COMM 324

INVESTMENTS AND PORTFOLIO MANAGEMENT

ASSIGNMENT 2
Due: October 20
1. In 1998 the rate of return on short term government securities (perceived to be risk-free) was
about 4.5%. Suppose the expected rate of return required by the market for a portfolio with a
beta of 1 is 11%. According to the CAPM:
a. What is the expected rate of return on the market portfolio?
11%

b. What would be the expected rate of return on a stock with beta = 0?

4.5 %

c. Suppose you consider buying a share of a stock at $40. The stock is expected to
pay a $3 dividend next year and you expected to sell the stock at $41. The stocks
beta has been estimated at beta=-0.5. Is the stock over valued or under valued?
E ( r ) = rf + ( E ( rM rf ) = 4.5% + ( .5)(11% 4.5%) = 1.25%
P=

$3 + $41
1 + 1.25%

= $43.46

So the stock is undervalued.

2. Two investment advisors are comparing performance. One averaged a 18 percent rate
of return and the other a 15 percent rate of return. However, the beta of the first
investor was 1.5, whereas that of the second was 1.
a. Can you tell which investor was a better predictor of individual stocks (aside
from the general movement in the market)?
To tell which investor was a better selector of individual stocks we look at their abnormal return, which is the
ex-post alpha, that is, the abnormal return is the difference between the actual return and that predicted by the
SML. Without information about the parameters of this equation (risk-free rate and market rate of return) we
cannot tell which investor was more accurate.

b. If the T-bill rate were 5 percent and the market return during the period were
13 percent, which investor would be the superior stock selector?
If r = 5 % and r = 13 %, then (using the notation of alpha for the abnormal return)
f
M
= 18 [5 + 1.5(13 5)] = 18 12 =16%
1
= 15 [5 + 1(13 5)] =15 13 = 2%
2
Here, the second investor has the larger abnormal return and thus he appears to be the superior stock selector.
By making better predictions the second investor appears to have tilted his portfolio toward under-priced stocks

c. What if the T-bill rate were 3 percent, and the market return were 14 percent?
If r = 3 % and r = 14 %, then
f
M
= 18 [3 + 1.5(14 3)] = 18 19.5 =-1.5 %
1
= 15 [3 + 1(14 3)] =15 14 = 1%
2
Here, not only does the second investor appear to be the superior stock selector, but the first investor's
predictions appear valueless (or worse).

3. (Spreadsheet question) From the course webpage you can download the daily
historical data for SP 500 Composite Index and the Microsoft stock (from 1997 to
2003). Assume the one-day T-bill return is 0.02%.
a. Calculate the arithmetic average rates return and standard deviations
AMR: MSFT stock = 0.090%;
STD: MSFT stock = 1.303%;

SP500 = 0.0319%
SP500 = 2.589%

b. Calculate the beta of the Microsoft stock

1.309

c. Calculate the security characteristic line for the Microsoft stock, and report the
regression results. Plot the SCL for the Microsoft stock, and also the historical
returns on the same graph.
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
Coefficients
0.000545
1.309851

Intercept
X Variable 1

0.659257
0.43462
0.434298
0.019468
1761
Standard Error
0.000464
0.035621
Y

Line Fit Plot

Predicted Y
25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
-8.00%

-6.00%

-4.00%

- 2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

- 5.00%

-10.00%

-15.00%

- 20.00%
SPX

d. What are the systematic risk and unsystematic risk in the Microsoft stock?
How do you interpret this numbers?
Systematic risk: beta^2*(variance of x) = 0.000222
Unsystematic Risk = (variance of y) (systematic risk = 0.000448
The unsystematic risk can be diversified away by forming a well-diversified portfolio

4. The SCL for stocks A and B are given below:

RA = 3% + .7 RM + eA
RB = 2% + 1.2 RM + eB

M = 20%; RA2 = .20; RB2 = .12

a. What is the standard deviation of each stock?

R =
2

=
2

2
A

.7 .20
2

= 0.098

.20

A = .3130
B M
2

B =
2

1.2 .20
2

RB

= 0.48

.12

B = 0.6928

b. Break down the variance of each stock to the system and firm-specific
components
A = A M + e
2

2
A

e = 0.098 0.0196 = 0.0784

2

e = 0.4224
2

c. What are the covariance and correlation coefficients between the two stocks?
It is reasonable to assume the firm-specific risks are uncorrelated. We can get
cov( rA , rB ) = A B M = 0.7 1.2 0.20 = 0.0336
2

( A, R ) =

cov( rA , rB )

A B

= 0.155

d. What is the covariance between each stock and the market portfolio?
cov( rA , rM ) = A M = 0.028
2

cov( rB , rM ) = B M = 0.048
2

e. Are the intercepts of the two regressions consistent with the CAPM? Interpret
their values.
No, the CAPM implies that the intercept should be zero. The value of alpha shows that A is under-priced,
while B is over-priced.

f.

