Problem 1 : LT expected returns

You are a market forecaster with an asset management firm. You are asked to set long-term
market return expectations for UK equities. You have gathered the following data :

Historical data
Equity compounded annual return (%) 11.2
Dividend yield (%) 4

Equity repurchase yield (%) -0.5

Nominal earnings growth return (%) 4.6
Risk Free rate (%) 4

Current and forward looking data

Current P/E 14.6
Expected equities real earnings growth rate (%) 2.7
Expected long-term inflation (%) 2.5
Payout ratio (%) 50
Risk free rate (%) 1

1. Determine the three components of the historical returns of UK equities. Explain how
you take into account the repurchase yield
Carry (income) is equal to the dividend yield (4%)
Cash flow growth is equal to 4.6% (nominal earnings growth)
The repurchase yield is equal to –0.5%, which means that there has been some net issuance of shares
over the period.
We need to calculate the valuation changes components
valuation changes component is equal to : Historical performance – (Dividend yield + Earnings
growth + repurchase yield)
Valuation changes = 3.1%

2. Determine the current expected long-term return for UK equities

Dividend yield = earnings Yield * payout ratio = 1/14.6 * 50 % = 3.4%.
We could also take intoaccount earnings growth rate.Earnings growth = real earnings growth +
inflation = 2.7% +2.5% = 5.2%
Expected Long-term return = 8.6%

3. Determine the historical excess return of UK equities and the UK ex ante Equity Risk
premium
Historical excess return = Equity annual return – Historical Risk free rate = 11.2% - 4%=7.2%
Equity Risk premium = Expected Long-term return – Current Risk free rate = 8.6%-1%=7.6%

Problem 2 : Factor Model

Suppose that the market model for stocks A and B is estimated with the following results :

RA= 3% + 0.7 RM + εA
RB= -2% + 1.2 RM + εB

σM=20%, σ εA = 5% and σ εB = 1%. The residual terms are uncorrelated

1. What is the standard deviation of each stock ?

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V(RA) = V(3% + 0.7 RM + εA) = 0.72 V(RM) + V(εA) = 0.72 20%2 + 5%2σA=14.87%
V(RB) = V(-2% + 1.2 RM + εA) = 1.22 V(RM) + V(εB) = 1.22 20%2 + 1%2σB=24.02%
2. Breakdown the variance of each stock to the systematic and specific risk
A Systematic Risk Variance = 0.72 V(RM)=1.96%
A Specific Risk Variance = 5%2 =0.25%
B Systematic Risk Variance = 1.22 V(RM)=5.76%
B Specific Risk Variance = 1%2 =0.01%
3. What are the covariance and correlation between the two stocks ?
Cov (RA,RB) = cov (3% + 0.7 RM + εA, -2% + 1.2 RM + εB)= 0.7 1.2 V(RM)=3.36%
Correlation = cov / (σA σB) = 94%
4. What is the covariance between each stock and the market ?

Cov (RA, RM ) = 0.7 V(RM)=2.8%

Cov (RB, RM ) = 1.2 V(RM)=4.8%
5. For Portfolio P with investment proportions of 60% in A and 40% in B, rework
questions 1,2 and 4
RP = 0.6 RA +0.4 RB = 1% + 0.9 RM + 0.6 εA + 0.4 εBV(RP) = V (1% + 0.9 RM + 0.6 εA + 0.4 εB) = 0.92 V(RM) + 0.62 V(εA) +
0.42 V(εB)σP=18.2%
Systematic risk variance= 0.92 V (RM) =3.24%
Specific risk variance = 0.62 V(εA) + 0.42 V(εB)=0.09%
Cov (RP , RM) = 0.9 V(RM) = 3.6%

Problem 3 : Mean-Variance Investor

Tylor Robinson, a senior analyst at RNC Investments, is reviewing the investment policies of two
new clients : Bob Carlson and Rick Olsen. Carlson's and Olsen's risk aversions are estimated to
be 8 and 2 respectively.
Robinson evaluates the following asset classes as possible investments :

Asset Class Expected return Expected Standard deviation

US large Cap 8.5% 15%
US SmallCap 12% 20%
US Fixed Income 5.5% 3%
Real estate 7% 12%

Robinson then creates four portfolios with the previous asset classes. The portfolios are as
follows :
Portfolio Exp. Exp.std Sharpe US large US Small US Fixed Real
return deviation ratio cap Cap Income Estate
1 6.5% 5.95% 0.756 12 13 5 70
2 7.25% 8.3% 0.633 22 5 21 52
3 8% 11.15% 0.538 32 18 15 35
4 8.75% 14.25% 0.474 42 21 22 15

1. Robinson recommended Portfolio 1 to Carlson and portfolio 4 to Olsen. Can you

estimate the mean-variance utility functions of portfolios 1 and 4 ?
The utility function is given by E(R) - 1/2 * Risk Aversion * V®
Portfolio 1 Utility = 6.5% -1/2 * 8 *5.95%2 =5.08%
Portfolio 4 Utility = 8.75% - 1/2 * 2* (14.25%)2 = 6.72%

2. Please comment the set of asset classes selected by Robinson

Not very well diversified :
- Strong Equity bias (Large-cap and small-cap)
- Home bias (no exposure to global markets)
- no corporate bonds positions

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3. Assuming no constraints against leverage, determine the optimal strategy for a mean-variance
investor, who wants to get a 7,5% return.
We have to select the portfolio with the highest Sharpe ratio. Portfolio 1 has the highest Sharpe ratioand its expected
return is 6.5%. We have to leverage Portfolio 1.The optimal strategy is the following :- x% in Portfolio 1- (x%-1)
borrowing at risk-Free assetx% * 6.5% - (x%-1) * 2% = 7.5%x=122%
Portfolio 1 has the highest Sharpe ratio, indicating that it offers the best risk-adjusted return among your available
options.

Problem 4 : CPPI

You want to determine the maximum value of the multiplier m in a CPPI strategy

Please use the following notations :

Vt = Portfolio value at t
Pt= Floor value at t
Ct= cushion value at t
St= Risky asset value at t

What is the portfolio value at t+1 ?

The cushion value is positive at t. Assume for simplification that the floor value remains constant
between t and t+1 and that cash accrued interest between t and t+1 is negligible.

Show that the value of m should be lower than (-1/stress test ) in order to have a positive
cushion at t+1

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