Acf321 Workshops Answers

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ACF321 Workshops Answers
Investments (Lancaster University)
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Investments Answers to Problem Set 2 Lent 2021
True-False (plus reasons; I am expecting no more than two-three sentences for

each):
1. A share that has a weekly volatility of returns of 5% will have an annual

volatility of returns of about 35%.
True. To annualise weekly returns, multiply by the square root of the

number of weeks in a year. With the square root of 52 being 7.2, the annual
volatility is 7.2 x 5% = 36%.
2. If share A is much more volatile than share B, then in the long term it is
likely to do better than share B.
False. There is no empirical evidence, and no theoretical reason, for

believing that volatility by itself attracts a reward. While investors may
require reward for holding volatile portfolios, the volatility of an individual
share may make very little difference to the volatility of the portfolio as a
whole if its risk is uncorrelated with the risk of the rest of the portfolio.
3. If share A and share B have a correlation of returns of 0.8, and if share B is

very volatile then share A must also be quite volatile.
False. Even if the two shares were perfectly correlated, they could have
very different volatilities. For example if share B is like a portfolio that is
10% share A and 90% cash, it will be perfectly correlated with A (assuming
the cash is non-volatile) but it will have only 10% of the volatility.
4. If two shares have zero correlation, then it is possible to construct a portfolio

consisting of the two shares that has zero volatility.
False. If the two shares have volatility a and b respectively then a portfolio
that has proportion x in a and 1-x in b has variance x2a2 + (1-x)2b2 which
can only be zero if a or b is zero.
5. If two portfolios are both on the mean-variance efficient frontier, then the
one that has the higher expected return will also have the higher volatility.
True. If they are both mean-variance efficient, then neither can be

dominated by the other. (If you interpret the frontier to include the entire
frontier region, including the frontier below the feasible set, then the
answer is false).
6. Assuming the CAPM is correct, a share with a higher beta will have a higher
expected return than one with a lower beta even if it has much lower total
risk.

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True. The CAPM says that expected return is proportional to beta. And a
firm with higher beta can have lower total risk if it has much smaller
idiosyncratic risk.
Questions
1. If a share has a annual volatility of 25%, and a correlation with the market
of 0.3, and the market has an annual volatility of 15%, what is the beta of
the share, and what is its idiosyncratic risk?
s 25%
s = sm = 0.3 = 0.5.
m 15%
The market risk of the share is therefore 0.5x15% or 7.5%. The rest of
the risk of the share is idiosyncratic. Total risk2 = market risk2 +
idiosyncratic risk2, so idiosyncratic risk2 = 25%2 – 7.5%2 = 0.056875,
and idiosyncratic risk = 23.85%.
2. In the previous question, if the risk-free rate is 4% and the market risk
premium (the difference between the expected return on the market and the
risk-free rate) is 6%, what is the expected return on the share?
E rs  = rf + s ( E rm  − rf ) = 4% + 0.5 x 6% = 7%.
3. If two shares each have a beta of 1 and annual volatility of 30% while the
market has an annual volatility of 20%, what is the correlation between each
of the shares and the market? What is the covariance of returns of the two
shares, and what is the correlation between the two shares, assuming that
the idiosyncratic risk of the two shares is uncorrelated?
Call the shares a and b. For the first question, look at share a (b is
identical):
m 20%
am = a = 1 = 0.67.
a 30%
The return on each share can be written as:
rA =  A + rM +  A
rB =  B + rM +  B
Where the ’s are constant, rM is the market return and the ‘s are the
idiosyncratic return. The covariance can be written as:

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Cov ( rA , rB ) = Cov ( rM , rM ) + Cov ( rM ,  B ) + Cov (  A , rM ) + Cov (  A ,  B ) .

Cov ( rM , rM ) =  M2 ;
Cov ( rM ,  B ) = Cov (  A , rM ) = 0 since  is uncorrelated with rM by definition
Cov (  A ,  B ) = 0 since  ' s are uncorrelated with each other by assumption,
so Cov ( rA , rB ) =  M2 = 0.22 = 0.04.
Using the definition of correlation:
Cov ( ra , rb ) 0.04
ab = = = 0.444.
 a b 0.3  0.3
4. How many shares would you need to hold in a portfolio to have an annual
volatility of no more than 22%, assuming that they are as in the previous
question (volatility of 30%, beta of 1 and idiosyncratic risk uncorrelated
across stocks)?
Numbering the shares 1 to N, the variance of a portfolio composed of equal

holdings of the N shares is:
N  ij
 p2 = N
i , j =1
2
.
When i = j ij = 0.32 = 0.09. Otherwise, ij = 0.04 (from above). So:
N  N  0.09 + N ( N − 1)  0.04 
 ij
 p2 = N = 2
N2

i , j =1  
0.09 + ( N − 1)  0.04 0.05
= = 0.04 + .
N N
If we want p < 22%, then we need:
0.05
0.04 +  0.222 = 0.0484,
N
0.05 0.05
so  0.0084, or N  = 5.95.
N 0.0084
At least six shares are needed.
The pension fund …
a. Assuming that the trustees want to remain fully invested in equities,

draw the set of feasible portfolios (that is all possible combinations of
mean and standard deviation) if the fund is invested in a mix of US and
Japanese equities for both forecasts. Is a 100% US portfolio efficient? If
it is not efficient, identify a better portfolio that is efficient.

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On the optimistic forecast, both markets have the same mean, so

diversifying into Japan would have no effect on the mean return. If a
proportion a is put into the Japanese market the volatility would be:
a 2 J2 + 2  a (1 − a )  J  U + (1 − a )  U2
2
= 0.0324a 2 + 0.02016a (1 − a ) + 0.0256 (1 − a )

2
The term inside the square root sign is 0.03784a2 – 0.03104a + 0.0256.
Differentiating with respect to a this gives 0.07568a – 0.03104. The
volatility is minimized by setting the derivative equal to zero, so a =
3104/7568 = 0.41. So to get minimum risk, it is necessary to put 41% of the
money into Japan. This is the efficient portfolio. It has a volatility of 13.9%.
If the expected return on Japan is only 6%, then there is a trade-off

between risk and return shown below in red (the crosses represent 100%
US or 100% Japan, and the minimum variance portfolios; the blue line is
for the optimistic case, the dotted lines allow for going short):
11%
10%
9%
n
r
u
t 8%
e
R
7%
6%
5%
13% 15% 17% 19%
Risk
The 100% US portfolio is efficient if you want to maximise return.
b. The US interest rate is 3%. The fund is free to put some of its money
into cash, when it will earn this rate. The fund can also borrow at the
same rate. Draw the feasible set and again say whether a portfolio that
is 100% invested in the US is efficient. If the portfolio is not efficient
suggest a better portfolio that is efficient.
In the optimistic case, the efficient portfolios are necessarily some mixture
of the minimum variance portfolio (59:41 US:Japan) and cash. In the
pessimistic case, need to find the tangency portfolio – the equity portfolio
that gives the maximum extra return over the riskless rate per unit of risk.
Using solver, we can find this. It has 97% in the US and 3% in Japan –

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virtually an all US portfolio. This can barely be seen in the graph where the
all US portfolio is just below the efficient blue line:
12%
10%
Return 8%
6%
4%
2%
0% 5% 10% 15%
Risk
The tangency portfolio has volatility of 15.7% and expected return of

9.88%. If we leverage it up by borrowing 2% of the value of portfolio, and
putting 102% of the fund into the tangency portfolio, the expected return
would only be 10.004% - trivially different from the all US portfolio.
c. The consultants’ report did suggest that the fund put some money into
the Japanese market. This suggestion was met with scorn by one trustee,
who argued as follows: …
Is the argument valid? (Assume the numbers are correct).
The case for investing in Japan is not just that it has low correlation with
the US, but that it has a low covariance, and hence a low beta, with the US
market. The beta of Japan is:
 J 0.35  0.18
J = = = 0.39375.
U 0.16
To be worth including in the portfolio, the expected return on Japan would

need to exceed:
rf +  J ( E  rU  − rf ) = 3% + 0.39375  (10% − 3% ) = 5.76%
which it does. A typical US stock has a beta of one against the US market
and would need to be expected to beat the market to be worth including.

