MS08-105-G Quantitative Methods for Finance

Exercises

1. Dividend yield is the annual dividend per share a company pays divided by the current market price
per share expressed as a percentage. A sample of 10 large US companies provided the following
dividend yield data.

Company Dividend yield % Company Dividend yield %

Altria Group 5.0 General Motors 3.7
American Express 0.8 JPMorgan Chase 3.5
Caterpillar 1.8 McDonald’s 1.6
Eastman Kodak 1.9 United Technology 1.5
Exxon Mobil 2.5 Wal-Mart Stores 0.7

a. What is the z-score for General Motors? Interpret this z-score.

b. Based on z-scores, do the data contain any outliers?

2. A group of investment managers were asked about their short-term investment outlook. Their
responses showed that 4% were very optimistic, 39% were optimistic, 29% were neutral, 21% were
pessimistic, and 7% were very pessimistic. Let x be the random variable reflecting the level of optimism
about the market. Set x = 5 for very optimistic, down through x = 1 for very pessimistic.

a. Develop a probability distribution for the level of optimism of investment managers.

b. Compute the expected value, variance and standard deviation for the level of optimism.
c. Comment on what your results imply about the level of optimism and its variability.

3. The average return for companies making up a stock portfolio is 30% and the standard deviation is
8.2%. Assume that stock returns are normally distributed.

a. What is the probability that a company will have a return of at least 40%?
b. How high does a return have to be, to put a company in the top 10%?
4. Suppose the following monthly returns of stock A and the corresponding stock market index m.
Calculate all possible historical risk-return measures.

A m
1 12.05 12.28
2 15.27 5.99
3 -4.12 2.41
4 1.57 4.48
5 3.16 4.41
6 -2.79 4.43
7 -8.97 -6.77
8 -1.18 -2.11
9 1.07 3.46
10 12.75 6.16
11 7.48 2.47
12 -0.94 -1.15

5. Suppose the following yearly returns of FTSE100, UK. Calculate the mean arithmetic return, the
mean geometric return, the sample variance and standard deviation, the sample skewness, and the
sample kurtosis.

June FTSE100, UK
2003 -13.43%
2004 10.74%
2005 14.54%
2006 14.86%
2007 13.28%

6. Suppose that the monthly exchange rates of EUR-USD are normally distributed, with a mean of 1%
and standard deviation of 8%. What is the probability that the exchange rates are: a) Over 1.5%, b)
Under 3%, and c) Between -2% and 4%.

7. A population has a mean of 200 and a standard deviation of 50. A simple random sample of size 100
will be taken and the sample mean x will be used to estimate the population mean.

a. What is the expected value and standard deviation of x ?

b. Describe the sampling distribution of x . What does this sampling distribution show?
c. What is the probability that the sample mean will be within +/- 10 of the population mean?
8. A simple random sample of 60 items resulted in a sample mean of 80. The population standard
deviation is σ = 15.

a. Compute the 95% confidence interval for the population mean.

b. Assume that the same sample mean was obtained from a sample of 120 items. Provide a 95%
confidence interval for the population mean.
c. What is the effect of a larger sample size on the interval estimate?

9. The average annual total return for domestic equity funds from 1999 to 2003 was 4.1%. A researcher
would like to conduct a hypothesis test to see whether the returns for international equity funds over
the same period are significantly different from the average for domestic equity funds.

a. Formulate the hypotheses that can be used to determine whether the mean annual return for
international equity funds differ from the mean for domestic equity mutual funds.
b. A sample of 40 international equity funds provides a mean return of x = 3.4%. Assume the
population standard deviation for international equity funds is known from previous studies to
be σ = 2%. Use the sample results to compute the test statistic and p-value for the hypothesis
test.
c. At α = .05, what is your conclusion?

10. The volatility of a stock price is 30% per annum. What is the standard deviation of the percentage
price change in one trading day?

11. Suppose that observations on a stock price (in dollars) at the end of each of 15 consecutive weeks
are as follows:
30.2, 32.0, 31.1, 30.1, 30.2, 30.3, 30.6, 33.0, 32.9, 33.0, 33.5, 33.5, 33.7, 33.5, 33.2

Estimate the stock price volatility. What is the standard error of your estimate?

12. Consider a position consisting of a $100,000 investment in asset A and a $100,000 investment in
asset B. Assume that the daily volatilities of both assets are 1% and that the coefficient of correlation
between their returns is 0.3. What is the 5-day 99% VaR for the portfolio?

13. Consider a position consisting of a $300,000 investment in gold and a $500,000 investment in silver.
Suppose that the daily volatilities of these two assets are 1.8% and 1.2% respectively, and that the
coefficient of correlation between their returns is 0.6. What is the 10-day 97.5% VaR for the portfolio?
By how much does diversification reduce the VaR?

14. A stock price is currently 50. Its expected return and volatility are 12% and 30%, respectively. What
is the probability that the stock price will be greater than 80 in two years?
15. A stock price is currently $50. Assume that the expected return from the stock is 18% per annum
and its volatility is 30% per annum. What is the probability distribution for the stock price in two years?
Calculate the mean and standard deviation of the distribution. Determine the 95% confidence interval.

16. Consider a stock with an expected return of 17% per annum and a volatility of 20% per annum. The
probability distribution for the average rate of return realized over 3 years is normal. Calculate the
corresponding mean and standard deviation per annum. Also, construct a 95% confidence interval for
the average return.

