SCHOOL OF BUSINESS SCIENCES AND MANAGEMENT

DEPARTMENT OF ACCOUNTING SCIENCES AND FINANCE

INVESTMENT ANALYSIS & PORTIFOLIO MANAGEMENT

PRACTICE QUESTIONS

Question 1

A. Which of the following statements about the security market line (SML) are true?
i. The SML provides a benchmark for evaluating expected investment
performance.[1]
ii. The SML leads all investors to invest in the same portfolio of risky assets.[1]
iii. The SML is a graphic representation of the relationship between expected
return and beta.[1]
iv. Properly valued assets plot exactly on the SML. [1]

B. Risk aversion has all of the following implications for the investment process
except:
i. The security market line is upward sloping.
ii. The promised yield on AAA-rated bonds is higher than on A-rated bonds.
iii. Investors expect a positive relationship between expected return and risk.
iv. Investors prefer portfolios that lie on the efficient frontier to other
portfolios with equal expected rates of return.[2]
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 C. What is the beta of a portfolio with E(Rp) - 20%, if Rf- 5% and E(Rm) -15%?[2]

D. Are the following statements true or false? Explain.

i. Stocks with a beta of zero offers an expected rate of return of zero. [2]
ii. The CAPM implies that investors require a higher return to hold highly
volatile securities. [2]
iii. You can construct a portfolio with a beta of 0.75 by investing 0.75 of the
budget in T-bills and the remainder in the market portfolio. [2]

[15 marks]

Question 2

Hennessy & Associates manages a $30 million equity portfolio for the multimanager
Wilstead Pension Fund. Jason Jones, financial vice president of Wilstead, noted that
Hennessy had rather consistently achieved the best record among the Walstead’s six
equity managers. Performance of the Hennessy portfolio had been clearly superior to that
of the S&P 500 in four of the past five years. In the one less favorable year, the shortfall
was trivial.

Hennessy is a “bottom-up” manager. The firm largely avoids any attempt to “time the
market.” It also focuses on selection of individual stocks, rather than the weighting of
favored industries. There is no apparent conformity of style among the six equity
managers. The five managers, other than Hennessy, manage portfolios aggregating $250
million, made up of more than 150 individual issues.

Jones is convinced that Hennessy is able to apply superior skill to stock selection, but the
favorable results are limited by the high degree of diversification in the portfolio. Over
the years, the portfolio generally held 40–50 stocks, with about 2% to 3% of total funds
committed to each issue. The reason Hennessy seemed to do well most years was because
the firm was able to identify each year 10 or 12 issues that registered particularly large
gains. Based on this overview, Jones outlined the following plan to the Wilstead pension
committee:

“Let’s tell Hennessy to limit the portfolio to no more than 20 stocks. Hennessy
will double the commitments to the stocks that it really favors and eliminate the
remainder. Except for this one new restriction, Hennessy should be free to manage the
portfolio exactly as before.”

All the members of the pension committee generally supported Jones’s proposal, because
all agreed that Hennessy had seemed to demonstrate superior skill in selecting stocks.
Yet, the proposal was a considerable departure from previous practice, and several
committee members raised questions.

Required

a. Will the limitation of 20 stocks likely increase or decrease the risk of the portfolio?
Explain.[4]
b. Is there any way Hennessy could reduce the number of issues from 40 to 20 without
significantly affecting risk? Explain. [3]
c. One committee member was particularly enthusiastic concerning Jones’s proposal.
He suggested that Hennessy’s performance might benefit further from reduction in
the number of issues to 10. If the reduction to 20 could be expected to be
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 advantageous,explain why reduction to 10 might be less likely to be advantageous.
(Assume that Wilstead will evaluate the Hennessy portfolio independently of the
other portfolios in the fund.) [4]
d. Another committee member suggested that, rather than evaluate each managed
portfolio independently of other portfolios, it might be better to consider the
effects of a change in the Hennessy portfolio on the total fund. Explain how this
broader point of view could affect the committee decision to limit the holdings in
the Hennessy portfolio to either 10 or 20 issues. [5]

[15 marks]

Question 3 [ASGT 2]

a. Within the context of CAPM, assume;

 Expected return on the market = 15%

 Risk free rate = 8%
 Expected rate of return on RTG security = 17%
 Beta of RTG security = 1.25
i. What is the alpha of RTG? Plot the SML? [5]
ii. Is RTG overpriced, under priced or fairly priced? Why? [3]

b. i. A portfolio has an expected rate of return of 20% and standard deviation of 20%.
Bills offer a sure rate of return of 7%. Which investment alternative will be
chosen by an investor whose A=4? What if A=8.[4]

ii. You have the following information about the following corporations, Circle
Cement and TN Holdings.

