Problem 1 (10 marks)

a) Define primary and secondary markets for securities and discuss how they differ.

b) List and briefly define the three forms of the efficient market hypothesis.

c) Is short selling always profitable? Explain why or why not.

Problem 2 (7 marks)
Assume that the returns on large-company stocks are normally distributed (see figure
below). Capital market history tells you that the average annual return is 5.7 % and
standard deviation is 9.2 %. Suppose you have invested 10000 in these bonds.

a) Based on this historical record, what is the probability that your return in a given
year will be higher than 5.7 %?

b) Is the probability that you will have no positive return (i.e. zero return or negative
return) in a given year higher than 16 %? Explain your answer.

c) What is the approximate probability that you will lose more than 2000 in a given year?

Problem 3 (4 marks)
Assume you want to run a computer program to derive the efficient frontier for your
feasible set of stocks. What information must you input to the program?

Problem 4 (6 marks)
Correct / Not Correct? Please insert.

When adding a security to a portfolio, the average covariance between

it and the other securities in a portfolio is less important than the securitys own risk.

In a large portfolio, portfolio risk will consist almost entirely of each

securitys own risk contribution to the total portfolio risk.

In a large portfolio, the covariance term can be driven almost to zero.

Proper diversification can reduce or eliminate systematic risk.

Because diversification reduces a portfolios total risk, it necessarily

reduces the portfolios expected return.

Typically, as more securities are added to a portfolio, total risk is expected to fall at a decreasing rate.

Problem 5 (10 marks)

a) How does the possibility to lend and borrow at the risk-free rate change the Markowitz model? Use a graph to illustrate your answer.
Will rational investors still choose portfolios along the efficient frontier? Use your
graph to explain.

b) How does your graph in your answer to a) change if the borrowing at the riskless
rate is not allowed?

Problem 6 (10 marks)

The single-index model can be expressed by the following equation:

Ri = i + i Rm + ei

with
Ri
= the rate of return on security i
Rm = the rate of the return on the market index
ei
= random residual error
a)
b)
c)
d)

What are the assumptions of this model?

Explain i .
Given the model, what is the expected return on security i ?
2
Given the model, the risk of an individual security is i2 = i 2m + ei2 . Explain

m and ei .
2

e) If the single-index model holds, the variance of a portfolio P with N securities is

given by
N

P = P m + xi ei
2

i =1

with P = xi i
i =1

Based on this formula how would a rational investor reduce this risk of her / his
portfolio?

Problem 7 (4 marks)
Compared to Markowitzs efficient frontier, how does the single-index model simplify the portfolio selection process?

Problem 8 (6 marks)
A stock has a beta ( ) of 0.9. The variance of returns on the market index ( 2m ) is
90. If the variance of returns on the stock is 120, what proportion of the stocks total
risk is systematic, and what proportion is residual risk?

Problem 9 (10 marks)

a)

Which of the following functions describes the security market line?

R i = i ( R M RF )

R i = RF + i R M

R i = RF + i ( R M RF )

Mark the correct function.

b) Suppose the risk-free rate is 2 %. The expected return on the market is 12 %. If a

particular stock A has a beta ( A ) of 0.7, what is its expected return based on
the CAPM? If another stock B has an expected return of 16 %, what must its beta ( B ) be?
[Hint: You may use a graph to find the answers.]

c)

Design the arbitrage opportunity, if there exist a stock C with a beta ( C ) of 1.0
and an expected return of 14 %.

Problem 10 (5 marks)
The risk of a foreign stock is measured by the standard deviation of its returns denot1/ 2
ed in the base currency. It equals = [ x2 + H2 + 2 Hx ] . x2 denotes the variance of
the exchange rate changes, and H2 is the variance of the stocks returns in its home
country.
Explain Hx .

Problem 11 (9 marks)
The tables below refer to investments in common equity indexes and long-term bond
indexes of several countries for the period 1990-2000. These indexes are valueweighted indexes.

10

a)

What does value-weighted mean?

b) What is the base currency?

c)

Does the column Exchange Risk incorporate Hx ? Explain your answer.

d) Check your answer to c) with the definition of in Problem 10.

11

Problem 12 (9 marks)
The International Capital Asset Pricing Model (ICAPM) describes the expected return of an asset i as follows:

R i = RF + iw RPw + i 1 SRP1 + i 2 SRP2 + .... + ik SRPk

with R F

= the domestic currency risk-free rate

iw = the market exposure of asset i
RPw = the market risk premium
SRP1 to SRPk = foreign currency risk premiums
iw = the market exposure of asset i
i 1 to ik = currency exposures of asset i.

a) What is the market in the context of the ICAPM?

b) Define forward currency risk premiums.
c) Suppose that for currency k the assets exposure ik is negative. What does this
mean? Use an example to explain.

12