Strictly for course ECA5333 internal circulation only.

NUS Business School

ECA5333 Financial Markets and Portfolio Management
Tutorial 3 Solution

1) (RBC7P3) The following are the monthly rates of return for Madison Cookies and for
Sophie Electric during a six-month period.

Month Madison Cookies Sophie Electric

1 -0.04 0.07
2 0.06 -0.02
3 -0.07 -0.10
4 0.12 0.15
5 -0.02 -0.06
6 0.05 0.02

Compute the following.

a) Average monthly rate of return for each stock
b) Standard deviation of returns for each stock
c) Covariance between the rates of return
d) The correlation coefficient between the rates of return
What level of correlation did you expect? How did your expectations compare with the
computed correlation? Would these two stocks be good choices for diversification? Why
or why not?

Answer:
(a). E(RMadison) = .10/6 = .0167 E(RSophie) = .06/6 = .01
(b).
Madison Sophie [Ri-E(Ri)] x
Month Cookies(Ri) Electric(Rj) Ri-E(Ri) Rj-E(Rj) [Rj-E(Rj)]
1 -.04 .07 -.057 .06 -.0034
2 .06 -.02 .043 -.03 -.0013
3 -.07 -.10 -.087 -.11 .0096
4 .12 .15 .103 .14 .0144
5 -.02 -.06 -.037 -.07 .0026
6 .05 .02 .033 .01 .0003
Sum .10 .06 .0222

(c). COVij = 1/5 (.0222) = .0044

(d).

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One should have expected a positive correlation between the two stocks, since they
tend to move in the same direction(s). Risk can be reduced by combining assets
that have low positive or negative correlations, which is not the case for Madison
Cookies and Sophie Electric.

2) (RBC7P6) Given: E(R1) = 0.12, E(R2) = 0.16, E(1) = 0.04, E(2) = 0.06.
Calculate the expected returns and expected standard deviations of a two-stock portfolio
having a correlation coefficient of 0.70 under the following conditions.
a) w1 = 1.00
b) w1 = 0.75
c) w1 = 0.50
d) w1 = 0.25
e) w1 = 0.05

Plot the results on a return-risk graph. Without calculations, draw in what the curve would
look like first if the correlation coefficient had been 0.00 and then if it had been -0.70.

Answer: (a). E(Rp) = (1.00 x .12) + (.00 x .16) = .12

(b). E(Rp) = (.75 x .12) + (.25 x .16) = .13

(c). E(Rp) = (.50 x .12) + (.50 x .16) = .14

(d). E(Rp) = (.25 x .12) + (.75 x .16) = .15

(e). E(Rp) = (.05 x .12) + (.95 x .16) = .158

3) (RBC7A1) Given two assets with the following characteristics:

E(R1) = 0.12 1 = 0.04
E(R2) = 0.16 2 = 0.06
Assume that r1,2 = -1.00. What is the weight that would yield a zero variance for the
portfolio?

Answer: (a). When E(1) = E(2), the problem can be solved by substitution,

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(b).

4) . Given the following. A,B = 0.5, A = 1. The investor utility function is .

X Y
r 10% 18%
 20% 35%

Find the weight of X, i.e. wx of the optimal portfolio.

Answer: wx = 0.081. Optimal portfolio (r, ) = (0.330, 0.1735)

5) (RBC8P5) Based on five years of monthly data, you derive the following information for
the companies listed:

Company ai (Intercept) i riM

Intel 0.22 12.10% 0.72
Ford 0.10 14.60 0.33
Anheuser Busch 0.17 7.60 0.55
Merck 0.05 10.20 0.60
S&P 500 0.00 5.50 1.00

a) Compute the beta coefficient for each stock.

b) Assuming a risk-free rate of 8 percent and an expected return for the market portfolio
of 15 percent, compute the expected (required) return for all the stocks and plot them
on the SML.
c) Plot the following estimated returns for the next year on the SML and indicate which
stocks are undervalued or overvalued.
 Intel -- 20 percent

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 Ford -- 15 percent
 Anheuser Busch -- 19 percent
 Merck -- 10 percent

Answer: (a).

then COVi,m = (ri,m)(i)( m)

For Intel:

COV i,m = (.72)(.1210)(.0550) = .00479

For Ford:

COV i,m = (.33)(.1460)(.0550) = .00265

For Anheuser Busch:

COV i,m = (.55)(.0760)(.0550) = .00230

For Merck:

COV i,m = (.60)(.1020)(.0550) = .00337

(b). E(Ri) = RFR + Bi(RM - RFR)

= .08 + Bi(.15 - .08)
= .08 + .07Bi
Stock Beta E(Ri) = .08 + .07Bi
Intel 1.583 0.1908
Ford .876 0.1413
Anheuser Busch .760 0.1332
Merck 1.114 0.1580

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(c). .20 *Intel

*AB

RM = .15 *Ford

.10 *Merck
RFR=.08

1.0 Beta

Intel, Ford, and Anheuser all have estimated return (given in part c) exceeding their
expected returns (computed in part b); they are undervalued and are potential “buy”
candidates. Merck is overvalued as its estimated return (10%) is less than the return
required by the SML (15.8%); it is a potential candidate for selling.

6) (BKMC9CFAQ2) Wilson is now evaluating the expected performance of two common

stocks, Furhman Labs Inc. and Garten Testing Inc. He has gathered the following
information:
 The risk-free rate is 5%.
 The expected return on the market portfolio is 11.5%.
 The beta of Furhman stock is 1.5.
 The beta of Garten stock is 0.8.
Based on his own analysis, Wilson’s forecasts of the returns on the two stocks are 13.25%
for Furhman stock and 11.25% for Garten stock. Calculate the required rate of return for
Furhman Labs stock and for Gaten Testing stock. Indicate whether each stock is
undervalued, fairly valued, or overvalued.

Answer: E(r) = rf + β × [E(r M ) − rf ]

Furhman Labs: E(r) = .05 + 1.5 × [.115 − .05] = 14.75%
Garten Testing: E(r) = .05 + 0.8 × [.115 − .05] = 10.20%
If the forecast rate of return is less than (greater than) the required rate of return, then
the security is overvalued (undervalued).
Furhman Labs: Forecast return – Required return = 13.25% − 14.75% = −1.50%
Garten Testing: Forecast return – Required return = 11.25% − 10.20% = 1.05%
Therefore, Furhman Labs is overvalued and Garten Testing is undervalued.

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