FIN 441, Fall 2016

Investments

Homework #2
Coverage: Classes 6-11
SOLUTION

1. You have $10,000 and want to know if Tar Heel Championship, LLC is a good buy. The
firms total risk is 15%, its systematic risk is 1.3, the T-bill rate is 2.0%, and the average
market return is 8.8%.
1) What is the expected return on Tar Heel Championship, LLC?
We use the CAPM formula to compute the expected return. To use the CAPM, we need
the systemic risk and the risk-free rate, which we proxy by using the T-bill rate. Hence,
we have: () = + ( ) = 2.0% + 1.3 (8.8% 2.0%) = 10.84%.

2) Assume you constructed a DCF model to evaluate Tar Heel Championship and found
that the current market price of the stock implies an expected return of 11.0%. [Note:
You do not actually have to do a DCF model for this problem.] Given you answer in part
1), is the firm overvalued, undervalued, or properly priced? Explain.

The expected return on Tar Heel Championship, according to the CAPM (given its
systematic risk), is lower than your forecasted return of 11.0%. Thus, the stock is
underpriced. In other words, the CAPM says it should earn a return of 10.84%, but given
the current market price, you forecast it will return 11.0%. Since you believe it will
return more than it needs to, given its risk, your model suggests its a good investment.

2. You are considering an investment in firm BXY. You know the risk free rate is 1.7%, the
expected return on the market portfolio is 9.2%, and the standard deviation of the market
portfolio is 22.09%. You also know that stock BXY has a standard deviation of 45.3% but it
is uncorrelated with the market portfolio.
1) What is the beta of stock BXY?
Since the stock is uncorrelated with the market portfolio, it must have a beta of 0.
2) According to the CAPM, what is the expected return on stock BXY?
The CAPM formula is: () = + ( ) . Since the beta is zero, the stock is
expected to earn the risk free rate of 1.7%.
3) You know that firm BXY has a high standard deviation. How do you explain the return
in part 2) and the fact that it has a high standard deviation? In particular, what do you
know about the risk?
If the stock has high total risk but a beta of zero, it must be that the risk is idiosyncratic
risk. Since we can diversify away this risk, we dont earn any compensation for taking it
(so the expected return of the stock is just the risk-free rate).
1

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3. You manage a risky portfolio with expected rate of return of 16% and standard deviation of
29%. The T-bill rate is 8%. Your clients degree of risk aversion is A = 3.5.
1) What proportion, y, of the total investment should be invested in your fund?
With y proportion of the total investment in the risky portfolio, the expected value and
standard deviation of the rate of return on the complete portfolio is:
( ) = + ( ) = 8% + (16% 8%) = 0.08 + 0.08
= y = 29% = 0.29
1

Your clients utility is given by = ( ) 2 2 = + ( ) 2 2 .

To find the optimized y that maximizes U, we take the first-order derivative of U with
regard to y. By FOC, we have:

= ( ) 2 = 0

( )
0.08
=
=
= 27.1785%
2
3.5 0.292

2) What is the expected value and standard deviation of the rate of return on your clients
optimized portfolio?
( ) = + ( ) = 0.08 + 0.08 27.1785% = 10.1743%
= y = 0.29 = 0.29 27.1785% = 7.8818%
4. You have $50,000 in cash and you would like to allocate it between the common stock of
Apple (AAPL) and AT&T (T). Before making your investment, you have decided to
examine the past performance of these stocks under the assumption that their performance
from January 1, 2011 to December. 31, 2011 is representative of their expected future
performance. Assume that the risk-free rate is 0%.
For details, see the Excel file titled FIN441-Homework-2-FL16-Solution-Q4.xlsx.
1) Using Yahoo Finance, download the daily stock prices in 2011 for both firms. Using the
adjusted closing price (which accounts for dividends), calculate the daily return. What
was the mean, standard deviation, variance, and covariance of the two series?
Mean (daily) Return
Standard Deviation of Daily Return
Variance of Daily Return
Covariance of the Two Daily Return Series
2

