OFFICE USE ONLY

Monash University
Semester Two Examination 2011

Faculty of Business and Economics

Department of Accounting and Finance
EXAM CODES: AFF9350

TITLE OF PAPER: Portfolio Management and Theory

EXAM DURATION: 3 hours

READING TIME: 10 minutes

THIS PAPER IS FOR STUDENTS STUDYING AT: (office use only - tick where applicable)

 Berwick  Clayton  Peninsula  Distance Education  Open Learning

 Caulfield  Gippsland  Sunway  Enhancement Studies  Other (specify)

During an exam, you must not have in your possession, a book, notes, paper, calculator, pencil case, mobile
phone or any other material/item which has not been authorised for the exam or specifically permitted as noted
below. Any material or item on your desk, chair or person will be deemed to be in your possession. You are
reminded that possession of unauthorised materials in an exam is a disciplinable offence under Monash Statute
4.1.

AUTHORISED MATERIALS

CALCULATORS  YES  NO
(Only calculators with an ‘approved for use’ Faculty label are permitted)

OPEN BOOK  YES  NO

SPECIFICALLY PERMITTED ITEMS  YES  NO

if yes, items permitted are:

This paper consists of Eight (8) questions, One (1) formulae sheet and Four (4) discount/future values tables
printed on a total of Fifteen (15) pages. The total mark for this examination paper is 100 and it counts for 70%
of your final mark in this unit.

Students must attempt to answer ALL questions.

STUDENT ID: …………………………... DESK NUMBER: …………………….

PLEASE CHECK THE PAPER BEFORE COMMENCING. THIS IS A FINAL PAPER.

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THIS EXAMINATION PAPER MUST BE INSERTED INTO THE ANSWER BOOK AT THE
COMPLETION OF THE PAPER. NO EXAMINATION PAPERS SHOULD BE REMOVED FROM
THE EXAMINATION ROOM

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Question 1

Each question carries an equal weighting of 1 mark each. Circle the appropriate answer.

Q1-1. The uncertainty of investment returns associated with how a firm finances its investment is
known as
a. Business risk
b. Liquidity risk
c. Exchange rate risk
d. Financial risk
e. Market risk

Q1-2. Coefficient of variation of an investment is defined as the investment’s return standard

deviation divided by the investment’s expected rate of return. It is a measure of
a. Central tendency
b. Absolute variability
c. Absolute dispersion
d. Relative variability
e. Relative return

Q1-3. The stage in an individual investor’s life cycle will affect his/her
a. Return requirements
b. Risk tolerance
c. Asset Allocation
d. A and B
e. A, B and C

Q1-4. Which of the following is not considered to be an investment objectives

a. Capital preservation
b. Capital appreciation
c. Current income
d. Total return
e. None of the above (that is, all are considered investment objectives)

Q1-5. All of the following are purposes of an investment policy statement (IPS) EXCEPT
a. Identity portfolio manager
b. Identify target return
c. Identify investment constraints
d. Provide a mechanism for evaluation
e. None of the above (that is, all are considered purposes of an IPS)

Q1-6. The asset allocation decision must involve a consideration of

a. The objectives stated in the investor’s policy statement
b. The types of assets that are appropriate for the investor
c. The risk associated with different investments
d. The relationship between asset classes
e. All of the above

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Q1-7. The most important criteria when adding new investments to a portfolio is the
a. Expected return of the new investment
b. Standard deviation of the new investment
c. Correlation of the new investment with the portfolio
d. Both a and b
e. All of the above are equally important

Q 1-8. John is 55 years old has $55,000 outstanding on a mortgage and no other debt. John
typically saves $5,000 in an individual retirement account and another $10,000 in a company
pension. John is most likely in the:
a. Discovery phase
b. Accumulation phase
c. Consolidation phase
d. Spending phase
e. Gifting phase

Q1-9. A 25 year old individual with $10,000 invested in an retirement account and an average risk
tolerance should be concerned about:
a. Taxes, and should invest 70% in equities and 30% in bonds.
b. Taxes, and should invest 30% in equities and 70% in bonds.
c. Inflation, and should invest 70% in equities and 30% in bonds.
d. Inflation, and should invest 30% in equities and 70% in bonds.
e. Taxes and inflation

Q 1-10. Important reasons for constructing an investment policy statement include

a. Help investors decide on realistic investment goals
b. Create a standard by which to judge the performance of the portfolio manager
c. Develop an instrument to judge risk
d. Choices a and b
e. All of the above

(10 marks)

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Question 2

a. Portfolio theory assumes that investors are risk averse. Explain what it means if investors are
risk averse. Be explicit in your answer.

