ACTL3004/5109 FINANCIAL ECONOMICS

Draft Solutions to Mid-Session Exam, S2, 2012

1. (a) For the market, the mean is
E (Rm ) = (0.22 + 0.15 0.06)

1
= 0.1033
3

and variance is

1
V ar (Rm ) = 0.222 + 0.152 + 0.062 (0.1033)2 = 0.01416.
3
The CML equation is thus given by
E (Rp ) = rF +

p
[E (Rm ) rF ]
m

for any efficient portfolio p. Thus, the CML equation is

p
[0.1033 0.06]
0.119
= 0.06 + 0.3642 p ,

E (Rp ) = 0.06 +

written as a function of the portfolio standard deviation.

(b) The SML equation is given by
E (Rp ) = rF + p [E (Rm ) rF ]
for any portfolio p. Thus, the SML equation is
E (Rp ) = 0.06 + p [0.1033 0.06]
= 0.06 + 0.0433 p ,
written as a function of the security beta.
(c) For security A, its mean is
E (RA ) = (0.25 + 0.20 0.10)

1
= 0.1133
3

Since
Cov (RA , Rm ) = E [(RA E (RA )) (Rm E (Rm ))] = 0.019288,
We have
A =

Cov (RA , Rm )
= 1.3626.
2
m

According to the Security Market Line, the expected return for security A would
be
E (RA ) = 0.1190.
which illustrates that the analysts prediction are not consistent with CAPM.
1

2. (a) Both have mean return of 7%. For the risk measures: For A:
Variance is
1
((0 0.07)2 + (0.03 0.07)2 + (0.18 0.07)2 ) = 0.0062
3
Semi Variance is
1
((0 0.07)2 + (0.03 0.07)2 = 0.00216667
3
shortfall probability vs benchmark of 3.5% is 2/3
For B:
Recall that a poisson random variable has the same variance as its mean.
Hence variance is
0.022 V ar(Y ) = 0.022 (3.5) = 0.0014
Semi Variance is
P (Y = 0)(0 0.07)2 + P (Y = 1)(0.02 0.07)2
+P (Y = 2)(0.04 0.07)2 + P (Y = 3)(0.06 0.07)2
= 0.00060024
shortfall probability vs 3.5% is
P (Y = 0) + P (Y = 1) = 0.136
(b) Observe that the utility is defined on the wealth (not the returns), although we
have, for random return R,
W = 10000(1 + R)
Since he will make decisions according to expected utility with a quadratic utility,
he considers
E[U (W )] = E[W ] b(V ar(W ) + (E[W ])2 )
but we see that
V ar(W ) = V ar(10000(1 + R)) = 100002 V ar(R)
and since the mean returns (and hence E[W ] is the same for both assets, under
quadratic utility he will prefer the asset with the lower variance i.e. Asset B.
3. (a) The covariance (with tangency portfolio returns) vector is
z r1
(10 1 z) r (10 1 1)

= wt =

while the variance of the tangency is

t2 = wt0 =

wt0 z r
(10 1 z) r (10 1 1)

hence on solving for (10 1 z) r (10 1 1) we have

z r1 =

zt r
t2

where each component is equation (1) in the question.

(b) Mathematically it is similar, but economically it is different. CAPM is an equilibrium model where via economic arguments we have that the tangency is the
market portfolio (in which case we have the security market line, where in equation 1 we replace zt by zm ), where we have assumed that the riskless asset is in
zero net supply. However until the economic ideas are included they are not the
same. For example, the tangency portfolio may well have negative weights in
individual assets, whereas the market portfolio must have positive weights.
4. (a) We have
zA = 0.05 + 0 + 0.5(0.06) + 1.5(0.05) = 15.5%
zB = 0.05 + 0.75(0.02) + 0.8(0.06) + 0.8(0.05) = 15.3%
(b) The betas are weighted average of the individual betas, so
1 = 0.6(0) + 0.4(0.75) = 0.3
2 = 0.62
3 = 1.22
the expected return can be calculated using betas, or just by weighted average of
the answers in (a) to get 15.42%