COMM 324

INVESTMENTS AND PORTFOLIO MANAGEMENT

ASSIGNMENT 1
Due: Jan 27
Section 2 Group Members:
Michael Do Thoi: Student Number - 10205122
Michelle Liu: Student Number 10106394
Henry Tian: Student Number 10111586
Michael Wong: Student Number 10106491

1. Download the monthly price data (Jan 1990-Dec 2015) for the following stocks from
your favorite sources: S&P 500, Citigroup, Intel, Johnson and Johnson, and
McDonald.
a. Calculate the average return (arithmetic), sample variance, skewness, and
kurtosis of the returns for each of the companies. Give some brief
interpretation to your results.
Company
S&P 500
Citigroup
Intel
J&J
McDonalds

Arithmetic
Ave. Return
2.26
11.36
17.10
9.48
5.76

Sample
Variance
212230.1
23036.8
101.6
673.76
854.96

Skewness

Kurtosis

0.136
0.653
0.527
0.696
1.062

-0.536
-1.16
0.745
0.056
-0.194

Arithmetic average return is the mean of the return per month from Jan. 1990
to Dec. 2015. For example, S&P 500 averaged an arithmetic return of 2.26
times compared to its initial price in Jan 1990.
Sample variance measures how far a set of numbers is spread out. A variance
of 0 indicates that the entire sample is identical. A high variance indicates that
the numbers are very spread out from the mean and from each other. S&P 500
has the greatest variance, while Intel has the lowest.
Skewness describes the asymmetry from the normal distribution of a sample.
Positive skewness indicates that data piles up on the normal distributions
peaks left side, with a tail to the right. Negative skewness indicates that data
piles up on the peaks right side, and the tail is to the left. Negatively skewed
distributions have long left tail, which for investors can mean a greater chance
of extremely negative outcomes. Positive skew would mean frequent small
negative outcomes, but extremely bad scenarios are not as likely. All data sets
are positively skewed.
Kurtosis describes whether the shape of the data distribution matches the
normal distribution. A normal distribution has a kurtosis of zero. A flatter
distribution has a negative kurtosis, and a distribution that is more peaked than
a normal distribution has a positive kurtosis. Only Intel and J&J have positive
kurtosis, indicating the shape of their distribution is more peaked than the
normal.

b. Repeat the same calculations for the time period of Jan 2005- Dec 2015.
Offer some explanations if the results are different from a).
Company
S&P 500
Citigroup
Intel
J&J
McDonalds

Arithmetic
Ave. Return
0.201
-0.613
0.228
0.327
1.64

Sample
Variance
112474.9
28142.9
35.5
378.2
693.2

Skewness

Kurtosis

0.569
0.930
1.05
1.05
0.046

-0.392
-0.940
0.476
-0.445
-1.322

The arithmetic average returns for all companies are significantly lower than
in part a). This is because the investment period is only 5 years, whereas the
period in part a) was 25 years. Also, the recession in 2008 likely had a big
factor in lowering the arithmetic average returns for most companies,
especially Citigroup because it is a bank. McDonalds has the highest return,
and this may be because fast food was relatively unaffected by the recession,
as consumers may turn from more expensive meal options to cheaper fast food
during times of economic hardship.
c. Plot the return histogram for S&P 500.

Return Histogram of S&P 500

2. You are considering the choice between investing $50,000 in a conventional bank CD
offering an interest rate of 7% and a one-year Inflation-Plus CD offering 3.5% plus
the rate of inflation
a. Which one is a safer investment if you only care about purchasing power?
What if you only care about nominal returns?
You would invest in a one-year inflation-plus CD offering 3.5% plus the rate of inflation,
because it guarantees the purchasing power of your investment your interest earnings
will not be offset by the reduction in purchasing power of the dollars you will receive at
the end of the year. If you only care about nominal returns, you would choose to invest
$50,000 in a conventional bank CD because the interest rate is higher.

b. Which one should offer a higher expected return and why?

