finm8016 Mid-Semester Exam

SCHOOL OF FINANCE, ACTUARIAL STUDIES AND APPLIED STATISTICS

Mid-Semester Examination

Applied Portfolio Construction (FINM 3008)

Study Period: 15 minutes

Time Allowed: 2 hours

Permitted Material:

A4 sheet of notes (2-sided), calculator, dictionary

Instructions to Candidates:

?This exam is worth a total of 20 marks. It comprises 19 questions in two parts. Part A contains sixteen (16) multiple choice questions, each worth 0.5 marks. Part B contains three (3) questions requiring written answers, each worth 4 marks.

?Part A: Multiple choice – Select only one answer from the five options provided.

Answers are to be submitted via a multiple choice answer sheet. It is highly

recommended that students complete the answer sheet with a 2B pencil, as this makes alteration of answers easier. (Note: Deductions will not be made for incorrect multiple choice answers.)

?Part B: Written answer questions – Answers are to be submitted via a script book.

Where the question refers to either ‘describe’ or ‘identify’ or ‘list’, a fact-based answer is expected. Where the question refers to either ‘explain’, ‘discuss’ or ‘outline’, the answer should demonstrate an understanding of the underlying concepts and their application. ?Candidates are expected to attempt ALL questions.

?This examination paper consists of 8 pages in total, including the cover page.

Page 1

PART A: MULTIPLE CHOICE (16 questions, 0.5 marks each)

Question 1

Which of these trends has been observed in the fund management industry over the last 5-

10 years?

(a) High industry growth rates - in excess of GDP

(b) Movement towards defined contribution pension funds, relative to defined benefit

(c) Growth in the hedge fund industry

(d) Concentration of fund managers, especially at the larger end

(e) All of the above

Question 2

Which of the following types of funds are less likely to be considered part of the wholesale (i.e. institutional) segment of the fund management industry?

(a) Defined Benefit Superannuation Funds

(b) Retail Superannuation Funds

(c) Self-Managed Superannuation Funds (SMSFs)

(d) Endowments and Foundations

(e) Sovereign Wealth Funds

Question 3

Which of the following investors is most likely to be concerned about tracking error risk?

(a) Private investor

(b) Insurance company

(c) Fund manager

(d) Defined benefit superannuation fund

(e) Sovereign wealth fund

Investors typically receive the same gross ‘market’ return. Listed below are some ways in which investors may differ. For the sake of argument, assume that investors differ along only one of these dimensions. Which would be least likely to imply that investors place different values on the returns they receive?

(a) Tax rates

(b) Costs incurred when investing

(c) Objectives

(d) Risk aversion

(e) Baseline (i.e. reference) portfolio

Question 5

Which of the following statements about illiquidity is more correct?

(a) Illiquidity relates to the additional cost of trading illiquid securities.

(b) Illiquidity can have a significantly different impact across investors.

(c) Illiquidity risk relates to the possibility that an investor may not be able to sell.

(d) Illiquidity risk is a constant in the market.

(e) Illiquidity is simple to analyze.

Question 6

Which of the following statements is incorrect?

a) Confidence interval around per-annum expected return usually narrows with

investment horizon.

b) Confidence interval around wealth can either widen or narrow with investment

horizon.

c) Variance is a linear function of time horizon only if returns are independent.

d) Risk as measured by a shortfall constraint depends on the mean and variance of

returns.

e) Risk as measured by a shortfall constraint does not depend on investment

horizon.

Assume you intend to estimate the Sharpe ratio and compound returns for a portfolio. Your analysis is to be based on a time series of historical asset returns, with the mean of the series adjusted in line with the expected return according to the ‘implied views’ method. Which of the following set of Excel functions can be used to perform this analysis?

(a) AVERAGE(), SUMPRODUCT(), SLOPE(), STDEV(), LN(), EXP()

(b) MEAN(), SUMPRODUCT(), BETA(), STDEV(), LOG(), EXP()

(c) AVERAGE(), SUMPRODUCT(), BETA(), STDEV(), LN(), EXP()

(d) AVERAGE(), PRODUCT(), BETA(), STDEV(), LOG(), EXP()

(e) MEAN(), PRODUCT(), SLOPE(), STDEV(), LN(), EXPON()

Question 8

Nominate which of the following statements best describes the concept of ‘sequential risk’ when applied to defined contribution pension funds, as discussed in the course reading by Smith and Collie (2008).

(a) The timing of contributions has an important influence on pension fund risk.

(b) Pension fund investors lose the most when they suffer a sequence of negative

returns.

(c) The impact of negative returns is greatest when it occurs early in the

accumulation phase.