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Investments Problem Sheet 3 Lent Term 2021
True-False
1. The best way of estimating the future beta of a share is to use the historic beta,
computed by regressing the share return on the market return.
Questionable. If the business of the firm has not changed and nor has its financial
leverage, then historic beta is a good starting point.
2. If the stock market index goes down, high beta shares are also likely to go down, but
not by as much as the market index.
False. If the CAPM is true, the expected return on a share, r, given that the market
return is rm, is rf + (rm-rf). In general, if rm is less than rf, the higher the beta, the
lower the expected return.
3. The evidence that high beta shares have a higher expected return than low beta shares,
after controlling for other factors, is weak.
True. Fama and French (1992) for example show that after controlling for factors
such as size and book-to-market ratio, there is no significant difference between high
and low beta shares.
Questions
1. Assets A and B are predicted to have the following returns in the five possible states of the world
next period:
State Probability Return on:

A B
1 10% 25% 15%
2 30% 15% 20%
3 20% 10% 0%
4 30% 5% 0%
5 10% -5% 5%
What is the expected return and standard deviation of returns on A and B? What is the
correlation between the returns on A and the returns on B? Given that the only two assets
you can invest in are A and B, is there any reason why anyone should want to buy some of
B?
The calculations involves the standard formulae, and are contained in the following
embedded spreadsheet (right click on the soft version, and use “worksheet
object/open):

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Squared Product
State Probability Return on: deviations of devs
A B
1 10% 25% 15% 0.0225 0.0049 0.0105
2 30% 15% 20% 0.0025 0.0144 0.006
3 20% 10% 0% 0 0.0064 0
4 30% 5% 0% 0.0025 0.0064 0.004
5 10% -5% 5% 0.0225 0.0009 0.0045
100%
Mean 10.00% 8.00%
SD 7.75% 9.00%
Correl 0.645
The means are obtained by multiplying each of the returns by the probability (using
the sumproduct function); having obtained the means, the squared deviation from
the means are computed, and these are multiplied by the probabilities to give the
variance, and then square rooted to give the standard deviation. The correlation is
obtained by dividing the covariance by the product of the two standard deviations.
Although B has lower mean and higher standard deviation than A, it might well be
attractive to someone who values money in states 2 and 5 (whatever they may be)
when B will beat A.
2. Mr Entrepreneur’s entire wealth of £50m consists of shares in the company he founded.
He is not happy holding such an undiversified portfolio, but is unwilling to sell any of his
shares because he does not want to lose control of the company. A friend suggests that he
could diversify by borrowing some money from the bank against the security of his shares
and invest it in the stock market. In this way he would have a much more diversified
portfolio. The bank is ready to lend him up to £25m. Can he reduce his total risk by doing
as his friend suggests? Explain carefully.
Dollar volatility of existing shares = £50m*σexisting shares
Dollar volatility of new shares = £25m*σnew shares
If dollar volatility of existing shares is a and of new shares is b, then variance of new
portfolio is a2+2rab+b2, where r is the correlation. This is only less than the original
a2 if r < -b/2a. The existing shares must have negative correlation with the market
(negative beta) to get any benefit at all.
Problems
1. An investor can invest in two risky assets 1 and 2, and the risk-free asset. The expected
returns on the risky assets are 1 = 0.15, 2 = 0.2, and their variance-covariance matrix is
  11  12   0.3 0.2 
  =   .
  21  22   0.2 0.3 
(so each share has a volatility of √0.3, or about 55%, and their correlation is 2/3). The
risk-free rate RF is 5%.
(a) What is the expected return and standard deviation of returns for a portfolio with:

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(i) 50% invested in each of the two risky assets?

(ii) 25% invested in asset 1 and 75% invested in asset 2?
Var-cov matrix Ex rets
1 0.3 0.2 15%
2 0.2 0.3 20%
Risk free 5%
Proportion in 1: 50% 25%

Ex ret: 17.50% 18.75%
(b) Compute the Sharpe ratio for the four portfolios (100,0;25,75;50,50;0,100) where the
Sharpe ratio is defined as
E( RP ) − RF
P
and sketch on a graph.

(c) Pretend that asset 2 is the market portfolio. Compute its correlation with the other
portfolios, and their betas on it. Verify whether or not the Capital Asset Pricing Model
holds if asset 2 is indeed the market portfolio.
(b) Compute the Sharpe ratio for the four portfolios (100,0;25,75;50,50;0,100) where the
E( RP ) − RF
Sharpe ratio is defined as and sketch on a graph.
P
The answers to parts (a) and (b) are in the embedded spreadsheet. The portfolio that
has 0 in share 1 and 100% in share 2 has the highest Sharpe Ratio.
Var-cov matrix Ex rets
1 0.3 0.2 15%
2 0.2 0.3 20%
Risk free 5%
Proportion in 1: 50% 25% 0% 100%

Ex ret: 17.50% 18.75% 20.00% 15.00%
Std Dev: 50.00% 51.23% 54.77% 54.77%
Sharpe ratio 0.25 0.268373 0.273861 0.182574
0.3
-100% -90% -80% -70% -60% -50%
25.00% 24.50% 24.00% 23.50% 23.00% 22.50%
83.67% 80.12% 76.68% 73.35% 70.14% 67.08%
Sharpe Ratio
0.239046 0.25
0.24337 0.247779 0.252221 0.25662 0.260875
0.2
0.15
-100% -50% 0% 50% 100%
Proportion in 1

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(c) Pretend that asset 2 is the market portfolio. Compute its correlation with the other
portfolios, and their betas on it. Verify whether or not the Capital Asset Pricing Model
holds if asset 2 is indeed the market portfolio.
The beta of share 1 on share 2 is cov(1,2)/var(2) = 2/3. The risk free rate is 5%, and
the expected return on the “market” (share 2) is 20%, so the expected return on
share 1 should be 5% + 2/3(20%-5%) = 15% - just as the “CAPM” would predict. In
general, if you take M as the portfolio with maximum Sharpe ratio, then the
“CAPM” relationship will hold for any asset with M as the market portfolio.

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2. The following annual excess rates of return were obtained for nine individual stocks and a
market index.
Market
Year Excess A B C D E F G H I
Returns(%)
1 29.65 33.88 -25.20 36.48 42.89 -39.89 39.67 74.57 40.22 90.19
2 -11.91 -49.87 24.70 -25.11 -54.39 44.92 -54.33 -79.76 -71.58 -26.64
3 14.73 65.14 -25.04 18.91 -39.86 -3.91 -5.69 26.73 14.49 18.14
4 27.68 14.46 -38.64 -23.31 -0.72 -3.21 92.39 -3.82 13.74 0.09
5 5.18 15.67 61.93 63.95 -32.82 44.26 -42.96 101.67 24.24 8.98
6 25.97 -32.17 44.94 -19.56 69.42 90.43 76.72 1.72 77.22 72.38
7 10.64 -31.55 -74.65 50.18 74.52 15.38 21.95 -43.95 -13.40 28.95
8 1.02 -23.79 47.02 -42.28 28.61 -17.64 28.83 98.01 28.12 39.41
9 18.82 -4.59 28.69 -0.54 2.32 42.36 18.93 -2.45 37.65 94.67
10 23.92 -8.03 48.61 23.65 26.26 -3.65 23.31 15.36 80.59 52.51
11 -41.61 78.22 -85.02 -0.79 -68.70 -85.71 -45.64 2.27 -72.47 -80.26
12 -6.64 4.75 42.95 -48.60 26.27 13.24 -34.34 -54.47 -1.50 -24.46
a. Perform the first-stage regressions and tabulate the summary statistics

Using the regression feature of Excel with the data presented in the text, the first-stage
time-series (Security Characteristic Line) estimation results are:
Stock A B C D E F G H I
R-square 0.06 0.06 0.06 0.37 0.17 0.59 0.06 0.67 0.70
Observations 12 12 12 12 12 12 12 12 12
Alpha 9.00 -0.63 -0.64 -5.05 0.73 -4.53 5.94 -2.41 5.92
Beta -0.47 0.59 0.42 1.38 0.90 1.78 0.66 1.91 2.08
t-Alpha 0.73 -0.04 -0.06 -0.41 0.05 -0.45 0.33 -0.27 0.64
t-Beta -0.81 0.78 0.78 2.42 1.42 3.83 0.78 4.51 4.81
b. Specify the hypothesis for a test of the second-stage cross-sectional regression for the
Security Market Line.
Answer: The hypotheses for the second-stage regression for the Security Market Line
are:
• The intercept is zero.
• The slope is equal to the average return on the index portfolio.

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c. Perform the second-stage cross-sectional regression (Security Market Line regression) by

regressing the average excess return of each portfolio on its beta.
Answer: The second-stage data from the first-stage time-series (SCL) estimates are:
Average Excess Return Beta

A 5.18 -0.47
B 4.19 0.59
C 2.75 0.42
D 6.15 1.38
E 8.05 0.90
F 9.90 1.78
G 11.32 0.66
H 13.11 1.91
I 22.83 2.08
The second-stage cross-sectional regression yields:
Regression Statistics
Multiple R 0.7074
R-square 0.5004
Adjusted R-square 0.4291
Standard error 4.62 Observations 9
Coefficients Standard Error t Statistic for β=0 t Statistic for β=8.12

Intercept 3.92 2.54 1.54
Slope 5.21 1.97 2.65 -1.48
d. Summarize your test results and compare them to the results reported in the text.
Answer: As we saw in the chapter, the intercept is too high (3.92% per year instead of 0)
and the slope is too flat (5.21% instead of a predicted value equal to the sample-average
risk premium: rM - rf = 8.12%). The intercept is not significantly greater than zero (the
t-statistic is less than 1.96) and the slope is not significantly different from its theoretical
value (the t-statistic for this hypothesis is -1.48). This lack of statistical significance is
probably due to the small size of the sample.
e. Group the nine stocks into three portfolios, maximizing the dispersion of the betas of the three
resultant portfolios. Repeat the test and explain any changes in the results.

