Question 1

A. Which of the following statements about the security market line (SML) are true?
i. The SML provides a benchmark for evaluating expected investment
performance.[1]TRUE
ii. The SML leads all investors to invest in the same portfolio of risky assets.[1]
FALSE
iii. The SML is a graphic representation of the relationship between expected
return and beta.[1]TRUE
iv. Properly valued assets plot exactly on the SML. [1]TRUE

B. Risk aversion has all of the following implications for the investment process except:
i. The security market line is upward sloping. TRUE
ii. The promised yield on AAA-rated bonds is higher than on A-rated bonds.
FALSE
iii. Investors expect a positive relationship between expected return and risk.
TRUE
iv. Investors prefer portfolios that lie on the efficient frontier to other portfolios
with equal expected rates of return.[2]TRUE

C. What is the beta of a portfolio with E(Rp) - 20%, if Rf- 5% and E(Rm) -15%?[2]
E(Rp)=Rf+β(E(Rm)-Rf)
-20=-5+β(-15--5)
-20=-5-20β
20β=15
Β=0.75

D. Are the following statements true or false? Explain.

i. Stocks with a beta of zero offers an expected rate of return of zero. [2]
ii. The CAPM implies that investors require a higher return to hold highly
volatile securities. [2]
iii. You can construct a portfolio with a beta of 0.75 by investing 0.75 of the
budgets in T-bills and the remainder in the market portfolio. [2]

[15 marks]

Question 2

Hennessy & Associates manages a $30 million equity portfolio for the multimanager
Wilstead Pension Fund. Jason Jones, financial vice president of Wilstead, noted that
Hennessy had rather consistently achieved the best record among the Walstead’s six equity
managers. Performance of the Hennessy portfolio had been clearly superior to that of the
S&P 500 in four of the past five years. In the one less favorable year, the shortfall was trivial.
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Hennessy is a “bottom-up” manager. The firm largely avoids any attempt to “time the
market.” It also focuses on selection of individual stocks, rather than the weighting of favored
industries. There is no apparent conformity of style among the six equity managers. The five
managers, other than Hennessy, manage portfolios aggregating $250 million, made up of
more than 150 individual issues.

Jones is convinced that Hennessy is able to apply superior skill to stock selection, but the
favorable results are limited by the high degree of diversification in the portfolio. Over the
years, the portfolio generally held 40–50 stocks, with about 2% to 3% of total funds
committed to each issue. The reason Hennessy seemed to do well most years was because the
firm was able to identify each year 10 or 12 issues that registered particularly large gains.
Based on this overview, Jones outlined the following plan to the Wilstead pension committee:

“Let’s tell Hennessy to limit the portfolio to no more than 20 stocks. Hennessy will
double the commitments to the stocks that it really favors and eliminate the remainder.
Except for this one new restriction, Hennessy should be free to manage the portfolio exactly
as before.”

All the members of the pension committee generally supported Jones’s proposal, because all
agreed that Hennessy had seemed to demonstrate superior skill in selecting stocks. Yet, the
proposal was a considerable departure from previous practice, and several committee
members raised questions.

Required

a. Will the limitation of 20 stocks likely increase or decrease the risk of the portfolio?
Explain.[4]
b. Is there any way Hennessy could reduce the number of issues from 40 to 20 without
significantly affecting risk? Explain. [3]
c. One committee member was particularly enthusiastic concerning Jones’s proposal. He
suggested that Hennessy’s performance might benefit further from reduction in the
number of issues to 10. If the reduction to 20 could be expected to be advantageous,
explain why reduction to 10 might be less likely to be advantageous. (Assume
that Wilstead will evaluate the Hennessy portfolio independently of the other
portfolios in the fund.) [4]
d. Another committee member suggested that, rather than evaluate each managed
portfolio independently of other portfolios, it might be better to consider the effects of
a change in the Hennessy portfolio on the total fund. Explain how this broader point
of view could affect the committee decision to limit the holdings in the Hennessy
portfolio to either 10 or 20 issues. [5]
[15 marks]
ANSWER
a. The limitation of 20 stocks will likely increase the risk of the portfolio. Here’s why:
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 i. Concentration risk: By focusing on fewer stocks, the portfolio becomes more
concentrated, meaning that the performance of each stock has a greater impact on the
overall portfolio. This increases the risk of significant losses if any of the selected
stocks perform poorly.
ii. Reduced diversification: Diversification helps spread risk across various stocks,
industries, and sectors. With only 20 stocks, the portfolio becomes less diversified,
making it more vulnerable to market fluctuations and sector-specific risks.
iii. Overexposure to individual stocks: Doubling the commitment to favored stocks
increases exposure to individual stock risks, such as company-specific issues,
management errors, or industry disruptions.

While Hennessy’s skill in selecting stocks is acknowledged, the reduced diversification and
increased concentration risk may offset some of the potential benefits, making the portfolio
more volatile and risky.

b. Yes, Hennessy could reduce the number of issues from 40 to 20 without significantly
affecting risk by:

1. Optimizing portfolio construction: Use advanced techniques, such as risk parity or factor-
based portfolio construction, to select the 20 stocks that provide the most diversification and
risk reduction.
2. Diversifying across factors: Ensure the 20 stocks represent a diverse range of factors, such
as value, momentum, size, and quality, to reduce reliance on any single factor.
3. Sector and industry diversification: Maintain a balanced representation of sectors and
industries, even with fewer stocks, to minimize exposure to specific market segments.

By implementing these strategies, Hennessy can reduce the number of stocks while
maintaining an acceptable level of diversification and risk management.

c. Reducing the number of stocks from 40 to 20 might be beneficial, but further reducing it to
10 might be less advantageous for several reasons:

1. Over-concentration: With only 10 stocks, the portfolio becomes extremely concentrated,

making it highly dependent on the performance of just a few stocks. This increases the risk of
significant losses if any of these stocks perform poorly.
2. Lack of diversification: With fewer stocks, the portfolio may not be adequately diversified,
leading to increased exposure to specific industry or market risks.
3. Increased reliance on individual stocks: With only 10 stocks, the portfolio’s performance
becomes heavily reliant on the success of each individual stock, making it more vulnerable to
company-specific risks.

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While reducing the number of stocks from 40 to 20 might allow Hennessy to focus on their
best ideas, reducing it further to 10 might lead to an overly concentrated and risky portfolio.

d. So, when making a decision about the Hennessy portfolio, the committee is considering
three main things:

1. Risk: They don’t want the whole fund to be too risky, so they might limit Hennessy’s
portfolio to 20 stocks to keep things balanced.
2. Overlap: They don’t want Hennessy’s portfolio to be too similar to other portfolios in the
fund, so they might keep it a bit more diversified (20 stocks) to avoid duplication.
3. Trade-offs: They’re weighing the potential benefits (higher returns) against potential risks
(losing money) and considering how it all fits together.

It's like planning a team strategy:

- Risk is like avoiding a risky play that might lose the game.
- Overlap is like making sure each player has a unique role to avoid duplication.
- Trade-offs are like deciding whether to try a tricky play that might win the game or play it
safe.

By considering these factors, the committee can make a decision that’s best for the whole
fund.

Question 3

a. Within the context of CAPM, assume;

 Expected return on the market = 15%

 Risk free rate = 8%
 Expected rate of return on RTG security = 17%
 Beta of RTG security = 1.25

i. What is the alpha of RTG? Plot the SML? [5]

i. To find the alpha of RTG, we can use the CAPM formula:

Expected Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)

Rearranging the formula to solve for alpha (the excess return):

Alpha = Expected Return – (Risk-Free Rate + Beta × (Market Return – Risk-Free Rate))

Alpha = 17% - (8% + 1.25 × (15% - 8%))

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 Alpha = 17% - (8% + 1.25 × 7%)
Alpha = 17% - (8% + 8.75%)
Alpha = 17% - 16.75%
Alpha = 0.25%

The alpha of RTG is 0.25% or 25 basis points.

To plot the SML, we can use the CAPM formula with the given values:

SML: Expected Return = 8% + 1.25 × (15% - 8%)

Expected Return = 8% + 1.25 × 7%
Expected Return = 8% + 8.75%
Expected Return = 16.75%

The SML is a straight line with an intercept of 8% (the risk-free rate) and a slope of 1.25 (the
beta).

ii. Is RTG overpriced, underpriced or fairly priced? Why? [3]

To determine if RTG is overpriced, underpriced, or fairly priced, we can compare its
expected return (17%) to the expected return predicted by the SML (16.75%).

Since 17% > 16.75%, RTG is overpriced. The excess return (alpha) of 0.25% indicates that
the security is expected to earn 25 basis points more than its fair return, given its beta.

Therefore, RTG is overpriced, and investors may consider selling or avoiding it until its price
adjusts to a level that reflects its fair value.

b. i. A portfolio has an expected rate of return of 20% and standard deviation of 20%. Bills offer
a sure rate of return of 7%. Which investment alternative will be chosen by an investor
whose A=4? What if A=8.[4]
U = E(ri) – 0.005Aσi2
Where A=4
U=20-0.005(4)(20^2)=12

WHERE A=8
U=20 – 0.005(8)(20^2)=4
Therefore, the investor will choose the investment with a higher utility of 12 where a is 4

ii. You have the following information about the following corporations, Circle Cement and
TN Holdings.

