Investment Analysis and
Portfolio Management
Lecture 11
Gareth Myles
Introduction

This revision lecture will talk about the 2010
exam paper
 The important points about the questions will
be discussed
 The usual mistakes will be noted
Question 1
(i) Describe what the Capital Asset Pricing Model
(CAPM) is intended to explain.
[8 marks]
(ii) What assumptions does the CAPM make? Which of
these assumptions are not made by the Markovitz
model of portfolio choice? What is the consequence of
the additional assumptions?
[8 marks]
(iii) What is the security market line? If the CAPM is true,
will all securities have observed returns that are on the
security market line? Explain your answer. [10 marks]
(iv) How can you use CAPM to value a new issue of
stock?
[7 marks]
Question 1
(i) Describe what the Capital Asset Pricing Model
(CAPM) is intended to explain.
[8 marks]
This part of the question is usually treated too briefly.
There should be two or three coherent paragraphs of
explanation.
What should this say?
The CAPM is intended to explain how the returns on
assets are related to the risks.
The CAPM is intended to explain the equilibrium
pattern of returns in a financial market.
Question 1
The CAPM is intended to explain the equilibrium
prices of assets in a financial market.
The CAPM is intended to explain the nature of
equilibrium in a financial market.
It can also be claimed to explain how individual
choices lead to an equilibrium.
Question 1
(ii) What assumptions does the CAPM make? Which of
these assumptions are not made by the Markovitz
model of portfolio choice? What is the consequence of
the additional assumptions?
[8 marks]
The assumption should be listed.
It is necessary to explain what the Markovitz model is:
a model of individual portfolio choice.
What assumptions does it make? You can refer back
to the CAPM assumptions.
What are the additional assumptions of CAPM? That
all investors have the same expectations.
Question 1
This additional assumption has strong implications: it
ensures all investors face the same efficient frontier.
From this they face the same tangency portfolio, and
this must be the market portfolio.
Question 1
(iii) What is the security market line? If the CAPM is true,
will all securities have observed returns that are on the
security market line? Explain your answer. [10 marks]
It is necessary to explain that the security market line
is an equilibrium relationship between the expected
return on an asset and the covariance between the
return on the asset and the return on the market
portfolio.
Then the equation for the security market line can be
derived from the diagram relating expected return and
covariance.
Question 1
The important step in the construction is the definition
of beta.
The final part – are observed returns on the SML – is
the one that causes mistakes. It is expected return that
appears in the SML. The meaning of expected return
needs to be carefully distinguished from observed
return.
Question 1
(iv) How can you use CAPM to value a new issue of
stock?
[7 marks]
This question should be answered by reference to the
pricing formula.
But then it must be observed that there are two
unknowns in this formula: the beta and the expected
future price. Some comments should be offered on
how beta might be estimated.
e
i
Question 2
(i) What is the single index model?
[3 marks]
(ii) Assume that asset returns are generated by a model
for which the market is the single index. The details of
the model for three stocks are:
Stock
Alpha
Beta
A
0.1
1.2
2
B
-0.2
0.75
1
C
0.3
0.9
2
The expected return on the market is 12% with a
standard deviation of 25%. The risk free rate is 5%.
Plot the portfolio frontier for stocks A and B.
Plot the portfolio frontier for stock B and C.
e
i
Question 2
How would you construct the portfolio frontier for all
three stocks?
[15 marks]
(iii) An investor you are advising has decided to short sell
stock A to finance the purchase of stock B. Would you
advise for or against this investment? Explain your
reasoning.
[5 marks]
(iv) Are the data in the table consistent with the
predictions of the Capital Asset Pricing Model? If not,
would this imply rejection of the CAPM or the single
index model?
[10 marks]
e
i
Question 2
(i)
(ii)
The answer should describe the single index as a
statistical model of returns. The equation should also
be given with an explanation of alpha, beta, and the
error term. The answer should also say something
about the choice of index.
The calculations for parts (a) and (b) should use the
usual table giving return and standard deviation for
portfolios with different proportions of the two assets
in each part. 11 points should be adequate. The term
“plot” means draw two axes on the answer sheet,
mark the axes, and plot the points. It does not have
to be excessively accurate.
e
i
Question 2
The answer for part (c) should observe that the
portfolio frontier for 3 assets is found be calculating
return and variance for all combinations of the
assets. It should also observe that it is the outer
envelope.
(iii) The answer should relate back to the plot. Where on
the frontier is shortselling of stock A? It is either on
the efficient part or the inefficient part. Its location
determines the advice.
(iv) Use the Security Market Line to calculate returns
implied by CAPM. Compare to what the single index
model applies. CAPM in this case.
e
i
Question 4
(i) What is an option? Describe the major features of
call and put options, and distinguish between
European and American options.
[6 marks]
This is very straightforward. It helps to say it is a
derivative security whose value is derived from that
of an underlying asset.
e
i
Question 4
(ii) Explain the put-call parity relationship. A stock is
currently trading at £10. A European call option on
that stock which expires in 3 months and has an
exercise price of £11 is currently trading at £1. If the
(annual) risk-free rate of return is 6%, what is the
price of a put option on the stock with the same
exercise price and expiry date?
[6 marks]
Explain here means provide a description of it as a
relationship between the values of puts and calls.
Observe that it derives from an arbitrage argument
using a risk-free portfolio. State the equation.
e
i
Question 4
The remainder is the application of put-call parity. It
is an annual rate of interest so the discrete
discounting formula should be applied.
(iii) Compute the equilibrium price of a European put
option with 6 months until the exercise date if the
exercise price is £5.10, the current stock price £5.00,
and the stock price at the exercise date may be
£5.25 or £4.80. Assume that the annual risk free rate
of return is 5%.
[7 marks]
Observe that it is a put. It has 6 months until exercise
but the interest rate is for 1 year.
e
i
Question 4
It is always a good idea to draw the binomial tree.
Even if the calculations are wrong this can be
marked.
(iv) Note that this now switches to an expiry of 9 months.
So the interest rate will need adjusting to take
account of this. Which answer is “best”? The
argument has to be that more sub-periods is always
better since the analysis then become closer to
approximating the actual behaviour of a stock price.
(v) We didn’t do American this year.