Homework - Set - Solutions Finance 2.2 PDF

homework set, antwoorden 2013
Homework_set_solutions.pdf
Vrije Universiteit Amsterdam (VU) | Financiering: financieel modelleren
Verspreiden niet toegestaan | Gedownload door: Imad Fadili | E-mail adres: imadelfadili@gmail.com
Homework Exercises
NB: These exercises are similar to those that you will encounter on the exam and more difficult than
those in Berk and DeMarzo book. Making these exercises is not obligatory but of course if you do not
make them, most likely you will not be able to pass the exam. During AWVs these exercises will be
discussed. Needless to say, additionally you should be able to solve all the problems at the ends of
Chapters 10-13; these problems are similar to your MyFinanceLab tests.
1. It is well-known that the volatility of gold prices has been very low historically: around 12% per
annum. Lately, the annualized gold volatility has reached 32%. For both historical and current
gold volatilities, compute also the daily, weekly and monthly gold volatilities.
Historic:
day = 12%/(251) = 0.757%
Current:
day = 32%/(251) = 2.020%
week = 12%/(52) = 1.664%

week = 32%/(52) = 4.438%
month = 12%/(12)= 3.464%

month = 32%/(12)= 9.238%

2. Historical annualized return on stocks is approximately 8% and the annualized volatility is 35%.
a) Compute daily, weekly and monthly volatilities.
b) Compute 95% confidence intervals for daily, weekly, monthly and yearly expected returns.
a) day = 35%/(251) = 2.209% , week = 35%/(52) = 4.854% , month = 35%/(12)= 10.104%
b) Return per month: 1.08^(1/12)-1= 0.643%
Return per week: 1.08^(1/52)-1= 0.148%
Return per day: 1.08^(1/251)-1= 0.0307%
[R - 1.96*, R + 1.96*] yearly: [8%-1.96*35%, 8%+1.96*35%]= [-60.6%, +76.6%] etc.

3. The following table gives monthly closing prices of two stocks for the last 12 months.

Date QLogic Mattel
Dec 27.6 22.8

Jan 25.4 21.7
Feb 26.4 22.6
Mar 28.6 23.5
Apr 27.9 23.6
May 25.2 22.0
Jun 25.8 22.8
Jul 26.1 23.2
Aug 21.5 19.9
Sep 19.2 17.2
Oct 19.1 16.3
Nov 19.9 16.4

a) Compute monthly stock price returns. Assume no dividends. Compute average monthly returns.
b) Compute variances, volatilities and annualized volatilities of both stock returns.
c) Compute the 95% confidence intervals for the average monthly returns computed in a) and for
an expected monthly return.
d) Compute the covariance between these stock returns and the correlation coefficient.
e) What are the average return, variance and annualized volatility of the portfolio consisting for
50% of QLogic and 50% of Mattel?
f) Now suppose you have 10 000 $ to invest. You borrow and short sell 5 000 $ worth of Mattel
stock and invest the resulting 15 000 $ into QLogic. What is now the expected return and the
monthly and yearly volatility of your portfolio?
g) Explain what happens to the portfolio volatility in e) and in f) if the correlation between the
stock increases? Why this happens?
a) Returns(t+1): (Rt+1-Rt)/Rt Qlogic: Return(jan): (25.4-27.6)/27.6= -0.0797 or -7.97%
Return(feb): (26.4-25.4)/25.4= 0.0394 or 3.94% etc.

Mattel: Return(jan): (21.7-22.8)/22.8= -4.82%

Return(feb): (22.6-21.7)/21.7= 4.15% etc.
R =
1
T
(R1
Average monthly returns:

Qlogic= -2.631% , Mattel= -2.734%

b)
Var (R) =
1
T ! 1
" (R
+ R2 + ! + RT ) =
1 T
! Rt
T t = 1 :
! R)

Var(RQlogic, monthly)=( (-7.97% - -2.631%)2 + (3.94% + 2.631%)2 + )/(11-1)= 0.00622,
Qlogic(monthly)= (0.00622)= 7.89%, Qlogic(yearly)= (12)*7.89%= 27.32%
Var(RMattel,monthly)=( ( -4.82%- -2.734%)2 + (4.15% + 2.734%)2 + )/(11-1) = 0.00451,
Mattel(monthly)= (0.00451)= 6.71%, Mattel(yearly)= (12)*6.71%= 23.26%

c) Average: [-2.631% -1.96*(7.89%/(11)), -2.631% +1.96*(7.89%/(11))]= [-7.29%, 2.03%]
you divide by sqrt(11) because you have less uncertainty
Expected: [-2.631% -1.96*7.89%, -2.631% +1.96*7.89%]= [-18.09%, 12.83%] Here you do
not divide by sqrt(11) because you have more uncertainty, its about expectations
For Mattel: Average=[-6.70%, 1.23%], Expected= [ -15.89%, 10.43%]

d)
Cov(Ri ,R j ) =
t =1
1
" (Ri,t ! Ri ) (R j ,t ! R j )
T ! 1 t

((-7.97% - -2.631%)*( -4.82%- -2.734%)+(3.94% + 2.631%)*(4.15% + 2.734%)+ )/(11-1)=

