(a) Explain how the stochastic discount factor approach can generate multi-factor models of asset prices. (60%)
(b) Evaluate the recent attempts to use the factor model of asset prices to
explain various asset-pricing anomalies. (40%)
8. There are two assets available with the following characteristics:
Asset A:
E(R
A
) =
A
;
SD(R
B
) =
A
;
Asset B :
E(R
B
) =
B
; SD(R
B
) =
B
;
Corr(R
A
R
B
) =
.
where E(.) is the expected return, SD(.) is the standard deviation of the return
on the asset and Corr(.) is the correlation between the return on asset A and
that on asset B.
(a)Construct the portfolio that represents the stochastic discount factor if
these two assets span the pay-off space. (70%)
(b)Discuss how such a construction can be used as a method of evaluating
fund management. (30%)
9.
(a)Show that the present value formula for asset prices when expected
returns are time varying can be approximated as,
1
1
)
(
constant
i
i
t
i
t
i
t
t
t
r
d
E
d
p
where r
t
is the return on the asset at time t, and lower-case letters denotes
the logarithm of the upper-case variable, P
t
, the price of the asset at time t, D
t
,
the dividend paid on the asset at time t. Also let,
D
P
D
P
/
1
/
where
P
and
D
are the average price and dividend respectively. (65%)

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AO7113
Page 5
End of Paper
(b) Discuss the results obtained from an empirical application of the idea
captured by this formula. (35%)
10. (a) Discuss reasons why financial market arbitrage is not complete and
hence irrationality can persist in financial markets. (50%)
(b) Explain how the existence of noise traders can be used to explain

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- Winter '18
- Economics