Question

QUESTION ONE a) Financial engineering has been disparaged as nothing more than paper shuffling. Critics argue that resources used for rearranging wealth (i.e. bundling and unbundling financial assets) might be better spent on creating wealth (ie. creating real assets) Evaluate this criticism. (15 Marks) b) You are given the following data about available investments: State of the Economy Probability Return (A) Return (B) Strong Boom 0.15 -0.60 0.75 Weak Boom 0.20 0.50 Average 0.05 0.15 -0.10 Weak Recession 0.40 0.20 Strong Recession 0.80 -0.35 Compute and fully interpret the following for these investments: I. II. III. IV. V. VI. Mean rate of return for each investment (5 Marks) Standard deviation for each investment. (5 Marks) Coefficient of variation for each investment. (3 Marks) Covariance among the rates of retum. (4 Marks) Correlation coefficient of the rates of return. (3 Marks) Briefly explain the difference in assumptions underlying Portfolio Theory and the Capital Asset Pricing Model (CAPM) (5 Marks) [TOTAL: 40 MARKS]

investment analysis

Answer 1

Ans.

State of the Economy	Probability	Return(A)	Return (B)	E(A) i.e. (Probabilty* Return A)	E(B) i.e (Probabilty* Return B)	Variance(A) = (Return(A) - E(A))^2* Probability	Variance(B) = (Return(B) - E(A))^2* Probability	Covariance= ((Return(A) - E(A)* (Return(B) - E(B))* Probaility
Strong Boom	0.15	-0.6	0.75	-0.09	0.1125	0.07038375	0.06144	-0.06576
Weak Boom	0.2	-0.3	0.5	-0.06	0.1	0.029645	0.03042	-0.03003
Average	0.05	-0.1	0.15	-0.005	0.0075	0.00171125	0.00008	-0.00037
Weak Recession	0.4	0.2	-0.1	0.08	-0.04	0.00529	0.01764	-0.00966
Strong Recession	0.2	0.8	-0.35	0.16	-0.07	0.102245	0.04232	-0.06578
	1			0.085	0.11	0.209275	0.1519	-0.1716
1....Mean Rate of Return				0.085	0.11
II...Standard Deviation = Square root of Variance						0.457465846	0.389743505
III. Coefficient of Variation= Standard deviation/mean						5.381951126	3.543122776
IV. Covariance						-0.1716
Correlation coefficient = Covariance/(Standard deviation of A * Standard Deviation of B)						-0.962453423

VI.

	CML	SML
Scope	CML only Covers efficient portfolios which is one risky asset and risk-free assets	SM Covers all the capital assets irrespective of whether they lie on SML or not
Measuring Asset Risks	Standard deviation is used	The beta coefficient or covariance is used
Objectives	CML aims to identify the optimum portfolios for investors	SML seeks to describe how assets are priced by efficient markets in equilibrium