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1. Compute time plots of monthly prices and returns and comment.

projectPrices.z
130 13

vfinx

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growth of $1

vbltx 70 80 90

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35

vfinx veurx veiex vbltx vbisx vpacx

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Are there any unusually large or small returns? o Yes


For all stock indexes there are unusually large negative returns for the last quarter of 2008. Following the negative return there seems to be an correction at the beginning of 2009 followed by a subsequent downturn again, followed by an enormous large return. As returns of stock indices declined rapidly during the last quarter of 2008, Bond indices seem to have a large upswing in returns.

Can you identify any news events that may explain these unusual values? o Yes
Subprime mortgage crises, Financial Crisis, Systemic Risk, Collapse of American Insurance Group, Lehman Brothers. Buying out of Washington Mutual, Wachovia, Merrill Lynch. Unemployment, Fear/hysteria,

Give a plot showing the growth of $1 in each of the funds over the five year period. Which fund gives the highest future value? o VEIEX gives the highest future value

2. Create four panel diagnostic plots containing histograms, smoothed density plots, boxplots and qq-plots for each return series and comment.

vfinx monthly returns


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vfinx monthly returns


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veiex monthly returns


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vpacx monthly returns


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Sample Quantiles density estimate 6

Normal Q-Q Plot


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Do the returns look normally distributed? o No Are there any outliers in the data? o Yes

3. Compute univariate descriptive statistics (mean, variance, standard deviation, skewness, kurtosis, quantiles) for each return series and comment.

Table Stats Observations NAs Minimum Quartile 1 Median Arithmetic Mean Geometric Mean Quartile 3 Maximum SE Mean LCL Mean (0.95) UCL Mean (0.95) Variance Stdev Skewness Kurtosis Emp. Quantiles 0.05 0.01

vfinx

veurx 60 60 0 0 -0.1838 -0.2454 -0.0223 -0.0292 0.0125 0.0084 0.00047 0.001998 -0.0009 -0.0005 0.0326 0.0443 0.0913 0.1314 0.006707 0.009033 -0.013 -0.0161 0.0139 0.0201 0.002699 0.004896 0.051952 0.069973 -0.9468 -0.89 1.3551 1.5167 vfinx veurx -0.141786 -0.18776 -0.088523 -0.131263

veiex

vbltx 60 60 0 0 -0.3241 -0.0751 -0.0266 -0.0092 0.0117 0.0088 0.009486 0.005899 0.0056 0.0055 0.0698 0.0205 0.1666 0.108 0.011037 0.003794 -0.0126 -0.0017 0.0316 0.0135 0.007309 0.000864 0.085491 0.029388 -1.0045 0.4408 2.27 2.6585 veiex vbltx -0.237264 -0.069246 -0.113756 -0.036779

vbisx

vpacx 60 60 0 0 -0.0117 -0.2029 0.0012 -0.0233 0.0037 0.0065 0.004218 0.00098 0.0042 -0.0007 0.0072 0.0323 0.0209 0.1128 0.000805 0.00739 0.0026 -0.0138 0.0058 0.0158 3.89E-05 0.003277 0.006236 0.057243 0.2253 -0.8035 1.0345 1.3844 vbisx vpacx -0.010974 -0.152052 -0.004418 -0.100496

How are these estimates related to the parameters of the constant expected return (CER) model? o These estimates are the plug-in estimates needed to utilize the CER model to find the unknown parameters of the asset. They are also our best guess and first inputs for finding the true parameter.

4. Using a monthly risk free rate equal to 0.0004167 per month (which corresponds to a continuously compounded annual rate of 0.5%), compute Sharpe's slope for each asset.
Sharpe slope vfinx veurx veiex vbltx vbisx vpacx 0.001022 0.022593 0.106088 0.186539 0.609509 0.009835

