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FIN 3102 Investment Analysis and Portfolio Management

Luis Goncalves-Pinto / Sem 1, AY 14/15

Solution to Practice Problems #1

1. You sell short 100 shares of Loser Co. at a market price of $45 per share. What is your maximum

possible loss? Explain.

SOLUTI ON:

When you sell short a security, you need to buy it back in the future but there is no limit as to the

price at which you buy back the security. Your gain (loss) is the difference between the price at which

you sold (bought) the stock, and the price at which you buy (sell) the stock back. When the price of

the stock rises, the maximum possible loss of a short sale is unlimited, as there is no limit to how the

stock price can rise.

Technically, however, one can also default (i.e. walk away) when the stock price goes up. In which

case the maximum you can lose is the money you put in (the collateral on the stock loan of $4500). In

this case, note that the $4500 is collateral you put together with the $4500 from the short sales

proceed to buy back shares at $90/share for total of $9000 (when the cumulative loss is $4500).

2. The investment bank you work for is writing its annual investments newsletter and you are in charge of

the international markets outlook for next year. To prepare your section, you collect data on yearly returns

of World Stocks (WORLD_STOCKS) and those of the US S&P500 portfolio over the last 75 years. Then,

you run the following regression:

r

WORLD_STOCKS

= a + | r

SP500

+ error

The regression produces the following output:

SUMMARY OUTPUT

Regression Statistics

R Square 0.739

Standard Error 0.094

Observations 75

Coefficients Standard Error

T-Stat

Intercept 0.0172 0.0125 1.3787

X Variable 1 0.7710 0.0525 14.6943

2.a. What is the regression estimate for the beta of WORLD_STOCKS with respect to the S&P500?

SOLUTI ON:

Beta =0.7710 (the slope of the regression). This is the coefficient estimate on the first X variable (X

Variable 1) in the regression output.

2.b. What is the 95% confidence interval around this estimate for the beta of WORLD_STOCKS with

respect to the SP500? Give both the lower and the upper bounds of the interval.

SOLUTI ON:

Confidence interval = [0.666;0.876]. The standard error of an estimate measures the accuracy of the

regression estimate. The standard error is 0.0525. The 95% confidence interval around an estimate is

the estimate plus/minus 2 standard errors (1.96 to be more precise), which in this case is [0.7710-

2*0.0525; 0.7710+2*0.0525].

2.c. Is the beta of WORLD_STOCKS with respect to the SP500 statistically different from one? Explain.

SOLUTI ON:

Yes, we can reject that Beta equals 1 with 95% confidence because 1 does not fall inside the 95%

confidence interval around the estimated Beta [0.666;0.876]. Alternatively, we would reach the same

conclusion if we conducted a T-test for whether Beta=1. The T-stat for the test would be T=[|-1]/

Stderror(|)=[0.7710-1]/0.0525=-4.3619 which is larger (in absolute value) than the threshold of -2 for

95% confidence level.

2.d. The research department in your bank has put out next years prediction for the US market (S&P500

portfolio) as 10%. For the investment newsletter, you need to provide what is your best estimate of the

performance next year for WORLD_STOCKS. Using your answer to 2.a., what is your estimate of the

expected return on WORLD_STOCKS for next year? Explain.

SOLUTI ON:

9.43%. We use the regression results r

WORLD_STOCKS

=0.0172 +0.7710 r

SP500

to make the prediction.

When r

SP500

=0.10, we get r

WORLD_STOCKS

=0.0172 +0.7710*0.10 =0.0943 or 9.43%.

3. Stock As expected return and standard deviation are E[r

A

] = 10% and o

A

= 18%, while stock Bs

expected return and standard deviation are E[r

B

] = 12% and o

B

= 21%.

3.a. Determine the expected return and standard deviation of the return on a portfolio with weights e

A

=0.3

and e

B

=0.7 for the following alternative values of correlation between A and B:

AB

=0.6 and

AB

= -0.4.

SOLUTI ON:

E[r

P

] = e

A

E[r

A

] +e

B

E[r

B

]

= 0.30(0.10)+0.70(0.12) = 0.114

regardless of the correlation coefficient value.

