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Faculty of Business and Economics

FINA2802_FINA2320_D – Investments and Portfolio Analysis

1st SEMESTER, 2017-2018

The input list of Markowitz Model for a n risky securities portfolio:

n estimates of expected returns

n estimates of variances

𝑛2 − 𝑛

estimates of covariances

2

𝒏𝟐 − 𝒏

𝟐𝒏 + 𝒕𝒐𝒕𝒂𝒍 𝒆𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒔

𝟐

ri = E(ri ) + Ui

Ui has a mean of zero and a SD of σi

ri = E(ri ) + βi m + ei

m is the uncertainty about the economy: it has a E(rm ) = 0 and σm

βi measures the sensitivity of stock i to the macroeconomic factor

ei is the uncertainty about the particular firm: it has a E(rei ) = 0 and σei

m and ei are uncorrelated

σi = β2i σ2m + σ2ei

2

ei and ej are uncorrelated across securities

Cov(ri , rj ) = βi βj σ2m

The regression equation of the Single-Index Model

𝐑 𝐢 = 𝛂𝐢 + 𝛃𝐢 𝐑 𝐌 + 𝐞𝐢

R M = rm − rf is the market index excess return: it has a E(R M ) and σM

R i = ri − rf is the security excess return: it has a E(R i ) and σi

βi measures the sensitivity of stock i to the macroeconomic factor

ei is the uncertainty about the particular firm: it has a E(rei ) = 0 and σei

M and ei are uncorrelated

M is correlated across securities.

ei and ej are uncorrelated across securities

𝐄(𝐑 𝐢 ) = 𝛂𝐢 + 𝛃𝐢 𝐄(𝐑 𝐌 )

Tutorial 6

Tutorial 6

𝐂𝐨𝐯(𝐫𝐢 , 𝐫𝐣 ) = 𝛃𝐢 𝛃𝐣 𝛔𝟐𝐌

𝛃𝐢 𝛃𝐣 𝛔𝟐𝐌

𝛒𝐢,𝐣 =

𝛔𝐢 𝛔𝐣

The set of estimates needed for the Single-Index Model for n risky securities

n estimates of αi

n estimates of βi

n estimates of σ2ei

1 estimates of E(R M )

1 estimates of σ2M

𝟑𝒏 + 𝟐 𝒕𝒐𝒕𝒂𝒍 𝒆𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒔

𝐑 𝐏 = 𝛂𝐏 + 𝛃𝐏 𝐑 𝐌 + 𝐞𝐏

𝐧

𝛂𝐏 = ∑ 𝐰𝐢 𝛂𝐢

𝐢=𝟏

𝐧

𝛃𝐏 = ∑ 𝐰𝐢 𝛃𝐢

𝐢=𝟏

𝐧

𝐞𝐏 = ∑ 𝐰𝐢 𝐞𝐢

𝐢=𝟏

Tutorial 6

Tutorial 6

𝛃𝟐𝐢 𝛔𝟐𝐌 𝐄𝐱𝐩𝐥𝐚𝐢𝐧𝐞𝐝 𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞 SS Regression

𝐑𝟐 = 𝟐 𝟐 = (From ANOVA table = )

𝛃𝐢 𝛔𝐌 + 𝛔𝟐𝐞𝐢 𝐓𝐨𝐭𝐚𝐥 𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞 SS Total

We are using the Market excess return to explain the security’s excess return, so only

systematic risk component can be explained by the factor – Market excess return.

Tutorial 6

Tutorial 6

PROBLEM SET 1

A portfolio management organization analyzes 60 stocks and constructs a mean-variance

efficient portfolio using only these 60 securities.

a. How many estimates of expected returns, variances, and covariances are needed to

optimize this portfolio?

n = 60 estimates of means

n = 60 estimates of variances

𝐧𝟐 − 𝐧

= 𝟏𝟕𝟕𝟎 𝐞𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐬

𝟐

Therefore, in total

𝐧𝟐 + 𝟑𝐧

= 𝟏𝟖𝟗𝟎 𝐞𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐬

𝟐

:

b. If one could safely assume that stock market returns closely resemble a single-index

structure, how many estimates would be needed?

n = 60 estimates of the sensitivity coefficient β i

n = 60 estimates of the firm-specific variance σ2(ei )

1 estimate of the market mean E(rM )

1 estimate of the market variance 𝛔𝟐𝐌

Therefore, in total, 182 estimates.

Tutorial 6

Tutorial 6

PROBLEM SET 2

The following are estimates for two stocks.

Stock Expected Return Beta Firm-Specific Standard Deviation

A 13% 0.8 30%

B 18 1.2 40

The market index has a standard deviations of 22% and the risk-free rate is 8%.

a. What are the standard deviations of stocks A and B?

σ2i = β2i σ2M + σ2ei

σA = √0.82 × 0.222 + 0.302 = 34.78%

σB = √1.22 × 0.222 + 0.402 = 47.93%

Stock A: 0.30

Stock B: 0.45

T-bills: 0.25

Compute the expected return, beta, nonsystematic standard deviation, and standard

deviation of the portfolio.