Which asset has the highest slope? o SBIX

5. Compute estimated standard errors and form 95% confidence intervals for the the estimates of the mean and standard deviation.
Sample SD vfinx veurx veiex vbltx vbisx vpacx Sample Mean vfinx veurx veiex vbltx vbisx vpacx sigmahat.vals se.sigmahat sigma.lower sigma.upper 0.051952 0.004743 0.042467 0.061438 0.069973 0.006388 0.057198 0.082748 0.085491 0.007804 0.069882 0.101099 0.029388 0.002683 0.024022 0.034753 0.006236 0.000569 0.005098 0.007375 0.057243 0.005226 0.046792 0.067694 muhat.vals se.muhat mu.lower mu.upper 0.00047 0.006707 -0.012944 0.013884 0.001998 0.009033 -0.016069 0.020065 0.009486 0.011037 -0.012587 0.03156 0.005899 0.003794 -0.001689 0.013487 0.004218 0.000805 0.002607 0.005828 0.00098 0.00739 -0.0138 0.01576

Are these means and standard deviations estimated very precisely? o Means are not. o SD are. Which estimates are more precise: the estimated means or standard deviations? o SDs are more precise

6. Convert the monthly sample means into annual estimates by multiplying by 12 and convert the monthly sample SDs into annual estimates by multiplying by the square root of 12. Comment on the values of these annual numbers. Assuming you get the average annual return every year for 5 years, how much would $1 grow to after 5 years?
Annualized Mean vfinx veurx veiex vbltx vbisx vpacx mean*12 (1+r)^5 wealth 0.57% 1.028586 $ 1.00 2.43% 1.127336 $ 1.00 12.06% 1.766807 $ 1.00 7.34% 1.424645 $ 1.00 5.19% 1.28795 $ 1.00 1.18% 1.060545 $ 1.00 End. Wealth $ 1.03 $ 1.13 $ 1.77 $ 1.42 $ 1.29 $ 1.06 Annual SD vfinx veurx veiex vbltx vbisx vpacx sd*sqrt(12) 0.179968 0.242394 0.296148 0.101802 0.021604 0.198295

Comment on the values of these annual numbers. o Vfinx is surprisingly low o Veiex is unsurprisingly high Assuming you get the average annual return every year for 5 years, how much would $1 grow to after 5 years? o Veiex

7. Compute and plot all pair-wise scatterplots between your 6 assets.

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vbisx
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vpacx
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Briefly comment on any relationships you see. o The linear association seems to be the strongest within equity securities. Linear association within fixed income security also shows strength. However linear association between asset classes is weak.

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8. Compute the sample covariance matrix of the returns on your six assets. Compute the sample correlation matrix of the returns on your six assets.
Covariance Matrix vfinx veurx veiex vbltx vbisx vpacx Correlation Matrix vfinx veurx veiex vbltx vbisx vpacx vfinx 0.002699 0.003369 0.003809 0.00029 4.91E-06 0.002614 vfinx 1 0.926715 0.857496 0.19019 0.015159 0.879128 veurx 0.003369 0.004896 0.005477 0.000584 4.85E-05 0.003758 veurx 0.926715 1 0.915523 0.283852 0.111031 0.938114 veiex 0.003809 0.005477 0.007309 0.000643 4.14E-05 0.004441 veiex 0.857496 0.915523 1 0.255872 0.07765 0.907502 vbltx vbisx 0.00029 4.91E-06 0.000584 4.85E-05 0.000643 4.14E-05 0.000864 0.000128 0.000128 3.89E-05 0.000572 4.24E-05 vbltx 0.19019 0.283852 0.255872 1 0.700536 0.339785 vbisx 0.015159 0.111031 0.07765 0.700536 1 0.11864 vpacx 0.002614 0.003758 0.004441 0.000572 4.24E-05 0.003277 vpacx 0.879128 0.938114 0.907502 0.339785 0.11864 1

Comment on the direction of linear association between the asset returns. o The linear association seems to be the strongest within equity securities. Linear association within fixed income security also shows strength. However linear association between asset classes is weak. Which assets are most highly correlated? o VFINX and VEURX are the most correlated Which are least correlated? o Vbisx and VEIEX are the least correlated