0.004823
Measurement of the variance between stocks
Positive: returns tend to move in the same direction, Negative: returns tend to move in the
opposite direction
Corr (Ri ,R j ) =
Cov(Ri ,R j )
SD(Ri ) SD(R j )
Correlation=i,j=0.004823/(7.89%*6.71%)= 0.9165
normalized covariance, always between -1 and +1. If Ri on average changes with x% then Rj
will on average change with i,j*x%

e)
RP = x1 R1 + x2 R2 + ! + xn Rn =
! xR
i
Rp=0.5*-2.631%+0.5*-2.734%=-
2.682%

Var (R ) = x 2Var (R ) + x 2Var (R ) + 2 x x Cov(R ,R )
P
1
1
2
2
1 2
1
2

Var(Rp)= 0.5^2*0.00622 +0.5^2*0.00451 + 2*0.5*0.5*0.004823 = 0.00511
(monthly)= (0.00511)= 7.147%, (yearly)= (12)* 7.147%= 24.76%
0,9
0,8
0,7
0,5
0,6
0,4
0,3
0,2
0,1
-0,1
-0,2
-0,3
-0,4
-0,5
-0,6
-0,7
-0,8
-1
16,00%
14,00%
12,00%
10,00%
8,00%
6,00%
4,00%
2,00%
0,00%
-0,9
volatility (%)
f) Weights: Qlogic = 15000/10000= 1.5(150%) , Mattel= -5000/10000= -0.5(-50%)

Rp=1.5*-2.631%+-0.5*-2.734%=-2.579%
Var(Rp)= 1.5^2*0.00622 +(-0.5)^2*0.00451 + 2*1.5*0.5*0.004823 = 0.00784
(monthly)= (0.00784)= 8.855%, (yearly)= (12)* 8.855%= 30.67%

g) Voor e: Correlation increases Diversification decreases Volatiliteit increases
Voor f: For a higher correlation the volatility decreases, because the volatility of the hedged
portfolio decreases.
correlation
Volatility(portfolio 3e)
Volatility(portfolio 3f)

4. Do exactly the same as in the previous exercise (questions a)-e)), but now for the Dow Jones and
NIKKEI example (the data is at the end of the exercise set: Appendix 1). Note that there daily
closing prices (and not monthly) are given. You can use Excel or scientific calculator. Instead of
question f), consider the following: you have 1 M $ to invest and you borrow additional 0,5 M $
against US risk free rate of 3%. You invest your resulting 1,5 M $ equally in Dow Jones and
Nikkei. What is the expected return and the volatility of your portfolio? (disregard the exchange
rate volatility).
a) Returns(t+1): (Rt+1-Rt)/Rt Nikkei: Dag 1: (16788-16506)/16506= 1.7085%
Dag 2: (16700-16788)/16788= -0.5242% etc.
DJ: Dag 1: (12163-12002)/12002= 1.3414%

Dag 2: (12090-12163)/12163= -0.6002% etc

Nikkei: Rn(day)= 0.1046%,

Dow Jones: Rdj(day)= 0.1323%

Rn(monthly)= (1+0.1046%)^(251/12)-1 = 2.21% Rdj(monthly)=2.80%
b) Var(N,daily)= ( (0.17085%-0.1046%)2 + (-0.5242%-0.1046%)2 + ..) / (20-1) = 0.0001612

N(daily)= (0.0001612)= 1.2698% , N (Yearly)=(251)*1.2698% = 20.12%

Var(DJ, daily)= ( (1.3414%-0.1323%)2 + (-0.6002%-0.1323%)2 + ) /(20-1)= 0.0000484

DJ (daily)= (0.0000484)= 0.6954% , DJ (Yearly)=(251)*0.6954% = 11.02%

c) Nikkei: average:[-9.2%, 13.6%] and expected: [-37.2%, 41.6%]
Dow jones: Average:[-3.4%, 9.0%] , expected:[-18.8%, 24.4%]
d) Cov(N, DJ)= ((1.7085%-0.1046)*(-0.5242%-0.1323%) + (-0.5242%-0.1046%)*(-0.6002%-
0.1323%) + )/(20-1) = 0.00000215
Corr(N, DJ)= 0.00000215/(1.2698%*0.6954%) = -0.0244
e) Rp= 0.5*0.1046% + 0.5*0.1323% = 0.118%, Rp(Yearly)= (1+0.118%)^251 -1 = 34.61%
Var(Rp)= 0.5^2*1.2698%^2 + 0.5^2*0.6954%^2 + 2*0.5*0.5*0.00000215= 0.000051
VolRp, Yearly)= (0.000051*251) = 11.35%
f) Weights: Nikkei= 0.75M/1M=0.75, DJ=0.75M/1M=0.75, Rf=-0.5M/1M=-0.5
Rf(daily)= 1.03^(1/251)-1= 0.0118%
Rp= 0.75*0.1046% + 0.75*0.1323% -0.5*0.0118% = 0.172%,

Rp(Yearly)= (1+0.172%)^251 -1 = 52.87%
Var(Rp)= 0.75^2*1.2698%^2 + 0.75^2*0.6954%^2 + 2*0.75*0.75*0.00000215= 0.000115
VolRp, Yearly)= (0.000051*251) = 17.02%
g) For both portfolios: correlation increases volatility increase