RATES OF RETURN

Circle Cement TN Holdings

PROBABILITY % %
0.1 20 10
0.4 10 40
0.5 -5 45

Risk free return (Rf) = 15%

A = 5
WCIRCLE = 40%
WTN = 60%

Draw a pie chart to show how the investor will allocate their funds between the
risky portfolio (P) and the risk free asset. Illustrate your answer with a CAL.
comment on your findings. [8]

[20 marks]

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 Question 4

A pension fund manager at Old Mutual Zimbabwe is considering investing in 3

mutual funds. The first is a stock fund, the second is a long-term corporate bond
fund, and the third is a T-Bill money market fund that yields a rate of 8%. The
return probability distributions of the risky funds are as follows

Expected Return % Standard deviation %

30
Stock Fund [S] 20
15
Bond Fund [B] 12
Correlation coefficient between Stock Fund and Bond Fund =0.20

a) Solve numerically for the proportions invested in each asset, the

expected return and standard deviation of the optimal risky portfolio.
[10]
b) Find the reward to variability ratio of the CAL supported by T-Bills and Portfolio P.
[2]
c) Calculate the complete portfolio allocated to P and to T-Bills if A=4. Outline your
answer with a pie chart.[8]

[20 marks]

Question 5

I. Consider the two (excess return) index model regression for A and B
RA= 1%+1.2RM
R-SQR=0.576 RESID STD DEV-N=10.3%
RB=-2%+0.8RM
R-SQR=0.436 RESID STD DEV-N=9.1%
a) Which stock has more firm specific risk? (4)
b) Which stock has greater market risk? (4)
Comment in each case.
[8 marks]

Question 6

Estimate the index model and the total variance when given the following information
about the 6 month performance of the Airplus Corporation and the ZSE Index below.
Comment on the significance of your results and illustrate your answer with a Security
Characteristic Line (SCL). [22]

Month Airplus ZSE Index- HPR Treasury bill rate

Corporation-HPR (%) (%)
(%)
JANUARY 10 4 5
FEBRUARY 9 6 5.5
MARCH 12 9 7.4
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 APRIL 15 13.4 11
MAY 16 11 12
JUNE 8.9 11.5 11.9

6.2 Question- APT model

An investment manager identifies two pervasive macroeconomic factors. The risk premium
on factor 1 is 8% whilst on factor 2 is 12%. The risk free rate is given as 4%. You are also
given the following:
Security B1 B2
A 1.50 0.30
B -1.20 2.20
C -0.20 1.80

a) Calculate the required rate of return according to arbitrage pricing model. [6 marks]
b) Suppose the expected return in the market is as follows:

Security Expected Return

A 16%
B 18%
C 20%

Explain how an arbitrageur will create a factor portfolio on each security to make a
riskless profit. [9 marks]
[total 15 marks]

Question 7

A. Which of the following assumptions imply (i.e.) an informationally efficient

market?[2]
i. Many profit-maximizing participants, each acting independently of the
others, analyze and value securities.
ii. The timing of one news announcement is generally dependent on other
news announcements.
iii. Security prices adjust rapidly to reflect new information.
iv. A risk-free asset exists, and investors can borrow and lend unlimited
amounts at the risk-free rate.

B. Which of the following most appears to contradict the proposition that the stock
market is weakly efficient? Explain.[2]
i. Over 25% of mutual funds outperform the market on average.
ii. Insiders earn abnormal trading profits.
iii. Every January, the stock market earns above normal returns.

C. Suppose, after conducting an analysis of past stock prices, you come up with the
following observations. Which one would appear to contradict the weak form of the
efficient market hypothesis? Explain.[1]
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 i. The average rate of return is significantly greater than zero.
ii. The correlation between the market return one week and the return the
following week is zero.
iii. One could have made superior returns by buying stock after a 10% rise in
price and selling after a 10% fall.
iv. One could have made higher than average capital gains by holding stock
with low dividend yields.

D. State if the following statements are true or false if the efficient market
hypothesis holds?
i. It implies perfect forecasting ability.[0.5]
ii. It implies that prices reflect all available information.[0.5]
iii. It implies that the market is irrational.[0.5]
iv. It implies that prices do not fluctuate.[0.5]

E. A market anomaly refers to:[2]

i. An exogenous shock to the market that is sharp but not persistent.
ii. A price or volume event that is inconsistent with historical price or volume
trends.
iii. A trading or pricing structure that interferes with efficient buying and
selling of securities.
iv. Price behaviour that differs from the behaviour predicted by the efficient
market hypothesis.

F. “If the business cycle is predictable, and a stock has a positive beta, the stock’s
returns also must be predictable.” Respond explaining your reasoning.[2]

G. Some scholars contend that professional managers are incapable of outperforming

the market. Others come to an opposite conclusion. Compare and contrast the
assumptions about the stock market that support
(a) Passive portfolio management and [2]
(b) Active portfolio management.[2]

H. You are a portfolio manager meeting a client. During the conversation that
followed your formal review of her account, your client asked the following
question:
“My grandson, who is studying investments, tells me that one of the best ways to
make money in the stock market is to buy the stocks of small-capitalization firms
late in December and to sell the stocks one month later. What is he talking
about?”

i. Identify the apparent market anomalies that would justify the proposed
strategy.[3]
ii. Explain why you believe such a strategy might or might not work in the
future.[2]

[20 marks]
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Question 8

As director of research for a medium-sized investment firm, Jeff Cheney was concerned
about the mediocre investment results experienced by the firm in recent years. He met
with his two senior equity analysts to consider alternatives to the stock selection
techniques employed in the past.
One of the analysts suggested that the current literature has examined the relationship
between Price– Earnings (P/E) ratios and securities returns. A number of studies had
concluded that high P/E stocks tended to have higher betas and lower risk-adjusted
returns than stocks with low P/E ratios.

The analyst also referred to recent studies analyzing the relationship between security
returns and company size as measured by equity capitalization. The studies concluded
that when compared to the S&P 500 index, small-capitalization stocks tended to provide
above-average risk-adjusted returns, while large-capitalization stocks tended to provide
below-average risk adjusted returns. It was further noted that little correlation was found
to exist between a company’s P/E ratio and the size of its equity capitalization.