E(rP ) = (0.30 × 13%) + (0.45 × 18%) + (0.25 × 8%)

= 14%

βP = wA × βA + wB × βB + wf × β f

βP = (0.30 × 0.8) + (0.45 × 1.2) + (0.25 × 0.0)

= 0.78

= (0.302 × 0.302 ) + (0.452 × 0.402 ) + (0.252 × 0)

= 0.0405

σep = √0.0405 = 𝟎. 𝟐𝟎𝟏𝟐

= 0.782 0.222 + 0.20122

= 0.069928

σp = √0.069928 = 𝟎. 𝟐𝟔𝟒𝟒

Tutorial 6

Tutorial 6

PROBLEM SET 3

Consider the following two regression lines for stocks A and B in the following figure.

The two figures depict the stocks’ security characteristic lines (SCL). Stock A has higher

firm-specific risk because the deviations of the observations from the SCL are larger for

Stock A than for Stock B. Deviations are measured by the vertical distance of each

observation from the SCL.

Beta is the slope of the SCL, which is the measure of systematic risk. The SCL for Stock

B is steeper; hence Stock B’s systematic risk is greater.

The R2 (or squared correlation coefficient) of the SCL is the ratio of the explained

variance of the stock’s return to total variance, and the total variance is the sum of the

explained variance plus the unexplained variance (the stock’s residual variance):

2

β2i σ2M Explained Variance

R = 2 2 =

βi σM + σ2ei Total Variance

Since the explained variance for Stock B is greater than for Stock A (the explained variance

isβ2p σ2M , which is greater since its beta is higher), and its residual variance σ2eB is smaller, its

R2 is higher than Stock A’s.

Alpha is the intercept of the SCL with the expected return axis. Stock A has a small

positive alpha whereas Stock B has a negative alpha; hence, Stock A’s alpha is larger.

The correlation coefficient is simply the square root of R2, so Stock B’s correlation with

the market is higher.

Tutorial 6

Tutorial 6

PROBLEM SET 4

Consider the two (excess return) index model regression results for A and B:

Firm-specific risk is measured by the residual standard deviation. Thus, stock A has

more firm-specific risk: 10.3% > 9.1%

Market risk is measured by beta, the slope coefficient of the regression. A has a larger

beta coefficient: 1.2 > 0.8

c. For which stock does market movement explain a greater fraction of return variability?

R2 measures the fraction of total variance of return explained by the market return.

A’s R2 is larger than B’s: 0.576 > 0.436

Tutorial 6

Tutorial 6

PROBLEM SET 5

Use the following data for sections a through f. Suppose that the index model for

stocks A and B is estimated from excess returns with the following results:

β2i σ2M

R2 = 2 2

βi σM + σ2ei

β2A σ2M

σ2A =

R2

2

0.72 × 0.22

σA =

0.20

σA = √0.0980 = 𝟎. 𝟑𝟏𝟑𝟏

β2B σ2M

σ2B =

R2

2

1.22 × 0.22

σB =

0.12

σB = √0.48 = 𝟎. 𝟔𝟗𝟐𝟖

b. Break down the variance of each stock to the systematic and firm-specific components.

β2A σ2M = 0.72 × 0.22 = 𝟎. 𝟎𝟏𝟗𝟔

σ2A = β2A σ2M + σ2eA

0.0980 = 0.0196 + σ2eA

σ2eA = 𝟎. 𝟎𝟕𝟖𝟒

σ2B = β2B σ2M + σ2eB

0.48 = 0.0576 + σ2eB

σ2eB = 𝟎. 𝟒𝟐𝟐𝟒

Tutorial 6

Tutorial 6

c. What are the covariance and correlation coefficient between the two stocks?

Cov(rA , rB ) = βA βB σ2M

= 0.70 × 1.2 × 0.202

= 𝟎. 𝟎𝟑𝟑𝟔

βA βB σ2M

ρA,B =

σA σB

0.0336

=

0.3131 × 0.6928

= 𝟎. 𝟏𝟓𝟓

d. What is the covariance between each stock and the market index?

Cov(rA , rM ) = βA βM σ2M

= 0.70 × 1 × 0.202

= 𝟎. 𝟎𝟐𝟖

Cov(rB , rM ) = βB βM σ2M

= 1.2 × 1 × 0.202

= 𝟎. 𝟎𝟒𝟖

e. For portfolio P with investment proportions of 60% in A and 40% in B, what is the variance

related to the systematic and unsystematic components, the standard deviation of P and the

covariance of the portfolio P and the market index?

