Midterm Practice Problems

1. Assume the risk free rate equals R 1 = 4%, and the return on the market
portfolio has expectation E [RM] = 12% and standard deviation aM = 15%. We
suppose that the CAPM holds.
(a) What is the equilibrium risk premium (that is, the excess return on the market
portfolio)?
(b) If a certain stock has a realized return of 14%, what can we say about the beta
of this stock?
(c) If a certain stock has an expected return of 14%, what can we say about the beta
of this stock?
2. Suppose that the CAPM holds. The risk-free rate is 3%, the expected
return on the market is 10%, and the stock has a beta of 1.5.
(a) What's the expected return of the stock?
(b) Suppose that another stock, GenTech, has an expected return of 3%. How do you
explain that with the CAPM?
(c) Suppose that gold has an expected return of 0%. How do you explain that with
the CAPM?
3. Suppose your returns were: 30% in year 1, and -40% in year 2.(a) What's
your arithmetic average return?
(b) What's your geometric average return?
4. Consider the following data:
Expected Return Standard Deviation
Russell Fund 16% 12%
Windsor Fund 14% 10%
S&P Fund 12% 8%
The correlation between the returns on the Russell Fund and the S&P Fund is .7. The
rate on T-bills is 6%. Which of the following portfolios would you prefer to hold in
combination with T-bills and why? Assume that you are a mean-variance investor, as
seen in class.
(a) Russell Fund
(b) Windsor Fund
(c) S&P Fund
(d) A portfolio of 60% Russell Fund and 40% S&P Fund.
5. The expected returns and standard deviation of returns for two securities
are as follows:
Security Y Security Z
Expected Return 10% 10%
Standard Deviation ay =20% az =40%

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 The correlation between the returns is p = 0.3. Suppose that your portfolio is formed
with a fraction w in Y and 1 - w in Z
(a) What's your portfolio's expected return, as a function of w?
(b) What's your portfolio's variance, as a function of w?
(c) What's the value of w that minimizes your variance?
(d) Suppose that the risk-free rate is R 1 = 2%, and the only stocks available are Y
and Z. What's the tangency portfolio?
(e) Draw the mean-standard deviation frontier.
6. Suppose Ann and Bob care only about the mean and standard deviation of
their portfolio return. Ann is less risk averse than Bob. Suppose that Bob holds the
tangency portfolio. Which portfolio might Ann hold? Explain why.
(a) The riskfree asset
(b) The tangency portfolio
(c) The tangency portfolio leveraged by the risk-free asset
(d) None of the above
7. Assume the variance of Apple is 0.16 and the variance of Google is 0.25. If the
variance of an equally weighted portfolio of these stocks is 0.0525, then what's the
covariance between these stocks?
8. There are 3 states (1, 2, 3), and 3 securities (A, B, C). The payoffs in each state are as
follows:
Security A Security B Security C
State 1 110 100 100
State 2 100 110 100
State 3 100 100 110
The prices at time 0 of the securities A,B,C are respectively $98, $100, $105.
(a) What's a replicating portfolio for the risk-free asset, i.e. a combination of stock
A, B, C that generates a sure payoff of $1 in each state?
(b) What's the risk-free rate?
(c) What's the replicating portfolio for an Arrow-Debreu security that generates 1 in
state 1, and 0 in states 2, 3?
(d) What's the price of that Arrow-Debreu security?
(e) If the risk-free rate was 10%, what arbitrage would you set up to take advantage
of the mispricing?
9. (harder question) Suppose that the expected return and standard deviation
of portfolio A is 0.2, and the expected return and standard deviation of portfolio B
is 0.3. The correlation between A and B is 0. Suppose you put 80% of your wealth
in portfolio A and the rest in portfolio B. Is this portfolio efficient (on the efficient
frontier)? Explain why or why not.

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 10. For each of the following pairs of concepts, explain the distinction between them. (You
may do this by defining them precisely, by showing examples in which one applies and the
other does not, or by stating and explaining a formula that relates the two.)

(a) Buying on margin vs. short selling.

11. A producer of chemical products has been sued for damages over cancer cases in the
community where one of its plants is located. Tomorrow the case will be decided. If the
decision goes in the company's favor, its stock price, currently $2.00, will increase to $5.00.
If the decision goes against the company, the firm will be liquidated and the stock price will
drop to zero. The firm has also issued bonds, each of which will be worth $1.00 (face value)
tomorrow if the decision goes in the company's favor. If the company is liquidated, each
bond will be worth only $0.25.
For simplicity, you may assume that the overnight interest rate for money invested safely
is zero. That is, $1.00 invested today at the safe interest rate will be worth $1.00 tomorrow
for sure.
a) Using the stock and the riskfree asset, construct a portfolio that pays $1.00 tomorrow
if the company wins the case, and $0.00 if the company loses. (Both long and short positions
are permitted.) What is the price of this portfolio today?
b) Using the stock and the riskfree asset, construct a portfolio that pays $1.00 tomorrow
if the company loses the case, and $0.00 if the company wins. (Both long and short positions
are permitted.) What is the price of this portfolio?
c) Label the two states of the world tomorrow as state 1 if the company wins the case,
and state 2 if the company loses. What is the Arrow-Debreu state price vector in this
example?
d) Use your answers to parts a) through c) to determine the price of the company's bonds
today, under the assumption that there are no arbitrage opportunities.
e) Suppose the company's bonds are selling today for $0.60. Show that there is an
arbitrage opportunity, and show how you would trade to exploit it.
f) Explain why you don't need to know the probability that the company will win the
case to answer any part of this question.