RATES OF RETURN

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 Circle Cement TN Holdings
PROBABILITY % %
0.1 20 10
0.4 10 40
0.5 -5 45

Risk free return (Rf) = 15%

A = 5
WCIRCLE = 40%
WTN = 60%

Draw a pie chart to show how the investor will allocate their funds between the risky
portfolio (P) and the risk-free asset. Illustrate your answer with a CAL. comment on your
findings. [8]

[20 marks]

Question 4

A pension fund manager at Old Mutual Zimbabwe is considering investing in 3 mutual

funds. The first is a stock fund, the second is a long-term corporate bond fund, and the third is
a T-Bill money market fund that yields a rate of 8%. The return probability distributions of
the risky funds are as follows

Expected Return % Standard deviation %

30
Stock Fund [S] 20
15
Bond Fund [B] 12

Correlation coefficient between Stock Fund and Bond Fund =0.20

a.) Solve numerically for the proportions invested in each asset, the expected return and
standard deviation of the optimal risky portfolio.[10]
a) Find the reward to variability ratio of the CAL supported by T-Bills and Portfolio P.
[2]
b) Calculate the complete portfolio allocated to P and to T-Bills if A=4. Outline your
answer with a pie chart.[8] [20 marks]

Question 5

I. Consider the two (excess return) index model regression for A and B
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 RA= 1%+1.2RM
R-SQR=0.576 RESID STD DEV-N=10.3%
RB=-2%+0.8RM
R-SQR=0.436 RESID STD DEV-N=9.1%
a) Which stock has more firm specific risk? (4)
b) Which stock has greater market risk? (4)
Comment in each case.
[8 marks]
a) Based on the Residual Standard Deviation (Resid Std Dev-N) values:

Stock A: 10.3%
Stock B: 9.1%

Stock A has more firm-specific risk.

Comment: Firm-specific risk refers to the risk unique to an individual firm, unrelated to
market movements. A higher Residual Standard Deviation indicates greater firm-specific
risk, as it represents the variability of excess returns not explained by the market return. In
this case, Stock A has a higher Residual Standard Deviation, indicating more firm-specific
risk.

b) Based on the beta (β) coefficients:

Stock A: 1.2
Stock B: 0.8

Stock A has greater market risk.

Comment: Market risk refers to the risk associated with market movements. A higher beta
coefficient indicates greater market risk, as it represents the sensitivity of excess returns to
market returns. In this case, Stock A has a higher beta, indicating greater market risk. This
means that Stock A's excess returns are more responsive to market movements, making it
riskier in terms of market risk.

Question 6

Estimate the index model and the total variance when given the following information about
the 6-month performance of the Airplus Corporation and the ZSE Index below. Comment on
the significance of your results and illustrate your answer with a Security Characteristic Line
(SCL). [22]

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 Month Airplus ZSE Index- HPR Treasury bill rate
Corporation-HPR (%) (%)
(%)
JANUARY 10 4 5
FEBRUARY 9 6 5.5
MARCH 12 9 7.4
APRIL 15 13.4 11
MAY 16 11 12
JUNE 8.9 11.5 11.9

Question 6.2
An investment manager identifies two pervasive macroeconomic factors. The risk premium
on factor 1 is 8% whilst on factor 2 is 12%. The risk-free rate is given as 4%. You are also
given the following:
Security B1 B2
A 1.50 0.30
B -1.20 2.20
C -0.20 1.80

a) Calculate the required rate of return according to arbitrage pricing model. [6 marks]
b) Suppose the expected return in the market is as follows:

Security Expected Return

A 16%
B 18%
C 20%

Explain how an arbitrageur will create a factor portfolio on each security to make a
riskless profit. [9 marks]
[total 15 marks]

Question 7

A. Which of the following assumptions imply (i.e.) an informationally efficient market?

[2]
i. Many profit-maximizing participants, each acting independently of the others,
analyse and value securities. TRUE
ii. The timing of one news announcement is generally dependent on other news
announcements.
iii. Security prices adjust rapidly to reflect new information. TRUE
iv. A risk-free asset exists, and investors can borrow and lend unlimited amounts
at the risk-free rate.

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 B. Which of the following most appears to contradict the proposition that the stock
market is weakly efficient? Explain.[2]
i. Over 25% of mutual funds outperform the market on average.
CONTRADICTS
ii. Insiders earn abnormal trading profits.
iii. Every January, the stock market earns above normal returns.

C. Suppose, after conducting an analysis of past stock prices, you come up with the
following observations. Which one would appear to contradict the weak form of the
efficient market hypothesis? Explain.[1]
i. The average rate of return is significantly greater than zero.
ii. The correlation between the market returns one week and the return the
following week is zero.
iii. One could have made superior returns by buying stock after a 10% rise in
price and selling after a 10% fall. CONTRADICTS
iv. One could have made higher than average capital gains by holding stock with
low dividend yields.

D. State if the following statements are true or false if the efficient market hypothesis
holds?
i. It implies perfect forecasting ability. [0.5] FALSE
ii. It implies that prices reflect all available information. [0.5] TRUE
iii. It implies that the market is irrational. [0.5] FALSE
iv. It implies that prices do not fluctuate. [0.5] FALSE

E. A market anomaly refers to:[2]

i. An exogenous shock to the market that is sharp but not persistent.
ii. A price or Volume event that is inconsistent with historical price or volume
trends. CORRECT
iii. A trading or pricing structure that interferes with efficient buying and selling
of securities.
iv. Price behaviour that differs from the behaviour predicted by the efficient
market hypothesis. CORRECT

F. “If the business cycle is predictable, and a stock has a positive beta, the stock’s
returns also must be predictable.” Respond explaining your reasoning.[2]
IF the business cycle is predictable, it means that the overall state of the economy and
the market can be forecasted with some degree of accuracy. A stock with a positive
beta is one that tends to move in the same direction as the overall market. Therefore,
if you can predict the market’s ups and downs and a stock tends to move in the same
direction as the market than you can predict the stock returns.

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 G. Some scholars contend that professional managers are incapable of outperforming the
market. Others come to an opposite conclusion. Compare and contrast the
assumptions about the stock market that support
(a) Passive portfolio management and [2]
(b) Active portfolio management.[2]

a) Passive Portfolio Management:

Assumptions:
- Efficient Market Hypothesis (EMH): markets are informationally efficient, and prices
reflect all available information.
- Random Walk Theory: stock prices move randomly and unpredictably.
- No consistent patterns or predictable anomalies exist in the market.
- Professional managers cannot consistently beat the market.

Implications:
- Passive management involves tracking a market index or benchmark.
- No attempt is made to beat the market or time the market.
- Low fees and turnover, as no active decisions are made.
- Suitable for investors with a long-term perspective and minimal effort.

(b) Active Portfolio Management:

Assumptions:
- Inefficient markets: prices do not always reflect all available information.
- Patterns and predictable anomalies exist in the market.
- Skilled professional managers can identify and exploit these opportunities.
- Beating the market is possible with superior analysis and decision-making.

Implications:
- Active management involves trying to beat the market through research, analysis, and
timing.
- High fees and turnover, as active decisions are made regularly.
- Suitable for investors seeking higher returns and willing to take on additional risk.

H. You are a portfolio manager meeting a client. During the conversation that followed your
formal review of her account, your client asked the following question:
“My grandson, who is studying investments, tells me that one of the best ways to make
money in the stock market is to buy the stocks of small-capitalization firms late in
December and to sell the stocks one month later. What is he talking about?”

i. Identify the apparent market anomalies that would justify the proposed strategy.[3]

10 | P a g e
  January Effect: Stocks that are underperformed in the fourth quarter of the prior year
(December) tend to outperform the markets in January.
 Small firm effect: Smaller firms tend to outperform larger companies as smaller firms
have longer runways for growth than larger companies

ii. Explain why you believe such a strategy might or might not work in the future.[2]

While the January Effect has been observed in the past, there are reasons to believe it
might not work in the future:

- Market efficiency: As more investors become aware of the anomaly, they may exploit it,
reducing its profitability.
- Changing market conditions: Shifts in investor behaviour, regulatory environments, or
economic conditions can render the anomaly obsolete.
- Random fluctuations: Past observations may be due to chance rather than a persistent
pattern.

However, there are also reasons to believe the strategy might still work:

- Persistent investor behaviour: Window dressing and tax-loss harvesting may continue to
drive prices in January.
- Market sentiment: Small-cap stocks may remain underrepresented in institutional
portfolios, maintaining the anomaly.

Question 8

As director of research for a medium-sized investment firm, Jeff Cheney was concerned
about the mediocre investment results experienced by the firm in recent years. He met with
his two senior equity analysts to consider alternatives to the stock selection techniques
employed in the past.
One of the analysts suggested that the current literature has examined the relationship
between Price– Earnings (P/E) ratios and securities returns. A number of studies had
concluded that high P/E stocks tended to have higher betas and lower risk-adjusted returns
than stocks with low P/E ratios.

