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FIN 4600 Practice Mid-Term Exam #1- Robert Uptegraff

Investment Analysis & Portfolio Management (Oakland University)

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Oakland University
FIN 4600 Investment & Portfolio Management
Mid-Term Exam #1-Practice
30 Questions

Mutual Fund and Other Investment Companies:

1) You are considering an investment in a mutual fund with a 3% load and an expense ratio of
0.75%. You can invest instead in a bank CD paying 5% interest. If you plan to invest for six years,
what annual rate of return must the fund portfolio earn for you to be better off in the fund than
in the CD? Assume annual compounding of returns.

If you invest for six years, then the portfolio return must satisfy:
0.97 × (1 + r − 0.0075)6 > (1.05)6 = 1.3401
(1 + r − 0.0075)6 > 1.3815
1 + r − 0.0075 > 1.0553
1 + r > 1.0628
r > 6.28%

2) You purchased 1,200 shares of the New Fund at a price of $20 per share at the beginning of the
year. You paid a front-end load of 4%. The securities in which the fund invests increase in value
by 10% during the year. The fund's expense ratio is 1.4%. What is your rate of return on the fund
if you sell your shares at the end of the year?

Because the 4% load was paid up front and reduced the actual amount invested, only 96% (1.00 − 0.04)
of the contribution was invested. Given the value of the portfolio increased by 10% and the expense
ratio was 1.4%, we can calculate the end value of the investment against the initial contribution:

1 + r = 0.96 × (1 + 0.10 − 0.014) = 1.0426

Thus, the rate of return was: 1.0426 − 1 = 0.0426 = 4.26%

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3) Consider a mutual fund with $216 million in assets at the start of the year and with 10 million
shares outstanding. The fund invests in a portfolio of stocks that provides dividend income at the
end of the year of $2 million. The stocks included in the fund's portfolio increase in price by 9%,
but no securities are sold, and there are no capital gains distributions. The fund charges 12b-1
fees of 1.00%, which are deducted from portfolio assets at year-end. What is the rate of return
for an investor in the fund?

Given the dividends per share is $0.20, we can calculate the rate of return using the following equation:

Δ(NAV) + Distributions
Rate of return =
Start of year NAV

($23.309 − $21.600) + $0.20

=
$21.600

= 0.884 or .84%

4) Consider a no-load mutual fund with $325 million in assets and 13 million shares at the start of
the year and with $375 million in assets and 14 million shares at the end of the year. During the
year investors have received income distributions of $3 per share and capital gain distributions
of $0.20 per share. If the fund carries no debt, and that the total expense ratio is 2%, what is the
rate of return on the fund?

NAV0 = $325/13 = $25.00

NAV1 = [$375 – ($375 × 0.02)]/14 = $26.25
Gross return = ($26.25 – $25 + $3 + $0.20)/$25 = 17.80%

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Risk, Return, and the Historical Record:

5) You invested in a 3-month certificate of deposit at your bank. Your investment was $2,036, and
at the end of the term you will receive $2,394. What is the holding period return (HPR) on your
investment? What is the annual percentage rate (APR)? What is the effective annual rate (EAR)?

The HPR equals (2,394 – 2,036) / 2,036 = 17.58%

The APR is the 3-month rate times the number of three-month periods in one year.

APR = 17.58% × (12/3) = 70.33%

The EAR is calculated as:

1+ EAR =(1+APRn)n = (1+0.70334)4 = 1.91151⁢+ EAR =(1+APRn)n = (1+0.70334)4 = 1.9115

EAR = 91.15%

6) The following data represent the probability distribution of the holding period returns for an
investment in Lazy Rapids Kayaks (LARK) stock.

State of the Economy Scenario #(s) Probability, p(s) HPR

Boom 1 0.336 28.40%
Normal growth 2 0.414 7.90%
Recession 3 0.25 -18.90%

a. What is the expected return on LARK?

b. What is the standard deviation of the returns on LARK?

a. The expected return is:

E(r) = Σs=13 p(s)r(s) = 0.336×28.40%+0.414×7.90%+0.25×(−18.90%) =8.09%

b. The standard deviation is the square root of the variance. The variance is given by the formula:

VAR⁢(r) =Σs= p(s)[r(s)−E(r)]2

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To find the variance of the returns it is helpful to set up a table for the calculations. Each column in the
table below has a column number at the top (indicated in parentheses), which is used to indicate how
the column is used in calculations.