The expected return on the one-year Inflation-Plus CD would depend on the expected
inflation rate for next year. If the inflation rate is higher than 3.5%, then the one-year
Inflation Plus CD will offer a higher expected return than the conventional CD, and
vice versa.
c. If you expect the rate of inflation to be 3% over the next year, which one is a
better investment? Why?
The conventional bank CD would be a better investment when comparing the expected
real rate of return between the two investments. The real rate for conventional bank CD is
0.5% higher than the Inflation-Plus CD.
E(r)conventional bank CD = 0.07 0.03 = 4%
E(r)Inflationplus CD = 3.5%
However, the future real rate is unknown, therefore the real rate of return is risky even if
the nominal rate is risk-free.
d. If you make the investment based in your answer to part c), will your actual
return at the end of next year be better than the alternative?
No. The difference between the nominal rate (7%) and the real risk-free rate (3.5%) does
not necessarily imply that the expected rate of inflation is exactly 3.5%. The difference can
be attributed to the risk-premium related to the uncertainty of real rate of return on the
conventional CDs, which means that the expected rate of inflation is actually less than
3.5% per year.
3. During the past 5 years, you owned 2 stocks that had the following rates of return
Year
Stock T
Stock B
1
0.19
0.08
2
0.08
0.03
3
-0.12
-0.09
4
-0.03
0.02
5
0.15
0.04
a. Compute the arithmetic mean annual rate of return for each stock. Which
stock is most desirable by this measure?
E(r)A = 0.2(0.19) + 0.2(0.08) + 0.2(0.12) + 0.2(0.03) + 0.2(0.15) = .054
= 5.4%
E(r)B = 0.2(0.08) + 0.2(0.03) + 0.2(0.09) + 0.2(0.02) + 0.2(0.04) = .016
= 1.6%
Stock A is more desirable.

b. Compute the standard deviation of annual rate of return for each stock. Which
stock is most desirable by this measure?
=
5

1
[() ()]2

1
: = (0.19 0.054)2 + ( 0.08 0.054)2 + (0.12 0.054)2
5
=

+ (0.03 0.054)2 + (0.15 0.054)2 = 0.013144

1

= [() ()]2 = 0.013144 0.1146

5

1
: = (0.08 0.016)2 + ( 0.03 0.016)2 + (0.09 0.016)2
5
=

+ (0.02 0.016)2 + (0.04 0.016)2 = 0.004668

= 0.004668 0.06832
Stock B is more desirable because the standard deviation is smaller, which implies that
the stock is less volatile and more certainty of outcomes.
c. Compute the geometric mean annual rate of return for each stock. Discuss the
differences in the mean returns relative to the standard deviation of the return
for each stock.
= (1 + 1 ) (1 + 2 ) (1 + 3 ) (1 + 4 ) (1 + 5 )

= (1 + 0.19) (1 + 0.08) (1 0.12) (1 0.03)
(1 + 0.15) = 1.2616
1/5
= 1.2616 1 = 0.04757 = 4.745%

= (1 + 0.08) (1 + 0.03) (1 0.09) (1 + 0.02)
(1 + 0.04) = 1.07383
= 1.073831/5 1 = 0.014348 = 1.4348%
4. The investment manager of a corporate pension fund has purchased a Treasury bill
with 182 days to maturity at a purchase price of $9,600 per $10,000 face value. The
manager has computed the bank discount yield at 8%
a. Calculate the bond equivalent yield for the bill. Show your calculations.
=

10,000 9,600 365

= 0.08356 = 8.356%
9600
182

b. Briefly state two reasons why a bills bond equivalent yield is always different
from the discount yield.
BEY is different than the discount yield because 1) the discount yield is computed
by dividing the dollar discount from par ($10,000) rather than the bills price
($9,600), and 2) the discount rate is annualized by 360 days rather than 365 days.
c. What is the effective annual yield?
= (1 +

10000 9600 365

)182 1 = 0.08531 = 8.531%
9600

5. (Margin Trading) John Jones recently opened a margin account with the Evergreen
Investment Company. Evergreen currently has a 50% initial margin requirement and
a 30% maintenance margin. Mr. Jones initially purchases 300 shares of Micro-Tech
stock at $50 per share.
a. By how much must the price of Micro-Tech stock decline before a margin call
is required?
= 300 (50)(0.5) = 7500
300 7500
0.3 =
300
90 = 300 7500
7500 = 210
= $35.71
The price must drop to $35.71 per share before a margin call is required.
b.

If the market price of Micro-Tech falls to $30 at the end of the day, how much
must Mr. Jones deposit in his brokerage account in order to bring the margin
back to the 40% level?

