Fall 2019, Investment Analysis (FIN 756), Ravi Shukla

Exam 2
Friday, December 13, 2019
12:45 PM—2:45 PM
[100 Points]

Exam Policies

1 You have two hours (120 minutes) to answer this exam. The exam will be available on the
course Blackboard site at 12:45 PM in the item labeled Exam 2 in the Material tab. You should
download the exam to your desktop and then work on it. You must submit your solutions via
Blackboard by clicking on Exam 2 in the title by 2:50 PM.
2 You are being given an extra 5 minutes for downloading and uploading the exam. The
Blackboard interface will close at 2:50 PM. After that you will have to send me the exam by
email. You will be penalized 25 points for late submission. Late submissions will be acccpted
until 3:00 PM. Submissions received after 3:00 PM will be ignored.
3 Perform your calculations using this Excel spreadsheet only. You will also be given two
sheets of plain paper. You may use these sheets to write any intermediate answers,
explanations, etc. and turn it in to me at the end of the exam. Write your name in the box on
the top right of the sheets. Please write legibly and clearly indicate the problem and part for
which you are showing the work.
4 You may consult one 8-1/2" x 11" or A4 size paper with handwritten notes on both sides.
Consulting any other material (physical or electronic) is a violation of academic integrity.
5 By submitting your solutions to this exam, you certify that the solutions represent your own
work started and completed during the exam period, and without help from another person
or resource other than the sheet of handwritten notes.
6 Make sure that your answers are clearly labeled. Here is an example:

This example is only a suggestion. You may choose a different way to label or highlight your
answers. The important thing is that your answer should be clearly marked or labeled.
Name: Aashna Mehta
NetID: amehta06
Consider the following information for the risk-free security and two portfolios, X and Y:

E(r) s
Risk-free 2% 0%
X 10% 18%
Y 12% 26%

(a) [5 points] An investor is indifferent between the two portfolios. What is his risk aversion?

(b) [5 points] If the investor has to choose either X or Y to combine with the risk-free security,
which would be the right choice?

(c) [5 points] What will be the composition of the optimal combination of risk-free security and
the portfolio chosen in part (b)?

(d) [5 points] What are the expected return and standard deviation of return of this
combination?

(e) [5 points] What is the probability of loss for this combination?

a) risk aversion (A) 1.136364 (calculation on the sheet)

b) For X, slope = 0.444444444444444

For Y, slope = 0.384615384615385 Depending on the slope, X should ne the right choice

c) y* 2.17283881086442 217%

expected return of
d) combination 19.3827%
SD of combination 0.391110985955596

e) PoL 0.310095092287131 31.01%

z score -0.495580824444444
ope, X should ne the right choice
This problem is in the CAPM framework.

Suppose the market is made up only 5 stocks. Information about them is shown below:

Shares
Stock Beta P0 Outstanding
1 0.65 $29.75 300
2 1.32 $65.47 500
3 0.81 $16.95 900
4 0.92 $30.52 700
5 ? $18.74 800

(a) [10 points] What should be the beta of stock 5? If you don't know how to answer this part,
assume that the beta of stock 5 is 0.8.

The risk-free rate and the market risk-premium are as shown below

rf 2.00%
MRP 6.00%

These stocks pay dividends annually and the next dividend will be paid one year from now. Expected
value of dividends and the ex-dividend prices of the stocks are shown below.

Stock E(Div1) E(P1)

1 $0.40 $31.08
2 $1.57 $70.35
3 $0.90 $17.20
4 $0.95 $31.90
5 $0.72 $19.35

(b) [15 points] Is the market in equilibrium? Calculate equilibrium prices of the stocks to answer this
question. For the purposes of this question, a difference of up to five cents can be
considered negligible.
a) beta COV(R1,R2)/VAR(R2)

b) rf 2.00%
MRP 6.00%

equilibrium equilibrium
Stock E(Div1) E(P1) Beta expected return price Difference
1 $0.40 $31.08 0.65 5.900% $29.73 $1.35
2 $1.57 $70.35 1.32 9.920% $65.43 $4.92
3 $0.90 $17.20 0.81 6.860% $16.94 $0.26
4 $0.95 $31.90 0.92 7.520% $30.55 $1.35
5 $0.72 $19.35 0.8 6.800% $18.79 $0.56

No, the market is not in equilibrium

Statistics for the risk-free security, market portfolio and four securities are provided below:

E(r) s
Risk-free 2% 0%
Market 9% 14%

Security a b s(e) Stock Price

Stock1 0.50% 0.7 15% $30.25
Stock2 -0.30% 1.2 18% $73.52
Stock3 0.80% 0.3 17% $19.98
Stock 4 0.30% 0.5 14% $6.74

(a) [10 points] Find the weights of the optimal portfolio of these four stocks to be combined with
the risk-free security.

(b) [10 points] An investor with risk aversion parameter of 5 has $500,000 to invest. How many
shares of each stock should he buy? How much should he invest in the risk-free
security?

