Multiple Choice Questions (3 points per question)

Question 1. Which of the following securities is a money market instrument? A. Treasury note. B. Treasury bond. C. Treasury bill. D. Municipal bond. E. Preferred stock. Answer C. Only Treasury bill is a money market security. The others are capital market instruments

Question 2. Consider the following limit-order book for a share of stock. Limit Buy Orders

Limit Sell Orders

Price

Shares

Price

Shares

$115

200

$118

400

$114

300

$119

500

$113

2000

$122

1000

What is the bid-ask spread? A. B. C. D. E.

$1 $2 $3 $4 None of these are correct.

Answer C. See page 64

Question 3. According to the Capital Asset Pricing Model (CAPM), what is the expected return of a zero-beta security? A. B. C. D.

The market rate of return. Zero rate of return. A negative rate of return. The risk-free rate.

Answer D. E(RS) = rf + 0(RM - rf) = rf.

Question 4. Which one of the following portfolios cannot lie on the efficient frontier as described by Markowitz?

A. Only portfolio W cannot lie on the efficient frontier. B. Only portfolio X cannot lie on the efficient frontier C. Only portfolio Y cannot lie on the efficient frontier D. Only portfolio Z cannot lie on the efficient frontier E. Cannot tell from the information given Answer A. When plotting the above portfolios, only W lies below the efficient frontier as described by Markowitz. It has a higher standard deviation than Z with a lower expected return.

Question 5. The open interest on silver futures at a particular time is the A. number of silver futures contracts traded during the day B. number of outstanding silver futures contracts for delivery within the next month C. number of silver futures contracts traded the previous day D. number of all long or short silver futures contracts outstanding Answer D. Open interest is the number of contracts outstanding. When contracts begin trading, open interest is zero; as time passes more contracts are entered. Page 777.

Question 6. An example of ________ is that a person may reject an investment when it is posed in terms of risk surrounding potential gains, but may accept the same investment if it is posed in terms of risk surrounding potential losses. A. B. C. D. E.

framing regret avoidance overconfidence conservatism affect

Answer: A. An example of framing is that a person may reject an investment when it is posed in terms of risk surrounding potential gains, but may accept the same investment if it is posed in terms of risk surrounding potential losses. Page 391

Your answer Question 1

c

Question 2

c

Question 3

d

Question 4

a

Question 5

d

Question 6

a

Essay Questions (28 points)

Question 7. Briefly explain two differences between hedge funds and mutual funds. (6 points)

Hedge funds are typically open only to wealthy or institutional investors, are commonly structured as private partnerships, are only subject to minimal SEC regulation, and can pursue strategies not available to mutual funds such as short selling, heavy use of derivatives, and leverage. Chapter 4 Question 8. Suppose that the market portfolio offers an expected rate of return of 9% and a standard deviation of 22%. The risk free rate of return is 3%. (a) Draw the capital market line (CML) on an expected return—standard deviation diagram. (5 points) (b) Suppose that you choose to invest 50% of you portfolio in the market portfolio and 50% in a risk-free asset. Show the position of your portfolio on the CML. (5 points) Pages 188 and 292-293

Question 9. With regard to market efficiency, what is meant by the term "anomaly"? (6 points) Give three examples of market anomalies and explain why each is considered to be an anomaly. (6 points) Anomalies are patterns that should not exist if the market is truly efficient. Investors might be able to make abnormal profits by exploiting the anomalies, which doesn't make sense in an efficient market.

The small-firm effect - average annual returns are consistently higher for small-firm portfolios, even when adjusted for risk by using the CAPM.

The January effect - the small-firm effect occurs virtually entirely in January.

The neglected-firm effect - small firms tend to be ignored by large institutional traders and stock analysts. This lack of monitoring makes them riskier and they earn higher risk-adjusted returns.

Book-to-market ratios - firms with the higher book-to-market-value ratios have higher risk-adjusted returns, suggesting that they are underpriced. When combined with the firm-size factor, this ratio explained returns better than systematic risk as measured by beta.

The reversal effect - stocks that have performed best in the recent past seem to underperform the rest of the market in the following periods, and vice versa. Other studies indicated that this effect might be an illusion. Investors should not be able to earn excess returns by taking advantage of any of these. The market should adjust prices to their proper levels. But these things have been documented to occur repeatedly. See pages 366-371

Computational Questions (6 points per question)

Question 10. You purchased a call option for $3.90 two weeks ago. The call has a strike price of $45 and the stock is now trading for $55. If you exercise the call today, what will be your holding period return?

Part 1: If the call is exercised the gross profit is $55 - 45 = $10. The net profit is $10 - 3.90 = $6.10. Part 2: The holding period return is $6.10/$3.90 = 1.5641 (156.41%). Pages 679-680 6 points (3 points for each part)

Question 11. Consider the following two funds to construct a portfolio. Expected Return

Standard Deviation

Risky fund

20%

30%

Risk-free fund

12%

0%

If you construct a portfolio with standard deviation of 20%, what is the expected rate of return? 0.2*(20/30)+ 0.12 *(1-20/30) =0.17333  17.33% 6 or 3 points

Question 12. You want to evaluate two mutual funds using the Jensen measure for performance evaluation. The risk free return during the sample period is 0.5%. The average return on the market portfolio is 9 %. The information on the two funds are given in the table below. Average Return

Beta

Fund A

12%

1.2

Fund B

14%

1.8

Calculate the Jensen measure for both Fund A and Fund B. Which one would outperform the other one?

