Andrew Kane

On my honor, I have neither solicited nor received unauthorized assistance on this assignment.

HW 2

Step 1: Calculate the realized returns for a hypothetical portfolio

invested equally in the three stocks. You may simply average the
three returns.2 We will refer to this as the equally weighted
portfolio. Calculate the mean (average) realized return and standard
deviation of the realized returns for each stock, the S&P 500 index,
and the equally weighted portfolio.

a. Compare and contrast the mean and standard deviations of these five possible
investments. What are the noticeable differences?

S&P Harris Urban Maya Equal-Weighted Portfolio

Return 0.75 0.58 0.83 1.08 0.83
Sd 4.34 5.80 8.24 12.60 8.88
Sharpe Ratio 0.070 0.023 0.046 0.050 0.043

The noticeable difference comes in the standard deviation (risk) of the investments. Maya
stock is clearly the riskiest investment on its own and as one would expect, it also has the highest
return. Another interesting point is that the S&P has a higher return than Harris, even with a
lower standard deviation.

b. When choosing between the three individual stock investments and ignoring
combinations of these investments, which would you suggest to our hypothetical investors?
Why?
The 28 year old would prefer the Maya stock because it has the greatest return and at this
point in life he or she is wanting to maximize return even at the risk of higher volatility. The
older investor would invest in Harris because it is by far the safest option, even if it will return
less.

c. How does your answer change if you add the index as an allowable
investment?

It would not change my answer for either investor.

Step 2: Calculate the correlation between each of the three stocks

and between the S&P 500 and the equally weighted portfolio.
Assume that the average return, standard deviation and correlation
Correlation of Harris with Urban 0.3038
Correlation of Harris with Maya 0.0801
Correlation of Urban with Maya 0.2288

of each of these assets from 1990 to 2009 are a good estimate of

these same measures for the future. Using the template provided in
the second tab, construct a graph that shows the expected future
relation between the returns (vertical axis) and standard deviations
(horizontal axis) of a pair of the stock investments (your choice
which pair).3

Portfolio with Two Assets (Harris and Urban)

1.00000
Return

0.75000

0.50000
5.00 6.00 7.00 8.00 9.00

Standard Deviation
a. Is there an intuitive explanation for the shape of the curve you
have generated?

Yes, it resembles an efficient frontier. This could be expected as it is a

combination of risky assets.

b. How does the shape of the curve change as you alter the
correlation (which is bounded by −1 and 1, inclusive)?

A correlation that approaches positive 1 creates a graph that is

approaching a straight line because both assets are moving together. On the
opposite spectrum, the parabola becomes more pronounced as you approach
-1.

c. What do the correlations between the individual stocks indicate?

What insight is provided by the correlation between the equally
weighted portfolio and the S&P 500 index?

The correlation between the stocks indicate how similarly they will
behave in the market. Highly correlated stocks will move together, while the
opposite is true for negatively correlated stocks. Stocks with little correlation
will not have a defined movement pattern in relation to each other. The
correlation between the equally weighted portfolio and the S&P, would show
how the portfolio would perform in various market (S&P) conditions.

Step 3: Using the template provided, construct a graph that shows

the expected returns and standard deviations of all possible
combinations of the three stocks. This graph was constructed in a
fashion analogous to the two-asset graph, but expanded to three
stocks.4 This graph describes the complete investment space offered
by the three stock investments.
 Portfolios with Three Assets
1.5000

1.2500
Monthly Return

1.0000

0.7500

0.5000

Risk
0.2500
free
rate 2.5000 5.0000 7.5000 10.0000 12.5000 15.0000
Standard Deviation

a. Restricting yourself to combinations of the three stocks, what

portfolio of stock investments would you recommend for our two
hypothetical investors?

For the younger 28 year-old investor, I would recommend choosing the furthest point on
the curve and investing at the lowest risk level given for the combination of the three with the
lowest return. For the older investor, I would recommend investing in a combination much less
risky and toward the left side of the frontier in which there is much lower risk.

b. Locate the S&P 500 index on this graph. Explain the location of
this index relative to the set of possible three-stock combinations.

The S&P is located at 4.34, 0.75. This option is giving higher return for
the given risk level than the three stock combinations. Therefore, it is a
better investment at that level of risk.

Step 4: We can expand the set of financial assets by considering a

risk-free bond (U.S. government security). We will assume that the
return on the bond is 0.45% a month, which is about 5.5% per year.
This risk-free asset can be combined with the market portfolio to
yield another set of possible investments. This line is referred to as
the capital market line. Add the capital market line to your graph
from Step 3. The can be done by adding points to the graph that
represent linear combinations of the bond and the market.

a. What would be the diversification benefits from adding a bond?

The bond is “risk-free” and so having a standard deviation of zero

means that it is not going to correlate very much with the existing stocks and
therefore diversify the portfolio to a large degree. Adding a different sort of
financial instrument to the existing equities will improve diversification.

b. Explain the shape of the capital market line.

The CML is a theoretical concept that shows the optimal combination of

the risk-free rate and the market portfolio. Since it is always the optimal
combination, it is a straight line all the way through at any given level of risk.

c. Now consider all the possible investments you have identified

(the three individual stocks, all combinations of the three stocks,
the index, and the security market line). What would you
recommend to our two hypothetical investors? Be very specific in
your recommendation.

For the younger investor, I would suggest investing entirely in Maya because of its return
and risk profile and likely fits his or her risk tolerance and investment horizon. For the older
investor, I would stick with my earlier recommendation of a combination of the three stocks that
focuses on lower risk.

Step 5

a. Based on the betas, which firm is the most risky? Least risky?
How does your answer compare with the answer you provided based
on standard deviations? Which one is appropriate for our
hypothetical investors? Explain why.

*Used formulas not regression for these betas*

Harris Beta: 0.39

Urban Beta: 0.94

Maya Beta: 1.30

 Harris remains the least risky investment as Maya also remains the riskiest. It is the same
as based on standard deviation. The decisions remain the same for the hypothetical investors.

b. What is the economic meaning of the alpha?

Alpha is the excess return of a portfolio when compared to a

benchmark or index. Alpha is often used as a way to gauge an active
investor’s performance and view what they are adding whether by selection
effect, industry effect, etc.

Step 6

a. How do the realized returns compare with the expected returns?

Assuming the CAPM describes the appropriate expected returns for
these stocks, describe how prices might respond if, at some point,
the expected returns on the three stocks differed from what was
predicted by the CAPM.

*Using assumptions from the case for rf rate and MRP)

Harris Urban Maya

Expected Monthly
Return 0.65 0.92 1.10
Expected Annual Return 7.75 11.05 13.2
Realized Annual Return 6.99 9.90 12.95

If CAPM is predictive, the realized returns would slowly grow toward the expectations.