MIDTERM EXAM 2 BUS 431a: Investment and Portfolio Management AUBG: Spring 2012

NAME____________________________________ Solution Guide (1)

INSTRUCTIONS: 1. You have 75 minutes to complete the exam. 2. The exam is worth a total of 100 points. 3. You may use a calculator and scratch paper sheets. You must hand in the sheet with your exam (put your name on it). 4. Allocate your time wisely. Use the number of points assigned to each problem as your guide. 5. In order to get full credit on the problems, you must show ALL your work! 6. You can get partial credits if you show your calculations or provide arguments to support your answer. 7. No credits will be warded if you fail to state your assumptions or conclusions explicitly.
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A. Multiple choice questions (2 points each, total 24 points): 1. A random walk occurs when: A. Stock price changes are random but predictable B. Stock prices respond slowly to both new and old information C. Future price changes are uncorrelated with the past price changes D. Past information is useful in predicting future prices Answer: C. Random walk implies that current changes are independent of past price changes, as well as no predictability is observable. 2. The Arbitrage Pricing Theory (APT) differs from the single-factor Capital Asset Pricing Model (CAPM) because the APT: A. Place more emphasis on market risk B. Minimize the importance of diversification C. Recognize multiple unsystematic risk factors D. Recognize multiple systematic risk factors Answer: D. In contrast to CAPM, which impose only one systematic risk factor the market risk, the APT recognizes multiple sources of systematic risk. 3. In contrast to Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT): A. Requires that markets be in equilibrium B. Uses risk premiums based on micro-economic variables C. Specifies the exact number of and identifies specific factors that determine expected returns D. Does not require the restrictive assumption concerning the market portfolio. Answer: D. While CAPM is built on the first two assumptions APT says nothing about the exact number of the risk factors. It also doesnt give any special role to the market portfolio as a benchmark portfolio. 4. Assume that a company is announcing an unexpectedly large dividend to its shareholders. In an efficient market without information leakage, one might expect: A. An abnormal price change at the announcement B. An abnormal price change before the announcement C. An abnormal price change after the announcement D. No abnormal price change before or after the announcement Answer: A. There should be an instantaneous price adjustment at the announcement. 5. According to the efficient market hypothesis:: A. High-beta stocks are consistently overpriced B. Low-beta stocks are consistently overpriced C. Positive alpha on stocks will quickly disappear D. Negative alpha stocks consistently yield low return for arbitrageurs Answer: C. Both (high-beta and low-beta) stocks are fairly priced, and positive alpha on stocks will quickly disappear. 6. According to the efficient markets view, value stocks earn higher expected return than growth stocks because: A. Value stocks are riskier than growth stock B. Value stocks are less risky than growth stock C. Value stocks have higher expected future payoffs than growth stock D. Value stocks have lower expected future payoffs than growth stock
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Answer: D. Value stocks provide higher expected return because earnings (and dividend) growth rates of growth stocks are consistently overestimated by investors, and those of value stocks - consistently underestimate (see also question 13). 7. An investor will take as large a position as possible when an equilibrium price relationship is violated. This is an example of _________. A. A dominance argument B. Tthe mean-variance efficiency frontier C. A risk-free arbitrage D. The capital asset pricing model E. None of the above Answer C. When the equilibrium price is violated, the investor will buy the lower priced asset and simultaneously place an order to sell the higher priced asset. Such transactions result in risk-free arbitrage. The larger the positions, the greater the risk-free arbitrage profits. 8. Arbel (1985) found that: A. The January effect was highest for neglected firms B. The book-to-market value ratio effect was highest in January C. The liquidity effect was highest for small firms D. The neglected firm effect was independent of the small firm effect E. Small firms had higher book-to-market value ratios Answer: A. Arbel divided firms into highly researched, moderately researched, and neglected groups based on the number of institutions holding the stock and find that the January effect was in fact largest for the neglected firms. 9. Circle all true statements. According to the behavioral finance view of the financial market: A. Investors sentiment may move stocks prices away from the fundamental values B. Arbitrage forces cannot always correct the mis-valuations generated by investors sentiment C. Arbitrage forces can never correct the mis-valuations generated by investors sentiment D. Prices are not likely to be more inefficient for stocks with higher arbitrage costs. Answer: A and B. According to the behavioral finance view of the financial market even the fully rational investors cannot force prices in equality with fully rational intrinsic values. In practice, the actions of arbitrageurs are limited. So, assumptions A and B should be true. 10. ____________ may be responsible for the prevalence of active versus passive investments management. A. Forecasting errors B. Overconfidence C. Mental accounting D. Conservatism E. Regret avoidance Answer: B. Overconfidence may be responsible for the prevalence of active versus passive investments management. 11. When a bond indenture includes a sinking fund provision
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A. Firms must establish a cash fund for future bond redemption. B. Bondholders always benefit, because principal repayment on the scheduled maturity date is guaranteed. C. Bondholders may lose because their bonds can be repurchased by the corporation at below-market prices. D. Both A and B are true. E. None of the above are true. Answer: C. A sinking fund provisions requires the firm to redeem bonds over several years, either by open market purchase or at a special call price from bondholders. This can result in repurchase in advance of scheduled maturity at below-market prices. 12. Swingin' Soiree, Inc. is a firm that has its main office on the Right Bank in Paris. The firm just issued bonds with a final payment amount that depends on whether the Seine River floods. This type of bond is known as A. a contingency bond B. a catastrophe bond C. an emergency bond D. an incident bond an eventuality bond Answer: B. Catastrophe bonds are used to transfer risk from the firm to the capital markets.

