FINC3017 Investments and Portfolio Management Tutorial 4 Solutions Single Index Model
1.
Estimate the Single-Index Model for Cabcharge, David Jones, Macquarie Group and Tabcorp using excess returns for the full sample from 31 January 2001 to 31 July 2012. a) Which stock has greater systematic risk? Comment on the differences in the estimates of systematic risk across the four companies. b) Which stock has the highest firm-specific risk? c) Which stock has the highest alpha? d) Which stock would you want to invest in for the next 12 months?
2.
What is the difference between the Markowitz approach and the Sharpe approach to solving the portfolio choice problem?
Solving the portfolio choice problem involves determining the portfolio weights that either maximise return given a particular level of risk, or minimises the variance for a particular level of portfolio return. As such, three inputs are required: asset expected returns, variances and covariances. The standard Markowitz approach requires the estimation of the full covariance matrix. For example, if there are 20 shares in a portfolio, the Markowitz approach requires 20 expected returns, 20 variance estimates and N(N1) covariances (e.g. 20(19)/2 = 190 covariance estimates, or 230 estimates in total. The Sharpe approach uses the market model to simplify this step by reducing the number of parameters which must be estimated. By relating to an index, the number of estimates required is three for every asset and then another two to describe the behaviour of the market. This makes 3N+2 which equates to 62 estimates for a 20 asset portfolio. Since each of these terms may be estimated with error, it is advantageous to minimise the number of required calculations.
3.
Why do we call alpha a nonmarket return premium? Why are high alpha stocks desirable investments for active portfolio managers? With all other parameters held fixed, what would happen to a portfolios Sharpe ratio as the alpha of its component securities increased?
The total risk premium equals: + ( market risk premium). We call alpha a nonmarket return premium because it is the portion of the return premium that is independent of market performance. The Sharpe ratio indicates that a higher alpha makes a security more desirable. Alpha, the numerator of the Sharpe ratio, is a fixed number that is not affected by the standard deviation of returns, the denominator of the Sharpe ratio. Hence, an increase in alpha increases the Sharpe ratio. Since the portfolio alpha is the portfolio-weighted average of the securities alphas, then, holding all other parameters fixed, an increase in a securitys alpha results in an increase in the portfolio Sharpe ratio.
4.
The following are estimates for two stocks. Stock Expected Return Beta Firm-specific standard deviation A 13% 0.8 30% B 18% 1.2 40% The market index has a standard deviation of 22% and the risk-free rate is 8%. a) What are the standard deviations of A and B? b) Suppose that we were to construct a portfolio with proportions: Stock A: 0.3 Stock B: 0.45 T-bills: 0.25 Compute the expected return, standard deviation, beta and nonsystematic standard deviation of the portfolio. a. The standard deviation of each individual stock is given by: 2 1/ 2 i [ i2 2 M (e i )] Since A = 0.8, B = 1.2, (eA ) = 30%, (eB ) = 40%, and M = 22%, we get: A = (0.82 222 + 302 )1/2 = 34.78% B = (1.22 222 + 402 )1/2 = 47.93%
b. The expected rate of return on a portfolio is the weighted average of the expected returns of the individual securities: E(rP ) = wA E(rA ) + wB E(rB ) + wf rf E(rP ) = (0.30 13%) + (0.45 18%) + (0.25 8%) = 14% The beta of a portfolio is similarly a weighted average of the betas of the individual securities: P = wA A + wB B + wf f P = (0.30 0.8) + (0.45 1.2) + (0.25 0.0) = 0.78 The variance of this portfolio is: 2 2 2 2 P P M (e P ) 2 2 (e P ) is the nonsystematic where 2 PM component. Since the residuals (ei ) are uncorrelated, the non-systematic variance is: 2 2 2 2 (eP ) wA 2 (eA ) wB 2 (eB ) w2 f (e f ) = (0.302 302 ) + (0.452 402 ) + (0.252 0) = 405 where 2(eA ) and 2(eB ) are the firm-specific (nonsystematic) variances of Stocks A and B, and 2(e f ), the nonsystematic variance of T-bills, is zero. The residual standard deviation of the portfolio is thus: (eP ) = (405)1/2 = 20.12% The total variance of the portfolio is then: 2 2 2 P (0.78 22 ) 405 699 .47 The total standard deviation is 26.45%.
5.
Suppose that the index model for stocks A and B is estimated from excess returns with the following results: RA = 3% + 0.7RM + eA RB = -2% + 1.2RM + eB M = 20%; R-squareA = 0.20; R-squareB = 0.12
a) What is the standard deviation of each stock? b) Break down the variance of each stock to the systematic and firm-specific components. c) What are the covariance and correlation between the two stocks? d) What is the covariance between each stock and the market index? a. The standard deviation of each stock can be derived from the following equation for R2: 2 2 Explained variance R i2 i 2 M Total variance
i
Therefore:
2 A
2 2 0.7 2 20 2 AM 980 0.20 R2 A
A 31.30% For stock B: 1.2 2 20 2 2 4,800 B 0.12 B 69.28%
b. The systematic risk for A is: 2 2 A M 0.702 202 196 The firm-specific risk of A (the residual variance) is the difference between As total risk and its systematic risk: 980 196 = 784 The systematic risk for B is: 2 2 B M 1.202 202 576 Bs firm-specific risk (residual variance) is: 4800 576 = 4224
c.
The covariance between the returns of A and B is (since the residuals are assumed to be uncorrelated): Cov (rA , rB ) A B 2 M 0.70 1.20 400 336 The correlation coefficient between the returns of A and B is: Cov (rA , rB ) 336 AB 0.155 AB 31 .30 69 .28 Note that the correlation is the square root of R2: R 2 Cov(rA, rM ) A M 0.201/2 31.30 20 280
Cov(rB , rM ) B M 0.121/2 69.28 20 480
d.