The analyst also referred to recent studies analysing the relationship between security returns
and company size as measured by equity capitalization. The studies concluded that when
compared to the S&P 500 index, small-capitalization stocks tended to provide above-average
risk-adjusted returns, while large-capitalization stocks tended to provide below-average risk
adjusted returns. It was further noted that little correlation was found to exist between a
company’s P/E ratio and the size of its equity capitalization.

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Jeff’s firm has employed a strategy of complete diversification and the use of beta as a
measure of portfolio risk. He and his analysts were intrigued as to how these recent studies
might be applied to their stock selection techniques and thereby improve their performance.
Given the results of the studies indicated above:

a) Explain how the results of these studies might be used in the stock selection and
portfolio management process. Briefly discuss the effects on the objectives of
diversification and on the measurement of portfolio risk.[10]
b) List the reasons and briefly discuss why this firm might not want to adopt a new
strategy based on these studies in place of its current strategy of complete
diversification and the use of beta as a measure of portfolio risk.[10]

[20 marks]

a. The studies’ results can be applied in the stock selection and portfolio management process
as follows:

 P/E ratio: Focus on stocks with low P/E ratios, which tend to have lower betas and
higher risk-adjusted returns.
 Company size: Include a mix of small- and mid-capitalization stocks, which tend to
provide above-average risk-adjusted returns.
 Diversification: Continue to maintain a diversified portfolio to minimize risk, but
consider tilting the portfolio towards smaller capitalization stocks and those with
lower P/E ratios.
 Risk measurement: Supplement beta with other risk measures, such as standard
deviation or value-at-risk, to get a more comprehensive picture of portfolio risk.

b) Reasons why the firm might not want to adopt a new strategy:

 Overreliance on past research: The studies’ findings may not hold in the future.
 Market efficiency: Other investors may already be exploiting these strategies,
reducing their effectiveness.
 Risk of overconcentration: Tilting the portfolio towards specific stocks or sectors may
increase risk.
 Higher transaction costs: Implementing a new strategy may involve higher trading
costs.
 Incompatibility with existing processes: The new strategy may require significant
changes to the firm’s existing research, analysis, and portfolio management processes.
 Uncertainty about optimal implementation: The firm may be unsure how to best
incorporate these strategies into their existing framework.
 Concerns about client suitability: The new strategy may not be suitable for all clients,
particularly those with conservative risk profiles.

12 | P a g e
  Performance measurement challenges: Evaluating the success of the new strategy may
be difficult due to the complexity of the factors involved.
 Dependence on data quality: The accuracy of the research findings relies on high-
quality data, which may not always be available.
 Firm’s existing strengths: The firm may have existing strengths in their current
strategy and may not want to abandon a proven approach.

Question 9

I. Consider the following table, which gives a security analyst’s expected return on two
stocks for two particular market returns:

Market Return,Rm Aggressive Stock, A Defensive Stock ,B

5% 2% 3.5%

20% 32% 14%

a) What are the betas of the two stocks?[2]

b) What is the expected rate of return on each stock if the market return is equally likely
to be 5% or 20%?[3]
c) If the T-bill rate is 8%, and the market return is equally likely to be 5% or 20%, draw
the SML for this economy.[5]
d) Plot the two securities on the SML graph. What are the alphas of each and advise on
the significance of the alpha measure?[5]
e) What hurdle rate should be used by the management of the aggressive firm for a
project with the risk characteristics of the defensive firm’s stock?[5]

[20 marks]

Question 10

An investor has gathered the following information about the Zimbabwean market
Bond Fund Equity Fund
E( R) 25% 45%
𝝈 30% 60%

Covariance between bonds and equities is - 125

Expected return on Treasury bills is 15%
Investor’s risk aversion coefficient is 4
Required
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 i. Calculate the weight invested in the bond fund, equity fund and the money
market. Illustrate your answer graphically in a pie chart. [7]
ii. Calculate the expected return and standard deviation of the risky portfolio and the
complete portfolio. Draw a Capital allocation Line to illustrate your answer.
Calculate the Reward to Variability ratio supported by the risk-free asset and the
risky portfolio. [8]
iii. Briefly describe the action to be taken by the investor [5]

[20 marks]

Question 11

a. Outline the differences and similarities between the Single Index model and the Capital
Asset Pricing model. In your opinion, which of the two models makes a better assessment of
the return on a security? [20]

b. Consider the following table, which gives a security analyst’s expected return on two
stocks for two particular market returns:

Market Return,Rm Aggressive Stock, A Defensive Stock ,B

10% 4% 7%

40% 64% 28%

i. What are the betas of the two stocks?[2]

ii. What is the expected rate of return on each stock if the market return is equally likely
to be 10% or 40%?[3]
iii. If the T-bill rate is 8%, and the market return is equally likely to be 10% or 40%, draw
the SML for this economy.[5]
iv. Plot the two securities on the SML graph. What are the alphas of each and advise on
the significance of the alpha measure?[5]
v. What hurdle rate should be used by the management of the aggressive firm for a
project with the risk characteristics of the defensive firm’s stock?[5]

Question 12

An investor has gathered the following information about the Zimbabwean market
Bond Fund Equity Fund
E(R) 25% 45%
Std dev 30% 60%
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 Covariance between bonds and equities is - 125
Expected return on Treasury bills is 15%
Investor’s risk aversion coefficient is 4
Required
i. Calculate the weight invested in the bond fund, equity fund and the money
market. Illustrate your answer graphically in a pie chart. [7]
ii. Calculate the expected return and standard deviation of the risky portfolio and the
complete portfolio. Draw a Capital allocation Line to illustrate your answer.
Calculate the Reward to Variability ratio supported by the risk-free asset and the
risky portfolio. [8]
iii. Briefly describe the action to be taken by the investor [5]

[20 marks]

Question 13 GROUP A

Outline the differences and similarities between the Single Index model and the Capital Asset
Pricing model. In your opinion, which of the two models makes a better assessment of the
return on a security? [20]
Question 14

1(a) Track the performance of any counter of your choice from the Zimbabwe Stock
Exchange for a period of at least five years (can track annually, semiannually,
quarterly, monthly) and comment on your findings. Advise shareholders and
prospective shareholders on the course of action to take. Your comment should
include the movement of the share price, Earnings per Share, Net Asset Book Value,
Return on Average Shareholders’ funds, P/E ratios, PBV ratios, PS ratios, Return on
Average Assets and Dividends paid or not paid. (90)

(b) How has the operating environment affected your counter (positively or negatively) for
the years under study? What should the management do to counter or take advantage
of the operating environment affecting your counter? (10)

QUESTION 15

a) A portfolio has an expected rate of return of 20% and standard deviation of 20%. Bills
offer a sure rate of return of 7%. Which investment alternative will be chosen by an
investor whose A=4? What if A=8. (5)

b) You have the following information about the following corporations, PPC and
Econet .

RATES OF RETURN
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 PPC ECONET
PROBABILITY % %
0.1 20 10
0.4 10 40
0.5 -5 45

Risk free return (Rf) = 15%

A = 5
WPPC = 40%
WECONET = 60%
Draw a pie chart to show how the investor will allocate their funds between the
risky portfolio (P) and the risk-free asset. Illustrate your answer with a CAL.
comment on your findings. [10]

QUESTION 16.1

A pension fund manager is considering three mutual funds. The first is a stock fund, the
second is a long-term corporate bond fund, and the third is a T-Bill money market fund that
yields a rate of 8%. The probability distribution of the risky fund is as follows

Expected Return % Standard deviation %

30
Stock Fund [S] 20
15
Bond Fund [B] 12
Correlation coefficient between Stock fund and Bond fund =0.10

a. Solve numerically for the proportions of each asset and for the expected return and
standard deviation of the optimal risky portfolio.(10)
b. Find the reward to variability ratio of the CAL supported by T-Bills and Portfolio P. (2)
c. Calculate the complete portfolio allocated to P and to T-Bills if A=4. Outline Your
answer with a pie chart.(8)

QUESTION 16.2
A universe of available securities includes two risky stock funds, A and B, and Treasury
Bills. The data for the universe are as follows:

Expected Return % Standard deviation %

A 10 20
B 30 60

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 Treasury bills 5 0

The correlation coefficient between A, B = -0.2

a) Find the optimal risky portfolio, P, and its expected return and standard deviation.(10)
b) Find the minimum variance portfolio and compute the corresponding expected return and
standard deviation (6 marks)
c) Find the slope of the CAL supported by T-Bills and Portfolio P. (2)
d) How much will an investor with A=5 invest in funds A, B and in T-Bills? (8)

QUESTION 17

Consider the two (excess return) index model regression for A and B
RA= 1%+1.2RM
R-SQR=0.576 RESID STD DEV-N=10.3%
RB=-2%+0.8RM
R-SQR=0.436 RESID STD DEV-N=9.1%
c) Which stock has more firm specific risk? (5)
d) Which stock has greater market risk? (5)
Comment in each case.
QUESTION 18

Estimate the index model and the total variance when given the following
information about the 6-month performance of the Star Corporation and the ZSE
Index below. Comment on the significance of your results and illustrate your answer
with a Security Characteristic Line (SCL). [25]

