In the file that can be found on the course web site you will find the weekly return

history
for 4 different stocks: JPMorgan, Exxon Mobil, Johnson & Johnson, and Microsoft; in
addition you will find the market (S&P500) returns. Suppose your investment
horizon is
3 months (12 weeks).

a) Estimate the expected return for the 5 different assets.

b) Estimate the Variance-Covariance matrix for the 5 assets where you estimate
different entries of the matrix separately. How many parameters do you need
to
estimate?

c) In general when there are four stocks and the market index one can estimate
the
Variance Covariance matrix based on only 9 parameters. What is the procedure
for such calculation?

Estimate the matrix using this procedure.

d) Why is the answer in part c) different from part b)? Explain.

e) Assume now that your estimates in a) and b) are precise. In addition, you can
also
lend or borrow at risk free rate of 1% per annum. Does the CAPM hold in the
data? Explain.

f) Suppose that instead of four stocks there are many stocks and the procedure
in
part c) yields the correct estimate. Would the CAPM hold in that case? Explain.

Question 2

Your investment strategy is to maximize expected return but with a risk level
(standard
deviation) that does not exceed 15%. Since you are a CAPM believer you hold a
combination of the market portfolio and the risk free asset. The market expected
return is
10% with a standard deviation of 20% and the risk free rate is 3%.

a) What portfolio do you hold?

NASA has just announced that it not only found water on Mars but it also plans to
open a
resort on Mars named Mars for Life. NASA wishes to sell the new venture to
investors
in an initial public offering (IPO). An analyst estimates expected profits (RevenuesExpenses) would be $1B one year from now. The analysts mention that these are
the
expected profits and the risk (standard deviation) of this venture is 30% and the
correlation with the market is 0.2. For simplicity we assume that this is a one year
project where all revenues and expenses occur one year from now.

b) In the public offering NASA plans to sell 50M shares. What is the minimal
share
price at which you will invest in the new venture?

c) Suppose that the price for Mars for Life is 10% lower than your answer in
part
b). How would your answer to part a) change? What portfolio would you hold?

Question 3

Consider
a two period
increases or

binomial

model

where

in each round

the stock

decreases by 10%. The current stock price is $20 and the risk free rate
is 3.33% each
period.

We first consider a European call option with a strike of $20.

a) Calculate value of the option based on replication. Specify what

will be the
replicating portfolio in each round.

b) Calculate the value of the option based on risk neutral probabilities.

c) In this part we are interested in an option on option. Specifically

consider a
European call option on the original option that lets you buy it to buy the
option at
a price of $1 at t=1. What is the fair market value for this option?