MODERN PORTFOLIO THEORY

Exercises: Questions
Final CIIA

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 MODERN PORTFOLIO THEORY

Copyright  2013, AZEK/ILPIP

All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, or transmitted, in any form or by any means, electronic, mechanical, photocopying,
recording, or otherwise, without the prior written permission of AZEK/ILPIP.

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 Q1: Market model
Consider the stocks of three companies, A, B and C. The market portfolio has a return of 12%
and a standard deviation of 4%. The risk-free rate is 5%. For every stock you run the
following regression:

R it = α i + β i ( R Mt ) + ε it

and you get:

β i α i random error
term σ ε i

A 1.20 -1.0% 10.0%

B 1.00 0.2% 21.5%
C 0.60 0.0% 8.0%

a) In the CAPM, the standard deviation of a security is split into market and specific risk.
Explain the differences between the two types of risk.

b) Compute the covariances of the asset returns with the market return.

c) What is the big advantage of calculating the efficient frontier by the market model and not
using the Markovitz Portfolio Theory?

d) Assume that the estimated parameters are statistically significant. In the CAPM framework,
are the stocks correctly priced, overvalued or undervalued?

Q2: APT
Two portfolios A and B have the following expected return and sensitivities to factors F1 and
F2:
E(RA) = 10% β A1 = 1 β A2 = 0
E(RB) = 8% β B1 = 0 β B2 = 1

The risk free rate is 6%.

a) Compute the risk premium paid for each factor assuming a market at equilibrium!

b) Compute the expected return of portfolio C with sensitivities βC1 = 1.9, βC2 = 1.4.

c) A two-factor regression of the return of security i gave the result:

Ri=0.01+1.2F1+0.9F2+εi

Your analyst made the following forecast regarding both the factors:

E(F1) = 0.03, E(F2) = 0.07

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 Calculate the expected return of this security.

d) Consider a portfolio made up of 1.2 million CHF in portfolio A and 0.9 million CHF in
portfolio B and 1.1 million CHF short in the risk-free asset (total market value 1 million
CHF). Compute the expected return of portfolio K.

e) Compare the results of c) and d) and decide if security i is over- or undervalued. What
assumption must be made about εi to justify the comparison?

Q3: Market Model

In a market whose volatility is 15%, you have the following stocks:

Stock Beta Volatility

A 0.9 14%
B 1.2 20%
C 1.6 40%

a) What is the beta of an equally-weighted portfolio of the 3 stocks A, B and C?

b) Compute the following covariances: cov (A, B), cov (A, C) and cov (B, C).

c) What are the R2 of the three regressions, which yielded the betas of the 3 stocks A, B and
C?

d) Finally, find the specific (unsystematic) risk of the 3 stocks A, B and C.

Q4: Market Model and CAPM

The pension fund CDP has three managers viz., A, B and C managing its domestic stocks.
The risk free rate is 4% p.a. Last year's performance of each manager is as follows:

Manager Beta Return Volatility R2

A 0.96 20% 22% 0.76
B 1.00 20% 20% 1.00
C 1.06 22% 22% 0.92

a) What can you say about manager B?

b) What is the alpha of managers A, B and C?

c) One of your friends who is a physician, comments that “You can’t rely on the above
models because the R2 of 92% and 76% are not large enough”. What is your reaction to his
remark?

d) How can you interpret the coefficient of determination (R2)? What do the following values
mean: R2=0.76 and (1- R2)=0.24?

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 Q5: APT and CAPM
You have classified the market in four portfolios as follows:
• Small Value
• Large Value
• Small Growth
• Large Growth
The weight of the each portfolio in the index is also given. Suppose the risk free rate is 2%
and accordingly you have designed the following model:

Sensitivity to Sensitivity to Sensitivity to

Factor I Factor II Factor III
Portfolios Weight (Market beta) (Price/Book) (Average
capitalisation)
Small Value 5% 0.85 0.8 1
Small Growth 5% 0.95 1.3 1
Large Value 40% 0.90 2.0 8
Large Growth 50% 1.10 3.0 10
Risk premium 8% -2% 0.1%

a) When using the APT, which portfolio has the highest expected return? Show your
calculations.

b) Still using the APT, what is the expected return of the market and how does it compare
with the returns of the other 4 portfolios?

c) One of your competitors uses the CAPM. Based on the betas above, which portfolio
would he choose when he wants to maximise his expected return?

d) In order to diversify his anticipated risk, another competitor wants to combine the Small
Value and the Large Growth Portfolios. The new portfolio should have an overall
sensibility to factor I of one. Show how much the competitor must invest in Small Value
and how much in Large Growth. The portfolio must be fully invested. Short sales are not
allowed.

