ECO423A: Financial Economics

Assignment 1
Date: 25th May 2019
Last date of Submission: 14th June by midnight (positively)
Total Marks 100
Instructions:
1. All questions are compulsory
2. It is an individual assignment and it is compulsory for everyone
3. You can submit the assignment handwritten.
4. Please go through the lecture notes and Bodie, Kane and Marcus (BKM) Chapters 5-10 to
understand the problem statement.
5. Spreadsheet work needs solver and for your convenience, I have attached the user document that
explains the usage of Solver. An excel file is also attached for your reference. Please have a look.
6. Considering the difficulty-adjusted return, all questions carry equal marks. Please try to maximize
your difficulty based Sharpe ratio.

1. Assume that you are considering selecting assets from among the following four candidates:

Asset 1 Asset 2
Market Return Probability Market Return Probability
condition condition
Good 12 ¼ Good 3 ¼
Average 10 ½ Average 6 ½
Poor 8 ¼
Poor 4 ¼

Asset 3 Asset 4
Market Return Probability Rainfall Return Probability
condition
Plentiful 12 1/3
Good 15 ¼
Average 11 ½ Average 10 1/3
Poor 4 ¼ Light 5 1/3

Assume that there is no relationship between the amount of rainfall and the condition of the stock
market.
 a) Solve for the expected return and the standard deviation of return for each separate
investment.
b) Solve for the correlation coefficient and the covariance between each pair of investments.
c) Solve for the expected return and variance of each of the portfolios shows in the following

Portfolio Asset 1 Asset 2 Asset 3 Asset 4

A ½ ½
B ½ ½
C ½ ½
D ½ ½
E ½ ½
F 1/3 1/3 1/3
G 1/3 1/3 1/3
H 1/3 1/3 1/3
I 1/4 1/4 1/4 1/4
d) Plot the original assets and each of the portfolios from Part C in expected return and
standard deviation space.
2. A portfolio consists of 4 securities, 1, 2, 3, and 4. The proportions of these securities are: w1=0.3,
w2=0.2, w3=0.2, and w4=0.3. The standard deviations of returns on these securities (in
percentage terms) are : σ1=5, σ2=6, σ3=12, and σ4=8. The correlation coefficients among
security returns are: ρ12=0.2, ρ13=0.6, ρ14=0.3, ρ23=0.4, ρ24=0.6, and ρ34=0.5. Assume equi-
proportional investment.
a. What is the standard deviation of portfolio return?

3. The returns of 4 assets, A, B, C, and D over a period of 5 years have been as follows:
Portfolio Year 1 Year 2 Year 3 Year 4 Year 5
A 8% 10% -6% -1% 9%
B 10% 6% -9% 4% 11%
C 9% 6% 3% 5% 8%
D 10% 8% 13% 7% 12%

Calculate the expected return on:

a. portfolio of one stock at a time
b. portfolios of two stocks at a time
c. portfolios of three stocks at a time.
d. a portfolio of all the four stocks.

4. The required return on the market portfolio is 16 percent. The beta of stock A is 1.6. The required
return on the stock is 22 percent. The expected dividend growth on stock A is 12 percent. The
price per share of stock A is Rs.260.
a. What is the expected dividend per share of stock A next year?
 b. What will be the combined effect of the following on the price per share of stock?
i. The inflation premium increases by 5 percent.
ii. The decrease in the degree of risk-aversion reduces the differential between the
return on market portfolio and the risk-free return by one-half.
iii. The expected growth rate of dividend on stock A decrease to 10 percent.
iv. The beta of stock A falls to 1.1

5. You decide to invest your money in a stock portfolio consisting of 60% TATA motors and 40%
in Flipkart. Using the data in the following table, you find that TATA has an annual standard
deviation of 0.363 and Flipkart 0.34. The correlation coefficient between the returns of both stock
is 0.34.
a. Calculate the variance and standard deviation of this portfolio.
b. Calculate the relative contribution of each stock to this portfolio’s variance
c. Calculate the β of each stock relative to this two-stock portfolio. Check your results
d. Now calculate portfolio risk (standard deviation) and return using some different values
for the weights and plot the results in risk-return space. Using the given table.
e. The graph you plotted under (d) gives you a good idea what the minimum variance
portfolio looks like, but can you calculate the properties exactly? What weights give the
portfolio its minimum variance? What are this portfolio’s standard deviation and return?
f. How would the graph under (d) look if TATA and Flipkart were perfectly positively
correlated?

