441 Final Sample Questions

Question 1
a. If the CAPM is valid, is the following situation possible? Explain your answer.
Stock Exp return Std dev
A 10% 25%
B 12% 20%
Yes. According to the CAPM there is no connection between expected return and standard
deviation for individual stocks, so anything would be possible in such a table.
b. If the CAPM is valid, is the following situation possible? Explain your answer.
Stock Exp return Beta
A 10% 1
B 14% 1.5
C 4% 0
Stock A => E[rM]=10%

Stock C => rf = 4%
CAPM => Stock B’s expected return = 4% + 1.5 (10% - 4%) = 13%.
Impossible.
c. If the CAPM is valid and the risk free rate is 2%, is the following situation possible?
Explain your answer.
Exp ret Std dev
Market 8% 16%
Stock A 12% 18%
Sharpe ratio of market = (8 – 2) / 16 = 0.375

Sharpe ratio of stock A = (12 – 2) / 18 = 0.56
Impossible because, according to the CAPM, the market portfolio has the highest possible
Sharpe ratio
d. If the CAPM is valid, the risk free rate is 2% and the correlation between Tristan and Isolde
is minus 0.2, is the following situation possible? Explain your answer.
Exp return Std dev
Market portfolio 8% 15%
Tristan hedge fund 11% 26%
Isolde hedge fund 13% 32%
(Hint: compute the expected return and standard deviation of an equally weighted portfolio of
Tristan and Isolde).
Exp. Return of equally weighted portfolio = 12%

Variance = (0.5)^2 (0.26)^2 + (0.5)^2(0.32)^2 -2 (0.5) (0.5) (.2) (.26) (.32) = 0.03418
Std dev. = 18.49%
Sharpe ratio of portfolio = (12 – 2) / 18.49 = 0.54
Sharpe ratio of market = (8 – 2) / 15 = 0.4
Impossible because, if the CAPM holds, the market has the highest Sharpe ratio.
Question 2
The expected rates of return of funds A and B are 8% and 6%, respectively. The beta of fund
A is 0.9, while that of fund B is 1.2. The standard deviation of A is 28% annually, while that
of B is 19%.
The riskless rate is currently 1%. The expected rate of return on the market portfolio is 6%
and its standard deviation is 15%.
a. If you currently hold the market portfolio, would you choose to add either of these funds to
your holdings?
In this situation the alpha is the relevant performance measure:

Alpha of A = 2.5%
Alpha of B = -1%
A is interesting. The manager could charge up to 1% extra fee and still have a positive alpha.
b. If instead you could invest only in riskless assets plus only one of these funds, which one
would you choose?
Sharpe ratio of A = 0.25

SR of B = 0.263
B is more interesting
c. Which one of the two funds is better diversified? (Hint: assume that the risk free rate is
constant over time, so var(R i-Rf) = var(Ri) and var(i(Rm-Rf)) = var(iRm) = i2var(Rm))
Look at R2= var(i(Rm-Rf)) / var(Ri-Rf)

Fund A: 0.92(0.15)2/0.282 = 0.23
Fund B: 1.22(0.15)2/0.192 = 0.90
Fund B is better diversified
Question 3
Assume that the stock of Vandalay Industries trades for $117, and
that the interest rate over the next year is 2.5% (the same rate
applies for lending and borrowing).
a. What should be the price of a forward contract to purchase one

share of Vandalay in one year?
Replicating strategy: borrow $117 to purchase one share right now.
Then you have to repay $119.93 in one year.
So the forward price must be $119.93
b. Assume that the forward price is equal to your answer in part a,

minus one dollar. Can you propose an arbitrage strategy? Please
describe it as precisely as possible.
Today:
Sign one forward contract to buy in one year (forward price =
118.93).
Short sell one share of Vandalay right now.
Invest the proceeds of the sale ($117) in riskless assets.
In one year:
You receive $119.93 from the riskless investment.
You pay $118.93 and receive one share from the forward contract.
You use that share to end the short sale.
Net profit: one dollar per share.
Question 4
In the context of the single factor version of the APT, take two stocks
that are exposed to the same factor of risk. There is no specific risk,
and the risk free rate is 3%.
o Krueger: expected return = 10%, factor loading = 2

o Pendant: expected return = 8%, factor loading = 1
a. Is arbitrage available? If it is, describe the arbitrage strategy as

precisely as possible.
APT implies: E[rP] = rf + RP => RP = 5%

But then Krueger’s expected return must be r f + 2 RP = 13%, so
Krueger is a bad deal (low expected return/overpriced).
Form a portfolio with 50% Krueger, 50% riskless assets. It has an
expected return of 6.5% and a factor sensitivity of one.
Short sell the portfolio and invest in Pendant. Risk cancels out and
the profit is 1.5% of the portfolio value (for example, if you short sell
$10,000 of the portfolio and buy $10,000 worth of Pendant, the profit
is $150).
b. Briefly explain how, in the real world where specific risk is present,
a hedge fund would take advantage of this type of situation.
The hedge fund would find short sell many stocks that are overpriced
and buy many stocks that are underpriced. It would adjust the
amounts so that the factor sensitivity is approximately zero. The
specific risks would be diversified away and have a negligible impact
on the P/L.
Question 5
“The standard deviation of a portfolio is always equal to the weighted

average of the standard deviations of the individual components of
the portfolio.” True or false? Please briefly explain your answer.
False. The formula shows that the standard deviation of the portfolio
is always less than the weighted average, except when the
correlation is one (in that case, it is equal).

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Question 1

Stock A => E[rM]=10%

Sharpe ratio of market = (8 – 2) / 16 = 0.375

Exp. Return of equally weighted portfolio = 12%

In this situation the alpha is the relevant performance measure:

Sharpe ratio of A = 0.25

Look at R2= var(i(Rm-Rf)) / var(Ri-Rf)

a. What should be the price of a forward contract to purchase one

b. Assume that the forward price is equal to your answer in part a,

o Krueger: expected return = 10%, factor loading = 2

a. Is arbitrage available? If it is, describe the arbitrage strategy as

APT implies: E[rP] = rf + RP => RP = 5%

“The standard deviation of a portfolio is always equal to the weighted

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