5. A portfolio consists of three stocks, 30% is invested in the first stock, 25% in the second stock
and 45% in the third. The yearly average return is 10% for the first stock, 12% for the second and
13% for the third. The below table gives the historical Variance-Covariance matrix of the
(yearly) stock returns:

0.1 0.04 0.03
0.04 0.2 0.04
0.03 0.04 0.6

a) Compute the average return of the portfolio.
b) Compute the yearly variance and volatility of the portfolio return.
c) Suppose you have 1M $ to invest and, using this as the collateral, you borrow the additional
1M $ against the risk free rate of 5%. You then invest your available 2M in the same three
stocks and in the same proportion as above. What is now your expected return and the
annualized volatility?
d) Same as c), only now you invest half of your 1M into risk free bond paying 3% p/a and the
remaining half into the above three stocks in the same proportions. What is now your
expected return and the annualized volatility?

a) Rp= x1*R1+x2*R2+x3*R3 = 0.3*10%+0.25*12%+0.45*13%= 11.85%

b)

So Var(Rp)= (w1)2*var(R1) + (w2)2*var(R2) + (w2)2*var(R2) + 2*(w1*w2*Cov(R1,R2))

+ 2*(w1*w3*Cov(R1,R3))

+ 2*(w2*w3*Cov(R2,R3))
Var(Rp)= (0.3)2*0.1 + (0.25)2*0.2 + (0.45)2*0.6 + 2*(0.3*0.25*0.04) + 2*(0.3*0.45*0.03) +
2*(0.25*0.45*0.04) = 0.1661
Vol(Rp) = (Var(Rp) = (0.1661) = 40.755%
c) Invest: 2M in stocks 1M at 5%
Rp = 2*Rs 1*Rf = 2*11.85% - 5% = 18.70%
Vol(Rp)= 2*40.755% = 81.51%

d) Invest: 0.5M in stocks + 0.5M in Rf bond at 3%
Rp= 0.5*Rs + 0.5*3% = 0.5*11.85% + 0.5*3% = 7.425%
Vol (Rp)= 0.5*40.755% = 20.38%

6. A portfolio consists of 8 stocks. The following is known about the weights wi, the volatilities and
the correlations:
w1 = w2 = 0.2; w3 = w4 = w5 = w6 = w7 = w8 = 0.1
corr(ij) = constant = 0.3
vol(i) = constant = 40%
a) Compute the variance and volatility of the portfolio return.
b) Now suppose all the weights are the same. Again compute the variance and volatility of the
portfolio return.
c) As the number of these stocks in your portfolio increases, what happens to the expected
return and the volatility of your portfolio?

a) Variance van aandeel is 0.40^2=0.16, Covariantie= 0.4*0.4*0.3 = 0.048

Var(Rp)= 2*(0.2)2*0.16 + 6*(0.1)2*0.16 + 2*0.2*0.2*0.048 + 12*2*0.2*0.1*0.048 +
15*2*0.1*0.1*0.048= 0.06368
Vol(Rp)= (0.06368) = 25.235%
b) w=0.125 Var(Rp)= 8*(0.125)2*0.16 + 28*2*0.1252*0.048= 0.062, or
Var(Rp)=(1/n)*Var(Ri) + (1-(1/n)*Cov(Ri,Rj) = (1/8)*0.16+ (1-1/8)*0.048=0.062
Vol(Rp) = (0.062) = 24.90%
c) Verwachte return kan je niks over zeggen, niet gegeven. Maar verwacht dat deze
hetzelfde blijft want de aandelen lijken exact hetzelfde.
1 aandeel in portfolio Var= 0.16
8 aandelen in portfolio Var= 0.062 Dus neemt af

7. A portfolio consists of four stocks, 25% is invested in each stock. The yearly average return is
10% for the first stock, 12% for the second stock, 15% for the third stock and 17% for the fourth
stock. The yearly volatilities are 25% for the first and the second stocks and 30% for the third
and fourth stocks. Correlations between all pairs of stocks are the same and equal to 0.4.
a) Compute the average portfolio return.
b) Compute the yearly variance and volatility of the portfolio return.
c) Estimate the 95% Value-at-Risk of the 10-day horizon on the basis of the variance/volatility obtained
in b) and the assumption of normality of the asset returns.
a) Rp= 0.25*10% + 0.25*12% + 0.25*15% + 0.25*17% = 13.5%
b) Var(Rp)= (0.252*0.252)*2 + (0.252*0.302)*2 + 2*(0.25*0.25)*(0.25*0.25*0.4) +
2*(0.25*0.25)*(0.25*0.3*0.4)*4 + 2*(0.25*0.25)*(0.3*0.3*0.4)= 0.0417
Vol(Rp)=(0.0417)= 20.42%

c) VaR(95%): z=-1.645, VaR=ABS((1.135^(10/251)-1)-1.645*20.42%*(10/251))= 6.20%

(T=252 VaR=6.19%)

