Answer correctly.

You have been assigned to construct a portfolio comprising two risky assets (Portfolios A & B) while considering your client's risk tolerance. The attached spread sheet shows historical monthly returns of the two portfolios; the market portfolio as represented by the S&P 500 index; and the risk free rate as represented by 90-day Treasury Bills. Also shown are the annualized returns for each investment during the period. The first risky asset (Portfolio A) is a US equity strategy that uses publically available valuation, technical and sentiment factors to assess which stocks are over-priced and which are under-priced. Fundamental factors indicate the magnitude and quality of a company's earnings and the strength of its balance sheet. Examples of such factors include: cash flow growth, cash flow return on invested capital, price to cash flow, and accruals which assess earnings quality (low quality earnings indicate that management may be manipulating earnings by adjusting accruals). Companies with favorable fundamental factors tend to outperform those with less favorable factors. Technical and sentiment factors seek to identify mis-pricings resulting from investor behavior. Examples include: momentum and price reversals where investors tend to over-react to good news by bidding up prices ABOVE fair value and bad news by bidding down prices BELOW fair value; short interest on a stock which can indicate the investor sentiment about the company's prospects; share buybacks which can indicate a positive signal from management's optimism regarding a firm's future prospects; and earnings / revenue surprise. Firms with favorable technical and sentiment factors also tend to outperform. For example, firms whose earnings and revenue exceed analysts' expectations tend to continue to outperform vs. those firms that experience earnings surprise due to cost cutting. Starting with the market portfolio, the US equity strategy over-weights those stocks with more favorable fundamental, technical and sentiment factors and under-weights or avoids those stocks with less-favorable or un-favorable factors. The strategy seeks to out-perform the market portfolio as represented by the S&P 500. The monthly returns of the US equity strategy are shown in the attached spreadsheet (Portfolio A). The second risky asset (Portfolio B) is a global macro hedge fund. This strategy seeks to benefit from mis-pricings within and across broad asset classes by taking long and short positions in equity markets, bond markets and currencies. For example, if the manager believes that US equities will out-perform Japanese equities, the portfolio will go long S&P 500 futures and short TOPIX futures (TOPIX is an index that serves as a proxy for Japanese equities). This long/short trade is not impacted by the overall direction of global equities, but rather the relative movement between US and Japanese equities. Similarly for bonds, if the manager believes that interest rates in the United Kingdom (UK) will decline more so than interest rates in Australia, then the manager will buy UK gilt futures (gilt is the 10-year UK bond) and short Australian 10-year bond futures. Again, this trade is not impacted by the overall direction of global interest rates, but rather the relative movement between UK and Australian rates. Recall that bond prices rise as interest rates decline. The global macro hedge fund is mostly market neutral meaning that long positions equal short positions thereby dramatically reducing systematic exposures (low beta). Portfolios A & B are much more volatile than the risk free rate. You will find that their correlation is small indicating that there is a diversification benefit to be had from holding both in a portfolio (you will need to calculate this using the excel function "=correl(range 1, range2)". You will be meeting with a client that is looking for investment advice from you based on the two strategies A & B. In preparation for your upcoming meeting with the client, your boss asks that you respond to the questions below and be ready to discuss. Hint: You will need to determine the correlations and volatilities for each risk premium.

Your client believes in the weak form of market efficiency as it relates to security selection. Is Portfolio A's performance sufficient justification to prove this belief? Why or why not.

Section 2.

Use the following information to answer the questions below.

Mike Durham is a Managing Director in the Derivatives branch at ACE Capital Management, an investment management firm. Durham specializes in advising institutional clients on the use of forward contracts in their portfolio management strategies. Durham is preparing to meet with three of the firms U.S. based clients: Anne Markit, Antoine Fore, and John Elder. Anne Markit manages equity and fixed income portfolios for a pension fund. One month ago, Markit had indicated to Durham that the pension fund expected a large inflow of cash in 60 days. In order to hedge against a potential rise in equity values over this period, Durham advised her to enter into a forward contract on the S&P 500 stock index expiring in 60 days. In a follow-up call, Markit asks Durham to update her with the current value of the forward position initiated 30 days ago. During that call, Markit also mentions that her fixed income portfolio could be improved through swaps. Markit is not really clear on how interest rate swaps relate to forward rate agreements or options, but she still plans to establish some minor positions to gain experience before actively using swaps. She knows that the most basic type of swap is the plain vanilla swap, where one counterparty pays LIBOR as the floating rate and the other counterparty pays a fixed rate determined by the swap market. She feels this would be a good place to begin and plans to enter into a 2-year, annual-pay plain vanilla swap with $1M notional principal, where she pays LIBOR and receives the fixed swap rate from the other counterparty. Markit ask Durham for help. After the call, Durham feels uncertain of the level of Markit's familiarity with swaps. He wants to make sure that this instrument is appropriate for Markit; he thinks it would be necessary to provide her with (1) pricing, and valuation information as interest rates change, and (2) an explanation of the risks inherent to swaps. For that matter, he collects market data on current and forecasted LIBOR term structure. The data are shown in exhibit 1. Exhibit 1: Term Structure of Interest Rates LIBOR RATES Year Current Forecast (1 year) 0.5 3.50% 3.80% 1 4.20% 4.30% 1.5 2 4.45% 4.60% 4.50% 4.70% After his conversation with Markit, Durham receives a call from Antoine Fore, the owner of a local football team. Three month ago, Fore had to purchase 10,000 bonds with a 5% coupon rate and a maturity of 7 years from the date of issuance (the bonds were purchased at the issuance date). The bonds have a face value of $1,000 and pays interest every 180 days from the date of issue. Fore is concerned about a potential increase in interest rate over the next year and has approached Durham for advice on how he can use forward contracts to manage his risk. Durham advises Fore to enter into a forward contract agreement expiring in 360 days. The current price of the bond issue with accrued interest is $1,071.33 per bond. Fore asks Durham to calculate the appropriate price for the forward contract. At the end of the call, Fore asks, "Mike, could you also tell me if there be any credit risk associated with this forward position?"