A's alpha 12% - [0.5% + 1.2*(9%-0.5%)] = 1.3%. B's alpha 14% - [0.5% + 1.8(9%-0.5% )] = -1.8%.

Fund A outperforms Fund B. 6 or 3 points

Question 13. The composition of the portfolio of a closed-end fund is as follows:

Stocks Apple, Inc Starbucks Corporation Wal-Mart Stores Inc. Microsoft Corporation

Shares Price 50 000 $111 18 000 $59 15 000 $58 30 000 $47

The fund has liabilities of $1million and 2.2 million shares outstanding. If the fund sells for $3.65 per share, what is its premium or discount as a percent of net asset value?

50 000 18 000 15 000 30 000

111 59 58 47

5550000 1062000 870000 1410000 8892000

Part 1  Fund assets: 8,892,000 Part 2  NAV: (8,892,000-1,000,000)/2,200,000=  $3.587 Part 3 Premium (or discount) =

Pr ice  NAV $3.65  $3.587 = = 0.0176, or 1.76% $3.587 NAV

The fund sells at a 1.76% premium from NAV. 6 points (3*2 points)

Question 14. Your client is evaluating two investment alternatives. One is a passive portfolio that mimics the OMX Stockholm 30 index. The expected rate of return of the passive portfolio is 13% with a standard deviation of 25%. The other is a managed portfolio with an expected return of 18% and a standard deviation of 28%. Your client's degree of risk aversion is A = 3.5. Assume the utility function is U = E(r) − 0.5 × Aσ Based on the utility function above, which investment would your client choose? Part 1: Passive portfolio: U = E(r) − 0.5 × Aσ

2

= 0.13-0.5*3.5*0.25^2=0.0206

Managed portfolio: U = E(r) − 0.5 × Aσ

2

=0.18-0.5*3.5*0.28^2=0.0428

2

Part 2: The client would choose the managed portfolio See pages 170-172. 6 points (3 points for each part)

Question 15. You are a U. S. investor who purchased British securities for 1,100 pounds one year ago when the British pound cost $1.40. No dividends were paid on the British securities in the past year. What was your total return based on U. S. dollars if the value of the securities is now 1,200 pounds and the pound is worth $1.60?

Part 1: (1200*1.6 – 1100*1.4)/(1100*1.4) Part 3: ($1,920 - $1540)/$1.540 = 0.24675, or 24.68%.

6 points (3 points for each part)

Question 16. A mutual fund had NAV of $10.00 on January 1, 2014. On December 31 of the same year the fund's rate of return for the year was 5.0%. Income distributions were $1.50 and the fund had capital gain distributions of $0.20. Without considering taxes and transactions costs, what was the NAV of the mutual fund on December 31, 2014?

Part 1: 0.05 = (P - 10.00 + 1.50 + 0.20)/10.00

Part 2:  0.05*10.00 = P - 10.00 + 1.50 + 0.20  0.05*10.00 + 10.00 - 1.50 – 0.20 = P; P = 8.80

6 points (3 points for each part) Question 17. You are bullish on Internet stock. The current market price is $25 per share, and you have $10,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest rate of 9% per year and invest $15,000 in the stock. How far does the price of Internet stock have to fall for you to get a margin call if the maintenance margin is 45%? Assume the price fall happens immediately.

Price 25 Equity 10000 Borrow 5000 Total invest: 10 000 + 5 000 = 15 000 Shares: 15 000/25=600 Maintenance margin 45% The limit price for getting a margin call: 5000/(600-0.45*600)=15.1515 The price has to fall by 25-15.1515= 9.8485 Check Remaining investment value after the price fall: 600*15.1515=9090.909 Remaining debt after the price fall: 5000 (9090.909-5000)/9090.909=0.45 45%

6 or 3 points

Question 18. You are considering an investment in a mutual fund with a 4% front-end load and an expense ratio of 0.5%. Alternatively, you can invest in a bank CD paying 1% interest. If you plan to invest for 6 years, what annual rate of return (before any fees) must the fund portfolio earn for you to be better off relative to investing in the CD? Assume annual compounding of returns.

Part 1: If you invest for six years, then the portfolio return must satisfy: 0.96  (1 + r – 0.005)6 > 1.016 ; 1.016 = 1.06152; 1.06152/0.96=1.10575 Part 2: (1 + r – 0.005)6 > 1.10575; 1.105751/6 = 1.016895 1 + r – 0.005 > 1.016895 r > 1.016895 + 0.005-1 r > 0.021895 or 2.19% Check: 0.96  (1+0.021895-0.005)6 = 1.06152=1.016 See pages 100-102. 6 points (3 points for each part)