Section A.

You have been assigned to construct a portfolio comprising two risky assets (Portfolios A & B) while considering your client's risk tolerance. The attached spread sheet shows historical monthly returns of the two portfolios; the market portfolio as represented by the S&P 500 index; and the risk free rate as represented by 90-day Treasury Bills. Also shown are the annualized returns for each investment during the period. The first risky asset (Portfolio A) is a US equity strategy that uses publically available valuation, technical and sentiment factors to assess which stocks are over-priced and which are under-priced. Fundamental factors indicate the magnitude and quality of a company's earnings and the strength of its balance sheet. Examples of such factors include: cash flow growth, cash flow return on invested capital, price to cash flow, and accruals which assess earnings quality (low quality earnings indicate that management may be manipulating earnings by adjusting accruals). Companies with favorable fundamental factors tend to outperform those with less favorable factors. Technical and sentiment factors seek to identify mis-pricings resulting from investor behavior. Examples include: momentum and price reversals where investors tend to over-react to good news by bidding up prices ABOVE fair value and bad news by bidding down prices BELOW fair value; short interest on a stock which can indicate the investor sentiment about the company's prospects; share buybacks which can indicate a positive signal from management's optimism regarding a firm's future prospects; and earnings / revenue surprise. Firms with favorable technical and sentiment factors also tend to outperform. For example, firms whose earnings and revenue exceed analysts' expectations tend to continue to outperform vs. those firms that experience earnings surprise due to cost cutting. Starting with the market portfolio, the US equity strategy over-weights those stocks with more favorable fundamental, technical and sentiment factors and under-weights or avoids those stocks with less-favorable or un-favorable factors. The strategy seeks to out-perform the market portfolio as represented by the S&P 500. The monthly returns of the US equity strategy are shown in the attached spreadsheet (Portfolio A). The second risky asset (Portfolio B) is a global macro hedge fund. This strategy seeks to benefit from mis-pricings within and across broad asset classes by taking long and short positions in equity markets, bond markets and currencies. For example, if the manager believes that US equities will out-perform Japanese equities, the portfolio will go long S&P 500 futures and short TOPIX futures (TOPIX is an index that serves as a proxy for Japanese equities). This long/short trade is not impacted by the overall direction of global equities, but rather the relative movement between US and Japanese equities. Similarly for bonds, if the manager believes that interest rates in the United Kingdom (UK) will decline more so than interest rates in Australia, then the manager will buy UK gilt futures (gilt is the 10-year UK bond) and short Australian 10-year bond futures. Again, this trade is not impacted by the overall direction of global interest rates, but rather the relative movement between UK and Australian rates. Recall that bond prices rise as interest rates decline. The global macro hedge fund is mostly market neutral meaning that long positions equal short positions thereby dramatically reducing systematic exposures (low beta). Portfolios A & B are much more volatile than the risk free rate. You will find that their correlation is small indicating that there is a diversification benefit to be had from holding both in a portfolio (you will need to calculate this using the excel function "=correl(range 1, range2)". You will be meeting with a client that is looking for investment advice from you based on the two strategies A & B. In preparation for your upcoming meeting with the client, your boss asks that you respond to the questions below and be ready to discuss. Hint: You will need to determine the correlations and volatilities for each risk premium.

Your client believes in the weak form of market efficiency as it relates to security selection. Is Portfolio A's performance sufficient justification to prove this belief? Why or why not.

Section B.

Indicate whether it's true or false and give reasons.

______1. Insurance is a method of transferring risk from one party to another.

______2. It is more important to insure large risks with a small probability of occurrence than to insure smaller risks that have a high probability of occurrence.

______3. Insurance is a major expense and plays a significant role in your personal budget.

______4. Insurance is a means of protecting yourself from speculative risk.

______5. You can only insure those items in which you have an insurable interest.

False 6. Peril is the uncertainty of a loss occurring.

True7. Insurance underwriters are responsible for determining the premium that should be charged for each policy written.

______8. Federal law requires insurance companies to accept all applications which they receive but do permit the companies to individually determine the premium for each policy.

______9. The greater the risk that is being transferred, the higher the insurance premium.

______10. The probability of dying at a particular age is determined by an underwriter.

______11. An exclusion is the amount of each loss that will be paid by the individual.

______12. All insurance policies that offer the same coverage will charge the same premium.

______13. Once you transfer your risk to an insurance company, you can be totally assured of payment by that company if you incur a covered risk.

______14. Liability is usually the largest loss incurred.

______15. If your state has no-fault insurance laws, it is not necessary for you to carry liability auto insurance.

______16. If you carry underinsured auto coverage, your company may pay claims in excess of those paid by the other driver who was at-fault.

______17. If you are injured by a driver who has no auto insurance, you will receive benefits under your personal policy if you carry underinsured coverage.

