ANALYTICAL PROBLEM SET (APS) 1

LECTURES PROFESSOR ROBERT KOSOWSKI

TUTORIALS JOE TAN

PART 1: PURPOSE AND DESCRIPTION:

This APS is designed to cover the readings for lecture 1-2 of the IPM Course (see
course outline).

SECTION A

(BKM Ch. 9) Use the following table for questions 1 & 2 which show the risk and return
measures for two portfolios.
Portfolio Average Annual Rate of Return Stand. Deviation Beta
R 11% 10% 0.5
S&P 500 14% 12% 1.0

Q1. (1 Point)
When plotting R relative to the SML, portfolio R lies:
a. On the SML
b. Below the SML
c. Above the SML
d. Insufficient data given.
Q2. (1 Point)
When plotting portfolio R relative to the capital market line, portfolio R lies:
a. On the CML.
b. Below the CML.
c. Above the CML.
d. Insufficient data given.

Q3. (1 Point)
(BKM Ch. 9) Use the following information for questions 3-6:
Karen Kay, a portfolio manager at Collins Asset Management, is using the capital asset
pricing model for making recommendations to her clients. Her research department has
developed the information shown in the following exhibit.

Forecast Return Standard Deviation Beta

Stock X 14% 23% 0.6
Stock Y 16% 12% 1.3
Market Index 18% 13% 1.0
Risk-free rate 7.0%

i. What is the alpha for stock X?

a. 0.7%
b. 1.1%
c. 2.4%
d. 0.4%

Q4. (1 Point)
What is the alpha for stock Y?
a. -3%
b. -5.9%
c. -4.2%
d. -5.3?%
Q5. (1 Point)
Identify and justify which stock would be more appropriate for an investor who wants to
add his stock to a well diversified portfolio.
a. Stock X
b. Stock Y.

Q6. (1 Point)
Identify and justify which stock would be more appropriate for an investor who wants
to hold this stock as a single stock portfolio. (1 Points)
a. Stock X
b. Stock Y

BKM Chapter 10 related questions:

(Use the following for questions 7 and 8)
Based on current dividend yields and expected growth rates, the expected rates of
return on stocks A and B are 15% and 22%, respectively. The beta of stock A. is 0.5,
while that of stock B is 1.4. The T-bill rate is currently 4%, while the expected rate of
return on the S&P500 index is 17%. The standard deviation of stock A is 22% annually,
while that of stock B is 20%.
Q7. (1 Point)
i. If you currently hold a well-diversified portfolio, would you choose to:
a. hold a positive weight in both stocks.
b. a positive weight in stock A.
c. a positive weight in stock B.
d. neither hold A nor B.

Q8 (1 Point). If instead you could invest only in bills and one of these stocks, which
stock would you choose?
a. choose neither A nor B.
b. choose A.
c. choose B.
Q9. (1 Point)
The correlation between the Charlottesville International Fund and the EAFE Market
Index is 1.0. The expected return on the EAFE INDEX is 18%, the expected return on
Charlottesvilles International Fund is 12%, and the risk-free return in EAFE countries is
3%. Based on this analysis, the implied beta of Charlottesville International is:
a. 0.57
b. 0.73
c. 0.60
d. 1.00

Q10. (1 Point)
Assume the correlation coefficient between Baker Fund and the S&P 500 Stock Index is
0.5. What percentage of Baker Fund’s total risk is specific (i.e. non-systematic)?
a. 45%
b. 55%
c. 65%
d. 75%

Q11. (1 Point)
(Dividend Growth Model, BKM Chapter 22) A common stock pays an annual dividend
per share of $5.84. The risk-free rate is 10%
and the risk premium for this stock is 5%. If the annual dividend is expected to remain at
$5.84, the value of the stock is closest to:
a. $38.90
b. $42.50
c. $53.40
d. $71.20

Q12. (1 Point)
Which of the following assumptions does the constant-growth dividend discount model
require?
I. Dividends grow at a constant rate.
II. The dividend growth rate continues indefinitely.
III. The required rate of return is less than the dividend growth rate.
a. I only.
b. III only.
c. I and II only.
d. I, II, and III.

