Behavioural Economics combines ________ and ___________ to understand the decision making process of consumers.

(i) Set down the equations for the expected returns based on the Capital

Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT).

Define all symbols used.

(ii) Briefly explain the major differences between these models.

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2 (i) Briefly discuss how liabilities can be incorporated into portfolio

selection models. [3]

(ii) Outline how Monte Carlo simulation can be used in asset liability

modelling.

You are given the following information for returns on two stocks / and Z. Z 0.04 0.09 1.20 1.50 0.25 0.40 R. = 0.16 and g. = 0.20 The returns generating process is assumed to be as follows: R=a+ BR +e where R is a random variable representing the return on the stock; R is a random variable representing the return on a market index; e is the residual term; o',of, and of are the variances of the stock, index and residual term, respectively. The residual terms of the returns generating processes for stocks / and Z are assumed uncorrelated with each other and have a mean of zero. Calculate the following: (1) The mean and variance of the returns of each stock. 131 (ii) The covariance of returns between the stocks. [1] (iii) The beta of an equally-weighted portfolio of the two stocks. [1] (iv) The expected return and variance of an equally-weighted portfolio of the two stocks. [3]12 Let R(0) = gross real yield on an irredeemable index linked bond at the end of year t Q(0) = cumulative inflation index at the end of year : C() = gross nominal yield on an irredeemable conventional bond I(0) = In- Q(!) (1 -1) ERD = ED I(D) + (1 - ED) El(t- 1), where ED is a constant. (1) Assuming that coupons are paid annually in arrear and that there is no lag in the indexing, write down an expression for the total return earned on the index linked bond over the year f to f + 1 in terms of Q and R. [4] (ii) Explain why El() might be regarded as representing expected inflation. [3] (iii) Let CZ() and RZ(Q) be independent standard normal variates. CMU, QMU, RMU, RSD, CSD, CA, RAI, RA2 are all constants. State in words the key features and properties of the following two models for long term interest rates. Comment on their plausibility for stochastic asset modelling. (a) In R(t) = In RMU + RA [In R(t - 1) - In RMU] + RSD . RZ() In (1 + C(1) = EI(t) + In (1 + R(0) + CMU + CSD . CZ() (b) In (1 + C(m) = CMU + CAI [EI(I) - QMU] + CSD . CZ(Q In (1 + R() = RMU + RAl [(In (1 + CO)) - CMU) -(EI(D) - QMU)] + RA2 [In (1 + R( - 1)) - RMU] + RSD . RZ(Q)