300(30) 7500 +
300(30)
3600 = 9000 7500 +
= 2100
Mr. Jones must deposit $2100 into his brokerage account in order to bring the
margin back to the 40% level.
0.4 =

c.

i)

What is the return in one year if the stock price is $55 and the financing cost is
4.5% per year? What if the stock price turns out to be $46?
P = $55

=
ii)

300(55) (7500 1.045) 7500

= 0.155 = 15.5%
7500

P = $46
=

300(46) (7500 1.045) 7500

= 0.205 = 20.5%
7500

6. (Short Sale) You decide to sell short 100 shares of Charlotte House Farms when it is
selling at it yearly high of $56. Your broker tells that the margin requirement is 50%,
and the minimum margin is 30%.
a. How much money do you have to put in your margin account?
= 100(56)(0.5) = 2800
b.

How far does the stock price have to change before you receive a margin call
from you broker? How much money do you have to put in your margin
account in order to bring the margin back to its maintenance level if all the
end of the day the stock price increases to 66?

[100(56) + 2800] 100

100
30 = 8400 100
130 = 8400
= $64.62
You will receive a margin call if the price of the stock increases to $64.62 per
0.3 =

share.
(8400 + ) 100(66)
100(66)
1980 = (8400 + ) 6600
8400 + = 8580
= 180
You will need to put an additional $180 into the brokerage account to bring the
margin back to 0.3.
0.3 =

c. While you are short the stock, it pays a $1.50 dividend per share. At the end of
the year you buy 100 shares at $50 per share to close out your position and
pay $80 commission for the transaction. What is the rate of return for this
transaction?
= 100(56) 1.5(100) 100(50) 80 = $370
370
=
= 0.06607 = 6.607%
5600
7. Discuss why trading futures is a risky strategy.
Trading futures is not more inherently risking than trading other investments. Similar
to investments such as stocks, the price of a futures contract may fluctuate up or
down, and do carry more risk than guaranteed fixed-income investments. However,
the maximum leverage in futures trading is usually much higher than other
investments. For example, futures trading offers leverage up to 90 or 95%, while the
leverage for purchasing stocks is usually no more than 50%. This means that
investors can invest in futures contracts by only putting 10% of the value of the

contract. The leverage magnifies the effect of prices changes so that even small
changes in price can result in significant profits or losses.
8. Four investment opportunities are list in the following table:

a. Based on the utility formula above, which investment would you select if you
were risk averse with A=4?
1
= () 2
2
1 = .12 0.5(4)(0.3)2 = 0.06
2 = .15 0.5(4)(0.5)2 = 0.35
3 = .21 0.5(4)(0.16)2 = 0.1588
4 = .24 0.5(4)(0.21)2 = 0.1518
You would select investment 3.
b. Based on the utility formula above, which investment would you select if you
were risk neutral?
Investment 4 would be selected because it offers the highest expected return regardless of
the riskiness of the investment.
9. The average annual rate of return on the TSE 300 Index over the past has averaged
about 3.62% more than the Treasury bill return and that the TSE 300 standard
deviation has been about 16.24% per year. Assume that these values are
representative of investors expectations for future performance and that the recent Tbill rate is 5%.
a. Calculate the expected return and standard deviation of portfolios invested in
T-bills and the TSE 300 index with weights as follows:
0
0.2
0.4
0.6
0.8
1.0
wbill
windex

1.0

0.8

0.6

0.4

0.2

= ar
=1

= + +
=
Portfolio 1:
1 = 0 5% + 1 8.62% = 8.62%
1 = 1 16.24% = 16.24%
Portfolio 2:
2 = 0.2 5% + 0.8 8.62% = 7.90%
2 = 0.8 16.24% = 12.992%
Portfolio 3:
3 = 0.4 5% + 0.6 8.62% = 7.17%
3 = 0.6 16.24% = 9.744%
Portfolio 4:
4 = 0.6 5% + 0.4 8.62% = 6.45%
4 = 0.4 16.24% = 6.496%
Portfolio 5:
5 = 0.8 5% + 0.2 8.62% = 5.72%
5 = 0.2 16.24% = 3.248%
Portfolio 6:
6 = 1 5% + 0 8.62% = 5%
6 = 0 16.24% = 0%
b. Calculate the level of utility for each of the portfolios in a) for an investor
with A=3.
Portfolio 1:
U = 8.62% - 0.5 * 3 * 16.24^2 = 4.6639
Portfolio 2:
U = 7.90% - 0.5 * 3 * 16.24^2 = 3.9439
Portfolio 3:
U = 7.17% - 0.5 * 3 * 16.24^2 = 3.2139
Portfolio 4:
U = 6.45% - 0.5 * 3 * 16.24^2 = 2.4939
Portfolio 5:
U = 5.72% - 0.5 * 3 * 16.24^2 = 1.7639
Portfolio 6:
U = 5% - 0.5 * 3 * 16.24^2 = 1.0349

