3. a) When adding a risky asset to a portfolio of many risky assets, which property of the asset

is more important, its standard deviation or its covariance with the other assets? Explain.

b) Suppose that the risky premium on the market portfolio is estimated at 8% with a standard deviation of 22%. What is the risk premium of a portfolio invested 25% in CEMENCO and 75% in Monrovia Breweries, if they have Betas of 1.1 and 1.25 respectively?

c) Suppose the two factor portfolios, here called portfolio 1 and 2, have Expected Returns E (r₁) = 10% and E(r₂) = 12%. Suppose further that the risk-free-rate is 4%. The risk premium on the first factor portfolio is therefore 6%, while that on the second factor portfolio is 8%. Now consider an arbitrary well-diversified Portfolio (P), with Beta on the first factor, BP₁ =.2 and the second factor BP₂ = 1.4. Find the fair rate of return on the security.

d) What do most empirical studies suggest about the stock market?

4. a) Which of the following statements are true if efficient market hypothesis holds?

(i) It implies that future events can be forecast with perfect accuracy.

(ii) It implies that prices reflect all available information.

It implies that security prices change with no discernable reasons.

It implies that prices do not fluctuate.

b) What is a Bond Yield to Maturity (YTM)?

c) Why are bond ratings important to both firms and investors?

d) What is the bond indenture? What are protective covenants? Give examples.

5. a) Define the following types of bonds:

(i) Euro bond

(ii) Zero-coupon bond

Samurai bond

Convertible bond

Indexed bond

b) What is the option embedded in a callable bond? A puttable bond?

c) What are the cash flows associated with a bond?

d) A Metro gates industries bond has a 10 percent coupon rate and a US$1,000 face value. Interest is paid semiannually, and the bond has 20 years to maturity. If investors require a 12 percent yield, what is the bond value? What is the effective annual yield on the bond?