8. A portfolio consists of four stocks: KLM, BP, Nestle en Alcom. 25% is invested in each stock. The
yearly average returns are 13.8 % for KLM, 9 % for BP, 14.2 % for Nestle en 20 % for Alcom. The
yearly volatilities are 0.55, 0.24, 0.15 and 0.3 respectively for KLM, BP, Nestle en Alcom. The
next table gives the historical correlation matrix:
KLM BP Nestle Alcom
KLM 1 0.3 0.3 0.5
BP 0.3 1 0.3 0.4
Nestle 0.3 0.3 1 0.3
Alcom 0.5 0.4 0.3 1

a) Compute the average yearly return on the portfolio.

b) Compute Variance-Covariance matrix.
c) Compute the yearly variance and volatility of the portfolio return.
d) Estimate the 95% VaR for the horizon of 10 days on the basis of the variance/volatility found in
b) and the assumption of the normal distribution of stock returns.
a) Rp= 0.25*13.8% +0.25*9%+ 0.25*14.2% + 0.25*20%= 14.25%
b) Cov(Ri, Rj) = Corr(Ri, Rj)*Vol(Ri)*Vol(Rj)
Var-Covar
KLM
BP
Nestle
Alcom
KLM
0,3025
0,0396
0,0248
0,0825
BP
0,0396
0,0576
0,0108
0,0288
Nestle
0,0248
0,0108
0,0225
0,0135
Alcom
0,0825
0,0288
0,0135
0,0900
2
2
2
c) Var(Rp)= 0.25 *0.3025 + 0.25 *0.0576 + 0.25 *0.0225 + 0.252*0.09 +2*0.252*0.0396 +
2*0.252*0.0248 + 2*0.252*0.0825 + 2*0.252*0.0108 + 2*0.252*0.0288 + 2*0.252*0.0135=
0.0545
Vol(Rp)=(0.0545)= 23.35%
d) N(0.95)= 1.645 VaR(95%)=ABS( (1.1425^(10/251)-1) -1.645*0.2335*(10/251))= 7.12%

9. A portfolio is worth today 10 mln euro. Appendix 2 reports 100 sorted historical values of this
portfolio after 1 day.
a) Compute VaR(95%, 1 day), VaR(97.5%, 1 day), VaR(90%, 1 day) and the corresponding
Expected Shortfalls with the help of these historical data.
b) Furthermore, it is known that the average portfolio value change (absolute, so not relative)
is 0.08 and the standard deviation of the value change is 0.158. Compute the same VaRs as
in a) with the help of the normal distribution assumption. Give your meaning about the
suitability of the normal distribution for this portfolio.
c) Compute the VaR(95%, 5 days) and VaR(95%, 10 days) with the help of your answers b).
Solution in excel
10. Consider the following portfolio: 100 shares of Royal Dutch, todays price 50 euro per share.
Furthermore it is known that the average return in one year is 12,5% and the yearly volatility is
30%. Compute VaR(1 year, 95%) and VaR(1 year, 99%) assuming that the returns are normally
distributed. Compute also VaR(95%, 1 month) and VaR(95%, 1 day) .
100 shares, 50 euro per share. 1-year average return = 12.5%. 1-year = 30%.
VaR(1 year, 95%) = ABS(12.5 1.645*30) = 36.85%
VaR(1 year, 99%) = ABS(12.5 2.326*30) = 57.28%
VaR(95%, 1 month) = ABS((1.125^1/12 -1) 1.645 * 30/sqrt(12)) = 13.204%
VaR(95%, 1 day) = ABS((1.125^1/251 -1) 1.645 * 30/sqrt(251)) = 3.0655%
Can also be calculated in real terms, just multiply with the portfolio value (50*100)

11. An amount of 100 000 Euros is invested in oil futures. In the Appendix 3 you will find 400 sorted
historical changes in the portfolio value after one day.
a) Compute historical VaR(95%, 1 day), VaR(97.5%, 1 day), VaR(99%, 1 day) and the
corresponding Expected Shortfalls.
b) Furthermore, it is known that the average portfolio value change in 1 day is equal to 45 and
the standard deviation of the value changes is 2100. Compute the same three VaRs as in a)
with the help of the normal distribution assumption. Give your opinion about the suitability
of the normal distribution for this portfolio.
c) Compute the VaR(95%, 5 days) en VaR(95%, 10 days) with the help of your answers in b).
Solution in excel

12. Portfolio consists of stocks all with the same volatility (40%) and the same correlation of 0.3
between each pair of stocks.
a) Imagine this is the model for the AEX index (the index is of course a value-weighted
portfolio; however, here just for the purpose of illustration we assume it is an equally
weighted portfolio). What is the volatility of the index (i.e., of a portfolio consisting of 25 of
these stocks)?
b) How many stocks of this kind your portfolio should have so that the portfolio volatility is
30% ? And how many stocks so that the portfolio volatility is 20%?
c) What is the lowest portfolio volatility that you can achieve using these stocks?
a) Var= 0.42= 0.16, Cov=0.4*0.4*0.3= 0.048

Var(Rp) = 1/n (average variance of the individual stocks) + (1-1/n)(average covariance
between the stocks) = (1/25)*0.16 + (1-1/25)*(0.048)= 0.05248