9. Compute estimated standard errors and 95% confidence intervals for your estimates.
Sample Rho vfinx,veurx vfinx,veiex vfinx,vbltx vfinx,vbisx vfinx,vpacx veurx,veiex veurx,vbltx veurx,vbisx veurx,vpacx veiex,vbltx veiex,vbisx veiex,vpacx vbltx,vbisx vbltx,vpacx vbisx,vpacx rhohat.vals 0.926715017 0.857495572 0.190189786 0.015158639 0.879127817 0.915522823 0.283851601 0.111030813 0.938113822 0.255872212 0.07765017 0.907501796 0.700535858 0.339784727 0.118639693 se.rhohat 0.018228748 0.034172797 0.12442964 0.12906978 0.02932291 0.020890609 0.118697679 0.127507927 0.015484505 0.120647228 0.128321033 0.022778369 0.065743829 0.114194441 0.127282322 rho.lower 0.890257521 0.789149978 -0.05866949 -0.24298092 0.820481997 0.873741605 0.046456242 -0.14398504 0.907144813 0.014577756 -0.1789919 0.861945057 0.569048199 0.111395844 -0.13592495 rho.upper 0.963172514 0.925841165 0.439049066 0.273298198 0.937773636 0.957304041 0.521246959 0.366046668 0.969082831 0.497166669 0.334292237 0.953058534 0.832023516 0.56817361 0.373204336

How precise are these correlation estimates. o Correlation estimates are more precise with relation to the indices asset classes. There is a smaller SE within stock indices correlation. There is a smaller SE within bond indices correlation. As we move in between asset classes we loose a great deal of precision. Finally, based on the estimated correlation values do you think diversification will reduce risk with these assets? o Yes diversification can reduce significant risk between bonds and stock, however it seems like many of the diversification benefits of equity securities are already realized within each indices portfolio.

10.

Assume that you have $100,000 to invest starting at September 30, 2009. For each asset, determine the 1% and 5% value-at-risk of the $100,000 investment over a one month investment horizon based on the normal distribution using the estimated means and variances of your assets.
vfinx veurx veiex vbltx vbisx vpacx -8147.322 -10693.67 -12289.9 -4155.165 -602.2308 -8896.717 -11342.49 -14852.41 -17254 -6055.601 -1023.786 -12382.29

Var Var.05 VaR.01

Which assets have the highest and lowest VaR at each horizon? o Veiex has the highest o Vbsix has the lowest Using the monthly mean and standard deviation estimates, compute the annualized mean (12 time monthly mean) and standard deviation (square root of 12 time monthly std dev) and determine the 1% and 5% value-at-risk of the $100,000 investment over a one year investment horizon.
vfinx veurx veiex vbltx vbisx vpacx -29039.47 -37447.69 -36659.63 -9411.363 1637.485 -31436.91 -41295.31 -53954.71 -86442.09 -16344.05 166.2697 -44940.79

11.

Annual Var VaR.05 VaR.01

12.

Use the bootstrap to compute estimated standard errors and 95% confidence intervals for your 5% VaR estimates.
Original Bias Std.E Normal (Up, Low) Percentile -8147 144.2 1362 -10962 -5621 -16200 -5439 -10694 -10694 1755 -14292 -7413 -14244 -7241 -12290 144.7 2318 -16978 -7891 -16876 -7631 -4155 116 692.5 -5628 -2914 -5432 -2726 -602.2 13.58 132.6 -875.7 -355.9 -848.8 -331.8 -8897 199 1488 -12012 -6179 -11531 -5771

Bootstrap Var vfinx veurx veiex vbltx vbisx vpacx

Using these results, comment on the precision of your VaR estimates. o There seems be the most precision for the bond indices as compared to the stock indices.

13.

Repeat the VaR analysis (but skip the bootstrapping), but this time use the empirical 1% and 5% quantiles of the return distributions (which do not assume a normal distribution - this method is often called historical simulation).
vfinx veurx veiex vbltx vbisx vpacx -0.142 -0.188 -0.2373 -0.069246 -0.011 -0.152 -0.089 -0.131 -0.1138 -0.036779 -0.004 -0.1 -14179 -18776 -23726 -6924.585 -1097 -15205 -8852 -13126 -11376 -3677.85 -441.8 -10050

Emp. Quantiles 0.05 0.01 Var.05 Var.01

How different are the results from those based on the normal distribution? o Empirical quantiles are computed from historical distributions and based on pdf of the observed sample. The normal distribution is pdf, cdf, and quantiles are standardized.

