ECB3BL

International Investment Management

Welcome!
Lecture 2
1
Last week and this week
 Last week
 Workig of financial market
 Risk, return, and the Sharpe ratio
 This week
 How can we construct an efficient portfolio with risky assets?
 What about the complete portfolio involving the risk-free asset as well?
 Estimating required return and risk
 How can we profit if our expectation is not in line with the requirement?
 Tutorial
 First case study presentation & discussion
 All groups: handin presentation 12 hours before the start of your tutorial

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ECB3BL
International Investment Management

Asset classes and

financial
instruments
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Treasury bills
 Short-term government borrowing
 Investors buy the bills at a discount of the face value
 Return generated is referred to as yield

Similar to last
week‘s “market
order”

Similar to
last week‘s
“limit order”

Source: www.treasurydirect.gov

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Treasury bills
 Part of the Money Market
 Very short-term, highly marketable, debt securities
 Also: Certificates of deposit (Time deposits), Commercial paper, Federal funds, etc.
 Other short-term rates and indicators
 LIBOR rate
 Short-term interest rate at which banks are willing to lend money amongst themselves
 TED-spread
 LIBOR minus T-bill rate
 Relevance of TED-spread?
 Indicator of credit risk in banking industry

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Treasury bills
 TED spread development

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The stock market
 Stock market index
 Measures the average performance of its constituents
 Different weighting schemes…
 Dow Jones Industrial Average (30 blue-chips): price-weighted
 Standard & Poor’s 500 (500 large firms): market-value-weighted
 …lead to different outcomes:

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The stock market
 Price-weighted index
25+100
 Year 0: = 62.5
2
30+90
 Year 1: = 60
2
60−62.5
 Return: = −4%
62.5
 Market-value-weighted index
 Year 0: $25 × 20𝑚𝑚 + $100 × 1𝑚𝑚 = 600 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
 Year 1: $30 × 20𝑚𝑚 + $90 × 1𝑚𝑚 = 690 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
 Take 100 as a base value for the index
 This value corresponds to initial market value of 600 million
690
 Then after 1 year, index level at 100 × = 115
600
690−600
 Return: = 15%
600

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The stock market
 Which methodology do you favor?
 Another one: equal-weighting
 Why? And the drawback?
 A broad index is regarded as “the market”
 Local indices in addition to DJIA and S&P500
 AEX index in the Netherlands, DAX-30 index in Germany, BEL-20 index in Belgium,
CAC-40 index in France, etc. etc.
 Morgan Stanley Capital International (MSCI) is market leader in computation of
country indexes and regional indexes

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The stock market
100 years of S&P 500 data

Source: Deutsche Bank

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This week
 How do we determine the optimal portfolio for an investor?
 Consist of a combination of risky assets and the risk-free asset
 Three-step approach
1. Consider all risky assets and determine efficient combinations of assets
2. Choose the optimal risky portfolio that maximizes the return-to-risk ratio
3. Let risk aversion determine how much to invest in this optimal risky portfolio and
how much in the risk-free asset

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ECB3BL
International Investment Management

Step 1
Optimal risky
portfolios
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Two-security portfolio
Return
 P, the risky portfolio consists of multiple assets. In this case, assume two assets,
namely D and E
 𝑟𝑟𝑝𝑝 = 𝑤𝑤𝐷𝐷 𝑟𝑟𝐷𝐷 + 𝑤𝑤𝐸𝐸 𝑟𝑟𝐸𝐸
 𝑟𝑟𝑝𝑝 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
 𝑤𝑤𝐷𝐷 = 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤
 𝑟𝑟𝐷𝐷 = 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
 𝑤𝑤𝐸𝐸 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤
 𝑟𝑟𝐸𝐸 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

 𝐸𝐸 𝑟𝑟𝑝𝑝 = 𝑤𝑤𝐷𝐷 𝐸𝐸 𝑟𝑟𝐷𝐷 + 𝑤𝑤𝐸𝐸 𝐸𝐸(𝑟𝑟𝐸𝐸 )