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Answer:
Year ABC DEG FHI
1 15.05 25.86 56.69
2 -16.76 -29.74 -50.85
3 19.67 -5.68 8.98
4 -15.83 -2.58 35.41
5 47.18 37.70 -3.25
6 -2.26 53.86 75.44
7 -18.67 15.32 12.50
8 -6.35 36.33 32.12
9 7.85 14.08 50.42
10 21.41 12.66 52.14
11 -2.53 -50.71 -66.12
12 -0.30 -4.99 -20.10
Average 4.04 8.51 15.28
Std. Dev. 19.30 29.47 43.96
The first-stage time-series (SCL) estimates are:
ABC DEG FHI

R-square 0.04 0.48 0.82
Observations 12 12 12
Alpha 2.58 0.54 -0.34
Beta 0.18 0.98 1.92
t-Alpha 0.42 0.08 -0.06
t-Beta 0.62 3.02 6.83
Grouping into portfolios has improved the SCL estimates as is evident from the higher R-
square for Portfolio DEG and Portfolio FHI. This means that the beta (slope) is measured
with greater precision, reducing the error-in-measurement problem at the expense of leaving
fewer observations for the second pass.
The inputs for the second-stage cross-sectional regression are:
Average Excess Return Beta

ABC 4.04 0.18
DEH 8.51 0.98
FGI 15.28 1.92
M 8.12
The second-stage cross-sectional estimates are:

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Multiple R 0.9975
R-square 0.9949
Standard error 0.5693
Observations 3
Coefficients Standard Error t Statistic for β =0 t Statistic for β =8.12
Intercept 2.62 0.58 4.55

Slope 6.47 0.46 14.03 -3.58
Despite the decrease in the intercept and the increase in slope, the intercept is now
significantly positive, and the slope is significantly less than the hypothesized value by more
than three times the standard error.

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True-False
1. Arbitrage Pricing Theory says that if there is no arbitrage then all share prices must be
driven by a small number of factors.
False. The APT assumes that all share prices are driven by a small number of
factors.
2. If a substantial body of investors decided to exclude “sin stocks” (eg tobacco,

armaments) from their portfolios, both the Arbitrage Pricing Theory (APT) and the
Capital Asset Pricing Model (CAPM) would continue to hold.
False. The CAPM would not hold. If some investors exclude sin stocks, their
price would drop, their expected return would rise, and unrestricted investors
would find it worth buying more sin stocks. The market would no longer be
efficient; the efficient portfolio would be overweight sin stocks. The CAPM
would only hold if the market portfolio is interpreted as the portfolio held by
unrestricted investors. APT would continue to hold but there is likely to be a
priced “sin” factor.
3. If expected return rises with beta as shown in the following figure, there is a clear
arbitrage opportunity.
True. A long position in a portfolio (P) comprised of Portfolios A and B will offer an
expected return-beta tradeoff lying on a straight line between points A and B.
Therefore, we can choose weights such that βP = βC but with expected return higher
than that of Portfolio C. Hence, combining P with a short position in C will create
an arbitrage portfolio with zero investment, zero beta, and positive rate of return.

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Questions
1. You are working for an investment house that believes in the APT. They use a four
factor model, as in Chen, Roll and Ross. They have constructed four portfolios that are
maximally correlated with each of the four factors (unexpected changes in inflation,
slope of the term structure, corporate risk premium and output). They have estimated
factor betas for a number of shares, and you are particularly interested in three of the
shares (A, B and C). Their betas are given below:
Share Factor1 Factor 2 Factor 3 Factor 4

A +0.5 +1.4 -0.2 +1.0
B -0.8 +2.0 +0.5 +0.7
C +3.1 +0.2 -1.6 +1.6
i. Given that the risk free rate is 5% and the risk premium on the four factors is
estimated at 2.0%, 1.0%, 1.5% and 1.0%, what is the expected return on each of
the shares?
On A the expected return is 5% + 0.5x2.0% + 1.4x1.0% - 0.2x1.5% +
1.0x1.0% =8.1%. On B it is 5% - 0.8x2.0% + 2.0x1.0% + 0.5x1.5% +
0.7x1.0% =6.85%, while on C it is 5% +3.1x2.0% + 0.2x1.0% - 1.6x1.5% +
1.6x1.0% =10.6%.
ii. What are the betas of a portfolio that is invested two thirds in B and one third in
C? What is its expected return? How does the portfolio differ from one that is
invested fully in A?
The betas are {(-2x0.8 + 3.1)/3, (2x2.0+0.2)/3, (2x0.5-1.6)/3, (2x0.7+1.6)/3}.
These are {0.5, 1.4, -0.2, 1.0} which is the same as A. The expected return
must be the same as A, at 8.1%. The difference between the portfolio and A is
idiosyncratic risk – risk that is uncorrelated with any of the four factors, and
which attracts no expected return.

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2. The following annual excess rates of return were obtained for nine individual stocks and a
market index.
Market
Year Excess A B C D E F G H I
Returns(%)
1 29.65 33.88 -25.20 36.48 42.89 -39.89 39.67 74.57 40.22 90.19
2 -11.91 -49.87 24.70 -25.11 -54.39 44.92 -54.33 -79.76 -71.58 -26.64
3 14.73 65.14 -25.04 18.91 -39.86 -3.91 -5.69 26.73 14.49 18.14
4 27.68 14.46 -38.64 -23.31 -0.72 -3.21 92.39 -3.82 13.74 0.09
5 5.18 15.67 61.93 63.95 -32.82 44.26 -42.96 101.67 24.24 8.98
6 25.97 -32.17 44.94 -19.56 69.42 90.43 76.72 1.72 77.22 72.38
7 10.64 -31.55 -74.65 50.18 74.52 15.38 21.95 -43.95 -13.40 28.95
8 1.02 -23.79 47.02 -42.28 28.61 -17.64 28.83 98.01 28.12 39.41
9 18.82 -4.59 28.69 -0.54 2.32 42.36 18.93 -2.45 37.65 94.67
10 23.92 -8.03 48.61 23.65 26.26 -3.65 23.31 15.36 80.59 52.51
11 -41.61 78.22 -85.02 -0.79 -68.70 -85.71 -45.64 2.27 -72.47 -80.26
12 -6.64 4.75 42.95 -48.60 26.27 13.24 -34.34 -54.47 -1.50 -24.46
Suppose that in addition to the market factor that has been considered, a second factor is considered.
The values of this factor for years1 to 12 were as follows:
Year % Change in Factor Value

1 -9.84
2 6.46
3 16.12
4 -16.51
5 17.82
6 -13.31
7 -3.52
8 8.43
9 8.23
10 7.06
11 -15.74
12 2.03
a. Perform the first-stage time-series regressions and tabulate the relevant summary statistics
(Hints: use a multiple regression as in a standard spreadsheet package. Estimate the betas of
the 12 stocks on the two factors).

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Answer:
The first-stage time-series (SCL) regression results are summarized below:
A B C D E F G H I
R-square 0.07 0.36 0.11 0.44 0.24 0.84 0.12 0.68 0.71
Observations 12 12 12 12 12 12 12 12 12
Intercept 9.19 -1.89 -1.00 -4.48 0.17 -3.47 5.32 -2.64 5.66
Beta M -0.47 0.58 0.41 1.39 0.89 1.79 0.65 1.91 2.08
Beta F -0.35 2.33 0.67 -1.05 1.03 -1.95 1.15 0.43 0.48
t-intercept 0.71 -0.13 -0.08 -0.37 0.01 -0.52 0.29 -0.28 0.59
t-Beta M -0.77 0.87 0.75 2.46 1.40 5.80 0.75 4.35 4.65
t-Beta F -0.34 2.06 0.71 -1.08 0.94 -3.69 0.77 0.57 0.63
b. Specify the hypothesis for a test of a second-stage regression for the two-factor Security
Market Line.
Answer:
The hypotheses for the second-stage cross-sectional regression for the two-factor SML are:
• The intercept is zero.

• The market-index slope coefficient equals the market-index average return.
• The factor slope coefficient equals the average return on the factor.(Note that the first
two hypotheses are the same as those for the single factor model.)
c. Do the data suggest a two-factor economy?

Answer:
The inputs for the second-stage cross-sectional regression are:
Average Excess Return Beta M Beta F

A 5.18 -0.47 -0.35
B 4.19 0.58 2.33
C 2.75 0.41 0.67
D 6.15 1.39 -1.05
E 8.05 0.89 1.03
F 9.90 1.79 -1.95
G 11.32 0.65 1.15
H 13.11 1.91 0.43
I 22.83 2.08 0.48
M 8.12

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F 0.60
The second-stage cross-sectional regression yields:
Multiple R 0.7234
R-square 0.5233
Standard error 4.87 Observations 9
t Statistic t Statistic for β t Statistic for β

Coefficients Standard Error
for β =0 =8.12 =0.6
Intercept 3.35 2.88 1.16
Beta M 5.53 2.16 2.56 -1.20
Beta F 0.80 1.42 0.56 0.14
These results are slightly better than those for the single factor test; that is, the intercept is
smaller and the slope of M is slightly greater. We cannot expect a great improvement since
the factor we added does not appear to carry a large risk premium (average excess return is
less than 1%), and its effect on mean returns is therefore small. The data do not reject the
second factor because the slope is close to the average excess return and the difference is less
than one standard error. However, with this sample size, the power of this test is extremely
low.