Month Star Corporation- ZSE Index- HPR Treasury bill rate

HPR (%) (%) (%)
JANUARY 100 44 50
FEBRUARY 99 69 50
MARCH 121 91 75
APRIL 154 150 110
MAY 166 111 120
JUNE 87 177 120

QUESTION 19

A fund manager is considering investing in three mutual funds. The first is a stock
fund, the second is a long-term corporate bond fund, and the third is a T-Bill money
market fund that yields a rate of 8%. The probability distribution of the risky fund is
as follows
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 Expected Return % Standard deviation %
30
Stock Fund [S] 20
15
Bond Fund [B] 12
Correlation coefficient between Stock fund and Bond fund =0.10
a) Solve numerically for the proportions of each asset , the expected return
and standard deviation of the optimal risky portfolio. (10)
b) Find the reward to variability ratio of the CAL supported by T-Bills and
Portfolio P. (2)
c) Calculate the complete portfolio allocated to P and to T-Bills if A=4. Outline
your answer with a pie chart.(8)

QUESTION 20

A fund manager is considering investing in three mutual funds. The first is a stock
fund, the second is a long-term corporate bond fund, and the third is a T-Bill
money market fund that yields a rate of 8%. The probability distribution of the
risky fund is as follows

Expected Return % Standard deviation %

30
Stock Fund [S] 20
15
Bond Fund [B] 12
Correlation coefficient between Stock fund and Bond fund =0.10

I. Solve numerically for the proportions of each asset , the expected return and
standard deviation of the optimal risky portfolio. (10)
II. Find the reward to variability ratio of the CAL supported by T-Bills and Portfolio P.
(2)
III. Calculate the complete portfolio allocated to P and to T-Bills if A=4. Outline your
answer with a pie chart.(8)
[20 marks]

QUESTION 21

A pension fund manager is considering three mutual funds. The first is a stock fund, the
second is a long-term government and corporate bond fund, and the third is a T-bill money

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market fund that yields a sure rate of 5.5%. The probability distributions of the risky funds
are:

Expected Return Standard Deviation

Stock fund (S) 15% 32%

Bond fund (B) 9 23

The correlation between the fund returns is 0.15.

a. Tabulate and draw the investment opportunity set of the two risky funds.
b. Use investment proportions for the stock fund of 0 to 100% in increments of 20%.
c. What expected return and standard deviation does your graph show for the minimum
variance portfolio?
d. Draw a tangent from the risk-free rate to the opportunity set. What does your graph
show for the expected return and standard deviation of the optimal risky portfolio?
e. What is the reward-to-variability ratio of the best feasible CAL?
f. Suppose now that your portfolio must yield an expected return of 12% and be
efficient, that is, on the best feasible CAL.
i. What is the standard deviation of your portfolio?
ii.. What is the proportion invested in the T-bill fund and each of the two risky funds?
g. If you were to use only the two risky funds and still require an expected return of
12%, what would be the investment proportions of your portfolio? Compare its
standard deviation to that of the optimal portfolio in the previous problem. What do
you conclude?
[30
marks]
QUESTION 22
a) Several mechanisms have been put in place to mitigate the principal agency problem.
Explain in detail these mechanisms. (4)

b) Who are the clients of the financial system? Elaborate on the needs of each of these
clients. Also highlight how the environment has responded to the clients’ demands.(5)

c) Calculate the gross proceeds, total costs and net proceeds of a bankers Acceptance
with the following details.(6)

Nominal value, N $10 000 000

Discount rate, I 10.5%
Term to maturity, d 90 days
Stamp duty, Sd 0.03%
Commission, c 0.6%

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 d. Assume you bought a government $10 000 000 value Treasury bond on July
16,2006. The T-Bond matures on January 2,2009 and has a coupon rate of 11%
payable semi-annually and a yield (discount rate) of 7%. Calculate the T-
Bonds dirty price, accrued interest and clean price. Assuming that the bond is
Cum- interest and we use an actual/365-day convention.(10)

QUESTION 23

Bear Normal Bull

Probability 0.2 0.5 0.3

Rate of return on stock X -20% 18% 50%
Rate of return on stock Y -15% 20% 10%

a) What is the expected return of shares of stocks X and Y and also them
respective standard errors.(5)
b) Calculate the expected return as well as the standard deviation of the
Portfolio. (5)

NB. Assume that the portfolio is equally weighted between X and Y

QUESTION 24

Suppose we have two securities

E (rA) =20%
E (rB) =30%
A =25%
B =40%

Construct the following portfolios. Comment on your findings. (20)

WA WB E(rP) P P
(%) (%) (%) rA,B=25% rA,B=75%

a. 0 100
b. 100 0
c. 40 60

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QUESTION 25

A portfolio has an expected rate of return of 20% and standard deviation of 20%. Bills offer a
sure rate of return of 7%. Which investment alternative will be chosen by an investor whose
A=4? What if A=8. (5)

QUESTION 26

PPC ECONET
Rates of Return (%)
Probability
0.10 20 10
0.40 10 40
0.50 -5 45

Risk free return = 15%

A = 5
WPPC = 40%
WEC = 60%
Draw a pie chart to show how the investor will allocate their funds between the risky
portfolio (P) and the risk-free asset. Illustrate your answer with a CAL. comment on your
findings. (20)

QUESTION 27

An analyst estimates that a stock has the following probabilities of return depending
on the state of the economy.

State of the economy Probability Return%

Good 0.1 15
Normal 0.6 13
Poor 0.3 7

a) Calculate the expected return as well as the standard error of the stock.
Comment on your findings. (5)

QUESTION 28

Based on the scenarios below, what is the expected return and standard deviation for
security y with the following return profile? Comment. (5)

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 Bear Normal Bull

Probability 0.2 0.5 0.3

Rate of return on stock Y -25% 10% 24%

QUESTION 29

Suppose we have two securities

E (rX) = 40%
E (rY) = 60%
X = 20%
Y = 30%

Construct the following portfolios. Comment on your findings. (20)

WX WY E(rP) P P
(%) (%) (%) rX,Y=30% rXY=80%

a. 100 0
b. 0 100
c. 30 70

QUESTION 30

A portfolio has an expected rate of return of 20% and standard deviation of 20%. Bills offer a
sure rate of return of 10%. Which investment alternative will be chosen by an investor
whose A=3? What if A=10? (5)

QUESTION 31
A universe of available securities includes two risky stock funds, A and B, and Treasury
Bills. The data for the universe are as follows:

Expected Return (%) Standard Deviation (%)

A 10 20
B 30 60

T-bills 5 0

The correlation coefficient between A, B = -0.2

c) Find the optimal risky portfolio, P, and its expected return and standard deviation.(10)
d) Find the slope of the CAL supported by T-Bills and Portfolio P. (2)

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 c) How much will an investor with A=5 invest in funds A, B and in T-Bills? (8)

Question 32
a. Define market and briefly discuss the characteristics of a good market. [6]

b. You own 100 shares of Econet stock and you want to sell it because you need the money to
make a down payment on a car. Assume there is absolutely no secondary market system of
shares. How would you go about selling the share? Discuss what you would have to do to
find a buyer, how long it might take, and the price you might receive.[5]

c. Define liquidity and discuss the factors that contribute to it. Give examples of a liquid asset
and an illiquid asset, and discuss why they are considered liquid and illiquid. [5]
d. From your understanding what is liquidity? Compare the liquidity of an investment in raw
land with that of an investment in common stock. Be specific as to why and how they differ.
[5]

ANSWER
a) Definition of Market:
A market is a platform where buyers and sellers interact to exchange goods, services, or
securities.
Characteristics of a Good Market:
Efficiency: Prices reflect all available information.
Liquidity: Ease of buying and selling with minimal price impact.
Depth: Large volume of trades without significantly affecting prices.
Breadth: Wide range of products or securities available.
Transparency: Clear and accessible information about market conditions.
Fairness: Equal access and opportunities for all participants.

b) Selling Shares without a Secondary Market:

Without a secondary market, finding a buyer would be challenging. You would need to:
Identify potential buyers: Reach out to friends, family, colleagues, and acquaintances.
Negotiate a price: Agree on a price based on the company’s financials and market
conditions.
Conduct due diligence: Provide financial information and answer buyer questions.
Draft a sales agreement: Create a contract outlining terms and conditions.

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 This process could take weeks or even months, and the price received might be lower
than expected due to the lack of market liquidity.

c) Definition of Liquidity:
Liquidity refers to the ease and speed with which an asset can be bought or sold without
significantly affecting its price.

Factors contributing to liquidity:

Market demand and supply
Trading volume and frequency
Information availability and transparency
Market infrastructure and regulations
Examples:
- Liquid asset: Stocks like Apple or Microsoft, which are highly traded and easily sold.
- Illiquid asset: A rare art piece, which may take months or years to find a buyer.

D) Liquidity Comparison: Raw Land vs. Common Stock

Investing in raw land is illiquid due to:
Limited market demand
Difficulty in valuing the land
High transaction costs
Long negotiation and sales process
In contrast, common stock is liquid due to:
Active markets and high trading volume
Easy access to market information
Standardized contracts and trading procedures
Quick and efficient transaction processing
Raw land is illiquid because it’s a unique asset with limited demand, while common stock is
liquid due to its standardized nature and active markets.