For a portfolio P with investment proportion of .6 in A and .4 in B, rework the

problems a, b and d.
rP = .6 rA + .4 rB

P =

.6 A + .4 B + 2 .6 .4 cov( rA , rB )
2

= .3580
cov( rP , rM ) = .6 cov( rA , rM ) + .4 cov( rB , rM ) = 0.036

g. Rework problem f for portfolio Q with investment proportions of .5 in P, .3 in the

market portfolio ad .2 in T-bills
rQ = .5rP + .3rM + .2 rf

Q =

.5 P + .3 M + 2 .5 .3 cov( rP , rM )
2

= .2150
cov( rQ , rM ) = .5 cov( rP , rM ) + .3 cov( rM , rM ) = 0.03

5. he following is a scenario for three stocks constructed by the security analysts

Scenario Rate of Return (%)

Stock
Price
Recession
Average
Boom
A
10
-15
20
30
B
15
25
10
-10
C
50
12
15
12
a. Construct an arbitrage portfolio using these stocks
One of the arbitrage portfolio would be setup an equally weighted portfolio P using A and B first. This gives the
following returns
Scenario Rate of Return (%)
Recession
Average
Boom
P
5
15
10
We can see that the return of P never exceeds that of the stock C. So to construct an arbitrage portfolio, one can
simply short portfolio P and buy stock C, say by sell $100 worth of P and buy $100 worth C
CF
$ Payoff
Recession
Average
Boom
P
$100
-$5
-$15
-$10
S
-$100
$12
$15
$12
Total
0
$7
$0
$2
We get a non-negative return in every state, and positive in some sates which is an arbitrage portfolio by
definition.

b. How might these prices change when equilibrium is restored? Give an

example where a change in stock Cs price is sufficient to restore equilibrium,
assuming that the dollar payoffs to stock C remains the same.
Should prices of A and B go down due to excess short selling and price of C go up because of buying pressures,
then the rate of return on (A + B) will go up and the rate of return on C will fall.

NOTE: There are many different ways to construct the arbitrage portfolio

6. Assume that a two-factor APT model is descriptive of reality. Determine the equation
that describes the equilibrium returns for the following three portfolios
Portfolio
Exp Ret
bi1
bi 2
Q
11%
1
0.6
R
13%
2
.1
Z
11%
2
-0.6
Use the information you have obtained, and assume the following portfolio called Q
exits:
E (rS ) = 15%, bS 1 = 2, bS 2 = 0.25
Determine if arbitrage opportunities exist in this case, and if it exits, show how you
can profit from them.
First, find the market price of risks by solving the following linear equations

0 + 1 + 0.62 = 11%
0 + 21 + 0.12 = 13%
0 + 21 0.62 = 11%

You can either do it by hand, or through excel, to get

0 = 0.059, 1 = 0.034, 2 = 0.029

Under the APT theory, all securities should satisfy the following: if their return can be expressed as

ri = E (ri ) + bi1F1 + bi 2 F2 + ei
then the expected return will be

E (r )i = 0 + bi11 + bi 22

Otherwise, arbitrage opportunities would exist. For portfolio S, we have

15% 0 + 21 .252 = 12%

which implies that S is under-valued. To setup an arbitrage portfolio, we construct a portfolio P using Q, R and Z with

w1 , w2 , w3 such that the risks of P matches that of S by solving

w1 + w2 + w3 = 1

weights

w1 + 2 w2 + 2 w3 = 2
0.6w1 + 0.1w2 0.6 w3 = 0.25
This gives w1 = 0, w2 = 0.5, w3 = 0.5 . The expected return of this portfolio is 12% (not surprisingly). The
arbitrage portfolio would be short S and buy P in this way, the risks is zero but the return would be 15%-12%=3%.
Note: There were some typos in the table for earlier versions of the assignment. Students wont be penalized for different
numbers, as long as the they handle the question in the right way.