B. Short answer (5 points each, 20 in total) (Be brief and to the point. For each question, there is a 5-sentence limit with penalty for run-ons. Less than 5 sentences are also acceptable). 1. (5 points) The APT itself doesnt provide guidance concerning the factors that one might expect to determine risk premium. Two principles guide us when we specify a reasonable list of factors.. Answer: First, we want to restrict ourselves to a limited number of systematic factors with considerable ability to explain security returns. If our model calls for many explanatory factors, it does little to simplify our description of security returns. Second, we wish to choose factors that seem likely to be important risk factors, that is, factors that concern investors sufficiently that they will demand meaningful risk premiums to bear exposure to those sources of risk. Some of these factors are used in Chen, Roll and Ross (1986) model, while firm-characteristic variables (SMB and HML) are chosen in the Fama-French (1996) model, because of the long-standing observations that these two variables predict deviations of average stock returns from the levels consistent with CAPM.

2. (5 points) In a recent closely contested lawsuit, Apex sued Bpex for patent infringement. The jury came back today with its decision. The rate of return on Apex stocks was rA = 3.1%. The rate of return on Bpex stocks was only rB = 2.5%. The market today responded to very encouraging news about the unemployment rate, and rM = 3.0%. The historical relationship between returns on these stocks and the market portfolio has been estimated from index model regressions as: Apex: rA = 0.2% +1.4rM Bpex: rB = -0.1% +0.6rM Based on these data, which company does you think won the lawsuit? Answer: Given market performance, predicted returns on the two stocks would be: Apex: 0.2% + (1.4 3%) = 4.4% ( = -1.3) Bpex: 0.1% + (0.6 3%) = 1.7% ( = +0.8) Apex underperformed this prediction; Bpex outperformed the prediction. We conclude that Bpex won the lawsuit.

3. (5 points) A mutual fund with beta of 0.8 has an expected rate of return of 14%. If risk-free rate of return is rf = 5%, and you expect the rate of return on market portfolio to be 15%, should you invest in this fund? a) What is the funds alpha? b) What passive portfolio comprised of a market-index portfolio and a money-market account would have the same beta as the fund? (Note: show that the difference between the expected rate of return on this passive portfolio and that of the fund equals the alpha from question a) Answer: a) E(rP) = rf + P [E(rM ) rf ] = 5% + 0.8 (15% 5%) = 13% = 14% 13% = 1% You should invest in this fund because alpha is positive. b) The passive portfolio with the same beta as the fund should be invested 80% in the market-index portfolio and 20% in the money-market account. For this portfolio: E(rP) = (0.8 15%) + (0.2 5%) = 13% 14% 13% = 1% = 4. (5 points) Consider the following data for a one-factor economy. All portfolios are assumed to be well diversified. Portfolio A F Expected return 12% 6% Beta 1.2 0.0

Suppose that another portfolio, portfolio E, is well diversified with a beta of 0.6 and expected return of 8%. Would an arbitrage opportunity exist? If so, what would be the arbitrage strategy? (Note: show what the percentage profit from arbitrage will be) Answer: The expected return for Portfolio F equals the risk-free rate since its beta equals 0. For Portfolio A, the ratio of risk premium to beta is: (12 - 6)/1.2 = 5 For Portfolio E, the ratio is lower at: (8 6)/0.6 = 3.33 This implies that an arbitrage opportunity exists. For instance, you can create a Portfolio G with beta equal to 0.6 (the same as Es) by combining Portfolio A and Portfolio F in equal weights. The expected return and beta for Portfolio G are then: E(rG ) = (0.5 12%) + (0.5 6%) = 9% G = (0.5 1.2) + (0.5 0) = 0.6 Comparing Portfolio G to Portfolio E, G has the same beta and higher return. Therefore, an arbitrage opportunity exists by buying Portfolio G and selling an equal amount of Portfolio E. The profit for this arbitrage will be:
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rG rE =[9% + (0.6 F)] [8% + (0.6 F)] = 1% That is, 1% of the funds (long or short) in each portfolio.

