Ross, Westerfield, and Jaffe's Spreadsheet Master Corporate Finance, 9th edition by Brad Jordan and Joe Smolira

Version 9.0

Chapter 11
SQRT COVAR CORREL Adding a trendline Regression estimates SLOPE INTERCEPT The following conventions are used in these spreadsheets: 1) Given data in blue 2) Calculations in red
NOTE: Some functions used in these spreadsheets may require that the "Analysis ToolPak" or "Solver Add-In" be installed in Excel. To install these, click on the Office button then "Excel Options," "Add-Ins" and select "Go." Check "Analysis ToolPak" and "Solver Add-In," then click "OK."

In these spreadsheets, you will learn how to use the following Excel f

the following Excel functions:

adsheets:

Chapter 11 - Section 2 Expected Return, Variance, and Covariance

In Chapter 10, we used the AVERAGE, VAR, and STDEV functions to calculate the average, variance, and standard d have built-in functions that handle unequal probabilities, so we need to create our own equations. Supertech (1) State of Economy Depression Recession Normal Boom (2) Probability of State 0.25 0.25 0.25 0.25 (3) Return if State Occurs -0.20 0.10 0.30 0.50 Expected return = (4) Product (2) (3) -0.05 0.025 0.075 0.125 0.175 (5) Deviation from Expected Return (3) - E(R) -0.375 -0.075 0.125 0.325

The standard deviation is the square root of the variance, so the standard deviation is: Standard deviation: 25.86%

RWJ Excel Tip Excel has a built-in function, SQRT, that finds the square root of a number. SQRT is found under the Math & Trig ta

We should also note that the square root (or any other power) can be calculated using the caret key (^). For examp

And for Slowpoke: Slowpoke

(1) State of Economy Depression Recession Normal Boom

(2) Probability of State 0.25 0.25 0.25 0.25

(3) Return if State Occurs 0.05 0.20 -0.12 0.09 Expected return = 11.50%

(4) Product (2) (3) 0.0125 0.0500 -0.0300 0.0225 0.055

(5) Deviation from Expected Return (3) - E(R) -0.005 0.145 -0.175 0.035

Standard deviation:

To calculate the covariance and correlation, we need to calculate the product of the return deviations, multiply thi then sum to find the covariance. Doing so, we find: Deviation of Supertech Return from the Expected Return -0.375 -0.075 0.125 0.325 Deviation of Slowpoke Return from the Expected Return -0.005 0.145 -0.175 0.035

State of Economy Depression Recession Normal Boom

Probability of State 0.25 0.25 0.25 0.25

Product of the Deviations 0.001875 -0.010875 -0.021875 0.011375 Covariance =

Since the correlation is the covariance divided by the product of the standard deviations, the correlation between S Correlation: -0.1639

Covariance and Correlation with Historic Data While we just discussed the calculation of covariance and correlation using unequal probabilities, both calculations data, Excel has built-in functions that will calculate the covariance and correlation for you. Suppose we have the following returns for the market and a stock: Year 1 2 3 4 5 6 Market return 18% 27% 5% 13% -17% 6% Stock return 7% 25% 21% 4% -16% 19%

7 8 9 10

-21% 34% 19% 11%

-38% 29% 15% 16%

What is the covariance and correlation of the returns between this stock and the market? Covariance: Correlation: 0.0281 0.8648

RWJ Excel Tip The functions for covariance (COVAR) and correlation (CORREL) are both located under More Functions, Statistical. data is located.

To use COVAR and CORREL, select the first data array, tab to Array2, and select the second data array. It is irrelevan between A and B is equal to the correlation between B and A.

Covariance and correlation A Quick Statistics Review are measures of how much two variables move together. If two variables tend to vary t then the other variable tends to be above its expected value too), then the covariance and correlation between the them is above its expected value the other variable tends to be below its expected value, then the covariance and

The main difference between covariance and correlation is the interpretation. Covariance is an unstandardized num two variables is large, or because of a strong relationship between the two variables. Thus, the only interpretation or negative.