Vol(Rp)= (0.05248)= 22.91%
b) Via excel solver: Vol(Rp)= 30% stock=2.66, so 2
Vol(Rp)=20% kan niet
c) Using infinite number of stocks: first term=0 and second term= 0.048
So Vol=(0.048)= 21.91%

13. Calculate 95% 1-day VaR for the following portfolio: 20-mln $ portfolio with the annual return
volatility of 22%. Assume that the average daily return is zero.
20M $, average daily return = 0%, annual return volatility = 22%
VaR(95%, 1 day) = ABS(20M * (0 1.645 * 0.22/sqrt(251)))= 0.457M

14. Consider the Dutch stock market. The average market return is 10% p/a and risk-free rate is
3,25% p/a.
a) What is the beta and the risk premium of the Dutch Treasury Certificates?
b) What is the beta and the risk premium of the AEX index?
c) You invest 1 mln euros in DTCs and 2 mln euros in AEX. What is the beta of your portfolio?
d) TomTom has beta of 2,2 and Shell of 0,6. What average return investors expect from these
companies?
e) You can invest in a company with beta of 1,7 and the average historical return of 15%. On
the basis of CAPM, would you do that?
a) DTC = 0,
risk premiumDTC = 0
b) AEX = 1,
risk premiumAEX = 10 3.25 = 6.75%
c) portfolio = wAEX * AEX + wDTC * DTC = 2/3
d) rTomTom = rf + TomTom * (rm rf) = 3.25 + 2.2 * 6.75 = 18.1%
rshell = rf + shell * (rm rf) = 3.25 + 0.6 * 6.75 = 7.3%
e) r? = rf + ? * (rm rf) = 3.25 + 1.7 * 6.75 = 14.725% < 15% Yes, here is an opportunity.

15. You performed a simple linear regression (e.g., with Excel) to determine the beta of a company.
Your output looks like this:
Coefficient Standard error
Intercept 0,08 0,05
Slope 0,58 0,13
On the basis of this output, give the 95% confidence interval for the beta. You also looked up the
beta for this company on Bloombergs website and saw that it is 0,7. Is this in conflict with your
results?
95% Confidence Interval for the gives 0.58 1.96 * 0.13 = [0.325 ; 0.835]

The beta of 0.7 lies within the interval so is not in conflict with the findings
16. A computer company has a beta of 1,8. The average market return is 9% and the risk free rate is
3,75%.
a) Draw the Security Market Line.
b) What average return investors expect from this company?
c) This company decided to develop a new business in computer games. The management
considers this business comparable to the core business. What discount factor should the
management use to discount future cash flows of the new business?
d) Consultants claim that the new business is more risky, and is more comparable with the core
business of Nintendo, whos beta is 2,2. What discount factor would consultants use?
a)

b) rcomp = rf + comp * (rf rm) = 3.75 + 1.8 * (9- 3.75) = 13.2%
c) The same risk as the core business, so the discountfactor is the same as the one of the
core business. The discountfactor is equal to the expected return= 13.2%
d) dfcomp = rcomp = rf + nintendo * (rf rm) = 3.75 + 2.2 * (9- 3.75) = 15.3%
17. In the next table you see the average returns and volatilities of various portfolios. Draw them on
a plot with the volatilities on x-axis and returns on y-axis. Which portfolios are definitely not
efficient?
Portfolio A B C D E F G H I
r(%) 15 10 12 20 17 17 15 11.5 13
vol(%) 7.5 6 5 15 12 15 10 4.5 5.5
Portfolio B, F and G are definitely not efficient. There are other portfolios that have a higher
return with the same volatility or a lower volatility with the same return.
B vs C/H/I, F vs. D/E, G vs. A
18. The betas of the following companies are: 2,2 for Amazon, 1,7 for Microsoft, 0,4 for Exxon and
0,3 for Coca Cola, the corresponding volatilities are 55%, 50%, 40% and 35%. The average
market return (represented by S&P500) is 10%, the risk free rate is 3,15% and the volatility of
the stock index is 20% p/a.
a) Draw the Security Market Line. Which return investors expect from these companies?
b) What are the correlations of these four stocks with S&P500?
c) Assume that the correlation between Amazon and Microsoft returns is 0,4 and all other
pairwise correlations are 0,2. What is the expected return and the volatility of the portfolio
equally invested in these four stocks? What is the Sharpe ratio of this portfolio?
d) Can you achieve the same return but with a lower volatility by investing in S&P500 and US
Treasury bills? If yes, then how?
a)

b)

c)

ramazon = rf + amazon * (rm rf) = 3.15 + 2.2 * (10 3.15) = 18.22%
rmicrosoft = rf + microsoft * (rm rf) = 3.15 + 1.7 * (10 3.15) = 14.8%
rexxon = rf + exxon * (rm rf) = 3.15 + 0.4 * (10 3.15) = 5.9%
rcoca-cola = rf + coca-cola * (rm rf) = 3.15 + 0.3 * (10 3.15) = 5.21%
Formula 11.23 gives: i = (SD(Ri) * Corr(Ri, Rmkt))/SD(Rmkt).
Corr( Ramazon, Rmkt) = (2.2*20)/55 = 0.8
Corr( Rmicrosoft, Rmkt) = (1.7*20)/50 = 0.68
Corr( Rexxon, Rmkt) = (0.4*20)/40 = 0.2
Corr( Rcoca-cola, Rmkt) = (0.3*20)/35 = 0.171429
rportfolio = 0.25* ramazon + 0.25* rmicrosoft + 0.25* rexxon + 0.25* rcoca-cola = 11.0325%
Cov(Ri,Rj)= SD(Ri)*SD(Rj)*Corr(Ri,Rj), on the diagonal variances of the stocks