Give a choice between two assets with equal rates of return, they will select the asset with
the lower level of risk.

b. The efficient frontier represents the set of portfolios that have the maximum rate of return for
every given level of risk or the minimum risk for every level of return.
a) Draw a graph of a typical efficient frontier. Explain why the efficient frontier is
shaped the way it is.

The typical shape results from the fact that assets' returns are not perfectly
(positively or negatively). Note: as long as students mention that its due the
correlations between stocks then its correct. (2 MARKS FOR THE
EXPLNATION AND 1 MARK FOR THE GRAPH)

b) Which one of the following portfolios cannot lie on the efficient frontier as
described by Markowitz? Explain your reasons.

When plotting the above portfolios, only W lies below the efficient frontier as
described by Markowitz. It has a higher standard deviation than Z with a lower
expected return (1 MARK FOR THE ANSWER (PORTFOLIO W), 1 MARK
FOR THE EXPLANATION)

c. A portfolio contains the following two assets

Asset (A) Asset (B)

E(RA) = 16% E(RB) = 14%

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(A) = 3% (B) = 8%
WA = 0.5 WB = 0.5
correlationA,B = 0.4

a) Refer to the information above, what is the expected return of the portfolio?
E(Rp) = WAE(RA) + WBE(RB)
= (0.5)(16) + (0.5)(14) = 15%
(2 MARKS FOR THE CORRECT ANSWER 0 OTHERWISE, IF THE
ANSWER IS MARGINALLY DIFFERENT DUE TO ROUNDING ITS
CORRECT)

b) Refer to the information above, what is the standard deviation of this portfolio?
covariance = 0.0014 * 0.03 * 0.08 = 0.00096
p = [(WA)2 (A)2 + (WB)2 (B)2 + (2)(WA)(WB)(COVA,B)]1/2
= [(0.5)2(0.03)2 + (0.5)2(0.08)2 + (2)(0.5)(0.5)(0.00096)]1/2
= (0.002305)1/2 = 4.801%
(2 MARKS FOR THE CORRECT ANSWER 0 OTHERWISE, IF THE
ANSWER IS MARGINALLY DIFFERENT DUE TO ROUNDING ITS
CORRECT)
(2 + (3 + 2) + (2 + 2)) = 11 marks
Question 3

a. The top-down approach in security analysis begins with a look at the overall economic
picture and then narrows it down to sectors, industries and companies that are expected to
perform well. Analysis of the fundamentals of a given security is the final step.

a) Discuss the economic cycle and how this concept can be used by security analysts.

Economic cycle is the fluctuation of the economy between periods of expansion and contraction.
Macroeconomic factors such as GDP, interest rates, inflation, levels of employment and
consumer spending can help to determine the curresnt stage of the economic cycle.

A basic premise of the economic cycle approach to security analysis is that security prices
anticipate fluctuations in the economic cycle. Over the course of a economic cycle, this approach
to investing would work roughly as follows. As the investor perceives that the top of a economic
cycle is approaching, stocks purchased should not be vulnerable to a recession. When the
investor perceives that a downturn is at hand, stock holdings should be lightened with proceeds
invested in fixed-income securities. Once the recession has matured to some extent, and interest
rates fall, bond prices will rise. As the investor perceives that the recession is about to end, profits
should be taken in the bonds and reinvested in stocks, particularly those in cyclical industries
with a high beta.