Correlation is standardized and will be between -1 and 1. The closer the correlation is to -1, the stronger the negat correlation is to 1, the stronger the positive relationship between the two variables. Therefore, correlation measur between two variables.

Correlation and Diversification

So why is correlation important to diversification? Correlation (and covariance) measure how two assets move toge assets, the greater the diversification benefit. If you think of two assets with a negative correlation, as one asset ha below its average. This will smooth out the returns of a portfolio of these two assets. However, if the assets have a the other asset will also have a return above its mean, so there is less benefit to diversification. For an application, be expected to have a high correlation because many of the firm specific risks that would affect GM also affect For Microsoft, so we would expect GM and Microsoft to have a lower correlation than GM and Ford, and therefore hav

verage, variance, and standard deviation for historical returns. Unfortunately, Excel does not r own equations.

(6) Squared Value of Deviation 0.140625 0.005625 0.015625 0.105625 Variance =

(7) Product (2) (5) 0.0351563 0.0014063 0.0039063 0.0264063 0.0668750

s found under the Math & Trig tab. The function looks like this:

using the caret key (^). For example, we could have entered an equation as H13^(1/2).

(6) Squared Value of Deviation 0.000025 0.021025 0.030625 0.001225 Variance =

(7) Product (2) (5) 0.0000062 0.0052563 0.0076563 0.0003063 0.0132250

he return deviations, multiply this product by the probability of the state of the economy, and

Probability of State of the Economy times Product of the Deviations 0.000469 -0.002719 -0.005469 0.002844 -0.004875

ations, the correlation between Supertech and Slowpoke is:

al probabilities, both calculations are often done using historic market data. When using historic for you.

under More Functions, Statistical. Both functions use similar inputs, namely the arrays that the

e second data array. It is irrelevant which data array you select first. That is, the correlation

er. If two variables tend to vary together (that is, when one of them is above its expected value, ance and correlation between the two variables will be positive. On the other hand, when one of d value, then the covariance and correlation between the two variables will be negative.

variance is an unstandardized number. A large covariance can arise because the variance of the es. Thus, the only interpretation we can take from the covariance is the direction, either positive

n is to -1, the stronger the negative relationship between the variables, and the closer the es. Therefore, correlation measures both the direction and magnitude of the relationship

easure how two assets move together. All else the same, the lower the correlation between two ative correlation, as one asset has a return above its average, the other asset will have a return ets. However, if the assets have a positive correlation, as one asset has a return above its mean, iversification. For an application, think of GM and Ford. Both are auto manufacturers and would t would affect GM also affect Ford. However, GM is less likely to share firm specific risk with n GM and Ford, and therefore have a greater diversification benefit.

Chapter 11 - Section 4 The Return and Risk for Portfolios

In the textbook, the equation for the standard deviation of a portfolio is presented. Given the following informatio deviation of the portfolio? Stock A 9% 19% 30% 0.10 Stock B 14% 55% 70%

Expected return Standard deviation Weight of stock Correlation

The expected return and standard deviation of the portfolio are: Expected return: Standard deviation: 12.50% 39.48%

Of course, we could be interested in examining the opportunity set for the two assets. To see this, we can create a expected return and standard deviation of the two assets for various portfolio weights is: Expected Return 14.00% 13.75% 13.50% 13.25% 13.00% 12.75% 12.50% 12.25% 12.00% 11.75% 11.50% 11.25% 11.00% 10.75% 10.50% 10.25% 10.00% 9.75% 9.50% Standard Deviation 55.00% 52.35% 49.73% 47.12% 44.54% 41.99% 39.48% 37.01% 34.60% 32.25% 29.98% 27.81% 25.77% 23.89% 22.20% 20.77% 19.63% 18.86% 18.48%

Weight of Stock A 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90%

95% 100%

9.25% 9.00%

18.53% 19.00%

So what does the opportunity set for these two assets look like? Below, you will see. To examine how a change in t correlation in the cell above.