(1) (2) (3) (4) (5) (6)

State of the EconomyProbability, p(s) HPR HPR - E(r) (4) squared (2) × (5)
Boom 0.336 28.40% 20.31% 0.041257734 0.013862599
Normal growth 0.414 7.90% -0.19% 0.000003534 0.000001463
Recession 0.25 -18.90% -26.99% 0.072835214 0.018208804

VAR = sum of (6) = 0.032072866

SD =VAR−−−−√VAR = 17.91%

7) The common stock of Perforated Pool Liners, Inc. now sells for $47.00 per share. The table below
shows the anticipated stock price and the dividend to be paid one year from now. Both the price
and the dividend will depend on the level of growth experienced by the firm.

State Probability, p(s) End-of-Year Price Annual Dividend

Super high growth 0.090 $59 $3
High growth 0.198 $58 $3
Normal growth 0.400 $56 $2
Low growth 0.200 $50 $2
No growth 0.112 $46 $0

a. Calculate the holding period return (HPR) for each of the possible states, assuming a one-year holding
period.

b. What is the expected return for a holder of Perforated Pool Liners stock?

c. What is the standard deviation of the returns?

a. The holding period return (HPR) for each state is calculated as

End of year price + Dividend - Beginning of year price

HPR =
Beginning of year price

State End-of-Year Price Annual Dividend HPR

Super high growth $59 $3 (59+3-47)/47 = 31.91%
High growth $58 $3 (58+3-47)/47 = 29.79%
Normal growth $56 $2 (56+2-47)/47 = 23.40%
Low growth $50 $2 (50+2-47)/47 = 11%
No growth $46 $0 (46+0-47)/47 = -2.13%

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b. The expected return is:

E(r) = Σs p(s)r(s)E(r)
= 0.090 × 31.91% + 0.200 × 30% + 0.400 × 23% + 0.200 × 10.640% + 0.090 × (-2.13%) = 20.02%

c. The standard deviation is the square root of the variance. The variance is given by the formula
VAR(r)=Σs p(s)[r(s)−E(r)]2

since there are 5 possible outcomes. The calculations are shown in the table below. Each column in the
table has a column number at the top (indicated in parentheses), which is used to indicate how the
column is used in calculations.

(1) (2) (3) (4) (5) (6)

State HPR (from part
Probability p(s) a) HPR - E(r) (4) squared (2) × (5)
Super high 0.090 31.91% 11.89% 0.014146 0.001273
growth
High growth 0.198 29.79% 9.77% 0.009537 0.001888
Normal growth 0.400 23.40% 3.38% 0.001144 0.000458
Low growth 0.200 10.64% -9.38% 0.008804 0.001761
No growth 0.112 -2.13% -22.15% 0.049058 0.005494

Variance 0.010875
Std. deviation 10.43%

8) You earned a nominal rate of return equal to 11.10% on your investments last year. The annual
inflation rate was 2.90%.

a. What was your approximate real rate of return?

b. What was your exact real rate of return?

a. The approximate rate of return equals the nominal rate minus the inflation rate:

r≅R – i = 11.10% − 2.90% = 8.20%.

b. The exact real rate of return is calculated from the equation

1+r= (1+R)/ (1+i) = 1.111/1.029= 1.0797

r = 7.97%

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9) You are the manager of the Mighty Fine mutual fund. The following table reflects the activity of
the fund during the last quarter. The fund started the quarter on January 1 with a balance of $80
million and will be liquidated at the end of March.

Mighty Fine Mutual Fund

Monthly Data (measured at end of month)
January February March
Net inflows ($ million) 4.9 -4.8 0
HPR (%) -1.10 5.90 5.80

a. Calculate the quarterly arithmetic average return on the fund.

b. Calculate the quarterly geometric (time-weighted) average return on the fund.

c. Calculate the quarterly dollar-weighted average return on the fund.

a. The arithmetic average equals the sum of the months’ returns divided by the number of months.