Apple
0.0957%
1.6521%
0.000273

AT&T
0.0371%
1.1476%
0.000132
0.000092

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Investments

2) Your friend suggests that you split your money evenly between the two stocks. If you
had invested your money evenly in the two stocks in 2011, what would the daily return of
this portfolio have been? What would the variance of this portfolio have been? Use a
bordered covariance to calculate the variance of this portfolio (be sure to show your
bordered covariance matrix).
= 2=1 = 0.5 0.0957% + 0.5 0.0371% = 0.0664%
Bordered Covariance
Matrix
Apple
0.5
AT&T
0.5

Apple
0.5
0.000068
0.000023

AT&T
0.5
0.000023
0.000033

2 = 12 12 + 22 22 + 21 2 (1 , 1 )
= 0.000068 + 0.000033 + 2 0.000023 = 0.000147

3) What was the Sharpe Ratio for the portfolio you calculated in part (2)?
Sharpe Ratio = / = 0.0664% 0.000147 = 0.0547

4) Instead of splitting your money evenly between the two stocks, you have decided to
calculate the optimal risky portfolio. How much money (in dollars) should you invest in
Apple? How much money should you invest in AT&T?
[Hint: You do not need to derive the equation for the optimal portfolio, just plug the
numbers you calculated in part 1) into equation 7.13 from Bodie, Kane, and Marcus (the
textbook), page 217 (or the formula on pages 5-6 of the lecture notes for Class 8.]
The formulas we use to compute the optimal portfolio weights are:
=

2
( )
( )( , )
2
2
)
)
( +( [( )+( )]( , )

and

= 1

The resulting optimal weights are 87.6429% in Apple and 12.3571% in AT&T. In
dollars, you should invest $43,821.47 in Apple and $6,178.53 in AT&T.
5) Using your weights from part 4), calculate the mean return and variance of this optimal
risky portfolio in 2011.
= 2=1 = 0.876429 0.0957% + 0.123571 0.0371% = 0.0885%
Bordered Covariance
Matrix
Apple
87.6429%
AT&T
12.3571%

Apple
AT&T
87.6429% 12.3571%
0.000210 0.000010
0.000010 0.000002

FIN 441, Fall 2016

Investments

2 = 12 12 + 22 22 + 21 2 (1 , 1 )
= 0.000210 + 0.000002 + 2 0.000010 = 0.000232

6) What was the Sharpe Ratio for this optimal risky portfolio?

Sharpe Ratio = / = 0.0885% 0.000232 = 0.0581

7) True or False: The Sharpe ratio from the optimal portfolio will always be the Sharpe
ratio from any other combination of the two assets. Briefly explain your answer.
True. By definition, the optimal portfolio is the portfolio that maximizes the risk-return
tradeoff, i.e., the Sharpe Ratio. Thus, the expected Sharpe Ratio from the optimal
portfolio should always be at least as large as the Sharpe ratio of any other combination
of the assets, and it will typically be larger.

5. In Question 4 you calculated the optimal combination of Apple stock and AT&T stock using
a Markowitz optimization. How much different would your answer be if, instead, you used
an index model? Follow the steps below to find the answer. [Note: You do not need to do
any regression analysis, just use the information provided below.]
For details, see the Excel file titled FIN441-Homework-2-FL16-Solution-Q5.xlsx.
1) Collect the data necessary to calculate the index model.
You run two regressions and get the output shown below:
Apple
Regression Statistics
Multiple R
0.6762
R Square
0.4573
Adjusted R Square
0.4551
Standard Error
0.0122
Observations
251
ANOVA
df
Regression
Residual
Total

Intercept
S&P 500

SS
0.0312
0.0370
0.0682

MS
0.0312
0.0001

Coefficients Standard Error

0.0009
0.0008
0.7697
0.0531

t Stat
1.1045
14.4854

1
249
250

F
Significance F
209.8260
0.0000

P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.2704
-0.0007
0.0024
-0.0007
0.0024
0.0000
0.6651
0.8744
0.6651
0.8744

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Investments

AT&T
Regression Statistics
Multiple R
0.7661
R Square
0.5870
Adjusted R Square
0.5853
Standard Error
0.0074
Observations
251
ANOVA
df
Regression
Residual
Total

