True/False Questions [20 points - 2 points for each]

For each of the following statements, mark (a) if the statement is true or (b) if the statement
is false.

1. Due to market risks, we cannot eliminate all risks of a portfolio through diversification.

(a) True ✓
(b) False

2. If investors have different coefficients of risk aversion, the Capital Asset Pricing Model
would not hold.

(a) True
(b) False ✓

3. According to the Capital Asset Pricing Model, all securities should offer returns that
are higher than or equal to the risk-free rate.

(a) True
(b) False ✓

4. The Fama-French model attempts to approximate the sources of systematic risks using
portfolio returns.

(a) True ✓
(b) False

5. Suppose that the financial market is weak-form efficient. Then, we may generate
abnormal profits by utilizing earnings forecasts by professional analysts.

(a) True ✓
(b) False

1
 6. Behavioral components in decision making will affect asset valuation only when all
market participants are irrational.

(a) True
(b) False ✓

7. When investors extrapolate a recent upward trend in stock market and expect the same
trend to hold in the future indefinitely, a price bubble may be formed.

(a) True ✓
(b) False

8. If short-sales are not allowed in financial markets, the law of one price might not hold
in reality.

(a) True ✓
(b) False

9. Suppose that the financial market is strong-form efficient. Then, all stock prices should
appreciate at the same rate on average, irrespective of their CAPM beta.

(a) True
(b) False ✓

10. Suppose that only a fraction of investors are irrational and other rational investors have
NO limit to arbitrage. Then, technical analysis will not be able to generate abnormal
profits.

(a) True ✓
(b) False

2
Multiple Choices [20 points - 2 points for each]

11. An automaker has a beta of 0.8, and its total assets are $20 billion. It considers
merging with a software company whose beta is 1.7, and total assets are $1 billion. If
they indeed merge, what would be the discount rate for the combined company? The
risk-free rate is 1%, and the market risk premium is 7%.

(a) 6.06%
(b) 6.90%
(c) 8.50%
(d) 9.75%
20 1
Solution: (b). The beta of the merged company is 0.8 × 21
+ 1.7 × 21
= 0.843.
According to the CAPM, the expected return is then

E(r) = 0.01 + 0.843 × 0.07 = 0.069.

12. Which of the following statements are correct?

(i) Investors do not require compensation for exposure to firm-specific risk.

(ii) Certain investment strategies result in an average return higher than the CAPM
predicts. A possible explanation of this finding is that the CAPM may not be
sufficient to capture all sources of systematic risk.

(iii) Most fund managers have not yet figured out a strategy to beat a benchmark
consistently. This finding implies that all market participants are rational.

(iv) Suppose that an investor correctly perceives the probability of future stock prices.
The correct understanding will always lead to a rational decision in stock invest-
ment.

(a) (i), (ii)

(b) (ii), (iii)
(c) (ii), (iv)
(d) (ii), (iii), (iv)

Solution: (a) (iii) has another interpretation; some investors may be irrational, but
rational investors cannot take advantage of mis-pricing due to limits to arbitrages.

3
 (iv) Even when they understand the correct probability, decisions may be irrational
due to investors’ mood and disposition.
[Questions 13-14]Consider a company whose stock has a beta of 2.0. The market
value of its outstanding equity is $100 million. The risk-free rate is 3%.

13. Suppose that the single index model holds in reality. Thus, before a firm-specific event,
the stock’s excess return equals the market’s excess return multiplied by the beta. The
market’s rate of return turns out to be 8%. What would be the stock’s rate of return?

(a) 13%
(b) 16%
(c) 19%
(d) 22%

Solution: (a) The stock’s rate of return would be

0.03 + 2(0.08 − 0.03) = 0.13.

14. Suppose now that the company wins a lawsuit, which has been expected to bring
$10 million to the company as a settlement. The actual settlement turns out to be
$7 million. Including this firm-specific event, what would be the stock’s rate of re-
turn? (Assume that the market-wide component in the stock return is the same as the
previous question)

(a) 10%
(b) 16%
(c) 20%
(d) 26%

Solution: (a) The additional surprise return due to the firm-specific event is

7 − 10
= −0.03.
100

Adding this firm-specific component to the market-wide component, the rate of return
becomes 0.13 - 0.03 = 0.1.

4
 [Questions 15-16] A manufacturing company has an ROE = 18% and a beta of 1.5.
It has been maintaining a plowback ratio of 0.5. Its earnings in year 1 are expected
to be $3 per share. The market consensus is that the coming year’s market return is
10%, and T-bills currently offer a 2% return.