7. This question has two parts

a. Briefly explain the concept of efficient market hypothesis (EMH) and each of
the three forms. And briefly discuss the degree to which the existing empirical
evidence supports each of the three forms of EMH.
The efficient market hypothesis (EMH) states that a market is efficient if security prices immediately and fully reflect
all available relevant information. If the market fully reflects information, the knowledge of that information would not
allow anyone to profit from it because stock prices already incorporate the information.
i. The weak form asserts that stock prices already reflect all the information that can be derived by examining market
trading data such as the history of past prices and trading volume.
A strong body of evidence supports weak-form efficiency in the major U.S. securities markets. For example, test
results suggest that technical trading rules do not produce superior returns after adjusting for transactions costs and
taxes.
ii. The semistrong form says that a firms stock price already reflects all publicly available information about a firms
prospects. Examples of publicly available information are annual reports of companies and investment advisory data.
Evidence strongly supports the notion of semi-strong efficiency, but occasional studies (e.g., those identifying market
anomalies such as the small-firm-in-January or book-to-market effects) and events such as the stock market crash of
October 19, 1987) are inconsistent with this form of market efficiency. However, there is a question concerning the extent
to which these anomalies result from data mining.
iii. The strong form of the EMH holds that current market prices reflect all information (whether publicly available or
privately held) that can be relevant to the valuation of the firm.
Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct,
prices would fully reflect all information. Therefore even insiders could not earn excess returns. But the evidence is
that corporate officers do have access to pertinent information long enough before public release to enable them to
profit from trading on this information.

b. Briefly discuss the implications of the efficient market hypothesis for

investment policy as it applies to:
i. Technical analysis in the form of charting
ii. Fundamental analysis
Technical analysis involves the search for recurrent and predictable patterns in stock prices in order to
enhance returns. The EMH implies that technical analysis is without value. If past prices contain no useful
information for predicting future prices, there is no point in following any technical trading rule.
Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest
rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts that most fundamental
analysis is doomed to failure. According to semi-strong form efficiency, no investor can earn excess returns from
trading rules based on publicly available information. Only analysts with unique insight receive superior returns.
In summary, the EMH holds that the market appears to adjust so quickly to information about individual
stocks and the economy as a whole that no technique of selecting a portfolio using either technical or fundamental
analysis can consistently outperform a strategy of simply buying and holding a diversified group of securities, such
as those making up the popular market indexes.

c. Briefly explain the roles or responsibilities of portfolio managers in an

efficient market environment.
Portfolio managers have several roles and responsibilities even in perfectly efficient markets. The most
important responsibility is to identify the risk/return objectives for the portfolio given the investors constraints. In
an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investors needs, rather
than to beat the market, which requires identifying the clients return requirements and risk tolerance. Rational
portfolio management also requires examining the investors constraints, including liquidity, time horizon, laws and
regulations, taxes, and unique preferences and circumstances such as age and employment.

8. Your investment client asks for information concerning the benefits of active
portfolio management. She is particularly interests in the question of whether or not
active managers can be expected to consistently exploit inefficiencies in the capital
markets to produce above-average returns without assuming higher risk.
a. Identify which form of the EMH is relevant to your clients concerns.
The relevant for is semi-strong from since active management involves picking under-valued stocks

b. Identify and explain two examples of empirical evidence that tend to support
the EMH implication stated above
Some empirical evidence that supports the EMH is that (i) professional money managers do not typically earn higher
returns than comparable risk, passive index strategies; (ii) event studies typically show that stocks respond immediately to
the public release of relevant news; (iii) most tests of technical analysis find that it is difficult to identify price trends that
can be exploited to earn superior risk-adjusted investment returns

c. Identify and explain two examples of empirical evidence that tend to refute
the EMH implication stated above
Some evidence that is difficult to reconcile with the EMH concerns simple portfolio strategies that apparently would have
provided high risk-adjusted returns in the past. Some examples of portfolios with attractive historical returns: (i) low P/E
stocks; (ii) high book-to-market ratio stocks; (iii) small firms in January; (iv) firms with very poor stock price performance
in the last few months. Other evidence concerns post-earnings-announcement stock price drift and intermediate-term price
momentum

d. Discuss reasons why the investor might choose not index even if the markets
were, in fact, semistrong form efficient
An investor may choose not to index even if markets are efficient because he or she may want to tailor a portfolio to
specific tax considerations or to specific risk management issues, for example, the need to hedge (or at least not add
to) exposure to a particular source of risk (e.g., industry exposure).