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Investments Problem Set 5 Lent 2021
True-False (plus reasons; I am expecting no more than two-three sentences for each):
1. If markets are efficient, the correlation coefficient between stock returns for two non-
overlapping time periods should be zero.
True. If not, one could use returns from one period to predict returns in later periods
and make abnormal profits.
2. If markets are semi-strong form efficient, the following are viable strategies to earn
abnormally high trading profits.
a. Buy shares in companies with low P/E ratios
False.
b. Buy shares in companies with recent above-average price changes
False.
c. Buy shares in companies for which you have advance knowledge of an improvement
in management team
True.
In a semistrong-form efficient market, it is not possible to earn abnormally high

profits by trading on publicly available information. Information about P/E ratios
and recent price changes is publicly known. On the other hand, an investor who has
advance knowledge of management improvements could earn abnormally high
trading profits (unless the market is also strong-form efficient).
3. If the business cycle is predictable, and a stock has a positive beta, the stock’s (abnormal)
returns also must be predictable
False. While positive beta stocks respond well to favorable new information about the
economy’s progress through the business cycle, they should not show abnormal returns
around already anticipated events. If a recovery, for example, is already anticipated, the
actual recovery is not news. The stock price should already reflect the coming recovery.
4. The following are consistent with efficient market hypothesis

a. Nearly half of all professionally managed mutual funds are able to outperform the
S&P 500 in a typical year
True. Based on pure luck, half of all managers should beat the market in any
year.
b. Money managers that outperform the market (on a risk-adjusted basis) in one year are
likely to outperform in the following year
False. This would be the basis of an “easy money” rule: simply invest with last
year's best managers.
c. Stock prices tend to be predictably volatile in January than in other months

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True. In contrast to predictable returns, predictable volatility does not convey a

means to earn abnormal returns.
d. Stock prices of companies that announce increased earnings in January tend to
outperform the market in February
False. The abnormal performance ought to occur in January when earnings are
announced.
e. Stocks that perform well in one week perform poorly in the following week
False. Reversals offer a means to earn easy money: just buy last week’s losers.
Questions
1. The monthly rate of return in T-bills is 1%. The market went up this month by 1.5%. In
addition, AmbChaser, Inc., which has an equity beta of 2, surprisingly just won a lawsuit that
awards it $1 million immediately.
a. If the original value of the equity were $100 million, what would you guess was the
rate of return of its stock this month?
Based on broad market trends, the CAPM indicates that AmbChaser stock
should have increased by: 1.0% + 2.0 × (1.5% – 1.0%) = 2.0%
Its firm-specific (nonsystematic) return due to the lawsuit is $1 million per $100
million initial equity, or 1%. Therefore, the total return should be 3%. (It is
assumed here that the outcome of the lawsuit had a zero expected value.)
b. What is your answer to (a) if the market had expected AmbChaser to win $2min?
If the settlement was expected to be $2 million, then the actual settlement was a
“$1 million disappointment,” and so the firm-specific return would be –1%, for
a total return of 2% – 1% = 1%.
2. Investors expect the market rate of return in the coming year to be 12%. The T-bill rate is
4%. Changing fortunes Industries’ stock has a beta of 0.5. The market value of its
outstanding equity is $100 million.
a. What is your best guess currently as to the expected rate of return on Changing
Fortunes’ stock? You believe the stock is fairly priced.
E(rM ) = 12%, rf = 4% and β = 0.5
Therefore, the expected rate of return is:
4% + 0.5 × (12% – 4%) = 8%
If the stock is fairly priced, then E(r) = 8%.
b. If the market return in the coming year actually turns out to be 10%, what is your best
guess as to the rate of return that will be earned in Changing Fortunes’ stock?
If rM falls short of your expectation by 2% (that is, 10% – 12%) then you would
expect the return for Changing Fortunes Industries to fall short of your original
expectation by: β × 2% = 1%
Therefore, you would forecast a “revised” expectation for Changing Fortunes of:
8% – 1% = 7%
c. Suppose now that the company wins a major lawsuit during the year. The settlement
is $5 million. The company’s stock return during the year turns out to be 10%. What
is your best guess as to the settlement the market previously expected Changing
Fortunes to receive from the lawsuit? (Continue to assume that the market return in

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the year turned out to be 10 %.) The magnitude of the settlement is the only
unexpected firm-specific event during the year.
Given a market return of 10%, you would forecast a return for Changing
Fortunes of 7%. The actual return is 10%. Therefore, the surprise due to firm-
specific factors is 10% – 7% = 3% which we attribute to the settlement. Because
the firm is initially worth $100 million, the surprise amount of the settlement is
3% of $100 million, or $3 million, implying that the prior expectation for the
settlement was only $2 million.
3. Suppose that during a certain week the Fed announces a new monetary growth policy,
Congress surprisingly passes legislation restricting imports of foreign automobiles, and Ford
comes out with a new car model that it believes will increase profits substantially. How
might you go about measuring the market’s assessment of Ford’s new model?
Here we need a two-factor model relating Ford’s return to those of both the broad
market and the auto industry. If we call r I the industry return, then we would first
estimate parameters    M ,  IND in the following regression:
rFORD =  +  M rM +  IND rIND + 

Given these estimates we would calculate Ford’s firm-specific return as:
rFORD − [ +  M rM +  IND rIND +  ]
This estimate of firm-specific news would measure the market’s assessment of the
potential profitability of Ford’s new model.
4. Suppose that the market can be described by the following three sources of systematic risk
with associated risk premiums
Factor Risk Premium

Industrial Production (I) 6%
Interest Rate (R) 2%
Consumer Confidence (C) 4%
The return on a particular stock is generated according to the following equation:
r = 15% + 1.0I + 0.5R + 0.75C + e

(Note that I, R and C are shocks, so they have an expected value of zero)
Find the equilibrium rate of return on this stock using the APT. The T-bill rate is 6%. Is the
stock over or underpriced? Explain
The APT required (i.e., equilibrium) rate of return on the stock based on rf and the
factor betas is:
required E(r) = 6% + (1 × 6%) + (0.5 × 2%) + (0.75 × 4%) = 16%
According to the equation for the return on the stock, the actually expected return on
the stock is 15% (because the expected surprises on all factors are zero by definition).

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Because the actually expected return based on risk is less than the equilibrium return,
we conclude that the stock is overpriced.
5. Suppose that there are many stocks in the security market and that the characteristics of
Stocks A and B are given as follows
Stock Expected Return Standard Deviation

A 10% 5%
B 15% 10%
Correlation = -1
Suppose that it is possible to borrow at the risk-free rate, rf. What must be the value of the
risk-free rate?
If the correlation between the stocks is –1, we can form a perfect riskless hedge.
Therefore, the return on this portfolio must be equal to the risk-free rate.
If we use the formula for the minimum-variance portfolio, we get
 22 −  12 0.12 − 0.05(0.10)(−1)
wA = = = 0.667
 22 − 2 12 +  12 0.12 − 2(0.05)(.10)(−1) + 0.05 2
Therefore, .3333 is the weight of B. Substituting these values into the formula for
portfolio variance, you will see that a zero-variance has been achieved. Accordingly,
E(rp) = rp = .6667(.10) + .3333(.15) = .1167.
The riskless rate and the certain return of the riskless portfolio must be the same;
otherwise, there are riskless arbitrage opportunities.

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Investments Answers to Problem Sheet 6 Lent Term 2021
True-false questions
1. If you have split your portfolio between several managers, it is not important how
much risk each manager takes because risks are likely to diversify away across
managers.
FALSE. It is only the idiosyncratic risk of shares that is likely to diversify away. You
are interested in the risk that each manager contributes to the risk of the overall
portfolio. So if for example there are a large number of managers each holding
equities in the same market, the main risk in the whole portfolio is likely to be
market risk, and you will be concerned with the excess return of each manager per
unit of market risk.
2. The value-weighted return on a portfolio is generally higher than the time-weighted

return.
FALSE. There is no necessary relationship between the two. The value weighted
return will be higher if there have been inflows before a good year and outflows
before a bad year.
3. If an actively managed equity portfolio has a Treynor measure of 8% per annum, then
the same portfolio combined with a holding of risk free bonds will also have a
Treynor measure of 8% per annum.
TRUE. If we put a proportion x into bonds and 1-x into the equity portfolio, the
return will be xrf + (1-x)rp while the beta will be (1-x)bp. The Treynor measure is
then {( xrf + (1-x)rp)-rf}/{(1-x)bp} = {rp-rf}/{bp} = Treynor measure of original
portfolio.
4. If an actively managed equity portfolio has a Treynor measure of 8% per annum,

then the same portfolio combined with a holding of an index fund will also have a
Treynor measure of 8% per annum.
FALSE. Using subscript I for the index fund, the Treynor measure of the combined
portfolio is {( xri + (1-x)rp)-rf}/{xbi + (1-x)bp}. This equals {rp-rf}/{bp} only if the
Treynor measure of the index fund is also 8%.
5. If the CAPM holds, then a randomly chosen portfolio will have a Fama measure of
zero.
FALSE. The Fama measure penalises portfolios for all risk. A random portfolio will
have market risk, which is rewarded, and idiosyncratic risk that is not rewarded. In
algebraic terms F = rP – rF – P/M(rM – rF). If CAPM holds then rP = rF + P (rM – rF)
+ . So F = (P– P/M)(rM – rF) +  = −(P/M)(1-)(rM – rF) +  which is negative on
average. It is the Jensen measure that will be zero on average.

