FINA 5250, 2019 Final Exam Practice Questions

Problem I. [Multiple Choices (single answer)]

(1) Which of the following plots is not a valid density function?

(a) plot 1 (b) plot 2 (c)plot 3 (d) plot 4

(2) Which dataset represented by the following time series plot has the heaviest tail?
3

6
4
2

2
1

0
0

−2
−1

−4
−2

−6
−3

0 200 400 600 800 1000 0 200 400 600 800 1000

(a) (b)
3

5
2
1

0
0
−1
−2

−5
−3

0 200 400 600 800 1000 0 200 400 600 800 1000

(c) (d)

(a) (b) (c) (d)

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(3-4). The following Q-Q plots compare the daily returns on S&P500 index with the normal
distribution and Cauchy distribution.

(3) The plots suggest that

(a) The returns have lighter tails than both normal and Cauchy.
(b) The returns have lighter tails than normal and heavier tails than Cauchy.
(c) The returns have heavier tails than normal and lighter tails than Cauchy.
(d) The returns have heavier tails than both normal and Cauchy.
(4) The 1% VaR and expected shortfall (ES) computed based on the normal assumption
are v and s respectively. Which of the following is most likely the case for the true
1% VaR and ES?
(a) VaR0.01 > v, ES0.01 < s (b) VaR0.01 < v, ES0.01 < s
(c) VaR0.01 < v, ES0.01 > s (d) VaR0.01 > v, ES0.01 > s

(5) The correlation between X and Y in the plot below is closest to

(a) 1 (b) 0.7 (c) -0.7 (d) 0.05

(6) A random vector (X, Y ) follows a bivariate normal distribution with:

1
   
2 2
µ= , and Σ = ,
0 2 4
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what is the correlation between X and Y ?

(a)0.707 (b) 0.000 (c) 0.800 (d) 0.250

(7) A dataset has 100 observations and the smallest 20 of them are:
-3.51 -2.17 -1.64 -1.63 -1.59 -1.58 -1.55 -1.54 -1.50 -1.47
-1.41 -1.38 -1.31 -1.28 -1.27 -1.21 -1.15 -1.11 -1.09 -1.05
What is the empirical 2%-quantile of this dataset?
(a) -1.05 (b) 2.17 (c) -2.17 (d) -1.47

(8) Bank A reports that 1% VaR for monthly return is 2%. What is the proper interpre-
tation of this?
(a) If the bank invests $ 100 million for a month, we will always see losses larger than
$ 2 million.
(b) There is a 1% probability that the bank will gain less than 2% over a month.
(c) There is a 1% probability that the bank will lose more than 2% over a month.
(d) There is a 1% probability that the bank will lose less than 2% over a month.
(9) You are considering three investment plans for the next 36 months. Plan X, plan Y,
and plan Z which is a mixture of X and Y that requires rebalancing at the beginning
of each month. Which of the following is correct about plan Z?
(a) Plan Z must be worse than the better one between plans X and Y.
(b) The performance of plan Z can be slightly better than both plans X and Y but
can not be substantially better.
(c) The performance of plan Z must be between the performance of plans X and Y.
(d) The performance of plan Z can be substantially better than both plans X and Y.
(10) (Optional Exercise, won’t be covered in Exam.) The plots below are generated by 3
different processes, identify each of them:
20
6
150

10
4

0
2
100

−10
0
a

−20
−2
50

−30
−4

−40
−6
0

−50

0 200 400 600 800 1000 0 200 400 600 800 1000 0 200 400 600 800 1000

Time Time Time

(a) A: White Noise, B:Random Walk with drift, C: Random Walk

(b) A: Random Walk with drift, B: Random Walk, C: White Noise
(c) A: Random Walk with drift, B: White Noise, C: Random Walk
(d) A: Random Walk, B: White Noise, C: Random Walk with drift
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Problem II. [True or False]

(1) T F Expected shortfall measures the average loss.

(2) T F A√random variable X ∼ N (0, 1). It√is known that the density of N (0, 1)
at 0 equals 1/ 2π, and so P (X = 0) equals 1/ 2π.

(3) T F All the normal distributions form a location-scale family, and if Y ∼

N (µ, σ 2 ), then Y can be written as µ + σZ for Z ∼ N (0, 1).

(4) T F In kernel density estimation, the choice of kernel is crucial.

(5) T F It is possible that X and Y are independent but ρ(X, Y ) 6= 0.