14. For each asset, compute 24 month rolling estimates of the mean and standard

deviation of the continuously compounded returns. Graph these rolling estimates together with the returns. VFINX
24-month rolling means and sds for VFINX
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VEURX
24-month rolling means and sds for VEURX

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Rolling means Rolling sds VEURX returns 2006 2007 2008 Index 2009 2010

Rolling means Rolling sds VFINX returns 2006 2007 2008 Index 2009 2010

VPACX
24-month rolling means and sds for VPACX

VEIEX
24-month rolling means and sds for VEIEX

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Rolling means Rolling sds VPACX returns 2006 2007 2008 Index 2009 2010

Rolling means Rolling sds VEIEX returns 2006 2007 2008 Index 2009 2010

VBLTX
24-month rolling means and sds for VBISX

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VBSIX
24-month rolling means and sds for VBLTX
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Rolling means Rolling sds VBISX returns 2006 2007 2008 Index 2009 2010

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Rolling means Rolling sds VBLTX returns 2006 2007 2008 Index 2009 2010

Briefly comment on the stability of the mean and SD parameters of the constant expected return model.

1. Compute the global minimum variance portfolio and calculate the expected return and SD of this portfolio. o Annualize the the monthly mean and SD by multiplying the mean by 12 and the SD by the square root of 12. o Compute VaR 5% and 1% for 100,000. o Graph the weights of the 6 assets in this portfolio using a bar chart.
Portfolio Weights

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Global Minumum Portfolio weight vfinx veurx veiex vbltx vbisx vpacx E[Rp.m] sd(rp.m) mvec constraint var(rp,m) 0.05725 1 2.4E-05 -0.058 -0.0019 -0.1425 1.10391 0.04132 sigmat w0 VaR05 Var01 0.37% muhat 0.49% 0.0037 0.00488 100000 -426.4 -756.7

Compare this value to the VaR values for the individual assets. o VaR is significant better than for individual asset. By using asset allocation we are able to maximize diversification benefits, allowing us to achieve the most efficient risk per unit of return. Briefly comment on these values relative to those for each asset. o Assets that are inefficient are shorted to provide more weight to efficient assets. Vfinx is left to provide added diversification benefits. Veiex and Vpacx are also not shorted to provide return. Are there any negative weights in the global minimum variance portfolio? o Yes.

2. Compute the global minimum variance portfolio with the added restriction that short-sales are not allowed, and calculate the expected return and SD of this portfolio. o Graph the weights of the 6 assets in this portfolio. o Annualize the the monthly estimates by multiplying the ER by 12 and the SD by the square root of 12. o Assume that you have $100,000 to invest for a year starting at September 30, 2009. For the global minimum variance portfolio with short-sales not allowed, determine the 1% and 5% value-at-risk of the $100,000 investment over a one month investment horizon.

Global Min No Short


120% 100% 80% 60% 40% 20% 0% vfinx veurx veiex vbltx vbisx vpacx 1% 0% 0% 0% 0% 99%

Global Minumum Portfolio (NoShort) weight mvec constraint var(rp,m) vfinx 0.01246 1 3.8E-05 veurx 0 veiex 0 vbltx 0 vbisx 0.98754 vpacx 0 E[Rp.m] sigmat w0 VaR05 Var01 0.42% muhat sd(rp.m) 0.62% 0.0042 0.0062 100000 -601.3 -1020

Compare this portfolio with the global minimum variance portfolio that allows short-sales. o Allowing short sales allows us to achieve highest return per risk by putting more weight towards efficient assets such as Vbisx. If we are limited to not shorting, we loose that added benefit of putting more weight into efficient assets.

3. Compute the tangency portfolio. o Graph the weights of the 6 assets in this portfolio.

Tangent Portfolio Weights


120% 100% 80% 60% 40% 20% 0% -20% vfinx veurx veiex vbltx vbisx vpacx -6% 3% 6% -12% -3% 112%

Are any of the weights on the 6 funds negative? o Yes Interpret the negative weights.
o

Negative weight suggests shorting. It seems that inefficient assets, lower return per unit risk are shorted. Whereas efficient assets such as Vbisx use the shorted funds to maximize return per unit risk. It also seems like we use the diversification benefits of Vfinx as well as the strong return characteristics of Veiex.