C. Problem Solving (10 or 12 points each, 46 in total) 5. (12 points) Suppose the economy can be .in one of the following two states: (i) Boom or good state and (ii) Recession or bad state. Each state can occur with an equal opportunity. The annual return on the market and a certain security X in the two states of the economy are as follows: Market: at the end of the year, the market is expected to yield a return of 30% in the good state and a return of (-10%) in the bad state; Security X: at the end of the year, the security is expected to yield a return of 40% in the good state and a return of (-35%) in the bad state; Furthermore, assume that annual risk-free rate of return is 5%. A. (5 points) Calculate the beta of security X relative to the market. (Note: find the covariance between market portfolio return and security return.) B. (2 points) Calculate the alpha of security X. (Note: use CAPM prediction) C. (5 points) Draw the security market line (SML). Please, label the axes and all points (including the market portfolio, the risk-free security, and security X) in the graph clearly. Identify alpha in the graph. Solution: 1. Beta of security X is: Market portfolio: (1/2) probability of getting 30% and (1/2) probability of getting -10%. So, expected/mean return and the standard deviation of the market are: E (rM ) = (0.5)(30%) + (0.5)(10%) = 10% 2 (rM ) = (0.5)(30 10) 2 + (0.5)(10 10) 2 = 400 Security X: (1/2) probability of getting 40% and (1/2) probability of getting -35%. So, expected/mean return and the standard deviation of security X are: E (rX ) = (0.5)(40%) + (0.5)(35%) = 2.5% 2 (rX ) = (0.5)(40 2.5) 2 + (0.5)(35 2.5) 2 = 1,496 The covariance between the market return and the security X return is: cov(X, M ) = (0.5)(30 10)(40 2.5) + (0.5)(10 10)(35 2.5) = 750 (a formula that comes from CF class)
2 Therefore, the beta of security X will be: = cov(X, M ) / (M ) = 750 / 400 = 1.875

2. Securitys alpha is: ( X ) = E (rX ) [r f + X ( E (rM ) r f )] = 2.5% [5% + 1.875(10% 5%)] = 11.875% The first term in the equation above is the actual return and the second term is the CAPM predicted (required) return of security X. 3. (2 points) Security market line graph is:

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6. (12 points) Suppose the economy can be in one of the following three states: (i) Boom or good state, (ii) Neutral state, and (iii) Recession or bad state. Each state can occur with an equal probability. There are three securities available in the economy: A, B and C. The net payoffs of these securities are as follows: Security A: at the end of the year, the security is expected to yield a net payoff of $30 in the good state, $10 in the neutral state, and -$10 in the bad state. Security B: at the end of the year, the security is expected to yield a net payoff of -$10 in the good state, $10 in the neutral state, and $30 in the bad state. Security C: at the end of the year, the security is expected to yield a net payoff of $35 in the good state, $30 in the neutral state, and $25 in the bad state. The current prices of these securities, A, B and C, are $10, $10, and $20, respectively. A. (5 points) Relative to the intrinsic (true) value, which security (if any) are fairly priced? Which securities are under-priced? Which securities are overpriced? Explain clearly. For simplicity, ignore the discount rate. B. (5 points) Construct an arbitrage portfolio using these securities. Mention clearly which securities (and their quantities) you would long/short and calculate the net payoffs of the arbitrage portfolio in the three states. C. (2 points) How should the prices of securities A, B and C change so that the existing arbitrage opportunity disappears? Please, explain briefly (2-3 lines) Solution: A. Excess security prices are: Probability (1/3) Probability (1/3) Probability (1/3) security Note: the are must use value of expected net payoffs. Prices (given) Intrinsic value = expected net payoffs Excess price $30 $10 -$10 A $10 $10 -$10 $10 $30 B $10 $10 $35 Boom $30 Neutral $25 Recession C

$20 $30 Here we are assuming that discount rate is zero. $0 $0 -$10 Therefore, the intrinsic values fairly fairly under- simply the expected net payoffs. If a priced priced priced discount rate is given, you it to compute the present

For security A: Expected net payoff = (1/3)*($30) + (1.3)*($10) + (1/3)*(-$10) = $10. Similarly for security B: Expected net payoff = $10 Similarly for security C: Expected net payoff = $30 B. Arbitrage strategy is based on: Since security C in under-priced, we should long it. Then, we can short sell securities A and B. So, the arbitrage strategy will be: - Long security C, and - Short securities A and B. How many units to long/short sell? You have to use a trial-and-error approach to make sure the net payoffs are positive in each state of the economy. In the given problem:
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- Long 1 unit of C; in this case Cost = $20 - Short 1 unit of A and 1 unit of B; in this case Revenue = $10 +$10 = $20. Thus, Cost = Revenue, therefore we have a zero-cost portfolio. In other words, the arbitrage portfolio is self-financing. Net payoffs for the arbitrage portfolio are: $35 $30 $25 Long C $30 $10 -$10 Short A -$10 $10 = $30 Short B $15 $10 $5 Net Boom Neutral Recession payoff

As we have positive payoff in each state of the economy, an arbitrage opportunity exist. C. How the prices of the three securities changes? The price of security C must rise (the demand for this asset would be higher) and/or prices of securities A and B must fall. For example, if Price (C) = $30, all securities are fairly priced and the arbitrage opportunity disappears.

