Question 1 (20 marks) Fund A offer an expected return of 8% with a standard deviation of 15%, and Fund B offers an expected return of 5% with a standard deviation of 25%.

a. Would Fund B be held by investors? Explain with the aid of a diagram using Markowitz Portfolio theory. (8 marks)

b. How would you answer part a. if the correlation coefficient between Funds A and B were 1? Could these expected returns and standard deviations represent an equilibrium in the market? (12 marks)

Question 2 (20 marks)

a. SCB is expected to have a constant growth of dividends indefinitely. The company had earnings per share (EPS) of $2 in 2019. The dividend payout ratio is 0.6. The company is expected to earn a return on equity (ROE) of 16 percent on its investments and the required rate of return is 13 percent. Assume that all dividends are paid at the end of the year. i. Estimate the value of the companys stock at the beginning of 2020. (3 marks) ii. Calculate the present value of growth opportunities (PVGO). What does this PVGO mean to active portfolio management? (7 marks)

b. The estimated factor sensitivities of HSU Ltd to Fama-French factors and the risk premia associated with those factors are given in the following table: Factor Sensitivity Risk Premium (%) Market factor 0.2 4.3 Size factor -0.2 2.4 Value factor -0.3 4.1 i. Based on the Fama-French model, calculate the required return for HSU Limited using these estimates. Assume that the Treasury bill rate is 5 percent. (4 marks) ii. What do you know about HSU Limited based on its factor sensitivities? (6 marks)

Question 3 (25 marks) 2 (if it is held in isolation) Stock X 30% 1.3 Stock Y 40% 0.9 Suppose the average risk aversion of investors is 2,2 M = 10% and risk-free return is 2%.

a. Compute the expected returns of X and Y. (4 marks)

b. How much risk (measured in terms of variance) can be reduced if X and Y are added to a well-diversified portfolio? (4 marks)

c. Use Sharpe measure to determine which stock performs better if the actual returns are 29% for X and 22% for Y and they are added to a well-diversified portfolio. (4 marks) d. Suppose investors now are less risk averse because they have more wealth than before. As a result, the average risk aversion of investors falls from 2 to 1.2. Compute the changes in expected returns of X and Y and explain, with the aid of a diagram, the intuition behind the changes. (13 marks)

Question 4 (15 marks) Suppose Joey holds a share of SCB common stock, currently valued at $48. She is concerned that over the next few months the value of her holding might decline and she would like to hedge that risk by supplementing her holding with one of the following two option positions, all of which expire at the same point in the future.

a. Complete a table similar to the following for each of the following positions:

i. A long position in a put option with an exercise price of $45 and a premium of $2. (3 marks)

ii. A short position in a call option with an exercise price of $45 and a premium of $4. (3 marks) In calculating combined terminal position value, ignore the time differential between the initial option expense or receipt and the terminal payoff. Expiration date SCB stock price Expiration date option payoff Initial option premium Combined terminal position value 25 30 35 40 45 50 55 60 65 70 75

b. Graph the combined terminal position value for each of the above hedged positions, using combined terminal position value on the vertical axis (Y) and SCBs expiration date stock price on the horizontal axis (X). (4 marks)

c. Explain which of the two hedging strategies mentioned above is better if Joeys objective is also to enjoy the upside gain of the stock. (5 marks)

Question 5 (20 marks) Based on current dividend yields and expected capital gains, the expected return on portfolios A and B are 11% and 14% respectively. The beta of A is 0.8 while that of B is 1.5. The rate of exchange fund bill is currently 6%, while the expected return of the Hang Seng Index is 12%. The standard deviation of portfolio A is 10%, while that of B is 31%, and that of the index is 20%.

a. If you currently hold the Hang Seng Index, would you choose to add portfolio A or B to your holdings? (6 marks)

b. If you currently hold the exchange fund bills, which one would you choose (i.e. portfolio A, portfolio B or the Hang Seng Index) to add to your holdings? (8 marks) c. What would happen if we measure the performance of a poorly diversified portfolio using Treynor measure? (6 marks)