Investments

Midterm Exam – Fall 2020

Professor Giorgio Ottonello

Professor Emanuele Rizzo

October 19 (19:00 – 20:30)

This exam consists of 10 Multiple Choice (MC) questions and 4 open questions. Each MC
question is worth 1.2 points; the open questions are worth a total of 8 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 (10) of the exam.
Only one-line (financial) calculators are permitted. We suggest you 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

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Name: _________________________________ Number (on Student Card): _____________

Multiple choice questions

1. Consider the table below. It contains the returns for stocks X and Y under three different
scenarios, and P(E) stands for the probability of each scenario E.

P(E) X Y
0.3 -12.00% -0.50%
0.45 3.00% 10.00%
0.25 4.00% 3.00%

What are expected return and variance for stocks X, Y?

A. X: -2.40%, 0.50%; Y: 5.10%, 1.85%.

B. X: -1.25%, 0.50%; Y: 5.10%, 0.21%.
C. X: 1.80%, 0.79%; Y: -2.47%, 1.33%.
D. X: -1.25%, 1.91%; Y: -2.47%, 0.21%.

2. A stock Beta pays no dividends the first 2 years. After the second year it generates per-
share dividends of $8 in years 3 through 7 included, dividends of $9 in years 8 through 12
included, and grows at 3% per year thereafter. Assume that the risk-free rate equals 1% and
the risk premium is 4.5%. What is the stock price today?

A. Stock Price: $246.466

B. Stock Price: $252.147
C. Stock Price: $427.913
D. Stock Price: $443.395

3. Imagine now that the stock Beta is trading at the price you found in Ex. 2, and you obtain
new private information about it before the rest of the market. This information indicates
that expected growth rate of dividends after year 12 should be revised downwards to 1%.
What position should you take on stock Beta after receiving the news? What would be your
return assuming the rest of the market obtains the information the moment after you take a
position on the stock?

A. You should buy the stock, and your return would be 17.117%.
B. You should short-sell the stock, and your return would be 35.212%.
C. You should short-sell the stock, and your return would be 17.117%.
D. You should buy the stock, and your return would be 35.212%.

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Name: _________________________________ Number (on Student Card): _____________

4. Consider the following information about a risky portfolio that you manage: Expected
return of the risky portfolio equals 18%; the variance of the risky portfolio equals 8%.
Moreover, the risk-free rate equals 5%. Your client wants the lowest possible standard
deviation subject to the constraint that you guarantee her an expected return no lower than
15%. What will be the standard deviation of your client portfolio?

A. The standard deviation is 13.211%.

B. The standard deviation is 18.808%.
C. The standard deviation is 21.757%.
D. The standard deviation is 25.976%.

5. Choose the answer that best completes the following statement: “An investor with a
higher degree of risk aversion, compared to one with a lower degree, will prefer
investment portfolios…”

A. With higher risk premia.

B. That are riskier (i.e., with higher standard deviation).
C. With higher Sharpe Ratio.
D. None of the above.

6. Suppose that there are 2 risky assets (X and Y) and one risk-free asset in the market.
Information about these 3 assets is in the table below:

Expected Return St. Deviation Corr(X,Y)

X 15% 18% 0.4
Y 9% 10%
RF 4.5%

How much should an investor with wealth of 100$ and coefficient of risk aversion of 4
borrow to be optimally invested (i.e., divide his/her wealth between the tangency portfolio
computed using X and Y, and the risk-free asset)? And, what is the Sharpe ratio of this
portfolio?

A. The investor should borrow 31$ and the portfolio has a Sharpe ratio of 0.629.
B. The investor should borrow 55$ and the portfolio has a Sharpe ratio of 0.671.
C. The investor should borrow 116$, and the portfolio has a Sharpe ratio of 0.814.
D. The investor should borrow 131$ and the portfolio has a Sharpe ratio of 0.629.

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Name: _________________________________ Number (on Student Card): _____________

7. The security market line depicts:

A. The market portfolio as the optimal portfolio of risky securities.

B. A security’s expected return as a function of its systematic risk.
C. The relationship between a security’s return and the return on an index.
D. The complete portfolio as a combination of the market portfolio and the risk-free asset.

