No. of Pages:
No. of Questions:
3
5
EC7084
JANUARY EXAMINATIONS 2008
Subject
ECONOMICS (POSTGRADUATE)
Title of Paper
EC7084 PRINCIPLES OF FINANCE
Time Allowed
TWO HOURS
___________________________________________________________________________________________________
Instructions to candidates
Answer THREE questions:
Question 1 from Section A and TWO questions from Section B.
All questions have equal weights.
___________________________________________________________________________________________________
SECTION A
(Compulsory Question)
1. Provide a brief explanation for all of the following concepts below:
(a) Subjective rate of time preference in the context of optimal decision-making in a world of
certain returns
[20%]
(b) Order-preserving property of utility function
[20%]
(c) Pure security and market security in the state preference theory of portfolio choice
[20%]
(d) Efficient set of portfolios in the minimum variance theory of portfolio choice
[20%]
(e) Portfolio beta in the context of CAPM
[20%]
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CONTINUED …
EC7084
SECTION B
(Answer TWO questions)
2. (a) The diagram below is drawn for two individuals, Mr X and Mrs Y, whose endowment of income
at the start and the end of the period is, respectively, (x0, x1) and (y0, y1). Carefully explain all
elements of the diagram, together with the assumptions which the diagram incorporates. [35%]
C1
y1
x1
y0
x0
C0
(b) Explain and illustrate diagrammatically the Fisher Separation principle for the two individuals
whose tastes and production opportunities are depicted in the diagram.
[40%]
(c) Assume that the capital market is no longer perfect. Explain how the diagram and the analysis of
the optimal consumption/investment decisions for the depicted individuals would need to change
to reflect this assumption.
[25%]
3. (a) State, explain and critically evaluate the assumptions required in derivation of the expected
utility theorem.
[35%]
(b) The table below summarises your estimates of the probabilities of the earnings per share for
companies A and B. Using the second order stochastic dominance criterion, compare the two
investment opportunities offered by these two companies (assuming you can only invest into one
of these companies).
[35%]
Company A
Company B
Return Probability Return Probability
-0.25
0.2
-0.50
0.1
1.00
0.2
-0.25
0.1
1.50
0.2
1.00
0.1
3.50
0.2
1.50
0.4
4.00
0.2
2.00
0.1
3.00
0.2
(c) In the context of the data given in Question 3(b), explain how some investors might choose to
invest into Company A, while others might choose to invest into Company B if preferences are
based on mean and variance.
[30%]
CONTINUED …
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EC7084
4.
(a) State and explain the assumptions of the state preference theory. Which of these assumptions are
likely to be invalid in the real world?
[30%]
(b) Let R1 and R2 be the returns for two securities with E(R1) = 0.01, E(R2) = 0.1, VAR (R1) = 0.03,
VAR(R2) = 0.07, COV(R1, R2) = – 0.04. Plot the set of feasible mean-variance combinations of
return, assuming that the two securities above are the only investment vehicles available.
[35%]
(c) Given the data of Q. 4(b), find the composition of the two securities in a portfolio which
minimises risk. Calculate the risk and expected return of this portfolio.
[35%]
5.
(a) Critically evaluate the robustness of the capital asset pricing model.
[35%]
(b) For an efficient portfolio j, Rj represents the return on the portfolio with E(Rj)= 30%, while the
risk-free rate is Rf = 7%, the expected return on the market portfolio is E(Rm) = 15%, and the
standard deviation of returns on the market portfolio is σm = 25%. Find the beta and σj of
portfolio j, as well as its correlation coefficient with the market portfolio.
[35%]
(c) State, explain and critically evaluate the assumptions required in formulating the arbitrage
pricing theory.
[30%]
END OF PAPER
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