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Finance week 4 assignment

ou have recently been appointed chief investment officer of a major charitable foundation. Its large endowment fund is currently invested in a broadly diversified portfolio of stocks(60 percent) and bonds (40 percent). The foundation’s board of trustees is a group of prominent individuals whose knowledge of modern investment theory and practice is superficial.You decide a discussion of basic investment principles would be helpful.a. Explain the concepts of specific risk, systematic risk, variance, covariance, standard deviation, and beta as they relate to investment management. You believe that theaddition of other asset classes to the endowment portfolio would improve the portfolio by reducing risk and enhancing return. You are aware that depressed conditions inU.S. real estate markets are providing opportunities for property acquisition at levels of expected return that are unusually high by historical standards. You believe that aninvestment in U.S. real estate would be both appropriate and timely, and have decided to recommend a 20 percent position be established with funds taken equally fromstocks and bonds. Preliminary discussions revealed that several trustees believe real estate is too risky to include in the portfolio. The board chairman, however, hasscheduled a special meeting for further discussion of the matter and has asked you to provide background information that will clarify the risk issue. To assist you, thefollowing expectation data have been developed:Asset Class ReturnStandardDeviationU.S.StocksU.S.BondsCORRELATION MATRIXU.S.Real EstateU.S.T-BillsU.S. Stocks 12.0% 21.0% 1.00U.S. Bonds 8.0 10.5 0.14 1.00U.S. Real Estate 12.0 9.0 ?0.04 ?0.03 1.00U.S. Treasury Bills 4.0 0.0 ?0.05 ?0.03 0.25 1.00b. Explain the effect on both portfolio risk and return that would result from the addition of U.S. real estate. Include in your answer two reasons for any change you expect in portfoliorisk. (Note: It is not necessary to compute expected risk and return.)c. Your understanding of capital market theory causes you to doubt the validity of the expected return and risk for U.S. real estate. Justify your skepticism.You are evaluating various investment opportunities currently available and you have calculatedexpected returns and standard deviations for five different well-diversified portfoliosof risky assets:Portfolio Expected Return Standard DeviationQ 7.8% 10.5%R 10.0 14.0S 4.6 5.0T 11.7 18.5U 6.2 7.5a. For each portfolio, calculate the risk premium per unit of risk that you expect to receive([E(R) ? RFR]/?). Assume that the risk-free rate is 3.0 percent.b. Using your computations in Part a, explain which of these five portfolios is most likely tobe the market portfolio. Use your calculations to draw the capital market line (CML).c. If you are only willing to make an investment with ? = 7.0%, is it possible for you toearn a return of 7.0 percent?d. What is the minimum level of risk that would be necessary for an investment to earn7.0 percent? What is the composition of the portfolio along the CML that will generatethat expected return?e. Suppose you are now willing to make an investment with ? = 18.2%. What would bethe investment proportions in the riskless asset and the market portfolio for this portfolio?What is the expected return for this portfolio?Assume the following daily closings for the Dow Jones Industrial Average:DayDJIADayDJIA113,010713,220213,100813,130313,165913,250413,0801013,315513,0701113,240613,1501213,310a. Calculate a four-day moving average for Days 4 through 12.b. Assume that the index on Day 13 closes at 13,300. Would this signal a buy or sell decision?The cumulative advance-decline line reported in Barron’s at the end of the month is 21,240.During the first week of the following month, the daily report for the Exchange is as follows:Day12345Issues traded 3,5443,5333,5403,5313,521Advances1,7371,5791,7591,2171,326Declines1,2891,4841,2401,7161,519Unchanged518470541598596a. Compute the daily net advance-decline line for each of the five days.b. Compute the cumulative advance-decline line for each day and the final value at the end of the week.It is widely believed that changes in certain macroeconomic variables may directly affect performance of an equity portfolio. As the chief investment officer of a hedge fundemploying a global macro-oriented investment strategy, you often consider how various macroeconomic events might impact your security selection decisions and portfolioperformance. Briefly explain how each of the following economic factors would affect portfolio risk and return:(a) industrial production,(b) inflation,(c) risk premier,(d) term structure,(e) aggregate consumption, and(f) oil prices.Consider the following questions related to empirical tests of the APT:a. Briefly discuss one study that does not support the APT. Briefly discuss a study that doessupport the APT. Which position seems more plausible?b. Briefly discuss why Shanken contends that the APT is not testable. What is thecontrary view to Shanken’s position?You have been assigned the task of estimating the expected returns for three differentstocks: QRS, TUV, and WXY. Your preliminary analysis has established the historical riskpremiums associated with three risk factors that could potentially be included in your calculations:the excess return on a proxy for the market portfolio (MKT), and two variablescapturing general macroeconomic exposures (MACRO1 and MACRO2). These values are:?MKT = 7.5%, ?MACRO1 = ?0.3%, and ?MACRO2 = 0.6%. You have also estimated the followingfactor betas (i.e., loadings) for all three stocks with respect to each of these potentialrisk factors:FACTOR LOADINGStock MKT MACRO1 MACRO2QRS 1.24 ?0.42 0.00TUV 0.91 0.54 0.23WXY 1.03 ?0.09 0.00a. Calculate expected returns for the three stocks using just the MKT risk factor. Assume arisk-free rate of 4.5%.b. Calculate the expected returns for the three stocks using all three risk factors and thesame 4.5% risk-free rate.c. Discuss the differences between the expected return estimates from the single-factormodel and those from the multifactor model. Which estimates are most likely to bemore useful in practice?d. What sort of exposure might MACRO2 represent? Given the estimated factor betas, is itreally reasonable to consider it a common (i.e., systematic) risk factor?Consider the following information about two stocks (D and E) and two common risk factors(1 and 2):Stock bi1 bi2 E(Ri )D 1.2 3.4 13.1%E 2.6 2.6 15.4%a. Assuming that the risk-free rate is 5.0%, calculate the levels of the factor risk premia thatare consistent with the reported values for the factor betas and the expected returns forthe two stocks.b. You expect that in one year the prices for Stocks D and E will be $55 and $36, respectively.Also, neither stock is expected to pay a dividend over the next year. What shouldthe price of each stock be today to be consistent with the expected return levels listed atthe beginning of the problem?c. Suppose now that the risk premium for Factor 1 that you calculated in Part a suddenlyincreases by 0.25% (i.e., from x% to (x + 0.25)%, where x is the value established in Parta. What are the new expected returns for Stocks D and E?d. If the increase in the Factor 1 risk premium in Part c does not cause you to change youropinion about what the stock prices will be in one year, what adjustment will be necessaryin the current (i.e., today’s) prices?

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