Using

o

p

2

=e

A

2

o

A

2

+e

B

2

o

B

2

+ 2e

A

e

B

AB

o

A

o

B

, for

AB

=0.6,

o

p

2

= (.30)

2

(.18)

2

+(.70)

2

(.21)

2

+2(.30)(.70)(0.6)(.18)(.21)

= 0.034051

or, o

p

= 18.45%

For

AB

=-0.4,

o

p

2

= (.30)

2

(.18)

2

+(.70)

2

(.21)

2

+2(.30)(.70)(-0.4)(.18)(.21)

= 0.018175

or, o

p

= 13.48%

3.b. Assume now that

AB

=-1.0 and find the portfolio (p) of stocks A and B that has no risk (i.e. such that

o

p

=0). Can you do the same when

AB

=1.0? If not, why? If so, find that portfolio. Explain.

SOLUTI ON:

From

o

p

2

=e

A

2

o

A

2

+e

B

2

o

B

2

+ 2e

A

e

B

AB

o

A

o

B

, we want to find e

A

such that o

p

2

=0, when

AB

=-1.0.

Since e

B

=1-e

A

, we need to solve

e

A

2

o

A

2

+(1e

A

)

2

o

B

2

2e

A

(1e

A

)o

A

o

B

=0,

or equivalently,

e

A

o

A

(1e

A

)o

B

( )

2

= 0.

This has the solution

5385 . 0

21 . 0 18 . 0

21 . 0

=

+

=

+

=

B A

B

A

o o

o

e .

The remaining weight is e

B

=1-e

A

=0.4615.

For the case when

AB

=1.0, we need to solve

e

A

2

o

A

2

+(1e

A

)

2

o

B

2

+2e

A

(1e

A

)o

A

o

B

=0,

or equivalently,

e

A

o

A

+ (1e

A

)o

B

( )

2

= 0.

This has the solution

7

18 . 0 21 . 0

21 . 0

=

=

A B

B

A

o o

o

e ,

and e

B

=1-e

A

=-6 (which is a short position).

An alternative method is to use the Solver or Goal Seek tools in Excel. This has the disadvantage

that the computer may stop looking for a solution when it is close enough, but may still be

significantly off.

3.c. Finally, assume that

AB

=0. Find the standard deviations of portfolios with the following expected

returns: 8%, 9%, 10%, 11%, 12%, 13%, 14% and 15%. Plot the pairs of expected return and standard

deviation on a graph (with the standard deviations on the horizontal axis, and the expected returns on the

vertical axis).

SOLUTI ON:

To figure out the portfolio weights needed to generate each expected return, you can solve E[r

P

] = e

A

E[r

A

] +e

B

E[r

B

] for e

A

, using e

B

=1-e

A

,

% 2

] [ % 12

% 12 % 10

% 12 ] [

] [ ] [

] [ ] [

P P

B A

B P

A

r E r E

r E r E

r E r E

=

= e

for each desired level of E[r

P

]. Once you determine e

A

, and since

AB

=0, we can then get the standard

deviation for each portfolio, using

2 2 2 2 2 2 2 2

21 . 0 ) 1 ( 18 . 0

A A B B A A p

e e o e o e o + = + =

Mean-Standard Deviation Frontier

8%

9%

10%

11%

12%

13%

14%

15%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7

Standard Deviation

E

x

p

e

c

t

e

d

R

e

t

u

r

n

4. Every time a certain asset A experiences a 1 percent increase in its rate of return, the return on asset B

experiences exactly a 0.5 percent decrease (with no error). What is the correlation coefficient between the

returns of these two assets? Explain.

SOLUTI ON:

There is a negative perfect correlation (correl =-1) between assets A and B. When A goes up, asset B

goes down by a certain amount (with no error). Therefore the correlation between the two asset returns

is exactly -1. I f we had run a regression of return of asset B on return of asset A we would have found

that the beta (slope) would be -0.5 and the fit of the line was perfect.

On slide 38 of Lecture Notes 2 (Quantitative Review), the very last expression on the properties of the

correlation measure, can be re-written as follows:

Corr(a+b*r1, r2)=[Cov(a+b*r1, r2)]/[SD(a+b*r1)*SD(r2)]=[b*Cov(r1, r2)]/[|b|*SD(r1)*SD(r2)]=

[Cov(r1, r2)]/[SD(r1)*SD(r2)] =Corr(r1,r2) if b>0 or =- Corr(r1,r2) if b<0 or =0 if b=0

Therefore: Corr(a+b*r1, r2) =Corr(r1,r2) if b>0 or =- Corr(r1,r2) if b<0 or =0 if b=0

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