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Question 33
a. Define a primary and secondary market for securities and discuss how they differ. Discuss
why the primary market is dependent on the secondary market.[5]
b. Give an example of an initial public offering (IPO) in the primary market. Give an example
of a seasoned equity issue in the primary market. Discuss which would involve greater risk to
the buyer. [5]
c. Briefly define each of the following terms and give an example:
i. Market order
ii. Limit order
iii. Short sale
iv. Stop loss order

ANSWER
a) Primary Market:
The primary market is where new securities are issued and sold to investors for the first
time, typically through an initial public offering (IPO) or a private placement. It’s where
companies raise capital for various purposes.
Secondary Market:
The secondary market is where existing securities are traded among investors, such as
stock exchanges or over-the-counter markets. It provides liquidity to investors and
allows them to buy and sell securities.
The primary market depends on the secondary market because:
- The secondary market provides a platform for investors to sell their securities, making
it more attractive for companies to issue new securities in the primary market.
- The secondary market’s liquidity and price discovery help determine the issue price and
demand for new securities in the primary market.
b) Examples:
- Initial Public Offering (IPO): A company issues new shares to the public for the first
time, raising capital for expansion. Example: Facebook’s IPO in 2012.
- Seasoned Equity Issue: A company issues new shares to the public after its initial
public offering, to raise additional capital. Example: Apple’s repeated equity issues over
the years.
The IPO would involve greater risk to the buyer because:
- IPOs often have limited financial information and a shorter operating history.
- The company’s stock price may fluctuate significantly after listing.

c) Definitions and Examples:

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 i. Market Order: An instruction to buy or sell a security at the best
available price in the market.
Example: Buying 100 shares of Apple stock at the current market price.
ii. Limit Order: An instruction to buy or sell a security at a specific price or
better.
Example: Buying 100 shares of Apple stock at $150 or lower.
iii. Short Sale: Selling a security that the seller does not own, with the
expectation of buying it back later at a lower price.
Example: Selling 100 shares of Apple stock short, expecting the price to drop.
iv. Stop Loss Order: An instruction to sell a security when it falls to a
specified price, limiting potential losses.
Example: Setting a stop loss order to sell 100 shares of Apple stock if it falls to $120.

Question 34

a. Young people with little wealth should not invest money in risky assets such as the stock
market, because they can’t afford to lose what little money they have.” Do you agree or
disagree with this statement? Why? [5]
b. Your healthy 63-year-old neighbor is about to retire and comes to you for advice. From
talking with her, you find out she was planning on taking all the money out of her company’s
retirement plan and investing it in bond mutual funds and money market funds. What advice
should you give her?
c. Discuss how an individual’s investment strategy may change as he or she goes through the
accumulation, consolidation, spending, and gifting phases of life. [10]
ANSWER
a) I disagree with the statement. While it’s true that young people with little wealth may
not have much to invest, it’s also important to consider the potential long-term benefits
of investing in the stock market. Historically, the stock market has provided higher
returns over the long-term compared to other asset classes, which can help young people
build wealth over time. Additionally, investing small amounts regularly can help reduce
risk and take advantage of dollar-cost averaging. It’s important to educate oneself and
seek professional advice before investing.
b) I would advise your neighbor to diversify her investments beyond just bond mutual
funds and money market funds. While these investments are generally considered safe,
they may not provide enough growth to sustain her retirement income. I would
recommend exploring other asset classes, such as dividend-paying stocks or real estate
investment trusts (REITs), which can provide a steady income stream. Additionally, I
would suggest considering tax implications and inflation protection to ensure her
retirement savings last throughout her golden years.

26 | P a g e
 c) An individual’s investment strategy should evolve as they progress through different
phases of life:
Accumulation Phase (20s-40s):
- Focus on growth investments, such as stocks and real estate
- Take on moderate to high risk to build wealth
Consolidation Phase (40s-60s):
- Gradually shift to more conservative investments, such as bonds and dividend-paying
stocks
- Reduce risk to protect accumulated wealth
Spending Phase (60s+):
- Emphasize income-generating investments, such as dividend stocks, REITs, and bonds
- Prioritize capital preservation and tax efficiency
Gifting Phase (later life):
- Consider transferring wealth to heirs or charitable organizations
- Explore tax-efficient strategies, such as trusts and estate planning

Question 35
a. Why is a policy statement important? How is the knowledge of a client’s risk profile
important in the writing of an Investment Policy Statement [5;5]
b. Your 45-year-old uncle is 20 years away from retirement; your 35-year-old older sister is
about 30 years away from retirement. How might their investment policy statements differ?
[5]
c. What information is necessary before a financial planner can assist a person in constructing
an investment policy statement?
ANSWER
a) A policy statement is important because it:
 Clearly outlines investment objectives and constraints
 Establishes a framework for decision-making
 Helps investors stay disciplined and avoid emotional decisions
 Ensures alignment with their risk tolerance and goals
 Facilitates ongoing monitoring and adjustments

Knowledge of a client’s risk profile is crucial in writing an Investment Policy Statement

(IPS) because it:

27 | P a g e
 o Helps determine the optimal asset allocation
o Guides the selection of appropriate investment vehicles
o Ensures the IPS aligns with the client’s risk tolerance
o Enables the creation of a tailored investment strategy
o Facilitates ongoing monitoring and adjustments

b) The investment policy statements of your uncle and sister might differ in:

o Risk tolerance: Your uncle, being closer to retirement, may have a lower risk
tolerance, while your sister, with a longer time horizon, may have a higher risk
tolerance.
o Time horizon: Your sister’s IPS may focus on long-term growth, while your uncle’s
IPS may prioritize income generation and capital preservation.
o Asset allocation: Your uncle’s IPS may allocate more to fixed-income investments,
while your sister’s IPS may allocate more to equities.
o Investment objectives: Your uncle’s IPS may focus on retirement income, while your
sister's IPS may prioritize wealth accumulation.

c) Before constructing an investment policy statement, a financial planner needs to

know:
o Client’s financial goals and objectives
o Risk tolerance and risk capacity
o Time horizon and investment horizon
o Current financial situation and assets
o Income and expense needs
o Tax status and constraints
o Investment knowledge and experience
o Any legal or regulatory constraints
o Client’s preferences and biases
o Any existing investment accounts or assets

Question 36
On some financial-planning firms.

28 | P a g e
 a. What strategies do they emphasize?
b. What do they say about their asset allocation strategy?
c. What is the meaning of :
i. value investing
ii. international diversification
iii. principal preservation
iv. retirement
v. estate planning [20]
ANSWER

Question 37
Mr. Franklin is 70 years of age, is in excellent health, pursues a simple but active lifestyle,
and has no children. He has interest in a private company for $90 million and has decided that
a medical research foundation will receive half the proceeds now; it will also be the primary
beneficiary of his estate upon his death. Mr. Franklin is committed to the foundation’s well-
being because he believes strongly that, through it, a cure will be found for the disease that
killed his wife. He now realizes that an appropriate investment policy and asset allocations
are required if his goals are to be met through investment of his considerable assets.
Currently, the following assets are available for use in building an appropriate portfolio:
$45.0 million cash (from sale of the private company interest, net of pending
$45 million gift to the foundation)
10.0 million stocks and bonds ($5 million each)
9.0 million warehouse properties (now fully leased)
1.0 million Franklin residence
Total:
$65.0 million total available assets

Required
a. Formulate and justify an investment policy statement setting forth the appropriate
guidelines within which future investment actions should take place. Your policy statement
must encompass all relevant objective and constraint considerations.[15]

b. Recommend and justify a long-term asset allocation that is consistent with the investment
policy statement you created in Part a. Briefly explain the key assumptions you made in
generating your allocation. [15]
ANSWER

International Investment Decisions

Question 38
a. Discuss why international diversification reduces portfolio risk. [5]

29 | P a g e
b. Why would you expect low correlation in the rates of return for domestic and foreign
securities? [5]
c. Some investors believe that international investing introduces additional risks.
Substantiating your response with examples ,discuss these risks and how they can affect your
return.[5]

ANSWER
a) International diversification reduces portfolio risk by:
o Spreading risk across different markets and economies
o Reducing exposure to any one market or currency
o Increasing potential returns through access to foreign growth opportunities
o Smoothing out market fluctuations through low correlations between domestic
and foreign securities
o Enhancing overall portfolio stability and resilience

b) Low correlation in rates of return for domestic and foreign securities can be expected
due to:
o Different economic cycles and growth patterns
o Distinct monetary and fiscal policies
o Varied industry and sector exposures
o Unrelated market and currency fluctuations
o Diverse political and regulatory environments

c) International investing introduces additional risks, including:

o Currency risk (exchange rate fluctuations)
o Political risk (government instability, trade restrictions)
o Economic risk (different economic cycles, growth rates)
o Market risk (different market structures, liquidity)
o 5. Regulatory risk (varying legal and regulatory frameworks)
Examples:
- Currency risk: A strong US dollar can reduce returns on foreign investments.
- Political risk: Trade tensions or sanctions can impact international investments.

30 | P a g e
 - Economic risk: A recession in one country can affect returns on investments in that
market.
These risks can affect returns by reducing investment value, generating losses, or
increasing volatility. However, careful research, diversification, and risk management
strategies can mitigate these risks and enhance the benefits of international
diversification.