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Diversification and portfolio risk
 Market risk
 Systematic or non-diversifiable
 Firm-specific risk
 Diversifiable or nonsystematic

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Two-security portfolio
Risk
 Portfolio risk depends on the correlation between the returns of the assets in
the portfolio
 Covariance and the correlation coefficient provide a measure of the way returns of
two assets vary
 𝐶𝐶𝐶𝐶𝐶𝐶 𝑟𝑟𝐷𝐷 , 𝑟𝑟𝐸𝐸 = 𝜌𝜌𝐷𝐷,𝐸𝐸 𝜎𝜎𝐷𝐷 𝜎𝜎𝐸𝐸
 𝜌𝜌𝐷𝐷,𝐸𝐸 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
 𝜎𝜎𝐷𝐷 = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑓𝑓𝑓𝑓𝑓𝑓 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐷𝐷
 𝜎𝜎𝐸𝐸 = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑓𝑓𝑓𝑓𝑓𝑓 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐸𝐸
 𝜎𝜎𝑃𝑃 2 = 𝑤𝑤𝐷𝐷 2 𝜎𝜎𝐷𝐷 2 + 𝑤𝑤𝐸𝐸 2 𝜎𝜎𝐸𝐸 2 + 2𝑤𝑤𝐷𝐷 𝑤𝑤𝐸𝐸 𝐶𝐶𝐶𝐶𝐶𝐶(𝑟𝑟𝐷𝐷 , 𝑟𝑟𝐸𝐸 )
 𝜎𝜎𝐷𝐷 2 = 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐷𝐷
 𝜎𝜎𝐸𝐸 2 = 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑜𝑜𝑜𝑜 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐸𝐸

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Two-security portfolio
Portfolio E(r) as a function of risk


 Where is our optimal risky portfolio in this case?

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Markowitz model
Finding the minimum variance frontier
 This procedure also works if our portfolio has multiple assets:
Return

AB

Risk

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Markowitz model
Finding the minimum variance frontier

Return

B
N
AB
A

Risk

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Markowitz model
Finding the minimum variance frontier

Return

B
ABN N
AB
A

Risk

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Markowitz model
Finding the minimum variance frontier
Goal is to move up and
Return left—less risk, more
return

B
ABN N
AB
A

Risk

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Markowitz model
Finding the minimum variance frontier

Expected return (%)

Standard deviation

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Markowitz model
Minimum variance frontier of risky assets

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ECB3BL
International Investment Management

Step 2
Capital allocation line
and Sharpe ratio
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Capital allocation
Combining risky and risk-free asset
 Control risk
 Asset allocation choice
 It is possible to split investment funds between safe and risky assets
 Risky assets: fraction of assets invested in a risky portfolio
 Risk-free asset: remainder of the portfolio invested in Treasury bills (or other safe
money market securities)
 Generally, T-bills viewed as the risk-free asset

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The Sharpe ratio
 Given this range of efficient portfolios;
which one is optimal?
 If you partly invest in the risk free rate
then which risky portfolio is optimal?
 The Capital Allocation Line represents
the line that provides combinations
between risky and risk-free asset
 Maximize the slope of CAL for any
possible portfolio, p

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Capital allocation
Capital Allocation Line (CAL)
 The investment opportunity set
 Risky asset or portfolio (𝑃𝑃) and risk-free asset
 𝐸𝐸(𝑟𝑟) on vertical axis, risk on the horizontal axis

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Capital allocation
Complete portfolios: risk and return
 Return
 𝐸𝐸 𝑟𝑟𝑐𝑐 = 𝑦𝑦𝑦𝑦 𝑟𝑟𝑝𝑝 + 1 − 𝑦𝑦 𝑟𝑟𝑓𝑓
 𝐸𝐸 𝑟𝑟𝑐𝑐 = 𝑟𝑟𝑓𝑓 + 𝑦𝑦 𝐸𝐸 𝑟𝑟𝑝𝑝 − 𝑟𝑟𝑓𝑓
 𝑟𝑟𝑐𝑐 = 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
 𝑦𝑦 = % 𝑖𝑖𝑖𝑖 𝑝𝑝
 1 − 𝑦𝑦 = % 𝑖𝑖𝑖𝑖 𝑟𝑟𝑓𝑓
 Risk
 𝜎𝜎𝑐𝑐 = 𝑦𝑦 × 𝜎𝜎𝑝𝑝 + (1 − 𝑦𝑦) × 𝜎𝜎𝑓𝑓
 𝜎𝜎𝑓𝑓 = 0
 𝜎𝜎𝑐𝑐 = 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

