1.Choose one question to answer from Section A. Answers need to be presented in an essay form. 2.The answer to the essay-type question in Section A should not exceed a 2-sided A4 size paper. 3.Answer all numerical questions in Section B. Show all your calculations. 4.All answers must be typed using font size 12.

5.Hand in your coursework to the student office on or
6.before the deadline and retain the receipt as proof of submission.

Section A: Essay Questions (50%)

Question 1:

Discuss whether the Arbitrage Pricing Model is a better model than the Capital Asset Pricing Model in estimating a security’s expected return.

Question 2:

Do financial instrument traded in the money markets and the capital markets have the same characteristics? Give examples to explain.

Question 3:

‘Market efficiency does not mean that share prices can be forecasted with accuracy’. Do you agree with this statement? Explain your answer.

Section B: Numerical Questions (50%)

Question 1: (20%)

Use the following information to answer part a to c.

An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns A and B is 0.4. The risk-free rate of return is 5%.

a.Find the proportion of the optimal risky portfolio that should be invested in stock B. b.Find the expected return on the optimal risky portfolio.
c.Find the standard deviation of the returns on the optimal risky portfolio.

Question 2: (15%)

Assume that both X and Y are well-diversified portfolios and the risk-free rate is 8%. Portfolio X has an expected return of 14% and a beta of 1.00. Portfolio Y has an expected return of 9.5% and a beta...

...Chapter 10
Arbitrage Pricing Theory and Multifactor Models of Risk and Return
Multiple Choice Questions
1. ___________ a relationship between expected return and risk.
A. APT stipulates
B. CAPM stipulates
C. Both CAPM and APT stipulate
D. Neither CAPM nor APT stipulate
E. No pricingmodel has found
Both models attempt to explain assetpricing based on risk/return relationships.
Difficulty: Easy
2. ___________ a relationship between expected return and risk.
A. APT stipulates
B. CAPM stipulates
C. CCAPM stipulates
D. APT, CAPM, and CCAPM stipulate
E. No pricingmodel has found
APT, CAPM, and CCAPM models attempt to explain assetpricing based on risk/return relationships.
Difficulty: Easy
3. In a multi-factor APT model, the coefficients on the macro factors are often called ______.
A. systemic risk
B. factor sensitivities
C. idiosyncratic risk
D. factor betas
E. B and D
The coefficients are called factor betas, factor sensitivities, or factor loadings.
Difficulty: Easy
6. Which pricingmodel provides no guidance concerning the determination of the risk premium on factor portfolios?
A. The CAPM
B. The multifactor APT
C. Both the CAPM and the multifactor APT
D. Neither the CAPM nor the...

...1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
Undiversifiable (market )risk:
Market risk is the variability in all riskyassets caused by macroeconomic variables. This risk cannot be avoided, regardless of the amount of diversification. Systematic risk (Market risk) factors are those macroeconomic variables that affect the valuation of all riskyassets such as variability in the growth of the money supply, interest rate volatility, variability in aggregate industrial production, and natural shocks like drought, earth quake, hurricane, etc.
Diversifiable (unique )risk:
Many of the risks faced by an individual company are peculiar to its activity, its management, etc. These are the unique risks and can be diversified away. Examples of unique risks are a company winning a large contract, wildcat strikes hitting a company, litigation hitting a company or the company facing a governmental investigation.
a. A large fire severely damages three major U.S. cities.
Diversifiable risk
The entire economy will not be affected by a large fire in three major US cities. In fact some companies in cities not affected by fire will benefit as they will meet the demand not being met by companies...

...each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There's a substantial unexpected increase in inflation.
b. There's a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.
2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the MarketPortfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.
b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8.
c. What do you think the Beta (β) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.
3. In one page explain what you think is the main 'message' of the CapitalAssetPricingModel to corporations and what is the main message of the CAPM to investors?
1. For each of the scenarios below, explain whether or not it represents a diversifiable or an un-diversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There’s a substantial...