Question 39

a. Chris Smith of XYZ Pension Plan has historically invested in the stocks of only South
African based companies. Recently, he has decided to add international exposure to the plan
portfolio. Identify and briefly discuss three potential problems that Smith may confront in
selecting international stocks that he did not face in choosing SA stocks. [9]

b. TMP has been experiencing increasing demand from its institutional clients for
information and assistance related to international investment management. Recognizing that
this is an area of growing importance, the firm has hired an experienced analyst/portfolio
manager specializing in international equities and market strategy. His first assignment is to
represent TMP before a client company’s investment committee to discuss the possibility of
changing their present “U.S. securities only” investment approach to one including
international investments. He is told that the committee wants a presentation that fully and
objectively examines the basic, substantive considerations on which the committee should
focus its attention, including both theory and evidence. The company’s pension plan has no
legal or other barriers to adoption of an international approach; no non-U.S. pension
liabilities currently exist.

i. Identify and briefly discuss three reasons for adding international securities to the pension
portfolio and three problems associated with such an approach.[9]

ii. Assume that the committee has adopted a policy to include international securities in its
pension portfolio. Identify and briefly discuss three additional policy-level investment
decisions the committee must make before management selection and actual implementation
can begin. [11]

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Efficient Capital Markets
Question 40
Tom Max, TMP’s quantitative analyst, has developed a portfolio construction model about
which he is excited. To create the model, Max made a list of the stocks currently in the S&P
500 Stock Index and obtained annual operating cash flow, price, and total return data for each
issue for the past five years. As of each year-end, this universe was divided into five equal-
weighted portfolios of 100 issues each, with selection based solely on the price/cash flow
rankings of the individual stocks.
Each portfolio’s average annual return was then calculated. During this five-year period, the
linked returns from the portfolios with the lowest price/cash flow ratio generated an
annualized total return of 19.0 percent, or 3.1 percentage points better than the 15.9 percent
return on the S&P 500 Stock Index. Max also noted that the lowest price–cash-flow
portfolio had a below-market beta of 0.91 over this same time span.

a. Briefly comment on Max’s use of the beta measure as an indicator of portfolio risk in light
of recent academic tests of its explanatory power with respect to stock returns. [5]

b. You are familiar with the literature on market anomalies and inefficiencies. Against this
background, discuss Max’s use of a single-factor model (price–cash flow) in his research. [8 ]

c. Identify and briefly describe four specific concerns about Max’s test procedures and model
design. (The issues already discussed in your answers to Parts a and b may not be used in
answering Part c.) [7]

[20 marks]

Question 41
a. Briefly explain the concept of the efficient market hypothesis (EMH) and each of its three
forms—weak, semi strong, and strong—and briefly discuss the degree to which existing
empirical evidence supports each of the three forms of the EMH. [15]
b. Briefly discuss the implications of the efficient market hypothesis for investment policy as
it applies to:
(i) Technical analysis in the form of charting, and [4]
(ii) Fundamental analysis. [4 ]

c. Discuss the role/responsibilities of a portfolio manager in a perfectly efficient market

environment [9]

d. Briefly discuss whether active asset allocation among countries could consistently
outperform a world market index. Include a discussion of the implications of integration
versus segmentation of international financial markets as it pertains to portfolio
diversification, but ignore the issue of stock selection. [6 ]

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ANSWER
. a) Efficient Market Hypothesis (EMH):
The EMH states that financial markets process information efficiently, making it impossible
to consistently achieve returns in excess of the market’s average.
1. Weak EMH: Past stock prices and returns are reflected in current stock prices, making
technical analysis useless.
o Current prices reflect only the information contained in past prices
o Past data on stocks are of no use in predicting future stock price changes
o Technical analysis is of little or no use

2. Semi-Strong EMH: All publicly available information is reflected in current stock prices,
making fundamental analysis useless.
o Current prices reflect all publicly available information
o Abnormally large profits cannot be consistently earned using public information
o Fundamental analysis is of little or no use

3. Strong EMH: All information, public or private, is reflected in current stock prices, making
any analysis useless.
o Current prices reflect all information (historical, public, private ) that can possibly be
known to anyone
o There is no information that allows investors to earn consistently high returns
o Insider information is of little use

Empirical evidence:
- Weak EMH: Supported by most studies
- Semi-Strong EMH: Partially supported, with some studies finding anomalies
- Strong EMH: Not supported, as insiders and analysts can earn excess returns

b) Implications for investment policy:

(i) Technical analysis: Not useful in a weak EMH environment, as past prices are already
reflected in current prices.
Technical analysis involves the search for recurrent and predictable patterns in stock prices in
order to enhance returns. The EMH implies that technical analysis is without value. If past
prices contain no useful information for predicting future prices, there is no point in
following any technical trading rule.

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(ii) Fundamental analysis: Not useful in a semi-strong EMH environment, as all public
information is already reflected in current prices.
Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future
interest rates, and risk evaluation of the firm to determine proper stock prices. The EMH
predicts that most fundamental analysis is doomed to failure. According to semi-strong form
efficiency, no investor can earn excess returns from trading rules based on publicly available
information. Only analysts with unique insight receive superior returns.
In summary, the EMH holds that the market appears to adjust so quickly to information about
individual stocks and the economy as a whole that no technique of selecting a portfolio using
either technical or fundamental analysis can consistently outperform a strategy of simply
buying and holding a diversified group of securities, such as those making up the popular
market indexes

c) Role of a portfolio manager in a perfectly efficient market:

I. Identify the risk/return objectives for the portfolio given the investor's constraints. In an
efficient market, portfolio managers are responsible for tailoring the portfolio to meet the
investor's needs rather than to beat the market, which requires identifying the client's return
requirements and risk tolerance. Rational portfolio management also requires examining the
investor's constraints, such as liquidity, time horizon, laws and regulations, taxes, and such
unique preferences and circumstances as age and employment. Other roles and
responsibilities include:
2. Developing a well-diversified portfolio with the selected risk level. Although an efficient
market prices securities fairly, each security still has firm-specific risk that portfolio
managers can eliminate through diversification. Therefore, rational security selection requires
selecting a well-diversified portfolio that provides the level of systematic risk that matches
the investor's risk tolerance.
3. Reducing transaction costs with a buy-and-hold strategy. Proponents of the EMH advocate
a passive investment strategy that does not try to find under- or overvalued stocks. A buy
and-hold strategy is consistent with passive management. Because the efficient market theory
suggests that securities are fairly priced, frequently buying and selling securities, which
generate large brokerage fees without increasing expected performance, makes little sense.
One common strategy for passive management is to create an index fund that is designed to
replicate the performance of a broad-based index of stocks.
4. Developing capital market expectations. As part of the asset-allocation decision, portfolio
managers need to consider their expectations for the relative returns of the various capital
34 | P a g e
markets to choose an appropriate asset allocation.
5. Implement the chosen investment strategy and review it regularly for any needed
adjustments. Under the EMH, portfolio managers have the responsibility of implementing
and updating the previously determined investment strategy for each client

d) Active asset allocation among countries:

- In a perfectly efficient market, it’s impossible to consistently outperform a world market
index.
- Integration of international financial markets: Diversification benefits are reduced, as
markets are highly correlated.
- Segmentation: Diversification benefits exist, as markets are less correlated.
Whether active asset allocation among countries could consistently outperform a world
market index depends on the degree of international market efficiency and the skill of the
portfolio manager. Investment professionals often view the basic issue of international market
efficiency in terms of cross-border financial market integration or segmentation. An
integrated world financial market would achieve international efficiency in the sense that
arbitrage across markets would take advantage of any new information throughout the world.
In an efficient integrated international market, prices of all assets would be in line with their
relative investment values. Some claim that international markets are not integrated, but
segmented. Each national market might be efficient, but factors might prevent international
capital flows from taking advantage of relative mispricing among countries. These factors
include psychological barriers, legal restrictions, transaction costs, discriminatory taxation,
political risks, and exchange risks. Markets do not appear fully integrated or fully segmented.
Markets may or may not become more correlated as they become more integrated since other
factors help to determine correlation. Therefore, the degree of international market efficiency
is an empirical question that has not yet been answer

Question 42
I. Which of the following assumptions imply(ies) an informationally efficient market?
a) Many profit-maximizing participants, each acting independently of the others, analyze and
value securities. TRUE
b) The timing of one news announcement is generally dependent on other news
announcements. FALSE
c) Security prices adjust rapidly to reflect new information. TRUE
d) A risk-free asset exists, and investors can borrow and lend unlimited amounts at the risk-
free rate. [2] FALSE

II. If markets are efficient, what should be the correlation coefficient between stock
returns for two non-overlapping time periods? [2] SHOULD BE ZERO
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 If markets are efficient, the correlation coefficient between stock returns for two non-
overlapping time periods should be approximately zero (0).
In an efficient market, past returns do not predict future returns, and each period’s returns
are independent of the previous period’s returns. This is known as the "random walk”
theory, where stock prices follow a random and unpredictable path.
Therefore, the correlation coefficient, which measures the degree of linear relationship
between two variables, should be close to zero, indicating no systematic relationship
between returns in different time periods.

