The Capital Asset Pricing Model [CAPM]

Answer the following independent questions:
a) Explain why international stock might have high volatility but low betas. (5 marks)
b) Do you agree with the following statement? And explain why. (5 marks)
“The Capital Asset Pricing Model [CAPM] assumes that the stock market is dominated by
welldiversified investors who are concerned with specific risk. “
c) Illustrate how to synthesize a forward hedging strategy by using only the money markets, in order
to hedge against the foreign exchange risk. (5 marks)
d) Use a numerical example to illustrate that when there is a large change in the interest rate, the
approximation error by using the duration and convexity rule is smaller than the approximation
error by using the duration rule only. (5 marks)
e) Why do we say a coupon bond can be seen as a package of zero-coupon bonds? Please use a
numerical example for illustration. (5 marks)
f) If the spot exchange between Euro and pound is Euro 1.1/Pound, and the UK Guilt returns a 0.5%
yield. It is also known that the Euro is expected to depreciate against the pound by 0.5%. What is
the yield of a French government bond? (10 marks)

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