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1
VU Master in Finance
In which M is the tangency portfolio, MRP the minimum risk point, and F the risk free rate. The
shape of the efficient frontier is determined by the correlation between the assets.
a. (4 points) Explain the risk-return characteristics of point M in the figure above.
Imagine that you have a set of 600 stocks for which you want to construct the efficient frontier.
b. (6 points) Explain which steps you need to take to construct a figure of the efficient
frontier using, for example, Excel (no need to give equations).
Fama and McBeth (1973) try to find empirical evidence for the CAPM. Specifically, they test
whether a stocks is related to expected returns. To do so, they develop a method which has
become famous as the Fama-McBeth method.
b. (6 points) Explain the Fama-McBeth method in steps.
Fama and McBeth (1973) derive three testable hypotheses from the CAPM model,:
1. The relation between expected return and risk is linear
2. Beta is a complete measure of risk of security i in portfolio m
3. Higher risk should be associated with higher expected returns
The three hypotheses are tested using the following equation.
In which si is stock is idiosyncratic risk. The table below gives the main estimation results (tvalues in parentheses):
Sample
period
0-rf
1935
1968
.0020
.0114
-.0026
.0516
.0008
(.55)
(1.85)
(-.86)
(1.11)
(.20)
c. (6 points) Explain to what extent the results in the table support the three hypotheses
given above.
< Please turn over for question 3 >
Jegadeesh and Titman (1993) find that stocks that are recent winners (losers) continue to be
winners (losers) over the coming months.
b. (5 points) Explain why the result of Jegadeesh and Titman (1993) is a stronger rejection of
the Efficient Market Hypothesis (EMH) than the results of Fama and French (1992).
Whereas Fama and Frech and Jegadeesh and Titman only focus on the United States, Hou et al.
(2012) study the determinants of the cross-section of stock returns for global markets. In contrast
to the US results, Hou et al. (2012) find that the market factor, cash flow over price (C/P) and
momentum are significant determinants.
c. (7 points) What is your interpretation of the fact that the determinants of expected returns for
the United States are different from the determinants of expected returns for all other
countries?
DeLong, Shleifer, Summer, and Waldman (1990) focus on one specific limit to arbitrage, namely
noise trader risk. Their main result is that noise trader are not necessarily driven out of the
market, but actually could make a higher return than sophisticated (fully rational) traders.
b. (5 points) Explain how it is possible that less rational traders can generate higher return
than more rational traders.
Baker and Wurgler (2007) try to quantify noise trader risk by measuring market sentiment. Part
of their results are given in the figure below
The figure shows that high (low) sentiment in the preceding month is related to high (low)
returns in the current month.
c. (6 points) Explain the mechanism behind the results in the figure.
The figure below is taken from the paper by Hong and Sraer (2012), who give a possible
explanation for the failure of the CAPM using disagreement and short sale constraints. The
figure shows that in case of low (high) disagreement, there is a positive (negative) relation
between market beta and expected returns.
c. (6 points) Explain the mechanism behind the results of Hong and Sraer (2012) in the
figure above.
< Please turn over for question 6 >
The figure shows a convex relation between performance and capital inflow. Assume that a fund
manager is judged by the size of its fund.
b. (6 points) Explain the incentive that results from the figure above in combination with the
bonus structure of the manager.
Many mutual funds attempt to track a benchmark. For example, S&P500 funds try to mimic the
returns of the S&P500 index. Researcher have found that when a stock is added to the S&P500
index, it makes a price jump.
c. (6 points) Explain the price jump explained above using the tendency of funds to
benchmark.
< End of the Exam! >