(b) [5 points] What is the investor's value at risk of from investing in the combination? Your
answer should be in dollars and cents.
Consider a factor model with three factors: interest rates (INT), GDP Growth (GDP) and
Unemployment (UE). Expected returns, sensitivities of five stocks to these factors and
standard devations of residual returns are shown below:

Stock E(r) bINT bGDP bUE s(e)

1 10.20% -0.20 1.30 0.60 12%
2 9.50% -0.30 0.80 1.50 15%
3 9.20% 0.10 -0.40 1.70 16%
4 8.20% -0.40 1.50 -0.30 13%
5 10.70% -0.20 3.10 0.80 11%

Create a portfolio that requires zero investment and has zero factor risk following
these steps.

(a) [5 points] Start with an equally weighted portfolio. Calculate the expected return,
betas and residual standard deviation of this portfolio.

(b) [15 points] Now use Solver to find the weights that minimize the residual standard
deviation of the portfolio subject to the constraints that all three betas
of the portfolio are zero and the sum of weights is zero. To avoid getting
the trivial solution where all the weights are zero, add a constraint that
the weight of stock 1 is 0.05. (The choice of stock and the weight are
arbitrary. I could have chosen any stock and set its weight to any
non-zero value.)

(b) [5 points] Is this an arbitrage portfolio? Explain.

 Stock w E(r) bINT bGDP bUE s(e) w^2
1 20.00% 10.20% -0.20 1.30 0.60 12% 1.4400%
2 20.00% 9.50% -0.30 0.80 1.50 15% 2.2500%
3 20.00% 9.20% 0.10 -0.40 1.70 16% 2.5600%
4 20.00% 8.20% -0.40 1.50 -0.30 13% 1.6900%
5 20.00% 10.70% -0.20 3.10 0.80 11% 1.2100%
100%

a) expected return 9.56%

bINT -0.2
bGDP 1.26
bUE 0.86
residual std dev 0.060498 0.00366

b) Stock w expected r 0.05%

1 5.00% bINT 0.00%
2 -0.10% bGDP 0.00%
3 -1.50% bUE 0.00%
4 -2.20% residual st 0.0052%
5 -1.20%
0%

It's an arbitrage
portfolio. This is
because it has
zero risk and
investment and
non zero expected
c) return
s^2(e)
4.00%
4.00%
4.00%
4.00%
4.00%
The table below shows the returns on the risk-free security, the market portfolio (S&P
500) and Vanguard Wellesely fund.

(a) [15 points) Calculate alpha, M-squared and T squared for the fund.

(b) [10 points] Is the manager of this portfolio skilled? Support your answer with a suitable
statistical test on alpha. Use a 5% level of significance (95% level of confidence).

If you do not know how to calculate sigma(e) of the portfolio, you may assume it to be
2%. I will deduct 2 points for this.

