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University of Birmingham
Birmingham Business School
PORTFOLIO THEORY AND INVESTMENT ANALYSIS

MSc Investments programme

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January 2013

Time allowed: 3 Hours

Answer THREE questions, you must answer at least ONE question from
Section A and ONE from Section B
All questions carry equal marks

Calculators may be used in this examination but must not be used

to store text. Calculators with the ability to store text should have
their memories deleted prior to the start of the examination

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Section A
1.

Mrs Watson has been investing in the ordinary shares of a number

of companies which were recommended in an investment newsletter
she subscribed to. She recently liquidated some of her shares but
still holds a portfolio of four different companies shares. Details of
this portfolio are as follows:
Company

Expected
Return

Company
Shares

Value of share
holding

7.3%

0.20

1,200

10.4%

0.80

1,200

12.2%

1.20

1,200

18.8%

1.60

2,400

The returns on the risk-free asset and on the market portfolio are
expected to be 4 percent and 12 percent respectively.
REQUIRED:
(a)

Calculate the beta and the expected return of Mrs Watsons

[25%]

portfolio.
(b)

Determine whether or not the individual shares lie on the security

market line (SML), and comment on the associated action Mrs
[25%]

Watson should take based on what you find.

(c)

What is meant by Beta? Do you agree that beta is a relevant

[25%]

measure of risk? And why?

(d)

Discuss the alternative applications and technical problems of the

Capital Asset Pricing Model (CAPM).

[25%]
[100% in total]

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2.

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You have two alternative investment opportunities. One is a
passive market portfolio with an expected return of 10 percent and
a standard deviation of 16 percent. The other is a fund that is
actively managed by your broker. This fund has an expected return
of 15 percent and a standard deviation of 20 percent. The risk-free
rate is currently 7 percent.

(a)

What is the slope of the Capital Market Line (CML)? And what is
[25%]

the slope of the capital allocation line (CAL) offered by your

brokers fund?
(b)

Draw both the CML and the CAL on one graph.(No graph paper is

[25%]

required)
(c)

What is the maximum fee your broker could charge and still leave
you as well off as if you had invested in the passive market fund?
Explain the effect, if any, on the CML or CAL if the broker was to
charge the maximum fee.
(Assume that the fee would be a percentage of the investment in

(d)

the brokers fund, and would be deducted at the end of the year.)

[25%]

Briefly discuss the differences between the CML and the SML.

[25%]
[100% in total]

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3.

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You manage a $11.5 million portfolio, currently all invested in
equities. You believe that the market is on the verge of a big but
short-lived downturn, and you would switch your portfolio
temporarily into T-bills, but you do not want to incur the transaction
costs of liquidating and re-establishing your equity position.
Instead, you decide to temporarily hedge your equity holdings with
S&P 500 index futures contracts.

(a)

Should you be long or short the S&P 500 index futures contracts?

[25%]

Explain clearly.
(b)

How many S&P 500 index futures contracts should you enter into
to hedge your portfolio? The S&P 500 index is now at 1,150 and
[25%]

the contract multiplier is $250.

(c)

How does your answer to (b) change if the beta of your portfolio is
[25%]

0.6?
(d)

Briefly explain the main differences between forward and futures

[25%]

contracts.

[100% in total]

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Section B
4.

(a)

Discuss critically the concepts and applications of the opportunity

set and efficient frontier. Include an appropriate diagram to
[50%]

illustrate your answer (no graph paper is required).

(b)

Discuss how the risk and return of purely domestic asset portfolios
change when the portfolio is modified to include international
[50%]

assets.

[100% in total]

5.
Describe the protected put and covered call option trading
strategies and draw the pay-off diagrams for each strategy (no
graph paper is required). Discuss, using appropriate examples,
how investment managers can benefit from these two strategies.
[100% in total]

6.

The capital asset pricing model (CAPM) is not a perfect description of

the relationship between risk and return. Moreover, the model is
severely limited in its operational applications to financial managers.
The arbitrage pricing theory (APT) provides an alternative asset pricing
model, which mainly addresses the limitations of the CAPM. Discuss.

[100% in total]

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(End of exam)

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