Opportunity Set of Two Assets

15%

13%

Total Return on Portfolio

11%

9%

7%

5% 10% 15% 20% 25% 30% 35% 40% 45% Risk (Standard Deviation of Portfolio's Return)

So how do we find the minimum variance portfolio? The best way is to use Solver. Try this for yourself and see if yo portfolio is about 92.93%

n the following information concerning two stocks, what is the expected return and standard

o see this, we can create a table for various portfolio weights and then graph the results. The

xamine how a change in the correlation will affect the shape of the opportunity set, change the

50%

55%

60%

s for yourself and see if you don't agree that the weight of Stock A in the minimum variance

Chapter 11 - Section 8 Market Equilibrium

In this section, you will learn how beta is estimated. Before we begin that discussion, we want to start with a graph month end values for the S&P 500, a common proxy for the market as a whole, and the adjusted closing price for A beta, 60 monthly returns is a commonly used number of historical returns. Since we are going to be using a statisti possible. However, the further back in time we go, the less the company is like the current company. For example, years. But is AT&T in its current form actually comparable to AT&T in 1930? Not really. For this and other reasons, estimating beta.

To begin, we would like to graph the returns of Amazon.com stock against the returns of the S&P 500. In this case,

Performance of Amazon.com Stock and the S&P Index Model

60% 50% y = 1.454x + 0.0217 Amazon.com Return 40% 30% 20% 10% 0% -15% -10% -5% -10% -20% -30% -40% S&P 500 Return 0%

-20%

Notice that we have added a trend line in this graph. This trend line is called the characteristic line. The slope of thi market returns. The slope of this line is the beta of the stock. RWJ Excel Tip To add a trend line to a chart, do the following: 1) Click anywhere in the chart. This displays the Chart Tools, adding the Design, Layout, and Format tabs. 2) On the Layout tab, in the Analysis group, click Trend line.

3) You can use any of the predefined options. Note that on the chart there is an equation. We went to More O graph. We will have more to say about this equation later.

The equation in the graph above is a linear regression. We can use the trend line option on a graph to estimate a li regression as well as give us more statistical information about the regression estimate. RWJ Excel Tip To estimate a linear regression, go to the Data tab, Data Analysis, and select Regression, then OK.

The input box for our linear regression looks like this:

The Y input range is the dependent variable, in this case the stock returns, and the X input range is the independen data and selected the Labels box, which will put a label on the output for the variables. Finally, we selected the Con interval. The output for this regression is below.

SUMMARY OUTPUT Regression Statistics Multiple R 0.442264434 R Square 0.19559783 Adjusted R Square 0.181728827 Standard Error 0.133348438 Observations 60 ANOVA df Regression Residual Total 1 58 59 SS 0.250781015 1.031344739 1.282125754 MS 0.250781015 0.017781806 F 14.10323659

Intercept X Variable 1

Coefficients Standard Error 0.021665877 0.017237604 1.454009866 0.38717558

t Stat 1.256896101 3.755427617

P-value 0.213829509 0.000403123

More Regression

If you are just interested in the slope and intercept for a regression, Excel has functions that will calculate these va Beta (slope): Intercept: 1.45401 0.02167

RWJ Excel Tip Both the SLOPE and INTERCEPT functions are located under More Functions, Statistical. The inputs for each functio inputs we used for our results.

on, we want to start with a graph of actual stock returns. On the next tab, you will find the nd the adjusted closing price for Amazon.com stock over a 60 month period. When estimating we are going to be using a statistical process to estimate beta, we would like as much data as e current company. For example, with AT&T, we could get stock prices for more than 100 eally. For this and other reasons, 60 monthly returns has become relatively standard when

urns of the S&P 500. In this case, we used a scatter plot which resulted in the graph below.

com Stock and the S&P 500: Single dex Model

5%

10%

15%

20%

&P 500 Return

haracteristic line. The slope of this line represents how the stock's returns respond to the

gn, Layout, and Format tabs.

s an equation. We went to More Options and selected the box to display the equation on the

option on a graph to estimate a linear regression, but Excel has a tool that will estimate a linear mate.

