5io wit( 2D) in a risk#free asset wit( a ret!rn of L) and t(e rest in a risky asset wit( e4pe7ted ret!rn of F) and standard de<iation of L)* T(e standard de<iation for t(e portfo5io is (a) 2B*:)* (=) H*D)* (7) B)* (d) 2>)* (e) :*H)* D* $n in<estor (as a portfo5io wit( LB) in a risk#free asset wit( a ret!rn of D) and t(e rest in a risky asset wit( an e4pe7ted ret!rn of 12) and a standard de<iation of 1B)* Respe7ti<e5y, t(e e4pe7ted ret!rn and standard de<iation of t(e portfo5io are (a) >*A), L)*
(=) F*2), L)* (7) >*A), H)* (d) F*2), H)* (e) >*A), 1L)* L* a* =* 7* d* ;o! e4perien7e ret!rns of HB) t(en M2B)* N(at is yo!r arit(meti7 and 9eometri7 ann!a5 rate of ret!rnE $rit(meti7 is 1B) and 9eometri7 is 5ess t(an 1B)* $rit(meti7 and 9eometri7 is 1B)* $rit(meti7 is 1B) and 9eometri7 is 9reater t(an 1B)* Ieometri7 is 1B) and arit(meti7 is 5ess t(an 1B)*
>* @e(a<iora5 finan7e differs from t(e standard mode5 of finan7e =e7a!se =e(a<iora5 finan7e a* ,re75!des t(e impa7t of in<estor psy7(o5o9y* =* Cn75!des t(e impa7t of in<estor psy7(o5o9y* 7* $77epts t(e Effi7ient -arkets Oypot(esis* d* RePe7ts t(e idea of market anoma5ies* A* $77ordin9 to t(e weak#form effi7ient market (ypot(esis, sto7k pri7es f!55y ref5e7t a* $55 (istori7a5 information on5y* =* $55 p!=5i7 information on5y* 7* $55 (istori7a5, p!=5i7, and pri<ate information* d* $55 (istori7a5 and p!=5i7 information on5y* F* N(i7( of t(e fo55owin9 is not an ass!mption of an effi7ient marketE a* T(e presen7e of a 5ar9e n!m=er of profit ma4imiKin9 parti7ipants 7on7erned wit( t(e ana5ysis and <a5!ation of se7!rities* =* T(ere e4ists a sma55 9ro!p of in<estors w(o (a<e monopo5isti7 a77ess to 7ertain so!r7es of 6ery important information* 7* New information random5y 7omes to t(e market* d* Cn<estors adP!st se7!rity pri7es rapid5y to ref5e7t information* e* T(e se7!rity pri7es t(at pre<ai5 at any point in time s(o!5d =e an !n=iased ref5e7tion of a55 7!rrent5y a<ai5a=5e information* 1B* N(i7( sto7k is t(e =etter =!y re5ati<e to t(e +$,-E
a* =* 7* d*
a = 7 $55 are e !a55y <a5!a=5e
11* N(i7( of t(e fo55owin9 statements a=o!t 7orre5ation 7oeffi7ient is falseE a* T(e <a5!es ran9e =etween #1 to +1* =* $ <a5!e of +1 imp5ies t(at t(e ret!rns for t(e two sto7ks mo<e to9et(er in a 7omp5ete5y 5inear manner* 7* $ <a5!e of #1 imp5ies t(at t(e ret!rns mo<e in a 7omp5ete5y opposite dire7tion* d* $ <a5!e of Kero means t(at t(e ret!rns are independent*
e*
None of t(e a=o<e (t(at is, a55 statements are tr!e)
