MFIN1151_Spring19_Final_Version_A

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MFIN 1151 Final Exam: Spring 2019 Page 1 MFIN1151: Investments Spring 2019 Final Exam Prof. David Solomon INSTRUCTIONS You have two hours to complete this exam. This exam is closed book and closed notes, except for one sheet of 8.5x11 notes (both sides). Calculators are allowed. There are 18 questions for a total of 300 points Questions are not arranged in the order of difficulty. This exam is taken under the Academic Integrity Policy, which stipulates: Cheating is the fraudulent or dishonest presentation of work. Cheating includes but is not limited to: -the use or attempted use of unauthorized aids in examinations or other academic exercises submitted for evaluation; -copying from another student's work; -actions that destroy or alter the work of another student; -unauthorized cooperation in completing assignments or during an examination; -dishonesty in requests for make-up exams, for extensions of deadlines for submitting papers, and in any other matter relating to a course. Please sign your name below to acknowledge and accept the Academic Integrity Policy. SIGNATURE: (Please sign) NAME: (Please print) STUDENT ID:
MFIN 1151 Final Exam: Spring 2019 Page 2 1. (20 points) Explain which evidence lead to the CAPM being rejected in the data
MFIN 1151 Final Exam: Spring 2019 Page 3 2. (50 points) . Your friend Epictetus tells you that his calm and balanced approach to life has resulted in him being a great stock picker, and touts his high returns. You decide to investigate by compiling his past choices into a portfolio of returns and running some diagnostics. You run two regressions: one, a CAPM regression where you regress the monthly excess return of the portfolio (i.e. Rp= rp-rf where rf is the risk-free rate) on the excess returns of the market (RM= rM-rf), as well as a three factor regression where the portfolio excess returns are regressed on the excess returns of the market as well as the SMB and HML portfolios from Ken French’s website. In all regressions, returns are included as decimals (so a return of 1% is written as 0.01). Results for the two regressions are presented below: CAPM Regression: Regression Statistics R Square 0.617 Adjusted R Square 0.611 Observations 72 Coefficients Standard Error t Stat Intercept 0.0093 0.0036 2.57 Mkt-Rf 1.0419 0.0982 10.61 Fama French 3 Factor Model Regression Statistics R Square 0.871 Adjusted R Square 0.842 Observations 72 Coefficients Standard Error t Stat Intercept 0.0023 0.0037 0.62 Mkt-Rf 1.0325 0.0923 11.18 SMB 0.0318 0.0519 0.62 HML 0.2736 0.0857 3.19
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MFIN 1151 Final Exam: Spring 2019 Page 4 a) (10 points) What type of securities does Epictetus appear to invest in? b) (20 points) Does the Epictetus Fund appear to have skill relative to the CAPM? What about relative to a three factor model? If the answers are to both questions are the same, does this surprise you? If the answers are different, what might account for the difference?
MFIN 1151 Final Exam: Spring 2019 Page 5 c) (10 points) You decide to show Epictetus how you could generate a replica fund to his from factor portfolios. You want to have the same exposure to the Fama French 3 Factors (the market, SMB, and HML). Assuming you have $100,000 to invest, how would you invest your money? d) (10 points) How attractive is your replica fund likely to be compared to Epictetus ’s? Please explain.
MFIN 1151 Final Exam: Spring 2019 Page 6 3. (10 points) Which of the following is the best explanation for why all investors hold the market portfolio as the risky component of their portfolio under the CAPM? (No explanation necessary) i) Because the risk aversion of the average investor determines the market risk premium, the market portfolio has a level of risk (standard deviation) that all investors wish to hold ii) All investors wish to hold a combination of the tangency portfolio and the risk- free rate, and for markets to clear the tangency portfolio must equal the market portfolio iii) Only the market portfolio lies on the mean-variance efficient frontier of risky assets iv) Because adding risky assets always expands the mean-variance frontier up and to the left, the tangency portfolio will necessarily have weights on all risky assets, and hence be the market portfolio. 4. (10 points) Which of the following statements about the Fama French factors are true? Circle all that apply (no explanation necessary) i) The fact that growth and value stocks co-move means that HML is not an arbitrage, even if it is mispricing ii) A momentum portfolio will have a zero three factor alpha iii) SMB may be explained by risk if the average investor has equity in a small business that tends to drop in value at the same time as small cap stocks iv) If HML is considered a risk factor, then investors must consider growth stocks to be riskier than value stocks v) A portfolio of stocks with low returns over the past 3-5 years will have a positive alpha under the CAPM, but a zero alpha under the Fama French 3 Factor Model.
