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Assume there are two risky stocks available. Stock A has an expected return
of 12% and a standard deviation of 8%. Stock B has an expected return of 10%
and a standard deviation of 5%.
a. Assuming the returns on the two stocks are uncorrelated, calculate the
expected return and deviation of the portfolios consisting of:
i. X A .5 , ii. X A 0 , iii. X A 0.25 , iv. X A 0.5 , v. X A 0.75 vi. X A 1 .
b. Using the answers to (a), sketch the frontier of returns, the set of efficient
portfolios and mark on the minimum variance portfolio.
c. If all investors are risk averse, will short sales of either stock be observed?
2.
3.
How will an increase in the rate of interest affect the percentage of stock A in
the market portfolio?
i. What is the market model and how is the beta of a stock interpreted?
4. i. Assume that there are available two risky assets. Describe the efficient set when
the correlation of their returns is:
a. + 1
b. 1
c.
0.
ii. If the correlation is zero, show how the efficient set is modified when a riskfree asset is available.
ii. For case (ii), describe the portfolio choice of a risk-averse investor.
iii. How are the answers to (ii) and (iii) modified when the rate of interest for
borrowing is greater than that for lending?
5. i. Define the single index model. How does it differ from the CAPM?
ii. You have estimated a beta of 1.25 for M&P Inc. What factors would you take
into account in adjusting this value?
Consider the information on stocks A, B and C.
Asset
A
B
C
beta
1.5
0.9
0.7
Expected return
13
9.4
8.2
Variance of return
30
16
9
iii. If the variance of the return on the market is 12, find the idiosyncratic error for
each stock. Hence calculate the variance of a portfolio consisting of 100 of stock
A, 300 of stock B and a short sale of 200 of stock C.
iv. If the CAPM model applies, what are the expected return on the market and the
risk-free rate? Hence find the expected return and variance of return if the
portfolio in (iii) is 20% financed by borrowing.
6. i. Using the binomial pricing model calculate the value of a put option on a stock
that currently sells for 50 but may rise to 55 or fall to 45 when there is 1 year to
expiry, the risk free rate of return is 5% and the exercise price is 57.50.
ii. Repeat (i) under the assumption that the year is split into
i. 2 periods
and
ii. 3 periods
but retaining the assumption that the highest price is achieved 55 and the lowest
45.