Part

A:

Chapter 6: Questions 5 and 20 (pp132, 134). In addition, try the following questions:
1. OK, so index models are easy. Heres a question, though. You fit an index model
using the S&P500 for Qantas stock and found

! = +0.02 + 1.2 !" + !

I fit an index model using the ASX instead. I got:

! = 0.02 + 1.1 !"# + !

You say Qantas is a good investment because its alpha is 2.0%. I say Qantas is a
bad investment with an alpha of -2.0%.
a. How do we know who is correct?
b. Suppose I tell you that I fit an index model for S&P relative to ASX. I
found
!" = 0.002 + 0.95 !"# + !"
What could you do with this information?

2. Betting against Beta. Brand new research (accepted for publication but not in
print yet) suggests an interesting understanding of the index model approach.1
a. Draw an SML
b. Suppose you cannot borrow money; where does the SML stop?
c. If you are relatively risk loving, how will you get higher returns?
d. If some people want to over-weight high-risk stocks, prices will ___ and
returns will ___ for those stocks. This suggests the relationship between
beta and expected returns ___?

Part B:

Michael Jensen (1968) came up with a really influential idea: We should compare
mutual funds to the risk they take when studying performance.2 He proposed the index
model based on
1. Draw an SML
2. Put one dot above the SML (call it A) and one dot below it (call it B)
3. Describe the investment opportunities here
4. Suppose you take one of these investment opportunities. What market
movements are you exposed to? How might you think about protecting
yourself against market conditions?

1 http://www.sciencedirect.com/science/article/pii/S0304405X13002675. The Journal of Financial

Economics is one of our top journals for scientific study in finance.

2 http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1968.tb00815.x/pdf. Jensen is one of
Famas earliest students.