7.

a) Explain the differences between exchange trading and over-the-counter (OTC) trading.

b) Portfolio B consists of 15 stocks, 10 of which have beta 1 and idiosyncratic variance 0.02, and 5 of which have beta 1 and idiosyncratic variance 0.04. What is the minimum idiosyncratic variance one can achieve by investing in these stocks? You should assume that the idiosyncratic risks of the stocks included in B are independent across stocks. (Hint: the portfolio that minimises the idiosyncratic variance has equal weights in stocks with the same idiosyncratic variance.)

c) A pension fund discovers that it must make additional annual pension payments of $1m in years 6 through 10. The current interest rate is 5% and the term structure is flat. The pension fund seeks to hedge the additional liability by investing in two bond portfolios A and B with durations 5 and 15, respectively. The fund must also ensure that the investment in A and B matches the value of the additional pension payments. How much should be invested in portfolios A and B?