FINANCIAL MODELLING AND

D E R I VAT I V E S 2 0 2 2 - 2 0 2 3
TUTORIAL 2

1
QUESTION 0
• Please fill in your name and student number on Mentimeter in the following format:
• Student number, name
• Example: 1234567, Mark Dijkstra
• Please insert your information correctly, especially your student number! This makes
grading easier. Deal sweetener: Any student that inputs their student number
correctly for every week of the tutorial gets 5 bonus points on the tutorial!

2
QUESTION 1
Which one of the following is most directly affected by the level of systematic risk in
a security?
A. Variance of the return
B. Standard deviation of the return
C. Expected rate of return
D. Realized rate of return

3
QUESTION 1
• Think of the expected risk-return relationship.
• The correct answer is: C

4
QUESTION 2
Compare the following shares: Share A: Beta = 0.6, volatility = 40%. Share B:
Beta = 0.6, volatility = 70%. Which share has a higher expected return?
A. Share A
B. Share B
C. The shares have the same expected return
D. Impossible to say without additional information

5
QUESTION 2
• Investors only care about systematic risk because they can diversify idiosyncratic
risk. Systematic risk is captured by Beta.
• The correct answer is: C

6
QUESTION 3
• True or false: CAPM does not work for portfolios
A. True
B. False

7
QUESTION 3
• It applies to tradable investment opportunities, so it can also be applied to
portfolios.
• The correct answer is: B
• More information: Chapter 11 of Berk and DeMarzo

8
QUESTION 4
• Shares in Sirrius Radio have a beta of 1.5. If the risk-free rate is 2% and the
market risk premium is 6%, what is Sirrius's expected return?
A. 8%
B. 9%
C. 10%
D. 11%

9
QUESTION 4
• 𝔼 𝑟𝑖 = 𝑟𝑓 + 𝛽 𝔼 𝑟𝑚 − 𝑟𝑓
• Market risk premium = 𝔼 𝑟𝑚 − 𝑟𝑓 = 6%
• 𝔼 𝑟𝑖 = 0.02 + 1.5 ∙ 0.06 = 0.11 = 11%
• The correct answer is: D
• More information: Chapter 11 of Berk and DeMarzo

10
QUESTION 5
• Shares in Hodrick’s Hats have a beta of 1.34 and as such have an excess return
over a risk-free asset. What is this excess return called?
A. Market risk premium
B. Risk premium
C. Systematic return
D. Total return

11
QUESTION 5
• Market risk premium: 𝔼 𝑟𝑚 − 𝑟𝑓
• “ The market risk premium is the reward investors expect to earn for holding a
portfolio with a beta of 1 – the market portfolio itself.” (Chapter 10 of Berk and
DeMarzo)
• Risk premium:𝔼 𝑟𝑖 − 𝑟𝑓 = 𝛽(𝔼 𝑟𝑚 − 𝑟𝑓 )
• “The CAPM states that the risk premium equals the investment’s beta times the market
risk premium.” (Chapter 10 of Berk and DeMarzo)
• The correct answer is: B
• More information: Chapter 10 – 11 of Berk and DeMarzo

12
QUESTION 6
• Your friend has a portfolio focused on power tools. Her portfolio has a 0.33
weight in Kaathe Construction and a 0.67 weight in Frampt Tools. Kaathe has an
expected return of 15% and a beta of 1.2; Frampt has an expected return of
11% and a beta of 0.8. What is the beta of your friend’s portfolio?
A. 0.93
B. 1.07
Share Weight Expected return Beta
C. 1.12
Kaathe 0.33 15% 1.2
D. 2.00 Frampt 0.67 11% 0.8

13
QUESTION 6
• “The beta of a portfolio is the weighted average beta of the securities in the
portfolio” (Chapter 11 of Berk and DeMarzo)
• 𝛽𝑝 = σ𝑖 𝑤𝑖 𝛽𝑖 = 0.33 ∙ 1.2 + 0.67 ∙ 0.8 = 0.932
• The correct answer is: A
• More information: Chapter 11 of Berk and DeMarzo

