Tutorial Questions Week begin 28 March 2016Tutorial Questions Week begin 28 March 2016

Prefatory comments

The CAPM is conceptually challenging, a view supported by the divergent ways it is interpreted even amongst professional finance commentators and analysis. Its the lecturers view that the CAPMs complexity is best approached by devoting substantial time to illustrating the economic intuition and investment implications of the concepts.

Given the above, the questions this week are designed to deepen your understanding of the key concepts underpinning the CAPM rather than test your quantitative skills. I want to illustrate two general points with this weeks questions:

1. (a) problems requiring use of the concepts we have addressed dont always present themselves in standard ways; you need to develop a skill in recognising that a particular problem or issue is really a standard problem but packaged in a different way and once you identify the problem you can apply the concept you have learned to address it.
2. (b) It is important to develop your competence in articulating in both written and oral form your analysis succinctly and clearly. Lots of practise helps.

Question set 1: Modern Portfolio Theory (MPT)

On 15 March 2014 a news item from CNBC (copied below) reported that correlation in returns across asset classes has increased since the financial crisis of 2008.

1. Q1a: Why is increased correlation across asset classes bad news for investors?
2. Q1b: Why do you think return correlation across asset classes increases during a financial crisis?
3. Q1c: In the article, it is noted that investment-grade bonds ... have just a 31 percent correlation to

stocks, much better than junk bonds, which are at 85 percent. Why do you think junk bond returns are more closely correlated with equity returns than investment grade bond returns? (Hint: think about their economic characteristics ... what do they share in common?)

Q1d: The article reports that Gold has a negative correlation with equities. Why do you think this is the case?

Q 1 e : Would diversifying your portfolio by also investing in alternative asset classes (e.g., foreign equities or hedge funds or private equity) help you withstand a financial crisis? Why or why not? (Hint: This is a one of those questions where it depends is the right answer but you need to specify the dependent conditions)