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1st Test

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21 views3 pages

1st Test

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carlos.nascimento.work
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FEUC

_________________________ Financial and Risk Economics ______________________

Academic year: 2023 / 2024 Test Date: 02 / 11 /2023


Courses: ME, MG, PEDEA, MMQF Duration: 1 h 15 m

Note: The points for each question are in brackets.

[3 p.] 1. In world where everything is known with certainty, an individual had the endowments
of 1000 and 0 in years 1 and 2, respectively. Suppose that he has made the following decisions:
in year 1 invested productively 150, with a marginal rate of return of 8%, and a final value of
180; and in year 2 he consumed 288, which was all his wealth in that year.
[1 p.] 1.1. What is the consumption and financial investment (borrowing or lending) in year 1?
[2 p.] 1.2. If the interest rate is 7,5%, compared to the previous situation, would this individual
increase or decrease his utility? Using a graph, explain your answer.

[4 p.] 2. Suppose the following function: 𝑈(𝑊) = 4𝑊 − 0,04𝑊 . Assume that an economic
agent has the possibility to invest in an asset whose possible outcomes are 15 and 25, with
probabilities ¼ and ¾, respectively.
[1 p.] 2.1. Define the domain for which the function U(W) can represent a utility function. Justify.
[1 p.] 2.2. Compute the expected result of the asset.
[1 p.] 2.3. Compute the expected utility of the asset.
[1 p.] 2.4. Explain the statement that this economic agent has a positive risk premium.

[4 p.] 3. Financial markets are subject to high levels of uncertainty and risk that impact the
expected returns and volatility of financial assets.
[2 p.] 3.1. Suppose that two assets (L and H) are combined in a portfolio in such a way that the
risk of the portfolio is completely canceled out.
What would be the weight of each asset in the portfolio knowing that the risk of asset L is
L =0,09 and that of asset H is H =0,15.
[2 p.] 3.2. In the light of the Mean Variance model, what is the meaning of diversification?
Explain the effect of diversifying an investor’s portfolio of assets (considering N assets).
FEUC
[4,5 p.] 4. Suppose that, in a certain financial market, the portfolio composed by two assets has
the following characteristics:
Asset E(Ri) i weights
A 20% 0,75 0,4
B 16% 0,50 0,6

Consider that 𝜌 = −0,6


[2.5 p.] 4.1. Determine the expected return and the variance of this portfolio.
[2 p.] 4.2. Is it possible to have a weight of -0,75 for asset A and 1,75 to asset B? What does it
mean? Justify your answer.

[4,5 p.] 5. According to the CAPM two asset have the following characteristics:
E(Ri) βi
Asset 1 6% 0,5
Asset 2 10% 1,1

[2.5 p.] 5.1. What is the expected return of the riskless asset and of the market portfolio?
[2 p.] 5.2. Knowing that 𝜎 = 0,8 what is the covariance between asset 1 and the market
portfolio? Calculate also the covariance between asset 2 and the market portfolio.
FEUC
Correction grid
1.1.(1.p) C2=288>180, the individual receives the value of its financial investment.
Financial investment in year 2 = 288 -180 =108; Financial investment in year 1 = 108/(1+0,08)=100
C1= 1000-150-100=750
1.2. (2 p.) Graph where the line of financial investment with r=7,5% has a lower slope. This individual
decreases his utility since the gain decreases. In the graph the indifference curve indicates less utility.

2.1. (1 p.) U’(W)=4-0,08W>0; W<50


2.2. (1 p.) E(W) = 15x¼ +25x ¾ =22,5
2.3 (1 p.) E[U(W)] = ¼ (4x15-0,04x152)+ ¾ (4x25-0,04x252)=69
2.4. (1 p.) He is risk averse, it has a positive risk premium.

3.1. (2 p.) The risk is equal to zero → ρLH=-1


XL+XH=1  XH= 1-XL
/
σ = 𝑋 𝜎 + (1 − 𝑋 ) 𝜎 − 2𝑋 (1 − 𝑋 )𝜎 𝜎 =0

XL = σH /( σL + σH ) =0,625
e XH=0,375
3.2. (2 p.) A portfolio composed by N assets with Xi=1/N has a variance equal to
1
𝜎 = 𝜎 − 𝜎, +𝜎,
𝑁
The variance tends to the value of the average covariance (graph)

4.1 (2,5 p.) Rp= 0,4x0,2+0,6x16=0,176


σP2 = (0,4)2x(0,75)2 + (0,6)2x(0,5)2+ 2x0,4x0,6x(-0,6)x0,75x0,5 = 0,072
4.2 (2 p.) It is possible, it means that there is a negative position in the asset A (short-selling). The asset
A represents a source of funds. These funds are applied in asset B and XA+XB=1
Rp= 0,23 and variance = 2,17265

5.1 (2,5 p.) Resolution of a system:


First line (R1)=rf+ (E(Rm)-rf) β1 0,6=rf+0,5E(Rm) -0,5 rf
Second line (R2)= rf+ (E(Rm)-rf) β2 0,1=rf+1,1E(Rm) -1,1 rf
Results: rf=0,0267 e E(Rm)=0,0933
5.2 (2,5 p.) βi=cov i,M/varM

cov1M=0,4 and cov2M=0,88

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