14
QUESTION 7
• Suppose Astora Ice Cream has a market capitalization of $200 mln and
outstanding debt of $100 mln. If Astora’s equity beta is 1.8 and Astora's debt
beta is 0.3, what is Astora's asset beta?
A. 0.8
B. 1.3
C. 2.1
D. 3.6

15
QUESTION 7
• Similar to the previous question where we said that “the beta of a portfolio is the
weighted average beta of the securities in the portfolio”.
• In this case you assign relative weights based on the market value of equity and debt.
• The asset or unlevered beta is:
𝐸 𝐷
• 𝛽𝑈 = 𝛽 + 𝛽
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷
200 100
• 𝛽𝑈 = ∙ 1.8 + ∙ 0.3 = 1.3
200+100 200+100
• The correct answer is: B
• More information: Chapter 12 of Berk and DeMarzo

16
QUESTION 8
• Siegmeyer Onions has an equity beta of 1.2 and a market capitalization of $800
million. In its most recent annual report, Siegmeyer reported $650 million in assets
and $350 in debt on which it pays 3% interest. If the risk-free rate is 1%, the
market risk premium is 6% and the tax rate is 25%, what are Siegmeyers
weighted average costs of capital?
A. 5.55%
B. 6.05%
C. 6.39%
D. 7.01%

17
QUESTION 8
• 𝔼(𝑟𝐸 ) = 𝑟𝐹 + 𝛽 𝔼 𝑟𝑚 − 𝑟𝑓 = 0.01 + 1.2 ∙ 0.06 = 0.082
𝐸 𝐷
• 𝑟𝑤𝑎𝑐𝑐 = 𝑟 + 𝑟 1 − 𝜏𝐶
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷
• Use market value of equity, not the book value
• Interest expenses are tax deductible, tax shield
800 350
• 𝑟𝑤𝑎𝑐𝑐 = ∙ 0.082 + ∙ 0.03 ∙ 1 − 0.25 = 0.0639 = 6.39%
800+350 800+350

• The correct answer is: C

• More information: Chapter 12 of Berk and DeMarzo

18
QUESTION 9
• Suppose you observe the following situation. Assume Ornstein and Smough are correctly
priced. What is the risk-free rate of return?
Security Beta Expected return
Ornstein 1.2 12%
Smough 2 18%

A. 2%
B. 3%
C. 4%
D. 5%

19
QUESTION 9
• CAPM:
• 𝔼 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝔼(𝑟𝑚 − 𝑟𝑓 )
• Ornstein: 0.12 = 𝑟𝑓 + 1.2 𝔼(𝑟𝑚 − 𝑟𝑓 )
• Smough: 0.18 = 𝑟𝑓 + 2 𝔼(𝑟𝑚 − 𝑟𝑓 )
• Two equations with two unknown variables: 𝔼 𝑟𝑚 and 𝑟𝑓
• Write 𝔼 𝑟𝑚 in terms of 𝑟𝑓 in one of the two equations.
• Use this definition of 𝔼(𝑟𝑚 ) to solve for 𝑟𝑓 in the other equation.

20
QUESTION 9
• Smough: • Ornstein:
• 0.18 = 𝑟𝑓 + 2 𝔼(𝑟𝑚 − 𝑟𝑓 ) • 0.12 = 𝑟𝑓 + 1.2 𝔼(𝑟𝑚 − 𝑟𝑓 )
• 0.18 = 𝑟𝑓 + 2𝔼 𝑟𝑚 − 2𝑟𝑓 = 2𝔼 𝑟𝑚 − 𝑟𝑓 • 0.12 = 𝑟𝑓 + 1.2
0.18+𝑟𝑓
− 𝑟𝑓
2
• 0.18 + 𝑟𝑓 = 2𝔼 𝑟𝑚 1.2∙0.18 1.2
• 0.12 = 𝑟𝑓 + + 𝑟 − 1.2𝑟𝑓
0.18+𝑟𝑓 2 2 𝑓
• = 𝔼(𝑟𝑚 )
2 • 0.12 − 0.108 = 0.4𝑟𝑓
• Of course, you could start with the formula of 0.012
• = 0.03 = 𝑟𝑓
Ornstein instead of Smough to get the same 0.4
result. • The correct answer is: B

