BA 443

Final practice questions and solutions

To prepare for the quantitative material for the final, please study these questions, in-class examples
and in-class questions.

Textbook questions and problems:

Chapter 18: Questions 2, 7, 8 (ignore the call feature, state two factors),
Problem 7, 9(a), 10 (a, b), 11(a), 12, Appendix Exhibit 18A.1
19: Problems 1, 3 (a, b), 4 (a, b), 6, 7
25: Problems 1, 7

Extra questions:
1. As a portfolio manager, you use a constant proportion (CPPI) strategy to rebalance your portfolio. The
portfolios are rebalanced once a year with m = 1.2. One client has target portfolio weights of 60% equity
and 40% cash. This client has $2 million invested at the start of the year. If in each of the next two years the
equity component has returns of 8% and 7%, respectively, and the cash component remains unchanged,
what is the value of the portfolio at the end of the second year? What would the value be with a buy-and-
hold strategy?

2. What is the return for the month for the following two portfolios?

Portfolio 1: Beginning value= $500,000; cash inflow at the start of the month = $25,000; Ending
value = $530,000
Portfolio 2: Beginning value= $500,000; cash inflow in day 10 of the month = $20,000; portfolio
value at day 10 = $519,000; cash inflow on day 25 = $5,000; portfolio value at day 25 = $529,000;
Portfolio value at the end of the month = $530,000. Portfolio values include cash inflows.

3. An analyst wants to evaluate Portfolio X, consisting entirely of U.S. common stocks, using both the
Treynor and Sharpe measures. The following table provides the average annual rate of return for Portfolio
X, the market portfolio (S&P 500) and U.S. T-bills during the past 8 years.

Avg. Return Std. Dev. Beta

Portfolio X 10% 18% 0.6

S&P 500 12% 13%
T-bills 6%

a. Calculate both the Treynor and Sharpe measure for Portfolio X and the market. Did Portfolio X
overperform or underperform based on each of the measures?

b. Why do we find conflicting results using the two measures?

4. Based on the information provided below, provide a complete evaluation of the performance of the
equity portfolio. The period of evaluation is one year. The ending portfolio value, including a $100,000
cash inflow at the end of the year was $1.2 million. The starting portfolio value was $1 million. The
portfolio’s standard deviation is 20% and the portfolio beta is 1.2.

The portfolio is currently equally invested in two sectors although it is benchmarked against a portfolio that
has an equal weighting in four sectors. The benchmark portfolio return over the past year was 8%. The
benchmark portfolio’s standard deviation is 25% and its beta is 1.3.

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The portfolio’s tracking error was 10%. The S&P 500 return over the year was 6% with a standard
deviation of 18% and the risk-free rate was 4.5%.

Weightings Returns
Sector Portfolio Benchmark Portfolio Benchmark
1 50% 25% 11% 8%
2 50% 25% 9% 7%
3 25% 10%
4 25% 7%

1. Comment on the firm’s composite performance by calculating its Treynor, Sharpe and Information
Ratios.

2. Using attribution analysis, how much of the manager’s value added was due to the difference in
sector weighting compared to the benchmark and how much of the value added was due to
security selection?

Solutions

Chapter 18 questions:

18.2

2. The most crucial assumption the investor makes is that cash flows will be received in full and
reinvested at the promised yield. This assumption is crucial because it is implicit in the
mathematical equation that solves for promised yield. If the assumption is not valid, an alternative
method must be used, or the calculations will yield invalid solutions.

18.7

7(a). Given that you expect interest rates to decline during the next six months, you should choose
bonds that will have the largest price increase, that is, bonds with long durations.

7(b). Case 1: Given a choice between bonds A and B, you should select bond B, since duration is
inversely related to both coupon and yield to maturity.

Case 2: Given a choice between bonds C and D, you should select bond C, since duration is
positively related to maturity and inversely related to coupon.

Case 3: Given a choice between bonds E and F, you should select bond F, since duration is
positively related to maturity and inversely related to yield to maturity.

18.8
You should select portfolio A because it has a longer duration (5.7 versus 4.9 years) and greater
convexity (125.18 versus 40.30), thereby offering greater price appreciation. Portfolio A is also
noncallable, therefore there is no danger of the bonds being called in by the issuer when interest
rates decline (as you expect they will).

Chapter 18 problems:

18.7

19 - 2
7. CFA Examination I (1993)
7(a). Modified duration is Macaulay duration divided by 1 plus the yield to maturity divided by the
number of coupons per year:

Macaulay duration
Modified duration 
Yield
1
k
Where k is the number of coupons per year. If the Macaulay duration is 10 years and the yield to
maturity is 8 percent, then modified duration equals 10/(1+ (.08/2)) = 9.62.

