Section 1: True or False: If False, provide a corrected statement that is true.

[1 point each]
TRUE 1. The covariance of two risky assets measures their tendency to vary around their
standard deviation.
FALSE 2. The Security Market Line (SML) relates total risk to expected return.
>>The Security Market Line (SML) relates systematic risk to expected return.
FALSE 3. The CAPM assumes all investors are heterogeneous in rationality and expectations.
>>The CAPM assumes all investors are homogenous in rationality and expectations.
FALSE 4. An implication of the CAPM is that the risk premium on the market portfolio is proportional to its
risk and the degree of risk aversion.
>>Proportional to its variance and to the risk aversion of the average investor.
TRUE 5. One problem with testing the CAPM is that the market portfolio is unobservable.
FALSE 6. Due to its shortcomings, the CAPM is useless.
>> practical applications of the CAPM includes estimating required returns;
one example is for regulators.
Problem 1: Return Computation, ETFs, Levered ETFs, and Tracking Errors [16 points]
The SPY is an ETF that seeks to replicate the returns to the S&P 500 Index. Additionally, the UPRO is
an ETF that seeks to provide returns equaling 3 times the daily return to the S&P 500 Index, while the
SPXU is an ETF that seeks to provide returns equaling -3 times the daily return to the S&P 500 Index.
On blackboard, you will find the daily returns to both the index and these 3 ETFs for the period January
2011 through September 2011 (i.e. for an investor investing on 12/31/2010 through 9/30/2011). Use this
data to complete the following tasks:
A. [6 points] Using the data in the excel spreadsheet provided to you on Blackboard, compute the
arithmetic average return, the geometric average return, and the standard deviation of returns for
the S&P 500 index and the three ETFs (SPXU, SPY, and UPRO). Note, when computing the
geometric average return, do not use the approximation but instead use the exact computation.
S&P500 SPXU SPY UPRO
Arithmetic average return -0.038% 0.111% -0.039% -0.125%
Geometric average return -0.048% 0.028% -0.048% -0.210%
Standard deviation of returns 1.386% 4.100% 1.370% 4.085%
B. [2 points] Based on your answer to Part A, why is there a larger difference between the
arithmetic and geometric average returns for UPRO than for SPY?
Arithmetic average return is mean of daily returns, the numbers in data are independent from each other.
Geometric average return calucates by product of each numbers so the numbers used are dependent.
Geometric average return is more affected by outliers.
The lowest daily return of SPY is -6.514% and the highest daily return is 4.65%.
On the other hand, the lowest daily value of UPRO is -19.753% and the highest daily return is 13.906%.
Upro has greater range of daily returns and seem to have significant numbers
that affects geometric average returns.

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C. *2 points+ Use the approximation (Geometric Average Return Arithmetic Average Return 0.5
* return variance) to compute the geometric average return for the S&P 500, SPXU, SPY, and
UPRO, and compare those numbers to the geometric average returns from A.
S&P500 SPXU SPY UPRO
Geometric average return -0.048% 0.028% -0.048% -0.210%
Est. Geometric average return -0.048% 0.027% -0.048% -0.021%
The Geometric average return and estimated geometric average return is similar.
D. [3 points] Compute the holding period return for the S&P 500 index and the three ETFs (SPXU,
SPY, and UPRO) over the full holding period.
S&P500 SPXU SPY UPRO
HPR -8.68% -5.51% -8.717% -32.782%
E. [3 points] Define the daily tracking error for each ETF as the ETF return minus the benchmark
index return. To illustrate:
TESPY = SPY return S&P500 return,
TESPXU = SPXU return (-3 * S&P500 return),
TEUPRO = UPRO return (3 * S&P500 return).
TEspy Tespxu Teupro
40546 -0.00102 0.005382 -0.4975%
40547 0.000751 -0.00273 0.0744%
40548 5.84E-05 -0.00012 0.1531%
40549 -0.00022 0.00069 -0.0677%
40550 -0.00012 0.000352 0.0080%