c. Repeat your calculation in b) with A=5. What do you conclude?

Portfolio 1:
U = 8.62% - 0.5 * 5 * 16.24^2 = 2.0266
Portfolio 2:
U = 7.90% - 0.5 * 5 * 16.24^2 = 1.3066
Portfolio 3:
U = 7.17% - 0.5 * 5 * 16.24^2 = 0.5766
Portfolio 4:
U = 6.45% - 0.5 * 5 * 16.24^2 = -0.1434
Portfolio 5:
U = 5.72% - 0.5 * 5 * 16.24^2 = -0.8734
Portfolio 6:
U = 5% - 0.5 * 5 * 16.24^2 = -1.5934
With a risk aversion of 5, the willingness of the investor to trade-off return and risk
becomes negative for portfolios 4, 5, and 6. Evidently, the returns of 6.45%, 5.72% and
5% are too low for the investor making the utility of these portfolios negative as the risk
overweighs the potential return.

10. Consider the following information about a risky portfolio that you manage, and a
risk free asset: ( )=11%, =15%, =5%.
a. Your client wants to invest a proportion of her total investment budget in your
risky fund to provide an expected rate of return on her overall or complete
portfolio equal to 8%. What proportion should she invest in the risky
portfolio, P, and what proportion in the risk-free asset?
()= ()+ (1 )
8% = y*11%+(1-y)*5%
y = 0.5
Therefore, the client should invest 50% in the risky portfolio and 50% in
the risk free portfolio.
b. What will be the standard deviation of the rate of return on her portfolio?
=
= 0.5 0.15 = 0.075
The standard deviation on this portfolio will be 7.5%

c. Another client wants the highest return possible subject to the constraint that
you limit his standard deviation to be no more than 12%. Which client is more
risk averse?
The first client is more risk adverse, because his standard deviation tolerance
is only 7.5%.
11. Suppose that the borrowing rate that your client faces is 9%. Assume that the S&P
500 index has an expected return of 13% and standard deviation of 25%, that =5%,
and that your fund has the parameters given in Problem 10.
a. Draw a diagram of your clients CAL, accounting for the higher borrowing
rate. Superimpose on it two sets of indifference curves, one for a client who
will choose to borrow, and one who will invest in both the index fund and a
money market fund.

E(r)
Borrower
Lender
13%

CAL

9%
5%

25%

b. What is the range of risk aversion for which a client will neither borrow nor
lend, that is, for which = 1?
For lenders:
y = 100[E(r)-rf]/(A ^2)
A = 1.28
For borrowers:
y = 100[E(r)-rf(B)]/(A ^2)
A = 0.64
0.64 <= A <=1.28

c. Solve a) and b) for a client who uses your fund rather than an index fund.

E(r)
Borrower
Lender
CAL
11%
9%
5%

15%

For lenders:
y = 100[E(r)-rf]/(A ^2)
A = 2.67
For borrowers:
y = 100[E(r)-rf(B)]/(A ^2)
A = 0.89
0.89 <= A <=2.67
d. What is the largest percentage fee that a client who currently is lending ( <
1) will be willing to pay to invest in your fund? What about a client who is
borrowing ( > 1)?
This will depend on the Sharpe ratio.
S = (E(r) rf)/ )
For lenders:
(E(r1) rf - F)/ 1) = (E(r2) rf)/ 2)
(11 5 F)/15 = (13 5)/9
F = 1.2%
For borrowers:
(E(r1) rf - F)/ 1) = (E(r2) rf)/ 2)
(11 9 F)/15 = (13 9)/9
F<0
You can charge a maximum of 1.2% for lender clients to invest in your fund.
Your fund would be inferior for clients who are borrowing.