21
QUESTION 9
• Same idea, different notation • 0.18 = 𝑟𝑓 + 2
0.06+0.8𝑟𝑓
− 𝑟𝑓
0.8
Ornstein 0.18 = 𝑟𝑓 + 2 𝔼 𝑟𝑚 − 𝑟𝑓
2∙0.06 2∙0.8
Smough 0.12 = 𝑟𝑓 + 1.2 𝔼 𝑟𝑚 − 𝑟𝑓 • 0.18 = 𝑟𝑓 + + 𝑟 − 2𝑟𝑓
0.8 0.8 𝑓
0.06 = 0.8(𝔼 𝑟𝑚 − 𝑟𝑓 )
• 0.18 − 0.15 = 𝑟𝑓 + 2𝑟𝑓 − 2𝑟𝑓 = 𝑟𝑓

• 0.06 = 0.8𝔼 𝑟𝑚 − 0.8𝑟𝑓 • 0.03 = 𝑟𝑓

0.06+0.8𝑟𝑓 • The correct answer is: B

• = 𝔼 𝑟𝑚
0.8

22
QUESTION 10
Lautrec Garden Supplies’s stock returns have a daily volatility of 0.05 and a
correlation of 0.8 with the market portfolio. Calculate Lautrec’s beta if the market
portfolio’s returns have a daily volatility of 0.04.
A. 0.64
B. 0.80
C. 1.00
D. 1.25

23
QUESTION 10
𝐶𝑜𝑣 𝑅𝐿𝑎𝑢𝑡𝑟𝑒𝑐 ,𝑅𝑚 𝑆𝐷 𝑅𝐿𝑎𝑢𝑡𝑟𝑒𝑐 𝐶𝑜𝑟𝑟(𝑅𝐿𝑎𝑢𝑡𝑟𝑒𝑐 ,𝑅𝑚 )
• 𝛽𝐿𝑎𝑢𝑡𝑟𝑒𝑐 = =
𝑉𝑎𝑟 𝑅𝑚 𝑆𝐷(𝑅𝑚 )
0.05∙0.8 0.04
• 𝛽𝐻𝑜𝑟𝑖𝑠𝑜𝑛𝑡 = = = 1.00
0.04 0.04

• The correct answer is: C

• More information: Chapter 11 of Berk and DeMarzo

24
QUESTION 11
• Suppose that we have two stocks: Friede Fridges and Ariandel Appliances. The
correlation of their returns is equal to 0.6. Expected returns are 12% for Friede and 15%
for Ariandel. Volatilities are 14% for Friede and 24% for Ariandel. The risk-free rate is
3.5%. The expected return for the portfolio which consists of 50% Friede and 50%
Ariandel is:
A. 8.1%
B. 10.0%
C. 13.5%
D. 15.0%

25
QUESTION 11
• 𝔼 𝑟𝑝 = σ𝑛𝑖=1 𝑤𝑖 𝔼(𝑟𝑖 )

• 𝔼 𝑟𝑝 = 𝑤𝐹𝑟𝑖𝑒𝑑𝑒 𝔼 𝑟𝐹𝑟𝑖𝑒𝑑𝑒 + 𝑤𝐴𝑟𝑖𝑎𝑛𝑑𝑒𝑙 𝔼 𝑟𝐴𝑟𝑖𝑎𝑛𝑑𝑒𝑙

• 𝔼 𝑟𝑝 = 0.5 ∙ 0.12 + 0.5 ∙ 0.15 = 0.135

• The correct answer is: C
• More information: Chapter 11 of Berk and DeMarzo

26
QUESTION 12
• Suppose that we have two stocks: Friede Fridges and Ariandel Appliances. The
correlation of their returns is equal to 0.6. Expected returns are 12% for Friede and 15%
for Ariandel. Volatilities are 14% for Friede and 24% for Ariandel. The risk-free rate is
3.5%. The volatility for the portfolio which consists of 50% Friede and 50% Ariandel is:
A. 2.9%
B. 10.5%
C. 17.14%
D. 31.9%