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This is not the answer for this question but also students should know this:

The industry life cycle may be defined by the following stages: start up (rapid and
increasing growth), consolidation (stable growth), maturity (slowing growth), and
relative decline (minimal or negative growth). Investors interested in identifying new,
and presumably ultimately successful, industries will use this technique, trying to get
in on the "ground floor". In the start up stage, no historical data is present; thus, one
cannot identify potentially successful firms. However, typically, all of the firms are
selling at low prices and the investor will "diversify across the industry" by buying
many different stocks in the industry. If the industry becomes successful, the
surviving firms will appreciate substantially in value; the non-surviving firms will be
written off as losses. Typically, in this stage, firms are paying little or no dividends.
Investment in this stage is for the risk-tolerant investor. As the industry moves from
the start up to the consolidation stage, firms begin paying or increasing dividends; the
surviving firms become more successful, begin to enjoy economies of scale, and are
moving up the learning curve in terms of cost efficiency. In the maturity stage, the
growth has slowed and dividends may have increased; less risk is involved. By the
relative decline stage, the firm has no new exciting capital budgeting projects and may
have become an "income stock", by paying out a higher than average level of
dividends. At this stage, the stock may be attractive for the risk-averse retiree
interested in dividend income. However, the stock must be watched carefully in this
stage, as this industry may be dying (buggy whips). However, over the industry life
cycle, the clientele for the firms' stocks have changed, from the risk-tolerant to the
risk averse.
The problem with using this concept for investment purposes is identifying where the
industry is in the industry life cycle. In addition, all industries do not move through
the cycle in the same fashion. In fact, the goal is to avoid the relative decline stage.

(NB: STUDENT NEED TO UNDERSTAND THE CONCEPT OF ECONOMIC

CYCLE AND ITS RELATIONSHIP WITH INDUSTRYANALYSIS, LOOK AT THE
CONCEPT)
b) You believe that economy activity is approaching to the trough and the Reserve
Bank has loosened the monetary policy. What would be your recommendations in
the following industries:

i. Consumer durables
Consumer durables are viewed as a cyclical industry. As the economy is
approaching to the trough, activities in the market would be weaker.
Consumer durable may do less well compared to other industry sectors.

ii. Consumer staples

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Consumer staples are viewed as a defensive industry. They perform

relatively compared to other industry during market downturns. Investors
may want to increase the holding of consumer staples stocks (i.e. buy).

b. You have the following data:

Stock NAB ANZ BHP

Number of shares outstanding 1,000 1,000 10,000
Price 29/9/2010 $10 $5 $10
Price 30/9/2010 $12 $4 $14

Assume that a Value-Weighted and Equal-Weighted index of these stocks were all 1,000
at 29/9/2010.

Required:

(i) Calculate the Price and Equal Weighted Index as at 30/9/2010.

Equal-weighted = 1000 * (1 + 13%) = 1133
price-weighted = 1000 * (1 + 20%) = 1200
value-weighted = 1000 * (1 + 35.65%) = 1356

(ii) You find that NAB and ANZ are more volatile than BHP. Based on your finding,
which index weighting method (price-weighted or equally-weighted) would
exhibit higher volatility? Why?

Equal weighted, because total weight of these 2 stocks is 66.66% compared to

60% (under price-weighting)

(4 + (2 + 2) + 3 + 2) = 13 Marks

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Question 4

a. What is the definition of the market portfolio in the context of the CAPM? In empirical
studies of the CAPM, what are the typical proxies used for the market portfolio? Assuming
that the empirical proxy for the market portfolio is not a good proxy, what factors related to
the CAPM will be affected?

The market portfolio is a mean-variance efficient portfolio which includes all investable
assets. Empirical studies use the market indies such as S&P 500 as the proxy for the market.
Using a different proxy for the market portfolio will lead to a different beta value.

b. Your broker has advised you that he believes that the stock of Brat Inc. is going to rise from
$20 to $22.15 per share over the next year. You know that the annual return on the S&P 500
has been 11.25% and the 90-day T-bill (government treasury notes) rate has been yielding
4.75% per year over the past 10 years. The beta for Brat is 1.25. Is Brat Inc. overvalued or
undervalued? Would you purchase the stock?

No, because the stock is overvalued.

Expected Return = 4.75 + (1.25)(11.25  4.75) = 12.875%

Estimated Return = (22.15  20)  20 = 10.75%

Estimated Return < Expected Return

Stock is overvalued and should be sold.

c. Discuss the similarities and the differences between the CAPM and the APT with regard to
the following factors: capital market equilibrium, assumptions about risk aversion, risk-
return dominance, and the number of investors required to restore equilibrium.

