Question

QUESTION ONE

1. 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 ( i.e. creating real assets)

Evaluate this criticism.                                                                      (15 Marks)

2. 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	-0.30	0.50
Average	0.05	-0.10	0.15
Weak Recession	0.40	0.20	-0.10
Strong Recession	0.20	0.80	-0.35

Compute and fully interpret the following for these investments:

1. Mean rate of return for each investment                                                                     (5 Marks)
2. Standard deviation for each investment.                                                                    (5 Marks)
3. Coefficient of variation for each investment.                                                                    (3 Marks)
4. Covariance among the rates of return.                                                                            (4 Marks)
5. Correlation coefficient of the rates of return.                                                                            (3 Marks)
6. Briefly explain the difference in assumptions underlying Portfolio Theory and the Capital Asset Pricing Model (CAPM)                                                                         (5 Marks) [TOTAL: 40 MARKS]

Answer 1

Answers

I. Calculation of mean rate of return of each investment

State of Economy	Probability (a)	Return on A (b) (%)	Return on B (c) (%)	Mean Return A (d= a*b) (%)	Mean Return B (e= a*c) (%)
Strong Boom	0.15	-60	75	-9	11.25
Weak Boom	0.20	-30	50	-6	10
Average	0.05	-10	15	-5	0.75
Weak Recession	0.40	20	-10	8	-4
Strong Recession	0.20	80	-35	16	-7
	Total			8.50	11.00

II. a. Calculation of standard deviation of A

State of Economy	Probability (a)	Return on A (b) (%)	Mean Return A (c) (%)	Calculation (b-c)2*a=d
Strong Boom	0.15	-60	8.50	703.84
Weak Boom	0.20	-30	8.50	296.45
Average	0.05	-10	8.50	17.11
Weak Recession	0.40	20	8.50	52.90
Strong Recession	0.20	80	8.50	1022.45
	Total			2092.75

Standard Deviation of A= $\gamma 2092.75$

= 45.75

b. Calculation of standard deviation of b

State of Economy	Probability (a)	Return on B (b) (%)	Mean Return B (c) (%)	Calculation (b-c)2*a=d
Strong Boom	0.15	75	11	614.40
Weak Boom	0.20	50	11	304.20
Average	0.05	15	11	0.80
Weak Recession	0.40	-10	11	176.40
Strong Recession	0.20	-35	11	423.20
	Total			1519.00

Standard Deviation of B= $\gamma 1519$

= 38.97

III. Calculation of coefficient of Variation

= Standard Deviation/Expected Return

coefficient of Variation A= 45.75/8.5

= 5.38

coefficient of Variation B= 38.97/11

= 3.54