Var-Covar matrix
0,3025
0,11
0,11
0,25
0,044
0,04
0,0385
0,035
0,044
0,04
0,16
0,028
0,0385
0,035
0,028
0,1225

varianceportfolio = 0.252*0.3025+ 0.252*0.25+ 0.252*0.16+ 0.252*0.1225+
2*0.252*0.11 + 2*0.252*0.04 +2*0.252*0.0385 +2*0.252*0.04 +2*0.252*0.035 +0.028
=0.089, volatilityportfolio = sqrt(0.089) = 29.85%

SharpeRatioportfolio = premiumportfolio / volatilityportfolio = 7.8825%/29.85% = 0.264
d)
Returnportfolio = 11.0325%. You have to earn a premium of (11.0325-3.15) =
7.8825% with the investment. The S&P earns a premium of (10-3.15) = 6.85%. So put
7.88525/6.85 = 1.15 of your wealth in S&P to get the same return. Volatility is
(1.152*20%2) = 23% , so YES.

19. Let the average return on S&P500 be 8% p/a and the risk-free rate 3% p/a.

a) What are the betas and risk premia on S&P500 and on US Treasury bills?
b) You invest 3M in US Treasuries and 7M in S&P500. What is the beta of your investment?
c) McDonalds corporation has the beta of 0.4 and Apple has the beta of 1,7. What return do
investors expect from these companies?
d) Suppose the volatilities of McDonalds and Apple are 35% and 50% p/a respectively. How
correlated are the returns of McDonalds and of Apple with the American stock market, if the
volatility of S&P500 is 20% p/a?
e) What is the average return and the volatility of the portfolio consisting of 50% of McDonalds
and 50% of Apple, if the correlation between returns on these two stocks is 20%? What is
the Sharpe ratio of this portfolio?
f) How can you achieve the same return but with a lower volatility by investing in S&P500 and
US Treasury bills?
a) TB = 0, risk premiumTB = 0,
S&P = 1, risk premiumS&P = 8% 3% = 5%
b) portfolio = wS&P * S&P + wTB * TB = 0.7
c) rmacd = rf + macd * (rf rm) = 3 + 0.4 * (8 3) = 5
rapple = rf + apple * (rf rm) = 3 + 1.7 * (8 3) = 11.5
d) Formula 11.23 gives: i = (SD(Ri) * Corr(Ri, Rmkt))/SD(Rmkt)

Corr(Ri, Rmkt)=SD(Rmkt)*i/SD(Ri)
Corr( Rmacd, Rmkt) = (0.4*20)/35 = 0.228571
Corr( Rapple, Rmkt) = (1.7*20)/50 = 0.68
e) Returnportfolio = 0.5 * returnmacd + 0.5 * returnmacd =0.5*5+0.5*11.5= 8.25%
varportfolio= 0.52*35%2 + 0.52*50%2 + 0.5*0.5*0.20*35%*50% = 0.22125 dus
volatilityportfolio = 47.037%
SharpeRatioportfolio = premiumportfolio / volatilityportfolio = 5.25%/47.037% = 0.112

f) The premiumportfolio = 8.25% - 3% = 5.25%. The premiumS&P = 5%. You have to invest
5.25/5 = 1.05 of your wealth in S&P to get the same return. This gives a volatility of
sqrt(1.052*20%2) = 21%

20. Shell is considering a new oil exploration project in Australia. The beta of Shell (with respect to
the market (S&P500)) is 0.6, the risk-free rate 3% and the market risk premium 7%.
a) What is the cost of capital for this project, if we assume it is as risky as the core business of
Shell?
b) If we use Carhart 4-factor model, what is then the cost of capital? (Shell finance people have
estimated its betas with respect to SMb portfolio (0.2), HML portfolio (0.6) and momentum
portfolio (-0.3) and used historical returns on respective portfolios given in Table 13.1).
a)
The cost of capital is the expected return:

CoCshell = rshell = rf + shell * (rf rm) = 3 + 0.6 * 7 = 7.2%
b)
CoCshell = rshell = rf + S&P * 7 + SmB * SmB + HmL * HmL + mom * mom

Get the information using table 13.1 of the book, this gives:
Monthly returns: SMB=0.23%, HML=0.41%, MOM=0.77%, in the model yearly returns
are used
CoCshell = rshell = 3 + 0.6 * 7 + 0.2 *2.80% + 0.6 * 5.03% + (-0.3) * 9.64%= 6.09%

Additional problems related to Chapter 12
Consider the following information regarding corporate bonds (there was a mistake in this table in the
original exercise sheet: the average beta for BBB debt is 0.1 and NOT 1.0):

