Economics 1710

Midterm Exam 2
Professor Allan Feldman

November 6, 2008

Instructions: Please write you name on the exam questions and on your bluebook.
You must turn both in together. You must also initial the following

statement. If you do not initial the statement you will be penalized:

I will not discuss this exam with anyone before 2:30 p.m. on Nov. 6, 2008. I have not
discussed this exam with anyone before 2:30 p.m. on Nov. 6, 2006.

Note that there are 5 questions on this exam, with points as shown.
1.

(27 points. 3 points each.)

Define or explain briefly. (Note that a mathematical formula may be better than a
verbal explanation, and a well-labeled picture is worth a thousand words.)
(a) Beta, . For security i, i =

Cov(ri , rM )

.
M2
(b) Standard deviation, . is the (non-negative) square root of the variance.
(c) Capital market line. See picture.
(d) Security market line. See picture.
(e) Efficient frontier. See picture.
(f) Mutual fund theorem. Assume that there are n risky securities, and one risk
free; assume there is a set of investors, all of whom have beliefs about expected returns
and covariances for all the securities; assume that all the investors have the same beliefs.
Then every investor will want to split her money between the risk-free security and a
unique portfolio of risky securities. Moreover, that unique risky portfolio is the market
portfolio.
(g) Alt. A mortgage. A mortgage issued to a borrower who has provided lessthan-normal information about his/her income.
(h) Short sale of share of stock. An investor sells a borrowed share of stock,
hoping to replaces it later when the price is lower.
(i) Short sale of a house with a mortgage. A homeowner owes more on a
mortgage than the market value of the house. The mortgage owner allows the owner to
sell the house, and give the proceeds of the sale to the mortgage owner. In exchange, the
homeowner is released from mortgage, without a blot on his credit.
2.

(15 points. 3 points each.)

True or false. No explanation.

(a) According to the capital asset pricing model, firms offering securities such as
stocks and bonds should price them so as to maximize their firms
capitalizations. False.
(b) The capital allocation line is a list of stocks, published in Barrons, that
are recommended to experienced investors. False.
(c) According to the capital asset pricing model, an investor should divide his
wealth into 2 parts, as follows: a percentage y should be put in a market
index fund, a percentage 1-y should be put in a risk-free asset, and the
percentage y in the index fund should equal 100 minus the investors age.
False.
(d) Cov(rX , rY + rZ ) = Cov(rX , rY ) + Cov(rX , rZ ) + 2Cov(rY , rZ ) . False.
(e) Market efficiency is monitored by the SEC and other regulatory agencies.
False.

3.

(20 points. 10 points each.)

Stocks offer an expected rate of return of 18 percent, with a standard deviation of
22 percent. Gold offers an expected return of 10 percent with a standard
deviation of 30 percent.
(a) In light of the apparent inferiority of gold with respect to both expected
return and volatility, would an investor hold positive amounts of gold? If so,
demonstrate with a graph. If not, demonstrate with a graph. If yes and no,
provide two graphs. See pictures.
(b) Given the data above, re-answer part (a) with the additional
assumption that the correlation coefficient between gold and stocks
equals minus 1. In your graph, show how an investor could mix stocks and
gold and end up with a portfolio standard deviation of zero. Find the weights
which would produce the zero standard deviation. See picture.
The locus of investment possibilities is a pair of straight lines, one passing
through G and one passing through S. The straight lines intersect on the
vertical axis. At the intersection, wG G = wS S and wG + wS = 1 . Solving
S
.22
simultaneously gives wG =
=
= .423 and
G + S .52
G
.30
wS =
=
= .577 .
G + S .52

4.

(21 points. 7 points each.)

An investor is choosing a combined portfolio C , made up of a risky security P
and risk-free security F . Assume that E (rP ) = 0.15 , rf = 0.07 , and P = 0.20 .

Assume she puts a fraction y of her money in the risky security, and a fraction
1 y in the risk-free security.
(a) Sketch a graph of her capital allocation line. What is its slope and intercept?
See picture. Slope = .08 / .20 = 0.4. Intercept = 0.07.
(b) What would the expected return and standard deviation of C be if
(i) y = 0.5 ? Exp. return = 0.11, s.d. = 0.10.
(ii) y = 2.0 ? Exp. return = 0.23, s.d. = 0.40.
(c) Assume the investor has utility function U = E ( rC ) 0.5 C2 . What C does
she choose? From an equation for an indifference curve we find the slope is
dE (rC )
= C . Now set this equal to the slope of CAL, which is 0.4. This
d C
gives C = 0.4 .
5.

(17 points.)
Assume the risk free return is rf = 0.06 , and the expected rate of return on the
market is E (rM ) = 0.16 . A share of stock sells for $50 today. It is expected to
pay a dividend of $6 per share in one year. Assume = 1.2 for this stock. What
do investors expect the stock price to be in one year?
Investors are looking for a rate of return from the beta equation of
E ( r ) = rf + (( E (rM ) rf ) = 0.06 + 1.2(0.10) = 0.18 . But the rate of return equals
the capital gain plus the dividend, divided by the initial price. Let p0 be todays
price and p1 be the expected price in one year. Then
p1 p0 + 6 p1 44
=
= 0.18 . This implies p1 = 53 .
p0
50