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 12. Suppose that the Harvard Management Corporation invests Harvard's $25 billion
endowment in two asset classes: a portfolio of safe assets that deliver a known real return of
2% per year, and a diversified portfolio of risky assets that offer a risk premium of 8% per
year over safe assets, with a standard deviation of 20% per year.
a) Assume that returns from the endowment are the only source of income to Harvard.
The university is conservative, with a relative risk aversion coefficient of 8. What fraction
of the endowment should HMC invest in risky assets? With this investment strategy, what
is the average real rate of return on the endowment? What is the average real income that
Harvard gets from the endowment?
b) Now suppose that Harvard receives other revenue of $1.2 billion per year from tuition,
alumni donations, and sponsored research. Assume that this revenue is riskless and constant
in real terms. What holding of safe assets would generate the same revenue for Harvard?
c) Suppose that HMC takes the university's other revenue into account when determining
its investment policy for the endowment. How should the endowment now be invested?
(Hint: Imagine that HMC holds the safe assets from part b, as well as the endowment.
Continue to assume that the university has relative risk aversion of 8.) With this investment
strategy, what is the average real rate of return on the endowment? What is the average
real income that Harvard gets from the endowment?
d) If HMC takes the university's other revenue into account, as in part c, how should it
adjust the asset allocation of the endowment if the endowment does unusually poorly and
therefore decreases in value? What should Harvard therefore do in response to the crisis of
2007-2009?

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 13. You currently hold the market portfolio, which has an 8% mean return and a
20%standard deviation. The riskless interest rate is constant at 2%. You are considering
shifting some money into Cash Cow Fund, which has mean return 6%, standard deviation
10%, and covariance with the market portfolio 0.02. You are also looking at Dotcom Dog
Fund, which has mean return 12%, standard deviation 30%, and covariance with the
market portfolio 0.08.
a) Calculate Jensen's alpha for each fund. Which of the above numbers do you need for
this calculation, and which are irrelevant?
b) Consider small adjustments in your current holdings of the two funds. (Since you are
currently holding the market, your current holdings of the funds are proportional to their
weights in the market portfolio). How will such adjustments affect the expected return and
variance of your portfolio? Explain how to make adjustments that will reduce the variance
of the portfolio without changing its expected return.
c) Does the Capital Asset Pricing Model (CAPM) describe these funds? Why or why
not?

If you wish to spend extra time preparing for the exam, a good strategy is to make sure
you understand the Lecture Notes and Chapters 6, 7, 9 and 10 of Bodie, Kane, and Marcus.

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14. True/ False/ Uncertain? Explain
(a) Suppose that stocks with a high price-earning ratio tend to have low future rates
of returns. Does this contradicts the CAPM?
(b) Suppose that returns are 25% more volatile on average after negative earnings
announcements. Does that contradict the efficient market hypothesis?
(c)

15. Take a firm with return on equity (ROE) 10%, next-period earnings $10,

plowback (i.e. the reinvestment ratio B = 1 - D / E) 40%, and CAPM required rate of
return R =15%.
(a) What's the growth rate of the dividend today?
(b) What's its price today?
(c) What would be the price if the plowback was 0%
(d) What would be the price if the plowback was 100%?
(e) What would be its optimal value for the plowback B ( which should be in the
interval [O, 1]) ?

16. Stock A will pay dividend $4 in the coming year, and a dividend growth
rate equal to 2%. The risk-free rate is 1%, and the equity premium (excess return of
market portfolio) is 5%, inflation is 0%.
(a) What's expected return of Stock A if the CAPM beta of the stock is 0.5? 1? 1.5?
(you need to give one answer for each scenario)
(b) What's the stock price of Stock A if the CAPM beta of the stock is 0.5? 1? 1.5?
(you need to give one answer for each scenario)
(c) Suppose that the CAPM beta starting next year is either 0.5 or 1.5, with equal
probability (and that this is an idiosyncratic shock). What's the price today?

17. (Harder)
Suppose that a company's dividend is now $1, and every year: the company
becomes bankrupt with probability 8% and pays no future dividends if bankruptcy
happens, and if it does not become bankrupt then the bond price dividend grows
at a rate 3%. The discount rate of the company is 10%. Again assume investors
are risk-neutral, what's the stock price?