Problem 1
Jim Green’s father-in-law, who lives in California, would like Jim to move out from Tempe to California so he could see his grandchildren more often. Jim Green argues that housing is too expensive in California. Spouse’s pop responds:
Of course you pay more, but then housing prices in California appreciate faster, so in the long run it is a better investment.
Does Jim Green’s father-in-law think the markets for housing in Tempe and California are “efficient?” Explain briefly.
Problem 2
Answer each question below as clearly and succinctly as you can.
- Explain the difference between the Security Market Line (SML) and the Capital Market Line (CML).
- The treasury department of a large Fortune 500 corporation would like to estimate the company’s cost of capital in order to make capital budgeting decisions. Should they use the SML or the CML? Explain.
- The new treasurer of a large, east coast university in interested in evaluating whether the university’s endowment portfolio has been effectively managed. Should she compare its performance to the CML or the SML? Why?
Problem 3
Short Term Inc. has issued zero-coupon bonds that mature in one year. The returns from holding these bonds have a beta of 0.25. There is a chance of 70% that the bonds will pay full value, and a chance of 30% that they will only be worth 60 cents for each dollar of face value. Assume that the CAPM holds, that the riskless rate is 5% and that the expected return on the market is 15%.
- What is the current price of the bonds, per $100 face value?
- What is the yield to maturity on the bonds?
- What is the expected return on the bonds?
Problem 4
For all parts of this question, assume the following:
The CAPM holds. The riskless rate of return is 3%. The market portfolio has expected rate of return of 18% and standard deviation of 20%.
- KrustyKorp stock has an expected rate of return of 2% per year and standard deviation of 32%. Troy McClure says, “No rational person would hold a risky asset expected to return less than the riskless rate! It must be mispriced.” Is Troy correct? Explain.
- Consider the following data on two stocks whose returns are uncorrelated with each other:
Elizabeth Hoover has $500 worth of Shelbyville Shrimp stock, $500 worth of Capital Crab stock, and no other investments.
(a) Compute her portfolio beta, expected rate of return (% per year), and standard deviation.
(b) Ms. Hoover says she cannot tolerate any more standard deviation than her portfolio has now. Given this risk tolerance, is she maximizing her expected return? If she is, explain why? If she is not, explain how she should invest to maximize expected return (give a specific trading strategy).
Problem 5
You are on the board of the Springfield College Endowment Fund (SCEF), which is evaluating two potential managers for its investments: Mr. Monty Burns (MB) and Mr. Waylon Smithers (W S). The expected returns on portfolios MB and W S are 11% and 14%, respectively. The beta of MB is 0.8 while that of W S is 1.5. The T-Bill rate is 7%, while the expected return of the market index is 12%. The standard deviation of portfolio MB is 10%, while that of W S is 31%, and that of the index is 20%.
- Suppose SCEF currently holds a market index portfolio. Based on the data, would you add portfolios MB and/or W S to SCEF’s mix of holdings? (Hint: check for under/overpricing.)
- If SCEF were ordered to invest only in T-Bills and one of the portfolios MB or W S, which portfolio should SCEF invest? Why?
