Financiad Economics ECN134 Final Exam SSI 2008 Prof Farshid Mojaver Multiple Choice Questions There are 12 MC questions worth 12 points Please write the correct answer in your blue book 1 The expected return beta relationship is used A by regulatory commissions in determining the costs of capital for regulated firms B in court rulings to determine discount rates to evaluate claims of lost future incomes C to advise clients as to the composition of their portfolios D all of the above E none of the above Answer D 2 In the 1972 empirical study by Black Jensen and Scholes they found that the estimated slope of the security market line was what the CAPM would predict A higher than B equal to C less than D twice as much as E more information is required to answer this question Answer C 3 If a market proxy portfolio consistently beats all professionally managed portfolios on a risk adjusted basis it may be concluded that A the CAPM is valid B the market proxy is mean variance efficient C the CAPM is invalid D A and B E B and C Answer D 4 In the 1972 empirical study by Black Jensen and Scholes they found that the risk adjusted returns of high beta portfolios were the riskadjusted returns of low beta portfolios A greater than B equal to C less than D unrelated to E more information is necessary to answer this question Answer C 5 Malkiel 1995 calculated that the average alphas or abnormal returns on a large sample of mutual funds between 1972 and 1991 were A significantly positive B significantly negative C statistically indistinguishable from zero D positive before 1981 and negative thereafter E negative before 1981 and positive thereafter Answer C 6 Proponents of the EMH think technical analysts A should focus on relative strength B should focus on resistance levels C should focus on support levels D should focus on financial statements E are wasting their time Answer E 7 In an efficient market A security prices react quickly to new information B security prices are seldom far above or below their justified levels C security analysts will not enable investors to realize superior returns consistently D one cannot make money E A B and C Answer E 8 The weak form of the efficient market hypothesis contradicts A technical analysis but supports fundamental analysis as valid B fundamental analysis but supports technical analysis as valid C both fundamental analysis and technical analysis D technical analysis but is silent on the possibility of successful fundamental analysis E none of the above Answer D 9 Matthews Corporation has a beta of 1 2 The annualized market return yesterday was 13 and the risk free rate is currently 5 You observe that Matthews had an annualized return yesterday of 17 Assuming that markets are efficient this suggests that A bad news about Matthews was announced yesterday B good news about Matthews was announced yesterday C no news about Matthews was announced yesterday D interest rates rose yesterday E interest rates fell yesterday Answer B 10 Music Doctors has a beta of 2 25 The annualized market return yesterday was 12 and the risk free rate is currently 4 You observe that Music Doctors had an annualized return yesterday of 15 Assuming that markets are efficient this suggests that A bad news about Music Doctors was announced yesterday B good news about Music Doctors was announced yesterday C no news about Music Doctors was announced yesterday D interest rates rose yesterday E interest rates fell yesterday Answer A 11 The Food and Drug Administration FDA just announced yesterday that they would approve a new cancer fighting drug from King You observe that King had an abnormal return of 0 yesterday This suggests that A the market is not efficient B King stock will probably rise in value tomorrow C King stock will probably fall in value tomorrow D the approval was already anticipated by the market E none of the above Answer D 12 If you believe in the reversal effect you should A sell bonds in this period if you held stocks in the last period B sell stocks in this period if you held bonds in the last period C sell stocks this period that performed well last period D go long E C and D Answer C 6 pts 1 Portfolio Optimization Consider three risky securities A B and C A has the highest risk and expected return C has the lowest ones and B has ones in between a Draw a combination line between A and B assuming that there is zero correlation between the two securities What does it represent b Draw a combination line between securities B and C assuming these securities are not correlated c Draw a combination line for the three securities and mark the efficient frontier 6 pts 2 Optimal Risky Portfolio 1 Suppose you have a project that has 70 chance of doubling your investment in a year and 30 chance of halving your investment in a year What is the standard deviation of the rate of return on this investment Answer The probability distribution is Probability 0 7 0 3 Rate of Return 100 50 Mean 0 7 100 0 3 50 55 Variance 0 7 100 55 2 0 3 50 55 2 4725 Standard deviation 47251 2 68 74 6 pts 3 Optimal Risky Portfolio 2 Suppose that you have 1 million and the following two opportunities from which to construct a portfolio a Risk free asset earning 12 per year b Risky asset with expected return 30 per year and standard deviation of 40 If you construct a portfolio with a standard deviation of 30 what is the expected rate of return Answer P 30 y y y 0 75 E rP 12 0 75 30 12 25 5 12 pts 4 CAPM 1 Suppose the rate of return on short term government securities perceived to be risk free is about 5 Suppose also that the expected rate of return requires by the market for a portfolio with a beta of 1 is 12 According to the capital asset pricing model a What is the expected rate of return on the market portfolio b What would be the expected rate of return on a stock with 0 c Suppose you consider buying a share of stock at 40 The stock is expected to pay 3 dividends next year and you expect it to sell then for 41 The stock risk has been evaluated at 0 5 Is the stock over priced or under priced Answer a Since the market portfolio by definition has a beta of 1 its expected rate of return is 12 b 0 means no systematic risk Hence the stock s expected rate of return in market equilibrium is the risk free rate 5 c Using the SML the fair expected rate of return for a stock with 0 5 is E r 5 0 5 12 5 1 5 The actually expected rate of return using the expected price and dividend for next year is E r 41 1 40 …