Rating
AAA
AA
A
BBB
BB
B
CCC
Average Default Rate
0.0% 0.0% 0.2% 0.4% 2.1% 5.2% 9.9%
Recession Default Rate
0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 43.0%
Average Beta
0.05 0.05 0.05
0.1
0.17 0.26 0.31

21. Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of 7.0%,
and a BBB rating. The bondholders expected loss rate in the event of default is 70%. Assuming
a normal economy, what is the expected return on Wyatt Oil's debt?
rd = ytm - prob(default) loss rate = 7% - 0.4%*(70%) = 6.72%

22. Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of
8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%.
Assuming the economy is in recession, what is the expected return on Rearden Metal's debt?
rd = ytm - prob(default) loss rate = 8.6% - 16.0%*(50%) = 0.6%
Consider the following information regarding four companies:

Market
Total
Capitalization Enterprise
Equity
Debt
Company
($mm)
Value ($mm)
Beta
Rating
Taggart Transcontinental
$4,500
8,000
1.1
BBB
Rearden Metal
$3,800
7,200
1.3
AAA
Wyatt Oil
$2,400
3,800
0.9
A
Nielson Motors
$1,500
4,400
1.75
BB
and the following information regarding corporate bonds (same as above):

Rating
AAA
AA
A
BBB
BB
B
CCC
Average Default Rate
0.0% 0.0% 0.2% 0.4% 2.1% 5.2% 9.9%
Recession Default Rate
0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 43.0%
Average Beta
0.05 0.05 0.05
0.1
0.17 0.26 0.31

23. Estimate the asset beta for each company using the information in the two tables above.
For example, for Taggart we have: since Taggart has a rating of BBB, the appropriate debt beta
from the table is 0.10.
!
!
!, !""
!, !!! !, !""
!! = !! + !! =
!. ! +
!. ! = !. !!"#
!
!
!, !!!
!, !!!
Since Rearden has a rating of AAA, the appropriate debt beta from the table is 0.05.
!
!
!, !""
!, !"" !, !""
!! = !! + !! =
!. ! +
!. !" = !. !"#!$$
!
!
!, !""
!, !""

For other companies, the same arguments can be used.

24. Suppose that because of the large need for steel in building railroad infrastructure, Taggart
Transcontinental and Rearden Metal decide to into one large conglomerate. Estimate the asset
beta for this new conglomerate.
conglomerate
= WTT UTT + WRM U RM =
8,000
7, 200
( 0.6625) +
( 0.709722 ) = 0.684868
8,000 + 7, 200
8,000 + 7, 200

25. Galt Industries has a market capitalization of $50 billion, $30 billion in BBB rated debt, and $8
billion in cash. If Galt's equity beta is 1.15, what is then the Galt's underlying asset beta?
!! =

!
!!
!"
!" !
!! +
!! =
!. !" +
!. ! = !. !"
!+!
!+!!
!" + !" !
!" + !" !

26. Your firm is planning to invest in a new electrostatic power generation system. Electrostat Inc is
a firm that specializes in this business. Electrostat has a stock price of $25 per share with 16
million shares outstanding. Electrostat's equity beta is 1.18. It also has $220 million in debt
outstanding with a debt beta of 0.08. If the risk-free rate is 3%, and the market risk premium is
6%, estimate of your cost of capital for electrostatic power generators.
U =
E
D
$25 16
220
E +
D =
1.18 +
0.08 = 0.789677
E+D
E+D
$25 16 + 220
$25 16 + 220

ri = rrf + (rm - rrf) = .03 + .789677(.06) = .07738 or 7.74%

27. Luther Industries has 25 million shares outstanding trading at $18 per share. In addition, Luther
has $150 million in outstanding debt. Suppose Luther's equity cost of capital is 13%, its debt cost
of capital is 7%, and the corporate tax rate is 40%. Calculate:
a) Luther's unlevered cost of capital.
b) Luther's after-tax debt cost of capital.
c) Luther's weighted average cost of capital.

a)
!
!
$!" !"
$!"#
!! =
!! +
!! =
!"% +
!% = !!. !%
!+!
!+!
$!" !" + $!"#
$!" !" + $!"#

b) Effective after-tax interest rate = r(1 - Tc) = .07(1 - .40) = .042 or 4.2%

c) !! =
!
!!!
!! +
!
!!!
!! ! !! =
$!" !"
$!"#
!"% +
!% ! !. ! = !". !%
$!" !" + $!"#
$!" !" + $!"#

Appendix 1: Dow Jones and NIKKEI data

Date NIKKEI DJ
15/12/06 16829 12318
14/12/06 16693 12307
13/12/06 16638 12278
12/12/06 16418 12309
11/12/06 16371 12331
8/12/06 16266 12284
7/12/06 16321 12194
6/12/06 16076 12222
5/12/06 15855 12122
4/12/06 15734 12280
1/12/06 16163 12327
30/11/06 16289 12343
29/11/06 16022 12252
28/11/06 16198 12132
27/11/06 16393 12108
24/11/06 16350 12177
23/11/06 16399 12106
22/11/06 16811 11986
21/11/06 16700 12090
20/11/06 16788 12163
17/11/06 16506 12002