Arithmetic average =−1.10+5.90 + 5.803 = 3.53%

b. Geometric average = [(1-.011) × (1+.059) × (1+.058)] 1/3-1 = 3.48%

c. To find the dollar-weighted average return, first determine the net inflows and outflows, and then
calculate the internal rate of return.

January February March

Assets under management at beginning of month (million) 80 84.02 84.18
Investment profits during the month (HPR x Assets) -0.88 4.96 4.88
Net inflows during the month 4.9 -4.8 0.00
Assets under management at end of month 84.02 84.18 89.06

The timing of the relevant cash flows is shown below. The initial portfolio value can be considered an
outflow (investment). The ending portfolio value can be considered an inflow, as if the portfolio is
liquidated at that time. The relevant cash flows are shown below.

0 1 2 3
Net cash flow -80 4.9 -4.8 89.06

The internal rate of return is the rate that solves the equation:

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−80 = 4.9(1+IRR) +−4.8(1+IRR)2+89.06(1+IRR)3

IRR = 3.75%
Efficient Diversification:

10) The standard deviation of return on investment A is 28%, while the standard deviation of return
on investment B is 23%. If the covariance of returns on A and B is 0.005, the correlation
coefficient between the returns on A and B is?

0.005
Correlation= =0.078
[0.28(0.23)]

11) A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of
27%, while stock B has a standard deviation of return of 21%. Stock A comprises 70% of the
portfolio, while stock B comprises 30% of the portfolio. If the variance of return on the portfolio
is 0.046, the correlation coefficient between the returns on A and B is?

0.046 = (0.72) (0.272) + (0.32) (0.212) + 2(0.7) (0.3) (0.27) (0.21) ρ;

ρ = 0.265

12) The standard deviation of return on investment A is 26%, while the standard deviation of return
on investment B is 21%. If the correlation coefficient between the returns on A and B is −0.256,
the covariance of returns on A and B is?

Covariance = –0.256 (0.26) (0.21) = –0.0140

13) An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected
return of 20% and a standard deviation of return of 12.5%. Stock B has an expected return of
16% and a standard deviation of return of 5%. The correlation coefficient between the returns of
A and B is 0.80. The risk-free rate of return is 12%. The proportion of the optimal risky portfolio
that should be invested in stock A is?

W (0.20 – 0.12) (0.05)2 – (0.16 – 0.12) (0.05) (0.125) (0.80)

=
A (0.20 – 0.12) (0.80)2 + (0.16 – 0.12) (0.125)2 – (0.20 – 0.12 + 0.16 – 0.12) (0.05) (0.12) (0.80)

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WA = 0

Since the numerator equals zero, WA = 0 without any further calculations

14) An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected
return of 16% and a standard deviation of return of 30%. Stock B has an expected return of 11%
and a standard deviation of return of 15%. The correlation coefficient between the returns of A
and B is .5. The risk-free rate of return is 5%. The proportion of the optimal risky portfolio that
should be invested in stock B is approximately?

W (0.11 − 0.05) (0.302) − (0.16 − 0.05) (0.15) (0.30) (0.5)

=
B (0.11 − 0.05) (0.302) + (0.16 − 0.05) (0.152) − (0.11 − 0.05 + 0.16 − 0.05) (0.15) (0.30) (0.5)

WB = 72%

15) You find that the annual Sharpe ratio for stock A returns is equal to 1.94. For a 5-year holding
period, the Sharpe ratio would equal?

The Sharpe ration grows at a rate of s1√ T so the 5-year Sharpe ration would be 1.94 ×√ 5 = 4.34

16) The expected return of a portfolio is 10.8%, and the risk-free rate is 2%. If the portfolio standard
deviation is 13%, what is the reward-to-variability ratio of the portfolio?
Reward-to-variability ratio = (0.108 – 0.020)/0.13 = 0.68

17) The expected return of a portfolio is 10.6%, and the risk-free rate is 4%. If the portfolio standard
deviation is 20%, what is the reward-to-variability ratio of the portfolio?