Jeff’s firm has employed a strategy of complete diversification and the use of beta as a
measure of portfolio risk. He and his analysts were intrigued as to how these recent
studies might be applied to their stock selection techniques and thereby improve their
performance .Given the results of the studies indicated above:

a) Explain how the results of these studies might be used in the stock selection and
portfolio management process. Briefly discuss the effects on the objectives of
diversification and on the measurement of portfolio risk.[10]
b) List the reasons and briefly discuss why this firm might not want to adopt a new
strategy based on these studies in place of its current strategy of complete
diversification and the use of beta as a measure of portfolio risk.[10]

[20 marks]

Question 9

I. Consider the following table, which gives a security analyst’s expected return on
two stocks for two particular market returns:

Market Return,Rm Aggressive Stock, A Defensive Stock ,B

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 5% 2% 3.5%

20% 32% 14%

a) What are the betas of the two stocks?[2]

b) What is the expected rate of return on each stock if the market return is equally
likely to be 5% or 20%?[3]
c) If the T-bill rate is 8%, and the market return is equally likely to be 5% or 20%,
draw the SML for this economy.[5]
d) Plot the two securities on the SML graph. What are the alphas of each and advise
on the significance of the alpha measure?[5]
e) What hurdle rate should be used by the management of the aggressive firm for a
project with the risk characteristics of the defensive firm’s stock?[5]

[20 marks]

Question 10

An investor has gathered the following information about the Zimbabwean market
Bond Fund Equity Fund
E( R) 25% 45%
𝝈 30% 60%

Covariance between bonds and equities is - 125

Expected return on Treasury bills is 15%
Investor’s risk aversion coefficient is 4
Required
i. Calculate the weight invested in the bond fund, equity fund and the money
market. Illustrate your answer graphically in a pie chart. [7]
ii. Calculate the expected return and standard deviation of the risky portfolio and
the complete portfolio. Draw a Capital allocation Line to illustrate your
answer. Calculate the Reward to Variability ratio supported by the risk free
asset and the risky portfolio. [8]
iii. Briefly describe the action to be taken by the investor [5]

[20 marks]

Question 11 [ASGT2]

Outline the differences and similarities between the Single Index model and the Capital
Asset Pricing model. In your opinion, which of the two models makes a better assessment
of the return on a security? [20]

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 II. Consider the following table, which gives a security analyst’s expected return on
two stocks for two particular market returns:

Market Return,Rm Aggressive Stock, A Defensive Stock ,B

10% 4% 7%

40% 64% 28%

f) What are the betas of the two stocks?[2]

g) What is the expected rate of return on each stock if the market return is equally
likely to be 10% or 40%?[3]
h) If the T-bill rate is 8%, and the market return is equally likely to be 10% or 40%,
draw the SML for this economy.[5]
i) Plot the two securities on the SML graph. What are the alphas of each and advise
on the significance of the alpha measure?[5]
What hurdle rate should be used by the management of the aggressive firm for a project
with the risk characteristics of the defensive firm’s stock?[5]

Question 12

An investor has gathered the following information about the Zimbabwean market
Bond Fund Equity Fund
E( R) 25% 45%
Std dev 30% 60%

Covariance between bonds and equities is - 125

Expected return on Treasury bills is 15%
Investor’s risk aversion coefficient is 4
Required
i. Calculate the weight invested in the bond fund, equity fund and the money
market. Illustrate your answer graphically in a pie chart. [7]
ii. Calculate the expected return and standard deviation of the risky portfolio and
the complete portfolio. Draw a Capital allocation Line to illustrate your
answer. Calculate the Reward to Variability ratio supported by the risk free
asset and the risky portfolio. [8]
iii. Briefly describe the action to be taken by the investor [5]

[20 marks]

Question 13 GROUP A
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Outline the differences and similarities between the Single Index model and the Capital
Asset Pricing model. In your opinion, which of the two models makes a better assessment
of the return on a security? [20]

Question 14

1(a) Track the performance of any counter of your choice from the Zimbabwe Stock
Exchange for a period of at least five years (can track annually, semiannually,
quarterly, monthly) and comment on your findings. Advise shareholders and
prospective shareholders on the course of action to take. Your comment should
include the movement of the share price, Earnings per Share, Net Asset Book
Value, Return on Average Shareholders’ funds, P/E ratios, PBV ratios, PS ratios,
Return on Average Assets and Dividends paid or not paid. (90)

(b) How has the operating environment affected your counter (positively or negatively)
for the years under study? What should the management do to counter or take
advantage of the operating environment affecting your counter? (10)
QUESTION 15

a) A portfolio has an expected rate of return of 20% and standard deviation of 20%.
Bills offer a sure rate of return of 7%. Which investment alternative will be chosen
by an investor whose A=4? What if A=8. (5)

b) You have the following information about the following corporations, PPC and
Econet .

