BUS3026W Finance 2 Objective Test 4 7 May 2007

Total marks: 30 Time: 40 minutes

All questions are to be completed on this worksheet. For each question, please circle
the appropriate answer clearly or answer in the provided ‘Workings’ sections.

Multiple Choice Questions (Q 1 to 10): 2 marks each.

Incorrect answers: -1/2 mark each.
No answers: 0 marks each.

1. The correlation between the Charlottesville International Fund and the EAFE
Market Index is 1.0. The expected return on the EAFE Index is 11%, and the
expected return on the Charlottesville International Fund is 9%. The risk-free
return in EAFE countries is 3%. Based on the analysis, the implied beta of
Charlottesville International is:

a. Negative
b. 0.75
c. 0.82
d. 1.00

2. The CAPM states that a share has the same market risk and expected return as:

a. A portfolio with proportion β invested in Treasury Bills and 1 – β in the

market
b. A portfolio with β invested in the market and 1 – β in Treasury Bills.
c. A portfolio evenly divided between the market and Treasury Bills.
d. None of the above

3. Suppose two portfolios have the same average return, the same standard
deviation of returns, but portfolio A has a higher beta than portfolio B. According
to the Sharpe measure, the performance of portfolio A __________.

a. is better than the performance of portfolio B

b. is the same as the performance of portfolio B
c. is poorer than the performance of portfolio B
d. cannot be measured as there is no data on the alpha of the portfolio

4. Portfolio X has an expected return of 10% and standard deviation of 19%.

Portfolio Y has an expected return of 12% and standard deviation of 17%.
Rational investors will

a. Borrow at the risk-free rate and buy X

b. Sell Y short and buy X
c. Sell X short and buy Y
d. Borrow at the risk free rate and buy Y
e. Lend at the risk free rate and buy Y

5. The exploitation of security mispricing in such a way that risk-free economic

profits may be earned is called

a. Factoring
b. Capital asset pricing
c. Arbitrage
d. Fundamental Analysis
e. None of the above
6. Consider the following two regression lines for Shares A and B in the following
figures:

Share A Share B

a. Which stock has higher firm-specific risk? Why? [1]

Share A, as the dispersion of the returns around the regression line is far
greater than it is for B.

b. Which stock has greater systematic risk? Why? [1]

Share B, as it has the higher slope (β).

c. Which stock has a higher R2? Why? [1]

Share B, as the dispersion tracks the regression line quite closely.

d. Which stock has a higher alpha? Why? [1]

Share A, as its y-intercept is higher (positive) than that of B (negative).

7. The expected rate of return on a share is 14%. The risk free rate is 6% and the
market risk premium is 8.5%. What will be the new expected return of the security
if its correlation coefficient with the market portfolio doubles and all other
variables remain unchanged? [4]

Workings:

14% = 6% + β (8.5%)

Therefore β = 8%/8.5% = 0.94

If the correlation coefficient has doubled while all else remains constant we
should find that beta has also doubled, therefore:

E(R) = 6% + 1.88 (8.5%) = 21.98%

8. An investment committee has been presented with the following information
about two funds:

Average Annual Return Beta Std. Dev.

ELC Fund 22.1% 1.2
16.78%
MLC Fund 24.2% 0.8
20.20%

Average Annual Risk-Free Rate 5%

Average Annual Market Return 18.9%
Standard Deviation of Market Returns 13.8%

a. Calculate the Sharpe and Treynore measures for both funds. [2]

Workings:

SELC = (22.1 – 5)/16.8 = 1.02 SMLC = (24.2 – 5)/20.2 = 0.95

TELC = (22.1 – 5)/1.2 = 14.25 TMLC = (24.2 – 5)/0.8 = 24

b. The committee has noticed that the Sharpe and Treynor measures above
produce different performance rankings for the two funds. Explain why
these criteria may result in different rankings. [2]

The Sharpe measures looks at total risk while the Treynor measure
looks at only systematic risk. It is clear that the MLC portfolio has a
substantial amount of unsystematic risk as it has a lower beta than the
ELC portfolio and yet has a much higher total risk.

9. Assume that X and Y are well-diversified portfolios and the risk-free rate is 8%.

Portfolio Expected Return Beta

X 16% 1.00
Y 12% 0.25

Does an arbitrage opportunity exist? If so, how would you exploit it?
[4]

Workings:

Yes. We can create a portfolio with X and the risk-free rate that will match
the beta of Y by investing 0.25 in X and 0.75 in the risk-free rate.

The beta of the resulting portfolio is then (0.75 x 0) + (0.25 x 1) = 0.25

It thus has the same risk as Y but offers a return of:

(0.75 x 8) + (0.25 x 16) = 10%

We can therefore buy Y and sell short our combined portfolio above in
order to earn 2% in arbitrage profits.

10. What benefits does the APT model offer over the CAPM?
[3]
Discussion:

• It allows for multiple sources of risk affecting the underlying security.

• It does not make the restrictive assumptions that the CAPM does.
 • It requires fewer inputs to be estimated than the CAPM does.

• It does not rely on the existence of a hypothetical “market portfolio”

11. Give two reasons why passive investment strategies are deemed to be
technically flawed in South Africa? [2]

• There are no real passive investment instruments available to simulate

trade in the ALSI.

• Our market is heavily weighted towards resources stocks which limits

the ability to diversify risk away from that sector.

• There are significant concerns regarding the liquidity of many shares

listed on the exchange.

• There are concerns regarding local market efficiency.