a Explain how the stochastic discount factor approach can generate multi factor

# A explain how the stochastic discount factor approach

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(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%) Any Calculator 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 #### You've reached the end of your free preview.

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