Assignment Efficiency frontier and the CAPM

PART 1:
1.
Criteria for Selecting Portfolio Stocks:

No. of stocks
Risk associated with the stock.
Correlations amongst the stocks (should be low, i.e. portfolio should be diversified to reduce
risk)
Expected rate of return.

Impact of Diversification on Portfolio Risk:

CASE
A
B
C
D
E

PORTFOLIO
STANDARD DEV
0.085
0.0739
0.061
0.044
0.015
It can be seen that when coefficient of correlation is nearing 1, i.e. in case A the portfolio risk
increased t0 8.5%

In case E where correlation was 0 the portfolio risk was lowest, a mere 1.5%
Hence, diversification helps reduce portfolio risk.

The Efficiency Frontier

The efficient frontier represents that set of portfolios with the maximum rate of return for every
given level of risk, or the minimum risk for every level of return
Efficient frontier are portfolios of investments rather than individual securities except the assets
with the highest return and the asset with the lowest risk
The slope of the efficient frontier curve decreases steadily as you move upward.

2. Selected the following 5 CAC40 companies for the excersise.

Name
AIRBUS GROUP
BNP Paribas SA
Lafarge S.A
L'Oreal SA
Renault

Date

Date

Last Trade

Change

Volume

49.96
55.26
52.31
116.8
65.21

-0.30%
-2.09%
-2.82%
0.26%
1.42%

4,347,338
5,794,049
1,101,108
1,188,713
1,343,019

AIRBUS
Closing Price Monthly Return
10/9/2013
45.25
7.78%
10/10/2013
48.77
7.34%
10/11/2013
52.35
2.23%
10/12/2013
53.52
4.22%
10/1/2014
55.78
-4.55%
10/2/2014
53.24
-5.90%
12/3/2014
50.10

BNP PARIBAS
Date
Closing Price Monthly Return
10/9/2013
50.49
5.76%
10/10/2013
53.4
-0.24%
10/11/2013
53.27
-0.79%
10/12/2013
52.85
9.65%
10/1/2014
57.95
5.00%
10/2/2014
60.85
-5.57%
12/3/2014
57.46

LAFARGE
Date
Closing Price
Monthly Return
10/9/2013
51.31
-3.27%
10/10/2013
49.63
4.41%
10/11/2013
51.82
-1.83%
10/12/2013
50.87
10.32%
10/1/2014
56.12
-3.67%
10/2/2014
54.06
1.05%
12/3/2014
54.63

LOREAL
Closing Price Monthly Return
10/9/2013
124.75
0.64%
10/10/2013
125.55
-1.19%
10/11/2013
124.05
0.16%
10/12/2013
124.25
-1.13%
10/1/2014
122.85
0.16%
10/2/2014
123.05
-3.58%
12/3/2014
118.65

RENAULT
Date
Closing Price Monthly Return
10/9/2013
58.5
11.37%
10/10/2013
65.15
-5.66%
10/11/2013
61.46
-7.11%
10/12/2013
57.09
13.45%
10/1/2014
64.77
1.71%
10/2/2014
65.88
3.49%
12/3/2014
68.18

CAC 40
Date
Closing Price
Monthly Return
10/9/2013 4,106.63
2.76%
10/10/2013 4,219.98
1.04%
10/11/2013 4,263.78
-4.57%
10/12/2013 4,069.12
4.77%
10/1/2014 4,263.27
0.99%
10/2/2014 4,305.50
0.02%
12/3/2014 4,306.26

1
2
3
4
5
6

AIRBUS
7.78%
7.34%
2.23%
4.22%
-4.55%
-5.90%

Mean
STD DEV

0.02
0.05356

BNP PARIBAS
5.76%
-0.24%
-0.79%
9.65%
5.00%
-5.57%
0.02
0.050214944

LAFARGE
-3.27%
4.41%
-1.83%
10.32%
-3.67%
1.05%

LOREAL
0.64%
-1.19%
0.16%
-1.13%
0.16%
-3.58%

0.01
0.05

-0.01
0.01407888

RENAULT
11.37%
-5.66%
-7.11%
13.45%
1.71%
3.49%
0.03
0.077282161

CAC 40
2.76%
1.04%
-4.57%
4.77%
0.99%
0.02%
0.01
0.028606

Table1
Mean
Standard deviation

Stock 1
0.02
0.05356

Stock 2
Stock 3
0.02
0.01
0.050214944
0.05

Stock 4
-0.01
0.01407888

Stock 5
0.03
0.077282161

Table2
Covariance matrix
Stock 1
Stock 2
Stock 3
Stock 4
Stock 5

Stock 1
Stock 2
Stock 3
Stock 4
Stock 5
0.002599797
0.000837604
0.001509747
0.000218216 -0.000659871
0.000837604
0.002738356
0.001183205
0.000380012 0.002329065
0.001509747
0.001183205
0.002455587 -0.000202031 0.002243356
0.000218216
0.000380012 -0.000202031
0.000186469 -0.000303684
-0.000659871
0.002329065
0.002243356 -0.000303684 0.00543614