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7. (12 points) Bonds of Hello Corporation with a par value of $1000 sell for $960, mature in five years, and have a 7% annual coupon rate paid semi-annually. Calculate: A. (5 points) Compute current yield (CY)and yield to maturity (YTM) B. (5 points) Compute horizon yield (also called realized compound return) for an investor with a three-year holding period and a reinvestment rate of 6% annually over the holding period. Assume that at the end of the three years the 7% coupon bond with two years remaining to maturity will sell at par to yield 7%. (Note: Find first the future value of reinvested coupons, and then, use total proceeds in 3 years to find the realized return over that period) C. (2 points) Cite one major shortcoming for each of the fixed-income yield measures computed in part a) to c).

Solution: A. Compute current yield (CY) and yield to maturity (YTM) Current yield = Coupon/Price = 70/960 = 0.0729 = 7.29%. Using the financial calculator: N = 5 x 2 = 10; PV = -960; FV = 1000; PMT = 70/2 = 35; CPT

I/Y = 3.993%

So, YTM = 3.993% semiannually, or 7.986% annual bond equivalent yield. B. Realized compound yield is 4.166% (semi-annually), or 8.332% annual bond equivalent yield. To obtain this value, first calculate the future value of reinvested coupons at the end of the third year. There will be six payments of $35 each, reinvested semiannually at a per period rate of 3%: Using the financial calculator: N = 6; i = 3%; PV = 0; PMT = $35; CPT

FV = $226.39

The bond will be selling at par value of $1,000 in three years, since coupon is forecast to equal yield to maturity (YTM). Therefore, total proceeds in three years will be $1,226.39 ($1000 par value plus the reinvested coupons). To find realized compound yield on a semiannual basis (i.e., for six half-year periods), we solve: $960 (1 + Rrealized)^6 = $1,226.39 Rrealized = 4.166% (semiannual rate) (or use your financial calculator to find I/Y = R = 4.166%.) C. Shortcomings of each measure: (1) Current yield does not account for capital gains or losses on bonds bought at prices other than par value. It also does not account for reinvestment income on coupon payments. (2) Yield to maturity assumes that the bond is held to maturity and that all coupon income can be reinvested at a rate equal to the yield to maturity. (3) Realized compound yield (horizon yield) is affected by the forecast of reinvestment rates,
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holding period, and yield of the bond at the end of the investor's holding period. 8. (10 points) The table below contains data on market advances and declines. Calculate cumulative .breadth and decide whether this technical signal is bullish or bearish. If the trading volume in advancing shares on day 1 was 300 million shares, while the volume in declining issues was 200 million shares, what was the Trin statistics for that day? Was Trin bullish or bearish? Day 1 2 3 4 5 Advances 906 653 721 503 497 Declines 704 986 789 968 1095 Day 6 7 8 9 10 Advances 970 1002 903 850 766 Declines 702 609 722 748 766

Solution: Day 1 2 3 4 5 6 7 8 9 10 Advances 906 653 721 503 497 970 1,002 903 850 766 Declines 704 986 789 968 1,095 702 609 722 748 766 Net Advances 202 -333 - 68 -465 -598 268 393 181 102 0 Cumulative Breadth 202 -131 -199 -664
-1,262

-994 -601 -420 -318 -318

The signal is bearish as cumulative breadth is negative; however, the negative number is declining in magnitude, indicative of improvement. Perhaps the worst of the bear market has passed. Volume declining / Number declining 200 million / 704 = = 0.858 Volume advancing / Number advancing 300 million / 906 Trin = This is a slightly bullish indicator, with average volume in advancing issues a bit greater than average volume in declining issues.

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D. Essay question (10 points) Based on your research work and in-class discussions on different hot companies (e.g., Facebook, Apple, Priceline) choose one company of interest and explain why this company was able to consistently beat the market for years. Is this a violation of EMH? Do you believe that the behavioral biases might contribute to the current success of this company?

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E. Bonus questions (2 points each, 4 in total) 1. The Bulgarian Stock Exchange-Sofia uses a trading system similar to: The best answer is C. a. New York Stock Exchange b. American Stock Exchange c. German Stock Exchange d. Nasdaq 2. Who of the following is a nominee for the World Banks President position? The best answer is D. a. Paul Wolfowitz b. Bill Gates
c. Robert B. Zoellick d. Jim Yong Kim

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