40812 0.000428 -0.00112 0.2010%
40813 0.000493 -0.001 -0.0441%
40814 6.74E-05 0.001149 0.1042%
40815 -0.00031 -0.00061 0.1225%
40816 -6.9E-06 -0.00152 0.3672%
For each of the 3 ETFs, compute the average daily tracking error and the maximum and minimum
daily tracking error.
TESPY TESPXU TEUPRO
average -4.4E-06 -0.0045% -0.0094%
min -0.00159 -0.8123% -2.8420%
max 0.001445 0.6406% 2.8775%
Problem 2: The Efficient Frontier and the CAL [14 points; 2 points each]
Consider the 2-asset case. Asset 1 has an expected return of 1.00% and a standard deviation of 4.00%.
Asset 2 has an expected return of 6.00% and a standard deviation of 7.50%. The correlation coefficient
for the two assets is 0.12.
1. What is the covariance of Assets 1 and 2?
Asset 1: E(r1)=1%, 1=4%
Asset 2: E(r2)=6%, 2=7.5%
1,2 = 0.12
1,2 = 1,2/(1*2) = 1,2/(0.04*0.075) = 0.12
1,2= 0.00036
2. What are the expected return and standard deviation of a portfolio composed of 35% Asset 1 and
65% Asset 2? Refer to this portfolio as the (35,65) portfolio.
E(Rp) = W1E(R1)+W2E(R2) = (0.35*0.01)+(0.65*0.06) = 4.25%
p
2
= w1
2
*1
2
+w2
2
*2
2
+2w1*w2*1,2 = (0.35^2)(0.04^2)+(0.65^2)(0.075^2)+2(0.35*0.65*0.00036)
p
2
=0.00274 = 0.274%
p = 0.05231 = 5.231%
3. Now consider the risk-free asset. The return on the risk-free asset is 0.50%. What are the
expected return and standard deviation from allocating our wealth 20% to the risk-free asset and
80% to the (35,65) portfolio in Step #2?
E(RP+) = WrfE(Rrf) + WpE(Rp) = (0.2*0.005)+(0.8*0.0425) = 3.5%
p+
2
= Wp
2
* p
2
= (0.8^2)*(0.00274) = 0.1754%
p+ = 4.1876%
4. What is the slope of the line formed by all possible combinations of the risk-free asset and the
(35,65) portfolio?
Slope = rise / run = (E(RP) rf )/P = (4.25%-0.5%)/(5.231%) = 0.716880
5. What portfolio (selected from all the possible combinations of Asset 1 and 2) forms the best
possible Capital Allocation Line? The correct answer will define the portfolio according to the
weights, e.g. (w1,w2) = (35,65).
W2* = *(E(R2)-rf)*1
2
-(E(R1)-rf)*1,2+ / *(E(R2)-rf)*1
2
+ (E(R1)-rf)*2
2
(E(R1)-rf+E(R2)-rf)*1,2+
W1* = 1-W2*
W2* = [(0.06-0.005)*(0.04)
2
-(0.01-0.005)*(0.00036)]
/[(0.06-0.005)*(0.04)
2
+(0.01-0.005)*(0.075)
2
- [(0.01-0.005+0.06-0.005)*(0.00036)]
W2* =0.91193 = 91.193%
W1* = 1-0.91193 = 0.08807 = 8.807%
6. What is the slope of the Capital Market Line (CML)?
E(Rp) = W1E(R1)+W2E(R2) = (.08807*0.01)+(.91193*0.06) = 0.055597 = 5.5597%
p
2
= w1
2
*1
2
+w2
2
*2
2
+2w1*w2*1,2 =
(0.08807^2)(0.04^2)+(0.91193^2)(0.075^2)+2(0.91193*0.08807*0.00036)
p
2
=0.00475 = 0.475%
p = 0.06891 = 6.891%
Slope = rise / run = (E(RP) rf )/P = (5.5597%-0.5%)/(6.891%) = 0.734248
7. What are the expected return and standard deviation of a portfolio that invests -20% in the riskfree
asset and the remainder of the portfolio in the optimal portfolio found in Step #5?
E(r#7) = wrf * rf + wp * E(rp*) = (-0.2*0.005)+(1.2*0.055597) = 0.0672
E(r#7) =6.572%
p+ = Wp* p= (1.2)*(0.06891) = 0.08269 = 8.269%
Problem 3: 3 risky assets [9 points; 3 points each]
Consider three risky assets with the following properties.
Use this information to answer the following questions.

Expected Return Standard Deviation Covariances:

Asset1 3.00% 4.00% 1,2 = -0.00130
Asset2 11.00% 13.00% 1,3 = 0.00180
Asset3 6.50% 9.00% 2,3 = 0.00819
1. [3 points] What is the correlation coefficient for Assets 2 and 3?
2,3 = 0.00819
2 =0.13
3 = 0.09
2,3 =0.00819/(0.13*0.09) = 0.7
2. [3 points] What is the expected return for the portfolio that invests 30% in Asset 1, 30% in Asset
2, and 40% in Asset 3?
E(Rp) = W1E(R1)+W2E(R2) +W3E(R3) = (0.30*0.03)+(0.30*0.11) + (0.40*0.065)= 0.068 = 6.8%
3. [3 points] Compute the standard deviation for the portfolio that invests 30% in Asset 1, 30% in
Asset 2, and 40% in Asset 3?
p
2
= w1
2
* 1
2
+ w2
2
* 2
2
+ w3
2
* 3
2
+ 2w1 w2 1,2 + 2w1 w3 1,3 + 2w2 w3 2,3
p
2
= (0.30^2)(0.04^2) + (0.30^2)(0.13^2) +(0.40^2)(0.09^2)
+ 2(0.30*0.30*-0.0013) +2(0.30*0.40*0.0018) + 2(0.30*0.40*0.00819)
0.0051246
p= (0.00512)^0.5 = 0.07159 =7.159%