1. MFE 230G Section 2 Hari Phatak 21 August, 2008

2. Administrative Notes Homework, Friday 5:00pm: 3 options –Hard copy Envelope outside F633 (usually up on Wednesday) Mailbox in F534 –E-mail Aegis Section: Saturday 10:00am- 12:00pm, S480 Office hours: convenient?

3. Fundamental Risk Model (I) Stocks A and B have excess returns of 6% and 5%, respectively. Stock A’s specific variance is 0.01 and stock B’s specific variance is 0.01. The two stocks are in the same industry. Stock A has a loading of 0.5 on a size factor while stock B has a loading of 0.25 on the same factor.

5. Fundamental Risk Model (II) Assuming a two-factor (size and industry) risk model, compute the returns to factor- mimicking portfolios.

6. Fundamental Risk Model (III) What are the weights of A and B in the factor portfolios you have computed?

7. Fundamental Risk Model (IV) Now assume that the factor variance- covariance matrix is: The first column corresponds to the size factor Compute the variance-covariance matrix of asset returns

9. Beta Given the following data: Compute the beta of the portfolio with respect to the benchmark.

10. Given the following information Approximate the impact to total and active risk of a rebalancing trade resulting in: MCTR/MCAR

12. Valuation (I) Suppose as a stock analyst you expect next year’s earnings for firm A be $1 and $0.75 to be paid out as a dividend at year’s end. Compute the P/E ratio for firm A, given a return on equity of 15% and an expected return of 8%.

13. Valuation (II) Suppose the stock currently trades at a P/E ratio of 10 but you expect it to trade fairly by the year’s end. What return can you expect?

14. Valuation (III) Suppose the stock currently trades at a P/E ratio of 10, and you expect this P/E ratio to remain the same when you sell the stock at year’s end. What return can you expect?