7(b). For option-free coupon bonds, modified duration is a better measure of the bond’s sensitivity to
changes in interest rates. Maturity considers only the final cash flow, while modified duration
includes other factors. These factors are the size of coupon payments, the timing of coupon
payments, and the level of interest rates (yield-to-maturity).

7(c). Modified duration increases as the coupon decreases. Modified duration decreases as maturity
decreases.
7(d). Convexity measures the rate of change in modified duration as yields change. Convexity refers to
the shape of the price-yield relationship and can be used to refine the modified duration
approximation of the sensitivity of prices to interest rate changes. Convexity shows the extent to
which bond prices rise at a greater rate (as yields fall) than they fall (as yields rise). The effect of
duration on price and the effect of convexity on price should be added together to obtain an
improved approximation of the change in price for a given change in yield.

18.9
9(a). If yield-to-maturity (YTM) on Bond B falls 75 basis points:
-75 basis points = -75/100 = -.75 in YTM
Pro.Price  = (-modified duration) ( inYTM)+ (l/2)(convexity)( in YTM)2
= (-6.8)(-.75) + (1/2)(.6)(.75)2
= 5.1+.16875
= 5.27

So the projected price will rise to $105.27 from its current $100 price.

18.10
10(a). Final Spot Rate:
70 70 70 70 1070
1000 = + + + +
(1 + y1)1 (1 + y2)2 (1 + y3)3 (1 + y4)4 (1 + y5)5
70 70 70 70 1070
1000 = + + + +
(1.05)1 (1.0521)2 (1.0605)3 (1.0716)4 (1 + y5)5
1000 = 66.67 + 63.24 + 58.69 + 53.08 + 1070/ (1 + y5)5

1000 - 241.68 = 1070/(1 + y5)5

758.32 = 1070/(1 + y5)5

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 (1 + y5)5 = 1070/758.32
y5 = (1.411)1/5 – 1 = 7.13%
Final Forward Rate:
(1.0713)5 _ 1 = 1.411 _ 1 = 1.0699 - 1 = 7.00%
(1.0716)4 1.3187

10(b). Yield-to-maturity is a single discounting rate for a series of cash flows to equate these flows to a
current price. It is the internal rate of return.
Spot rates are the unique set of individual discounting rates for each period. They are used to
discount each cash flow to equate to a current price. Spot rates are the theoretical rates for zero
coupon bonds.
Spot rates can be determined from a series of yields-to-maturity in an internally consistent method
such that the cash flows from coupons and principal will be discounted individually to equate to
the series of yield-to-maturity rates.
Yield-to-maturity is not unique for any particular maturity, whereas spot rates and forward rates
are unique.
Forward rates are the implicit rates that link any two spot rates. They are a unique set of rates that
represent the marginal interest rate in a future period. They are directly related to spot rates, and
therefore yield-to-maturity. Some would argue (expectations theory) that forward rates are the
market expectations of future interest rates. Regardless, forward rates represent a break-even or
rate of indifference that link two spot rates. It is important to note that forward rates link spot rates,
not yield-to-maturity rates.

18.11

11(a). Calculation of One-Year Forward Rate for January 1, 1996:

Date Calculation of Forward Rate

1/1/93 3.5%
1/1/94 (1.045)2 = (1.035) (1 + f)
f = 0.0551 or 5.51%
1/1/95 (1.05)3 = (1.035) x (1.0551) x (1 + f)
f = 0.0601 or 6.01%
1/1/96 (1.055)4 = (1.035) x (1.0551) x (1.0601) x (1 + f)
f = 0.0701 or 7.01%

18.12
12(a). Current yield = Annual dollar coupon interest / Price = 70/960 = 7.3%.

The annual yield to maturity (YTM) is

n C M
P=  +
t=1
(1 + y)t (1 + y)n

where: P = price of the bond

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 C = semiannual coupon
M = maturity value
n = number of periods, and
y = semiannual yield to maturity.
That is,
10 35 1000
960 =  +
t=1
(1 + y)t (1 + y)10
y = 4.0% semiannual return, YTM=8% per year.
Horizon yield (also called total return) accounts for coupon interest, interest on interest, and
proceeds from sale of the bond.
1. Coupon interest + interest on interest

(1 + r)n - 1
= C
r
where: C = semiannual coupon
r = semiannual reinvestment rate, and
n = number of periods
That is,
(1.03)6 - 1
=35 = 226.39
0.03
2. Projected sale price at the end of three years is $1,000 because bonds that yield the required
rate of return always sell at par
3. Sum the results of Steps 1 and 2 to obtain $1.226.39.