12* Re5ati<e to ea7( ot(er, w(i7( one of t(ese portfo5ios 7o!5d not 5ie on t(e effi7ient frontierE E4pe7ted Ret!rn ?tandard de<iation $* H D @* D A +* L L G* > 12 E* 1B 2B 1:* $ss!me t(e +$,- (o5ds* ;o! (a<e a sto7k t(at (as a =eta of 1*D and an e4pe7ted ret!rn of 12)* Cf t(e risk free rate is :), w(at m!st t(e e4pe7ted ret!rn on t(e market =eE $* 1L*D) @* L) +* F) G* A) E* 1:*D) 1H* ;o! e4pe7t C@- to ret!rn 12) ne4t year* C@- (as a =eta of 1*2, t(e market is e4pe7ted to ret!rn 1B) ne4t year, and t(e risk free rate is 7!rrent5y D)* @ased on yo!r e4pe7tation t(at C@- wi55 earn 12) ne4t year, re5ati<e to t(e +$,-Q $* C@- is !nder<a5!ed* @* C@- is o<er<a5!ed* +* C@- is 7orre7t5y pri7ed* 1D* $ portfo5io mana9er is 7onsiderin9 addin9 anot(er se7!rity to (is portfo5io* T(e 7orre5ations of t(e D a5ternati<es a<ai5a=5e are 5isted =e5ow* N(i7( se7!rity wo!5d ena=5e t(e (i9(est 5e<e5 of risk di<ersifi7ationE C*e* Red!7e risk t(e mostE a* B*B =* B*2D 7* #B*2D d* #B*>D e* 1*B $ portfo5io is 7onsidered to =e effi7ient if. a* No ot(er portfo5io offers (i9(er e4pe7ted ret!rns wit( t(e same risk* =* No ot(er portfo5io offers 5ower risk wit( t(e same e4pe7ted ret!rn* 7* T(ere is no portfo5io wit( a (i9(er ret!rn* d* +(oi7es a and = e* $55 of t(e a=o<e N(i7( of t(e fo55owin9 statements is tr!e wit( re9ard to t(e +apita5 $sset ,ri7in9 -ode5 (+$,-) and t(e $r=itra9e ,ri7in9 T(eory ($,T)E a* +$,- is a sin95e#fa7tor mode5, w(i5e $,T 7an =e a m!5ti#fa7tor mode5* =* $,T identifies a55 of its fa7tors w(i5e t(e +$,- does not 7* @ot( $,T and +$,- ass!me ar=itra9e is possi=5e* d* +$,- does not ass!me 7ommon in<estment (oriKons, w(i5e $,T does*
1L*
1>*
1A*
T(e e4pe7ted ret!rn for R=rite sto7k 7a57!5ated !sin9 t(e +$,- is 1D*D)* T(e risk free rate is :*D) and t(e =eta of t(e sto7k is 1*2* +a57!5ate t(e imp5ied market risk premi!m* i*e* R m # rf a* D*D) =* L*D) 7* 1B*B) d* 1D*D) e* 12*B) 1F* T(e ?eparation T(eorem imp5ies a* t(at a55 in<estors (o5d t(e same market portfo5io re9ard5ess of risk a<ersion
=* t(at on5y risk ne!tra5 in<estors wi55 (o5d t(e same market portfo5io 7* t(at in<estors (o5d different sto7ks =ased on t(eir risk a<ersion d* t(at in<estors (o5d different market portfo5ios w(en t(e 5endin9 rate is e !a5 to t(e =orrowin9 rate* 2B* ,ortfo5io t(eory demonstrates w(en yo! (o5d many sto7ks, t(at a* on5y a sto7kSs standard de<iation s(o!5d =e pri7ed* =* on5y a sto7kSs 7o<arian7e wit( t(e market portfo5io s(o!5d =e pri7ed* 7* on5y a sto7kSs 7o<arian7e wit( t(e risk#free asset s(o!5d =e pri7ed* d* on5y a sto7kSs standard de<iation re5ati<e to t(e marketSs standard de<iation s(o!5d =e pri7ed* 21* ?t!dies s!99est t(at if yo! e4pe7t t(e market to fa55 1B), to make t(e most money, yo! s(o!5d a* s(ort#se55 5ow =eta sto7ks* =* s(ort#se55 (i9( =eta sto7ks* 7* =!y 5ow =eta sto7ks d* =!y (i9( =eta sto7ks* 8se t(e fo55owin9 information for t(e ne4t t(ree !estions* Tm = 1*LDA, $sset 1. Ti,m = *1FD, / = *2D, Ti = *H>1, $sset 2., Ti,m = 2, / = *>:, Ti = 1*2HD, $sset :, Ti,m = 1, / = *D, Ti = 1*2BH Tm = standard de<iation of market Ti = standard de<iation of indi<id!a5 asset Ti, m = 7o<arian7e of t(e market