Investment Science AMA532, S2, 2014/15, Assignment Two

Hand in your solutions to questions 2,5,7,9,11,15,18 and 19 by 6:30pm, 14 April. This is

worth 4% towards your final course mark. Late submissions may not be marked, and if
marked will receive reduced or zero credit.
1. You need to download an excel file under /Evaluation Tools/Assignments at
http://webct2.polyu.edu.hk/webct/public/home.pl
In the excel file, there are two sheets dataset1 and dataset2. The sheet dataset1
provides some examples how to use excel. However you may find the help in the
excel software will be much more useful, where you can learn how to calculate, such as
covariance, transpose and inverse and matrix multiplication.
The sheet dataset2 contains the data of daily closing prices (pij ) of 15 assets from
1/2/2005 to 30/6/2005, which are needed to do this question.
You need to use the data in dataset2 and excel to do this question.
Assume that the investment period T = 22. Normalize the data in the sheet dataset2
to obtain the rates of return by the formula
pi,j+T pi,j
Oij =
, i = 1, , 15, j = 1, 2, , K.
pi,j
For example, when i = 1, j = 1, p1,1 = 71 of the date 1/2/2005 and p1,23 = 71.25 of the
date 23/2/2005, O11 = 0.0035211. The rates of return for the period from 1/2/2005 to
23/2/2005, a 15 86 matrix (here K = 86), are obtained. Thus the expected rates of
return and the covariance matrix of 15 assets can be calculated.
(a) Find the minimum-variance portfolio, what is in this case? and
(b) Find the optimal portfolio with r = 0.06. and what are and ?
Hand in the computer printing out including the original data, means, covariance
matrix etc. Present your answers upto 4 decimal points.
2. (Bounds on returns) Consider a universe of just three securities. They have expected
rates of return of 20%, 30%, and 40%, respectively. Two portfolios are known as to lie
on the minimum-variance set. They are defined by the portfolio weights

0.3
0.5

w = 0.4 , v = 0.8 .
0.3
0.3

It is known that the market portfolio is efficient.

(a) Given this information, what are the minimum and maximum possible values for
the expected rate of return on the market portfolio?
(b) Now suppose you are told that v represents the minimum-variance portfolio. Does
this change your answers to part (a)?
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3. (Capital market line) Assume that the expected rate of return on the market portfolio
is 15% and the rate of return on T -bills (risk-free rate) is 4%. The standard deviation
of the market is 20%. Assume that the market portfolio is efficient.
(a) What is the equation of the capital market line?
(b) (i) If an expected return of 20% is desired, what is the standard deviation of this
position? (ii) If you have $1,000 to invest, how should you allocate it to achieve the
above position?
(c) If you invest $400 in the risk-free asset and $600 in the market portfolio, how much
money should you expect to have at the end of the year?
4. Assume that the following assets are correctly priced according to the security market
line. Derive the security market line. What is the expected return on an asset with a
Beta of 3?
r1 = 6%, 1 = 0.5,
r2 = 12%,

2 = 1.5.

5. In Simpleland there are only two risk stocks A and B, whose details are listed below.

Stock A
Stock B

Number of shares
Price
outstanding
per share
500
$10.00
500
$5.00

Expected
rate of return
50%
30%

Standard deviation
of return
10%
8%

Furthermore, the correlation coefficient between the returns of stocks A and B is AB =

1
. There is also a risk-free asset, and Simpleland satisfies the CAPM exactly.
3
(a) What is the expected rate of return of the market portfolio?
(b) What is the standard deviation of the market portfolio?
(c) What is the beta of stock A?
(d) What is the risk-free rate in Simpleland?
6. Election Wizards, Inc. (EWI) has a new idea for producing TV sets, and it is planning
to enter the development stage. Once the product is developed (which will be at the end
of 1 year), the company expects to sell its new process for a price p, with expected value
p = $24M. However, this sale price will depend on the market for TV sets at the time.
By examing the stock histories of various TV companies, it is determined that the final
2
sales price p is correlated with the market return as E[(p p)(rM rM )] = $20MM
.

To develop the process, EWI must invest in a research and development project. The
cost c of this project will be known shortly after the project is begun (when a technical
uncertainty will be resolved). The current estimate is that the cost will be either
c = $20M or c = $16M, and each of these is equally likely. (This uncertainty is
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uncorrelated with the final price and is also uncorrelated with the market.) Assume
that the risk-free rate is rf = 9% and the expected return on the market is rM = 33%.
(a) What is the expected rate of return of this project?
(b) What is the beta of this project?


Hint: In this case, note that E



p p
1
(rM rM ) = E
E[(p p)(rM rM )].
c
c


 

(c) Is this an acceptable project based on a CAPM criterion? In particular, what is

the excess rate of return (+ or ) above the return predicted by the CAPM?
7. Someone who believes that the collection of all stocks satisfies a single-factor model
with the market portfolio serving as the factor. The table below gives you information
on three stocks which make up a portfolio.
Standard deviation
Beta of random error term Weight in portfolio
Stock A 2.50
8.0%
20%
Stock B 0.90
2.0%
50%
Stock C 1.20
3.0%
30%
In addition, you know that the market portfolio has an expected rate of return of 15%
and a standard deviation of 20%. The risk-free rate is 6%.
(a) What is the portfolios expected rate of return?
(b) Assuming the factor model is accurate, what is the standard deviation of this rate
of return?
8. Write the CAPM shown below in price form
ri = 0.03 + 0.20i .
9. Stock X has an expected return of 5.5% and a risk of = 0.7. Stock Y has an expected
return of 16% and a risk of = 2. The markets expected return is 8%, and rf = 3%.
(a) What are the Jensen values of stocks X and Y? Draw these values on the (, r)space.
(b) According to the CAPM, which stock is a better buy?
10. Two stocks are believed to satisfy the two-factor model
r1 = a1 + 2f1 + f2 ,

r2 = a2 + 3f1 + 4f2 .