RATES OF RETURN

PPC ECONET
PROBABILITY % %
0.1 20 10
0.4 10 40
0.5 -5 45

Risk free return (Rf) = 15%

A = 5
WPPC = 40%
WECONET = 60%
Draw a pie chart to show how the investor will allocate their funds between the
risky portfolio (P) and the risk free asset. Illustrate your answer with a CAL.
comment on your findings. [10]

QUESTION 16

A pension fund manager is considering three mutual funds. The first is a stock fund,
the second is a long-term corporate bond fund, and the third is a T-Bill money market
fund that yields a rate of 8%. The probability distribution of the risky fund is as follows
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 Expected Return % Standard deviation %
30
Stock Fund [S] 20
15
Bond Fund [B] 12
Correlation coefficient between Stock fund and Bond fund =0.10
a. Solve numerically for the proportions of each asset and for the expected
return and standard deviation of the optimal risky portfolio.(10)
b. Find the reward to variability ratio of the CAL supported by T-Bills and
Portfolio P. (2)
c. Calculate the complete portfolio allocated to P and to T-Bills if A=4. Outline
Your answer with a pie chart.(8)

QUESTION 16

A universe of available securities includes two risky stock funds, A and B, and Treasury
Bills. The data for the universe are as follows:

Expected Return % Standard deviation %

A 10 20
B 30 60
Treasury bills 5 0

The correlation coefficient between A, B = -0.2

a) Find the optimal risky portfolio, P, and its expected return and standard
deviation.(10)
b) Find the minimum variance portfolio and compute the corresponding
expected return and standard deviation (6 marks)
c) Find the slope of the CAL supported by T-Bills and Portfolio P. (2)
c) How much will an investor with A=5 invest in funds A, B and in T-Bills? (8)

QUESTION 17

Consider the two (excess return) index model regression for A and B
RA= 1%+1.2RM
R-SQR=0.576 RESID STD DEV-N=10.3%
RB=-2%+0.8RM
R-SQR=0.436 RESID STD DEV-N=9.1%
c) Which stock has more firm specific risk? (5)
d) Which stock has greater market risk? (5)
Comment in each case.

QUESTION 18 [ASGT 2]

Estimate the index model and the total variance when given the following
information about the 6 month performance of the Star Corporation and the ZSE
Index below. Comment on the significance of your results and illustrate your
answer with a Security Characteristic Line (SCL). [25]

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 Month Star Corporation- ZSE Index- HPR Treasury bill rate
HPR (%) (%) (%)
JANUARY 100 44 50
FEBRUARY 99 69 50
MARCH 121 91 75
APRIL 154 150 110
MAY 166 111 120
JUNE 87 177 120

QUESTION 19 [ASGT 1]

A fund manager is considering investing in three mutual funds. The first is a stock
fund, the second is a long-term corporate bond fund, and the third is a T-Bill
money market fund that yields a rate of 8%. The probability distribution of the
risky fund is as follows

Expected Return % Standard deviation %

30
Stock Fund [S] 20
15
Bond Fund [B] 12
Correlation coefficient between Stock fund and Bond fund =0.10
d) Solve numerically for the proportions of each asset , the expected
return
and standard deviation of the optimal risky portfolio. (10)
e) Find the reward to variability ratio of the CAL supported by T-Bills and
Portfolio P. (2)
f) Calculate the complete portfolio allocated to P and to T-Bills if A=4.
Outline
your answer with a pie chart.(8)

QUESTION 20

A fund manager is considering investing in three mutual funds. The first is a

stock fund, the second is a long-term corporate bond fund, and the third is a T-
Bill money market fund that yields a rate of 8%. The probability distribution of
the risky fund is as follows

Expected Return % Standard deviation %

30
Stock Fund [S] 20
15
Bond Fund [B] 12
Correlation coefficient between Stock fund and Bond fund =0.10
g) Solve numerically for the proportions of each asset , the expected
return
and standard deviation of the optimal risky portfolio. (10)
h) Find the reward to variability ratio of the CAL supported by T-Bills and
Portfolio P. (2)
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 i) Calculate the complete portfolio allocated to P and to T-Bills if A=4.
Outline
your answer with a pie chart.(8)
[20
marks]

QUESTION 21 [ASGT1]

A pension fund manager is considering three mutual funds. The first is a stock fund,
the second is a long-term government and corporate bond fund, and the third is a
T-bill money market fund that yields a sure rate of 5.5%. The probability
distributions of the risky funds are:

Expected Return Standard Deviation

Stock fund (S) 15% 32%

Bond fund (B) 9 23

The correlation between the fund returns is 0.15.

a. Tabulate and draw the investment opportunity set of the two risky funds.
b. Use investment proportions for the stock fund of 0 to 100% in increments of 20%.
c. What expected return and standard deviation does your graph show for the
minimum variance portfolio?
d. Draw a tangent from the risk-free rate to the opportunity set. What does your
graph show for the expected return and standard deviation of the optimal risky
portfolio?
e. What is the reward-to-variability ratio of the best feasible CAL?
f. Suppose now that your portfolio must yield an expected return of 12% and be
efficient, that is, on the best feasible CAL.
i. . What is the standard deviation of your portfolio?
ii.. What is the proportion invested in the T-bill fund and each of the two risky
funds?
g. If you were to use only the two risky funds and still require an expected return of
12%, what would be the investment proportions of your portfolio? Compare its
standard deviation to that of the optimal portfolio in the previous problem. What
do you conclude?
[30
marks]

QUESTION 22
a. Several mechanisms have been put in place to mitigate the principal agency
problem. Explain in detail these mechanisms. (4)

b. Who are the clients of the financial system? Elaborate on the needs of each
of these clients. Also highlight how the environment has responded to the
clients’ demands.(5)

c. Calculate the gross proceeds, total costs and net proceeds of a bankers
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 Acceptance with the following details.(6)

