FIN320: Investments and Security Markets Spring 2017

FIN320: Investments and Security Markets Spring 2017

Question

This assignment is due in hard copy at the beginning of class

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markets-spring-2017
FIN320: Investments and Security Markets Spring 2017

Question

This assignment is due in hard copy at the beginning of class (in the section in which you are
enrolled) on
Tuesday, February 14. Collaboration is allowed, and you may work on this assignment in
groups of up to
three students. Please only collaborate with students from your own section, and hand in a
single
solution for your group with all members’ names on it. You must hand in your Excel output,
which must
be formatted for printing and have a professional appearance. No screen shots! Instructions
You will use Excel to plot an efficient portfolio frontier and a CML, for a 5-asset portfolio. You will
do this
by using the Solver function, which performs constrained optimization. Step-by-step instructions
are below.
Generally, solver maximizes or minimizes the value in a target cell, by changing a set of
allowable cells until
the optimization is achieved. Further, this optimization can be made subject to certain
constraints.
The spreadsheet on Blackboard contains data for five industry portfolios and the risk-free rate.
All units
are in percentage points per month. I used .csv format for the dataset to avoid compatibility
problems
among different versions of Excel. Be sure to save your work in Excel format (.xls or .xlsx), or
your formulas and graphs will be lost!
First, you will set up cells for the portfolio mean and portfolio standard deviation. With many
assets, it
is useful to employ matrix multiplication to do this.
1. Cells A29–E29 contain the portfolio weights, which for now are all .2 (i.e. each asset gets
equal weight).
This is a 1×n row-vector of weights T . In cell G29, construct the sum of the weights, using the
function
=SUM.
2. Set up a cell for the portfolio expected return. This is can be written as T µ0 , where µ is the
row vector

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of individual asset expected returns in A3–E3. To compute this, type into the cell which you
want
to contain this value =MMULT(A29:E29,TRANSPOSE(A3:E3)). Be sure to hit Ctrl-shift-enter
after
typing this, to make Excel understand that it is dealing with vectors and matrices.
3. Set up a cell for the portfolio variance. This can be written as T V T 0 where V is the
covariance
matrix for your assets, set up in B18–F22. To compute this, type into the cell which you want to
contain this value =MMULT(MMULT(A29:E29,B18:F22),TRANSPOSE(A29:E29)). Again, be
sure
to hit Ctrl-shift-enter.
4. Set up a cell for portfolio standard deviation, computed as square root of portfolio variance.
5. Set up a cell for the Sharpe Ratio.
6. Set up a graph, and plot the five individual industry portfolios in a space that has Expected
Return
on the vertical and Standard Deviation on the horizontal axis. Use an X-Y scatter plot for this,
and
be sure to select the plot type that does not join the points with a line for this series.
1 7. Now use solver to plot the minimum variance portfolio, the efficient portfolio frontier, and the
CML.
To do this, click on Tools and open up Solver (install the add-in if you cannot find it in the menu.
Using the most recent version of excel go to help and search for solver. Follow the directions
under
Load the Solver Add-in. Once it is loaded it is located under the data tab). Skip the target cell for
now and enter your portfolio weights as the cells that need to be changed. Also, enter a
constraint
that the weights need to sum to 1 (i.e. constrain the cell that contains the sum of the weights to
equal
1).
Note: Solver has a check box to constrain the obtained solution to be positive. This would
prevent
short selling. You do not want this option checked (i.e. you want to allow short selling).
(a) First, plot the efficient portfolio frontier. To do this, stipulate various levels of expected return,
and minimize portfolio standard deviation for each. This means your target cell will be your
portfolio standard deviation, and you will want to minimize it. Then add a constraint that sets
the portfolio return equal to that of your lowest-yielding asset. Click solve. This will change the
weights, the portfolio variance and standard deviation, as well as the portfolio expected return in
your spreadsheet. Copy the current set of weights as well as the portfolio standard deviation
and
expected return and paste them as values underneath, so you have them recorded. This is the
first point on your efficient portfolio frontier.
Go back to solver and increment the value to which the portfolio expected return is constrained
by a small amount. Click solve again. This will give you a new set of weights, portfolio standard
deviation, and portfolio expected return. Record these again. This is the next point on your
efficient portfolio frontier. Keep doing this until you get to setting the portfolio expected return
equal to that of your highest-yielding asset. Do about 20 solver runs in between.
Plot the combinations of expected returns and standard deviations on the same graph as your
individual portfolios, as a new series. This time, link these points with a line.
(b) Plot the minimum variance portfolio. To accomplish this, eliminate the constraint which sets
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 portfolio expected return equal to a specific value and re-run solver. This way you are
computing
the unconditional minimum standard deviation. Record the resulting weights, expected return,
and standard deviation, and plot the latter two on the graph as a new series.
(c) Finally, plot the tangency portfolio and the CML. To do this, change your target cell to the
cell containing your Sharpe Ratio, and instruct Solver to maximize this cell. You do not need
any expected-return constraints here. To plot your CML, construct the following sets of points
(i.e. E/S combinations): one consisting of a zero allocation to the tangency portfolio and a 100%
allocation to the risk-free asset, one consisting of a 100% allocation to the tangency portfolio
and a
zero allocation to the risk-free asset, and one consisting of a –100% allocation to the risk-free
asset
and a 200% allocation to the tangency portfolio. You should be able to set these up by simply
using the methodology discussed in class. To do this, think about how the CML is
parameterized
by the portfolio allocation between risky and risk-free asset. Plot the CML as an additional series
on the same graph.
If the tangency point for the CML lies beyond the portion of the efficient portfolio frontier which
you plotted, consider plotting more points, beyond the expected return of the highest-yielding
asset to show tangency. This last part, however, is optional.
(d) Make sure your graph is well-labeled and has a legend. Excel can generate all of this for
you. Do
not do this by hand after printing.
(e) Submit, in addition to the graph, that portion of your spreadsheet that contains the numbers
you
plotted for your efficient portfolio frontier, as well as those for the MVP and the three points of
the CML. 2

FIN320: Investments and Security Markets Spring 2017

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