17. Consider a Markov variable S that follows the process:

dS = μ dt + σ dz

For the first 3 years μ = 2 and σ = 3; for the next 3 years μ = 3 and σ = 4. If the initial value of the variable
is 5, what is the probability distribution of the variable at the end of year 6.

18. Assume the following data for 4 stocks. Calculate the expected return of each stock, the standard
deviation of each stock, the covariances and the correlation coefficients between all possible pairs of
stocks. Notice that Stock 4 has no correlation at all with Stocks 1, 2 and 3.

Stock 1 Stock 2
Condition Return Probability Condition Return Probability
Good 16 1/4 Good 4 1/4
Average 12 1/2 Average 6 1/2
Poor 8 1/4 Poor 8 1/4

Stock 3 Stock 4
Condition Return Probability Condition Return Probability
Good 20 1/4 Good 16 1/3
Average 14 1/2 Average 12 1/3
Poor 8 1/4 Poor 8 1/3

Also, calculate the expected return and standard deviation of the following portfolios:

1 2 3 4
Portfolio A 1/2 1/2
Portfolio B 1/2 1/2
Portfolio C 1/2 1/2
Portfolio D 1/2 1/2
Portfolio E 1/2 1/2
Portfolio F 1/3 1/3 1/3
Portfolio G 1/3 1/3 1/3
Portfolio H 1/3 1/3 1/3
Portfolio I 1/4 1/4 1/4 1/4
19. Assume the following returns time-series for 3 stocks, regarding the last 6 months. Calculate the
expected return of each stock, the standard deviation of each stock, the covariances and the
correlation coefficients between all possible pairs of stocks.

A B C
1 3.7% 10.5% 1.4%
2 0.4% 0.5% 14.9%
3 -6.5% 3.7% -1.4%
4 1.4% 1.0% 10.8%
5 6.2% 3.4% 4.9%
6 2.1% -1.4% 16.9%

Also, calculate the expected return and standard deviation of the following portfolios:

A B C
Portfolio 1 1/2 1/2
Portfolio 2 1/2 1/2
Portfolio 3 1/2 1/2
Portfolio 4 1/3 1/3 1/3

20. Monthly return data are presented below for 3 stocks and the corresponding market index,
regarding a 12-month period. Calculate the following quantities: a) Alpha of each stock, b) Beta of each
stock, c) The standard deviation of the residuals from each regression, d) The covariance and
correlation coefficient between each security and the market, e) The expected return of the market
index, and f) The variance of the market index.

A B C m
1 12.05 25.20 31.67 12.28
2 15.27 2.86 15.82 5.99
3 -4.12 5.45 10.58 2.41
4 1.57 4.56 -14.43 4.48
5 3.16 3.72 31.98 4.41
6 -2.79 10.79 -0.72 4.43
7 -8.97 5.38 -19.64 -6.77
8 -1.18 -2.97 -10.00 -2.11
9 1.07 1.52 -11.51 3.46
10 12.75 10.75 5.63 6.16
11 7.48 3.79 -4.67 2.47
12 -0.94 1.32 7.94 -1.15
21. Given the data below and the fact that E(Rm) = 8 and σm = 5, calculate: the expected return of each
security, the variance of each security’s return and the covariance of returns between each security.

A B C D
α 2 3 1 4
β 1.5 1.3 0.8 0.9
σεi 3 1 2 4

22. Using the previous problem’s data and assuming and equally weighted portfolio, calculate the
portfolio’s beta, the portfolio’s alpha, the portfolio’s variance and the portfolio’s expected return.

23. Assuming the following assets are correctly priced according to the security market line (SML):
E(R1) = 6% and β1 = 0.5
E(R2) = 12% and β2 = 1.5
Derive the security market line and calculate the expected return on an asset with a beta of 2?

24. Assume that over some period a CAPM was estimated:

E(Ri) = 0.06 + 0.19 x βi

Assume that over the same period two mutual funds had the following results:
Fund A: Actual Return = 10% and Beta = 0.8
Fund B: Actual Return = 15% and Beta = 1.2
What can be said about the mutual fund’s performance?

25. The most recent estimate of the daily volatility of an asset is 1.5% and the price of the asset at the
close of trading yesterday was $30.00. The parameter λ in the EWMA model is 0.94. Suppose that the
price of the asset at the close of trading today is $30.50. How will this cause the volatility to be updated
by the EWMA model?

26. Assume that S&P 500 at close of trading yesterday was 1,040 and the daily volatility of the index
was estimated as 1% per day at that time. The parameters in a GARCH (1,1) model are ω = 0.000002, α
= 0.06 and β = 0.92. If the level of the index at close of trading today is 1,060, what is the new volatility
estimate?

27. The parameters of a GARCH (1,1) model are estimated as ω = 0.000004, α = 0.05 and β = 0.92. What
is the long-run average volatility and what is the equation describing the way that the variance rate
reverts to its long-run average? If the current volatility is 20% per year, what is the expected volatility in
20 days?
28. The daily volatility of a stock market general index is presented in the following graph, as this has
been estimated for a 5-years horizon, by means of a GARCH (1,1) model. Comment on the findings of
the graph.

ω 0.00001
α 0.0782
β 0.9091

29. Derive the analytical form of an ARMA (1,1) model, from the condensed equation:

(1 - φ1 Β) Yt = c + (1 - θ1 Β) et

30. Derive the analytical form of an ARIMA (1,1,1,) model, from the condensed equation:

(1 - φ1 Β) (1 - B) Yt = c + (1 - θ1 Β) et