Nominal value, N $10 000 000

Discount rate, I 10.5%
Term to maturity, d 90 days
Stamp duty, sd 0.03%
Commission, c 0.6%

d. Assume you bought a government $10 000 000 value Treasury bond on July
16,2006. The T-Bond matures on January 2,2009 and has a coupon rate of 11%
payable semi-annually and a yield (discount rate) of 7%. Calculate the T-
Bonds dirty price, accrued interest and clean price. Assuming that the bond is
Cum- interest and we use an actual/365 day convention.(10)

QUESTION 23

Bear Normal Bull

Probability 0.2 0.5 0.3

Rate of return on stock X -20% 18% 50%
Rate of return on stock Y -15% 20% 10%

a) What are the expected return of shares of stocks X and Y and also their
respective standard errors.(5)
b) Calculate the expected return as well as the standard deviation of the
Portfolio. (5)

NB. Assume that the portfolio is equally weighted between X and Y

QUESTION 24

Suppose we have two securities

E (rA) =20%
E (rB) =30%
A =25%
B =40%

Construct the following portfolios. Comment on your findings. (20)

WA WB E(rP) P P
(%) (%) (%) rA,B=25% rA,B=75%

a. 0 100
b. 100 0
c. 40 60

QUESTION 25

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A portfolio has an expected rate of return of 20% and standard deviation of 20%. Bills offer
a sure rate of return of 7%. Which investment alternative will be chosen by an investor
whose A=4? What if A=8. (5)

QUESTION 26

PPC ECONET
Rates of Return (%)
Probability
0.10 20 10
0.40 10 40
0.50 -5 45

Risk free return = 15%

A = 5
WPPC = 40%
WEC = 60%
Draw a pie chart to show how the investor will allocate their funds between the risky
portfolio (P) and the risk free asset. Illustrate your answer with a CAL. comment on
your findings. (20)

QUESTION 27

An analyst estimates that a stock has the following probabilities of return

depending on the state of the economy.

State of the economy Probability Return%

Good 0.1 15
Normal 0.6 13
Poor 0.3 7

a) Calculate the expected return as well as the standard error of the stock.
Comment on your findings. (5)

QUESTION 28

Based on the scenarios below, what is the expected return and standard deviation
for a portfolio with the following return profile? Comment. (5)

Bear Normal Bull

Probability 0.2 0.5 0.3

Rate of return on stock Y -25% 10% 24%

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 QUESTION 29

Suppose we have two securities

E (rX) = 40%
E (rY) = 60%
X = 20%
Y = 30%

Construct the following portfolios. Comment on your findings. (20)

WX WY E(rP) P P
(%) (%) (%) rX,Y=30% rXY=80%

a. 100 0
b. 0 100
c. 30 70

QUESTION 30

A portfolio has an expected rate of return of 20% and standard deviation of 20%. Bills offer
a sure rate of return of 10%. Which investment alternative will be chosen by an
investor whose A=3? What if A=10? (5)

QUESTION 31
A universe of available securities includes two risky stock funds, A and B, and Treasury
Bills. The data for the universe are as follows:

Expected Return (%) Standard Deviation (%)

A 10 20
B 30 60

T-bills 5 0

The correlation coefficient between A, B = -0.2

d) Find the optimal risky portfolio, P, and its expected return and standard
deviation.(10)
e) Find the slope of the CAL supported by T-Bills and Portfolio P. (2)
c) How much will an investor with A=5 invest in funds A, B and in T-Bills? (8)

Question 32
a. Define market and briefly discuss the characteristics of a good market. [6]
b. You own 100 shares of Econet stock and you want to sell it because you need the money
to make a down payment on a car. Assume there is absolutely no secondary market system
of shares. How would you go about selling the share? Discuss what you would have to do to
find a buyer, how long it might take, and the price you might receive.[5]
c. Define liquidity and discuss the factors that contribute to it. Give examples of a liquid
asset and an illiquid asset, and discuss why they are considered liquid and illiquid. [5]

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d. From your understanding what is liquidity? Compare the liquidity of an investment in
raw land with that of an investment in common stock. Be specific as to why and how they
differ.[5]

Question 33
a. Define a primary and secondary market for securities and discuss how they differ.
Discuss why the primary market is dependent on the secondary market.[5]
b. Give an example of an initial public offering (IPO) in the primary market. Give an
example of a seasoned equity issue in the primary market. Discuss which would involve
greater risk to the buyer. [5]
c. Briefly define each of the following terms and give an example:
i. Market order
ii. Limit order
iii. Short sale
iv. Stop loss order

Asset Allocation Decisions

Question 34 Grup C Nemaramba
a. Young people with little wealth should not invest money in risky assets such as the stock
market, because they can’t afford to lose what little money they have.” Do you agree or
disagree with this statement? Why? [5]
b. Your healthy 63-year-old neighbour is about to retire and comes to you for advice. From
talking with her, you find out she was planning on taking all the money out of her
company’s retirement plan and investing it in bond mutual funds and money market funds.
What advice should you give her?

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c. Discuss how an individual’s investment strategy may change as he or she goes through
the accumulation, consolidation, spending, and gifting phases of life. [10]

Question 35 GROUP B
a. Why is a policy statement important? How is the knowledge of a clients risk profile
important in the writing of an Investment Policy Statement [5;5]
b. Your 45-year-old uncle is 20 years away from retirement; your 35-year-old older sister is
about 30 years away from retirement. How might their investment policy statements
differ?[5]
c. What information is necessary before a financial planner can assist a person in
constructing an investment policy statement?