wit( asset i* 22* N(i7( asset is most risky wit(in a portfo5io frameworkE a* $sset 1 =* $sset 2 7* $sset : d* T(ey a55 (a<e e !a5 risk 2:* Cf yo! were 9oin9 to p!t a55 yo!r money in on5y one of t(ese assets, w(i7( asset wo!5d =e 5east riskyE a* $sset 1 =* $sset 2 7* $sset : d* T(ey a55 (a<e e !a5 risk 2H* N(i7( assetSs =eta are yo! most 7onfident a=o!t in !sin9E a* T(e one wit( t(e (i9(est =eta =* T(e one wit( t(e 5owest standard de<iation 7* T(e one wit( t(e (i9(est r#s !are
8se t(e fo55owin9 for t(e ne4t two !estions. ;o! note t(e fo55owin9. e4pe7ted ret!rn on t(e market = 1B), e4pe7ted inf5ation rate = H), risk free rate = D), t(e =eta of a sto7k re5ati<e to t(e market is 1*2, and t(e =eta of t(is sto7k re5ati<e to inf5ation is B*D* 2D* $77ordin9 t(e +$,-, w(at is t(e e4pe7ted ret!rn on t(is sto7kE a* 1B) =* 11) 7* 12) d* 1:) e* 1H) 2L* $77ordin9 to a two fa7tor $,T mode5 w(ere t(e fa7tors are t(e market and inf5ation, w(at is t(e e4pe7ted ret!rn on t(is sto7kE a* 1B) =* 11) 7* 12)
d* 1:) e* 1H) 2>* N(at wo!5d yo! do first to ar=itra9e t(e fo55owin9 sit!ationE ;o! start o!t wit( one oran9e* a = app5es, o = oran9es, p = pineapp5es, = = =ananas 1o = 1a 1o = 1= 1p = 1a 2p = 1= a* Trade yo!r oran9e for an app5e =* Trade yo!r oran9e for a =anana 2A* Cn t(e +$,- mode5, if t(e risk#free rate de7reases (o5din9 a55 e5se e !a5, t(en t(e e4pe7ted ret!rn of a sto7k s(o!5d a* in7rease =* de7rease 7* wi55 not =e affe7ted d* 7o!5d eit(er in7rease or de7rease dependin9 on t(e sto7ks =eta* 2F* ;o! (a<e a sto7k wit( an e4pe7ted ret!rn of 1B) and a standard de<iation of 1D)* N(at is t(e pro=a=i5ity t(e sto7k wi55 (a<e a ret!rn 9reater t(an 2D)E a* DB) =* LA) 7* :2) d* 1L) e* D) :B* ;o! (a<e a sto7k wit( an e4pe7ted ret!rn of 1B) and a standard de<iation of 1D)* N(at is t(e pro=a=i5ity t(e sto7k wi55 ret!rn =etween #2B) and HB)
a* =* 7* d* e*
D) 2*D) 1) FD) FF)
8se t(e fo55owin9 fi9!re to answer t(e ne4t !estion*
+$J = +apita5 $55o7ation Jine :1* Cf t(ere are two risky assets de5ineated =y t(e two dark dots w(ere t(e 7orre5ation =etween t(ese two assets is e !a5 to Kero and t(ere is a risk#free asset de5ineated Rf, w(i7( is t(e +apita5 $55o7ation Jine, (+$J)E a* a =* = 7* 7 d* d 8se t(e fo55owin9 fi9!re to answer t(e ne4t two !estions*
:2* Cf t(ere are on5y two risky assets $ and @ and t(e 7orre5ation =etween t(e two assets is somew(ere =etween M 1*B and 1*B, say Kero for e4amp5e, w(i7( is t(e 7apita5 a55o7ation 5ineE $* Jine 1 @* Jine 2 +* Jine : ::* Cf t(ere are on5y two risky assets $ and @ and t(e 7orre5ation =etween t(e two assets is #1*B, w(i7( is t(e +$JE $* Jine 1 @* Jine 2 +* Jine : $nswers 1 = 2 =, 1D) : d H = D 7
L a, 9eo is D*A) > = A a F = 1B 7 11 e 12 = 1: 7 1H a 1D d 1L d 1> a 1A 7 1F a 2B = 21 = 22 = 2: a 2H 7 2D = 2L d 2> = 2A d 2F d :B d :1 a :2 = :: a