In addition, there is a risk-free asset with a rate of return of 5%. It is known that
r1 = 12% and r2 = 16%. What are the values of 0 , 1 and 2 for this model?
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11. (a) Three widely diversified portfolios are shown in the following table.
Portfolio Expected return
A
18
B
14
C
10

bi1
1.0
2.5
0.8

bi2
0.8
1.0
0.2

Find the APT model.

(b) Based on the data specified from (a), there is a portfolio named D constructed by
placing 1/3 of the funds in portfolio A, 1/3 of the funds in portfolio B, and 1/3 of the
funds in portfolio C. Another portfolio is given by
Portfolio Expected return
E
15

bi1
1.4333

bi2
0.6667

Compare the portfolios D and E.

(c) To make $3 profit from arbitraging D and E, how much amount of funds one need
to buy E and sell D short? Present the solution also in table form.
12. A record of annual percentage rates of return of the stock S is shown below.
Month
1
2
3
4
5
6
7
8
9
10
11
12

Percent rate of return

2.0
1.5
.5
3.2
3.7
3
2.1
3.1
2.7
.4
1.4
2.2

Month
13
14
15
16
17
18
19
20
21
22
23
24

Percent rate of return

3.2
1.5
3.5
3.1
2.7
2.7
4.2
1.4
1.7
2.9
2.9
2.1

(a) Estimate the arithmetic mean rate of return, expressed in percent per year.
(b) Estimate the arithmetic standard deviation of these returns, again as percent per
year.
(c) Estimate the accuracy of the estimates found in parts (a) and (b).
(d) How do you think the answers to (c) would change if you had 2 years of weekly
data instead of monthly data?
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13. (HSI) Historical data of closing prices for three stocks and one index in 2005 are shown
in table below.
Year HSBC HSB Cheung Kong
Jul
120
107
80
Aug
122
109
78
Sept
119
106
76
Oct
123
109
79
Nov
124
110
81
Dec
118
107
80

HSI
15
16
15
16
17
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Consider the single factor model: ri = ai + bi f + i . Calculate the following quantities:

A. the average return on each stock and the index.
B. the sample variance of each stock and the index.
C. the correlation between the stock and the index.
D. bi for each stock.
E. ai for each stock.
F. the variance of the error for each stock.
Check if the single factor model is accurate.
14. An investor has utility function U(x) = x1/3 + 1 for salary. He has a new job which
pays $100,000 with a bonus. The bonus will be $0, $10,000, $20,000, $30,000, $40,000,
or $50,000, each with equal probability. What is the certainty equivalent of this job
offer?
15. Let U(x) be a utility function. The Arrow-Pratt relative risk aversion coefficient is
defined by
xU 00(x)
.
(x) = 0
U (x)
Show that the utility functions U(x) = ln x and U(x) = x have constant relative risk
aversion coefficients.
16. Let U(x) = ax 21 bx2, x a/b, where a > 0 and b 0 be a concave utility function.
Show that the mean-variance optimization problem is equivalent to the maximization
of the expected utility of quadratic concave function U(x).

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17. Consider the following two investments:

Investment A

Investment B

Outcome Probability Outcome Probability

4
2/5
5
1/2
12
1/5
10
1/4
14
2/5
12
1/4
(a) Which is preferred if the utility function is U(x) = 2x .04x2 ?

(b) In investment B, the probability of a $5 return is 1/2 and the probability of $10
return is 1/4. What values would these probabilities have to change to so that the
investor is indifferent between investments A and B?

18. Suppose the utility function is U(x) = x.

(a) What is the utility at wealth levels $50,000 and $150,000?
(b) What is the expected utility for a simple prospect with two wealth levels in (a)
and half-half opportunity?
(c) What is the certainty equivalent of the risky prospect?
(d) Does this utility function also display risk aversion?
(e) Does this utility function display more or less risk aversion than the log utility
function?
19. An investor is considering to organize a forum to exhibit an education product on the
coming Sunday. The success of the event depends on the weather condition on that
day which could be one of the following three possibilities: Good (G), Moderate (M),
and Raining (R). The returns and probabilities together with a risk-free opportunity
(e.g. deposit money in a bank) are given below

G
M
R
Risk free

Return Probability
4.0
.4
1.0
.4
2.0
.2
1.2
1.0

The investors utility function is U(x) = ln x. Find the optimal portfolio.

20. Repeat Question ?? with the following data.

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G
M
R
Risk free

Return Probability
5.0
.3
3.0
.3
1.0
.4
1.3
1.0

21. (a) There are three investment opportunities in the film venture shown below.
Returns of
Returns of
Returns of
the
the risk-free the residual
Event
film venture alternative
rights
High success
3.0
1.2
6.0
Moderate success
1.0
1.2
0
Failure
0.0
1.2
0
Find the state prices.
(b) In addition to the three investment in (a), the promoter of the film venture offers a
new investment designed to attract reluctant investors. One unit of this new investment
has a payoff of $3,000 if the venture is highly successful, and it refunds the original
investment otherwise. What is the price of this money-back guaranteed investment
between the film venture and the risk-free asset?

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