Appendix 2

9,2837
9,4185
9,5057
9,6009
9,7032
9,7648
9,7718
9,7779
9,78
9,7802
9,7909
9,7945
9,7956
9,8004
9,817
9,822
9,8245
9,8249
9,8441
9,8596
9,8615
9,8712
9,8724
9,876
9,8841

9,8903
9,8955
9,897
9,9044
9,9074
9,9099
9,9143
9,9183
9,9256
9,9271
9,9282
9,9408
9,9446
9,9469
9,9477
9,9482
9,9504
9,9537
9,9559
9,9562
9,9581
9,9651
9,9728
9,9769
9,984

9,9879
9,9887
9,9898
9,992
9,9959
10,0044
10,007
10,0103
10,0131
10,0132
10,0145
10,0163
10,0221
10,0233
10,0358
10,0379
10,0392
10,0516
10,0521
10,0579
10,079
10,0856
10,0874
10,0877
10,0882

10,0916
10,0946
10,0967
10,099
10,1053
10,1073
10,1186
10,119
10,1211
10,1256
10,1364
10,141
10,1441
10,1473
10,1575
10,1583
10,1921
10,199
10,2429
10,2492
10,2494
10,2563
10,2746
10,2767
10,3534
Appendix 3

-8260
-5930
-5481
-5008
-4891
-4809
-4808
-4683
-4587
-4432
-4387
-4233
-4145
-4128
-4117
-3793
-3751
-3669
-3543
-3497
-3469
-3425
-3326
-3277
-3202
-3101
-3093
-2957
-2928
-2920
-2895
-2881
-2831
-2807
-2801
-2792
-2697
-2621
-2550
-2543
-2538
-2484
-2458
-2429
-2418
-2407
-2376
-2358
-2300
-2281
-2247
-2226
-2222
-2209
-2203
-2198
-2123
-2105
-2097
-2075
-2047
-2020
-2009
-1968
-1954
-1934
-1923
-1911
-1902
-1894
-1889
-1874
-1858
-1836
-1834
-1779
-1751
-1741
-1724
-1720
-1718
-1693
-1689
-1682
-1680
-1676
-1606
-1567
-1554
-1547
-1510
-1485
-1472
-1433
-1430
-1416
-1394
-1390
-1361
-1342
-1341
-1331
-1287
-1248
-1220
-1214
-1208
-1197
-1189
-1160
-1149
-1103
-1058
-1047
-1017
-1014
-1009
-987
-982
-977
-964
-951
-939
-922
-911
-897
-888
-874
-868
-801
-775
-770
-764
-725
-719
-696
-664
-645
-631
-610
-586
-568
-564
-563
-509
-483
-482
-371
-350
-347
-347
-340
-339
-337
-334
-326
-324
-323
-322
-316
-314
-304
-236
-224
-224
-220
-220
-219
-208
-169
-125
-119
-114
-113
-109
-109
-108
-107
-107
-102
-102
-102
-101
-99
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
92
102
102
104
105
109
110
113
118
209
217
217
219
222
227
232
239
246
306
318
330
335
339
350
360
361
409
436
524
526
534
538
543
573
596
597
598
624
646
648
664
665
680
703
725
743
756
766
797
802
805
813
817
823
859
882
902
918
924
932
934
964
973
976
1002
1002
1005
1016
1044
1074
1102
1105
1117
1136
1145
1149
1202
1204
1207
1214
1229
1244
1261
1263
1276
1294
1299
1325
1399
1399
1407
1418
1421
1423
1424
1433
1438
1439
1466
1494
1593
1630
1639
1673
1687
1690
1695
1706
1754
1764
1771
1772
1791
1818
1863
1863
1965
1990
1993
2019
2045
2052
2076
2090
2113
2126
2128
2149
2151
2158
2188
2195
2205
2208
2235
2240
2273
2291
2310
2339
2362
2365
2373
2396
2461
2464
2469
2476
2484
2546
2547
2556
2641
2641
2641
2644
2721
2756
2834
2861
2872
2938
3069
3151
3158
3199
3293
3303
3432
3467
3575
3588
3597
3639
3649
3728
3775
3776
3916
3997
4004
4167
4197
4253
4338
4367
4457
4651
4887
4979
5113
6494

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homework set, antwoorden 2013

Vrije Universiteit Amsterdam (VU) | Financiering: financieel modelleren

Average monthly returns:

((-7.97% - -2.631%)( -4.82%- -2.734%)+(3.94% + 2.631%)(4.15% + 2.734%)+ )/(11-1)=

Var (R ) = x 2Var (R ) + x 2Var (R ) + 2 x x Cov(R ,R )

f) Weights: Qlogic = 15000/10000= 1.5(150%) , Mattel= -5000/10000= -0.5(-50%)

a) Variance van aandeel is 0.40^2=0.16, Covariantie= 0.40.40.3 = 0.048

c) VaR(95%): z=-1.645, VaR=ABS((1.135^(10/251)-1)-1.64520.42%(10/251))= 6.20%

a) Compute the average yearly return on the portfolio.

Consider the following information regarding four companies:

= WTT UTT + WRM U RM =

Appendix 1: Dow Jones and NIKKEI data

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