1 of 2

Written examination in: GRA 65433 Introduction to Asset Pricing

Examination date: 01.12.10, 09:00 – 11:00

Permitted examination aids: A bilingual dictionary and BI-approved exam calculator type;

TEXAS INSTRUMENTS BA II PlusTM.

Total number of pages: 2

Answer sheets: Lines

Question 1 (40%)

a) Briefly discuss similarities and differences between CAPM and APT.

Consider the following one-factor model:

iifi RPRRE )(

There is a risk-free asset with a return of 3%. In addition there are two risky

investments, A and B. A has a beta of 1.0 and an expected return of 10%, while B has

a beta of 0.5 and an expected return of 7%. Both investments are fully diversified.

b) Is the market in equilibrium?

Consider the following two-factor model:

iiifi RPRPRRE 2211)(

where the expected risk premiums on the risk factors, RP1 and RP2, are 5% and 3%,

respectively. The variance of the two risk factors are as follows: Var(RP1) = 0.202 and

Var(RP2)=0.252.

Consider now the following two assets:

Asset 1: 75.011 0.111 and 020.0)( 1 Var

Asset 2: 0.121 5.022 and 012.0)( 2 Var

c) What are the variances of Asset 1 and Asset 2? What is the correlation between Asset

1 and Asset 2?

Department of Financial Economics

2 of 2

Assume that there is a third asset:

Asset 3: 031 5.032 and 0)( 3 Var

d) Now assume that also 1 2( ) 0 ( )Var Var . Show how you can construct a risk-free

portfolio.

e) Assume that security returns can be explained by a two-factor model (e.g. unexpected

GDP growth and unexpected changes in interest rates). How would you estimate the

risk premiums associated with exposure to each risk source?

Question 2 (40%)

a) According to the Capital Asset Pricing Model (CAPM) everyone would keep the same

risky portfolio (the market portfolio). Why?

b) CAPM states that expected return on a security i equals the risk-free rate plus the

market risk premium times the security’s beta (ßi):

fmifi RRERRE )()( .

Explain the derivation of CAPM.

c) Explain why liquidity may be important in explaining security returns.

d) It has been claimed that it is impossible to test CAPM. Explain.

Question 3 (20 %)

a) Why would you think that markets should behave according to the Efficient Market

Hypothesis?

b) You want to test whether the stock market reacts according to the Efficient Market

Hypothesis with regard to earnings announcements. Describe your suggested

methodology and expected results.

c) You have just found evidence that shares in companies with a high book-to-market

ratio perform better than shares in other companies. Is this finding consistent with the

Efficient Market Hypothesis?