27
QUESTION 12
• 𝑉𝑎𝑟 𝑟𝑝 = 𝜎 2 = 𝑤12 𝑉𝑎𝑟 𝑟1 + 𝑤22 𝑉𝑎𝑟 𝑟2 + 2𝑤1 𝑤2 𝐶𝑜𝑣 𝑟1 , 𝑟2

• 𝑉𝑎𝑟 𝑟𝑝 = 0.52 ∙ 0.142 +0.52 ∙ 0.242 + 2 ∙ 0.5 ∙ 0.5 ∙ 0.14 ∙ 0.24 ∙ 0.6

• 𝑉𝑎𝑟 𝑟𝑝 = 0.02938 𝐶𝑜𝑣 𝑟1 , 𝑟2 = 𝜎1 𝜎2 𝜌1,2

• 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 0.02938 = 0.1714 = 17.14%

• The correct answer is: C
• More information: Chapter 11 of Berk and DeMarzo

28
QUESTION 13
• Suppose that we have two stocks: Friede Fridges and Ariandel Appliances. The
correlation of their returns is equal to 0.6. Expected returns are 12% for Friede and 15%
for Ariandel. Volatilities are 14% for Friede and 24% for Ariandel. The risk-free rate is
3.5%. Remember that the expected portfolio return is 13.5% and that the volatility is
17.14%. The Sharpe ratio for the portfolio which consists of 50% Friede and 50%
Ariandel is:
A. 0.42
B. 0.58
C. 0.64
D. 0.79

29
QUESTION 13
• “The slope of the line (line that starts at 𝜎 = 0 and 𝔼 𝑟 = rf ) through a given portfolio P is often
referred to as the Sharpe ratio of the portfolio:
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 𝔼 𝑟𝑝 −𝑟𝑓
• 𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = =
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑆𝐷 𝑟𝑝

• The Sharpe ratio measures the ratio of reward-to-volatility provided by a portfolio” (Chapter 11
of Berk and DeMarzo)

𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 𝔼 𝑟𝑝 −𝑟𝑓 0.135−0.035

• 𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = = = = 0.5834
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑆𝐷 𝑟𝑝 0.1714

• The correct answer is: B

• More information: Chapter 11 of Berk and DeMarzo

30
QUESTION 14
• You have the following investment choices, all consisting of exactly the same assets with the same
allocation and all worth the same amount:
• P1 you invested in with your own money
• P2 you invested half of your money and half borrowed from a bank
• P3 you invested half of your money and half raised by short selling some other risky asset,
uncorrelated to the assets in your portfolio.
Which of the following statements is true?
A. P1 is the riskiest investment
B. P2 is the riskiest investment
C. P3 is the riskiest investment
D. We cannot tell which is the riskiest investment with only the information provided above

31
QUESTION 14
• “We refer to a positive investment in a security as a long position in the security. But is is
also possible to invest a negative amount in a stock, called a short position, by engaging
in a short sale, a transaction in which you sell a stock today that you do not own, with the
obligation to buy it back in the future.” (Chapter 11 of Berk and DeMarzo)
• A long position is profitable if a stock price increases, while short selling could be
profitable if you expect that a stock price will decline.
• The risk in a long position is a price decline (lower bound is a price of zero). The risk of a
short position is a price increase (no upper bound). The risk of loss on a short sale is
therefore theoretically unlimited since the price of any asset can climb to infinity.
• The correct answer is: C

32
QUESTION 15
• Consider an equally weighted portfolio of many stocks. If the average volatility of
these stocks is 40% and the average correlation between the stocks is 0.25, what
is the minimum volatility we can achieve by adding more and more stocks to this
portfolio?
A. 32%
B. 4%
C. 20%
D. 0%

33
QUESTION 15
1
• 𝑉𝑎𝑟 𝑟𝑃 = 𝑛 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑠𝑡𝑜𝑐𝑘𝑠 +

1
1− 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘𝑠
𝑛
1
• If n becomes sufficiently large, the first term can be neglected as 𝑛 approaches zero.
1
• The term 1 − is close to 1 if n is sufficiently large.
𝑛

• 𝑉𝑎𝑟 𝑟𝑃 = 0.25 ∙ 0.4 ∙ 0.4 = 0.04

• 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑟𝑃 = 𝑉𝑎𝑟(𝑟𝑃 ) = 0.04 = 0.2 = 20%