Intercept
S&P 500

SS
0.0193
0.0136
0.0329

MS
0.0193
0.0001

Coefficients Standard Error

0.0003
0.0005
0.6058
0.0322

t Stat
0.6142
18.8115

1
249
250

F
Significance F
353.8717
0.0000

P-value
Lower 95% Upper 95% Lower 95.0% Upper 95.0%
0.5397
-0.0006
0.0012
-0.0006
0.0012
0.0000
0.5424
0.6692
0.5424
0.6692

[Note: These regressions were run in Excel using the return on the SPY as a measure of
the S&P 500 return in 2011 (you can replicate the results using the regression feature in
Excel if you want, but you dont have to).]
The table below is set up to contain all of the information you need in order to calculate
the index model. Fill-in the table using data from the regression.
Alpha ()
Beta ()
Standard Deviation of Returns ()
Residual Standard Deviation
Residual Variances
Risk Premium
E[R] (note R = r rf)

S&P 500
0
1
0.2304
0.0000
0.0000
0.0350
0.0350

Apple
0.0009
0.7697
0.2623
0.1936
0.0375
0.0278
0.0278

AT&T
0.0003
0.6058
0.1822
0.1173
0.0138
0.0215
0.0215

Note that we assume the risk-free rate is 0%.

Hints:
The alpha and beta come directly from the regression coefficient estimates. [Note:
In the real world you would form your alpha estimate using fundamental analysis,
you would not take the regression result.]
The daily variance of returns can be calculated as the Total Sum of Squares (SS)
divided by the total degrees of freedom (df). We want to find the annual standard
deviation of returns (), so first multiply the daily variance by 252 to get the annual
variance (assuming 252 trading days per year) and then take the square root of that
value to get the annual standard deviation of returns.
Standard Deviation of Returns = [(Total Sum of Squares (SS) / Total Degrees of
Freedom) (252 trading days per year)]1/2
Apple: [(0.0682 / 250) 252]1/2 = 0.2623
AT&T: [(0.0329 / 250) 252]1/2 = 0.1822
5

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Investments

The residual standard deviation can be calculated from the Standard Error of the
regression (in the regression statistics box). Since we used daily data, we need to
convert the standard error to an annual number, so multiply the standard error of the
regression by the square root of 252 (again, we assume 252 trading days per year,
and since the standard deviation is the square root of the variance, to annualize it we
multiply by the square root of 252).
Residual Standard Deviation = Regression Standard Error 252
Apple: 0.0122 252 = 0.1936
AT&T: 0.0074 252 = 0.1173

Calculate the variance of the residuals as the square of residual standard deviation.
Apple: 0.19362 = 0.0375
AT&T: 0.11732 = 0.0138

Finally, calculate the risk premium using the expected return equation:
E[Ri] = i +i(Market Risk Premium)
Remember upper case R = r rf, so the expected return equation gives the risk
premium if we use upper case R (and the expected return if we use lower case r).
Apple: 0.09% + 0.7697 (3.5%) = 2.78%
AT&T: 0.03% + 0.6058 (3.5%) = 2.15%

2) Calculate the covariance matrix.

Complete the matrix below. Remember, the index model makes a simplifying
assumption about the covariance so we can use the formula: COV(ri, rj) = ijM2
S&P 500
Apple
AT&T

S&P 500
0.0531
0.0409
0.0322

Apple
0.0409
0.0315
0.0248

AT&T
0.0322
0.0248
0.0195

3) Now we have all the information we need to calculate the initial position in each security.
[Note: We will ignore systematic risk at first, to make things easier, and well account for
it later in the process.] Compute the initial position in each security, and scale them so
that these weights sum to one. What are the weights? [Hint: See steps 1-2 from the
Summary of Optimization Procedure in Bodie, Kane, and Marcus, page 276.]
Apple: 0.5215

AT&T: 0.4785

4) Using the weights you calculated in part 3), calculate the weighted average alpha, the
weighted average beta, and the weighted average residual variance. [Hint: See steps 3, 4,
and 6 from the Summary of Optimization Procedure in Bodie, Kane, and Marcus, page
276.]

