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ADM 4445 Theory of Finance E.Otuteye Fal12011 Midterm Exam
Wednesday October 19,2010; 1 - 2:20pm.
Name: Student #:
Part 1.(12 Marks) ]. Define/Explain the following terms:
a. Axiom of completeness of preferences
b. Fisher separation principle
c. Capital Market Line
ADM 4445 Fall 2011 Midterm Exam Page 1 of 5
Part 2. (28 Marks) 2. For each statement, state whether it is True, False, or Uncertain and explain why.
Marks will be given mainly for the explanation.
a. According to signaling theory, a signal can be credible if the cost of the signal is higher for the lower quality entity than for the higher quality entity.
b. The Arbitrage Pricing Theory specifies that there are two common factors that are sources of systematic risk.
c. The Fama-French 3-factor model is an example of a model that is derived based on how investors make their portfolio choices.
d. If you create a risk-free portfolio from two risky assets, the expected return of that portfolio must be zero.
ADM 4445 Fall 2011 Midterm Exam Page 2 of 5
Par 3. (20 Marks each)
3. Suppose there .. . are two Investors A & .~t1hty function is U(W) = 1 _ e-'w (a~o)l~,the following utility functions. A's2b
to a. Which of them is a risk a .' s utility function is U(W) = 2W· -:+ b. For the one you chose v~rlse mvest?r? Explain.
. . as ns ( averse mvest '11' 1 w~ney 1~ nsky assets as his wealth' or, WI this person invest more l' c.
m 111 he Invest a hi h mcreases? Explain . g er percentage of h' ]..'wea th mcreases? Explain. 1S wea th In risky assets as his
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ADM 4445 Fall 2011 Midterm Exam Page 3 of 5
4. An investor has a utility function ofU(W) = W-05 and his current wealth is $40. He is presented with a gamble that offers 50% chance of winning $20 and 50% chance of losing $20. Calculate6 a. The expected utility of the gamble'''f b. the utility of expected wealth from the gamble;
c. There is insurance that costs $1.75. Will this investor pay $1.75 to avoid t the gamble?
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ADM 4445 Fall 2011 Midterm Exam Page 4 of 5
5. Suppose asset returns follow a 2-factor APT: E(Ri) = .05 + .07bil + .06bi2. You are also given the following information:
Security i bij bi2 A -1.2 2.0 B 0.9 -0.2
a. Portfolio P is formed from A and Band bp 1 = 0.06. What is the expected return on P?
b. There a stock S, with bsJ = 1.0 and bs2 = .92. The stock is expected to sell for $114 next year and it is expected to pay di vidends of $1.20 per share during the year. Will you buy it if it is selling now for $99.507
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ADM 4445 Fall 2011 Midterm Exam Page 5 of 5