Correlation Matrix
Factset Delta ABC Flipkart TCS Return Ann. weight
St.dev
Factset 1 0.08 0.287 0.1
TATA 0.43 1 0.075 0.363 0.1
ABC 0.34 0.28 1 0.06 0.462 0.6
Flipkart 0.55 0.34 0.35 1 0.125 0.340 0.1
TCS 0.62 0.43 0.39 0.58 1 0.10 0.250 0.1

6. Assume that you are assigned the task of evaluating the stock of Reliance Industries. To evaluate
stock, you calculate its required return using the CAPM. The following information is available:
Expected market risk premium 5%
Risk-free rate 2%
Reliance industry’ beta 1.2
Using CAPM, calculate and interpret the expected return of reliance industries.
7. Suppose Godrej has the beta of 0.75 and an expected return of 13%. The risk free rate is 4%.
Calculate the market risk premium and the expected return on the market portfolio.

8. Suppose you have two portfolios A & B. A has 300 stocks which are worth Rs. 10/stocks.
Portfolio B has 50 stock which are worth Rs. 40/stock. You expect a return of 8% for stock A and
a return of 13% for stock B.
(a). What is the total value of the portfolio, what are the portfolio weights and what is the
expected return?
(b) Suppose stocks in portfolio A’s price rise up to Rs 12 and portfolio B’s stocks price fall to Rs.
36. What is the new value of the portfolio? What return did it earn? After the price change, what
are the new portfolio weights?

9. Consider a portfolio of two stocks.

Stock Expected return Volatility

Stock X 15% 40%

Stock Y 7% 30%

Let w denote the weight on Stock A and 1 - w denote the weight on Stock B. Correlation
coefficient equals  X ,Y .
a. Write down a mathematical expression for the portfolio’s mean return and volatility
(standard deviation) as a function of w.
b. What is the portfolio’s mean return and volatility when w = 0.4 if  X ,Y = 0?  X ,Y =
+1?  X ,Y = -1?
c. Suppose  X ,Y = -1? Are there portfolio weights that will result in a portfolio with
no volatility? If so, what are the weights?
10. Suppose you are hired buy a Hedge Fund firm and the firm has asked to give the buy/sell
recommendation using CAPM. You derive the following information for the broad market and
for the stock of ICICI bank.

Expected market risk premium 8%

Risk free rate 5%
Historical beta for ICICI 1.50

You believe that the historical betas do not provide good forecasts of future beta, and therefore
uses the following formula to forecast beta.
Forecasted beta = 0.80 + 0.20 * historical beta
After conducting a thorough examination of market trends and the ICICI financial statements,
you predict that the ICICI return will equal 10%. You should now derive the following required
return for ICICI along with the following valuation decision:
Valuation CAPM Required Return
 i. Overvalued 8.3%
ii. Overvalued 13.8%
iii. Undervalued 8.3%
iv. Undervalued 13.8%

11. Suppose we have portfolio of two stocks. We assume that the risk free rate is 3%.

Stock Expected return Volatility

Stock X 15% 40%

Stock Y 7% 30%

a. What is the minimum variance portfolio when  X ,Y = 0? What is its expected return
and volatility?
b. What is the minimum variance portfolio when  X ,Y = 0.4? What is its expected
return and volatility?
c. What is the minimum variance portfolio when  X ,Y = -0.4? What is its expected
return and volatility?
d. Determine the tangent portfolios and their respective mean returns and volatilities.

