MSc Finance: Workshop Questions on Portfolio Theory and Capital Asset Pricing Model, Study Guides, Projects, Research of Finance

Download MSc Finance: Workshop Questions on Portfolio Theory and Capital Asset Pricing Model and more Study Guides, Projects, Research Finance in PDF only on Docsity! M.Sc. Finance M.Sc. Investment and Finance M.Sc. International Banking and Finance M.Sc. International Accounting and Finance 2009/20 10 Finance II: Workshop Questions Specific questions will be set for completion on a weekly basis. The questions to be covered in the week beginning November 16th are 1 to 7. Q1. Given the following data on securities A, B and C A B C Expected Return 16% 18 % 15 % Standard Deviation of Return 12% 15 % 13 % Correlation Coefficient (A) 1.0 0. 7 0.5 (B) 0.7 1. 0 0.4 (C) 0.5 0. 4 1.0 calculate the expected return and risk of the following portfolios: a) 40 per cent invested in A and 60 per cent in B. b) 40 per cent in A, 25 per cent in B, and 35 per cent in C. c) Draw a diagram to show the risk‐return combination that are feasible when investing in A and B, and varying the weights for A and B. d) What weights for a portfolio made up of B and C will produce an expected return of 16 per cent? What is the risk of this portfolio. e) Determine the expected rate of return and risk on an equally weighted portfolio of A, B and C. Q2. a) Explain how it is possible to eliminate risk in a two asset portfolio.Given the following information calculate the composition of a zero risk portfolio: Security A Security B Expected return 6 per cent Expected return 12 per cent Standard deviation 5 per cent Standard deviation 10 per cent Correlation coefficient (ρ AB ) = ‐1.0 b) Determine the weights required for an efficient portfolio with a risk of 3 per cent. Q3. How many variance and covariance terms would there be in the risk equation for a portfolio made up of 100 securities? What problems do the estimation of these terms imply for the implementation of portfolio theory? e) Investor A is more prepared to accept risk than investor B: A invests 90 per cent in the market portfolio and 10 per cent in the risk free asset whereas B invests 30 per cent in the market portfolio and 70 per cent in this risk free asset. In what sense is it correct to say that the risk‐ return trade off is the same for both these investors? Q10. The expected return on the market portfolio is 16 per cent and the risk free rate of interest is 4 per cent. The beta for Alva plc is 1.4. Draw a diagram illustrating the idealised characteristic line (ie. a line consistent with the CAPM), and identify the key features of the diagram (the expected return on Alva, the slope of the characteristic line and the intercept term) Q11. Draw scatter diagrams and the characteristic lines for shares with a) a beta of 1.5 that has little diversifiable risk b) a share with a beta of 0.6 and considerable diversifiable risk. Assume the risk free rate is 5 per cent and the expected rate of return on the market portfolio is 15 per cent. (the diagram should show the approximate value for the key inputs.) Q12. a) Draw a characteristic line for an efficient portfolio that is made up of 40 per cent of the risk free asset and 60 per cent the market portfolio, given an expected rate of return on market is 16 per cent and the risk free rate is 4 per cent. Demonstrate on the diagram a sample of points showing the expected returns for the portfolio for a range of returns on the market portfolio. Comment on the scatter of points that this produces. b) Repeat questions (a) but now assume that the portfolio is made up of 140 per cent of the market portfolio, with an amount equivalent to 40 per cent of the initial wealth being borrowed. Q13. The correlation coefficient for the returns on Abas plc’s shares and the market portfolio is +0.4 and its standard deviation of returns is 20 per cent while the standard deviation of returns on the market portfolio is 16 per cent. The CAPM holds and the risk free rate is 6 per cent while the expected return on the market portfolio is 18 per cent. a) What is the expected return on Abas plc’s shares? b) What is the increase in the expected return on Abas’s shares in a time period when the market return is 10 per cent age points higher than the expected return? Q14. The beta of Donne plc’s shares has been estimated at 1.20. The company is entirely financed by equity and is valued at £300m. The company intends to raise £100 million through an issue of debt and use the funds to buy back £100m of shares. This will change the company’s capital structure. How will it affect the beta of the company’s shares? Specify your assumptions. Q15. Is it possible in principle for a risky asset to have a zero beta? Explain how this can arise. Now consider the consequences of a negative beta for the expected return on the asset. Assume a risk free 6 per cent, an expected rate of return on the market of 16 per cent and a beta of ‐0.2. Q16. The variance of the returns on Lewis plc has been estimated at 0.04 and the covariance of the company’s returns on the market at 0.024. The risk free rate is 0.04 and the expected return on the market portfolio is 0.14 with a variance of 0.0144. Determine the approximate expected return on Lewis’s shares. Now write out your calculations in percentage terms. Q17. The expected return on the shares of JP is 25 per cent and the beta of the shares has been estimated at 1.5. WT has an expected return of 16 per cent and a beta of 0.75. On the basis that the CAPM explained returns determine the risk free rate, the expected return on the market and the risk premium. Q18. The beta for Prism plc’s shares is 0.80, the variance of the returns on market portfolio is 225 and the variance of the returns on Prism is 400. Determine the correlation coefficient for the returns on Prism and the market portfolio. Q19. Dyfed Electric is a vertically integrated electricity company that has been recently privatised, and you are required to estimate a value for the beta of its shares. Its business is made up of electricity generation, accounting for 70 per cent of its assets, with electricity supply and distribution accounting for the remaining 30 per cent. Electric Supply plc is an all equity financed generating company, and has a beta of 0.7, whilst Northern REC is a specialist supply and distribution company and has an equity beta of 1.4. Northern REC is financed by 40 per cent debt and 60 per cent equity, and its debt is risk free. Dyfed Electric will be financed by 20 per cent debt and 80 per cent equity. Specify any assumptions that are necessary to complete the analysis, and explain how you derive your estimate. Q20. The finance director of Darren plc is reviewing the company’s capital budgeting procedures. Up until now a single cost of capital has been employed in the evaluation of investment proposals in the company’s two divisions. The finance director believes the risks of the divisions differ and that different required rates of return should be employed in the two divisions to reflect the risk differences. The company’s equity beta has been estimated at 1.60 and the company employs 40 per cent debt in its financing. The first division accounts of 75 per cent of the company’s assets and its business is very similar to an all equity financed company that has a beta of 1.10. If the risk free rate of interest is 6 per cent and the required rate of return on the market portfolio is 16 per cent, what rate of return should be set for divisions one and two? Q21. Explain and critically evaluate the proposition that the best available estimate of tomorrow’s price is today’s price. Q22. “BP announced a record increase in profits today but the share price fell by 3 per cent on the announcement.” Is this reaction consistent with the concept of market inefficiency. Q23. An efficient market will be characterised by an instantaneous response to new information. If a share price increases consequently for a number of days is this necessarily evidence against market efficiency? Q24. If the evidence indicates that share prices change in a random fashion is this convincing evidence in favour of market efficiency?