III. Which of the following most appears to contradict the proposition that the stock market is
weakly efficient? Explain.
a. Over 25% of mutual funds outperform the market on average. CONTRADICTS
b. Insiders earn abnormal trading profits.
c. Every January, the stock market earns above normal returns. [4]

IV. Suppose, after conducting an analysis of past stock prices, you come up with the
following observations. Which would appear to contradict the weak form of the efficient
market hypothesis? Explain.
a. The average rate of return is significantly greater than zero.
b. The correlation between the market returns one week and the return the following week is
zero.
c. One could have made superior returns by buying stock after a 10% rise in price and selling
after a 10% fall. CONTRADICTS
d. One could have made higher than average capital gains by holding stock with low dividend
yields. [4]

V. Which of the following statements are true if the efficient market hypothesis holds?
a. It implies perfect forecasting ability. FALSE
b. It implies that prices reflect all available information. TRUE
c. It implies that the market is irrational. FALSE
d. It implies that prices do not fluctuate. [2] FALSE

VI. A market anomaly refers to:

a. An exogenous shock to the market that is sharp but not persistent.
b. A price or volume event that is inconsistent with historical price or volume trends.
c. A trading or pricing structure that interferes with efficient buying and selling of securities.
d. Price behavior that differs from the behavior predicted by the efficient market hypothesis.
CORRECT

36 | P a g e
VII. Which of the following observations would provide evidence against the semi strong
form of the efficient market theory? Explain. [4]
a. Mutual fund managers do not on average make superior returns.
b. You cannot make superior profits by buying (or selling) stocks after the announcement of
an abnormal rise in earnings.
c. Low P/E stocks tend to provide abnormal risk-adjusted returns. CORRECT
d. In any year, approximately 50% of pension funds outperform the market.
The correct answer is © Low P/E stocks tend to provide abnormal risk-adjusted returns.
This observation provides evidence against the semi strong form of the efficient market
theory because it suggests that there is a pattern or anomaly in the market that can be
exploited to earn excess returns. According to the semi strong form of EMH, all publicly
available information is already reflected in stock prices, and no analysis can identify
undervalued or overvalued stocks. However, the observation that low P/E stocks tend to
provide abnormal risk-adjusted returns suggests that there is a systematic relationship
between P/E ratios and future returns, which contradicts the semi strong EMH.

Question 43
a. A successful firm like Delta Corporation has consistently generated large profits for years.
Is this a violation of the EMH? [4] NO, IT’S NOT A VIOLATION OF THE EMH.
Consistently generating large profits is a sign of a well-managed company, but it doesn’t
necessarily mean that the stock is mispriced or that investors can earn excess returns by
buying the stock.

b. Prices of stocks before stock splits show on average consistently positive abnormal returns.
Is this a violation of the EMH? [4] YES, THIS IS A VIOLATION OF THE EMH.
If prices consistently show positive abnormal returns before stock splits, it suggests that
investors can earn excess returns by buying stocks before splits, which contradicts the EMH.
c. “If the business cycle is predictable, and a stock has a positive beta, the stock’s returns also
must be predictable.” Respond.[4] FALSE.
A predictable business cycle and a positive beta only imply that the stock’s returns are more
volatile, not predictable.
While positive beta stocks will respond to new favourable information about the
economy’s progress through the business cycle, they should not show abnormal returns
around already anticipated events. If a recovery already is anticipated, the actual
recovery is not news. The stock price should already reflect the coming recovery.

d. “The expected return on all securities must be equal if markets are efficient.” Comment.
[4] FALSE.

37 | P a g e
The EMH states that all securities should have the same expected return after adjusting for
risk, not that all securities must have the same expected return

e. We know the market should respond positively to good news, and good news events such
as the coming end of a recession can be predicted with at least some accuracy. Why, then, can
we not predict that the market will go up as the economy recovers? [4]
The EMH states that markets reflect all publicly available information, including predictions
about future events. If the market expects a recession to end, prices will already reflect that
information, making it impossible to predict excess returns.
f. If prices are as likely to increase or decrease, why do investors earn positive returns from
the market on average? [2]
Investors earn positive returns on average because they demand a risk premium for investing
in the market, which is subject to uncertainty and volatility.
g. You know that firm XYZ is very poorly run. On a management scale of 1 (worst) to 10
(best), you would give it a score of 3. The market consensus evaluation is that the
management score is only 2. Should you buy or sell the stock? [3]
You should buy the stock. If you believe the management score is 3, but the market
consensus is 2, you think the company is undervalued, making it a good investment
opportunity.
h. Some scholars contend that professional managers are incapable of outperforming the
market. Others come to an opposite conclusion. Compare and contrast the assumptions about
the stock market that support
I. passive portfolio management and [3]
II. active portfolio management. [3]

i. Passive portfolio management assumes:

- Markets are efficient and reflect all publicly available information
- No one can consistently beat the market
- Low costs and broad diversification are key
ii. Active portfolio management assumes:
- Markets are not always efficient, and mispricings can occur
- Skilled managers can identify undervalued or overvalued securities
- Beating the market is possible with superior analysis or insight

Question 44

38 | P a g e
You are a portfolio manager meeting a client. During the conversation that followed your
formal review of her account, your client asked the following question: Prepared by A. “My
grandson, who is studying investments, tells me that one of the best ways to make money in
the stock market is to buy the stocks of small-capitalization firms late in December and to sell
the stocks one month later. What is he talking about?”
a. Identify the apparent market anomalies that would justify the proposed strategy. [8]
b. Explain why you believe such a strategy might or might not work in the future. [7]

Question 45
Which of the following phenomena would be either consistent with or in violation of the
efficient market hypothesis? Explain briefly.
a. Nearly half of all professionally managed mutual funds are able to outperform the S&P 500
in a typical year. [3] VIOLATION OF EMH.
If nearly half of professionally managed mutual funds can outperform the S&P 500, it
suggests that markets are not efficient, and skilled managers can consistently beat the
market.
b. Money managers that outperform the market (on a risk-adjusted basis) in one year are
likely to outperform the market in the following year. [3] VIOLATION OF EMH.
If money managers who outperform the market in one year are likely to do so in the
following year, it suggests that there is persistence in returns, which contradicts the
EMH.
c. Stock prices tend to be predictably more volatile in January than in other months.[3]
CONSISTENT WITH EMH.
Stock prices may be more volatile in January due to various factors like tax-loss selling or
window dressing, but this does not necessarily imply that returns can be predicted.
d. Stock prices of companies that announce increased earnings in January tend to outperform
the market in February.[3] VIOLATION OF EMH.
If stock prices of companies that announce increased earnings in January tend to outperform
the market in February, it suggests that investors can earn excess returns by buying
stocks after positive earnings announcements.

e. Stocks that perform well in one week perform poorly in the following week.[3]
CONSISTENT WITH EMH
Stock prices may fluctuate randomly, and short-term reversals in returns do not necessarily
imply that markets are inefficient or that excess returns can be earned.

Question 46
“Growth” and “Value” can be defined in several ways, but “growth” usually conveys the idea
of a portfolio emphasizing or including only issues believed to possess above average future
39 | P a g e
rates of per-share earnings growth. Low current yield, high price-to-book ratios, and high
price-to-earnings ratios are typical characteristics of such portfolios. “Value” usually conveys
the idea of portfolios emphasizing or including only issues currently showing low price-to-
book ratios, low price-to-earnings ratios, above-average levels of dividend yield, and market
prices believed to be below the issues’ intrinsic values.
a. Identify and explain three reasons why, over an extended period of time, value stock
investing might outperform growth stock investing. [6]
b. Explain why the outcome suggested in (a) above should not be possible in a market widely
regarded as being highly efficient. [4]
ANSWER
a. Three reasons why value stock investing might outperform growth stock investing over an
extended period:
o Mean reversion: Value stocks are often undervalued due to temporary market sentiment
or economic conditions. As these conditions reverse, value stocks tend to return to their
intrinsic value, resulting in higher returns.
o Risk reduction: Value stocks typically have lower price-to-book and price-to-earnings
ratios, indicating lower risk. This reduced risk can lead to higher returns over the long
term.
o Contrarian investing: Value investing involves going against the crowd, buying stocks
that are out of favor. This contrarian approach can lead to higher returns as the market
corrects its overreaction.
b. In a highly efficient market, it should not be possible for value stock investing to
consistently outperform growth stock investing because:
o All publicly available information is already reflected in stock prices.
o Markets are highly competitive, with many investors seeking to exploit any
mispricings.
o Any perceived differences in returns between value and growth stocks should be
quickly arbitraged away by investors seeking to profit from these differences.
In an efficient market, there is no systematic way to achieve excess returns, and any
perceived advantages of value investing should be temporary and self-correcting.

