Financial Engineering Program

Nanyang Business School

Nanyang Technological University
___________________________________________________________________________
FE8811 Asset Pricing Theory Trimester 1, Mini-term 1, 2010
Instructor: Dr. Charlie Charoenwong Office: S3-01c-104
Email: Charlie@pmail.ntu.edu.sg Tel: 6790 4799

Homework 4
(Due by 6:30PM on 26 August 2010)
Instruction: It is important that each student make an individual effort on each of the homework
exercises. All students must write up their work independently. Computer work and output, if
applicable, must be coded and generated independently by each student. All work submitted for
credit by any student will be assumed to carry that student's pledge of compliance with this
guiding principle.

Question 1
The standard CAPM states that
ri ) & rF % !E (~
E (~ rM ) $ rF " # !i

where rF, ri, rM are the rates of simple return on riskless asset, asset i, and the market portfolio M; and !i
is the standard beta of asset i.

From the above equation, derive the CAPM in terms of prices as shown below:
1 . ~E cov( ~
piE , ~
p ME +
piB &
RF -
' ~E
, E ( pi ) $ E ( p M ) $ RF p M #
B
( ~ E
var( p M ) *
)

where pBi and pBM are the beginning prices of asset i and the market portfolio M; pEi and pEM are the
ending prices of asset i and the market portfolio M; and RF is the gross return on the riskless asset.

Assume no dividend payment. Hence,

~
pE $ pB ~
pE $ pB
~
ri & i B i and ~
rM & M B M
pi pM

Question 2
Assume that you have a quadratic utility function and there exist only three risky assets in the
market with the following properties:

Standard Mean Correlation Coefficient

Asset Deviation Return A B C
A 0.20 0.15 1.0
B 0.30 0.20 0.8 1.0
C 0.25 0.10 -0.1 0.2 1.0

a) Find the portfolio weights of the global minimum variance portfolio. Compute its return
mean and standard deviation.
b) Suppose that your wealth is $1,000 and you expect 14% return on the investment. How
much should you invest, in dollar terms, in the above assets? What is the standard
deviation of the return on the investment?
c) Now suppose that there exists a risk-free asset that gives 6% return. Would your allocation
investment in part (b) change? If yes, what should be the $ amount invested in the risk-free
and risky assets? What is the standard deviation of the return on the investment?

1
Question 3
Consider the following two-factor model for the returns of three stocks. Assume that the
factors and epsilons are uncorrelated and have means of zero. Also, assume the factors have
variances of 0.01 and are uncorrelated with each other.

~ ~ ~
rA & 0.13 % 6F1 % 4F2 % ~
/A 0 /2A & 0.01
~ ~ ~
rB & 0.15 % 2F1 % 2F2 % ~
/ B , where 0 /2B & 0.04
~ ~ ~
rC & 0.07 % 5F1 $ 1F2 % ~
/C 0 /2C & 0.02

a) What are the variances of the returns of the three stocks?

b) What are the covariances and correlations between the three stocks?
c) What are the expected returns of the three stocks?
d) Construct the pure factor-one portfolio from the three stocks and compute its mean and
variance.
e) Construct the pure factor-two portfolio from the three stocks and compute its mean and
variance.
f) Compute the risk premium of the two pure factor portfolios in Parts (d) and (e). Assume
that the risk-free rate is the zero-beta rate implied by the factor equations for the three
stocks.

– END OF HOMEWORK 4 –