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Essentials of Investments (BKM 5th Ed.

Answers to Selected Problems – Lecture 6

Chapter 5:

14b. Time Cash flow Explanation

0 –300 Purchase of three shares at $100 each.
1 –208 Purchase of two shares at $110 less dividend income on three shares held.
2 110 Dividends on five shares plus sale of one share at price of $90 each.
3 396 Dividends on four shares plus sale of four shares at price of $95 each.

110 |
| |
Date: 1/1/96 1/1/97 1/1/98 1/1/99
| |
| |
| |
| 208

The Dollar-weighted return can be determined by doing an internal rate of return (IRR)
calculation. In other words, set the present value of the outflows equal to the present
value of the inflows (or the net present value to zero):

208 110 396

300 + = + = −0.001661 = −0.1661%
(1 + R) 1
(1 + R) 2
(1 + R) 3

Chapter 20:

3. b.

5. We need to distinguish between timing and selection abilities. The intercept of the scatter
diagram is a measure of stock selection ability. If the manager tends to have a positive
excess return even when the market’s performance is merely ‘neutral’ (i.e., has zero excess
return), then we conclude that the manager has on average made good stock picks – stock
selection must be the source of the positive excess returns.

Timing ability is indicated by curvature in the plotted line. Lines that become steeper as
you move to the right of the graph show good timing ability. An upward curved
relationship indicates that the portfolio was more sensitive to market moves when the
market was doing well and less sensitive to market moves when the market was doing
poorly -- this indicates good market timing skill. A downward curvature would indicate
poor market timing skill.

We can therefore classify performance ability for the four managers as follows:

Selection Ability Timing Ability

a. Bad Good
b. Good Good
c. Good Bad
d. Bad Bad

9. The manager’s alpha is:

10 - [6 + 0.5(14-6)] = 0

10. a) α(A) = 24 - [12 + 1.0(21-12)] = 3.0%

α(B) = 30 - [12 + 1.5(21-12)] = 4.5%
T(A) = (24 - 12)/1 = 12
T(B) = (30-12)/1.5 = 12

As an addition to a passive diversified portfolio, both A and B are candidates because

they both have positive alphas.

b) (i) The funds may have been trying to time the market. In that case, the SCL of the
funds may be non-linear (curved).

(ii) One year’s worth of data is too small a sample to make clear conclusions.

(iii) The funds may have significantly different levels of diversification. If both have
the same risk-adjusted return, the fund with the less diversified portfolio has a
higher exposure to risk because of its higher firm-specific risk. Since the above
measure adjusts only for systematic risk, it does not tell the entire story.

11. a) Indeed, the one year results were terrible, but one year is a short time period from which
to make clear conclusions. Also, the Board instructed the manager to give priority to long-
term results.

b) The sample pension funds had a much larger share in equities compared to Alpine’s.
Equities performed much better than bonds. Also, Alpine was told to hold down risk
investing at most 25% in equities. Alpine should not be held responsible for an asset
allocation policy dictated by the client.

c) Alpine’s alpha measures its risk-adjusted performance compared to the market’s:

α = 13.3 - [7.5 + 0.9(13.8 - 7.5)] = 0.13%, which is actually above zero!

d) Note that the last five years, especially the last one, have been bad for bonds – and
Alpine was encouraged to hold bonds. Within this asset class, Alpine did much better than
the index funds. Alpine’s performance within each asset class has been superior on a risk-
adjusted basis. Its disappointing performance overall was due to a heavy asset allocation
weighting toward bonds, which was the Board’s – not Alpine’s – choice.

e) A trustee may not care about the time-weighted return, but that return is more
indicative of the manager’s performance. After all, the manager has no control over the
cash inflow of the fund.