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Capital allocation
Passive strategies: the Capital Market Line
 So far, the CAL connected the risk-free asset and the risky portfolio
 What about passive investing?
 Avoiding any direct or indirect security analysis
 Well-diversified portfolio of common stocks
 Index funds or ETFs
 When combining the risk-free asset with the market portfolio, we get the Capital
Market Line (CML) instead of the CAL

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Capital allocation
Return, risk and Sharpe ratio
 Take another look at this
figure
 How do you call the slope of
this line?
𝐸𝐸 𝑟𝑟𝑃𝑃 −𝑟𝑟𝑓𝑓
 Sharpe ratio, 𝑆𝑆𝑃𝑃 =
𝜎𝜎𝑃𝑃

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International Investment Management

Step 3
Risk aversion and
capital allocation to
risky assets
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Available risky portfolios
 But, where do we invest on the Capital Allocation Line?
 Utility
 Which portfolio do you prefer?
 Risk-free rate (𝑟𝑟𝑓𝑓 ) is 5%

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Utility function
 Utility formula
1
 𝑈𝑈 = 𝐸𝐸 𝑟𝑟 − 𝐴𝐴𝜎𝜎 2
2

 𝑈𝑈 = Utility
 𝐸𝐸(𝑟𝑟) = Expected return on the asset
or portfolio
 𝐴𝐴 = Coefficient of risk aversion
 𝜎𝜎2 = Variance of returns

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Coefficient of risk aversion
Assess risk profile in the Netherlands
 Each bank has its own questionnaire
 Do you sleep worse when you lose 25%?
 And so on.
 Risk profile:
 Very defensive; defensive; neutral; offensive; very offensive
 But not always invested accordingly…

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The indifference curves
 To keep utility constant, higher risk needs to be offset by higher return
 Same utility along the line!
 How does the line look for a more risk averse investor?

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The indifference curve
U = .05 and U = .09 with A = 2 and A = 4
 Which investor has A = 4?

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The indifference curve
U = .05 and U = .09 with A = 2 and A = 4
 Notice: the higher the curve, the higher the utility

 Investors aim to invest in a portfolio that lies on the highest curve!

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Capital allocation
Complete portfolios: finding the optimum
 Apply these indifference curves to the CAL-setting
 Here, C is therefore the optimal combined portfolio. Where will C be for
more risk averse investors?

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Determination of optimal overall portfolio
Combining Steps 1, 2, and 3

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ECB3BL
International Investment Management

Index models

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Factor models
 Markowitz portfolio selection drawbacks
 No guidelines for forecasting returns
 Huge number of estimates in covariance matrix
 Factor models
 Simplify ways of describing sources of risk
 Try to explain stock returns using one or more factors
 For example: what is the profit or loss when the economy booms or contracts?

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Single Factor model
 Guidance to future returns
 Return can be decomposed in expected and unexpected part
 Unexpected returns (surprises) can come from economy as a whole and the firm in particular
 Some securities are more sensitive to macroeconomic shocks than others
 𝑟𝑟𝑖𝑖 = 𝐸𝐸 𝑟𝑟𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑚𝑚 + 𝑒𝑒𝑖𝑖
 𝛽𝛽𝑖𝑖 = index of a securities’ particular return to the factor
 𝑚𝑚 = a common macroeconomic surprise factor that affects all security returns, with an expected
value of 0
 𝑒𝑒𝑖𝑖 = firm-specific surprises

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Single Factor model (cont’d)
 Risk
 Similarly, risk can be attributed to market-risk and firm-specific risk
 Total risk for firm 𝑖𝑖 = Systematic risk + Firm-specific risk for 𝑖𝑖:
 𝜎𝜎𝑖𝑖 2 = 𝛽𝛽𝑖𝑖 2 𝜎𝜎𝑀𝑀 2 + 𝜎𝜎 2 (𝑒𝑒𝑖𝑖 )
 Covariance and correlation through the market
 For example: covariance between two asset returns equals the product of betas x market index volatility
(𝜎𝜎𝑀𝑀 2 )

Nice! No covariance matrix needed anymore!