MINIMUM RISK:
Stock 1
Weight

Stock 2
23.28%

Stock 3
0.00%

Portfolio standard deviation

Desired portfolio return
0.018605067
AVERAGE RISK:
Stock 1
Weight

Stock 2
52.77%

Stock 1

Stock 3

Stock 2
0.00%

0.00%

Portfolio standard deviation

Desired portfolio return
0.073730182

Stock 4
Stock 5
Total
11.81%
35.43%
100.00%

Portfolio return
2.00%
0.020001
Stock 3

0.00%

Stock 4
Stock 5
Total
56.68%
20.04%
100.00%

Portfolio return
0.50%
0.005

0.00%

Portfolio standard deviation

Desired portfolio return
0.034114997
MAXIMUM RETURN:
Weight

0.00%

0.00%

Stock 4
Stock 5
Total
0.00%
100.00%
100.00%

Portfolio return
3.00%
0.03

The desired returns of more than 3% fall out of the efficiency frontier..
Average return is about 2%, maximum is 3% and the minimum risk return would be 0.5%.
In all of the above portfolios stocks LAFARGE and BNP PARIBAS are not taken into consideration,
regardless any desired return.
At the minimum risk level we would invest the most in LOREAL.
At the maximum desired return we would invest all the money in RENAULT.

PART-2:
1.

The CAPM indicates what should be the expected or required rates of return on risky assets
The CAPM formula is used to calculate the expected return.
E(Ri)= RFR + *E (Rm) RFR]

The expected rate is then compared with required rates, and if the expected rate is lower then
the stock is underpriced and it should be bought and vice versa.

2. Risk Free Return (RFR) = 5%

Expected Market Return (E (Rm)) = 7%
= 1.2
Expected Return (E(Ri)) =?
Using, E(Ri)= RFR + [E (Rm) RFR]
= 5 + 1.2 *[ 7 5] = 7.4 %
2. Risk Free Return (RFR) = 12%
Expected Market Return (E (Rm)) = 6%
= 0.66
Expected Return (E(Ri)) =?
Using, E(Ri)= RFR + *E (Rm) RFR]
= 6 + 0.66 *[ 12 6] = 9.96 %
3. Expected Market Return (E (Rm)) = 10%
= 1.5
Expected Return (E(Ri)) =14%
Risk Free Return (RFR) = ?

Using, E(Ri)= RFR + *E (Rm) RFR]

14= RFR + 1.5*[ 10 RFR]
RFR= 2%
4. = .75
Expected Return (E(Ri)) =10%
Risk Free Return (RFR) = 4%
Expected Market Return (E (Rm)) = ?
Using, E(Ri)= RFR + *E (Rm) RFR]
10= RFR + 0.75*[ E (Rm) 4]
E (Rm) = 12%
5. Expected Return =15%
Expected Market Return (E (Rm)) = 6%
= 1.2
Risk Free Return (RFR) = 3%
Expected Return (E(Ri)) =?%
Using, E(Ri)= RFR + *E (Rm) RFR]
= 6.6%
As E(Ri)= 6.6% < Expected Return =15%, The stock is UNDERVALUED.
6. Current Stock Price = $30
Expected Market Return (E (Rm)) = 10%
= 1.25
Risk Free Return (RFR) = 4%
Future Stock Price = $33
Using, E(Ri)= RFR + *E (Rm) RFR] = 11.5%
Return provided by Stock= (33-30)/30 *100 = 10%
Since the return provided by the stock is < Expected Return calculated.
Hence, the stock is OVERVALUED, DONT BUY.
7. RFR= 5%
E (Rm)= 11%

a)
STOCK
A
B
C
D

1.33
0.7
1.5
0.66

Expected Return E(Ri)= RFR + *E (Rm) RFR]

12
12.98
10
9.20
14
14.00
9
8.96

OVER PRICED
UNDER PRICED
FAIRLY PRICED
UNDER PRICED

b)
STOCK
A
B
C
D

(Stocks expected return - risk-free rate)/

5.26
7.14
6.00
6.06

LOWEST
HIGHEST

c) Expected Return A = 12%

Portfolio of C & D
Let w1 be the weight of C in the portfolio and w2 be the weight of D
w2= 1 w1
Return on Portfolio = w1 * ER1 + w2 * ER2
= w1 * 14 + (1-w1) * 6
=5 w1 + 9
For 13% return which is higher than As return
13 =5 w1 + 9 -> w1 = 0.8
Therefore, Invest 80% in C and 20% in D.

d)
STOCK
C
D
C/D
Both the ratios are equal.

RISK PREMIUM
9.00
3.96
2.27

1.5
0.66
2.27