Department of Financial Economics

Written examination in: Examination date:

GRA 65433 Introduction to Asset Pricing 01.12.10, 09:00 11:00

Permitted examination aids: A bilingual dictionary and BI-approved exam calculator type; TEXAS INSTRUMENTS BA II PlusTM. Total number of pages: Answer sheets: 2 Lines

Question 1 (40%)
a) Briefly discuss similarities and differences between CAPM and APT. Consider the following one-factor model:

E ( Ri ) R f i RP i

There is a risk-free asset with a return of 3%. In addition there are two risky investments, A and B. A has a beta of 1.0 and an expected return of 10%, while B has a beta of 0.5 and an expected return of 7%. Both investments are fully diversified. b) Is the market in equilibrium? Consider the following two-factor model:

E ( Ri ) R f i1 RP1 i 2 RP2 i
where the expected risk premiums on the risk factors, RP1 and RP2, are 5% and 3%, respectively. The variance of the two risk factors are as follows: Var(RP1) = 0.202 and Var(RP2)=0.252. Consider now the following two assets: Asset 1: 11 0.75 11 1.0 and Var ( 1 ) 0.020 Asset 2: 21 1.0 22 0.5 and Var ( 2 ) 0.012

c) What are the variances of Asset 1 and Asset 2? What is the correlation between Asset 1 and Asset 2?

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Assume that there is a third asset: Asset 3: 31 0 32 0.5 and Var ( 3 ) 0 d) Now assume that also Var (1 ) 0 Var ( 2 ) . Show how you can construct a risk-free portfolio. e) Assume that security returns can be explained by a two-factor model (e.g. unexpected GDP growth and unexpected changes in interest rates). How would you estimate the risk premiums associated with exposure to each risk source?

Question 2 (40%)
a) According to the Capital Asset Pricing Model (CAPM) everyone would keep the same risky portfolio (the market portfolio). Why?

b) CAPM states that expected return on a security i equals the risk-free rate plus the market risk premium times the securitys beta (i):

E ( Ri ) R f i E ( Rm ) R f .
Explain the derivation of CAPM. c) Explain why liquidity may be important in explaining security returns.

d) It has been claimed that it is impossible to test CAPM. Explain.

Question 3 (20 %)
a) Why would you think that markets should behave according to the Efficient Market Hypothesis? b) You want to test whether the stock market reacts according to the Efficient Market Hypothesis with regard to earnings announcements. Describe your suggested methodology and expected results. c) You have just found evidence that shares in companies with a high book-to-market ratio perform better than shares in other companies. Is this finding consistent with the Efficient Market Hypothesis?

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