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Practice Exam Asset Pricing 4.

1
VU Master in Finance

Question 1: Portfolio Theory


Portfolio theory addresses the question how to form an optimal portfolio given the beliefs about
future risks and returns of the relevant assets. Specifically, it studies the risk-return profile of
combinations of assets. The figure below is central in portfolio theory

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).

The process to construct the efficient frontier can be rather time-consuming.


c. (6 points) What is an alternative way to form the tangency portfolio M? Explain.

< Please turn over for question 2 >

Question 2: The Capital Asset Pricing Model


The combination between portfolio theory and quadratic utility gives the Capital Asset Pricing
Model, or CAPM. The main relation is given by E(rp) = rf + [ E(rM) rf ] p , in which rp is the
return on the portfolio, rM the return on the market, and rf the risk free rate.
a. (5 points) Intuitively explain why expected returns are only driven by the exposure to
market risk in the CAPM, and not by idiosyncratic risk.

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 >

Question 3: Determinants of Expected Returns


Fama and French (1992) study whether expected returns are driven by different types of
company characteristics. The main characteristics they focus on, is beta, size (market value), and
book-to-market value.
One of the technical issues Fama and French encounter is the fact that there is a very strong
correlation between a companys beta and its size.
a. (5 points) Explain why this correlation is a problem and how Fama and French solve it.

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?

< Please turn over for question 4 >

Question 4: Limits to Arbitrage


Shleifer and Vishny (1997) argue that textbook arbitrage is not realistic because it is a) not
riskless and b) not without costs. They introduce the concept of risk arbitrage.
a. (5 points) Explain the mechanism explained by Shleifer and Vishny how arbitrage
pressure decreases as mispricing increasing in the short run.

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.

< Please turn over for question 5 >

Question 5: Alternative Preferences and Beliefs


The traditional assumption made by economists is based on Expected Utility Theory (i.e., risk
aversion, utility over final wealth). One of the implications of this assumption is the so-called
independence axiom, which implies that peoples preferences are always the same (if I prefer an
apple over a pear today, I will also prefer an apple over a pear tomorrow).
The alternative to Expected Utility Theory, is Prospect Theory. In prospect theory, utility is
defined over gains and losses, and people are risk averse over gains and risk seeking over losses.
a. (6 points) Explain why the independence axiom does not hold for Prospect Theory.

Disagreement is a central topic nowadays in finance research. Whereas traditional economists


would argue that disagreement does not matter (positive investors will cancel out negative
investors), we now know that this is not necessarily true in case of frictions or boundedly rational
expectations.
One of such frictions is short sale constraints.
b. (5 points) Explain how disagreement in combination with short sale constraints can lead
to mispricing.

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 >

Question 6: Delegated Asset Management


The so-called smart money hypothesis assumes that mutual fund investors are rational.
a. (5 points) Explain how we should be able to recognize smart money when looking at
the in- and outflows of mutual funds.
Siri and Tufano (1998) study the relationship between the performance of a mutual fund and
subsequent in- and out-flows into the fund. They find the following results:

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! >

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