Question 36 Group D Mercy Machenjeke

Use the Internet to find the home pages for some financial-planning firms. What strategies
do they emphasize? What do they say about their asset allocation strategy? What are their
firms’ emphases: value investing, international diversification, principal preservation,
retirement and estate planning, and such? [20]
Question 37
Mr. Franklin is 70 years of age, is in excellent health, pursues a simple but active lifestyle,
and has no children. He has interest in a private company for $90 million and has decided
that a medical research foundation will receive half the proceeds now; it will also be the
primary beneficiary of his estate upon his death. Mr. Franklin is committed to the
foundation’s well-being because he believes strongly that, through it, a cure will be found
for the disease that killed his wife. He now realizes that an appropriate investment policy
and asset allocations are required if his goals are to be met through investment of his
considerable assets. Currently, the following assets are available for use in building an
appropriate portfolio:
$45.0 million cash (from sale of the private company interest, net of pending
$45 million gift to the foundation)
10.0 million stocks and bonds ($5 million each)
9.0 million warehouse property (now fully leased)
1.0 million Franklin residence
Total:
$65.0 million total available assets
Required
a. Formulate and justify an investment policy statement setting forth the appropriate
guidelines within which future investment actions should take place. Your policy

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statement must encompass all relevant objective and constraint considerations.[15]
b. Recommend and justify a long-term asset allocation that is consistent with the
investment policy statement you created in Part a. Briefly explain the key assumptions you
made in generating your allocation. [15]

International Investment Decisions

Question 38 Group E Manyanda
a. Discuss why international diversification reduces portfolio risk. [5]
b. Why would you expect low correlation in the rates of return for domestic and foreign
securities? [5]
c. Some investors believe that international investing introduces additional risks.
Substantiating your response with examples ,discuss these risks and how they can affect
your return.[5]

Question 39 Group F mugumba

a. Chris Smith of XYZ Pension Plan has historically invested in the stocks of only South
African based companies. Recently, he has decided to add international exposure to the
plan portfolio. Identify and briefly discuss three potential problems that Smith may
confront in selecting international stocks that he did not face in choosing SA stocks. [9]

b. TMP has been experiencing increasing demand from its institutional clients for
information and assistance related to international investment management. Recognizing
that this is an area of growing importance, the firm has hired an experienced
analyst/portfolio manager specializing in international equities and market strategy. His
first assignment is to represent TMP before a client company’s investment committee to
discuss the possibility of changing their present “U.S. securities only” investment approach
to one including international investments. He is told that the committee wants a
presentation that fully and objectively examines the basic, substantive considerations on
which the committee should focus its attention, including both theory and evidence. The
company’s pension plan has no legal or other barriers to adoption of an international
approach; no non-U.S. pension liabilities currently exist.

i. Identify and briefly discuss three reasons for adding international securities to the
pension portfolio and three problems associated with such an approach.[9]
ii. Assume that the committee has adopted a policy to include international securities in
its pension portfolio. Identify and briefly discuss three additional policy-level investment
decisions the committee must make before management selection and actual
implementation can begin. [11]

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Efficient Capital Markets
Question 40
Tom Max, TMP’s quantitative analyst, has developed a portfolio construction model about
which he is excited. To create the model, Max made a list of the stocks currently in the
S&P 500 Stock Index and obtained annual operating cash flow, price, and total return data
for each issue for the past five years. As of each year-end, this universe was divided into
five equal-weighted portfolios of 100 issues each, with selection based solely on the
price/cash flow rankings of the individual stocks.
Each portfolio’s average annual return was then calculated. During this five-year period,
the linked returns from the portfolios with the lowest price/cash flow ratio generated an
annualized total return of 19.0 percent, or 3.1 percentage points better than the 15.9
percent return on the S&P 500 Stock Index. Max also noted that the lowest price–cash-flow
portfolio had a below-market beta of 0.91 over this same time span.
a. Briefly comment on Max’s use of the beta measure as an indicator of portfolio risk in
light of recent academic tests of its explanatory power with respect to stock returns. [5]
b. You are familiar with the literature on market anomalies and inefficiencies. Against this
background, discuss Max’s use of a single-factor model (price–cash flow) in his research. [8
]
c. Identify and briefly describe four specific concerns about Max’s test procedures and
model design. (The issues already discussed in your answers to Parts a and b may not be
used in answering Part c.) [7]

[20 marks]
Question 41 Group G Tumburai
a. Briefly explain the concept of the efficient market hypothesis (EMH) and each of its
three forms—weak, semi strong, and strong—and briefly discuss the degree to which
existing empirical evidence supports each of the three forms of the EMH. [15]
b. Briefly discuss the implications of the efficient market hypothesis for investment policy
as it applies to:

(i) Technical analysis in the form of charting, and [4]

(ii) Fundamental analysis. [4 ]
c. Discuss the role/responsibilities of a portfolio manager in a perfectly efficient market
environment [9]
d. Briefly discuss whether active asset allocation among countries could consistently
outperform a world market index. Include a discussion of the implications of

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integration versus segmentation of international financial markets as it pertains to
portfolio diversification, but ignore the issue of stock selection. [6 ]

Question 42 Group H Mutarangani

I. Which of the following assumptions imply(ies) an informationally efficient market?
a) Many profit-maximizing participants, each acting independently of the others, analyze
and value securities.
b) The timing of one news announcement is generally dependent on other news
announcements.
c) Security prices adjust rapidly to reflect new information.
d) A risk-free asset exists, and investors can borrow and lend unlimited amounts at the
risk-free rate. [2]

