Investment management Exam example

The exam example is based on historical exam given in the course and serves
as practice exercise and an illustration of the general form of the exam and
some of the possible types of questions. There may be also other types of
questions in future exams.

Problem 1 (13 pt.)

You have estimated the standard single-index model + + for three mutual funds.
Based on the model, you have calculated expected excess returns and systematic and firm-specific variances
for the funds. The figures are given in the table below. (The returns are percentages, i.e. 0.01 = 1 %). Assume
that the standard deviation of the market portfolio = 0.2, the expected excess return on the market portfolio
( ) = 0.05, and all betas are positive. Give arguments for your answers. No points will be given without a
valid explanation.

Fund A Fund B Fund C

Expected Excess Return E(ri - rf) 0.071 0.063 0.045

Systematic Variance 0.130 0.077 0.019

Firm-Specific Variance 0.022 0.033 0.011

(a) Which fund has the highest diversifiable risk? (Choices: Fund A, Fund B, Fund C)
(b) Which fund has the highest beta? (Choices: Fund A, Fund B, Fund C)
(c) Which fund has the highest alpha? (Choices: Fund A, Fund B, Fund C)
(d) Based on the data, which fund do you think is the most attractive investment opportunity (i.e.
which fund has offered the best risk-adjusted returns based on the single-index model)?
(Choices: Fund A, Fund B, Fund C)
(e) Now assume that the funds A and B have the same systematic variance and other parameters
remain unchanged. You use the model and the estimates to predict next years returns for the
two funds. Based on the data, which funds return do you expect to be closest to the predicted
return next year? (Choices: Fund A, Fund B, Both A and B to be equally close)

Problem 2 (12 pt.)

Company A has a corporate bond with a coupon rate of 4% and face value of 100. The bonds time to maturity
is two years, the next coupon is paid exactly one year from now, and the last coupon will be paid together with
the principal. The yield to maturity of the bond is 6%.

(a) What is the price of the bond? (Give your answer with at least two decimals.)
(b) If the duration of the bond is 1.96, what is its modified duration? (Give your answer with at least
two decimals.)
(c) Based on the modified duration calculated in part (b), what would the approximate percentage
change in the price of the bond be if interest rates went up by 2%? Use the modified duration to
calculate the approximate percentage change.
(d) Suppose that another company, company B, has two outstanding zero-coupon bonds with
different times to maturity. The time to maturity of the first bond is one year and its market price
is 95.2. The time to maturity of the second bond is two years and its market price is 85.3. The
face value of both bonds is 100. Based on this information, would you say that the market
generally sees the bond of company A as more risky, less risky, or equally risky as the bonds of
 company B? Give an explanation for your answer. No points will be given without a valid
explanation.

Problem 3 (12 pt.)

Each sub-question (i.e. a, b, and c) provides the necessary information to solve that particular sub-question.
In each sub-question, the investors maximize the standard utility function U = E(r) ,, where E(r) is the
portfolios expected return, A is the coefficient of risk aversion, and is the standard deviation of the portfolio
returns.
The formula for solving quadratic equations is:
-b b 2 - 4ac
x= , where ax 2 + bx + c = 0
2a

(a) Mrs. Johnson lives in an economy with two uncorrelated risky assets (X and Y) but no risk-free asset.
Asset X has expected return of 5% and a return standard deviation of 20%. Asset Y has expected return
of 10% and a return standard deviation of 25%. Mrs. Johnson has a coefficient of risk aversion equal
to 2. What proportion of her wealth should she invest in asset X?
(b) Mr. Smith lives in an economy with two perfectly correlated risky assets (X and Y) but no risk-free
asset. The expected return on asset X is 10% and the standard deviation of stock X returns is 15%. Asset
Y can be sold short but short-selling of asset X is not allowed. Mr. Smith has a coefficient of risk
aversion equal to 2. His optimally constructed portfolio has standard deviation of 20%. Returns on
asset Y have standard deviation of 5%. What is the expected return on asset Y?
(c) Miss Williams lives in an economy with two perfectly correlated risky assets (X and Y) but no risk-free
asset. The expected return on asset X is 10% and the standard deviation of stock X returns is 15%. Miss
Williams has a coefficient of risk aversion equal to 2. Her optimally constructed portfolio has standard
deviation of 22.5%. Returns on asset Y have standard deviation of 5%. Asset Y can be sold short with
no additional cost but short-selling asset X costs additional 2% fee (i.e. the expected return from short-
selling asset X is -10%-2%= -12%). What is the expected return on asset Y?
Model solutions
Problem 1
a) B (2 pt.) since it has the highest firm-specific variance
b) A (2 pt.) because it has the highest systematic variance = 2
M ,
2
M is the same for all funds and all
betas are positive
c) C (4 pt.)
= i rf ( M f)= i rf ( M f)