ession, then OK.

e X input range is the independent variable, or market return. We included the row above the ables. Finally, we selected the Confidence Interval box and asked for a 90 percent confidence

Significance F 0.000403123

Lower 95% -0.012838936 0.678993744

Upper 95% 0.05617069 2.229025988

Lower 90.0% -0.007147687 0.806825456

Upper 90.0% 0.050479441 2.101194277

ctions that will calculate these values separately, SLOPE and INTERCEPT.

stical. The inputs for each function are the Y values and the X values. Below, you will see the

Return Data
Date 5/3/2004 6/1/2004 7/1/2004 8/2/2004 9/1/2004 10/1/2004 11/1/2004 12/1/2004 1/3/2005 2/1/2005 3/1/2005 4/1/2005 5/2/2005 6/1/2005 7/1/2005 8/1/2005 9/1/2005 10/3/2005 11/1/2005 12/1/2005 1/3/2006 2/1/2006 3/1/2006 4/3/2006 5/1/2006 6/1/2006 7/3/2006 8/1/2006 9/1/2006 10/2/2006 11/1/2006 12/1/2006 1/3/2007 2/1/2007 3/1/2007 4/2/2007 5/1/2007 6/1/2007 7/2/2007 S&P 500 1120.68 1140.84 1101.72 1104.24 1114.58 1130.2 1173.82 1211.92 1181.27 1203.6 1180.59 1156.85 1191.5 1191.33 1234.18 1220.33 1228.81 1207.01 1249.48 1248.29 1280.08 1280.66 1294.87 1310.61 1270.09 1270.2 1276.66 1303.82 1335.85 1377.94 1400.63 1418.3 1438.24 1406.82 1420.86 1482.37 1530.62 1503.35 1455.27 Amazon.com $ 48.50 $ 54.40 $ 38.92 $ 38.14 $ 40.86 $ 34.13 $ 39.68 $ 44.29 $ 43.22 $ 35.18 $ 34.27 $ 32.36 $ 35.51 $ 33.09 $ 45.15 $ 42.70 $ 45.30 $ 39.86 $ 48.46 $ 47.15 $ 44.82 $ 37.44 $ 36.53 $ 35.21 $ 34.61 $ 38.68 $ 26.89 $ 30.83 $ 32.12 $ 38.09 $ 40.34 $ 39.46 $ 37.67 $ 39.14 $ 39.79 $ 61.33 $ 69.14 $ 68.41 $ 78.54 S&P 500 return 1.80% -3.43% 0.23% 0.94% 1.40% 3.86% 3.25% -2.53% 1.89% -1.91% -2.01% 3.00% -0.01% 3.60% -1.12% 0.69% -1.77% 3.52% -0.10% 2.55% 0.05% 1.11% 1.22% -3.09% 0.01% 0.51% 2.13% 2.46% 3.15% 1.65% 1.26% 1.41% -2.18% 1.00% 4.33% 3.25% -1.78% -3.20% Amazon return 12.16% -28.46% -2.00% 7.13% -16.47% 16.26% 11.62% -2.42% -18.60% -2.59% -5.57% 9.73% -6.81% 36.45% -5.43% 6.09% -12.01% 21.58% -2.70% -4.94% -16.47% -2.43% -3.61% -1.70% 11.76% -30.48% 14.65% 4.18% 18.59% 5.91% -2.18% -4.54% 3.90% 1.66% 54.13% 12.73% -1.06% 14.81%

8/1/2007 9/4/2007 10/1/2007 11/1/2007 12/3/2007 1/2/2008 2/1/2008 3/3/2008 4/1/2008 5/1/2008 6/2/2008 7/1/2008 8/1/2008 9/2/2008 10/1/2008 11/3/2008 12/1/2008 1/2/2009 2/2/2009 3/2/2009 4/1/2009 5/1/2009

1473.99 1526.75 1549.38 1481.14 1468.36 1378.55 1330.63 1322.7 1385.59 1400.38 1280 1267.38 1282.83 1164.74 968.75 896.24 903.25 825.88 735.09 797.87 872.81 919.14