15. Under the current reinvestment policy, what is the present value of growth opportuni-
ties? Assume that earnings in year 1 are $3 per share irrespective of whether earnings
are reinvested or paid as dividends.

(a) 0
(b) 8.57
(c) 21.43
(d) 38.57

Solution: (b). First, the discount rate of the company is

k = 0.02 + 1.5(0.1 − 0.02) = 0.14.

Under the current reinvestment policy, the first dividend will be 3×0.5, and the growth
rate of dividend is 0.18 × 0.5. Thus, the share price is

3 × 0.5
P = = $30.
0.14 − 0.18 × 0.5

In contrast, the assets in place is worth

3
= $21.429.
0.14

The difference between these two is PVGO, 30 − 21.429 = 8.571.

16. The company considers changing the plowback policy that will be effective immediately.
Which of the following plowback ratios leads to the highest price-earnings ratio P0 /E1 ?

(a) 0.00
(b) 0.25
(c) 0.50
(d) 0.75

Solution: (d) As ROE > k, higher plowback ratio leads to higher share price as long
as condition for Gordon growth formula (k > g) is satisfied.

5
 [Questions 17-18] An investor wants to conduct a security analysis of Apple stock.
Apple’s daily stock prices, Fama-French factor portfolio returns, and the risk-free rate
are provided in the accompanying Excel file “AAPL.xlxs”.

17. Let’s suppose that the Fama-French 3 factor model is the correct specification of the
systematic risk. What is Apple stock’s beta on HML factor (return on portfolio with
High Book-to-Market ratio - return on portfolio with Low Book-to-Market ratio)?
(Note that the risk-free rates in the provided period are all zero).

(a) 0.001
(b) 1.164
(c) -0.244
(d) -0.415

Solution: (d). The regression result is

RAAPL = 0.0006 + 1.164 × RM − 0.245 × SMB − 0.415 × HML + eAAPL

18. The investor now tries to identify a price trend using the moving average. Suppose
that she is on 31 December 2021 and computes the moving average of the prior 50
daily prices. According to the moving average, is the price in an upward or downward
trend?

(a) upward trend

(b) downward trend
(c) neutral trend
(d) More information is needed to conclude.

Solution: (a) Prior 50 observations are prices from 20 October 2021 to 30 December
2021. The average is 161.27, lower than the current price of 177.34. So, we conclude
the price is in an upward trend.

6
 [Questions 19-20] Suppose that systematic risks are identified by two factors F1 and
F2 . The risk-free rate is 2%. Two stocks X and Y have the following characteristics:

Stocks Beta on F1 Beta on F2 Expected Return

X 2.0 -1.0 10%
Y 0 1.5 8%

19. Suppose that the given expected returns on X and Y are fairly determined by the
Arbitrage Pricing Theory. What is the risk premium of F1 ?

(a) 2.0%
(b) 4.0%
(c) 6.0%
(d) 7.7%

Solution: (c). Let E(R1 ) and E(R2 ) denote the risk premiums of F1 and F2 , respec-
tively. They should satisfy

2.0E(R ) − 1.0E(R ) = 0.1 − 0.02
1 2
0E(R ) + 1.5E(R )
1 2 = 0.08 − 0.02

Solving for the unknowns, we find E(R1 ) = 0.06 and E(R2 ) = 0.04.

20. According to the table, the correct description of stock X’s excess return is

RX = α + (2.0)F1 − (1.0)F2 + eX .

An inexperienced analyst is not aware of two risk factors and instead tries to estimate
a single factor model as follows:

RX = γ + β1 F1 + eX .

Is the resulting β1 greater or smaller than the true value of 2.0? Assume that F1 and
x ,F1 )
F2 are positively correlated. (Hint: Use the fact β1 = cov(R
var(F1 )
)

(a) β1 > 2.0

(b) β1 < 2.0
(c) β1 = 2.0
(d) More information is needed to conclude.

7
Solution: (b). In the single factor model, the resulting beta is

cov(RX , F1 ) cov(α + 2F1 − F2 + eX , F1 )

β1 = =
var(F1 ) var(F1 )
cov(2F1 , F1 ) + cov(−F2 , F1 ) + cov(eX , F1 )
=
var(F1 )
cov(F1 , F1 ) cov(F2 , F1 )
=2 −
var(F1 ) var(F2 )
| {z } | {z }
=1 >0

<2

8
Short Answer Questions [60 points]
21. Consider a portfolio that allocates $700 in stock X and $300 in stock Y. Standard
deviation of stock returns are σX = 20% and σY = 30%. The correlation coefficient
between X and Y is 0.1. What is the standard deviation of the portfolio? [10 points]
Solution: The variance of the portfolio is
 
700 300
var(r) = var rX + rY
1000 1000
 2  2   
7 2 3 2 7 3
= σX + σY + 2 ρσx σY
10 10 10 10
= 0.03022.
√
The standard deviation is 0.03022 = 17.4%.

