Financial Management - Mid Term Exam Essay
Mid-Term Exam October 13, 2012 9:3o - 11:00 This exam consists of 5 exercises. Some questions are more difficult than others. To avoid getting hopelessly stuck on some questions: move forward and come back to the problematic question(s) later if time permits. Please do not forget to identify all your answer sheets. This is a closed book exam. Calculators are permitted. Good luck!
Exercise 1 (3 points) TRUE/FALSE questions Are the following statements true or false? Justify all your answers in maximum 3 lines each. a) According to the Capital Asset Pricing Model (CAPM), in equilibrium, all securities lie on
the security market line. (1 point)
TRUE: The SML depicts risk/return …show more content…
Security A B C D
E(r) 4.0% 4.0% 10.0%
St. dev. 3.0% 8.0% 3.0% 3.0%
Beta 0.2 1 0
a) Compute the expected return of asset D. What can you say about assets C and D? (1.5 points) E(rC) = E(rM) since βc = 1= βM, E(rD) = risk-free return since βD = 0 = βrf; Based on the information on security A, E(rA) = rf + βA[E(rM) – rf)]; rf = [E(rA) – βAE(rM)]/(1–βA)] = (0.04-0.2*0.1)/(1-0.2) = 2.5% = E(rD)
b) Explain briefly why securities A and B have the same expected return although their standard deviations are different. (1 point)
Their betas should be the same; in the CAPM, what matters for pricing a security is the systematic risk.
c) How would you construct a portfolio with a standard deviation of 4%? Explain. What is the expected return and the beta of this portfolio? Assume that asset C does not have specific risk. (2.5 points)
If the CAPM is valid, the portfolio is made up of the risk-free asset and the market portfolio. Asset C can be seen as the market (carries no specific risk) but note that although E(rD) = rf, D is not the risk-free asset because