Reward-to-variability ratio = (0.106 – 0.040)/0.20 = 0.33

18) A stock has a correlation with the market of 0.51. The standard deviation of the market is 27%,
and the standard deviation of the stock is 35%. What is the stock's beta?

β= COV rir =ρσriσrm =(0.51) (0.35) (0.27)= 0.66

m

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σ2rm σ2rm 0.272

19) A portfolio is composed of two stocks, A and B. Stock A has a standard deviation of return of
29%, while stock B has a standard deviation of return of 20%. Stock A comprises 60% of the
portfolio, while stock B comprises 40% of the portfolio. If the variance of return on the portfolio
is 0.051, the correlation coefficient between the returns on A and B is _________.

0.051 = (0.62) (0.292) + (0.42) (0.202) + 2(0.6) (0.4) (0.29) (0.20) ρ; ρ = 0.515

Capital Asset pricing and Arbitrage Pricing Theory:

20) Consider the single factor APT. Portfolio A has a beta of 1.2 and an expected return of 24%.
Portfolio B has a beta of .8 and an expected return of 20%. The risk-free rate of return is 7%. If
you wanted to take advantage of an arbitrage opportunity, you should take a short position in
portfolio __________ and a long position in portfolio _________.

0.24 – 0.07 0.20 – 0.07

< ; Short A; Buy B
1.2 0.8
A B

21) You have a $41,000 portfolio consisting of Intel, GE, and Con Edison. You put $22,800 in Intel,
$8,400 in GE, and the rest in Con Edison. Intel, GE, and Con Edison have betas of 1.3, 1, and .8,
respectively. What is your portfolio beta?

(22.841) (1.3) + (8.441) (1.0) + (9.841) (0.8) =1.119

22) Consider the CAPM. The risk-free rate is 8%, and the expected return on the market is 19%.
What is the expected return on a stock with a beta of 1.8?

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E[rs] = 8% + 1.8[19% – 8%] = 27.8%

23) Consider the CAPM. The expected return on the market is 19%. The expected return on a stock
with a beta of 1.8 is 27%. What is the risk-free rate?

27% = rF + 1.8(19 – rF); rF = 9%

24) The expected return on the market portfolio is 14%. The risk-free rate is 7%. The expected return
on SDA Corp. common stock is 13%. The beta of SDA Corp. common stock is 1.60. Within the
context of the capital asset pricing model, what is SDA’s alpha on its common stock?

α = 0.13 – [0.07 + 1.60(0.14 – 0.07)] = –0.0520

25) You consider buying a share of stock at a price of $21. The stock is expected to pay a dividend of
$2.04 next year, and your advisory service tells you that you can expect to sell the stock in 1 year
for $24. The stock's beta is 1.2, rf is 8%, and E[rm] = 18%. What is the stock's abnormal return?
rev: 03_30_2019_QC_CS-164617
E[r] = [24 − 21 + 2.0421]/21 x (100%) = 24%

Required return = 8% + 1.2(18% – 8%) = 20%

Abnormal return = 24% – 20% = 4%

Efficient Markets Hypothesis:

26) You are an investment manager who is currently managing assets worth $6 billion. You believe
that active management of your fund could generate an additional one-tenth of 1% return on
the portfolio. If you want to make sure your active strategy adds value, how much can you spend
on security analysis?

(.001) ($6 billion) = $6,000,000

27) Even if the markets are efficient, professional portfolio management is still important because it
provides investors with of the following?

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I. Low-cost diversification
II. A portfolio with a specified risk level
III. Better risk-adjusted returns than an index
I and II above

28) The term random walk is used with investments to refer to what?

stock price changes that are random and unpredictable

29) What are some of the important characteristics of market efficiency?

I. There are no arbitrage opportunities

II. Security prices react quickly to new information
III. Active trading strategies will not consistently outperform passive strategies

30) Assume that a company announces unexpectedly high earnings in a particular quarter. In an
efficient market, what would be expected in terms of the stock price reaction?
An abnormal price change immediately after the announcement

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