σ2p = β2p σ2M + σ2ep

βP = wA × βA + wB × βB

βP = (0.6 × 0.7) + (0.4 × 1.2)

= 0.90

= (0.62 × 0.0784) + (0.42 × 0.4224)

= 0.09581

σ2p = 0.1282

σp = √0.1282 = 𝟎. 𝟑𝟓𝟖𝟏

Cov(rP , rM ) = βP βM σ2M

= 0.90 × 1 × 0.202 = 𝟎. 𝟎𝟑𝟔

Tutorial 6

Tutorial 6

Cov(rP,rM )

= Cov(0.6rA + 0.4rB, rM )

= 0.6 × Cov(rA, rM ) + 0.4 × Cov(rB,rM )

= (0.6 × 0.028) + (0.4 × 0.048) = 0.036

f. Rework section e for portfolio Q with investment proportions of 50% in P, 30% in the

market index, and 20% in T-bills.

βQ = wP × βP + wM × βM + wf × βf

βQ = (0.5 × 0.9) + (0.3 × 1) + 0

= 0.75

2

× σ2eM + wF2 × σ2eF

= (0.5 × 0.09581) + (0.32 × 0) + 0

2

= 0.02395

σ2p = 0.04645

σp = √0.4645 = 𝟎. 𝟐𝟏𝟓𝟓

Cov(rQ , rM ) = βQ βM σ2M

= 0.75 × 1 × 0.202 = 𝟎. 𝟎𝟑𝟎

Tutorial 6

Tutorial 6

PROBLEM SET 6

Based on current dividend yields and expected growth rates, the expected rates of return on

stocks A and B are 11% and 14%, respectively. The beta of stock A is .8, while that of stock

B is 1.5. The T-bill rate is currently 6%, while the expected rate of return on the S&P 500

index is 12%. The standard deviation of stock A is 10% annually, while that of stock B is

11%. If you currently hold a passive index portfolio, would you choose to add either of

these stocks to your holdings?

αA = rA − [rf + βA × (rm − rf )]

αA = 11% − [6% + 0.8(12% − 6%)]

αA = 0.2%

αB = rB − [rf + βB × (rm − rf )]

αA = 14% − [6% + 1.5(12% − 6%)]

αA = −1%

Stock B may be desirable.

Tutorial 6

Tutorial 6

PROBLEM SET 7

When the annualized monthly percentage rates of return for a stock market index were

regressed against the returns for ABC and XYZ stocks over a 5-year period ending in 2008,

using an ordinary least squares regression, the following results were obtained:

Explain what these regression results tell the analyst about risk–return relationships for each

stock over the sample period. Comment on their implications for future risk–return

relationships, assuming both stocks were included in a diversified common stock portfolio,

especially in view of the following additional data obtained from two brokerage houses,

which are based on 2 years of weekly data ending in December 2008.

The regression results provide quantitative measures of return and risk based on

monthly returns over the five-year period.

β for ABC was 0.60, considerably less than the average stock’s β of 1.0. This indicates

that, when the S&P 500 rose or fell by 1 percentage point, ABC’s return on average

rose or fell by only 0.60 percentage point. Therefore, ABC’s systematic risk (or market

risk) was low relative to the typical value for stocks. ABC’s alpha (the intercept of the

regression) was –3.2%, indicating that when the market return was 0%, the average

return on ABC was –3.2%. ABC’s unsystematic risk (or residual risk), as measured by

σ(e), was 13.02%. For ABC, R2 was 0.35, indicating closeness of fit to the linear

regression greater than the value for a typical stock.

β for XYZ was somewhat higher, at 0.97, indicating XYZ’s return pattern was very

similar to the β for the market index. Therefore, XYZ stock had average systematic

risk for the period examined. Alpha for XYZ was positive and quite large, indicating a

return of 7.3%, on average, for XYZ independent of market return. Residual risk was

21.45%, half again as much as ABC’s, indicating a wider scatter of observations

around the regression line for XYZ. Correspondingly, the fit of the regression model

was considerably less than that of ABC, consistent with an R2 of only 0.17.

The effects of including one or the other of these stocks in a diversified portfolio may

be quite different. If it can be assumed that both stocks’ betas will remain stable over

time, then there is a large difference in systematic risk level. The betas obtained from

the two brokerage houses may help the analyst draw inferences for the future. The

three estimates of ABC’s β are similar, regardless of the sample period of the

underlying data. The range of these estimates is 0.60 to 0.71, well below the market

average β of 1.0. The three estimates of XYZ’s β vary significantly among the three

sources, ranging as high as 1.45 for the weekly data over the most recent two years.

Tutorial 6

Tutorial 6

One could infer that XYZ’s β for the future might be well above 1.0, meaning it might

have somewhat greater systematic risk than was implied by the monthly regression for

the five-year period.

These stocks appear to have significantly different systematic risk characteristics. If these

stocks are added to a diversified portfolio, XYZ will add more to total volatility.

Tutorial 6

Tutorial 6

PROBLEM SET 8

Assume the correlation coefficient between Baker Fund and the S&P 500 Stock Index is .70.

What percentage of Baker Fund’s total risk is specific (i.e., nonsystematic)?

The R2 of the regression is: 0.702 = 0.49

Therefore, 51% of total variance is unexplained by the market; this is

nonsystematic risk.

Tutorial 6

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