II. If markets are efficient, what should be the correlation coefficient between stock
returns for two non overlapping time periods? [2]

III. Which of the following most appears to contradict the proposition that the stock
market is weakly efficient? Explain.
a. Over 25% of mutual funds outperform the market on average.
b. Insiders earn abnormal trading profits.
c. Every January, the stock market earns above normal returns. [4]

IV. Suppose, after conducting an analysis of past stock prices, you come up with the
following observations. Which would appear to contradict the weak form of the efficient
market hypothesis? Explain.
a. The average rate of return is significantly greater than zero.
b. The correlation between the market return one week and the return the following week
is zero.
c. One could have made superior returns by buying stock after a 10% rise in price and
selling after a 10% fall.
d. One could have made higher than average capital gains by holding stock with low
dividend yields. [4]

V. Which of the following statements are true if the efficient market hypothesis holds?
a. It implies perfect forecasting ability.
b. It implies that prices reflect all available information.
c. It implies that the market is irrational.
d. It implies that prices do not fluctuate. [2]

VI. A market anomaly refers to:

a. An exogenous shock to the market that is sharp but not persistent.
b. A price or volume event that is inconsistent with historical price or volume trends.

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c. A trading or pricing structure that interferes with efficient buying and selling of
securities.
d. Price behavior that differs from the behavior predicted by the efficient market
hypothesis.

VII. Which of the following observations would provide evidence against the semistrong
form of the efficient market theory? Explain. [4]
a. Mutual fund managers do not on average make superior returns.
b. You cannot make superior profits by buying (or selling) stocks after the announcement
of an abnormal rise in earnings.
c. Low P/E stocks tend to provide abnormal risk-adjusted returns.
d. In any year, approximately 50% of pension funds outperform the market.

Question 43 Group I Mahwaini

a. A successful firm like Delta Corporation has consistently generated large profits for
years. Is this a violation of the EMH? [4]

b. Prices of stocks before stock splits show on average consistently positive abnormal
returns. Is this a violation of the EMH? [4]

c. “If the business cycle is predictable, and a stock has a positive beta, the stock’s returns
also must be predictable.” Respond.[4]

d. “The expected return on all securities must be equal if markets are efficient.”
Comment. [4]

e. We know the market should respond positively to good news, and good news events
such as the coming end of a recession can be predicted with at least some accuracy. Why,
then, can we not predict that the market will go up as the economy recovers? [4]
f. If prices are as likely to increase or decrease, why do investors earn positive returns
from the market on average? [2]
g. You know that firm XYZ is very poorly run. On a management scale of 1 (worst) to 10
(best), you would give it a score of 3. The market consensus evaluation is that the
management score is only 2. Should you buy or sell the stock? [3]
h. Some scholars contend that professional managers are incapable of outperforming the
market. Others come to an opposite conclusion. Compare and contrast the assumptions
about the stock market that support

(a) passive portfolio management and (b) active portfolio management. [3;3]
Question 44
You are a portfolio manager meeting a client. During the conversation that followed your
formal review of her account, your client asked the following question: Prepared by A.

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Prepared by R. Mbizi (Mcom Finance, MBA, Bcom Econs, Diploma PGDHE, IOBZ Dip)
“My grandson, who is studying investments, tells me that one of the best ways to make
money in the stock market is to buy the stocks of small-capitalization firms late in
December and to sell the stocks one month later. What is he talking about?”
a. Identify the apparent market anomalies that would justify the proposed strategy. [8]
b. Explain why you believe such a strategy might or might not work in the future. [7]

Question 45 Group J Mandingindo

Which of the following phenomena would be either consistent with or in violation of the
efficient market hypothesis? Explain briefly.
a. Nearly half of all professionally managed mutual funds are able to outperform the S&P
500 in a typical year. [3]
b. Money managers that outperform the market (on a risk-adjusted basis) in one year are
likely to outperform the market in the following year. [3]
c. Stock prices tend to be predictably more volatile in January than in other months.[3]
d. Stock prices of companies that announce increased earnings in January tend to
outperform the market in February.[3]
e. Stocks that perform well in one week perform poorly in the following week.[3]

Question 46
“Growth” and “Value” can be defined in several ways, but “growth” usually conveys the
idea of a portfolio emphasizing or including only issues believed to possess above average
future rates of per-share earnings growth. Low current yield, high price-to-book ratios,
and high price-to-earnings ratios are typical characteristics of such portfolios. “Value”
usually conveys the idea of portfolios emphasizing or including only issues currently
showing low price-to-book ratios, low price-to-earnings ratios, above-average levels of
dividend yield, and market prices believed to be below the issues’ intrinsic values.
a. Identify and explain three reasons why, over an extended period of time, value stock
investing might outperform growth stock investing. [6]
b. Explain why the outcome suggested in (a) above should not be possible in a market
widely regarded as being highly efficient. [4]

PORTIFOLIO THEORY
Question 47 Group K Dhliwayo
a. Why do most investors hold diversified portfolios? [5]
b. What is covariance, and why is it important in portfolio theory?[5]

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c. Why do most assets of the same type show positive covariances of returns with each
other? Would you expect positive co variances of returns between different types of assets
such as returns on Treasury bills, General Electric common stock, and commercial real
estate? Why or why not? [5]

