Exam Investment Analysis

323060
March 27, 2012

Available time: 3 hours

Teachers:
dr. R.G.P. Frehen
dr. P.C. de Goeij

This exam consists of 4 questions on 6 numbered pages

The credits available for each question are:
Question
Question
Question
Question

1:
2:
3:
4:

25
25
25
25

credits
credits
credits
credits

Start the answers for every question on a new sheet

This facilitates quick exam correction
Read all questions carefully before starting with the exam
Answers without motivation get zero points
If you need answers from previous questions that you were
unable to answer, make an assumption and express clearly
what assumption you make
Write down your name and ANR on every sheet you hand in!
Good Luck!
1

For all questions you should provide complete, concise and to the point answers
Question 1 (25 credits)
Note: answers without explanation receive zero points
During the lectures we talked about the Capital Asset Pricing Model (CAPM). Assume for
this question that it holds. If you need it in the question, you can assume that log returns
are considered. An investor holds a portfolio that consists of two risky assets (asset A and
B) and the risk free rate. In addition, the annual expected excess return on the market
portfolio equals 5.50% with a volatility of 13% and the risk free rate is 2% annually.
In addition, there is information about the covariances of the assets shown in the following
table.

Risky asset A
Risky asset B
Market Portfolio

Risky asset A

Risky asset B

Market Portfolio

.
.
.

0.0116
.
.

0.0154
0.0115
.

Moreover, the correlation between asset A and the market portfolio is 0.95 and the
correlation between asset B and the market portfolio is 0.63.
The investor invests 150,000 in each of the risky assets A and B and goes short in the
risk free deposit to the amount of 50,000. This is referred to as the total investment
portfolio (TIP). In addition, it is possible to construct a risky portfolio that consists of risky
assets A and B in an equally weighted fashion and this portfolio is referred to as RP.
a)

Calculate the monthly expected returns of the portfolios RP and TIP.

b)

Calculate the monthly volatility of the portfolios RP and TIP

c)

Draw a picture of the security market line, including the correct position of the risky
assets A and B, the portfolios RP and TIP and the market portfolio.

d)

Draw a picture of the capital market line, including the correct position of the risky
assets A and B. In addition, you should also put a sketch of the mean-variance frontier
in the picture as well.

e)

When considering both pictures you drew in c) and d), explain why in the context of
the CAPM only systematic market risk is priced (you can only use a maximum of 5
lines in your answer).

Question 2 (25 credits) start your answer on a new separate sheet!

Note: answers without explanation receive zero points
Anton invests in a portfolio that consists of three mutual funds and the risk free asset. The
mutual funds all have their own specific investment strategy. One focuses on investments
in European firms only, the second mutual fund focuses only on North- and South American
firms and the third mutual fund focuses on investments in Asia. Anton is diversifying his
risk by investing in all the assets described here.
a)

As we have seen during the lectures, the mean variance frontier can be constructed
by means of solving a particular kind of optimization problem. Formulate this
optimization problem, using matrix notation.

Anton has a risk aversion level of 3 and the annual risk free rate is equal to 4%. In addition,
the covariance matrix of the risky assets is

0.0155 0.0144 0.0116

= 0.0144 0.0246 0.0129

0.0116 0.0129 0.0196

Because Anton has followed lectures of the course Investment Analysis while in college, he
knows how to calculate his complete optimal portfolio weights, which are equal to

w*Anton

w*Anton, EU 0.5482
*

wAnton,US 0.2230
= *
=

wAnton, AS 0.0035
w*Anton, R 0.2323
f

b)

Using all of the information at hand, calculate the expected returns of the three
mutual funds.

c)

What are the expected return and standard deviation of the optimal complete
portfolio of Anton? In addition, calculate its Sharpe Ratio and give an interpretation.
If you did not find an answer to question b), use

E ( REU ) 0.0750

E ( RUS ) 0.0800
E ( R) =
=
to perform the calculations.
E ( RAS ) 0.0675

R
0.0400
f

d)

What are the portfolio weights, Expected Return and Standard deviation of the
Tangency Portfolio (also referred to as the optimal risky portfolio)?

Antons roommate Tomas has followed his advice to invest in the same risky assets (and
the risk free rate). Tomas has a different risk aversion level than Anton.
e)

Suppose the optimal complete portfolio weights for Tomas are equal to

*
wTomas

*
wTomas

0.2349
* , EU

wTomas,US 0.0956
= *
=
.
wTomas, AS 0.0015
*
wTomas
0.6710
,R f

Calculate the risk aversion level parameter of the Tomas and motivate your answer.

Question 3 (25 points) start your answer on a new separate sheet!

Note: answers without explanation receive zero points
Hansie plans to expand his bond portfolio with a 3 year bond with a quarterly coupon of
1% (i.e. the bond pays 1% interest every quarter and has a nominal value of 1,000) and
an annual yield of 9%.
a)

Compute the price and duration of the bond

Hansie is worried that the yield may change and the bond price drop. As a matter of fact,
Hansie re-computes the bond price, based on the duration approximation and expected
yield change and finds that the bond price declines by 8.29%. His friend Johan claims that
this is only an approximation and computes the exact price change. He finds that the price
declines exactly 7.92% in value.
b)

Which annual yield change did Hansie have in mind?

c)

What is the convexity of this bond for the expected yield change?

d)

Give a graphical representation of the above expected change in yield, duration

approximation and convexity

Question 4 (25 points) start your answer on a new separate sheet!

Note: answers without explanation receive zero points
a)

Name three important differences between hedge funds and mutual funds

Consider the two statements (I and II) below

I.
II.

A downward sloping term structure often predicts a recession

Under the liquidity preference theory, the expected short rate for year n equals
the forward rate for year n

Next, consider the 4 following answers (A, B, C and D)

A.
B.
C.
D.

b)

Both recommendations are true

Both recommendations are not true
I. is true and II. is not true
II. Is true and I. is not true

Select one of the answers (A, B, C or D) above. Motivate why.

Consider the term structure below for zero coupon bonds

Term

10

Yield

0.02

0.04

0.05

0.055

0.06

0.062

0.066

0.07

0.073

0.075

c)

Under the expectations hypothesis, what information does the shape of the above
term structure contain about the future economy?

Rene buys one five year zero-coupon bond and sells six year bonds short for exactly the
same amount.
d)

Define Renes cash flows for every year until year 7.

e)

Define the forward rate for year 6, the expected short rate for year 6 under the
expectations hypothesis and the spot rate for year 6.