Question 1                                                                     [100 marks in total]

A.   Consider the following securities

1)  Using the CAPM, calculate the beta of security 1, 2 and 3. [6 marks]

2)    Using the CAPM, calculate the expected return of security 1, 2 and 3.                  [6 marks]

3)  A portfolio manager invests 40% in security 1, 15% in security 2 and 45% in security 3.

a.   Calculate the portfolio historical return.

b.   Using the CAPM, calculate the portfolio beta.

c.    Using the CAPM, calculate the portfolio expected return. [6 marks]

4)  With the above-mentioned portfolio, a portfolio manager achieves a return of 6%. Calculate the Jensen’s alpha. [2 marks]

Correction:

B.   Consider the following graph:

1)  What is the point representing the optimal risky portfolio for any investor? Explain.

Point P: for any investor, point P is optimal given the current risk-free rate and efficient frontier. Point where CAL(P) is tangent for the frontier. [6 marks]

2)  Using the graph, explain the two-funds theorem.

The decision of any investor is divided in two: holding a combination of P and Rf, and then selecting the weights based on the indifference curve [6 marks]

3)  What does the indifference curve represent?

Utility of a given investor, that gives its optimal combination of the risky and risk -free asset. [6 marks]

4)  Can an investor access point K? If yes, how? If no, why not?

Yes, by borrowing [6 marks]

5)  How is the efficient frontier of risky assets calculated?

Alternative weights of risky assets to minimise the variance for a given return, or maximize the return for a given variance. [6 marks]

C.   Write an essay that answers the following elements:

1)  Explain the difference between active and passive management.

Active management: selection of stocks based on expected return. Stock picking. Passive

management: following a market return, without choosing some specific stocks.

2)  Does the CAPM support the use of active or passive management, or both?

All answers accepted if correctly supported. The CAPM supports passive management if one strictly follows its conclusions and hypothesis but can be used for active management if employed for valuation.

3)  How do the limitations in the CAPM qualify your answer to the previous question?

Use of some limitations of the CAPM to build an answer, such as: efficiency of the market; Roll’s critic of finding the best portfolio, etc. [50 marks]