• The correct answer is: C
• More information: Chapter 11 of Berk and DeMarzo

34
QUESTION 16
• Consider three stocks: Anri, BigHat and Chester, and consider an equally weighted
portfolio of these stocks. Assume these stocks have the following correlations with the
market: 0.4, 0.4 and 0.2; and the following volatilities: 40%, 50% and 30%. The
volatility of the market portfolio is 10%, the expected return on the market is 12%, and
the risk-free rate of interest is 2%. The expected return on the equally weighted portfolio
of the three stocks is:
A. 12%
B. 16%
C. 17%
D. 18%

35
QUESTION 16
𝐶𝑜𝑣 𝑟𝑖 ,𝑟𝑚 𝑆𝐷 𝑟𝑖 ∙𝐶𝑜𝑟𝑟 𝑟𝑖 ,𝑟𝑚
• 𝛽𝑖 = =
𝑉𝑎𝑟 𝑟𝑚 𝑆𝐷 𝑟𝑚
0.4∙0.4 0.5∙0.4 0.3∙0.2
• 𝛽𝐴 = = 1.6, 𝛽𝐵 = = 2, 𝛽𝐶 = = 0.6
0.1 0.1 0.1

• CAPM: 𝔼 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝔼 𝑟𝑚 − 𝑟𝑓
• 𝔼 𝑟𝐴 = 0.02 + 1.6 0.12 − 0.02 = 0.18 = 18%
• 𝔼 𝑟𝐵 = 0.02 + 2 0.12 − 0.02 = 0.22 = 22%
• 𝔼 𝑟𝐶 = 0.02 + 0.6 0.12 − 0.02 = 0.08 = 8%

36
QUESTION 16
• 𝔼 𝑟𝑃 = σ𝑛𝑖=1 𝑤𝑖 𝑟𝑖
1 1 1
• 𝔼 𝑟𝑃 = ∙ 0.18 + ∙ 0.22 + ∙ 0.08 = 0.16 = 16%
3 3 3

• The correct answer is: B

• More information: Chapter 11 of Berk and DeMarzo

37
QUESTION 17
Suppose you want to estimate the costs of equity for battery manufacturer Impulse. You have collected the following historical data on
the return on the market portfolio (here: S&P 500) and the risk-free rate (here: 10-year Treasury rate):
2010-2021 1930-2021
𝑟𝑚 7.5% 12.1%
𝑟𝑓 1.8% 5.2%
After looking up the most recent 10-year Treasury yield, you conclude that the current risk-free rate is 3.2%.
Furthermore, you’ve estimated a regression between Impulse’s daily returns (𝑟𝐼𝑚𝑝𝑢𝑙𝑠𝑒,𝑡 ) and daily returns on the S&P 500 (𝑟𝑚,𝑡 )
between 2010-2021 and found the following:
𝑟𝐼𝑚𝑝𝑢𝑙𝑠𝑒,𝑡 = 0.003 + 1.15𝑟𝑚,𝑡 + 𝜀𝑡

What are Impulse’s costs of equity?

A. 8.1%
B. 9.8%
C. 11.1%
D. 13.4%

38
QUESTION 17

Solution

• The correct answer is: C

• Use the longest time horizon for estimating the market risk premium because that minimizes the standard error
of estimation:

𝑀𝑅𝑃 = 12.1% − 5.2% = 6.9%

• Then, use the most recent risk-free rate, and don’t include alpha in the estimation.

𝐶𝐴𝑃𝑀: 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝑀𝑅𝑃 = 3.2% + 1.15 ∗ 6.9% = 11.1%

39
QUESTION 18
• Please fill in your name and student number on Mentimeter in the following format:
• Student number, name
• Example: 1234567, Mark Dijkstra
• Please insert your information correctly, especially your student number! This makes
grading easier. Deal sweetener: Any student that inputs their student number
correctly for every week of the tutorial gets 5 bonus points on the tutorial!

40
QUIZZES
• Don’t forget to take the quiz on Thursday
• 7:00 – 21:00
• Correct answers are shown after 22:00
• Use a decimal point and a comma as thousands separator
• For example: 12,345.67

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