(6) T F It is possible that X, Y are jointly normal, but X is not normal.

(7) T F The standard deviation of returns is usually smaller than the mean of
returns.

(8) T F The unconditional distribution of daily returns usually have fatter tails
than the normal distribution.

(9) T F Xt from a GARCH(1,1) process is determined by the past information.

(10) T F The market related variance and non market related variance can be
diversified away by holding a large enough portfolio.

Problem III. Suppose we have the following market models for assets A and B

RA,t = −0.000002 + 0.5RM,t + A,t

RB,t = 0.00001 + 1.5RM,t + B,t

The market volatility for tomorrow is σM,t+1 = 2%; the standard deviations for A,t and B,t
are τA = 0.001 and τB = 0.0015 respectively.
1. [6 points] Find the conditional covariance matrix Σt+1 for the returns of the two
assets.

2. [6 points] For a portfolio with 30% A and 70% B, calculate the portfolio αP , βP (the
intercept and slope of the market model for the portfolio) and the conditional variance of
2
the portfolio return σP,t+1 = Vart (RP,t+1 ).
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3. [4 points] Assume normality. For a portfolio with 0% A and 100% B, find the 1%
VaR for the one-day ahead return. Is this higher or lower than the one-day 1% VaR of the
portfolio considered in question 2 above?

Problem IV. Excess return "rex " of a stock has been fitted into a single factor model
with predictor market excess return "rMex " using LS regression. Here is the summary of the
fit:

lm(formula = r_ex ~ rM_ex)

Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) 0.123617 0.007175 17.23 <2e-16 ***
rM_ex 0.997074 0.007662 130.14 <2e-16 ***
---
Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
Residual standard error: 0.1139 on 250 degrees of freedom
Multiple R-squared: 0.9855, Adjusted R-squared: 0.9854
F-statistic: 1.694e+04 on 1 and 250 DF, p-value: < 2.2e-16

1. Based on the fitting result, is the predictor "rMex " useful in explaining the variation in
the return?

2. Is α significantly different from 0? If so, which direction?

3. Test if β is significantly different from 1.

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Suppose the excess return of stock is then fitted into Fama-French three factor model using
LS regression. Here is the summary of the fit:
lm(formula = r_ex ~ rM_ex + rSmB + rHmL)
Coefficients:
(Intercept) 0.087626 0.015218 5.758 2.51e-08 ***
rM_ex 0.999595 0.007262 137.638 < 2e-16 ***
rSmB 1.139450 0.217624 5.236 3.50e-07 ***
rHmL 1.349625 0.688321 1.961 0.051 .
---
Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
Residual standard error: 0.1076 on 248 degrees of freedom
Multiple R-squared: 0.9871, Adjusted R-squared: 0.987
F-statistic: 6329 on 3 and 248 DF, p-value: < 2.2e-16

4. Based on the fitted result, are the three factors as a whole statistically significant for
FF-3 factor model? Is any single one of the factors statistically significant for FF-3 factor
model? (Set significance level to be 5%) .

5. Based on all information given in this problem, how much can the single factor explain
the variation in the returns? How much can the three factors explain the variation in the
returns?

6. Suppose we conduct a partial-F test to check if the 3-factor model explian statistically
significantly more variation in the response than the single factor model. Here is the summary
of the partial-F test:
Analysis of Variance Table
Model 1: r_ex ~ rM_ex
Model 2: r_ex ~ rM_ex + rSmB + rHmL
Res.Df RSS Df Sum of Sq F Pr(>F)
1 250 3.2422
2 248 2.8737 2 0.36847 15.899 3.186e-07 ***
---
Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1

What can you conclude from this test result?

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Problem IV. The variance of a stock return data (n=500) is fitted by GARCH(1,1) mod-
el:
2
σt+1 = 0.000002 + 0.1 ∗ Xt2 + 0.78 ∗ σt2 , and the most recent 3 observations are listed below:

day-498 day-499 day-500

Return(Xt ) 0.0012 0.0009 -0.0001
σ̂t 0.0001
Assume returns Xt = σt Wt , where Wt ∼i.i.d. N (0, 1).

1. Compute the fitted volatilities σ̂499 and σ̂500 .

2. Forecast the (conditional standard) deviation for day-501 (given information up to day
500).

3. What is the distribution of the return at day-501 given all the information up to
day-500? Construct a 95% prediction interval for the return at day-501.