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6. If the CAPM holds, then all other portfolios are expected to have a lower Sharpe ratio
than the market portfolio.
TRUE. If a portfolio has a higher Sharpe ratio than the market than a combination
of the portfolio and cash can be constructed with the same expected return as the
market but lower risk. The market portfolio would then be inefficient, thus violating
the CAPM.
Problems
1. An equity fund has £100m under management at the beginning of the year. The following
table shows the cash inflows (positive) and cash outflows (negative) that occur at the end of
the year and at the end of the two subsequent years. It also shows the fund’s value after these
cash flows, and the annual returns on the market portfolio and on T-bills.
Year 1 Year 2 Year 3

Cash Flow (£m) 20 -20 0
Value (£m) 150 105 150
Market return 24% -20% 40%
T-bill return 10% 12% 14%
Beta 1 0.9 1.1
You estimate that the fund’s systematic variance was consistently equal to 85% of its total
variance, and that the annualised standard deviation of market returns remained a constant 20%
throughout the 3-year period.
(a) Calculate the time weighted return and the value weighted return on the fund over the
three year period. Explain the difference in the two values.
(b) Calculate the total standard deviation of returns of the fund and the diversifiable
standard deviation of the fund in each year.
(c) Calculate the Jensen and Fama measures and the Sharpe and Treynor ratios for the
fund for each year.
(d) Comment on the performance of the fund.
The relevant calculations are contained in the embedded spreadsheet:

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Year 1 Year 2 Year 3

Cash Flow (£m) 20 -20 0
Value (£m) 150 105 150
Market return 24% -20% 40%
T-bill return 10% 12% 14%
Beta 1 0.9 1.1
(a) Annual Returns 30.0% -16.7% 42.9%
Portfolio Market T-bill
Time weighted return 15.7% 11.6% 12.0%
Cash flow 100 20 -20 -150
Value weighted return 13.7%
You got money coming in before a bad year (yr 2) and
going out before a good year (yr 3) so your VWR < TWR
(b) Market SD 20% 20% 20%

Portfolio systematic SD 20.0% 18.0% 22.0%
Systematic/total variance 85% 85% 85%
Total SD 21.7% 19.5% 23.9%
Diversifiable SD 8.4% 7.6% 9.2%
Ave (arith)
(c) Jensen (P) 6.0% 0.1% 0.3% 2.1%
Treynor (P) 0.20 -0.32 0.26 0.05
Treynor (M) 0.14 -0.32 0.26 0.03
Fama (P) 4.8% 2.6% -2.2% 1.7%
Sharpe (P) 0.92 -1.47 1.21 0.22
Sharpe (M) 0.70 -1.60 1.30 0.13
d) Assuming that the manager has no control over cash inflows and outflows, it is the time
weighted return that is significant. On this basis, the manager appears to have done well,
beating both the market index and cash, with much of the out-performance occurring in the
first year. But that is without accounting for risk.
Assuming that the portfolio is one part of a larger portfolio, diversifiable risk is not
relevant, so we are interested in the Jensen and Treynor measures. The Jensen measure
shows that the manager out-performed the market each year, on average by 2.1%/year,
after allowing for market risk. This suggests that the manager has stock selection skills
(though the period is short, so the evidence is weak). The negative Treynor ratios for both
the portfolio and the market in year 2 are due to the market doing worse than cash that
year.
The portfolio actually beat the market by about 4% per annum over the period. The
difference between this and the Jensen measure is due to market timing. Although the fund

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had the same average beta as the market, the beta did vary and this led to an additional
benefit. The effect of varying beta is to increase the return each year by the difference
between actual and average beta times the excess return on the market:
( t −  )(rM ,t − r f ,t )
This is 0, +3.2% and +2.6% in the three years, averaging +1.9%/year. This is
evidence (again weak) of market timing ability.
If the portfolio is not part of a diversified portfolio, total risk is what matters and we
need to analyse the position using Fama and Sharpe. These measures will always
look worse than Jensen and Treynor if the market beats T-bills because the portfolio
is being charged for total risk and not just systematic risk (the measures will look
better in down markets like year 2). The positive Fama measure and the fact that the
Sharpe ratio beat that of the market both suggest that the manager earned positive
returns even allowing for the total risk.
2. A global equity manager is assigned to select stocks from a universe of large stocks
throughout the world. The manager will be evaluated by comparing her returns to the return
on the MSCI World Market Portfolio, but she is free to hold stocks from various countries in
whatever proportions she finds desirable. Results for one month are given in the following
table:
Country Weight in Return

MSCI Portfolio MSCI Portfolio
Index Index
UK 0.15 0.30 12% 20%
Japan 0.30 0.10 15% 15%
US 0.45 0.40 14% 10%
Germany 0.10 0.20 12% 5%
(a) Calculate the manager’s excess return on the portfolio as whole.
(b) Calculate the excess due to country allocation decisions.
(c) Calculate the excess due to stock selection within countries.
(d) Verify the sum of (b) and (c) is equal to (a).

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Index Index
UK 0.15 0.30 12% 20%
Japan 0.30 0.10 15% 15%
US 0.45 0.40 14% 10%
Shares
Germany 0.10 0.20 12% 5%
(a) Index Portfolio Excess return

13.80% 12.50% -1.30%
(b) With country index returns, portfolio return would have been 13.10%
so excess return due to country allocation is -0.70%
(c) To analyse country performance:

Country Weight in Return
Portfolio MSCI Portfolio Excess
Index
UK 0.30 12% 20% 8%
Japan 0.10 15% 15% 0%
US 0.40 14% 10% -4%
Germany 0.20 12% 5% -7%
The effect of stock selection is -0.6%
(d) (b)+(c)-(a) = 0.00000%
3. A portfolio P is invested in two assets A and B, with the remainder being invested in
the market M. The diversifiable components of A and B are uncorrelated with each
other. Over the last year, you have the following statistics, where T denotes T-bills in
which the portfolio was not invested:

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A B M T
Return 8.8% 9.6% 9.0% 4.4%
Beta 0.90 1.10 1.00
Standard Deviation 22.0% 25.4% 20.0%
Portfolio weight 14.0% 7.5% 78.5%
(a) compute the Jensen measure for each asset and for the portfolio as a whole
(b) Calculate the idiosyncratic standard deviation for both A and B.
(c) Calculate the portfolio’s beta, total standard deviation and idiosyncratic standard
deviation.
(d) Calculate the Sharpe ratio of the portfolio and of the market.
A B M P T
Return 8.8% 9.6% 9.0% 9.02% 4.4%
Beta 0.90 1.10 1.00 0.99
Standard Deviation 22.0% 25.4% 20.0% 20.0%
Systematic risk 18.0% 22.0% 20.0% 19.9%
Idiosyncratic risk 12.6% 12.7% 0.0% 2.0%
Portfolio weight 14.0% 7.5% 78.5%
Jensen 0.26% 0.14% 0.00% 0.05%

Sharpe 0.200 0.205 0.230 0.231
(a) The portfolio return and beta are simply the weighted average of its components. The
Jensen measure can then be computed.
(b) To get the idiosyncratic risk of A and B, first compute their market risk (beta times the
standard deviation of the market) and then compute the idiosyncratic risk by noting
that market variance plus idiosyncratic variance equals total variance.
(c) The portfolio’s beta has already been calculated. Its market risk is its beta times the
standard deviation of the market. Its idiosyncratic variance is the weighted sum of the
idiosyncratic variances of its components.
(d) The Jensen measures of both shares are positive, showing that they would improve
portfolio performance if added to a holding of the market portfolio. They also have
Sharpe measures that are lower than the market showing that neither held alone would
be better than the market. The relatively small exposure to A and B does improve the
Sharpe ratio of the portfolio. In fact, use of solver shows that this the portfolio that has
the maximum possible Sharpe ratio.