Q13. (1 Point)
i. Computer stocks currently provide an expected rate of return of 8%. MBI, a large
computer company, will pay a year-end dividend of $1.50 per share. If the stock is
selling at $20 per share, what must be the market’s expectation of the growth rate of
MBI dividends?
a. 1.0%
b. 1.2%
c. 0.5%
d. 2.1%

Q14. (1 Point)
If dividend growth forecasts for MBI are revised to 3% per year, what will happen to the
price of MBI stock?
a. $27.65
b. $30.00
c. $34.75
d. $25.00

BKM Chapter 10 related questions:

Q15. (1 Point)
Suppose that two factors have been identified for the U.S. economy: the growth rate of
industrial production, IP, and the inflation rate, IR. IP is expected to be 4% and IR 2%. A
stock with a beta of 0.6 on IP and 1 on IR currently is expected to provide a rate of
return of 8%. If industrial production actually grows by 8%, while the inflation rate turns
out to be 9%, what is your revised estimate of the expected rate of return on the stock?
a. 12.8%
b. 14.2%
c. 15.5%
d. 17.4%
(Use the following for questions 16-17)
Jeffrey Bruner, CFA, uses the capital asset pricing model (CAPM) to help identify
mispriced securities. A consultant suggests Bruner use arbitrage pricing theory (APT)
instead. In comparing CAPM and APT, the consultant made the following arguments.

Q16. (1 Point)
State whether the consultant’s arguments are correct or incorrect:
i. Both the CAPM and APT require a mean-variance efficient market portfolio
a. Correct
b. Incorrect

Q17. (1 Point)
Neither the CAPM nor APT assumes normally distributed security returns.
a. Correct
b. Incorrect

Q18. (1 Point)
Consider the following Table.
Which of the following statements do you agree with?
a. Small firms with high B/M ratios generate relatively high returns (compared to other
small firms) which compensate investors for the fact that the returns have a low
correlation with consumption.
b. Big firms with low B/M ratios generate relatively low returns (compared to other big
firms) which compensate investors for the fact that the returns have a high
correlation with consumption.
c. Small firms with low B/M ratios generate higher returns than medium-sized firms with
low B/M ratios.
d. The consumption risk associated with big firms that have low B/M ratios is higher than
the consumption risk associated with medium-sized firms that have low B/M
ratios.

(Use the following in questions 19-21)

Assume that stock market returns have the market index as a common factor, and that
all stocks in the economy have a beta of 1 on the market index. Firm-specific returns all
have a standard deviation of 30%.
Suppose that an analyst studies 20 stocks, and finds that one-half have an alpha of 2%,
and the other half an alpha of -2%. Suppose the analyst buys $1 million of an equally
weighted portfolio of the positive alpha stocks, and shorts $1 million of an equally
weighted portfolio of negative alpha stocks.

Q19. (1 Point)
i. What is the expected profit (in dollars)?
a. $20,000
b. $40,000
c. $60,000
d. $80,000

Q20. (1 Point) What is the standard deviation of the analyst’s profit?

a. $ 134,164
b. $ 234,164
c. $ 564,164
d. $ 783,164
Q21. (1 Point)
How does your answer for both the above questions change if the analyst examines 50
stocks instead of 20 stocks? Note: You will not be required to submit this answer,
it is here to aid intuition.

(Use the following for questions 22-23)

Consider the following multifactor (APT) model of security returns for a particular stock:
Factor Factor Beta Factor Risk Premium
Inflation 1.4 7%
Industrial production 0.7 9%
Oil prices 0.2 2%

Q22. (1 Point)
If T-bills currently offer a 4% yield, what is the expected rate of return on this stock if
the market views the stock as fairly priced?
a. 17.3%
b. 18.9%
c. 19.7%
d. 20.5%

Q23. (1 Point).
Suppose that the market expected the values for the three macro factors given in
column 1 below, but that the actual values turn out as given in column 2. What
are the revised expectations for the rate of return on the stock once the
‘surprises’ become know?
a. -1.6%
b. -0.5%
c. -1.3%
d. 0.4%
Factor Expected Rate of Change Actual Rate of Change
Inflation 6% 4%
Industrial production 3% 5%
Oil prices 2% 1%
SECTION B

Q24. (4 Points)

What assumptions does the CAPM make regarding investors in the model? In
which sense can their behaviour be described as myopic? (4 marks)

Use the Following in Questions 25-29:

You are working for City firm Society General. Your boss has told Jerry Kerwial (one the
firm’s rising portfolio managers) to take a holiday and get some rest after some
apparently successful months. Now it is your job to take over the management of Jerry’s
portfolio positions during his absence. Your boss also told you to carefully examine
Jerry’s positions first.