______18. Collision insurance pays for damage to your car regardless of who is at-fault.

______19. Your insurance costs will be the same regardless of where you live.

______20. An all risk homeowner's policy offers more protection than a named perils policy.

______21. An HO-1 policy offers greater insurance protection than an HO-2 policy.

______22. If you are a renter, you can purchase either HO-4 or HO-5 or HO-6 homeowner's insurance on your belongings.

______23. HO-# policies cover all risks on the dwelling and contents of a homeowner.

______24. Contents coverage is usually set a s stated percent of the face value of a homeowner's policy.

______25. Homeowner's insurance normally limits the company liability for jewelry.

Page 2 of 3

______26. If you want to schedule your jewelry, you will need to add a floater to your homeowner's policy.

______27. If you have a significant stamp or trading card collection, you should schedule them on your homeowner's policy.

______28. Homeowner's insurance automatically provides for the replacement of your home if it is totally

demolished in a storm.

______29. Earthquake damage is automatically included in the basic homeowner's policy.

______30. Flood insurance is covered by your homeowner's policy.

______31. If your roof is damaged by an ice storm, the insurance company will pay all costs associated with the

repair, if you have actual cash value coverage.

______32. Homeowner's can add an insurance endorsement to their policy that will automatically adjust the face value for inflation.

______33. Most homeowner policies carry a coinsurance requirement of eighty (80%) per cent.

______34. The higher the deductible on your homeowner's policy, the higher the annual premium.

______35. Insurance policies include the declarations page, definitions, agreement, exclusions and conditions.

MULTIPLE CHOICE - Select the best response to each of the following.

___c___1. A person hired to represent the buyer of insurance is called a(n):

a. actuaryb. agentc. brokerd. underwriter

______2. Losses which are totally exempt from insurance coverage are known as:

a. conditionsb. declarationsc. deductiblesd. exclusions

______3. If you receive an offer for limited insurance, your best course of action would probably be to:

a. purchase the insurance immediately because it is only offered for a very short period of time;

b. purchase the insurance because you will usually receive an excellent benefit for your dollar;

c. ignore the offer because you can get better coverage per insurance dollar with other policies;

d. ignore the offer because the insurance coverage is too broad and thus too expensive;

______4. You can reduce your insurance premiums by:

a. adding a rider;b. increasing your face value;

c. reducing your deductible;d. breaking your smoking habit.

______5. Damage caused by your car to someone else's property is covered by the:

a. property damage liability on your auto insurance; b. property damage liability on your homeowner's policy;

c. bodily injury liability on your auto insurance;d. bodily injury liability on your homeowner's insurance.

______6. Assume you have 50/100/50 auto liability insurance and that you cause an accident wherein you injure two pedestrians. One pedestrian incurs medical bills of $62,000 while the other only had $4500 in medical expenses. The insurance company would pay (Ignore any deductibles.)

a. $0;b. $50,000;c. $54,500;d. $66,500;

_______7. Auto liability insurance will NOT cover which of the following?

a. pain and suffering to passengers in another car when you hit that car in an auto accident

b. loss of earnings of a pedestrian who accidentally falls on your icy sidewalk.

c. medical costs for a friend who you permitted to drive your car & who was involved in an accident.

d. damage to a utility pole that you slid into during a snowstorm.

Page 3 of 3

______8. Assume that your car has a market value of $8,500. You are involved in a serious accident. The repair shop estimates that it will cost $9,300 to fix your car. The insurance company will:

a. repair your car and pay $9,300 less your deductible.

b. repair your car and pay the entire $9,300.

c. take your vehicle and give you $8,500.

d. will either repair your car or give you $9,300 whichever you prefer.

______9. Which one of the following will decrease your auto insurance premium?

a.buying a moderately priced sedan instead of the higher priced sports car.

b.decreasing your insurance deductible.

c.selecting single liability coverage instead of split liability coverage.

d.getting a speeding ticket as you drive to work.

______10. As a full-time student, you may NOT be covered by your parents homeowners ins if you:

a.are over age twenty-one and live at home;

b.reside in a college dormitory;

c.reside off campus while attending college.

d.live elsewhere but are injured while visiting your parents.

______11. Which one of the following offers the greatest insurance protection for a homeowner?

a. HO-2 policy;b. HO-3 policy;c. HO-5 policy;d. HO-15 policy;

_____12. You are planning on building a new home. The lot costs $38,000 and the home costs $160,000. The minimum homeowner's policy you should purchase is:

a. $128,000;b. $158,400;c. $160,000;d. $198,000;

______13. Umbrella policies pay:

a. all liability costs incurred from an accident or injury sustained either at home or in your car.

b. only liability costs in excess of your auto insurance liability coverage.

c. all liability costs in excess of your auto and homeowner's liability coverage.

d. liability costs in excess of your auto and homeowner's policy up to the coverage limits.

______14. An umbrella policy will cover which of the following?

a. only liability claims arising from an incident at home or in your car.

b. personal injury and property damage claims only.

c. personal injury and property damage claims as well as all legal costs incurred.

d. personal injury, property damage, libel and false arrest claims.

______15. The comprehensive coverage provided by your auto insurance does NOT cover which of the following?

a. damages to your car when a tree blows onto the roof during a windstorm.

b. losses incurred when someone decides to steal your custom wheels.

c. damages caused when your car is hit broadside at an intersection.

d. losses incurred when your electrical system shorts out causing your car to catch fire.