12. An investor had invested Rs.8 million each in DLF and Reliance Industries and Rs. 4 million in
BATA, only a week before his untimely demise. As per his WILL this portfolio of stocks were to
be inherited by his wife alone. As the partition among the family members had to wait for one year
as per the terms of the will, the portfolio of shares had to be maintained as they were for the time
being. The WILL had stipulated that the job of administering the estate for the benefit of the
beneficiaries and partitioning it in due course was to be done by the reputed firm of Chartered
Accountants, Menon Brothers. Meanwhile the widow of the deceased was very eager to know
certain details of the securities and had asked the senior partner of Menon Brothers to brief her in
this regard.
For this purpose, the senior partner has asked you to prepare a detailed note to him with
calculations using CAPM, to answer the following possible doubts.
a. What is the expected return and risk (standard deviation) of the portfolio?
b. What is the scope for appreciation in market price of the three stocks-are they overvalued
or undervalued?
You find that out the three stocks, your firm has already been tracking two viz. DLF (A) and
Reliance Industries (B)-their betas being 1.7 and 0.8 respectively. Further, you have obtained the
following historical data on the returns of Bata (BA):
Period Market Return (%) Return of Bata
 1 10 14
2 5 8
3 -2 -6
4 -1 4
5 5 10
6 8 11
7 10 15
On the future returns of the three stocks, you are able to obtain the following forecast from a
reputed firm of portfolio managers.
State of Probability Treasury DLF (%) Reliance BATA BSE-
the bills (%) Industries (%) Sensex
economy (%)
Recession 0.3 7 5 15 -10 -2
Normal 0.4 7 18 8 16 7
Boom 0.3 7 30 12 24 26

Required: Prepare your detailed note to the senior partner.

13. Suppose you have two stocks, P and Q, such that  P = 0.30,  Q = 0.80, RP = 0.10, RQ = 0.06
and rf = 0.02.
a. What is the minimum variance portfolio when  P ,Q = 0 and what is its volatility?
b. What is the minimum variance portfolio when  P ,Q = 0.6 and what is its volatility?
c. What is the minimum variance portfolio when  P,Q = −0.6 and what is its volatility?
d. Also determine the tangent portfolios and their respective mean returns and volatilities
14. Under the similar scenario of above question, suppose you have the investment exposure in three
risky assets whose covariance matrix Σ is
 0.09 0.045 0.01 
 
 =  0.045 0.25 0.06 
 0.01 0.06 0.04 
 
The expected returns are RP1 = 0.11, RP 2 = 0.09, RP 3 = 0.05. The risk-free rate is rf = 0.02.
Solve for the minimum variance portfolio using the first-order optimality conditions, i.e.,
without computing the inverse of the covariance matrix. What is the minimum variance?

15. We assume that the expected return on the tangent portfolio is 10% and its volatility is 40%. The
risk-free rate is 2%.
a. What is the equation of the Capital Market Line (CML)?
b. What is the standard deviation of an efficient portfolio whose expected return of 8%? How
would you allocate Rs.1000 to achieve this position?

16. Take another example and assume that the expected return on the tangent portfolio is 12% and its
volatility is 30%. The risk-free rate is 3%.
 a. What is the equation of the Capital Market Line (CML)?
b. What is the standard deviation of an efficient portfolio whose expected return of 16.5%?
How would you allocate Rs. 3000 to achieve this position?

17. Supper you are planning to invest in stock market with the assumption that the market premium
will be around 9%, market volatility will be 30% and the risk-free rate is hovering around 3%.
a. Given your assumption, could you please write-down the equation of the SML?
b. Suppose a stock invested has a beta of 0.6. According to the CAPM, what is its expected
return?
c. That same stock has a volatility of 60% and a correlation with the market portfolio of
25%. According to the CAPM, what is its expected return?
d. Under another scenario assume that stock invested has a volatility of 80% and a
correlation with the market portfolio of -25%. According to the CAPM, what is its
expected return?

18. Suppose the stock invested (call it X) in the above questions has a beta of 1.20 and you buy
another stock Y which has a beta of 0.8. Suppose rf = 2% and RM = 12%.
a. Following CAPM, what are the expected returns for each stock?
b. What is the expected return of an equally weighted portfolio of these two stocks?
c. What is the beta of an equally weighted portfolio of these two stocks?
d. How can you use your answer to part (c) to answer part (b)?