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True-false
1. If interest rates rise, bond prices fall.
True. Price is the present value of cash flows, so if the interest rate at which the
cash flows are discounted rises, the value of the bond falls.
2. The value of a portfolio that has zero duration is unaffected by small interest rate
changes.
True. Provided the shift in interest rates is parallel across the maturities held in the
portfolio.
3. If a bond is trading above par (i.e. its market value exceeds its face value) then its
interest or running yield is higher than its yield to maturity.
True. The return to holding a bond comes from the interest yield and the capital
gain. If the bond is above par, the latter component must be negative over
the life of the bond, so the average yield received over the life, which is the
yield to maturity, is below the interest yield.
4. The price of a five year bond with a 3% coupon should be exactly half way
between the price of two other five year bonds, one with zero coupon, and one
with and a 6% coupon.
True. The cash flow of £200 nominal of the 3% bond is identical to that of a
portfolio consisting of £100 nominal each of the other two bonds.
5. In general, you get a higher rate of return from long-dated bonds than from short-
dated bonds.
Possibly true. This is the liquidity preference theory. This is plausible if you
believe that investors tend to have a shorter horizon than borrowers, and
hence require a premium to persuade them to hold longer-dated bonds. The
empirical evidence supports the idea, but it is quite weak statistically.
6. If forward rates are higher than spot rates, yields on longer-dated bonds are higher
than yields on shorter-dated bonds.
True. If r1 is one year spot rate, and f1,2 is the one year forward rate one year
forward, then (1+r2)2 = (1+r1)(1+f1,2) so if f1,2 > r1 it is clear that r2 > r1. In words,
a long term spot rate is an average of the short term spot rate and forward rates,
so the result follows.
8. The dirty price of a bond tends to be more variable than the clean price.

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True. The dirty price rises (the bond becomes more valuable) as the coupon date
approaches, and then it drops as the bond goes ex-dividend. The clean price is
more or less unaffected by these changes over the coupon cycle, and its volatility
is due almost entirely to changes in the general level of interest rates.
Problems
1. The table below lists the prices of zero-coupon bonds of various maturities, expressed as a
price per $1000 of principal. Calculate the yields to maturity of each bond and the
sequence of implied forward rates.
Maturity Price of bond

(years) ($)
1 943.40
2 898.47
3 847.62
4 792.16
Assuming that the pure expectations hypothesis is valid, calculate the expected price path
of the four-year bond as time passes. What is the rate of return of the bond in each of the
four years?
Maturity Price Yield Fwd rate Price of current 4-yr bond

1 943.40 6.00% 6.00% Now 792.16
2 898.47 5.50% 5.00% 1 839.69
3 847.62 5.67% 6.00% 2 881.68
4 792.16 6.00% 7.00% 3 934.57
4 1000.00
The yields and forward rates use formulae from the lecture. For example the yield on
the four year bond is given by:
1000/(1+y)4 = 792.16
giving y = 6.00%. The forward rates are computed as follows: $1000 in year 3 is
worth $847.62 now. $1000 in year 4 is worth $792.16. So the implied interest rate
from year 3 to year 4 is 847.62/792.16-1 = 7%.
If the expectations hypothesis holds, the forward rate is the expected future spot rate,
so we can forecast the future price of the bond by discounting its pay-off by the
relevant forward rates. The expected return on the bond is then the forward rate (eg
the expected return on the bond in the third year is 6.0%).
The bond will be worth $1000 at the end of year 4. If the one year rate at the
beginning of year 4 is equal to the forward rate of 7%, the bond will be worth
$1000/1.07 = $934.57. If the one year yield at the beginning of year 3 is the forward
rate of 6%, the bond price will be the end year price discounted at 6%; this is
$934.57/1.06 or $881.68. And so on.

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2. The yield-to-maturity on one-year and two-year zero-coupon bonds is currently 7% and

8%, respectively. The Treasury plans to issue a two-year bond that pays an annual coupon
of 9% of face value. The face value of the bond is £100.
a. At what price will the bond sell?

The bond is equivalent to £109 of 2-year zero coupon bond and £9 of 1-year. It
is worth 9/1.07 + 109/1.082 = £101.86.
b. What will be the yield-to-maturity of the bond?
The yield solves 9/(1+y) + 109/(1+y)2 = 101.86, which gives a yield of 7.96%.
c. If the pure expectations hypothesis for the term structure of interest rates is
correct, what is the market expectation of the price that the bond will sell for next
year?
The one year spot rate next year is expected to be today’s forward rate of
93.46/85.73-1, or 9.01%. So the price of the bond is expected to be £109/1.0901
or £99.99.
d. Repeat the calculation in (c) assuming the liquidity preference hypothesis holds
with a liquidity premium of 1%.
If there is a 1% premium in the longer rate, then the expected future spot is
8.01%, and the expected bond value is £100.92.
The calculations are also done in the following embedded spreadsheet:
Zero coupon bond Tbond Cash flow Fwd rate

yield price Cash flow -101.86 Expected spot E price
1 7% 93.46 9 9.00
2 8% 85.73 109 109.00 9.01% 99.99
Price Yield 8.01% 100.92
101.86 7.96%
3.Without doing any detailed computations, and assuming that the term structure is flat at
5%, put the following bonds in order of increasing duration:
(a) a perpetual 5% coupon bond
(b) a perpetual 3% coupon bond
(c) a 25 year zero coupon bond
(d) a 10 year floating rate bond that pays LIBOR
(e) a 5 year 5% coupon bond
(f) a 5 year 6% coupon bond
A perpetual bond with yield y has a price of P = c/y so Dmod = -(1/P) dP/dy = 1/y. So
(a) and (b) will both have durations of about 20 years. (c) will have a duration of 25
years since all its cash flows are at that time, and a slightly smaller modified

lOMoARcPSD|35227084
duration (25/1.05 = 23.8 years). (d) will have a duration equal to the time to the next
coupon, so no more than a year. (e) and (f) will both have durations of somewhat
under 5 years, with (f) having more of its value being paid in coupons before
maturity and so have a shorter duration. The order is thus d, f, e, a=b, and then c.
4. The YTM on 1-year zero-coupon bonds is 5% and the YTM on 2-year zero-coupon is 6%.
The YTM on 2-year coupon bonds with coupon rates of 12% (paid annually) is 5.8%. What
arbitrage opportunity is available for an investment banking firm? What is the profit on the
activity?
Answer:
The price of the coupon bond, based on its yield to maturity, is:
[$120 × Annuity factor (5.8%, 2)] + [$1,000 × PV factor (5.8%, 2)] = $1,113.99
If the coupons were stripped and sold separately as zeros, then, based on the yield to maturity of
zeros with maturities of one and two years, respectively, the coupon payments could be sold
separately for:
$120 $1,120
+ = $1,111.08
1.05 1.06 2
The arbitrage strategy is to buy zeros with face values of $120 and $1,120, and respective
maturities of one year and two years, and simultaneously sell the coupon bond. The profit equals
$2.91 on each bond.

lOMoARcPSD|35227084
1. A 5 year bond with a coupon of 7%, that pays interest annually, has its next coupon
due in 12 months. It yields 5% per annum.
(a) compute the price of the bond.
(b) compute the duration of the bond. Use this to compute approximately how the price of
the bond will change if yields rise to 6%.
(c) Compute the convexity of the bond. Use this to obtain a more precise estimate of the
change in the price which will occur if the yield rises to 6%.
(a) The price of the bond is 7/1.05 + 7/1.052 + 7/1.053+ 7/1.054 + 107/1.055 = 108.66
(b) The duration of the bond is (7*1/1.05 + 7*2/1.052 + 7*3/1.053+ 7*4/1.054 +

107*5/1.055)/108.66 = 4.41 years. The modified duration is 4.41/1.05 = 4.20. A 1% rise
in yield can be expected to reduce the price by 4.2%, from £108.66 to £104.09.
(c) The convexity of the bond is (7*1*2/1.05 + 7*2*3/1.052 + 7*3*4/1.053+

7*4*5/1.054 + 107*5*6/1.055)/(108.66*1.052) = 22.99 years2. This implies a further
price correction from a 1% shift of +22.99*1%2/2 or +.1% to £104.22.
2. Firm XYZ is required to make a $5M payment in 1 year and a $4M payment in 3
years. The yield curve is flat at 10% APR with semi-annual compounding. Firm XYZ
wants to form a portfolio using 1-year and 4-year U.S. strips to fund the payments. How
much of each strip must the portfolio contain for it to still be able to fund the payments
after a shift in the yield curve?
The value of the liabilities is given by:
5M/[1+0.1/2]2 + 4M/[1+0.1/2]6 = 4.5351M + 2.9849M = 7.5200M
The duration of the liabilities is given by:
1* [4.5351/7.5200] + 3* [2.9849/7.5200] = 1.7938 years.
Modified Duration = 1.7938 years/(1+0.10/2) = 1.708 years.
Let A1 be the portfolio s dollar investment in the 1-year strips and A4 be the portfolio s
dollar investment in the 4-year strips.
The dollar value of the portfolio must equal the value of the liabilities. So
A1 + A4= 7.5200M.