4. Semiannual total return =

1/6
1226.39
-1 = 4.166%
960

5. Double the interest rate found in Step 4 for the annual total rate of return of
8.33
percent.
12(b). The shortcomings of the yield measures are as follows: (l) Current yield does not account for
interest on interest (compounding) or changes in bond price during the holding period. It also does not
allow for a gain or loss from a bond purchased at a discount or premium. (2) Yield to maturity assumes
that the bond is held to maturity and that all coupon interest can be reinvested at the yield-to-maturity
rate. Because yields change constantly, that assumption is incorrect. However, yield to maturity is the
industry standard for comparing one bond with another. (3) Total return (as calculated) assumes that all
coupons can be invested at a constant reinvestment rate and requires assumptions about holding period,
reinvestment rate, and yield on the bond at the end of the investor's holding period. Although it is a
more complete measure of return, it is only as accurate as its inputs.

Chapter 19 problems

19 - 5
19.1

1. Modified duration = 7/(1 + .10/2) = 6.67 years. We divide the market interest rate by two as most
U.S.-based bonds pay interest twice a year.

Percentage change in portfolio = +2 x -6.67 = -13.34 percent

Value of portfolio = $50 million x (1 - .1334) = $43.33 million

19.3

3(a). Computation of Duration (assuming 10% market yield)

(1) (2) (3) (4) (5) (6)

Year Cash Flow PV@10% PVof Flow PV as % of Price (1) x (5)
1 120 .9091 109.09 .1014 .1014
2 120 .8264 99.17 .0922 .1844
3 120 .7513 90.16 .0838 .2514
4 120 .6830 81.96 .0762 .3047
5 1120 .6209 695.41 .6464 3.2321
1075.79 1.0000 4.0740

Duration = 4.07 years

3(b). Computation of Duration (assuming 10% market yield)

(1) (2) (3) (4) (5) (6)

Year Cash Flow PV@10% PVof Flow PV as % of Price (1) x (5)
1 120 .9091 109.09 .1026 .1026
2 120 .8264 99.17 .0933 .1866
3 120 .7513 90.16 .0848 .2544
4 1120 .6830 764.96 .7194 2.8776
1063.38 1.0000 3.4212
Duration = 3.42 years

19.4

4(a). Computation of Duration (assuming 8% market yield)

(1) (2) (3) (4) (5) (6)

Year Cash Flow PV@8% PVof Flow PV as % of Price (1) x (5)
1 100 .9259 92.59 .0868 .0868
2 100 .8573 85.73 .0804 .1608
3 100 .7938 79.38 .0745 .2234
4 1100 .7350 808.50 .7583 3.0332
1066.24 1.0000 3.5042
Duration = 3.5 years

4(b). Computation of Duration (assuming 12% market yield)

(1) (2) (3) (4) (5) (6)

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 Year Cash Flow PV@12% PV of Flow PV as % of Price (1) x (5)
1 100 .8929 89.29 .0951 .0951
2 100 .7972 79.72 .0849 .1698
3 100 .7118 71.18 .0758 .2274
4 1100 .6355 699.05 .7442 2.9768
939.24 1.0000 3.4691
Duration = 3.47 years

19.6.
CURRENT CANDIDATE
BOND BOND
Dollar Investment 839.54 961.16
Coupon 90.00 110.00
i on One Coupon 2.59 3.16
Principal Value at Year End 841.95 961.71
Total Accrued 934.54 1,074.87
Realized Compound Yield 11.0125 11.4999

RCY = [SQRT (Total Accrued/Dollar Investment)-1] x 2

Value of swap: 48.6 basis points in one year

P0 = 45 x (16.04612) + 1,000 x (.11746) = 839.54

P0 = 55 x (15.53300) + 1,000 x (.10685) = 961.16
P0 = 45 x (15.80474) + 1,000 x (.13074) = 841.95
P0 = 55 x (15.31315) + 1,000 x (.11949) = 961.71

where:
16.04612 is the PVA factor and .11746 is the PV factor, both for 40 periods at 5.5 percent per period.

15.53300 is the PVA factor and .10685 is the PV factor, both for 40 periods at 5.75 percent per
period.
15.80474 is the PVA factor and .13074 is the PV factor, both for 38 periods at 5.5 percent per
period.
15.31315 is the PVA factor and .11949 is the PV factor, both for 38 periods at 5.75 percent per
period.