4. Compute the expected return, variance and standard deviation of the tangency portfolio. o Annualize the monthly ER and SD of the tangency portfolio by multiplying the ER by 12 and the SD by the square root of 12. o Give the value of Sharpe's slope for each asset as well as for the tangency portfolio.
Tangent + T-bill Portfolio asset vfinx veurx veiex vbltx vbisx vpacx E[Rp,t] SD[Rp,t] Sharpe ratio E[Rp,t]tvec constraint rf var(Rp,t) 3% 1 0.00404 2.89E-05 -6% 6% -12% 112% -3% muhat sigmat w0 0.0045 0.0045 0.00537 100000 0.0054 vfinx veurx veiex vbltx 0.001 0.0226 0.10609 0.186539 slope 0.7529

VaR05 Var01 -436.7 -800.5 vbisx vpacx 0.6095 0.0098

Which asset has the highest Sharpe's slope? Briefly comment. o Tangent portfolio, has the highest slope. The ability to use asset allocation allows us to achieve the greatest return per unit risk.

5. Compute the Markowitz bullet. o Create a plot o Show the tangency portfolio as well as combinations of T-bills and the tangency portfolio on a plot with the Markowitz bullet. That is, compute the efficient portfolios consisting of T-bills and risky assets
Efficient Frontier
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veiex

Portfolio ER

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vbltx vbisx

veurx
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vpacx vfinx

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6. Using a monthly risk free rate equal to 0.0004167 per month and the estimated means, variances and covariances compute the tangency portfolio imposing the additional restriction that short-sales are not allowed. o Compute the expected return, variance and standard deviation of the tangency portfolio. o Give the value of Sharpe's slope for the no-short sales tangency portfolio.
Tangent Port (No Short) muhat.vals tvec constraint Erp-rf var vfinx 0.00047 0.00% 1 0.00469 0.007025962 veurx rf sharpe 0.002 0.00% veiex 9.76% 0.00949 4.2E-05 0.055952714 vbltx 0.00% 0.0059 vbisx 0.00422 90.24% vpacx 0.00098 0.00% E[Rp,t] 0.00473 SD[Rp,t] 0.08382 Tangent + T-bill Portfolio E[Rp,t]asset tvec constraint rf var(Rp,t) slope vfinx 3% 1 0.00404 2.89E-05 0.7529 veurx -6% veiex 6% vbltx -12% vbisx 112% vpacx -3% muhat sigmat w0 VaR05 Var01 E[Rp,t] 0.0045 0.0045 0.00537 100000 -436.7 -800.5 SD[Rp,t] 0.0054 Sharpe vfinx veurx veiex vbltx vbisx vpacx ratio 0.001 0.0226 0.10609 0.186539 0.6095 0.0098

Compare this tangency portfolio with the tangency portfolio where shortsales are allowed.
o

We are able to achieve a higher Sharpe slope with shorting. Return per unit risk is maximized when we are able to short.

1. Suppose you wanted to achieve a target expected return of 8% per year (which corresponds to an expected return of 0.67% per month) using only the risky assets (6 Vanguard portfolios) and no short sales. Recall, you cannot short a mutual fund.

What is the efficient portfolio that achieves this target return? How much is invested in each of the Vanguard funds in this efficient portfolio? Compute the monthly SD on this efficient portfolio, as well as the monthly 1% and 5% value-at-risk based on an initial $100,000 investment.
Target 8% No short Sale muhat.vals yvec constraint target var(Rp) vfinx 0.05% 0% 1.0000 0.0067 0.0235 veurx 0.20% 0% veiex 0.95% 46% vbltx 0.59% 2% vbisx 0.42% 52% vpacx 0.10% 0% E[Rp,t] 0.0067 SD[Rp,t] 0.1532 muhat sigmat w0 VaR05 Var01 0.006666667 0.1532 100000 -21750 -29504.1

2. Now suppose you wanted to achieve a target expected return of 8% per year (which corresponds to an expected return of 0.67% per month) using a combination of T-Bills and the tangency portfolio (that does not allow for short sales). Compute the monthly SD on this efficient portfolio, as well as the monthly 1% and 5% value-at-risk based on an initial $100,000 investment.
Target Tangent 8% No short Sale weight xvec constraint target E[Rp,x var(Rp) Sd(Rp) vfinx 0.00% 1.0000 0.0067 0.0067 0.0011 0.0328 veurx 0.00% veiex 23.85% E[Rp-rf] var(rp slope vbltx 70.92% 0.00625 0.0011 0.1903 vbisx 5.22% vpacx 0.00% muhat sigmat w0 VaR05 Var01 0.006666667 0.0328 100000 -4625.1 -6735.449

In this allocation, how much is invested in each of the six Vanguard funds and how much is invested in T-Bills? o 100% Portfolio 0% T-bills Compare this with the VaR computed from the allocation of risky assets without short sales. o This VaR is considerably lower at the level of return that we are receiving in the portfolio. The allocation of assets by weight allows us to achieve a greater amount of return per unit risk.

