AF335, Spring 2020

Midterm Exam

NAME: Kunhong Zhou

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Multiple Choice Questions (3 points each)

1. Which of the following orders instructs the broker to sell at or above a specified price? 
A. Limit-buy order
B. Discretionary order
C. Limit-sell order
D. Stop-buy order

2. You purchased 1000 shares of CSCO common stock on margin at $19 per share. Assume the
initial margin is 50% and the maintenance margin is 30%. Below what stock price level would
you get a margin call? Assume the stock pays no dividend; ignore interest on margin. 
A. $12.86
B. $15.75
C. $19.67
D. $13.57

3. You purchased 100 shares of common stock on margin for $35 per share. The initial margin is
50% and the stock pays no dividend. What would your rate of return be if you sell the stock at
$42 per share? Ignore interest on margin. 
A. 28%
B. 33%
C. 14%
D. 40%

4. In the mean-standard deviation graph, which one of the following statements is true regarding
the indifference curve of a risk-averse investor? 
A. It is the set of points that have the same expected rates of return and different standard
deviations.
B. It is the set of points that have the same standard deviations and different rates of return.
C. It is the set of points that offer the same utility according to returns and standard
deviations.
D. It connects points that offer increasing utilities according to returns and standard deviations.

5. The optimal Capital Allocation Line provided by a risk-free security and N risky securities is 
A. the line that connects the risk-free rate and the global minimum-variance portfolio of the risky
securities.
B. the line that connects the risk-free rate and the portfolio of the risky securities that has the
highest expected return on the efficient frontier.
C. the line tangent to the efficient frontier of risky securities drawn from the risk-free rate.
D. the horizontal line drawn from the risk-free rate.

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6. Consider an investment opportunity set formed with two securities that are perfectly
negatively correlated. The global minimum variance portfolio has a standard deviation that is
always 
A. greater than zero.
B. equal to zero.
C. equal to the sum of the securities' standard deviations.
D. equal to -1.

7. As diversification increases, the standard deviation of a typical portfolio approaches

____________. 
A. 0
B. 1
C. infinity
D. the standard deviation of the market portfolio

8. Kurtosis is a measure of ____________. 

A. how fat the tails of a distribution are
B. the downside risk of a distribution
C. the skew of a distribution
D. C and B

9. Underwriting is one of the services provided by _____. 

A. the SEC
B. investment bankers
C. publicly traded companies
D. FDIC

10. The _________ price is the price at which a dealer is willing to purchase a security. 
A. bid
B. ask
C. clearing
D. settlement

11. The holding period return on a stock is equal to _________. 

A. the capital gain yield over the period plus the inflation rate
B. the capital gain yield over the period plus the dividend yield
C. the current yield plus the dividend yield
D. the dividend yield plus the risk premium

12. The geometric average of -12%, 20% and 25% is _________. 

A. 8.42%
B. 11.00%
C. 9.70%
D. 18.88%

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Problem 1 (12 points)

During a normal economy, an investment in common stock of D&F Oil provides 15 percent per
annum rate of return. During a recession, the rate of return is negative 12 percent and during a
boom, the rate of return is 35 percent. The probability of a normal economy is 80 percent while
the probability of a recession is 8 percent and the probability of a boom is 12 percent.

a) What is the expected return for D&F Oil? (6 pts)

Expected rate of return: 15%*80%+-12%*8%+35%*12%=15.24%

b) What is the standard deviation of D&F Oil’s expected return? (6 pts)

Standard deviation: 80%*(15%-15.24%) ^2+8%*(-12%-15.24%)^2+12%*(35%-

15.24%)^2=0.010626 sqrt0.010626=0.1030824=10.31%

Problem 2 (24 points)

Steven is considering allocating his funds between the Risky Portfolio of Stocks and the risk-free
T-bills. The Risky Portfolio of Stocks has the following characteristics: its expected return is
17.5% per year and its standard deviation is 22% per year. The risk-free T-bills pay 6% interest
per annum.

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U=E (R C )− ⋅A⋅σ 2C
Assume that Steven’s utility function is 2 . Steven’s coefficient of risk
aversion is equal to 7

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Problem 2 (continued)

a) What is Steven’s optimal allocation between the risky portfolio of stocks and risk-free T-
1
U=E (R C )− ⋅A⋅σ 2C
bill? (6 pts) 2
Y=(17.5%-6%)/(7*22%^2)=33.94%

1-Y=1-33.94%=66.06%%

33.94 for risky portfolio, 66.06% for risk freeT-Bill.

b) What is the expected return and standard deviation of Steven’s optimal complete
portfolio? (6 pts)

Expected rate of return: 33.94%*17.5%+66.06%*6%=0.099031=9.90%

Standard deviation:33.94%*22%=0.074668=7.47%

c) Calculate Risk Premium for Steven’s optimal complete portfolio. (6 pts)

Risk premium=9.90%-6%=3.90%

d) Calculate the Sharpe’s ratio for Steven’s optimal complete portfolio. (6 pts)
Sharpe ratio: = (9.90%-6%)/7.47%=0.522099=52.21%

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Problem 3 (24 pts)

Mary has access to risky stocks A and B. But she has no access to risk-free T-bills. The two
assets have the following characteristics:

Stock A: Expected return = 12.5% per annum, Standard deviation = 14% per annum

Stock B: Expected return = 5% per annum, Standard deviation = 8% per annum

The correlation coefficient between return on stock A and return on stock B is 0.10

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U=E (R C )− ⋅A⋅σ 2C
Mary’s utility function 2 and her coefficient of risk aversion is equal to 3

a) Suppose Mary wants to invest is a portfolio consisting of A and B such that the portfolio
has the smallest possible variance. What are the weights on asset A and asset B in such
portfolio? (6 pts)

Cov(A,B)=0.1*14%*8%=0.00112

WA= (8%^2-0.00112)/(14%^2+8%^2-2*0.00112)=0.22222=22.22%

WB=1-WA=77.78%

b) What is the expected return of the portfolio you found in part a? (6 pts)

Expected rate of return: 12.5%*22.22%+77.78%*5%=0.066665=6.67%

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Problem 3 (continued)

c) What is the standard deviation of the portfolio you found in part a? (6 pts)
22.22%^2*14%^2+77.78%^2*8%^2+2*22.22%*77.78%*0.00112=0.005227

Standard deviation=sqrt0.005227=0.0722979=7.23%

d) If Mary’s coefficient of risk aversion is 6 instead of 3, would your answer to part a

change? Answer either “Yes” or “ No” and briefly explain your answer. Note that you
don’t need to re-calculate your answer in part a. (6 pts)

No. In the formula to calculate the Covariance and weight calculation formulas, there is no
coefficient of risk aversion involved.