8006 Exam Dumps : Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

The underlying asset in a Treasury note futures contract is any long term Treasury note with a maturity of no less than 6.5 years and no more than 10 years. The underlying asset in a treasury bond futures contract is any long term US Treasury bond with a maturity of more than 15 years and not callable within 15 years.

Note the difference betwen what the underlying asset is for treasury bond futures and treasury note futures. In either case, adjustments will be made for the coupon and maturity of the actual bond delivered (the concept of the adjustment of 'cheapest-to-deliver').

When assets are uncorrelated, variances are additive. But volatility (which is standard deviation) is not. In the given situation, the total variance of the portfolio will be equal to the the square root of the sum of the variances of the assets in the portfolio weighted by the square of their weights. Its volatility will be the square root of this variance. Thus Choice 'c' is the correct answer.

(This is because V(cA + dB) = c^2 V(A) + d^2 V(B) - refer tutorial on combining variances.)

Choice 'a' is incorrect as it describes the calculation of variance, not volatility. Also, the presence of a large number of uncorrelated assets does not create a portfolio with volatility equal to zero or that of the market. The other choices are therefore incorrect.

This question requires us to use the CAPM.

Recall that according to CAPM the expected return on an asset = The risk free rate + β x Market risk premium.

Using the beta and expected return of security A, we can determine the market risk premium to be (8% - 3%)/1.2 = 4.1667%. The excess return is the return over the risk free rate, and for security B, this is nothing but the beta multiplied by the market risk premium. Therefore the correct answer is 4.1667% x 1.5 = 6.25%. Note that this is the 'excess return', and not the total return. (Total return will include the risk free rate).