Both the CAPM and the APT are market equilibrium models, which examine the factors
that affect securities' prices. In equilibrium, there are no overpriced or underpriced
securities. In both models, mispriced securities can be identified and purchased or sold as
appropriate to earn excess profits.

The CAPM is based on the idea that there are large numbers of investors who are focused

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on risk-return dominance. Under the CAPM, when a mispricing occurs, many individual
investors make small changes in their portfolios, guided by their degrees of risk aversion.
The aggregate effect of their actions brings the market back into equilibrium. Under the
APT, each investor wants an infinite arbitrage position in the mispriced asset. Therefore,
it would not take many investors to identify the arbitrage opportunity and act to bring the
market back to equilibrium.

d. Consider a two-factor APT model where the first factor is changes in the 30-year T-bond
rate, and the second factor is the percent growth in GNP. Based on historical estimates you
determine that the risk premium for the interest rate factor is 0.02, and the risk premium on
the GNP factor is 0.03. For a particular asset, the response coefficient for the interest rate
factor is 1.2, and the response coefficient for the GNP factor is 0.80. The rate of return on
the zero-beta asset is 0.03. Calculate the expected return for the asset.

e. E(R) = .03 + 0.02(1.2) + 0.03(0.80) = 3%

(4 + 3 + 4 + 2) = 13 Marks

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Question 5

a. In a particular year, ABC Mutual Fund earned a return of 1% by making the following
investments in equities and bonds asset classes:

The return on a bogey portfolio was 2%, calculated from the following information.

Required:

(i) What was the total excess return on the ABC Fund's managed portfolio?
1% - 2% = -1%.

(ii) What was the contribution (i.e. return) of asset allocation across markets to the
ABC Fund's total excess return?

(iii) What was the contribution (i.e. return) of selection within markets to the ABC
Fund’s total excess return?

b. Compare and contrast the time-weighted rate of return with the dollar-weighted rate of
return. In general terms, how is each calculated? Are there certain situations that would
cause the two methods to have drastic differences in the calculated rates of return?
The TWR reflects the investment growth of one unit of money initially
invested in the account. If external cash flows occur, then the account
must be valued as of the date of each of these cash flows; the
calculation of the TWR then requires computing a series of subperiod

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returns for the subperiods defined by the external cash flows. The
subperiod returns are then combined by chain-linking, and 1 is
subtracted from the result to arriveat the TWR. The dollar-weighted
rate of return (DWR) measures the compound growth rate in the value
of all funds invested in the account over the evaluation period. The
DWR is also called internal rate of return (IRR). The DWR is the growth
rate that will link the ending value of the account to its beginning value
plus all external cash flows. The DWR is computed using an iterative
procedure.
The DWR represents the average growth rate of all dollars invested in
an account, while the TWR represents the growth of a single unit of
money invested in the account. Consequently, the DWR is sensitive to
the size and timing of external cash flows contributed to and withdrawn
from the account, while the TWR is not affected by the cash flows.
Under ‘‘normal’’ conditions, these two return measures will produce
similar results. However, when external cash flows occur that are large
relative to the account’s value (rule of thumb: greater than 10 percent)
and the account’s performance fluctuates significantly, then the DWR
and the TWR can differ substantially.

c. Define and discuss the Sharpe ratio, information ratio and Jensen measures, and the
situation in which each measure is more appropriate measure.

Sharpe's measure, (rP - rf)/sP, is a relative measure of the average portfolio return in excess
of the average risk-free return over a period time per unit of risk, as measured by the
standard deviation of the returns of the portfolio over that time period.

Information aims defined as outperformance/tracking error. Outperformance is the

difference between portfolio return and benchmark return, tracking error is the standard
deviation of outperformance.

Jensen's measure, P = rP -[rf + P(rM - rf)], is a measure of absolute return (average return
on the portfolio over a period of time) over and above that predicted by the CAPM
As the risk measure in the Sharpe measure of portfolio performance evaluation is total
risk, this measure is appropriate for portfolio performance evaluation if the portfolio
being evaluated represents the investor's complete portfolio of assets.
The information ratio is used to measure the performance of a fund (portfolio) that tracks
a benchmark (e.g. index fund).

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As the Jensen measure, or Jensen's alpha, measures the return of a portfolio relative to
that predicted by the CAPM, this measure is appropriate for the evaluation of managers of
"subportfolios" of large funds.