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Index model and diversification
 Portfolio variance
 𝜎𝜎𝑃𝑃 2 = 𝛽𝛽𝑃𝑃 2 𝜎𝜎𝑀𝑀 2 + 𝜎𝜎 2 (𝑒𝑒𝑃𝑃 )
 Variance of the equally weighted portfolio of firm-specific components:
𝑛𝑛 1 2 2 1
 𝜎𝜎 2 (𝑒𝑒𝑃𝑃 ) = ∑𝑖𝑖=1 𝜎𝜎 𝑒𝑒𝑖𝑖 = 𝜎𝜎 2 (𝑒𝑒)
𝑛𝑛 𝑛𝑛
 When n gets large, 𝜎𝜎 2 (𝑒𝑒𝑃𝑃 ) becomes negligible
 Example:
 4 stocks, firm-specific risk 15%, 50%, 20% and 10%
2 1 0.152 +0.502 +0.202 +0.102
 𝜎𝜎 𝑒𝑒𝑃𝑃 = × = 0.020 (method if portfolio assets have equal-weighting)
4 4
 𝜎𝜎 2 𝑒𝑒𝑃𝑃 = 0.252 0.152 + 0.252 0.502 + 0.252 0.202 + 0.252 0.102 = 0.020
 𝜎𝜎 2 𝑒𝑒𝑃𝑃 = 0.020 → 𝜎𝜎 𝑒𝑒𝑝𝑝 = 0.14

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Index model and diversification (cont’d)
 See figure

 Index model can be used to obtain inputs (i.e., 𝛽𝛽, 𝜎𝜎(𝑒𝑒𝑖𝑖 ))

 Also for obtaining optimal portfolio in a different fashion, but portfolio optimization using
the single-index model is discussed only in the MSc. course Investment Management
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Single-Index model
 So, how do we get 𝛽𝛽 and 𝜎𝜎(𝑒𝑒𝑖𝑖 )?
 Operationalization of the single-factor model
 In order to find the sensitivity (beta), we must have a proxy for the macroeconomic
factor: the market index
 Excess returns!
 𝑅𝑅𝑖𝑖 = 𝑟𝑟𝑖𝑖 − 𝑟𝑟𝑓𝑓
 Regression equation:
 𝑅𝑅𝑖𝑖 𝑡𝑡 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑅𝑅𝑀𝑀 𝑡𝑡 + 𝑒𝑒𝑖𝑖 (𝑡𝑡)

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Single-Index model
Example: Randstad
 Randstad Holding is the Netherlands-based staffing services provider. It has
three main service concepts.
 The Staffing concept recruits workers with secondary education through temporary
or permanent placement, as well as offers human resources (HR) solutions, including
payroll services, outplacement, outsourcing and consultancy, among others.
 The Inhouse services concept provides on-site workforce solutions for managing
employees with specific skills, primarily in the manufacturing and logistics segments.
 The Professionals concept covers the recruitment of supervisors, managers,
professionals, interim specialists and consultants with professional qualifications, in
fields such as engineering, information technology (IT), finance, HR, legal, and marketing
and communication. The Company operates in the Netherlands, Germany, the United
Kingdom and the United States, among others. In June 2013, it acquired General
Staffing activities from USG People NV.
 Source: Reuters.com

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Single-Index model
Example: Randstad
50 500

45 450

40 400
Randstad stock price (€)

35 350

AEX Index level

30 300

25 250

20 200

15 150

10 100

5 50

0 0
Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14
Randstad Holding AEX Index

