Oregon State University
College of Business
BA 443
Midterm Examination
Instructor: Prem Mathew
Date: November 3, 2008
Time allowed: 1 hour and 50 minutes
Points: 50 (equivalent to 27% of the total course evaluation)
Student name:
___________________________________
Instructions:
1)
Attempt all questions.
2)
You may separate the formula sheets and additional pages at the end of the exam.
If you have work you would like to turn in on the additional pages, please slip it
inside the exam when finished.
Multiple Choice. Circle the correct answer. Each question is worth 1 point.
1. Which of the following is not an investor life cycle phase?
a) Discovery phase
b) Accumulation phase
c) Consolidation phase
d) Spending phase
e) Gifting phase
2. It is important to develop an Investment Policy Statement for a client because:
i. It allows clients to understand their needs and objectives.
ii. It ensures that the return generated by the portfolio will always exceed
the benchmark.
iii. It reduces the possibility of inappropriate behavior by the portfolio
manager.
a) i
b) i, ii
c) i, ii, iii
d) ii, iii
e) i, iii
3. What effect does a stock split have on a price-weighted series?
a) Index remains the same, divisor will increase/decrease.
b) Divisor remains the same, index will increase/decrease.
c) Index and divisor will both remain the same.
d) Index and divisor will both reflect the changes (immediately).
e) Not enough information is provided.
4. Which of the following are factors that make it difficult to create and maintain a bond
index?
a) The universe of bonds is broader than stocks.
b) The universe of bonds is constantly changing due to new issues, bond maturities,
calls, and bond sinking funds.
c) It is difficult to derive value, up-to-date prices.
d) Choices a and c
e) All of the above
5. Which of the following statements concerning active equity portfolio management
strategies is true?
a) The goal of active equity portfolio management is to earn a portfolio return that
exceeds the return of a passive benchmark portfolio (net of transaction costs) on a
risk-adjusted basis.
b) An actively managed equity portfolio has lower total transaction costs.
c) An actively managed equity portfolio has lower risk than the passive benchmark.
d) A key to success for an actively managed equity portfolio is to maximize trading
activity.
e) All of the above
6. Under the risk premium approach to determine the yield on an Investment Grade
Corporate Bond asset class you add the current Treasury Bond yield of the same
maturity to the following risk premium(s):
i. Inflation premium
ii. Tax premium
iii. Default premium
iv. Illiquidity premium
a) i, ii, iii
b) i, iii, iv
c) ii, iii, iv
d) i, ii, iv
e) i, ii, iii, iv
7. Although venture capital investments tend to be riskier than investments in public
firms, reported standard deviations for a VC index between 1980 and 2000 was
considerably lower than that for an index of publicly traded firms. This anomaly is
most likely because
a) VC index data is lagged
b) there is survivorship bias in the measurement of the indexes
c) VC investment data tends to be smoothed data
d) VC investments are actually less risky
e) none of the above
8. In passive equity management, compared to full replication, sampling has which of
the following advantage or disadvantage:
a) it has greater transaction costs
b) it has greater tracking error
c) it will generate greater returns
d) it will require investing in more stocks
e) none of the above
Use the following information to answer questions 9 and 10.
You are attempting to learn more about a particular ETF that you are interested in
investing in. You obtain the following output from a 4-factor model regression where you
regress 5 years of monthly returns for your ETF against the market, size, value and
momentum factors.
Intercept
Mkt
SMB
HML
MOM
Coefficient
1.21
1.31
0.56
1.11
0.23
t-stat
0.56
34.01
0.55
13.26
12.23
9. Based on the output, you conclude that the ETF is a
a) Small-cap Growth ETF
b) Mid-cap Value ETF
c) Large-cap Growth ETF
d) Large-cap Value ETF
e) Small-cap Value ETF
10. Calculate the expected risk premium for the ETF with the following historical risk
premiums for each of the risk factors: Mkt: 6.7%; SMB: 0.9%; HML: 3.8%; MOM:
11.7%. The ETF risk premium is
a) 16.19%
b) 17.4%
c) 14.71%
d) Cannot be determined without the risk free rate.
Short Answer.
1. (10 points) A portfolio manager is trying to establish a strategic asset allocation for
two different clients, Bob Bowman and Tom Luck. The characteristics of the three model
portfolios under consideration are provided in the table below.
Asset Mix
(weights)
Portfolio
A
B
C
Stock
0.75
0.4
0.3
Bond
0.25
0.6
0.7
Portfolio
Expected
Return
(%)
15
8
5
Portfolio
Standard
Deviation
(%)
20
10
5
a. If Mr. Bowman has a risk aversion parameter of 7 and Mr. Luck has a risk aversion
parameter of 1, which portfolio would you recommend for each of the clients?
b. Mr. Bowman’s initial portfolio has a value of $1 million. He would like to withdraw
$50,000 annually to contribute to charity. He would like an allocation that allows him to
have the greatest chance of withdrawing that amount without reducing his portfolio value
below $1 million. Which portfolio would you recommend?
c. Mr. Luck’s initial portfolio has a value of $100,000. He would like to purchase a boat
in 10 years that he believes will cost $210,000 at that time. Which of the portfolio(s)
would provide him the return to achieve his goal? Assume that the portfolio expected
return above represents an expected arithmetic return.
2. (6 points) One of the challenges in forecasting is that analysts and clients tend to have
biases in their forecasts and opinions. State and describe three psychological traps that
analysts or clients may fall into that would lead to biased forecasts.
3. (12 points) You have been asked to develop expected returns and a covariance matrix
for two asset classes, U.S. equities asset class (USE) and emerging market equities asset
class (EME). Your firm uses the ICAPM to develop these expectations. Your firm’s
proprietary models have estimated a Sharpe ratio for the global investable market (GIM)
of 0.28. Based on your analysis of historical data for these asset classes, you determine
that the USE is 80% integrated with the GIM and that the EME is 60% integrated with
the GIM. You also determine that the correlation between USE and the GIM is 0.65 and
the correlation between EME and the GIM is 0.55. The risk-free rate is 4% and the GIM
standard deviation is 18%. Other historical information is provided in the table below.
USE
EME
Avg. Return
12%
15%
Std. Dev
22%
30%
a. Estimate expected returns and a covariance matrix for the two asset classes.
b. Describe one way in which the ICAPM is superior to the traditional CAPM.
4. (12 points) Use the following quarterly information for 2007 to evaluate performance
of your passively managed portfolio.
Portfolio returns for 2007:
Q1
3%
Q2
3%
Q3
Q4
3.2% 3.3%
The benchmark for your portfolio is based on an unweighted (or equal-weighted) index
of the following 3 stocks using arithmetic averages.
Benchmark stock returns:
A
B
C
Q1
1.5%
4.2%
3.5%
Q2
1.7%
1.7%
4.5%
Q3
2.1%
1.5%
4.6%
Q4
2.2%
2.3%
5.7%
a. If at the start of Q1, the benchmark index had a value of 250, what would the index
value be at the end of Q4?
b. What is the annualized tracking error for your portfolio?
c. How well do you believe you have performed as a passive manager given your
tracking error?
Extra credit. 2 points.
The multifactor model and the ICAPM rely on historical averages to estimate future
performance. What inputs into these two models do you think may be affected by the
current financial crisis? Why?
BA 443 Midterm Formula Sheet
Return Objectives (from IPS):
Incorporating spending rate, inflation rate and expenses:
Return  (1  SR)(1  IR)(1  exp) - 1
Multiperiod return calculation:
CGR  E ( AR)  0.5 * 2
Risk objectives (from IPS):
Based on mean-variance utility:
U m  E( Rm )  0.005RA * m
2
Shortfall Risk: Roy’s safety first criterion:
SFRatio 
E ( R p )  RL
p
Adding asset classes to portfolio:
E ( Rnew )  RF
 new
 E ( R p )  RF