((2 + 3 + 3) + 4 +4)=16 Marks

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Question 6

a.
a. What is the duration of a zero coupon bond that matures in eight years at a face value
of $1,000?

Duration = 8

b. What do you know about the duration of a bond with 10 years to maturity and a
coupon rate of 4%?

Duration < 10

b. Calculate the duration of the following bond. The bond matures in six years and has a
coupon rate of 8%. The bond is priced at $1,000. Interest payments are paid annually. The
bond’s face value is $1,000.

I II III IV
PV
Cash
Year Flow CF (I)*(III)
0
1 80 74.07 74.07
2 80 68.59 137.18
3 80 63.51 190.53
4 80 58.80 235.2
5 80 54.45 272.25
6 1080 680.58 4083.48
Sum 1000.00 4992.71

Duration: 4992.71/1000 = 4.99

The question is given without the discount rate

because based on the face value, current bond
price and coupon rate, students should be able
to work out the discount rate. The bond is at par
so the discount rate (or bond's yield to maturity)
equals to its coupon rate.

c. Explain the concept of bond convexity via a graph.

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Convexity

YTM

Graph of the price yield curve. Curve is convex. This implies that a 1% increase in
YTM results in less than 1% fall in bond prices.

((1 + 1) + 4 + 3)= 9 Marks

Question 7
a. What are the major inputs into the Black-Sholes options pricing model? (2)
Stock price, Exercise price, Risk-free rate, Time to expiration, Volatility

b. What are the major differences between a forward and future contract? (3)

Futures:
Trade on an organized exchange
Marked to market
Margin and maintenance requirements
Contract terms not flexible
Standard terms and delivery procedures.

Forward contract:
Has counterparty risk; traded over the counter or between financial institutions
Contract terms flexible, not normally market to market;
May have margin or maintenance but not normally

c. Using the binominal option pricing model, find the value of the following call option. The
current stock price equals $22 and at the end of one year, the stock price will either be $26 or
$20. The stock pays no dividend. The risk-free rate equals 10% and the strike price of the
call option is K=$22. Assume annual compounding. (4)

d. Find the value of a put option K=22 in part (a) using put-call parity on the same stock with
the same strike and maturity. Must show work and use the concept of Put-Call parity to solve
the problem (3)

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(S0 + P0 – C0)(1 + Rf) = K

(22 + P0 – 2.54)(1 + 0.10) = 22; 22 + P0 – 2.54 = 20; P0 = 20 -22 + 2.54 = 0.54
P0 = $0.54

e. Find the implied one-year forward rate for the Australian $ with the US $ given the
following information: The risk-free rate per annum in Australia is 7% and 1% in the US.
The spot rate is $1AUD=$0.92USD. Assume annual compounding. (4)
Implied 1-year forward rate = $0.868; 1 AUD = 0.868 USD
Work: AUD: 100 become 107 end of 1-year; Rf = 7%
100 AUD = 92 USD given spot exchange rate
USD: 92 becomes 92.92 end of 1-year; Rf = 1%
92.92/107 = 0.868

((2 + 3) + 4 + 3 + 4) = 14 Marks

Question 8
a. Of the following individuals listed below, identify those associated with the South Sea and
Mississippi bubbles in the early 1700s, either directly by investing in the schemes or
indirectly by writing on the events surrounding the bubbles

1. William Shakespeare 6. Mayer Amschel Rothschild

2. Daniel Defoe 7. Walter Bagehot
3. Sarah Churchill 8. Charles Ponzi
4. John Law 9. John Maynard Keynes
5. Malachy Postlethwayt 10. Sir Isaac Newton

South Sea Bubble: Daniel Defoe Mississippi Bubble: John Law

Sarah Churchill
Sir Isaac Newton

Could include Postlethwayt is either or both as he wrote about these bubbles in his
“Dictionary.”

b. In each of the following five statements true or false? In each case provide a brief
explanation to support your decision
(i) Shakespeare’s The Merchant of Venice is an example documenting the positive
benefits of international diversification
(ii) ‘Shylock’ in modern language is a term used to represent an unscrupulous
moneylender who charges very high rates of interest
(iii) Daniel Defoe was very successful in financial speculation
(iv)The Mississippi Bubble (speculation) took place in America in the early 1700s.

