BUSN 20400

Midterm Examination
Winter 2021

Answer all of the questions on the exam. The exam is out of 200 points in total.

• The exam is open-book and open-notes, so you can use the lecture slides and/or the textbook. You
are not allowed to use the internet.

• Partial credit will be awarded, but you must show your work logically and clearly to receive it.

• Please report answers to 4 significant digits – report 7.4127528% as 7.413%.

• You are allowed to use a calculator for the exams; however, all optimization problems must be solved
using algebra (first-order conditions), not optimization software. For example, you will not be given
full credit if you calculate an answer by plugging inputs into Excel Solver or similar optimization
software.

• Some questions are labelled “hard”. If you get stuck on these, I would suggest working on other parts
first and coming back to these later.

• Remember to answer the questions using the tools, models, and frameworks we learned in class.

You must adhere to the standards of the Booth Honor Code and Booth Standards of Scholarship. You must
sign the following statement to receive credit for this exam. The relevant part for the exam is the following:
No student shall represent another’s work as his or her own. No person shall receive disallowed assistance of any
sort, or provide disallowed assistance to another student, at any time before, during, or after an examination or with
respect to other graded work for a course.
That is to say: you agree not to discuss or receive advice from anyone about this exam, including, but
not limited to, your classmates in this class.

Signed:

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Question 1
(50 points). Are the following statements true or false? Provide a short justification for your answer. (You
are evaluated on your justification.) Remember that a statement is false if any part of the statement is false.

a) (10 points). The CAPM states that expected returns depend on an asset’s loading on market risk.
Thus, any asset with a standard deviation greater than the standard deviation of the market portfolio
must have an expected return greater than the market portfolio, since it is riskier than the market.
If this were not the case, no investor would be willing to hold the risky asset in their portfolio, so
markets could not clear.

b) (10 points). One of the assumptions underlying the CAPM is that investors have quadratic preferences:

U = E − γσ2

Suppose all other assumptions underlying the CAPM hold, but investors have more general mean-
variance preferences, which may not be quadratic. Then the CAPM will generally not hold.

c) (10 points). Suppose the CAPM holds. The risk-free rate is rf . Consider an asset A with return r̃A .
Suppose you could invest in an asset B whose return r̃B is:

r̃B = 2rf − r̃A

r̃B and r̃A are perfectly correlated, so they are exposed to exactly the same risks. Thus, the expected
returns of assets A and B must be the same.

d) (10 points). Weak-form market efficiency implies that asset prices include all information in the
history of past prices. Thus, if markets are weak-form efficient, stock returns should not be predictable
using any function of past stock prices or returns.

e) (10 points, hard!). Suppose you have two risky assets, A and B, with different expected returns
EA , EB and standard deviations σA , σB . The risk-free rate is rf . You want to choose how much of our
portfolio to put in A and B. You can put at most 100% of your portfolio in each asset, and you are not
allowed to short, so you cannot have negative portfolio weights in A or B. That is, we must have:

0 6 wA 6 1, 0 6 wB 6 1

Suppose you want to pick a portfolio of risky assets to maximize your Sharpe ratio. As long as A
and B are not perfectly correlated, the portfolio of risky assets which maximizes your Sharpe ratio
always puts strictly positive weight on both A and B, due to benefits from diversification. That is, at
the portfolio which maximizes your Sharpe ratio, we will always have:

0 < wA < 1, 0 < wB < 1

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Question 2
(30 points). Suppose that the market portfolio has an expected return of 8%, and a standard deviation of
returns of 15%. The risk-free rate is 2%.

a) (10 points). Suppose that we estimate stock X’s expected return to be 11%. If the CAPM holds, what
is the beta of stock A?

b) (10 points). Suppose that stock Y has a beta of 0.2 and an expected return of 3%. We would like to
evaluate, according to the CAPM, whether this stock is overpriced or underpriced. First, construct a
tracking portfolio, made using weight w on the market portfolio and 1 − w on the risk-free rate, which
has the same beta as stock Y. What should w be?

c) (10 points). Now, compute the expected return on the tracking portfolio. Is it higher or lower than
the expected return on stock Y? If we are holding the market portfolio, how should we adjust our
portfolio to increase its Sharpe ratio?

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Question 3
(40 points). Suppose that the world is described by a two-factor model, so stock returns depend on two
systematic risk factors, F̃1 and F̃2 , which have mean 0.

r̃1 = 0.02 + 2F̃1 + 7F̃2 + ˜ 1

a) (10 points). Compute the portfolio weights and expected returns for the pure factor portfolios.

b) (10 points). Compute the portfolio weights which produce a portfolio with no systematic risk (i.e. 0
beta on both factors). What is its expected return?

c) (10 points). Compute the factor risk premia for factors 1 and 2.

d) (10 points). If an asset has factor beta 4 with factor 1 and factor beta 3 with factor 2, what should its
expected return be under arbitrage pricing theory?

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Question 4
(30 points). Suppose that the world is described by a one-factor model, so stock returns depend on one
systematic risk factor, F̃1 , which has mean 0.

r̃1 = 0.05 + 2F̃1 + ˜ 1

a) (5 points). Using only asset 1 and the risk-free asset, compute the portfolio weights and expected
returns for the pure factor portfolio, which has β1 = 1.

b) (5 points). Using only asset 2 and the risk-free asset, compute the portfolio weights and expected
returns for the pure factor portfolio, which has β1 = 1.

c) (5 points). What can we say about whether the arbitrage pricing theory holds?

d) (15 points). Suppose that SD (˜ 1 ) = 0.1, SD (˜ 2 ) = 0.2, and ˜ 1 and ˜ 2 are uncorrelated. Using assets 1,
2, and the risk-free asset, what is the highest Sharpe ratio that you can attain, using a portfolio with
β1 = 0?

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Question 5
(50 points) Suppose you are a hedge fund. You are trying to form a portfolio out of a number of risky assets
and a risk-free asset. Throughout the question, assume you can take arbitrarily large short or leveraged
positions on any (risky or risk-free) assets.
Assume that you are trying to form a portfolio out of three risky assets A, B and C, and a risk-free asset.
The expected returns and standard deviations of assets A, B and C are:

Asset Expected Return Standard Deviation

For the entire question, assume that the correlation is 0.25 between asset A and B, and that asset C is
uncorrelated with A and B.

a) (10 points). Write down the variance-covariance matrix for assets A, B and C.

b) (10 points). Assume that the risk-free rate is 2%. Find the minimum variance portfolio weights on A,
B and C, and the tangency portfolio weights on A, B and C.

c) (10 points). Suppose the risk-free rate is r%. Solve for the tangency portfolio weights as a function
of r. That is, write an algebraic expression, which includes only r and numbers that are given in the
problem, for the tangency portfolio weights on assets A, B and C.

d) (5 points). What is the relationship between the efficient frontier and the answer to part c?

e) (15 points, hard!). Suppose there is no riskless asset. Your client wants to maximize returns, but can
accept a maximum standard deviation of 30%. Solve for the portfolio weights ωA , ωB and ωC of the
three risky assets that you would recommend to your client. (Remember, since there is no riskless
asset, you cannot put any portfolio weight in the riskless asset!)