MBA 676: Securities Analysis, Derivatives and Portfolio Management Max points 10

Assignment # 1: Due date September 08, 2014.

Instructions: There are two questions in this assignment. The assignment will be done in groups
(made for the stock project presentation). On your submission, mention who helped with which
question. Regardless, each person should know how to answer both questions should the
question appear on the exam. Each question is worth 5 points.
Q1. Each member of the group has picked a stock for the class portfolio. This question asks you to
construct the efficient frontier comprising the group members stocks.
Use calendar year 2013 data for each stock and the corresponding periods BSE 100 index to proxy
for the market.
a. Using EXCEL, compute the historical annual mean and annual standard deviation of return
for all stocks in the groups portfolio. Also report the variance-covariance and correlation
matrices. Equate the historical mean to the expected return going forward.
b. Construct the efficient frontier using annual data. Show the frontier on a scatter plot. Clearly
label the axes, title of the chart, legends etc.
c. If the risk free rate is 4.2%, what is the Sharpe ratio maximizing tangency portfolio?
d. What is the beta of each stock?

Q2. The capital asset pricing model (CAPM) is a pricing model based on investor preferences. We
will apply the theoretical set up discussed in class to a specific utility function (preference function).
Let the end of period wealth for an individual be random

The initial wealth is

The utility
function of the individual is given by negative exponential of the form (

. Exponent
is called the coefficient of absolute risk aversion. Define the coefficient of relative risk aversion as

a. Express the utility function as function of

and

, where

is gross return equal to

b. The individual invests the wealth in n+1 assets, the first n being risky and the last one being
the risk free asset earning

The vector of expected returns on n risky assets is given by

.
The weight vector on the n risky assets is denoted by . If the variance-covariance matrix for
n risky assets is given by V, express the individuals expected utility maximization problem as
a function of ,

, V

and

.
c. Set up the constrained optimization problem and solve for the optimal

. What is the value

of the Lagrange multipliers?
d. Can you prove that an individual with preferences as above and initial wealth

, invests a
fixed dollar amount in risky assets? (Note: This result is very strong. It implies that as every
additional dollar above

is earned, say, as income from other sources, it is invested in the

risk free asset).