$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

79.91 93.15 89.15 90.56 92.64 77.70 64.47 71.30 78.63 81.62 73.33 76.34 80.81 72.76 57.24 42.70 51.28 58.82 64.79 73.44 80.52 77.99

1.29% 3.58% 1.48% -4.40% -0.86% -6.12% -3.48% -0.60% 4.75% 1.07% -8.60% -0.99% 1.22% -9.21% -16.83% -7.48% 0.78% -8.57% -10.99% 8.54% 9.39% 5.31%

1.74% 16.57% -4.29% 1.58% 2.30% -16.13% -17.03% 10.59% 10.28% 3.80% -10.16% 4.10% 5.86% -9.96% -21.33% -25.40% 20.09% 14.70% 10.15% 13.35% 9.64% -3.14%

Chapter 11 - Master it!

The CAPM is one of the most tested models in Finance. When beta is estimated in practice, a variation of CAPM called the maket model is often used. To derive the market model, we start with the CAPM: E(Ri ) = Rf + b [E(RM) - Rf ] Since CAPM is an equation, we can subtract the risk-free rate from both sides, which gives us: E(Ri ) - Rf = b [E(RM) - Rf ] This equation is deterministic, that is, exact. In a regression, we realize that there is some indeterminate error. We need to formally recognize this in the equation by adding epsilon, which represents this error: E(Ri ) - Rf = b [E(RM) - Rf ] + e Finally, think of the above equation in a regression. Since there is no intercept in the equation, the intercept is zero. However, when we estimate the regression equation, we can add an intercept term, which we will call alpha: E(Ri ) - Rf = ai + b [E(RM) - Rf ] + e This equation, known as the market model, is generally the model used for estimating beta. The intercept term is known as Jensen's alpha and represents the excess return. If CAPM holds exactly, this intercept should be zero. If you think of alpha in terms of the SML, if the alpha is positive, the stock plots above the SML and if alpha is negative, the stock plots below the SML.

a.

You want to estimate the market model for an individual stock and a mutual fund. First, go to finance.yahoo.com and download the adjusted prices for the last 61 months for an individual stock and a mutual fund, and the S&P 500. Next, go to the St. Louis Federal Reserve website at www.stlouisfed.org. You should find the FRED database on this website. Look for the 1-Month Treasury Constant Maturity Rate and download this data. This will be the proxy for the risk-free rate. When using this rate, you should be aware that this interest rate is the annual interest rate, while we are using monthly stock returns, so you will need to adjust the 1-month T-bill rate. For the stock and mutual fund you select, estimate the beta and alpha of the stock using the market model. When you estimate the regression model, find the box that says Residuals and check this box when you do each regression. Because you are saving the residuals, you may want to save the regression output in a new worksheet. 1) Are the alpha and beta for each regression statistically different from zero? 2) How do you interpret the alpha and beta for the stock and the mutual fund? 3) Which of the two regression estimates has the highest R squared? Is this what you would have expected? Why?

b.

In part a , you asked Excel to return the residuals of the regression, which is the epsilon in the regression equation. If you remember back to statistics, the residuals are the linear distance from each observation to the regression line. In this context, the residuals are the part of each monthly return that is not explained by the market model estimate. The residuals can be used to calculate the appraisal ratio, which is the alpha divided by the standard deviation of the residuals. 1) What do you think the appraisal ratio is intended to measure? 2) Calculate the appraisal ratio for the stock and the mutual fund. Which has a better appraisal ratio? 3) Often, the appraisal ratio is used to evaluate the performance of mutual fund managers. Why do you think the appraisal ratio is used more often for mutual funds, which are portfolios, than for individual stocks?

Master it! Solution

a.
Month/Year S&P 500 Stock price IBM Mutual fund price FMAGX Risk-free rate

S&P 500 return

Stock return

Mutual fund return

Market risk premium

Stock risk premium

Mutual fund risk premium