lOMoARcPSD|35227084
The duration of the portfolio equals: w1D1 +(1- w1) D4
where w1 = A1/ 7.5200M. The (Modified) duration of the 1-year strip is 1/(1+0.1/2) and
the duration of the 4-year strip is 4/(1+0.1/2).
Setting the duration of the portfolio equal to the duration of the liabilities gives:
1.708 = w1 D1 + (1- w1) D4 = w1 (.95) + (1- w1) 3.80 => w1 = 0.732.
Thus,
A1 = 0 .732 ´ 7.5200M = 5.50M
A4 = 7.5200M - 5.502M = 1.99M.
3. You are managing a portfolio of $1 million, Your target duration is 10 years, and you
can choose from two bonds: a zero-coupon bond with maturity of 5 years, and a
perpetuity, each currently yielding 5%
i) How much of each bond will you hold in your portfolio?
ii) How will these fractions change next year if target duration is now 9 years?
Answer:
The duration of the perpetuity is: 1.05/0.05 = 21 years
i)Call w the weight of the zero-coupon bond. Then:
(w × 5) + [(1 – w) × 21] = 10 w = 11/16 = 0.6875
Therefore, the portfolio weights would be as follows: 11/16 invested in the zero and 5/16 in the
perpetuity.
ii)Next year, the zero-coupon bond will have a duration of 4 years and the perpetuity will still have a
21-year duration. To obtain the target duration of nine years, which is now the duration of the
obligation, we again solve for w:
(w × 4) + [(1 – w) × 21] = 9 w = 12/17 = 0.7059
So, the proportion of the portfolio invested in the zero increases to 12/17 and the proportion invested
in the perpetuity falls to 5/17.
4. You will be paying $10,000 a year in tuition expenses at the end of the next 2 years. Bonds
currently yield 8%.

lOMoARcPSD|35227084
a) What is the present value and duration of your obligation?
b) What maturity zero-coupon bond would immunize your obligation?
c) Suppose you buy a zero-coupon bond with value and duration equal to
your obligation. Now suppose that rates immediately increase to 9%. What
happens to your net position? What if the rates fall to 7%?
Answer:
a) PV of the obligation = $10,000  Annuity factor (8%, 2) = $17,832.65
Time until PV of CF
Column (1) 
Payment Cash Flow (Discount rate Weight
Column (4)
(years) = 8%)
1 $10,000.00 $9,259.259 0.51923 0.51923
2 $10,000.00 $8,573.388 0.48077 0.96154
Column Sums $17,832.647 1.00000 1.48077
Duration = 1.4808 years
b) A zero-coupon bond maturing in 1.4808 years would immunize the obligation. Since the
present value of the zero-coupon bond must be $17,832.65, the face value (i.e., the future
redemption value) must be:
$17,832.65 × 1.081.4808 = $19,985.26
c) If the interest rate increases to 9%, the zero-coupon bond would decrease in value to:
$19,985.26
= $17,590.92
1.091.4808
The present value of the tuition obligation would decrease to: $17,591.11. The net
position decreases in value by: $0.19
If the interest rate decreases to 7%, the zero-coupon bond would increase in value to:
$19,985.26
= $18,079.99
1.071.4808
The present value of the tuition obligation would increase to: $18,080.18. The net
position decreases in value by: $0.19.
The reason the net position changes at all is that, as the interest rate changes, so does
the duration of the stream of tuition payments.
5. Long-term Treasury bonds currently are selling at yields to maturity of nearly 8%. You
expect interest rates to fall. The rest of the market thinks that they will remain unchanged
over the coming year. In each question, choose the bonds that will provide the higher
holding-period return over the next year if you are correct. Briefly explain your answer.
a) i. A Baa-rated bond with coupon rate 8% and time to maturity 20 years.
ii. An Aaa-rated bond with coupon rate of 8% and time to maturity 20 years.

lOMoARcPSD|35227084
b) i. An A-rated bond with coupon rate 4% and maturity 20 years.

ii.An A-rated bond with coupon rate 8% and maturity 20 years.
c) i. A 6% coupon T-bond with maturity 20 years and YTM = 8%.
ii. A 9% coupon T-bond with maturity 20 years and YTM = 8%.
Answer:
In each case, choose the longer-duration bond in order to benefit from a rate decrease.
a. ii. The Aaa-rated bond has the lower yield to maturity and therefore the longer
duration.
b. i. The lower-coupon bond has the longer duration
c. i. The lower coupon bond has the longer duration.
6. The current yield curve for default-free zero-coupon bonds are as follows:
a) What are the implied 1-year forward rates?
b) Assume that the pure expectations hypothesis of the term structure is correct.
If market expectations are accurate, what will be the pure yield curve next
year?
c) If you purchase a 2-year zero-coupon bond now, what is the expected total rate
of return over the next year? What if you purchase a 3-year zero-coupon
bond? Ignore taxes.
d) What should be the current price of a 3-year maturity bond with a 12% coupon
rate paid annually? If you purchased it at that price, what would your total
expected rate of return be over the next year? Ignore taxes.
Answer:
i) We obtain forward rates from the following table:
Maturity YTM Forward Rate Price (for parts c, d)
1 year 10% $1,000/1.10 = $909.09
2 years 11% (1.112/1.10) – 1 = 12.01% $1,000/1.112 = $811.62
3 years 12% (1.123/1.112) – 1 = 14.03% $1,000/1.123 = $711.78
ii) We obtain next year’s prices and yields by discounting each zero’s face value at the
forward rates for next year that we derived in part (a):

lOMoARcPSD|35227084
Maturity Price YTM

1 year $1,000/1.1201 = $892.78 12.01%
2 years $1,000/(1.1201 × 1.1403) = $782.93 13.02%
Note that this year’s upward sloping yield curve implies, according to the expectations
hypothesis, a shift upward in next year’s curve.
iii) Next year, the 2-year zero will be a 1-year zero, and will therefore sell at a price of:
$1,000/1.1201 = $892.78
Similarly, the current 3-year zero will be a 2-year zero and will sell for: $782.93
Expected total rate of return:
$892.78
2-year bond: − 1 = 1.1000 − 1 = 10.00%
$811.62
$782.93
3-year bond: − 1 = 1.1000 − 1 = 10.00%
$711.78
iv) The current price of the bond should equal the value of each payment times the present
value of $1 to be received at the “maturity” of that payment. The present value schedule
can be taken directly from the prices of zero-coupon bonds calculated above.
Current price = ($120 × 0.90909) + ($120 × 0.81162) + ($1,120 × 0.71178)
= $109.0908 + $97.3944 + $797.1936 = $1,003.68
Similarly, the expected prices of zeros one year from now can be used to calculate the
expected bond value at that time:
Expected price 1 year from now = ($120 × 0.89278) + ($1,120 × 0.78293)
= $107.1336 + $876.8816 = $984.02
Total expected rate of return =
$120 + ($984.02 − $1,003.68)
= 0.1000 = 10.00%
$1,003.68

lOMoARcPSD|35227084
Question 1
Explain the five major differences between hedge funds and mutual funds.
Answer:
The five major categories of differences are transparency, investors,
investment strategies, liquidity, and compensation structure.
Mutual funds are more highly regulated by the SEC and thus are required to be
far more transparent. Hedge funds provide only minimal information about portfolio
composition or strategy.
Investors in hedge funds differ in that investment minimums were traditionally
set at $250,000 to $1,000,000. While newer hedge funds are starting to reduce the
minimum investment to $25,000, this minimum is outside the reach of many mutual
fund investors.
Mutual funds must provide an investment strategy and are restricted in the use
of leverage, short selling, and in their use of derivatives. However, hedge funds are
less restricted and frequently make large bets that can results in large losses over the
short term.
Mutual funds are liquid and investors can redeem shares at NAV and have
proceeds within seven business days. Conversely, hedge funds often impose lock-up
periods as long as several years and require redemption notices of several months
even after the lock-up period is over. Thus, hedge funds are far less liquid.
While mutual funds charge a management fee, hedge funds add an incentive
fee as well. This incentive fee is similar to a call option and the portfolio manager
receives a "performance" bonus if the portfolio outperforms the chosen benchmark.
Question 2
Assuming Paulson & Co charges 20% incentive fee, 0% management fee and the agreed
hurdle rate (benchmark rate) is 0%.
Year High-Water Mark Year End Net Asset Value Performance Fee
2014 100 million 150 million 10 million
2015 ? 120 million ?
2016 ? 160 million ?
Given the above information, compute high-water mark and performance fee in 2015 and
2016.
Answer:

lOMoARcPSD|35227084
Year High-Water Mark Year End Net Asset Value Performance Fee
2014 100 million 150 million 10 million
2015 150 million 120 million 20% of 0=0 million
2016 150 million 160 million 20% of 10=2 million
Question 3
Consider a passive mutual fund, an active mutual fund, and a hedge fund. The mutual
funds claim to deliver the following gross returns:
rt passive fund before fees = rtstock market index
rt active fund before fees = 2.2% + rt stock market index + εt
The passive fund charges an annual fee of 0.10%. The active mutual fund charges a fee of
1.20% and seeks to beat the same stock market index by about 1% per year after fees.
The active mutual fund has a beta of 1 and has a tracking error variance (var(ε )) = 3.5%.
The hedge fund uses the same strategy as the active mutual fund to identify “good” and
“bad” stocks, but implements the strategy as a long-short hedge fund, applying 4 times
leverage. The risk free interest rate is rf=1% and the financing spread is zero (meaning
that borrowing and lending rates are equal). Therefore, the hedge fund’s return before
fees is
rt hedge fund before fees = 1% + 4 × (rt active fund before fees − rtstock market index )
(a) What is the hedge fund’s volatility?
Answer:
The hedge fund employs a long-short strategy meaning zero systematic risk with the
market and only fund specific risk. Thus, the hedge fund’s volatility is 4×Sqrt(3.5%) =
75%.
(b) What is the hedge fund’s beta?
Answer:
Since the hedge fund employs a long -short strategy, it indicates that the strategy
is market neutral, thus the hedge fund’s beta is zero.
(c) What is the hedge fund’s alpha before fees (based on the mutual fund’s alpha estimate)?

