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# Birla Institute of Technology and Science, Pilani -- Hyderabad Campus

Semester 1: 2015-16

## Comprehensive Examination 04/12/2015 Format: Open Book/Open Notes

Duration: Maximum 3 Hours Marks: 80 Weightage of grade: 40%

question to the best pf your ability.

1. (20 points) Use the following facts for this problem:
§ There are two factors that affect stock returns, real interest rates (factor 1) and inflation
(factor 2).
§ There are only two possible states for Inflation and interest rates: High and Low. We
know exactly how the following four securities will perform in each of the possible
states:

## State/ High real int. rates Low real int. rates

Stock return High infl. Low infl. High infl. Low infl.
Int. rate 4% 4% 0% 0%
Inflation 8% 2% 8% 2%
Probability 0.25 0.25 0.25 0.25
Apex (A) -44% -20% -4% 20%
Bull (B) 40% 28% 16% 4%
Crush (C) 64% 16% 56% 8%
Dreck (D) 22% 34% 2% 14%
The prices of all securities are
Rupees 10 per share.

a. (2 points) Calculate the values of f for both the interest rate factor and the inflation factor
in all states.
b. (6 points) Calculate from the above table, the expected returns of each of the four
securities, and the factor loadings (betas) for each security on each of the two factors.
c. (3 points) Using securities A,B, and C, calculate the implied risk-free rate, and the factor
premia for the two factors.
d. (6 points) Find the weights for an arbitrage portfolio using securities A,B,C, and D.
e. (3 points) Verify that the portfolio you formed leads to a risk-free arbitrage opportunity.

2. (15 points) In SimpleLand, there are only three risky assets X, Y, and Z. The expected
(annual) returns for these three assets are
⎡ E (r%X )⎤ ⎡ 0.1⎤

µ = ⎢ E (r% ⎥ ⎢ ⎥
Y ) ⎥ = ⎢ 0.2 ⎥

⎢⎣ E (r%
Z )⎦
⎥ ⎢⎣ 0.1⎥⎦
§ The Capital Asset Pricing Model (CAPM) holds in this economy. i.e. the market
portfolio is MVE.
§ There are two portfolios W and V known to lie on the mean-variance frontier (of
risky assets only) that have the following weights in X, Y and Z respectively.
⎡0.60 ⎤ ⎡ 0.80 ⎤
W = ⎢0.20 ⎥ and V = ⎢⎢ −0.20⎥⎥
⎢ ⎥
⎢⎣0.20 ⎥⎦ ⎢⎣ 0.40 ⎥⎦
a. (4 points) Find the expected return of portfolios W and V.
b. (8 points) Given this information, what are the maximum and minimum values for
the expected rate of return on the market portfolio, E (r%
m)
.
c. (3 points) Now suppose you are told that W represents the minimum variance
portfolio (MVP) of all risky assets in this economy. Does this change your answers to
part b) above?

3. (20 points) Use the following information to answer all parts of this question:
§ A two-factor APT (Arbitrage Pricing Theory) describes the returns of all well-diversified
U.S. portfolios. The two factors are unexpected growth in U.S. Gross Domestic Product
(factor 1), and a U.S. inflation factor (factor 2).
§ The prices of all well-diversified portfolios are set so that their expected returns over the
next year are given by:
E(ri ) = 0.05 + 0.08bi ,1 − 0.06bi ,2 , where bi ,1 and bi ,2 are the sensitivities of
portfolio i to factors 1 and 2 respectively
§ The market believes that the standard deviations of f 1 and f 2 are both 0.10 (10%), and
that the two factors are uncorrelated with each other.

a. (3 points) Find the risk-free rate and the factor risk premiums for each factor in this
economy.
b. (6 points) Assume that you have no more information than the market. You want to
maximize the expected return of your portfolio, for a given level of variance (our usual
assumption.) Suppose you can form factor mimicking portfolios for both the factors.
What is the Sharpe Ratio of the optimal risky portfolio that can be formed using the two
factor mimicking portfolios?
c. (5 points) Suppose all stocks in the economy can be classified as either “value” stocks or
“growth” stocks (for simplicity assume that the market for risky assets consists only of
stocks.)
A portfolio of all value stocks will have a return next year given by:
rV = E(rV ) + 1.90 f 1 − 0.80 f 2
A portfolio of all growth stocks will have a return next year given by:
rG = E(rG ) + 2.10 f 1 − 2.20 f 2
The current aggregate market capitalization of all value stocks is 1 trillion, and the
current aggregate market capitalization of all growth stocks is also 1 trillion. What is the
Sharpe Ratio of the Market portfolio?
d. (6 points) Comparing your answers parts b. and c. above, do you think the Capital Asset
Pricing Model (CAPM) holds for all well-diversified portfolios in this economy? Why or
why not?

4. Note: Both part of this question are standalone questions. Answer briefly.

a. (5 points) All of John’s retirement savings are in a mutualfund. In this month’s quarterly
statement, his fund management company informed him that they are currently
invested in 500 stocks. Infosys stock forms 30% of the fund’s portfolio, Maruti stock
forms another 20% of the portfolio, and the other stocks account for the remaining 50%
of the fund’s portfolio. Is John’s portfolio well-diversified? Briefly substantiate your yes
b. (5 points) We discussed in class Grossman and Stiglitz’s claim that “It is impossible for
markets to be perfectly (informationally) efficient”. Summarize their argument why
markets cannot be perfectly (i.e. 100%) efficient.

5. (15 points) Provided below are data on three zero coupon bonds. Assume annual
compounding for all parts of this question.

## Maturity Spot Face value E(short rate)

1 9.00% 100
2 ? 100 11.0092%
3 ? 100 13.0274%

Note: The data in the above table apply to both sub-questions (a and b) below.
a. (6 points) Assume that the expectation hypothesis of term structure is true. If you have
purchased two-year and three-year zero coupon bonds and your holding period
(investment horizon) is one year, what is your expected holding period return on these