22. A stock is expected to offer a return of 15%. Its beta is 2. The risk-free rate is 2%, and
the expected rate of return on the market portfolio is 10%. According to the Capital
Asset Pricing Model, what is the fair amount of the expected return on the stock? Is
it underpriced or overpriced? [10 points]

Solution: The expected return predicted by the CAPM is

E(r) = 0.02 + 2(0.1 − 0.02) = 18%.

As the given return 15% is lower than the CAPM predicts, the stock is overpriced.

23. Consider company X with an ROE of 20% and a risk-adjusted discount rate of 15%.
The average price-earnings ratio of the company’s peers that belong to the same in-
dustry is 8. A manager of company X wants to make its price-earnings ratio the same
as the industry average. Then, what is the required plowback ratio? [10 points]

9
 Solution: Let P0 denote the current share price and E1 is earnings in year one. Then,

P0 1−b
=
E1 k − ROE × b

where b is the plowback ratio, and k is the discount rate. To set the price-earnings
ratio equal to 8, b should satisfy

1−b
8= .
0.15 − 0.2 × b

Solving for the unknown, we find b = 0.333.

24. A company plans to pay $3-dividend every year from year 1 until year 3. From year
4, its business and dividends are expected to grow at 3% per year indefinitely. The
required return on the stock is 20%. What is the intrinsic value of the stock? [10
points]
Solution: Dividend in year 4 is 3 × 1.03, and it will grow at 3% per every year. Thus,
the year-3 value of these dividends from year 4 onward is

3 × 1.03
.
0.2 − 0.03

Next, the intrinsic value of stock in year 0 is

3 3 3 1 3 × 1.03
P0 = + + + = $16.84.
1.2 1.22 1.23 1.23 0.2 − 0.03

25. Stocks A and B have the excess returns as described below:

RA = 1.5RM + eA
RB = 2.0RM + eB .

The covariance between these two stock returns is 0.09. In addition, the highest Sharpe
ratio available in the market is 0.38. According to the CAPM, what is the expected
excess return on A, E(RA )? [10 points]

10
 Solution: The covariance between A and B is

2
cov (RA , RB ) = cov (1.5RM + eA , 2.0RM + eB ) = (1.5)(2.0)cov (RM , RM ) = (1.5)(2.0)σM

From the fact that the covariance is 0.09, we know σM = 0.1732. Next, the highest
Sharpe ratio should be provided by the market portfolio according to the CAPM. Thus,

E(rm ) − rf
= 0.38.
σM

Substituting the obtained σM for the above, we find E(rM ) − rf = (0.38)(0.1732).

Finally, the expected excess return on A is

E(rA ) − rf = βA (E(rM ) − rf ) = (1.5)(0.38)(0.1732) = 9.87%.

26. Suppose that systematic risks are identified by two factors F1 and F2 . The risk-free
rate is 3%, and the risk premiums for a unit exposure to F1 and F2 are 7% and 5%,
respectively. In the market, we have a well-diversified portfolio A with the following
characteristics:

Beta on F1 Beta on F2 Expected Return

portfolio A 1.0 1.5 20%

(a) According to the Arbitrage Pricing Theory, what is the fair amount of the expected
rate of return on portfolio A? [4 points]

Solution: The expected excess return on A predicted by the APT is

E(RA ) = (1.0)(0.07) + (1.5)(0.05) = 14.5%.

Then, the expected rate of return is

E(rA ) = E(RA ) + rf = 0.145 + 0.03 = 17.5%.

(b) Is there an arbitrage? If so, present a table listing required actions and resulting
cash flows of the arbitrage. [6 points]

Solution: As the given return of 20% is higher than the APT predicts, we can
make an arbitrage as follows:
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Action Cash flow today Cash flow in year 1
buy $1-worth of portfolio A -1 1(1 + 0.2 + 1.0F1 + 1.5F2 )
sell $1-worth of factor portfolio F1 1 −1(1 + 0.03 + 0.07 + F1 )
sell $1.5-worth of factor portfolio F2 1.5 −1.5(1 + 0.03 + 0.05 + F2 )
buy $1.5-worth of risk-free asset −1.5 1.5(1+0.03)
net 0 0.025

12