PORTIFOLIO THEORY
Question 47
a. Why do most investors hold diversified portfolios? [5]
b. What is covariance, and why is it important in portfolio theory?[5]

40 | P a g e
c. Why do most assets of the same type show positive covariances of returns with each other?
Would you expect positive co variances of returns between different types of assets such as
returns on Treasury bills, General Electric common stock, and commercial real estate? Why
or why not? [5]

ANSWER
a. Most investors hold diversified portfolios to reduce risk by spreading their investments
across various assets. This helps to:
- Reduce exposure to any one asset’s volatility
- Minimize the impact of any one asset’s potential decline
- Increase the potential for long-term returns
Diversification takes advantage of the idea that different assets perform well in different
market conditions, so a diversified portfolio can provide more consistent returns over time.

b. Covariance measures the degree to which two assets move together in terms of returns. It’s
important in portfolio theory because it helps investors understand how different assets
interact and affect overall portfolio risk. Covariance is used to calculate the portfolio’s
expected return and risk (measured by standard deviation).

c. Most assets of the same type (e.g., stocks) show positive covariances of returns because
they are often affected by similar market and economic factors. For example, technology
stocks tend to move together due to industry-specific trends and market conditions.
Between different types of assets (e.g., Treasury bills, General Electric common stock, and
commercial real estate), covariances can be:
o Positive: If they are affected by similar macroeconomic factors (e.g., interest rates, GDP
growth)
o Negative: If they have opposing reactions to market conditions (e.g., bonds and stocks
often move in opposite directions)
o Low or near-zero: If they are largely unrelated (e.g., gold prices and tech stocks)
Understanding these covariances helps investors create diversified portfolios that balance risk
and potential returns.

Question 48
a. What is the relationship between covariance and the correlation coefficient?[5]
b. Explain the shape of the efficient frontier. [4] Draw a properly labelled graph of the
Markowitz efficient frontier. Describe the efficient frontier in exact terms. Discuss the
concept of dominant portfolios and show an example of one on your graph.[5]
41 | P a g e
c. Why are investors’ utility curves important in portfolio theory? [4]
d. Explain how a given investor chooses an optimal portfolio. Will this choice always be a
diversified portfolio, or could it be a single asset? Explain your answer.[5]
e. Assume that you and a business associate develop an efficient frontier for a set of
investments. Why might the two of you select different portfolios on the frontier? [5]

ANSWER

a. The correlation coefficient (ρ) is a normalized version of covariance, ranging from -1 to 1.

Covariance measures the degree of linear relationship between two assets, while the
correlation coefficient expresses this relationship as a percentage.

b. The efficient frontier is a curve that shows the highest expected return for a given level of
risk (measured by standard deviation) or the lowest risk for a given expected return. It is
shaped like a curve bulging to the northwest, indicating a tradeoff between risk and return.

Graph:

[Insert graph with expected return on the y-axis and standard deviation on the x-axis]

The efficient frontier represents the optimal portfolios that offer the highest expected return
for a given risk level or the lowest risk for a given expected return. Dominant portfolios are
those that lie on the efficient frontier, meaning they have the highest expected return for their
risk level or the lowest risk for their expected return.

Example of a dominant portfolio:

[Insert point on the graph labeled “Dominant Portfolio”]

c. Investors’ utility curves are important in portfolio theory because they represent an
investor's preferences for risk and return. Utility curves are downward-sloping, indicating that
investors demand higher returns for taking on more risk.

d. An investor chooses an optimal portfolio by selecting the point on the efficient frontier that
aligns with their utility curve. This choice may not always be a diversified portfolio; if an
investor is highly risk-averse, they may choose a single asset with low risk, such as a
Treasury bill.

e. You and your business associate may select different portfolios on the efficient frontier
because of differing risk preferences, investment goals, or time horizons. For example, you
may be more risk-tolerant and choose a portfolio with higher expected returns, while your
associate may be more risk-averse and choose a portfolio with lower risk.

42 | P a g e
Question 49
a. Stocks K, L, and M each have the same expected return and standard deviation. The
correlation coefficients between each pair of these stocks are:

K and L is 0.8
K and M is 0.2
L and M is –0.4
Given these correlations, a portfolio constructed of which pair of stocks will have the lowest
standard deviation? Explain. [6]
The portfolio constructed containing stocks K and M would have the lowest standard
deviation. As demonstrated in the chapter, combining assets with equal risk and return but
with low positive or negative correlations will reduce the risk level of the portfolio

b. Which of the following statements about the standard deviation is/are true? A standard
deviation:
i. Is the square root of the variance TRUE
ii. Is denominated in the same units as the original data. TRUE
iii. Can be a positive or a negative number. [4] FALSE

c. Which of the following statements reflects the importance of the asset allocation decision
to the investment process? The asset allocation decision:
a. Helps the investor decide on realistic investment goals.
b. Identifies the specific securities to include in a portfolio.
c. Determines most of the portfolio’s returns and volatility over time. TRUE
d. Creates a standard by which to establish an appropriate investment time
horizon. [4]

ANSWER
a. The portfolio constructed with stocks K and M will have the lowest standard deviation.
This is because the correlation coefficient between K and M is 0.2, which is the lowest
among the three pairs.
A low correlation coefficient indicates that the prices of the two stocks move relatively
independently of each other, which reduces the overall risk of the portfolio.

b. The correct statements about standard deviation are:

- i. Is the square root of the variance (True)
- ii. Is denominated in the same units as the original data (True)
- iii. Can be a positive or a negative number (False – Standard deviation is always positive or
zero)

43 | P a g e
c. The correct statement reflecting the importance of the asset allocation decision is:
C. Determines most of the portfolio’s returns and volatility over time (True)
Asset allocation is the process of dividing an investment portfolio among different asset
classes, such as stocks, bonds, and cash. It is a crucial decision because it determines the
overall risk and return characteristics of the portfolio, and has a significant impact on the
portfolio’s performance over time.

Question 50
The stock of Business Adventures sells for $40 a share. Its likely dividend payout and end-of-
year price depend on the state of the economy by the end of the year as follows:

Dividend Stock price

Boom $2 $50
Normal economy $1 $43
Recession $ 0.50 $34

44 | P a g e
Formulas: Investment Analysis and Portfolio Management

1.
MV =P 1+
[ ( )( )]
d
365
i
100
Issuing certificates of deposits

MV
C=

[ ( )( )]
1+
d
365
i
100
Dealing in certificates of deposits

2. Treasury Bills

Y= (360t )( DF )
P=F 1−
[ (360Yt )]
( 365∗y )
BeY =
360−( y∗t )
(360∗y )
CDeY =
360− yt

Tender Price=
F− 1∗
d
365 [ ]
Required discount rate= 100
∗
d[
P−TP 365
∗100 ]
F−TP 365
∗ ∗100
Actual yield= TP d

45 | P a g e
 Consideration=
N− N∗
i
∗
d
100 365 [ ]
3. Bankers Acceptances

TC=N
[ d
365
( c +i ) +sd ]
GP=N − N∗
i
∗
d
100 365 [ ]
E ( R A )=∑ Pr* R A
3.

4.
σ
A2
[
=∑ R A −E ( R A )2 Pr ]

COV A , B
r A , B=
5. σ A σB

6. E ( Rp )=E ( Ri ) Wi

2 2 2 2
7. σ 2 p=W A
σ A
+W B
σ B 2 COV A , B W A W B

E ( Rp )−Rf
Sp=
8. σp

E ( Rp )−Rf
Y ¿=
9. 0. 01∗A∗σ 2 p

E ( Rm)−Rf
Y=
10. 0 . 01∗A∗σ 2 p

WD =
[ E ( R D )− Rf ] σ E −[ E ( R E ) − Rf ] COV D , E
2 2

11. [ E ( R D ) −Rf ] σ E + [ E ( R E ) − Rf ] σ D−[ E ( R D )− Rf + E ( R E ) − Rf ] COV D , E

12. α = ER −[ Rf + βE ( Rm ) ]

46 | P a g e
 D1 P1 −P0
HPR= +
13. P0 P0

14.
Ri =α+ βi Rm+ei

15. Rp=αp+ β pRm+ep

2
( ei )
16. σ 2 i=β 2 iσ 2 m +σ
Variance of the rate of return on a security

17.
COV ( Ri Rm )=βiσ 2 m

COV ( Ri , R j ) =COV ( β i Rm; β j Rm )

18.
=βiβjσ 2 m

β=
[ COV ( R i Rm ) ]
19. σ2 m

( 1
)∑ e t
2
σ 2 (ei )=
20. n−2 t=1

Variance attributable to firm specific factors

¿ 2
1
∑ RM −RM )
(
2
m
σ =
21. n−1
β 2 σ 2 m= Variance attributable to market forces
n

22.
σ 2 ( ep ) =∑
t =1
()
1 2 2
n
σ ei

β2 σ 2 m
R2 =
23. σ2
σ 2( e i )
R2 =1− 2
i
σ

47 | P a g e
 (∑ X ∑ Y )
∑ XY − n
β=
(∑ X )
2
∑ X 2− n
24.

¿
¿ ¿
25. α=Y −β X

Cu−Cd
h=
26. uS−dS

27.
U =e
√
σ T
n

1
d=
28. u

1+rf −d
∏¿ u−d
29.

30.
C 0 =N ( d 1 ) S−Xe−rft N ( d 2 )

31.
P0 =X e−rfT N ( −d 2 ) −SN ( −d 1 )

32.
In ( ) ( )
S
X
+r +
σ2
2
T

33.
d 2 =d 1 −σ √ T

D1
P0 =
34. Ke−g

D 365
d= ∗
35. S T

S−P 365
Yield= ∗
36. P T

N −P 360
rbd = ∗
37. N T
48 | P a g e
 [] [ ]
1 2 2 n−1
2
Q P=n Q + Q ji
38. n n

49 | P a g e