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MFIN 1151 Final Exam: Spring 2019 Page 7 5. (10 points). In the following graph of the Security Market Line, explain which features, if any, are inconsistent with the CAPM. Expected Return β 0.05 R F = A B C Market Slope = [E(R M )]
MFIN 1151 Final Exam: Spring 2019 Page 8 6. (20 points) Suppose that you have two stocks, Oracle and Sun. Oracle has expected returns of 12% and a standard deviation of 18%. Sun has expected returns of 10% and a standard deviation of 15%. Suppose that the risk-free rate is 3% and that you can both borrow and lend any amount at the risk free rate. Is there i) a combination of Oracle and the risk-free rate that dominates Sun in mean-variance terms, or ii) a combination of Sun and the risk-free rate that dominates Oracle in mean-variance terms, or iii) No combination of either security plus the risk free rate dominates the other security in mean-variance terms. Please explain your reasoning (If you choose i) or ii), explain why and provide an example of the dominant portfolio. If you choose iii), please explain why there is no dominant portfolio in this case)
MFIN 1151 Final Exam: Spring 2019 Page 9 7. (20 points total) In terms of the present value relationship, for each of the following scenarios describe whether the price today would increase, decrease, stay the same or if the answer is uncertain, and whether expected returns in the future would increase, decrease, stay the same, or whether the answer is uncertain. (No explanations necessary) a) (10 points) Caterpillar management provides guidance indicating that next quarter’s earnings are likely to be higher than normal. The price today would _____________ while the expected return in the future would _______________ b) (10 points) United airlines refinances their bank debt to a floating interest rate that is lower than their current interest rate. This is expected to make them pay lower average costs on their bank loans, and also to make the company more sensitive to fluctuations in overall economic conditions. The price today would _____________ while the expected return in the future would _______________
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MFIN 1151 Final Exam: Spring 2019 Page 10 8. ( 20 points) Which of the following situations are consistent with the CAPM? Please explain. a) (10 points) Portfolio Expected Return Beta Risk-free 10 0 Market 18 1.0 A 20 1.25
MFIN 1151 Final Exam: Spring 2019 Page 11 b) (10 points) Portfolio Expected Return Standard Deviation Beta A 12 35 1.1 B 15 25 1.5
MFIN 1151 Final Exam: Spring 2019 Page 12 9. (10 points) Consider the following (hypothetical) graph of abnormal returns relative to a 3 Factor Model for the average stock that announces a reduction in earnings. Assuming the only public announcement of the earnings occurs on date t=0, which of the following statements about market efficiency with respect to the 3-factor model are true? Circle all that apply. i) Markets are semi-strong form efficient. ii) Markets are semi-strong form inefficient. iii) Some inside information about the announcement is incorporated into the price before the announcement itself. iv) Markets are strong form inefficient. v) Markets are weak-form inefficient Abnormal Returns Time t=0 (Announcement) t=+1 week t=-1 week
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MFIN 1151 Final Exam: Spring 2019 Page 13 10. (10 points) Which of the following information would provide evidence against the semi-strong form of the efficient market hypothesis? Circle all that apply (no explanation necessary). i) The best hedge funds trading on public information tend to have abnormally positive returns. ii) You can make superior returns by buying stocks after the announcement of an abnormal rise in dividends iii) High P/E stocks tend to have negative abnormal returns. iv) Stocks with high returns in the past month tend to have negative abnormal returns this month. v) Stock prices in companies rise on average when it is announced that they are the target of a takeover bid. 11. (10 points) Suppose that the stock market rises in price on a given day. What interpretations might be consistent with this? Circle all that apply (no explanations necessary) i) The market anticipates that firms will have higher future dividends ii) Expected returns on the market are lower, but only if markets are efficient iii) Expected returns on the market are lower, but only if markets are inefficient iv) Expected returns on the market are higher, provided that expected future dividends have risen by a larger amount. v) Expected returns on the market are lower, provided that expected future dividends have fallen by a larger amount.