19.7 CURRENT CANDIDATE

BOND BOND
Dollar Investment 868.21 849.09
Coupon 90.00 90.00
i on One Coupon 2.36 2.36
Principal Value at Year End 869.40 869.40
Total Accrued 961.76 961.76
Total Gain 93.55 112.67
Gain per Invested Dollar .10775 .12370
Realized Compound Yield 10.50 12.856

RCY = [SQRT (Total Accrued/Dollar Investment)-1] x 2

Value of swap: 235.7 basis points in one year

19 - 7
 P0 = 45 x (17.57281) + 1,000 x (.07743) = 868.21
P0 = 45 x (17.24714) + 1,000 x (.07297) = 849.09
P0 = 45 x (17.41389) + 1,000 x (.08577) = 869.40

where:
17.57281 is the PVA factor and .07743 is the PV factor, both for 50 periods at 5.25 percent per
period.

17.24714 is the PVA factor and .07297 is the PV factor, both for 50 periods at 5.375 percent per
period.

17.41389 is the PVA factor and .08577 is the PV factor, both for 48 periods at 5.25 percent per
period.

Chapter 25 problems

25.1

1(a).
.15  .07 .08
SP    1.60
0.05 .05
.20  .07 .13
SQ    1.30
.10 .10
.10  .07 .03
SR    1.00
.03 .03
.17  .07 .10
SS    1.67
.06 .06
.13  .07 .06
Market    1.50
.04 .04
1(b).
.15  .07 .08
TP    .0800
1.00 1.00
.20  .07 .13
TQ    .0867
1.50 1.50
.10  .07 .03
TR    .0500
.60 .60
.17  .07 .10
TS    .0909
1.10 1.10
.13  .07 .06
Market    .0600
1.00 1.00

Sharpe Treynor

P 2 3
Q 4 2

19 - 8
 R 5 5
S 1 1
Market 3 4

1(c). It is apparent from the rankings above that Portfolio Q was poorly diversified since Treynor
ranked it #2 and Sharpe ranked it #4. Otherwise, the rankings are similar.

25-7

7(a)(i). .6(-5) + .3(-3.5) + .1(0.3) = -4.02%

7(a)(ii). .5(-4) + .2(-2.5) + .3(0.3) = -2.41%

7(a)(iii). .3(-5) + .4(-3.5) + .3(0.3) = -2.81%

Manager A outperformed the benchmark fund by 161 basis points while Manager B beat the
benchmark fund by 121 basis points.

7(b)(i). [.5(-4 + 5) + .2(-2.5 + 3.5) + .3(.3 -.3)] = 0.70%

7(b)(ii). [(.3 - .6) (-5 + 4.02) + (.4 - .3) (-3.5 + 4.02) + (.3 -.1)(.3 + 4.02)] = 1.21%

Manager A added value through her selection skills (70 of 161 basis points) and her allocation
skills (71 of 161 basis points). Manager B added value totally through his allocation skills (121 of
121 basis points).

Extra question solutions:

1.

Constant Proportion strategy:

Initial allocations:

Investment in equity = 1.2 (2M – 0.8M) = 1.44M

Therefore the initial cash allocation will be 2M – 1.44M = 0.56M

Portfolio value at the end of the year:

1.44M * 1.08 = 1,555,200 + 560,000 = 2,115,200

The portfolio is rebalanced at this time:

Investment in equity = 1.2 (2,115,200 – 800,000) = 1,578,240

This means that an additional 23,040 of equity will be purchased (cash balance reduced to
536,960)

Portfolio value at the end of the 2nd year:

1,578,240 * 1.07 + 536,960 = 2,225,676.80

Buy-and-hold: Since this is a do-nothing strategy our equity value will grow to :

19 - 9
 1,200,000 * 1.08 * 1.07 = 1,386,720

Portfolio value at the end of the second year will be: 1,386,720 + 800,000 = 2,186,720.

2.

Portfolio 1: (530000 – (500000 + 25000)) / (500000 + 25000) = 0.9524%

Portfolio 2: Using time-weighted returns:

Return for the first 10 days:

((519000 – 20000) – 500000 ) / 500000 =-0.2%

Return for days 11-25:

((529000 – 5000) – 519000) / 519000 = 0.963%

Return for days 26 – end of month:

(530000 – 529000) / 529000 = 0.189%

Return for the month: (1-0.002)(1+0.00963)(1+0.00189) – 1 = 0.9515%

3.

a. The Treynor measure (T) relates the rate of return earned above the risk-free rate to the portfolio beta
during the period under consideration. Therefore, the Treynor measure shows the risk premium
(excess return) earned per unit of systematic risk:
Ri- Rf
Ti =
i

where: Ri = average rate of return for portfolio i during the specified period
Rf = average rate of return- on a risk-free investment during the specified period
i = beta of portfolio i during the specified period.

