Homework AD 717

Week 10

Unless stated otherwise, round your answers to three decimals, and do not round intermediate calculations.

Building an active portfolio.

In this problem, we will build an active portfolio, that is, a portfolio consisting of individually selected
stocks to complement our passive investments. To do this, create an Excel worksheet. Use the following
instructions with a market risk premium 𝑟" − 𝑟$ of 5%.

Consider the following annualized information regarding a selection of six stocks (Apple Inc,
Amazon.com Inc, Intuitive Surgical Inc, Target Corp, Walmart Inc, and Exxon Mobil Corp) and the S&P
500 that we have obtained from a regression analysis:
SD of
SD of Excess SD of
Beta Systematic
Return Residual
Component

S&P 500 0.1701 1.00 0.1701 0.0000

$AAPL 0.2869 1.20 0.2041 0.2016
$AMZN 0.3554 1.60 0.2721 0.2286
$ISRG 0.3409 1.50 0.2551 0.2261
$TGT 0.2761 0.80 0.1361 0.2403
$WMT 0.2296 0.60 0.1020 0.2057
$XOM 0.2163 0.85 0.1446 0.1609

• Find the covariance matrix according to the index model, where the covariance between two
1 1
assets is defined as 𝐶𝑜𝑣(𝑟) , 𝑟+ , = 𝛽) 𝛽+ 𝜎" . [Hint: You can find the 𝜎" from the above table if you
compute the covariance of the index with itself because 𝛽2&4 566 = 1.]
• Create a forecast of 𝛼) for each company, that is, the return in percent you anticipate in excess
over the return expected through its 𝛽) in the coming year. [Example: If the 𝛽 of the company
were to be 1, you’d expect an excess return of 5% in the absence of 𝛼. However, if you
anticipated that the company’s stock was going to realize an excess return of 4% or 6%, then its
𝛼 would be -1% or +1%, respectively.] This forecast can just be a guess for this problem!
• Construct the risky portfolio according to Table 27.1 in your book or according to “How to build
your portfolio” in today’s lecture slides.

Compute and report the following parameters for your portfolio:

1. Weights of the securities in your active portfolio and its 𝛼.

2. Weight of the active portfolio in the overall portfolio.
3. Aggregate alpha and beta of the active portfolio and of the overall portfolio.
4. Compare the Sharpe ratio of an investment in the market with the Sharpe ratio of the overall
portfolio you have constructed!
You need to report answers with your own assumptions. But you can check your work with:

AAPL AMZN ISRG TGT WMT XOM

Alpha 0.5% 0.5% 1.0% -0.5% 1.0% -0.8%

Using these values for each stock, your active portfolio should have 𝛼4 = 3.263%, 𝛽4 = 1.584. The
overall portfolio should come out to 𝛼A = 0.527%, 𝛽A = 1.094. The Sharpe ratio of this overall
portfolio is 0.308, whereas the Sharpe ratio of the market portfolio is 0.294.