MFIN 1151 Final Exam: Spring 2019 Page 14 12. (20 points) Noted financial whiz-kid Elizabeth W. has decided that financial markets are in need of more regulation. She argues the following: “Certain stocks have negative expected returns, and high standard deviations. We should restrict access to these stocks, because even fully rational investors will never want to trade them.” Do you agree? Partially agree? Disagree? Explain why or why not.
MFIN 1151 Final Exam: Spring 2019 Page 15 13. (10 points) If investors with mean-variance preferences have access to many risky assets and a risk-free asset, and can take long or short positions in each, what types of portfolios will they pick? Please explain.
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MFIN 1151 Final Exam: Spring 2019 Page 16 14. (10 points) Consider the following 5 portfolios, A, B, C, D and E. The expected returns and standard deviations of each are plotted on the graph below. Which of the following statements are true ? Circle all that apply. (no explanation necessary) i) Under the CAPM, B and A will have the same β ii) Given a choice only between portfolio A and portfolio E, a risk-tolerant investor may rationally choose A iii) Under the CAPM, B may be the market portfolio, but A cannot be the market portfolio iv) C lies on the efficient frontier E(R) σ (R) A B C D E
MFIN 1151 Final Exam: Spring 2019 Page 17 15. (20 points total) You are an investment manager for an equity fund. An analyst at your fund comes to you with a valuation model for a trucking company. The company is an established and mature company that pays regular dividends. The analyst has evaluated from a discounted cash flow model that the fundamental value of the company ought to be $25 per share, but it is trading at a value of $15 per share. a) (10 points) How might you take advantage of this mispricing?
MFIN 1151 Final Exam: Spring 2019 Page 18 b) (10 points) What risks does the strategy have? i.e. How might you lose money if you did the above strategy?
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MFIN 1151 Final Exam: Spring 2019 Page 19 16. (20 points total) You manage an equity mutual fund with expected return of 12% and standard deviation of 24%. The T-Bill rate is 4%. a) (10 points) A prospective client comes to you saying that they want to invest in your fund and the T-Bill (either long or short), but only if they can obtain an expected return of 16% and a standard deviation of 30%. Can you satisfy their requirements?
MFIN 1151 Final Exam: Spring 2019 Page 20 b) (10 points) An S&P 500 Index fund yields an expected return of 10% and standard deviation of 20%. Continue to assume that T-Bill rate is 4%. A different client considers switching his risky portfolio, which is currently invested in your fund, to the S&P 500 Index fund. Should your client switch?
MFIN 1151 Final Exam: Spring 2019 Page 21 17. (20 points total) Years from now, you get a call from a guy named Nebuchadnezzar that you remember from Solomon’s Investments class back in the day. He’s now running a fancy asset management firm that invests in a combination of stocks and bonds. He wants you to invest, but you’re wa ry. You decide to evaluate his returns relative to a similar benchmark for balanced funds in terms of 2018 performance. At the start of 2018, they had a weight of 90% in stocks, and 10% in bonds. The return on their stock portfolio was -7%, and the return on their bond portfolio was 4%. You compare them with a benchmark portfolio that is 80% stocks, and 20% bonds. In 2018 the benchmark equity portfolio earned -5%, and the benchmark bond portfolio earned 3%. a) (10 points) What is the total abnormal performance of Nebuchadnezzar relative to the benchmark?
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MFIN 1151 Final Exam: Spring 2019 Page 22 b) (10 points) Out of the total abnormal performance, how much was due to security selection?
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MFIN 1151 Final Exam: Spring 2019 Page 23 18. (10 points) Which of the following predict lower returns for a company for this month? Circle all that apply (no explanation necessary) i) Having an earnings announcement 12 months ago ii) Having low returns 24 and 36 months ago iii) Having high returns last month iv) Having a negative earnings announcement last month v) Having a larger fraction of earnings made up of cash flows rather than accruals
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