Arizona State University - FIN 421 / FIN421 Practice Final Exam

Consider the following limit order book of a specialist in a market that allows partial execution of orders. The last trade in the stock took place at a price of $35. Bid Bid Qty Ask Qty Ask 34..25 34.25 100 1,000 35.50 33.50 400 2,000 35.75 32..00 You place a market sell order for 150 shares. What are your proceeds and what is the new stock price? A) $5; 187:50 ; $34:75 B) $5; 187:50 ; $34:25 C) $5; 325:00 ; $35:00 D) $5; 287:50 ; $35:25 E) $5; 287:50 ; $35:00 Answer: B Determining proceeds: Since you are trying to sell shares, you look to the bid price column to see what people are willing to pay for the shares. You are able to sell 100 shares at $34:75 and 50 shares at $34:25 100 shares × $34:75 + 50 shares × $34:25 = $5; 187:50 Determining new stock price: The stock price is the last price the stock was purchased for. In this case, it is the price you sold your last 50 shares for, which is $34:25. 2. An investor invests 40% of his wealth in a risky asset with an expected rate of return of 15% and a variance of 4% and 60% in a treasury bill that pays 6%. What is the portfolio’s standard deviation? A) 0.64 % B) 1.6 % C) 2.4 % D) 8.0 % E) 12.0% Answer: D :4 × p0:04 = 0:08 33. For the aggregate U.S. stock market, A) daily returns are very predictable B) daily squared returns are very predictable C) daily squared returns are positively autocorrelated D) daily squared returns are negatively autocorrelated E) B and D F) B and C Answer: F Daily squared returns are highly positively autocorrelated, i.e. they "cluster". In U.S. data, the autocorrelation coefficients of squared daily returns are positive up to at least 252 lags (one year). Therefore, squared daily returns are very predictable. Returns (rather than squared returns) are only predictable over longer horizons, such as a year. 4. Which of the following portfolios cannot be on the efficient frontier? Portfolio Expected Return Standard Deviation I 8% 10% J 16% 20% K 15% 25% L 25% 38% A) Portfolio I B) Portfolio J C) Portfolio K D) Portfolio L E) Cannot be determined Answer: C Portfolio K because of portfolio J. Look for one that is strictly dominated { higher mean with same risk or lower risk with same mean or both. 45. Market timing is possible based on which of the following asset allocation rules / portfolios? (circle the ones that are correct) A) tangency portfolio B) minimum variance portfolio C) risk parity D) 1=N E) all of the above Answer: A Market timing can be used in conjunction with an allocation rule that uses expected returns as an input. This is only true for the tangency portfolio. 6. A coupon bond which pays interest of $50 annually, has a par value of $1,000, matures in 2 years, and is selling today at $991.50. The current yield on this bond is . A) 4.34% B) 4.76% C) 5.00% D) 5.46% E) 5.94% Answer: D Without computer (or good calculator), it’s trial and error. You can eliminate A, B and C since the yield has to be higher than the coupon (price is below par!). Try $50=1:0546 + $1050=(1:0546)2 = 991:50 57. Suppose the Capital Asset Pricing Model (CAPM) assumptions hold. The market portfolio consists of only 2 risky assets, which are in positive net supply. The expected rate of return of assets A and B are 10% and 13% respectively, their market betas are 0.5 and 0.8 respectively, and the risk free rate is 5%. Is this economy in equilibrium? A) Yes, both assets lie on the SML, satisfying the optimality of the market. B) No, asset A is held in negative amount in the tangency portfolio in contrast to supply=demand condition. C) No, asset B is held in negative amount in the tangency portfolio in contrast to supply=demand condition. D) It is impossible to tell without further information about the correlation between the two assets E) None of the above Answer: B The elegant answer is: Both assets have betas less than one! Since the market must have a beta of one, it will consist of a short position in asset A: wAβA + (1 − wA)βB = 1; or 0:5wA + (1 − wA)0:8 = 1; or wA = −2=3: You can get to the same conclusion by computing the expected market return: 10%−5% = 0:5 × (µM − 5%), or µM = 15. The equation for the other stock holds as well. But, both stocks have expected returns lower than the market, therefore a short position would be necessary. 8. A put option is more valuable when A) it has more time to maturity and when it has a higher strike price B) it has more time to maturity and when it has a lower strike price C) it has less time to maturity and when it has a higher strike price D) it has less time to maturity and when it has a lower strike price E) none of the above Answer: A The value of any option (call or put) is higher when it has more time remaining until maturity. A put option is additionally more valuable when it has a higher strike price because it gives its owner to sell the underlying at that price. 6Part II. Short Answer Questions (5 points each) Answer each of the following questions in 2-3 sentences. Provide an explanation of similar length for true/false question(s). 1. When backtesting risk parity portfolios based on on an investment universe that includes both bonds and stocks over 1980 to 2014, one finds that the strategy produces a higher Sharpe ratio than the naive 1=N strategy. Explain why this is the case. Answer: Because interest rates have declined over this sample period, bonds have performed relatively well, i.e. they have had high Sharpe ratios. Because risk parity portfolios allocate large weights to low risk assets, i.e. bonds, they have performed better than strategies that invest more heavily in stocks, such as the 1=N strategy. 2. In the context of the CAPM, what is meant by the term ’anomaly’? Give an example of a market anomaly and explain why it is considered to be an anomaly. Answer: In the context of the CAPM, an anomaly is an investment strategy that earns high returns that are not related to market risk. An example is the momentum strategy, which buys stocks that have done well over the past year and sells stocks that have done poorly. This strategy is an anomaly because its excess returns remain significantly positive after adjusting for market risk. 73. True or False (Explain): Two assets that have identical cash flows must have the same price. Answer: TRUE Identical cash flows means their risk (discount rates) is also identical. Cash flows and discount rates determine the price. 4. You regress monthly excess returns on Funny Fund onto the four Carhart factors and a constant, i.e. you estimate the time series regression re t = α + βM · rM;t e + βSMB · rSMB;t + βHML · rHML;t + βWML · rWML;t + t and you obtain the parameter estimates ^ α = 0:005 (t-stat=0.6), β^M = 0:97 (t-stat=2.1), β^SMB = 0:43 (t-stat=2.9), β^HML = −0:08 (t-stat=-1.3), and β^WML = 0:70 (t-stat=3.1). What investment style does Funny fund follow, i.e. what types of stocks does it tend to buy? Answer: Funny has significantly positive loadings on both the size and the momentum factor. This implies that it tends to invest in small firms and firms with high returns over the past year. It loads insignificantly on the value factor and its market beta is close to one, implying no strong tilts along these dimensions.