Indian Institute of Management Kozhikode

CF Quiz 3, 17-11-2022, PGP 26 EF

Max Time 20 minutes, Max Marks 12

Instructions
1. This is an open-book, open notes quiz.

2. This is a pen and paper exam.

3. You can use Microsoft Excel in this quiz.

4. I will only award marks if I see the process you used to arrive at the solution.

5. If you send me an excel document after the exam to prove anything, I will ignore
it.

Name:

Roll No:
1. You have identified two stocks to invest your summer internship stipend. The two
stocks are A and B. The average returns of A is 18%, and that of B is 14%. Further,
the following table provides the variance-covariance matrix between the two stocks’
returns (the digaonal elements of the matrix are the variance terms, and the off
diagonal items are the covariance terms).

Table 1: Variance-Covariance Matrix

A B
A 0.25 0.075
B 0.075 0.1225

Suppose, you want your portfolio to provide you returns of 16%, how much do you
invest in A and how much in B? What is your portfolio’s overall standard deviation?
[4 marks]

Solution: Assume x is the weightage in stock A, then 0.18 × x + 0.14 × (1 − x)

= 0.16. Solving, x is 50%. Thus, you invest 50% in A and 50% in B. [2 marks for
estimating this]
2
Recall variance formula, Variance = wA × σA2 + wB2
× σB2 + 2 × wA × wB ×
covariance(A, B). Using this formula, variance is 0.130625, and standard de-
viation is 0.3614.

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2. The following table presents the performance of several portfolios in the market:

Name of the Asset Beta Actual Returns

A 1.4 7.50%
B 0 5%
C 0.95 7.10%
D 1 7%

Two fund managers working in your organization - Todd and Dott manage portfolios
that have a beta of 1.4 and 0.95 respectively. Both their bonuses are due. With the
given information, whom do you recommend a greater bonus? [4 Marks]

Solution: Key to solve this problem is identifying that B is the risk-free rate,
and D is the market given their Betas.
With this, expected return of Todd is: 0.05 + 1.4 × (0.07 − 0.05) = 0.078 or
7.8%. Similarly, expected return of Dott is: 0.05 + 0.95 × (0.07 − 0.05) = 0.069 or
6.9%. Comparing the actual performance of the two portfolio managers, Todd has
under performed his benchmark, while Dott has over performed his benchmark,
thus, Dott is rewarded more than Todd. Marking scheme, 1 mark for estimating
expected return of Todd, 1 mark for estimating expected return of Dott, and 2
marks for showing why Dott is paid a greater bonus.

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3. Following table provides variance-covariance matrix between the market, stock XYZ
and stock ABC. Suppose, treasury bill yields trade at 7%, and the market risk pre-
mium is 3.5%. At what discounting rate would you discount the cash flows to equity
for XYZ and ABC? [4 Marks]

Market XYZ ABC

Market 0.36 0.44 0.11
XYZ 0.44 0.45 0.04
ABC 0.11 0.04 0.55

COV AR(Rstock ,Rmarket )

Solution: Recall, Beta = σmarket
. Using the given table,
0.44 0.11
BetaXY Z = 0.36
= 1.222. BetaABC = 0.36
= 0.306.
Using these Betas, and the given data, Exp Return for XYZ is 0.07+1.222×0.035
= 11.278%, and Exp Return for ABC is 0.07 + 0.0306 × 0.035 = 8.069%.
Marking Scheme: 1 mark each for estimating both betas, total 2 marks. 1 mark
each for estimating expected returns, 2 marks.

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This space is for rough work

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