Treynor Measure Performance Relative to the Market (S&P 500)

10% - 6%
T= = 6.7% Outperformed
0.60

Market (S&P 500)

12% - 6%
TM = = 6.0%
1.00
The Treynor measure examines portfolio performance in relation to the security market line
(SML). Because the portfolio would plot above the SML, it outperformed the S&P 500 Index.
Because T was greater than TM, 6.7 percent versus 6.0 percent, respectively, the portfolio clearly
outperformed the market index.

19 - 10
 The Sharpe measure (S) relates the rate of return earned above the risk free rate to the total risk of
a portfolio by including the standard deviation of returns. Therefore, the Sharpe measure indicates
the risk premium (excess return) per unit of total risk:
Ri - Rf
S=
i
where: Ri = average rate of return for portfolio i during the specified period
Rf = average rate of return on a risk-free investment during the specified period
i = standard deviation of the rate of return for portfolio i during the specified
period.

Sharpe Measure Performance Relative to the Market (S&P 500)

10% - 6%
S= = 0.222% Underperformed
18%

Market (S&P 500)

12% - 6%
SM= = 0.462%
13%

The Sharpe measure uses total risk to compare portfolios with the capital market line (CML). The
portfolio would plot below the CML, indicating that it underperformed the market. Because S was
less than SM, 0.222 versus 0.462, respectively, the portfolio underperformed the market. I

b. The Treynor measure assumes that the appropriate risk measure for a portfolio is its systematic
risk, or beta. Hence, the Treynor measure implicitly assumes that the portfolio being measured is
fully diversified. The Sharpe measure is similar to the Treynor measure except that the excess
return on a portfolio is divided by the standard deviation of the portfolio.

For perfectly diversified portfolios (that is, those without any unsystematic or specific risk), the
Treynor and Sharpe measures would give consistent results relative to the market index because
the total variance of the portfolio would be the same as its systematic variance (beta). A poorly
diversified portfolio could show better performance relative to the market if the Treynor measure
is used but lower performance relative to the market if the Sharpe measure is used. Any difference
between the two measures relative to the markets would come directly from a difference in
diversification.

In particular, Portfolio X outperformed the market if measured by the Treynor measure but did not
perform as well as the market using the Sharpe measure. The reason is that Portfolio X has a large
amount of unsystematic risk. Such risk is not a factor in determining the value of the Treynor
measure for the portfolio, because the Treynor measure considers only systematic risk. The Sharpe
measure, however, considers total risk (that is, both systematic and unsystematic risk). Portfolio X,
which has a low amount of systematic risk, could have a high amount of total risk, because of its
lack of diversification. Hence, Portfolio X would have a high Treynor measure (because of low
systematic risk) and a low Sharpe measure (because of high total risk).

4.

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Since the portfolio cash flow occurs at the end of the year, it should not be included in the calculation of
return:

Portfolio return = ((1.2m – 0.1m) – 1m ) / 1m = 10%

The Treynor and Sharpe ratios are:

Portfolio Treynor: (10 – 4.5) / 1.2 = 4.58
Sharpe: (10 – 4.5) / 20 = 0.28

Benchmark Treynor: (8 – 4.5) / 1.3 = 2.69

Sharpe: (8 – 4.5) / 25 = 0.14

Market Treynor: (6 – 4.5) / 1 = 1.5

Sharpe: (6 – 4.5) / 18 = 0.08

The portfolio outperformed the benchmark and the market based on both the Treynor and the
Sharpe ratios.

Information Ratio: The tracking error for the portfolio represents the standard deviation of the
excess return so:

IR = (10 – 8) / 10 = 0.2

A positive number indicates that the portfolio outperformed the benchmark.

2. The value added return for the portfolio was: 10 – 8 = 2%

The allocation effect is:

(0.5 – 0.25)(8 – 8) + (0.5 – 0.25)(7-8) + (0 – 0.25)(10-8) + (0-0.25)(7-8) = -0.5%

The selection effect is:

0.5 * (10 – 8) + 0.5 * (9-7) = 2.5%

The selection and allocation effects equal the value added, so the calculations appear to be correct.

19 - 12