Final Exam Review
Hong Kong University of Science &
Technology
Abhiroop Mukherjee
Final Exam Announcements

Date, Time, and Venue

Material: Includes everything, even pre-midterm

Style:

Homework problems

Examples on lecture notes

Practice Final posted on canvas
Final Exam Announcements

Exam is closed-book and closed-notes.

Allowed:

2 cheat-sheets on standard A4 paper, 2-sided

Pen/pencil, calculator (with exponents capability)

Disallowed: phones, tablets, etc.

Write answers on exam questionnaire.

Scratch paper will be provided. Make sure to staple
everything together in one pack.
Exam Strategy

Time management

Allot time r/t points awarded/ability.

Some MC/SA questions (20 min total): more
conceptual, less calculations.

One multi-part quantitative problem (30 – 40
min): some basic calculations.
Exam Strategy

Maximize your partial credits!

Show all your work/thinking clearly.

If you need the result from part (a) in order to
answer part (b) and you don’t have it, assume
a number and clearly state what you assumed,
then proceed.
Avoid Careless Mistakes

Read questions carefully – It’s worth the time!

MV Frontier vs. MV efficient frontier

Returns (ri) vs. Excess returns (ri – rf)

Returns (ri) vs. Expected returns E(ri)

Pre-expense vs. post-expense returns
Markowitz Portfolio Analysis

Input list  expected returns, variances,
covariances

Find the optimal risky (tangency) portfolio.

Construct the minimum-variance efficient frontier.

Find the CAL with the maximum Sharpe Ratio.

Split money between the optimal risky portfolio
and the riskfree asset.

Two-fund separation theorem and possible
violations
The CAPM

Statements about equilibrium “fair”
level of returns.

Start with Markowitz portfolio
optimization.

Impose market clearing condition.
CAPM: Market Portfolio & CML
Expected
E(r) Return
E(rM)
Capital Market Line
(CML)
M
Market
Portfolio
M = P*
Market portfolio is MVE!
F
s
sM
Standard
Deviation
CAPM: Equilibrium Reward
to Risk
Security prices adjust until, in equilibrium,
they all offer the same reward to risk, thus:
[E(rx) – rf]
=
sMx
[E(rx) – rf] =
CAPM: E(rx) =
[E(rM) – rf]
sM 2
sMx
[E(r
)
–
r
]
M
f
sM2
rf + bx [E(rM) – rf]
Security Market Line (SML)
Expected
E(r) Return
E(rx), bx
x

SML
M

E(rM)
E(ry), by
y

E(rM) – rf = slope of the SML
rf
b
1
bM = 1
Main Results

Imply the expected return – beta linear
relationship.

The CAPM


Variations in market portfolio is the only source of
systematic risk.
Modification into multi-factor models

Additional factors may be priced.

Allows accommodation of patterns in the data such as
size effect, value premium, and momentum.

Remember the Fama- French 3- or 4-factor model?
Market Efficiency

What is causing a return to deviate from its
expected value?

What is the Efficient Market Hypothesis
(EMH)?

Three forms of market efficiency

Does EMH contradict with active research
and management?
Behavioral Finance

What are limits to arbitrage?

Examples of situations which support limits to
arbitrage theory, e.g., Twin Shares etc.

Psychological biases

How we apply the psych ideas to explain
financial market puzzles
Trading Strategies

What is the underlying idea?

How can you profit from it? (Talk about what
the trading strategy is).

Think about recent situations where you can
apply some of it.