= 0.071 0.130^(0.5)*0.05/0.2 = -0.0191

A

B = 0.063 0.077^(0.5)*0.05/0.2 = -0.0064

C = 0.045 0.019^(0.5)*0.05/0.2 = 0.0105

d) C (2 pt.) as it has the highest alpha
e) A (3 pt.) since it has lower firm-specific variance and the same systematic variance

Problem 2

a) P = 4 / (1+0.06) + 104 / (1+0.06)^2 = 96.33

b) Modified duration = Duration / ( 1+ yield to maturity) = 1.96/1.06 = 1.85
c) Approximate percentage change = - modified duration * interest rate change =- 1.85 * 0.02 = -3.7%
d) Bonds of company A are seen as less risky. Company Bs one-year return is 100/95.2-1 = 5.04% and
two-year return is (100/85.3)^0.5-1 = 8.27%. If bond As cash flow were discounted with these rates,
their present value would be 92.52 which is lower than the current market price. => The risk
premium on bond B is higher.

Problem 3

a) (4 pt.)

( )= +( )

( )= +( )

1
= +( ) ( +( ) )
2

Set the first derivative w.r.t. w equal to zero:

= ( + )=0

+
=> =
( + )

=> = 0.05-0.1+2*0.25^2/(2*(0.2^2+0.25^2)) = 0.075/0.205=0.3659

b) (4 pt.)

( )= +( )

( )= +( ) + 2 (1 )

=> + 2 + 2 2 + ( )=0

Perfectly correlated assets, = 1:

 => + 2 ( ) + ( )=0

2 ( ) 2 ( ) 4 ( ( ))
, =
2

0.05(0.15 0.05) ( 0.05(0.15 0.05)) 4(0.15 0.05) (0.05 0.2 )

, =
2 (0.15 0.05)

0.01 0.0016
, =
0.02

= .

2.5

But short-selling of asset X is not allowed. Therefore only is a solution.

1
= +( ) ( +( ) + 2 (1 ) )
2

Set the first derivative w.r.t. w equal to zero:

= ( + + 2 )=0

+
=> =
+ 2

0.1 + 2 0.05(0.05 0.15) 0.09

=> = =
2(0.15 0.05) 0.02

Combining with the weight derived from portfolio variance:

0.09 = 0.02 1.5 = 0.03
= 0.06

c) (5 pt.)

( )= +( )

( )= +( ) + 2 (1 )

=> + 2 + 2 2 + ( )=0

Perfectly correlated assets, = 1:

=> + 2 ( ) + ( )=0
 2 ( ) 2 ( ) 4 ( ( ))
, =
2

0.05(0.15 0.05) ( 0.05(0.15 0.05)) 4(0.15 0.05) (0.05 0.225 )

, =
2(0.15 0.05)

0.01 0.002025
, =
0.02

= 1.75

2.75

For w=1.75 there is no short-selling of asset X, thus no additional cost:

1
= +( ) ( +( ) + 2 (1 ) )
2

Set the first derivative w.r.t. w equal to zero:

= ( + + 2 )=0

+
=> =
+ 2

0.1 + 2 0.05(0.05 0.15) 0.09

=> = =
2(0.15 0.05) 0.02

0.09 = 0.02 1.75 = 0.035

= .

w=-2.75 there are additional costs 2% for short-selling asset X.

0.12 + 2 0.05(0.05 0.15) 0.11
=> = =
2 (0.15 0.05) 0.02

0.11 0.02 2.75 = 0.055

= .
To confirm that this is an optimum we should check that Miss Williams could not achieve
higher utility by not short-selling asset X when ry=0.165:
0.1 0.165 + 2 0.05(0.05 0.15)
= <0
2 (0.15 0.05)
Thus even with rx =0.1, its optimal to short-sell asset X and ry=0.165 is the second
solution.