lOMoARcPSD|35227084
Answer:
The hedge fund’s alpha before fees is its expected excess return minus its beta times the
equity risk premium, i.e., 4×2.20% = 8.80%.
Question 4.
You are working for a hedge fund and you have been researching a AAA (ie very low risk
of default) 10-year corporate bond which you believe is trading cheaply. You expect the
bond to have a return of 7.5% p.a., while the comparable 10-year Treasury bond has an
expected return of 6%. The annual volatility of the corporate bond is 6.5% and that of the
Treasury bond is 6%; the correlation between them is 0.95. You think of buying the
corporate bond and short selling the Treasury to hedge yourself, but the spread of only
1.5% between the expected returns on the two bonds makes this not a very exciting
proposition.
Your thoughts turn to leveraging your position. You can borrow or lend short term at the
Treasury bill rate of 5.4%.
(a) Supposing that you want to construct a portfolio consisting of the corporate bond, the
treasury bond, and borrowing or lending, design the portfolio that has an expected return
of 40% and minimum risk.
If you invest a fraction c of your portfolio in the corporate bond, and a fraction t in the
Treasury bond the expected return on the portfolio is:
E[rp] = 7.5% x c + 6% x t + 5.4% x (1 – t – c) = (5.4 + 2.1c + 0.6t)%
Using the standard formula for the variance of a portfolio, and noting that the risk of T-
bills is zero, the variance of the portfolio is:
Var[rp] = (6.5%)2c2 + 2 x 0.95 x 6.5% x 6% x ct + (6%)2t2
= (42.25c2 + 74.1ct + 36t2)%%
To get a return of 40%, need:
E[rp] = 40% so 5.4 + 2.1c + 0.6t = 40, and
t = (40 – 5.4 – 2.1c)/0.6 = 57.667 – 3.5c.
Substituting for t in the variance gives a variance (times 10000) of:
Var[rp] = 42.25c2 + 74.1c(57.667 – 3.5c) + 36(57.667 – 3.5c)2
= 223.9c2 – 10259c +119720
Differentiating, this is minimised when c = 10259/(2x223.9) = 22.91.
So t = 57.667 – 3.5c = -22.52. Thus for every £1m of initial capital, the portfolio goes long
£22.9m of the corporate bond, short £22.5m of the matching ten year bond, and puts
£0.6m in cash.

lOMoARcPSD|35227084
(b) What is the volatility of the portfolio?

Substituting back, this gives
Var[rp] =223.9(22.91)2 – 10259(22.91) +119720%%
so the standard deviation - the square root of the variance – is 47%. That means
that the standard deviation of annual gains or losses relative to the mean is £0.47m
on every £1m of capital invested.
(c) You set up the strategy. The correlation turns out to be 0.8 rather than the 0.95 you had
assumed. What would you expect the volatility of the portfolio to be?
Substituting into the formula for volatility gives a portfolio volatility of 90.8%.
This example is crudely modelled on one of the strategies followed by LTCM.
Question 5.
Assume that the stock market returns have the market index as a common factor, and that all
stocks in the economy have a beta of 1 on the market index. Firm-specific returns all have a
standard deviation of 30%. Suppose that an analyst studies 20 stocks, and finds that one-half
have an alpha of 2%, and the other half an alpha of -2%. Suppose the analyst buys $1 million
of an equally weighted portfolio of positive alphas, and shorts $1 million of an equally
weighted portfolio of the negative alpha stocks.
a. What is the expected profit (in dollars) and standard deviation of the analyst’s
profit?
Shorting an equally-weighted portfolio of the ten negative-alpha stocks and investing

the proceeds in an equally-weighted portfolio of the ten positive-alpha stocks
eliminates the market exposure and creates a zero-investment portfolio. Denoting
the systematic market factor as RM , the expected dollar return is (noting that the
expectation of non-systematic risk, e, is zero):
$1,000,000 × [0.02 + (1.0 × RM )] - $1,000,000 × [(–0.02) + (1.0 × RM )]
= $1,000,000 × 0.04 = $40,000
The sensitivity of the payoff of this portfolio to the market factor is zero because the
exposures of the positive alpha and negative alpha stocks cancel out. Thus, the
systematic component of total risk is also zero. The variance of the analyst’s profit
is not zero, however, since this portfolio is not well diversified.
For n = 20 stocks (i.e., long 10 stocks and short 10 stocks) the investor will have a
$100,000 position (either long or short) in each stock. Net market exposure is zero,
but firm-specific risk has not been fully diversified. The variance of dollar returns
from the positions in the 20 stocks is:

lOMoARcPSD|35227084
20 × [(100,000 × 0.30)2] = 18,000,000,000
The standard deviation of dollar returns is $134,164.
b. How does your answer change if the analyst examines 50 stocks instead of 20
stocks? 100 stocks?
If n = 50 stocks (25 stocks long and 25 stocks short), the investor will have a $40,000
position in each stock, and the variance of dollar returns is:
50 × [(40,000 × 0.30)2] = 7,200,000,000
Similarly, if n = 100 stocks (50 stocks long and 50 stocks short), the investor will
have a $20,000 position in each stock, and the variance of dollar returns is:
100 × [(20,000 × 0.30)2] = 3,600,000,000
Notice that, when the number of stocks increases by a factor of 5 (i.e., from 20 to
100), standard deviation decreases by a factor of = 2.23607 (from $134,164 to
$60,000).

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Investments (Lancaster University)

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Investments Answers to Problem Set 2 Lent 2021

True-False (plus reasons; I am expecting no more than two-three sentences for

1. A share that has a weekly volatility of returns of 5% will have an annual

True. To annualise weekly returns, multiply by the square root of the

False. There is no empirical evidence, and no theoretical reason, for

3. If share A and share B have a correlation of returns of 0.8, and if share B is

4. If two shares have zero correlation, then it is possible to construct a portfolio

True. If they are both mean-variance efficient, then neither can be

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E rs  = rf + s ( E rm  − rf ) = 4% + 0.5 x 6% = 7%.

The return on each share can be written as:

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Cov ( rA , rB ) = Cov ( rM , rM ) + Cov ( rM ,  B ) + Cov (  A , rM ) + Cov (  A ,  B ) .

Using the definition of correlation:

Numbering the shares 1 to N, the variance of a portfolio composed of equal

If we want p < 22%, then we need:

At least six shares are needed.

The pension fund …

a. Assuming that the trustees want to remain fully invested in equities,

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On the optimistic forecast, both markets have the same mean, so

= 0.0324a 2 + 0.02016a (1 − a ) + 0.0256 (1 − a )

If the expected return on Japan is only 6%, then there is a trade-off

The 100% US portfolio is efficient if you want to maximise return.

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The tangency portfolio has volatility of 15.7% and expected return of

Is the argument valid? (Assume the numbers are correct).

To be worth including in the portfolio, the expected return on Japan would

rf +  J ( E  rU  − rf ) = 3% + 0.39375  (10% − 3% ) = 5.76%

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Investments Problem Sheet 3 Lent Term 2021

State Probability Return on:

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Dollar volatility of new shares = £25m*σnew shares

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(i) 50% invested in each of the two risky assets?

Proportion in 1: 50% 25%

and sketch on a graph.

Proportion in 1: 50% 25% 0% 100%

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a. Perform the first-stage regressions and tabulate the summary statistics

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c. Perform the second-stage cross-sectional regression (Security Market Line regression) by

Average Excess Return Beta

The second-stage cross-sectional regression yields:

Adjusted R-square 0.4291

Standard error 4.62 Observations 9

Coefficients Standard Error t Statistic for β=0 t Statistic for β=8.12

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The first-stage time-series (SCL) estimates are:

ABC DEG FHI

The inputs for the second-stage cross-sectional regression are:

Average Excess Return Beta

The second-stage cross-sectional estimates are:

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Coefficients Standard Error t Statistic for β =0 t Statistic for β =8.12

Intercept 2.62 0.58 4.55