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EFN412 Topic 02 EFN412 Advanced Managerial Finance School of Economics and Finance, QUT Reading and Tutorial Guide 02 Topic: (2) Portfolio Theory and Asset Pricing 2: The Pricing of Risky Assets and the CAPM Reading: PBEHP 10 th edition, Ch.7 (7.6-7.7) Self-Test Problem 3, page 201. PBEHP 9 th edition, Ch.7 (7.6-7.7) Self-Test Problem 3, page 217. Background Reading: RTCWJ, 4 th edition or 3 rd Learning Objectives: A Primer on Diversification Efficient Portfolios and the CML The Beta and the CAPM Estimation using the Market Model Applications of the CAPM Presumed Knowledge: Last week we looked at an introduction to risk and return. This provides a starting point for the study of CAPM (this relies on work started in Managerial Finance) It is important that you have revised your Managerial Finance notes on the CAPM, Advanced Managerial Finance builds on these ideas in this lecture. 1

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EFN412 Topic 02 SELF-STUDY QUESTIONS Question 1 How is the existence of a riskfree asset crucial to the derivation of the CML? Question 2 Explain why beta is considered to be a relative measure of risk. Question 3 What are the equations for (1) the CAPM and (2) the Market Model? Briefly explain what each model describes. Question 4 Explain the difference between systematic and non-systematic risk within the context of (1) the CAPM and (2) the Market Model. Question 5 Evaluate the following statements: 1. "Efficient portfolios have a beta of one" 2. "A portfolio with a beta of one is efficient" Question 6 Past Exam Question The following incomplete covariance matrix has been provided: Covariances R 1 R 2 R 3 R 4 Market R 1 .7 R 2 .0514 .6 R 3 .1093 .075 .8 R 4 .055 .058 .0645 .76 Market .1858 .1658 .2116 .2048 .16 A portfolio comprising equal investment in each asset other than the market has been created and it has provided a return of 14% which was the level of expected return for the portfolio. 2
EFN412 Topic 02 Required: 1. Complete the covariance matrix. 2. Is a portfolio comprising of equal investments in each asset efficient? Provide calculations. 3. (a) What is the beta of R 1 , R 2 , R 3 , and R 4 ? (To five decimal places) (b) What is the beta of the portfolio created in (2)? Use the answers from 3(a) to derive the beta. 4. If the variance of a portfolio using 25% of the investment in R 2 and 75% of the investment in R 3 is .5156, what is the correlation between the two investments? (Work to two decimal places) 5. What is the correlation of R 1 with the market and R 4 with the market? Question 7 Past Exam Question Two stocks (A and B) have a covariance of 23. When combined in equal proportions into portfolio Y, the variance of the portfolio is 30.25. Stock A has a variance twice that of Stock B. Another portfolio (X) has an expected return of 17% and a variance of 50. Additional Information

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