49
Single-Index model
Example: Randstad
Randstad (€) AEX Index R(Randstad) R(AEX)
1 January 2009 14.55 245.94 Note: the calculation of monthly excess
1 Feb 2009 returns involves the monthly raw returns
15.29 245.96
(use data on the left) and the monthly risk
1 March 2009 10.09 208.84 free rate.
1 April 2009 12.815 220.7
1 May 2009 If you download monthly (or 3-month) rates,
17.44 240.76 take into account that annual rates are
1 June 2009 22.57 268.42 displayed.
1 July 2009 19.885 260.29
To arrive at monthly rates, use (1+r)^(1/12)-
1 August 2009 25.565 287.49 1.
1 Sept 2009 27.79 291
1 Oct 2009 28.395 305.74 Excess returns (R) on the next page took
this into account.
….
1 Feb 2014 46.07 383.63

50
Single-Index model
Example: Randstad
Randstad (€) AEX Index R(Randstad) R(AEX)
1 January 2009 14.55 245.94
1 Feb 2009 15.29 245.96 0.049 -0.002
1 March 2009 10.09 208.84 -0.342 -0.153
1 April 2009 12.815 220.7 0.269 0.055
1 May 2009 17.44 240.76 0.360 0.090
1 June 2009 22.57 268.42 0.293 0.114
1 July 2009 19.885 260.29 -0.120 -0.031
1 August 2009 25.565 287.49 0.285 0.104
1 Sept 2009 27.79 291 0.086 0.011
1 Oct 2009 28.395 305.74 0.021 0.050
….
1 Feb 2014 46.07 383.63 -0.023 -0.045

51
Single-Index model
Example: Randstad (scatter plot & SCL)
0.4

0.3

y = 1.947x + 0.0102
0.2
Excess returns, Randstad

0.1

0
-0.8 -0.7 -0.6 -0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

-0.1

-0.2

-0.3

-0.4
Excess returns, AEX

52
Single-Index model
Example: Randstad (regression statistics)
Regression statistics
Multiple R 0.8301
R-square 0.6890
Adjusted R-square 0.6837
Standard error 0.0691 (= firm-specific standard deviation)
Observations 61
ANOVA
Historical intercepts df SS MS
Regression are not stable. 1 0.6233 0.6233
Residual Additional analysis 59 0.2813 0.0048
needed to identify
Total future alpha! 60 0.9047
Coefficients Standard error t-Stat p-Value
Intercept 0.0102 0.0089 1.1398 0.2590
AEX Index 1.9470 0.1703 11.4334 0.0000
53
Alpha and security analysis
 Remember the regression equation:
 𝑅𝑅𝑖𝑖 𝑡𝑡 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑅𝑅𝑀𝑀 𝑡𝑡 + 𝑒𝑒𝑖𝑖 (𝑡𝑡)
 Here: intercept based on historical data
 Attributable to non-market risk factors
 ‘Skill’ if we talk about the alpha of a portfolio manager
 We can use this equation also forward-looking
 Firm-specific surprises are expected to be 0
 We get the required return-beta relationship:
 𝐸𝐸 𝑅𝑅𝑖𝑖 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝐸𝐸(𝑅𝑅𝑀𝑀 )
 Alpha (intercept) is regarded as the non-market risk premium
 Determined by a security analyst when rigorously studying the firm

54
Alpha and security analysis (cont’d)
 Example
 Assume the following stock, where statistical analysis lead to a beta of 1.4 and security
analysis to a non-market risk premium (alpha) of 0.04 (i.e., 4%).
 𝐸𝐸(𝑅𝑅𝑖𝑖 ) = 0.04 + 1.4𝑅𝑅𝑆𝑆&𝑃𝑃𝑃𝑃𝑃 + 𝑒𝑒𝑃𝑃
 Positive alpha, but high market risk
 Answer the following questions:
1. Should we buy or sell this asset?
2. How could we ‘isolate’ our alpha (i.e., how can we get rid of market risk)?

56
Alpha and security analysis (cont’d)
Solution

57
Alpha and security analysis (cont’d)
Solution

58
Alpha and security analysis (cont’d)
Solution

59
Alpha and security analysis (cont’d)
Solution

60
Alpha and security analysis (cont’d)
Solution

61
Thank you for your attention!

62