1. Below lists a number of possible facts about investor or price behavior. Please articulate how you would make money by exploiting these mistakes and the reasoning behind your strategy. The first one is given as an example.

1. (a) Fact: most retail investors naively buy stocks of companies that make products they are familiar with (e.g. McDonalds) and ignore companies they never heard of.

   Answer: this will tend to make less popular stocks undervalued and popular stocks overvalued. Therefore, I would exploit this by going long the unpopular stocks and short the popular ones.

2. (b) Fact: many investors prefer lottery stocks: companies that have low prices but have a small probability of price suddenly jumping up by a lot. (Their payoff is similar to the lottery). Please explain how you would exploit this fact.

3. (c) Fact: corporate bonds have credit ratings that indicate their default risk. The most highly rated is AAA (almost no default risk), followed by AA, A, BBB,

1

BB, B, and C. Bonds with ratings at or better than BBB is called investment grade; worse bonds are called high yield or junk bonds. Many institu- tional investors (e.g. pension funds) are legally prohibited to hold high-yield funds. Note that credit ratings do go up or down over time. If a bond gets downgraded from BBB to BB, all those funds will have to sell.

(d) Fact: company insiders (e.g. CEOs) often have a better idea whether their stock is over- or under-valued and will trade accordingly to gain profits for themselves. Insider trading is publicly disclosed in SEC form 4 therefore, we know who bought and sold.

2. Please compute Sharpe ratio for the following fund. Its average return is 12% and volatility is 4%. Risk-free rate is 6%.

3. Below are the returns of funds X and Y, together with the returns of their bench- mark indices. You should be able to answer this question by eyeballing the numbers, but you should feel free to do calculations too.

Please choose from the following options and give a brief explanation:

(A) Fund X has higher tracking error. (B) Fund Y has higher tracking error. (C) There isnt sufficient information provided.

Year Fund X X's benchmark Fund Y Y's benchmark 1999 35.7% 36.6% 1.6% 5.9% 2000 2.9% 2.6% 4.0% 0.2% 2001 -36.1% -35.8% 5.0% 4.3% 2002 0.1% 2.1% 10.5% 7.5% 2003 41.3% 42.3% 4.7% 3.7% 2004 -20.4% - 19.4% -8.7% 2.1% 2005 -52.8% -52.1% 3.3% 8.8% 2006 20.1% 18.4% 7.1% 3.5% 2007 20.7% 22.2% 1.4% 1.1% 2008 51.6% 50.3% -5.2% 3.8% 2009 -5.4% -5.4% -10.7% -1.0% 2010 1.1% 2.4% -1.8% -0.6% 2011 -1.0% -0.9% 10.4% 3.6% 2012 7.6% 7.8% 3.7% 3.3% 2013 -48.0% -48.4% 4.6% 4.0% 2014 -21.0% -22.1% 2.3% 3.6% 2015 -3.1% -2.0% 2.6% 3.3% 2016 13.3% 12.1% 5.5% 3.2% 2017 -40.6% -41.5% 1.9% 4.6% 2018 76.1% 76.1% 4.2% 1.7% 2019 21.6% 22.5% 3.8% -0.9% Year Fund X X's benchmark Fund Y Y's benchmark 1999 35.7% 36.6% 1.6% 5.9% 2000 2.9% 2.6% 4.0% 0.2% 2001 -36.1% -35.8% 5.0% 4.3% 2002 0.1% 2.1% 10.5% 7.5% 2003 41.3% 42.3% 4.7% 3.7% 2004 -20.4% - 19.4% -8.7% 2.1% 2005 -52.8% -52.1% 3.3% 8.8% 2006 20.1% 18.4% 7.1% 3.5% 2007 20.7% 22.2% 1.4% 1.1% 2008 51.6% 50.3% -5.2% 3.8% 2009 -5.4% -5.4% -10.7% -1.0% 2010 1.1% 2.4% -1.8% -0.6% 2011 -1.0% -0.9% 10.4% 3.6% 2012 7.6% 7.8% 3.7% 3.3% 2013 -48.0% -48.4% 4.6% 4.0% 2014 -21.0% -22.1% 2.3% 3.6% 2015 -3.1% -2.0% 2.6% 3.3% 2016 13.3% 12.1% 5.5% 3.2% 2017 -40.6% -41.5% 1.9% 4.6% 2018 76.1% 76.1% 4.2% 1.7% 2019 21.6% 22.5% 3.8% -0.9%