Financial Service Operations Management

Professor Lijian Lu
ISOM 4840,Spring 2024

Homework Assignment #1

Due: 23:59pm Mar 3, 2024

o Homework assignments can be done in groups of three or less. Only turn in one write-
up per group.

o In your write-up, include on the first page a summary of answers to all of the questions.
Give your answers to at least five digits after the decimal place (this makes it easier to
spot which answers are correct or where mistakes occur).

o In your solutions to the individual questions, explain the main steps or formulas used
to arrive at your solution. For example, show and explain the main formulas used in
any spreadsheets printouts that you hand in. The formulas in the annotated spreadsheet
printouts can be handwritten. It is also necessary to include row and column headings
in spreadsheet printouts. This can be done in Excel by choosing File—Print Preview
and then click on Setup, choose the Sheet tab and check the “row and column headings”
box.

o Spreadsheets should be created in a well-structured manner so that it is easy for others

to under- stand. Spend extra time after getting the answers correct to create nice-looking
and understandable spreadsheets.

o It is not sufficient to turn in a printout of a spreadsheet with only numbers showing.

Points will be deducted for write-ups turned in without the main formulas shown and
explained, even if the numerical solutions are correct. How much detail is needed in the
explanations? Enough detail should be provided so that someone else in the course
(student, instructor, or TA) could quickly, easily, and exactly reproduce your work and
final solutions using your write-up alone.
 Financial Service Operations Management
ISOM 4840, Spring 2024

1) (Is gold a good hedge for inflation?) An individual investor wants to create a hedge
against inflation for the next year. A financial advisor recommended invests a portion
of assets in gold. In the file hw1_spring24.xls in the sheet Q1 contains annual price
inflation results (annual relative changes in CPI-U) and the prices of gold ($/ounce).

a) What is the correlation between annual inflation and annual gold returns?
b) Do you think gold is a good inflation hedge? Why or why not? Give a brief answer,
but try to be quantitative in your answer.

2) (Hedging a stock portfolio) Sheet Q2 of hw1_spring24.xls contains monthly price

data on the S&P500 and five stocks (XOM, GOOG, TSLA, GS, and PG) from Jan 1,
2011 until January 1, 2022. The closing prices are adjusted for stock splits and
dividends during this period.

Suppose that “today” is Dec 1, 2021 and an investor’s portfolio consists of

Table 1 Portfolio (million shares)

XOM GOOG TSLA GS PG

2.5 3.7 0.6 1.0 2.2

The investor is worried about potential bad economic news and wants to hedge away
the overall market risk until the end of trading on Jan 1, 2022 (one month later).

You have been asked to advise the investor about hedging the stock portfolio using the
S&P500 index. In reality this can be done using S&P futures contracts which are traded
on the CME or by trading in an index tracking stock (e.g., SPDR). For simplicity,
assume that any fractional number of ‘shares’ of the S&P500 can be bought or sold at
the S&P500 index level at the close of today (Dec 1, 2021). Also, since the hedging
period is so short, ignore any interest expense or income in the questions below.

Note: Your answers will vary slightly depending on whether you use population
statistics or sample statistics. It will not make much difference, but you should state
which you are using.

a) What is the standard deviation of the monthly return the investor’s (unhedged)
portfolio?
b) What is the optimal hedge ratio the investor should use? How many ‘shares’ of
the S&P500 should the investor buy or sell at the close of Dec 1, 2021 in order
to minimize the variance of the hedged portfolio return? (Assume that fractional
shares can be purchased or sold.)
c) Using the hedge ratio recommended in part (b) and the same historical data,
what is the standard deviation of the monthly return the investor’s hedged
portfolio?
 Financial Service Operations Management
ISOM 4840, Spring 2024
d) What would the investor’s portfolio value have been at the close of January 1,
2022 if the portfolio had not been hedged? If it had been hedged according to
your recommendation in part (b)? Was the hedge a good idea?
e) (Alpha of buy and hold strategy) Assume that the investor has hold and keep
the same portfolio since the first day (Jan 1, 2011), and the annual risk-free rate
is 5%, during the whole holding period from Jan 1, 2011 to the close of “today”,
according to the CAPM, what is the beta of the portfolio, and what is the alpha
of the portfolio?
f) (Rolling Alpha) Continue with question e), can you generate and plot the
rolling alpha over time starting from Jan 1, 2013, where the alpha on date t is
calculated based on the monthly data in the latest 2 years (or 24 months, i.e.,
using data from month t-23 to t). Example,
• the alpha on Jan 1, 2013 is based on the data of latest 24 months from
Feb 1, 2011 to Jan 1, 2013,
• the alpha on Feb 1, 2013 is based on monthly data from Mar 1, 2011 to
Feb 1, 2013,…