Month Risk-free Market Portfolio

Nov 2014 0.001% 2.69% 1.27%
Dec 2014 0.003% -0.25% -2.70%
Jan 2015 0.002% -3.00% 3.22%
Feb 2015 0.001% 5.75% 0.82%
Mar 2015 0.002% -1.58% -0.77%
Apr 2015 0.004% 0.96% 1.18%
May 2015 0.000% 1.29% -0.15%
Jun 2015 0.001% -1.94% -2.71%
Jul 2015 0.002% 2.10% 1.95%
Aug 2015 0.003% -6.03% -1.89%
Sep 2015 0.000% -2.47% -0.92%
Oct 2015 0.000% 8.44% 4.18%
Nov 2015 0.001% 0.30% 0.00%
Dec 2015 0.009% -1.58% -4.03%
Jan 2016 0.012% -4.96% 3.18%
Feb 2016 0.018% -0.13% 0.45%
Mar 2016 0.019% 6.78% 2.85%
Apr 2016 0.015% 0.39% 1.57%
May 2016 0.013% 1.80% 0.59%
Jun 2016 0.022% 0.26% 1.44%
Jul 2016 0.017% 3.69% 2.12%
Aug 2016 0.016% 0.14% 0.00%
Sep 2016 0.022% 0.02% -0.99%
Oct 2016 0.017% -1.82% -0.56%
Nov 2016 0.017% 3.70% -0.74%
Dec 2016 0.032% 1.98% -0.59%
Jan 2017 0.037% 1.90% 2.23%
Feb 2017 0.042% 3.97% 1.96%
Mar 2017 0.033% 0.12% -0.69%
Apr 2017 0.062% 1.03% 1.36%
May 2017 0.057% 1.41% 1.15%
Jun 2017 0.072% 0.62% -0.30%
Jul 2017 0.070% 2.06% 1.60%
Aug 2017 0.083% 0.31% 0.53%
Sep 2017 0.079% 2.06% 0.11%
Oct 2017 0.080% 2.33% 1.64%
Nov 2017 0.083% 3.07% 1.08%
Dec 2017 0.095% 1.11% -0.88%
Jan 2018 0.107% 5.73% 2.55%
Feb 2018 0.119% -3.69% -2.73%
Mar 2018 0.125% -2.54% -0.91%
Apr 2018 0.136% 0.38% 0.14%
May 2018 0.137% 2.41% 0.65%
Jun 2018 0.147% 0.62% -0.65%
Jul 2018 0.147% 3.72% 2.87%
Aug 2018 0.162% 3.26% 0.57%
Sep 2018 0.162% 0.57% -0.97%
Oct 2018 0.177% -6.83% -1.53%
Nov 2018 0.183% 2.04% 1.63%
Dec 2018 0.192% -9.03% -6.93%
Jan 2019 0.203% 8.01% 8.61%
Feb 2019 0.202% 3.21% 1.51%
Mar 2019 0.203% 1.94% 1.09%
Apr 2019 0.202% 4.05% 1.86%
May 2019 0.202% -6.35% -0.65%
Jun 2019 0.196% 7.05% 2.42%
Jul 2019 0.182% 1.44% 1.19%
Aug 2019 0.168% -1.58% 1.68%
Sep 2019 0.175% 1.87% -0.11%
Oct 2019 0.159% 2.17% 1.33%
 Month rP-rf rM-rf rP-rM=M^2
Nov 2014 1.27% 2.69% -1.42%
Dec 2014 -2.71% -0.26% -2.45%
Jan 2015 3.22% -3.00% 6.22%
Feb 2015 0.82% 5.75% -4.93%
Mar 2015 -0.77% -1.58% 0.81%
Apr 2015 1.18% 0.96% 0.22%
May 2015 -0.15% 1.29% -1.44%
Jun 2015 -2.71% -1.94% -0.78%
Jul 2015 1.95% 2.09% -0.14%
Aug 2015 -1.89% -6.04% 4.15%
Sep 2015 -0.92% -2.47% 1.55%
Oct 2015 4.18% 8.44% -4.25%
Nov 2015 0.00% 0.30% -0.30%
Dec 2015 -4.04% -1.59% -2.45%
Jan 2016 3.17% -4.97% 8.15%
Feb 2016 0.43% -0.15% 0.58%
Mar 2016 2.83% 6.76% -3.94%
Apr 2016 1.55% 0.37% 1.18%
May 2016 0.57% 1.78% -1.21%
Jun 2016 1.42% 0.24% 1.18%
Jul 2016 2.11% 3.67% -1.56%
Aug 2016 -0.02% 0.12% -0.14%
Sep 2016 -1.01% 0.00% -1.00%
Oct 2016 -0.57% -1.84% 1.27%
Nov 2016 -0.75% 3.69% -4.44%
Dec 2016 -0.62% 1.94% -2.56%
Jan 2017 2.19% 1.86% 0.33%
Feb 2017 1.92% 3.93% -2.01%
Mar 2017 -0.72% 0.08% -0.81%
Apr 2017 1.30% 0.97% 0.33%
May 2017 1.10% 1.35% -0.26%
Jun 2017 -0.38% 0.55% -0.93%
Jul 2017 1.53% 1.99% -0.45%
Aug 2017 0.45% 0.22% 0.22%
Sep 2017 0.03% 1.98% -1.95%
Oct 2017 1.56% 2.25% -0.70%
Nov 2017 1.00% 2.98% -1.99%
Dec 2017 -0.98% 1.02% -1.99%
Jan 2018 2.44% 5.62% -3.17%
Feb 2018 -2.85% -3.80% 0.96%
Mar 2018 -1.04% -2.67% 1.63%
Apr 2018 0.01% 0.25% -0.24%
May 2018 0.52% 2.27% -1.75%
Jun 2018 -0.80% 0.47% -1.27%
Jul 2018 2.72% 3.57% -0.85%
Aug 2018 0.40% 3.10% -2.69%
Sep 2018 -1.14% 0.41% -1.54%
Oct 2018 -1.71% -7.01% 5.30%
Nov 2018 1.44% 1.85% -0.41%
Dec 2018 -7.13% -9.22% 2.10%
Jan 2019 8.41% 7.81% 0.60%
Feb 2019 1.31% 3.01% -1.70%
Mar 2019 0.89% 1.74% -0.85%
Apr 2019 1.66% 3.85% -2.18%
May 2019 -0.85% -6.56% 5.71%
Jun 2019 2.23% 6.85% -4.62%
Jul 2019 1.01% 1.26% -0.24%
Aug 2019 1.51% -1.75% 3.27%
Sep 2019 -0.29% 1.70% -1.98%
Oct 2019 1.17% 2.01% -0.84%

(a) a 0.11%
b 0.42

(b) sP 2.16%
sM 3.44%
s(e) 1.60%
N 60
s(a) 0.21%
Sig level 5%
Deg of Frdm 58
t critical 1.67
t sample 0.51
Since t
sample < t
critical, we
accept the
null
hypothesis
that the
manager is
unskilled and
reject the
claim that the
manager is
skilled.