(d) The impact of negative returns is greatest when it occurs close to retirement.

(e) None of the above describes sequential risk as discussed by Smith and Collie.

Question 9

Assume a return series demonstrates significant positive serial correlation. Which of the following statements is most likely to be incorrect under this situation?

(a) Variance of wealth tends to decrease with investment horizon.

(b) Variance of per annum returns tends to decrease with investment horizon.

(c) Variance of wealth tends to increase with investment horizon.

(d) Variance of per annum returns tends to increase with investment horizon.

(e) The underlying asset may be thinly-traded.

Question 10

An optimizer is used to generate mean-variance optimal portfolios. Some of the portfolios contain weightings of over 100% in international fixed income, the majority of which is offset by large short positions in local fixed income. What is the most likely source of this result?

(a) International fixed income is clearly the much more attractive asset.

(b) International fixed income has been given a higher expected return, while both

asset classes make a similar contribution to total portfolio risk.

(c) Stems from the failure of mean-variance analysis to take into account any

skewness in the return distribution.

(d) This outcome is a function of the assumed investment horizon.

(e) The optimizer package contains a bug.

Question 11

Under the taxonomy of ‘alpha’ versus ‘beta’, which of the following best describes the

‘industry’ definition of beta?

(a) Any market exposure that can be cheaply replicated

(b) Sensitivity to returns on some broad-based equity index, e.g. S&P500, MSCI

World Index

(c) Returns generated from market timing

(d) Some priced, non-diversifiable risk factor

(e) None of the above

Questions 12 to 16 refer to the following 5-period sequence of gross returns plus the supplementary information provided below:

Period Return

1 16%

2 -1%

3 30%

4 -10%

5 2%

Supplementary information:

Standard deviation of series 15.7%

Risk-free rate 3.0%

Question 12

What is the geometric mean of the 5-period return series provided (to the nearest decimal place)?

(a) 6.2%

(b) 6.3%

(c) 6.5%

(d) 7.4%

(e) None of the above

Question 13

What is the Sharpe ratio for the return series provided (to the nearest two decimal places)?

(a) 0.20

(b) 0.21

(c) 0.22

(d) 0.28

(e) 0.30

Question 14

Assume you invest $1 in the underlying asset or portfolio at the beginning of period 1. What is the value of wealth at the end of period 5 (to nearest cent)?

(a) $1.32

(b) $1.35

(c) $1.36

(d) $1.43

(e) None of the above

Question 15

Given the standard deviation of 15.7% and assuming independent returns, what is the standard deviation of wealth over 3 periods (to the nearest decimal place)?

(a) 22.2%

(b) 27.2%

(c) 47.1%

(d) 54.9%

(e) 68.6%

Question 16

Assume that the arithmetic mean of the series is adjusted towards an expected per-period return of 5%. After this adjustment, what is the probability of loss under non-parametric (i.e. data-based) methods?

(a) 20%

(b) 32%

(c) 38%

(d) 40%

(e) 60%

PART B: WRITTEN ANSWER QUESTIONS (3 questions, 4 marks each)

Question 17: Estimating expected returns (4 marks in total)

(a) Identify the key problem with using the sample mean as an estimate of expected return

for the purpose of mean-variance analysis of portfolios. (0.5 mark)

(b) List and briefly describe three (3) alternative methods of estimating expected returns for

this purpose. (1.5 marks)

(c) Explain the difference between ‘unconditional’ and ‘conditional’ modelling of asset

expected returns. (1 mark)

(d) Outline two (2) situations where an investor might use a conditional modelling approach.

(1 mark)

Question 18: Asset allocation frameworks (4 marks in total)

Under modern portfolio theory, an investor uses mean-variance portfolio optimization to generate the efficient frontier, and then selects the portfolio on the frontier which accords with their risk preference.

(a) Describe four (4) major problems with using this approach to form portfolios in practice.

(2 marks)

(b) Outline two (2) alternative approaches that an investor might use to set their asset

allocation. In doing so, identify which problems with mean-variance optimization that each approach helps to overcome. (2 marks)

Question 19 (4 marks)

Consider two equity market investors. The first investor is a hedge fund manager that relies on very active trading, and borrows from investment banks in order to leverage their investment. Their remuneration depends on total base fee earned by their fund as a percentage of net assets under management, plus a yearly bonus based on returns generated above a hurdle rate. The second investor is a high net-worth individual who is investing for their own retirement, which they anticipate to occur in 10 years or more. Identify three dimensions of risk that are likely to have a significantly different impact on these two investors. Explain the nature of the difference. Suggest aspects that each investor might monitor in order to control the risks most relevant to them.

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