...CapitalAssetPricingModel (CAPM): Pros and Cons.
CAPM defines the relationship between risk and return. The premise of the model is that the expected investment return varies in direct proportion to its risk, i.e., the riskier the investment - the higher the return you should expect.
Shows:
• how much risk you are taking when investing in an instrument?
• whether the instrument is rightly priced
• whether you are getting sufficient return for the risk you are taking
CAPM calculates the risk-adjusted discount rate with the risk-free rate, the market risk premium, and beta (mathematical formula):
Return (R) = Rf + beta x (Rm - Rf)
Rf is the rate of risk-free investments
Beta - the risk of loss associated with your investments.
Rm is the expected market return.
(Rm-Rf) – market risk premium
beta x (Rm - Rf) – risk premium of specific company
Investments are good if the expected return from the investment equals/exceeds required return.
Market Risk Premium [Rm-Rf]
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk
Its size depends on the perceived risk of the overall stock market and investors’ degree of risk aversion
Varies across time. Usually ranged between 4-8%
BETA in CAPM measures a stock’s degree of systematic or market risk. It can also be thought of as the stock’s contribution to the risk of a...

...CAPITALASSETPRICINGMODEL
The CapitalAssetPricingModel deals with independent investor problems that needs to undergo the procedure of selection of securities involving risks. The investors need to select the most advantageous security that produces the best possible outcome. This model deals with the estimation of securities as well as it links the risk and return (the expected shares). There is a direct relationship and risk and return provides higher expected return from that security. CAPM is considered the key model for helping in decision making regarding the selection of securities and also helps in planning the strategies.
Types Of Risks – The unsystematic or the diversifiable risk is related to the haphazard causes which can be eradicated or removed with the help of diversification. Similarly the systematic or the non-diversifiable risk is related to the factors of the market which cannot be removed with the help of diversification. The permutation of both the risks is the total risk. The investors choose the systematic risk over the unsystematic as it helps the investors in the selection of the assets.
The derivation of the CapitalAssetPricingModel has taken place with the assumption of indirect symmetry in the returns from the...

...
How far the CapitalAssetPricingModel has been successful in explaining asset returns, defining its approach and assumptions.
Semester 2013
Department of Accounting and Finance
Lord Ashcroft International Business School
Anglia Ruskin University
Table of Contents
Introduction…………………………………………………………………………......... 3
What’s CapitalAssetPricingModel…………………………………………………..... 3 1. Definition………………………………………………………………………………...3 2. Terminology……………………………………………………………………………...3
Risk and CapitalAssetPricingModel………………………………………………….. 3 1. Systematic Risk…………………………………………………………………………..3 2. Unsystematic Risk………………………………………………………………………..3
Asset Returns and CapitalAssetPricingModel……………………………………….. 3
CapitalAssetPricingModel...

...Chapter 9: Multifactor Models of Risk and Return. (QUESTIONS)
1. Both the capitalassetpricingmodel and the arbitrage pricing theory rely on the proposition that a no-risk, no-wealth investment should earn, on average, no return. Explain why this should be the case, being sure to describe briefly the similarities and differences between CAPM and APT. Also, using either of these theories, explain how superior investment performance can be establish.
Answer:
Both the CapitalAssetPricingModel and the Arbitrage PricingModel rest on the assumption that investors are reward with non-zero return for undertaking two activities:
(1) committing capital (non-zero investment); and (2) taking risk. If an investor could earn a positive return for no investment and no risk, then it should be possible for all investors to do the same. This would eliminate the source of the “something for nothing” return.
In either model, superior performance relative to a benchmark would be found by positive excess returns as measured by a statistically significant positive constant term, or alpha. This would be the return not explained by the variables in the model.
2. You are the lead manager of a large mutual fund. You have become aware that several equity analysts who have...

...University of Macau Faculty of Business Administration MFIN604 – Theory of Finance MSc in Finance (Fall 2012/13) Instructor: Prof. Keith Lam (Associate Professor of Finance) Office: L217 (Ext. 4167) Email: keithlam@umac.mo Webpage (intranet): http://personalweb.umac.mo/keithlam Course Objectives The course aims to provide students with solid theoretical frameworks in assetpricing and other fields of finance. For assetpricing, the concepts of risk and return, and state prices will be introduced as a stepping stone towards the discussions of more advanced topics including the CapitalAssetPricingModel (CAPM), the Arbitrage Pricing Theory (APT), and other more recent assetpricingmodels. Other topics in finance such as options and behavior finance may also be covered on an optional basis. Besides the theoretical frameworks, recent developments in empirical assetpricing and empirical finance will also be covered with an extensive use of academic research papers. (Pre-requisite: Principles of Accounting) Textbook 1. Elton, Edwin, Martin Gruber, Stephen J. Brown , and William Goetzmann, Modern Portfolio Theory and Investment Analysis, 8th Edition, John Wiley, 2011. Reference books: 1. Copeland, T.E., Weston, J.F., and Shastri, K. (CWS), Financial Theory and Corporate...

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