19. Suppose you are considering two risky assets for investment, X and Y, and a risk-free asset. The
two risky assets are in equal supply in the market, i.e., the market portfolio M = 0.5X + 0.5Y. It
is known that RM = 11%,  X = 20%,  Y = 40% and  X ,Y = 0:75. The risk-free rate is 2%.
Assume CAPM holds.
a. What is the beta for each stock?
b. What are the values for RX and RY ?
20. Suppose we have two assets, X and Y, and a risk-free asset. Stock X has 200 shares outstanding, a
price per share of Rs. 3.00, an expected return of 16% and a volatility of 30%. Stock Y has 300
shares outstanding, a price per share of Rs. 4.00, an expected return of 10% and a volatility of
15%. The correlation coefficient  X ,Y = 0:4. Assume CAPM holds.
a. What is expected return of the market portfolio?
b. What is volatility of the market portfolio?
c. What is the beta of each stock?
d. What is the risk-free rate?

21. Now assume two mutually exclusive portfolios of growth or value stocks (please read about
growth and value stocks). Suppose the growth stock portfolio and value stock portfolio have
equal size in terms of total value. Furthermore, suppose that the expected return of the value
stocks is 13% with a volatility of 12%, whereas the expected return of the growth stocks is 17%
with a volatility of 25%. The correlation of the returns of these two portfolios is 0.50. The risk-
free rate is 2%.
a. What is the expected return and volatility of the market portfolio (which is a 50-50
combination of the two portfolios)?
 b. Does CAPM hold in this economy?

22. Suppose you are working as an Investment Analyst in an investment firm and you have been
assigned one client. Your client has decided to invest in exactly one of two risky funds, P1 and
P2 . He comes to you for an investment advice. Whichever fund you recommend he will combine
it with the risk-free asset. Expected returns are RP1 = 13% and RP 2 = 18%. Assume the risk-free
rate is 4%. Volatilities are  P1 = 20% and  P 2 = 30%. Without knowing your client’s tolerance
for risk, which fund would you recommend?

23. Suppose you are now investor and you have hired a wealth manager who recommends you to
invest in Mutual Fund M. It has an expected return of 14% with a volatility of 20%. The risk-free
rate is 3.8%. Your Wealth Manager suggests you to add Stock B to your portfolio with a positive
weight. Stock B has an expected return of 20%, a volatility of 60% and a correlation of 0 with
Fund M.

a. Is your wealth manager right?

b. You follow your broker’s advice and make a substantial investment in Stock B so that now
60% is in Fund M and 40% is in Stock B. You tell your friend about your investment and
he says you made a mistake and should reduce your investment in Stock B. Is your friend
right?
c. You decide to follow your friend’s advice and reduce your exposure to Stock B. Now Stock
B represents only 15% of your risky portfolio with the rest invested in Fund M. Is the
correct amount to hold of Stock B?

24. Suppose now you are a trained investor and have standalone exposure in mutual funds which has
strong exposure to infrastructure (Say DSP Blackrock) and have investment in risk free asset as
well. The mutual funds (NAVs) have an expected return of 12% and a volatility of 25%. The risk-
free rate is 4%. Your old wealth manager is still in touch with you and suggests you to add
another mutual funds to your current portfolio (say SBI Magnum). The Magnum has an expected
return of 20%, a volatility of 80% and a correlation of 0.2 with the DSP mutual funds.
a. Is your Wealth Manager (WM) right?
b. Suppose you follow your WM ’s advice and put 50% of your money in the SBI fund.
(You sell 50% of your value of the DSP). What is the Sharpe ratio of your
new portfolio?
c. What is the optimal fraction of your wealth to invest in the SBI fund?

25. Download the monthly data (at-least five years) of five stocks of your choice from Yahoo
Finance and calculate the following:
a. Calculate the minimum variance portfolio with optimal weights by considering only two
stocks. Also, draw the efficient frontier of the same.
b. Find the optimal weights and maxim Sharpe ratio by considering all five stocks portfolio
and draw the efficient frontier.
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