FIN 441, Fall 2016

Investments

Weighted average alpha = 0.0006

Weighted average beta = 0.6913
Weighted average residue variance = 0.0133
5) Now that you know the weights for the individual assets, calculate how much money you
should put in the active portfolio. [Hint: See step 5 from the Summary of Optimization
Procedure in Bodie, Kane, and Marcus, page 276.]
The initial weight on the active portfolio: 0.0660
6) Next, we need to adjust the active portfolio weight you calculated in part 5) to account
for systematic risk. What is the weight on the active portfolio, after this adjustment?
[Hint: See step 7 from the Summary of Optimization Procedure in Bodie, Kane, and
Marcus, page 276.]
After correcting for systematic risk, the adjusted weight on the active portfolio: 0.0647
7) Finally, we need to adjust our individual asset weights to account for systematic risk. To
do this, multiply the weights you calculated for each asset in part 3) by the adjusted
active portfolio weight in part 6). What are the weights on each asset? [Hint: See step 8
from the Summary of Optimization Procedure in Bodie, Kane, and Marcus, page 276.]
Apple: 0.0337

AT&T: 0.0309

8) The weights you calculated in parts 6) and 7) give you the optimal portfolio. What is the
risk premium of this portfolio? What is the variance of this portfolio? [Hint: see steps 9
and 10 from the Summary of Optimization Procedure in Bodie, Kane, and Marcus,
page 266.]
The risk premium of this portfolio = 3.43%
The variance of this portfolio = (22.59%)2 = 0.051042

6. You have $1 million in cash and you would like to allocate it among the common stock of
the following three firms: firm ABC, firm DEF, and firm GHI. You know the risk free rate is
0% and you have the following information about the stock of the three firms:
Expected Return
Standard Deviation of Returns ()
Correlation(retABC, retDEF)
Correlation(retABC, retGHI)
Correlation(retDEF, retGHI)

Stock ABC
9%
25%
0.03636
0.02222

Stock DEF
11%
22%
0.03636
0.07576

Stock GHI
8%
18%
0.02222
0.07576

[Note: For this problem, you will compute an efficient portfolio in Excel using matrix
algebra.]

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For details, see the Excel file titled FIN441-Homework-2-FL16-Solution-Q6.xlsx.

1) You want to develop the efficient frontier using these assets, and youd like to find the
spot on the frontier that corresponds to a portfolio with an expected return of 10%. First,
define the return vector, r, and the covariance matrix, , of the assets (i.e., write out the
vector and matrix by hand and show the elements in them using the data in the table).
2) You know the solution to the portfolio optimization problem is zx = Ax-1b0, where zx is a
vector that contains the optimal portfolio weights. First, write out the matrix Ax. Note:
Ax is defined as 2x the covariance matrix (that is, multiply every element in the
covariance matrix by 2) and then add two additional rows to the bottom of the matrix and
two additional columns to the right of the matrix. [See page 17 of the lecture notes for
Class 9 for more details.] The first of these additional rows and columns should show the
expected returns from vector r, and the last of these rows and columns should have a 1
for each asset and then zeros elsewhere.
3) Then, define the vector b0 (i.e., write out the vector by hand and show the elements).
Note, b0 is a vector that has a 0 for each asset and then two additional rows. The first of
these rows contains the target rate of return youd like to earn on the efficient portfolio
and the last row always contains a 1.
4) Type the matrix Ax and the vector b0 into Excel and compute the inverse of matrix Ax
using the matrix inverse function MINVERSE. Note: To use matrix functions in Excel,
you need to highlight an area that has the same dimensions as the matrix that will result
from the calculation. For example, if matrix Ax is in cells A6 to E10 and youd like to
create the answer in cells A29 to E33, you would highlight cells A29 to E33, type
=MINVERSE(A6:AE10), and hit Ctrl + Shift + Enter at the same time to calculate the
result.
5) Using your answer from part 4), calculate the optimal weight vector using the matrix
multiplication function MMULT. You want to multiply the inverse of Ax and vector b0.
Again, you need to highlight an area that has the same dimension as the vector that will
result from the calculation. For example, if cells A29 to E33 is the location of Ax-1, cells
A18 to A22 is the location of b0, and youd like the optimal weight vector to appear in
cells A41 to A45, then highlight A41 to A45, type =MMULT(A29:E33,A18:A22), and
hit Ctrl + Shift + Enter at the same time to calculate the result. What is the optimal
weight vector?
Stock ABC:
Stock DEF:
Stock GHI:

22.18%
59.27%
18.54%

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Investments

6) Given your answer in part 5), what is the matrix algebra equation for the expected return
on the optimal portfolio? What is the expected return on the optimal portfolio? [Hint:
Use the MMULT function again and multiply the transpose of the optimal weight vector
by the expected return vector r.]
The matrix algebra equation for the expected return is = .

The expected return on the optimal portfolio is 10%. Note: For the optimization problem,
we defined a constraint that said the expected return should be 10% (in the 2nd to last row
of the vector b0), so this result is not surprising.
7) Given your answer in part 5), what is the matrix algebra equation for the expected
standard deviation on the optimal portfolio? What is the expected standard deviation on
the optimal portfolio? [Hint: You will use the MMULT function again, but you need to
break the problem into two steps. First, multiply the transpose of the optimal weights by
the covariance matrix; the answer will be a 1x3 vector. Then, multiply this vector by the
optimal weight vector to receive the expected portfolio standard deviation.]
The matrix algebra equation for the expected variance is 2 = .
The expected standard deviation is the square root of this number.

In this case, the expected portfolio variance is 0.0225, and the expected standard
deviation is 14.99%.
8) What is the Sharpe Ratio of the portfolio you just created?
With a risk-free rate of 0%, the Sharpe Ratio = (10.0% 0%) / 14.99% = 0.6672.
9) In the steps above, you found the weights of the most efficient portfolio that resulted in
an expected return of 10%. We saw in class that if we choose different target expected
returns and solve for the efficient portfolio, we can trace out the Markowitz efficient
frontier. We also saw that it is possible to find one unique portfolio on the frontier that is
the best possible portfolio (a.k.a., the tangency portfolio or the optimal portfolio). In
the next steps, well calculate the weights for the tangency portfolio. First, create a
vector of excess returns (i.e., define a vector = r rf). Youll also need a row vector
populated with 1s for each asset (i.e., create a row with 3 cells, each with a 1 in it).
10) The weights for tangency portfolio are given by the formula:
t=

1 1

1 1 1

where t is the vector of optimal weights. Thus, youll need the inverse of the covariance
matrix ( 1 ). Calculate the inverse of the covariance matrix using the MINVERSE
function.

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Investments

11) Well calculate the solution vector in two steps. First, calculate the numerator of t by
multiplying 1 and the excess return vector (r rf) using the MMULT function. Your
solution will be a vector that is 1 column wide and 3 rows long (one for each asset).

12) Next, well calculate the denominator by multiplying 1 and the excess return vector (r
rf) and then take the row vector of 1s and multiply it by the solution. For example,
your calculation will look like =MMULT(A96:C96,MMULT(A102:C104,A91:A93))
where cells A96:C96 represent the row vector of 1s, cells A102:C104 contain the inverse
of the covariance matrix, and cells A91:A93 contain the vector of excess returns.
13) Then, divide the numbers you calculated in part 11) by the number you calculated in step
12) to get the optimal weights for each asset. Your solution will by a vector that is 1
column wide and 3 rows long (one for each asset). What are the optimal weights?
Stock ABC:
Stock DEF:
Stock GHI:

23.67%
36.78%
39.55%

14) Finally, calculate the expected return, standard deviation, and Sharpe Ratio of this
portfolio using the same techniques you used in parts 6) through 8). What is the Sharpe
Ratio of the best possible portfolio?
The expected return of this portfolio = 9.34%
The standard deviation of this portfolio = 12.86%
Sharpe Ratio of this portfolio = 0.7266
Note that this Sharpe Ratio is greater than the ratio you found in part 8) since this is the
best possible portfolio on the frontier, i.e., the tangency portfolio.

10