8. Consider the following data and assume that CAPM holds:

EXP. RETURN ST. DEV. BETA

AMAZON 22% 31% 1.7
GENERAL MOTORS 10% 15% 0.5

Calculate the risk-free rate and the market’s expected return in this economy. Also,
compute the correlation coefficient between Amazon and General Motors using a CAPM
single-factor model. Assume that the volatility of the market portfolio is 16%.

A. Risk-free = 6%; Exp. Return Market = 16%; Correlation = 23.543%.

B. Risk-free = 5%; Exp. Return Market = 15%; Correlation = 28.112%.
C. Risk-free = 5%; Exp. Return Market = 15%; Correlation = 46.796%.
D. Risk-free = 6%; Exp. Return Market = 16%; Correlation = 48.981%.

9. Which of the following statements is true?

A. Portfolios on the SML are called efficient because they have no idiosyncratic risk.
B. A portfolio lying on the SML also lies on the CML.
C. If a security is on the SML, then it has a correlation of 1 with the market portfolio.
D. A portfolio lying on the CML also lies on the SML.

10. Which of the following, if true, would invalidate the semi-strong form of market
efficiency?
i) Trading on a company’s stock ahead of the public announcement of a value-
increasing M&A deal allows you to earn a positive abnormal return.

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Name: _________________________________ Number (on Student Card): _____________

ii) An unexpected macroeconomic event hits the economy and it has a much larger
negative impact on growth stocks (low B/M). As a result, value stocks (high B/M)
earn larger abnormal returns than growth stocks in the subsequent months.
iii) An investment strategy, which goes long on stocks with the highest average value
of net income in the past 5 years, and short on stocks with the lowest average
value of net income, earns a positive and significant alpha. The alpha cannot be
explained by exposure to any systematic sources of risk.
iv) As the economy enters a recession, investors’ tolerance for risk decreases, which
in turn increases the equity risk premium. As a result, high CAPM beta stocks
experience larger negative returns than low CAPM beta stocks.

A. i) and iii).
B. iii).
C. iv).
D. None of the above.

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Name: _________________________________ Number (on Student Card): _____________

On the following pages, you will 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 questions (8 points)

A. 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
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estimate market beta (𝛽𝑖,𝑀 ) and idiosyncratic variance (𝜎𝜀,𝑖 ) for each stock i=1,..,N, where
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𝜎𝜀,𝑖 is the variance of the residuals from each first-stage regression. Describe 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:
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𝐸(𝑟𝑖,𝑡 − 𝑟𝐹,𝑡 ) = 𝜆0 + 𝜆1 𝛽𝑖,𝑀 + 𝜆2 𝜎𝜀,𝑖 + 𝑢𝑖,𝑡

Answer:

B. For the next open question, use the following data:

EXP EXCESS RET ST. DEV. BETA(F1) BETA(F2)
PORTFOLIO A 5% 15% 0.5 0.8
PORTFOLIO B 12% 20% 1.4 0.5
F1=MKT 5% 10% 1 0
F2 8% 14% 0 1

RF 5% 0 0

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Name: _________________________________ Number (on Student Card): _____________

Does the two-factor APT model explain the returns of portfolios A and B correctly? If A
and/or B are mispriced, carefully document which portfolio is underpriced or overpriced
and what position you would take in each portfolio.

Answer:

C. Assume security returns are generated by a 4-factor model. The variances and covariances
of the factors (F1-F4) are described by the matrix ∑. Concisely discuss how using the factor
model can help improve portfolio optimization compared to basic Mean-Variance analysis.

Answer:

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Name: _________________________________ Number (on Student Card): _____________

D. What is a factor in the context of the APT model?

Answer:

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Name: _________________________________ Number (on Student Card): _____________

• 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 = 2
σD + σE2 − 2σ𝐷𝐸

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

𝜇𝐷𝑒 σE2 − 𝜇𝐸𝑒 𝜎𝐷𝐸

𝑤𝐷𝑇 =
𝜇𝐷𝑒 σE2 + 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.

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