Question 48 Group G Fireyi

a. What is the relationship between covariance and the correlation coefficient?[5]
b. Explain the shape of the efficient frontier. [4] Draw a properly labelled graph of the
Markowitz efficient frontier. Describe the efficient frontier in exact terms. Discuss the
concept of dominant portfolios and show an example of one on your graph.[5]
c. Why are investors’ utility curves important in portfolio theory? [4]
d. Explain how a given investor chooses an optimal portfolio. Will this choice always be a
diversified portfolio, or could it be a single asset? Explain your answer.[5]
e. Assume that you and a business associate develop an efficient frontier for a set of
investments. Why might the two of you select different portfolios on the frontier? [5]

Question 49
a. Stocks K, L, and M each have the same expected return and standard deviation. The
correlation coefficients between each pair of these stocks are:

K and L is 0.8
K and M is 0.2
L and M is –0.4
Given these correlations, a portfolio constructed of which pair of stocks will have the
lowest standard deviation? Explain. [6]
b. Which of the following statements about the standard deviation is/are true? A standard
deviation:
i. Is the square root of the variance
ii. Is denominated in the same units as the original data.
iii. Can be a positive or a negative number. [4]

c. Which of the following statements reflects the importance of the asset allocation
decision to the investment process? The asset allocation decision:
a. Helps the investor decide on realistic investment goals.
b. Identifies the specific securities to include in a portfolio.
c. Determines most of the portfolio’s returns and volatility over time.
d. Creates a standard by which to establish an appropriate investment time
horizon. [4]

Question 50
The stock of Business Adventures sells for $40 a share. Its likely dividend payout and end-
of-year price depend on the state of the economy by the end of the year as follows:

Dividend Stock price

Boom $2 $50
Normal $1 $43
economy
Recession $ 0.50 $34

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Formulas: Investment Analysis and Portfolio Management

1.
MV =P 1+
[ (365d )( 100i )]
Issuing certificates of deposits

MV
C=

[ ( )( )]
1+
d
365 100
i

Dealing in certificates of deposits

2. Treasury Bills

Y= (360t )( DF )
P=F 1−
[ ( )] Yt
360

( 365∗y )
BeY =
360−( y∗t )
(360∗y )
CDeY =
360− yt

Tender Price=
F− 1∗
d
[
365 ]
Required discount rate= 100
∗[
P−TP 365
d
∗100]
F−TP 365
∗ ∗100
Actual yield= TP d

Consideration=
N− N∗
i
∗[d
100 365 ]
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3. Bankers Acceptances

TC=N
[ d
365
( c +i ) +sd ]
GP=N − N∗
i
∗
d
100 365 [ ]
E ( R A )=∑ Pr* R A
3.

4.
σ
A2
[
=∑ R A −E ( R A )2 Pr ]
COV A , B
r A , B=
5. σ A σB

6. E ( Rp )=E ( Ri ) Wi

2 2 2 2
7. σ 2 p=W A
σ A
+W B
σ B 2 COV A , B W A W B

E ( Rp )−Rf
Sp=
8. σp

E ( Rp )−Rf
Y ¿=
9. 0. 01∗A∗σ 2 p

E ( Rm)−Rf
Y=
10. 0 . 01∗A∗σ 2 p
2

WD =
[ E ( R D )− Rf ] σ E −[ E ( R E ) − Rf ] COV D , E
2 2

11. [ E ( R D ) −Rf ] σ E + [ E ( R E ) − Rf ] σ D−[ E ( R D )− Rf + E ( R E ) − Rf ] COV D , E

12. α = ER −[ Rf + βE ( Rm ) ]

D1 P1 −P0
HPR= +
13. P0 P0

14.
Ri =α+ βi Rm+ei

15. Rp=αp+ β pRm+ep

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 2
( ei )
16. σ 2 i=β 2 iσ 2 m +σ
Variance of the rate of return on a security

17.
COV ( Ri Rm )= βiσ 2 m

COV ( Ri ,R j ) =COV ( β i Rm; β j Rm)

18.
=βiβjσ 2 m

β=
[ COV ( R i Rm ) ]
19. σ2 m

n
1
( )∑ e t
2
2
σ (ei )=
20. n−2 t=1
Variance attributable to firm specific factors

¿ 2
1
( )
2
σ m=
n−1
∑ RM −RM
21.
β 2 σ 2 m= Variance attributable to market forces
n

22.
σ ( ep ) =∑
2

t =1
() 1 2 2
n
σ ei

2β2 σ 2 m
R=
23. σ2
2
σ 2( e i )
R =1− 2
i
σ

(∑ X ∑ Y )
∑ XY − n
β=
( ∑ X 2)
∑ X 2− n
24.
¿
¿ ¿
25. α=Y −β X

Cu−Cd
h=
26. uS−dS

27.
U =e
√
σ T
n
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 1
d=
28. u

1+rf −d
∏¿ u−d
29.

30.
C 0 =N ( d 1 ) S−Xe−rft N ( d 2 )

31.
P0 =X e−rfT N ( −d 2 ) −SN ( −d 1 )

32.
In ( ) ( )
S
X
+r +
σ2
2
T

33.
d 2 =d 1 −σ √ T

D1
P0 =
34. Ke−g

D 365
d= ∗
35. S T

S−P 365
Yield= ∗
36. P T

N −P 360
rbd = ∗
37. N T

[] [ ]
1 2 2 n−1
2
P
Q =n Q + Q ji
38. n n

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