Q6: Market Model and CAPM

The following incomplete data is available on three stocks and a risk free asset:
Expected Std. Deviation (σ) Beta Residual Variance (σ ε2 )
Return
A 0.15 …… 2.00 0.10
B …… 0.25 0.75 0.04
C 0.09 …… 0.50 0.17
Risk free asset 0.07 …… …… ……

a) Calculate the expected rate of return on the market portfolio?

b) Complete the blanks in the table.

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 c) Define the notion of idiosyncratic returns εi?

Q7: APT
Assume that the returns on stocks, bonds and short-term financial assets are described by a
two-factor model. The factor sensitivities and average rates of return (estimated from past
data) are given in the table below. Note that the exchange rate is for the value of the Swiss
franc against the dollar. Assume that the relationship defined in the table will remain constant
in the future.
Asset Economic sensitivity Exchange rate Average rate of return
sensitivity (p.a.)
Stocks 1.5 -0.2 10%
Bonds -0.5 -0.6 8%
Short-term
financial assets 0.0 0.0 4%

You decide to invest 600’000 CHF in stocks - which proceed from short selling 200’000 CHF
of bonds together with 400’000 CHF of your own capital - and 600’000 CHF of own capital
in short-term financial assets. Assume that there is no transaction cost.

a) What is the portfolio sensitivity to each of the two factors?

b) Calculate the risk premiums of the economic factor and exchange rate factor? Write the
equations for each asset.

c) Your portfolio is 1’000’000 CHF worth; how would you create an asset mix from stocks,
bonds and short term financial assets such that its return does not depend upon economic
factor and its sensitivity to exchange rate fluctuation is 1? Calculate the expected return on
this portfolio.

d) Discuss the concepts of sensitivity and risk premium in the context of Arbitrage Pricing
Theory (APT).

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 Q8: APT
You assume that the returns on Swiss stocks are described by a three-factor model. In the table
below you find the factor sensitivities and the average rates of returns for four stocks. You
assume that the relationship defined in the table will not change in the future. The risk-free
rate Rf is 3% p.a.

Stock β 1 = long term β 2 = oil price β 3 = exchange rate Average rate of

interest rate sensitivity sensitivity on return p.a.
sensitivity EUR/CHF
ROG + 0.20 - 0.20 + 0.80 9.60%
CSGN + 0.70 + 0.10 + 0.60 8.10%
SGS 0 + 0.80 + 0.70 14.00%
ABBN + 0.60 - 0.20 + 0.70 7.80%

a) Compute the risk premium paid for each factor assuming a market at equilibrium,
knowing that the oil price risk premium is 5%.

b) You have to construct a portfolio consisting of all 4 stocks above totally insensitive to the
oil price. One of your colleagues proposes to include 12.5% of ROG, 25.0% of CSGN,
12.5% of SGS and 50% of ABBN. What are the values β1, β2 and β3 of the coefficients of
the new portfolio? Should you follow your colleague’s proposition? Are there other
portfolios that share the same property but which have a higher expected return? Justify
your answer.

c) Your research team gives you the factor sensitivities for the stock Adecco (ADEN):
β1ADEN = 0.32, β2ADEN = 0, β3ADEN = 0.57. It also tells you that the expected return of
ADEN is 11.35%. What can you say about the pricing of ADEN?

d) Compare a portfolio consisting of 30% ROG, 20% CSGN, 10% SGS, 20% ABBN and
20% Cash with the ADEN stock. What happens in an efficient market? Explain with
explicit calculations.

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