1. Using the R function lm. o For each regression, give the estimated single index model equation showing the estimated intercept and slope and indicate the estimated standard errors of the estimates in parentheses below the estimates. o Also present the estimated R-square and the estimated standard deviation of the residuals
SI Model veurx veiex vbltx vbisx vpacx alpha 0.00141 0.00882 0.00585 0.00422 0.00053 beta R^2 SE(Resid) SE(beta) tvalue 1.24817 0.859 0.0265 0.06646 18.78 1.41106 0.735 0.0444 0.11117 12.69 0.10758 0.0362 0.0291 0.07292 1.48 0.00182 0.00023 0.00629 0.01576 0.12 0.96865 0.773 0.0275 0.06895 14.05

Interpret the estimated slope coefficients (betas), comment on the precision of the estimates and comment on the values of R-square and 1 - (R-square). o The precision of the beta estimates are the most accurate with the VBISX, VPACX, and VEURX. And least accurate with VBLTX and VEIEX o VBISX and VBLTX seem to have almost no market risk. o Stock Indices seem to have a great degree of market risk. Which of your stocks are high beta stocks and which are low beta assets? o VEIEX, VEURX, VPACX are high beta. VBISX and VBLTX are low beta. Are there any surprises? o No, there are no surprises. What does it mean if an asset has a beta equal to 1? o If an asset has a beta equal to 1 that means it has perfect correlation with the market index. The asset will move in-synch with the market portfolio. Its expected return is equal to market risk premium. The risk of the asset is wholly made of the market risk. It has no systematic risk

2. For each single index model regression, test the hypotheses H0: beta = 1 vs. H1: beta (not equal to) 1 using a 5% test.
95% Test veurx veiex vbltx vbisx vpacx t statistic 3.73413 3.69756 -12.238 -63.336 -0.4546 lower 0.89067 0.81713 0.88005 0.97407 0.88658 lower 1.109327 1.182875 1.119953 1.025925 1.113424

3. Make a scatterplot of the average monthly returns for each asset (on the y-axis) against the estimated betas (on the x-axis).

Return vs Beta
0.01 0.009 0.008 0.007 Return 0.006 0.005 0.004 0.003 0.002 0.001 0 0 0.2 0.4 0.6 0.8 Beta 1 1.2 1.4 1.6 vfinx veurx veiex vbltx vbisx vpacx

Does there appear to be a linear relationship average return and beta as predicted by the CAPM? o There seems to be like there is none, however if we run a Least Sqaure regression, it would seem that there would be a regression line right between all the asset. In that case there would be a linear relationship

4. Using the estimated betas for your 6 assets (recall, the beta of the S&P 500 is one by definition), the weights in the global minimum variance portfolio and the weights in the tangency portfolio (allowing for short sales), compute the beta of the global minimum variance portfolio and the beta of the tangency portfolio (recall, the beta of a portfolio is a weighted average of the betas of the assets in the portfolio).

Global Minimum Variance: Beta asset veurx veiex vbltx vbisx vpacx vpacx weight 5.73% -5.80% -0.19% -14.25% 110.39% 4.13% beta 1 1.24817 1.411058 0.107584 0.00182 0.968652 P.Beta beta 1 1.24817 1.411058 0.107584 0.00182 0.968652 P.Beta p.Beta 0.057252 -0.072438 -0.002705 -0.015334 0.002009 0.040024 0.008808 p.beta 0.025843 -0.072526 0.084584 -0.012488 0.002032 -0.027304 0.00014

Tangency Portfolio: Beta asset vfinx veurx veiex vbltx vbisx vpacx weight 2.58% -5.81% 5.99% -11.61% 111.66% -2.82%

Comment: o It looks like the tangency portfolio beta has a smaller beta. This is probably due to the fact that the tangency portfolio is using the added benefit of the risk free asset.