Capital Asset Pricing Model and Optimal Risky Portfolio

ECS4080 Corporate Finance & Portfolio Management Coursework Submission Date: 16th January 2009

Instructions:

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