Q25. (1 Point)
(i) You notice that 3 securities (A, B, C) feature among the securities in Jerry’s
portfolio. Assume initially that security returns are generated by the following
single-index model:
Ri = αi + βiRM + ei.

where Ri is the excess return for security i and RM is the market’s excess return.
The risk-free rate is 2%.
You are provided with the following information about A, B and C.

Security βi E(Ri) σ(ei)

A 0.7 8% 24%
B 1 10% 11%
C 1.3 14% 18%

If σM = 10%; calculate the variance of returns for each security A, B and C.

Q26. (1 Point)
Going through Jerry’s notes you see that he had a long-short position in two stocks (D
and E). According to Jerry’s notes Jerry believed that both D and E had a market beta of
1 but that D had an alpha of -1% and E had an alpha of 4%. Jerry sold short £1000000
worth of stock D and bought £ 1000000 of stock E. What was Jerry’s expected profit (in
pounds) from this long-short position?
Q27. (1 Point)
Going further through Jerry’s notes you see that Jerry believed that security
D’s and security E’s firm specific risk were 10% each. What therefore is the
standard deviation of Jerry’s profit from the Long-short position in D and E
above?

Q28. (1 Point)
After a few hours of research you finally have a complete picture of Jerry’s
portfolio. Jerry reported a 12-month portfolio return of 25% to his boss (who was
very impressed and authorized Jerry’s bonus). Jerry’s portfolio consists of UK
stocks and you calculate the following information for the portfolio based a
regression analysis for those 12 months.
r(Jerry’s portfolio) - r(f) = α + β*R(Market) + e(i):
UK market index excess return 10%
r(Jerry’s portfolio): 25%
risk-free rate rf: 5%
Jerry’s portfolio beta β: 3
regression residual standard deviation σ(ei): 10%

Calculate Jerry’s portfolio’s alpha, information ratio. How do you interpret Jerry’s
performance in the light of the measures you have calculated?

Q29. (1 Point)
Following your analysis you think to yourself that you could do better than
Jerry and that in particular an application of the Treynor-Black security selection
model might help you. Outline the main steps in the Treynor-Black model and
describe what the weight of each analyzed security depends on.

Q30. (4 Points)

What predictions does the Fama-French three-factor asset pricing model

equation make for expected returns? How would you test the model implications
using a regression approach?
Use the following information for Questions 31-33:

Consider the Roll Critique discussed in the lectures. The Roll Critique states that if we
construct a market portfolio to be ex post mean variance efficient based on a set of
stocks, the individual stocks will as a result lie on the Securities Markets Line. These
questions illustrate this insight and you will prove it yourself.

Expected returns and correlations on stocks A, B, C and D were given. The riskless rate
was rf=3.5%. The weights of A, B, C and D in the Tangency/Market Portfolio were given
as w(MVE)= (0.2515, 0.3053, 0.2270, 0.2161).

Q31. (5 Points) (Challenge Question)

Derive the weights w(MVE) analytically for a general vector of risky asset returns, and a
general Variance-Covariance matrix of risky assets. Hint:

The risk tolerant investor might be interested in the maximum expected return to risk
portfolio, which can be called the MRR portfolio. The properties of this portfolio can be
worked out using the Lagrange method with the utility function u(μp, σp) = μp/ σp.
Graphically, the portfolio is on the efficient frontier at the tangent point of the line from
the origin. Here we express each risky asset return in excess return form, that is
μ(A)=E(r(A))-rf. As a result the capital market line starts at 0.

μp u

MRR=(σMRR, μMRR)

σp

Since a ratio is difficult to differentiate, we consider log (μp/σp). The objective function to
maximize in the Lagrangean problem implies maximizing log expected excess return
while minimizing log of risk and having the risky asset weights sum to 1.
Q32 (1 Point).
Using the expression you derived above, plug in the excess returns from the appendix in
Lecture 1 as well as the covariance matrix calculated from the correlation matrix and the
standard deviation and show that: w(MVE)= (0.2515, 0.3053, 0.2270, 0.2161).

Q33 (1 Point).
Repeat the calculations of betas for assets A, B, C and D and show that the assets lie
on the Security Market line.