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(v) Walter Bagehot argued that investors made excellent investment decisions
whenever interest rates fall below 2%

(i) False: international diversification did not work as all his four ships were “lost.”
(ii) True
(iii) False: he lost money
(iv) False: France
(v) False: the make poor financial decisions.

c. Financial history is a paper that is not offered in the business education curriculum. Does the
concept of efficient markets say anything about the value of having a knowledge of financial
history? Explain in detail.

Efficient market hypothesis says that all publicly traded information reflected in current
market prices. Studying the past (history) is of no or little benefit with respect to forecasting
or understanding the futures of price movements. So there is no need to study financial
history. Financial markets are weak and semi-strong efficient.

(4+5+3=12)

END OF EXAMINATION

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Formula sheet

FV
PV  g  [(1  r1 )  (1  r2 )  ...  (1  rn )]1/ n  1
(1  r ) n

c 1
PV   (1  ) Vt
r (1  r ) n n Rt  1
E ( R)   PR
i 1
i i
Vt 1
(1  r )  (1  g ) n n
FV  CF [ ] D = Macaulay Duration Dmod = Modified Duration
rg
n
Ct t
 (1  i)
t 1
t
Dmod 
D
 P  
D YTM  100   Dmod i CV 
n
Ct 1  P  R
 (1  i)
t 1
t
m

E[ R p ]  w1 r1  w2 r2  ...  wn rn  p2  w12 12  w22 22  2w1 w2 12 1 2  iM   iM  i M

n n
 iM n n n
R   Ri  Wi  p   wi  i i   P2   wi2 i2   ww cov ij
i 1 t 1  M2 i 1 i 1 j 1,i  j
i j

n
Cov A, B  E[( RA  E ( RA ))(RB  E ( RB )]   Pi ( RA,i  E ( RA ))(RB ,i  E ( RB ))
1

Ti 
 R  RFR 
i
Si 
 R  RFR 
i
IRi 
R i Rb  STi 
R  i  DR 
1
 ( Rit  R i ) 2
n R R
i i  ER DRi

n n n
GTt   ( w jt  w jt 1 ) R jt CS t   ( R jt  Rbjt ) w jt R   [( wai  w pi )  ( R pi  R p )]
j 1 j 1 i 1
n
R   [( wai )  ( R pi  R pi )] MV1  MV0 (1  r ) m  CF1 (1  r ) m  L (1)  ...  CFn (1  r ) m  L ( n )
i 1

E(R M )  RFR E(R )  RFR   [E(R )  RFR]

E(R port )  RFR   port [ ] i i M
M
E ( Ri )  0  bi1 1  bi 2 2  ...  bin n k  rrf   ( rm  rrf )

D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) n D (1  g ) ( D0  I )(1  g )
PV    ...  PV  0 PV 
(1  k ) (1  k ) 2
(1  k ) n
kg kg
P D /E P 1 Div (t c ) D  I D2  I 1
 1 1  I  PV  1  ( )
E1 kg E ke 1  tc 1  ke ke  g 1  ke

AFF9350 Dr Daniel Chai Page 18 of 11

 OFFICE USE ONLY

AFF5270 FUNDS MANAGEMENT

c0  SN (d1 )  X (e  ( RFR )T ) N (d 2 ) d1  [(ln( S / X )  ( RFR  0.5 2 )[T ])]  ( [T ]1 / 2 )

d 2  d1   [T ]1 / 2

p 0  [ SN ( d1 )  X (e  ( RFR )T ) N ( d 2 )]  X (e  ( RFR )T )  S p 0  X (e  ( RFR )T ) N (  d 2 )  SN ( d1 )

X  1  IRFC  ( p )C ju  (1  p )C jd
S 0  P0,T  C 0,T  foward  spot    C j 
(1  RFR) T  1  IR DC  r
rd
p F0,t  S 0  S 0 ( RFRt  d T ) F0,T  S 0  SC0,t  S 0  ( PC 0,T  i0,T  D0 ,T )
ud
Vt ,T  (Q )[ Ft ,T  F 0,T ]  (1  i ) (T t )

AFF9350 Dr Daniel Chai Page 19 of 11