p


Corr ( Rnew, R p )


Tracking error:
TE    P
 
T
Where
 
t 1
t


2
and
 t  R pt  Rbt
T 1
Index calculations:
N
Price-weighted:
Indext  
i 1
Pit
Dadj
N
Value-weighted
Indext 
P Q
i 1
N
it
it
P Q
i 1
ib
ib
* Beginning Index Value
Formulating Capital Market Expectations:
Multifactor models:
Rit  ai  bi1F1t  bi 2 F2t  ...  biK FKt  eit
General Expression:
Calculating expected returns, variance, correlations with two factors and
two asssets:
M1t  b11F1t  b12 F2t
Expected return:
Variance:
M ii  bi21Var( F1 )  bi22Var( F2 )  2bi1bi 2Cov( F1, F2 )
Covariance: M ij  bi1b j1Var( F1 )  bi 2b j 2Var( F2 )  (bi1b j 2  bi 2b j1 )Cov( F1, F2 )
Calculating expected returns with four factors (Mkt, SMB, HML, MOM)
E ( R)  RFR  a  b1 * ( MKT  RFR )  b2 * SMB  b3 * HML  b4 * MOM
Discounted Cash Flow Model:
Expected Return:
E ( Re ) 
D0 (1  g )
g
P0
Risk Premium Approach:
Fixed Income expected return:
E ( Rb )  real risk free interest rate inflation premium 
default risk premium  illiquidit y premium  maturity premium 
tax premium
Equity expected return:
E ( Re )  30  yr T - bond rate  equity risk premium
ICAPM Approach:
E ( Ri )  RF  i E ( RM )  RF 
Expected Return:
where
i  Cov( Ri , RM ) / Var ( RM )
Expected Risk premium assuming fullly integrated market:
 E ( RM )  RF
E ( Ri )  RF   i i ,M 
M




Expected Risk premium assuming completely segmented market:
 E ( RM )  RF
E ( Ri )  RF   i 
M




Expected Return assuming partially integrated market:
E ( Ri )  RF  (deg of integratio n * asset risk premium if fully integrated )
 ((1  degree of integratio n) * segmented risk premium)
Covariance of two assets:
2
Cov(AC1, AC2)   AC1 *  AC 2 *  mkt
Beta, covariance, and correlation
a 
Cov (rmkt , ra )
2
 mkt

 a ,mkt *  a
 mkt
Cov(rmkt , ra )  Corr(rmkt , ra ) * a * mkt