Brie°y de±ne the following terms If you write a formula,...

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Ec1723, Fall 2013: Final Exam Do all six questions. Read the questions carefully before starting to answer. You will be graded on the quality of your explanations as well as the accuracy of your answers. Each question is worth 30 points. You may use a calculator but no notes or textbook (except the formula sheet provided). 1. Brie°y de±ne the following terms. If you write a formula, de±ne the terms in it but do not write lengthy explanations. (6 points for each part.) a) Absolute risk aversion. b) Pseudo-probabilities (also known as risk-neutral probabilities). c) Stochastic discount factor. d) Security market line. e) Bid-ask bounce. 2. An endowment fund is allocating assets between an index of publicly traded equities, and a set of private equity funds. The public equity index has a standard deviation of 20%. The private equity funds all have a standard deviation of 40% and a correlation coe¢ cient of 0.25 with each other. The private equity funds are uncorrelated with the return on the public equity index. The public equity index and all the private equity funds have the same arithmetic average return. a) (i) What is the minimum-variance portfolio of private equity funds, and (ii) what is its variance as a function of the number of private equity funds available? (10 points.) b) If the endowment fund wishes to minimize the variance of its overall equity position, what total weight should it put on private equity if N private equity funds are available? (i) Derive a formula and (ii) state explicit numerical results for the cases of 1, 2, 5, and an in±nite number of private equity funds. (iii) Explain the economic intuition for the e/ect of N on your answer. (15 points.) c) Many endowments move gradually into new asset classes rather than investing heavily at once. Use your answer to part b) to o/er a possible justi±cation for this behavior. (5 points.) 1

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