Investment Management Problem Sheet 3-Answers Autumn Term 2021

Teaching Plan:

1. Discuss true false questions for 5-6 minutes.

2. Do questions 2,4,5 and 6. Pay particular attention to question 5.
3. If more time do some more questions.

True-False

1. Assuming the CAPM is correct, a share with a higher beta will have a higher
expected return than one with a lower beta even if it has much lower total risk.

True. The CAPM says that expected return is proportional to beta. And a firm with
higher beta can have lower total risk if it has much smaller idiosyncratic risk.

2. Assuming stock A has a beta of 1.5, and in the month of October 2018 it yielded a
return of 2%. Stock B as a beta of 0.8 and in the same month yielded a return of 4%. This
means that the CAPM does not hold.

False. The CAPM is a theory of expected, or average returns. The CAPM says that,
over time on average stock A should do better than stock B. The CAPM does not say
that stock A should do better than stock B, every period. Indeed, if it did mean that,
then the whole premise of the model that A is riskier then B makes no sense.

3. If expected return rises with beta as shown in the following figure, there is a clear
arbitrage opportunity.

True. A long position in a portfolio (P) comprised of Portfolios A and B will offer an
expected return-beta trade-off lying on a straight line between points A and B.
Therefore, we can choose weights such that βP = βC but with expected return higher
 than that of Portfolio C. Hence, combining P with a short position in C will create
an arbitrage portfolio with zero investment, zero beta, and positive rate of return.

Practical Questions

1. Company $1 discount store has a standard deviation of returns of 8% per year and a beta of
1.5. The corresponding figures for Company everything $5 are 10% and 1. Assuming
that the risk-free rate is 4% and that the expected return on the market portfolio is 10%,
what is the expected return on these two companies according to the CAPM?

The expected return is the return predicted by the CAPM for a given level of systematic risk.

E(r i)=r f + β i ×[E (r M )−r f ]

E(r $ 1 Discount )=.04+1.5 ×(.10−.04 )=.13 , or 13 %
E(r Everyt h ing $ 5)=.04 +1.0 ×(.10−.04 )=.10 , or 10 %

2. The expected equity risk premium in the market at any given time is E[r M]-rf. What
factors influence the equity risk premium?

To answer this question, we must consider the equilibrium implications of portfolio

construction.

Recall that each investor chooses the weight on the market portfolio by choosing y*
such that the following ratio is maximized:

E [ r M ] −r f
y∗¿ 2
AσM

Some investors may choose to borrow additional funds and invest in the risky asset
(so y* for them is >1). Others may lend, i.e., invest in the risk free asset, in which case
for them y*<1. However, in equilibrium over all investors, the amount borrowed
should equal the amount lent, so net borrowing and lending must be 0. This implies
that the average position in the risky asset is 100% or y*=1. (i.e., for each investor
who borrows there must be another investor who lends).

Substituting y*=1 and re-arranging gives: A σ M =E [ r M ] −r f , where A is the average risk

2

aversion of people in this economy.

 The result is very intuitive. The risk premium on the market portfolio is proportional
to the variance of the returns in this portfolio (the amount of risk) and the degree to
which investors are averse to such variance. When either quantity goes up, the
market risk premium goes up, which means that the prices of risky assets fall, and
thus their expected returns rise to compensate risk averse investors for holding them.

3. A manager is considering to invest in a project which costs 40 million. The project is

expected to generate cash flows of 15 million per year, in each of the following 10 years.
The project’s beta is 1.8, the risk free rate is 8% per year, and the expected return on the
market portfolio is 16% per year. What is the net present value of this project, according
to the CAPM?

The appropriate discount rate for the project is:

rf + β × [E(rM ) – rf ] = .08 + [1.8  (.16 – .08)] = .224, or 22.4%

Using this discount rate:

10
15
NPV=−$ 40+ ∑ =¿ $18.09
t=1 1.224t

Note here that the CAPM provided the opportunity cost of capital for this project, i.e., the
rate of return we can expect to earn if we invest in other projects with the same systematic
risk.

4. Read the paper by Roll, Richard. "A critique of the asset pricing theory's tests Part I: On
past and potential testability of the theory." Journal of financial economics 4.2 (1977):
129-176., and summarize the main difficulty identified by Roll, when empirically testing
whether the CAPM works.

According to the CAPM the market portfolio is mean-variance efficient.

However, empirically constructing the market portfolio is difficult. It contains all assets in
the economy, not just stocks. So its difficult for the econometrician to construct this
portfolio and calculate its E[r].
Roll points out that when we test whether the CAPM can price risky assets, we are jointly
testing the CAPM and the mean-variance efficiency of the proxy we have used as the
market portfolio. It may be the case that the CAPM works, but the proxy for the market
portfolio we have used is not mean-variance efficient, in which case our data will reject
the CAPM. But the rejection will not be due to a “bad model”, it will be due to bad inputs.
I suggest you read the paper closely to get a better understanding of Roll’s critique.
5. You are working for an investment house that believes in the APT. They use a four factor
model, as in Chen, Roll and Ross. They have constructed four portfolios that are
maximally correlated with each of the four factors (unexpected changes in inflation, slope
of the term structure, corporate risk premium and output). They have estimated factor
betas for a number of shares, and you are particularly interested in three of the shares (A,
B and C). Their betas are given below:

Shar Factor Factor Factor Factor

e 1 2 3 4
A +0.5 +1.4 -0.2 +1.0
B -0.8 +2.0 +0.5 +0.7
C +3.1 +0.2 -1.6 +1.6

i. Given that the risk free rate is 5% and the risk premium (E[r]-rf=E[R]) on the four
factors is estimated at 2.0%, 1.0%, 1.5% and 1.0%, what is the expected return on
each of the shares?
E [ r A ] =5 %+ 0.5× 2 %+1.4 ×1 %−0.2× 1.5 %+1 ×1 %=8.1 %
E [ r B ]=5 %−0.8 ×2 % +2 ×1 %+ 0.5× 1.5 %+ 0.7× 1 %=6.85 %
E [ r C ]=5 %+3.1 ×2 %+ 0.2× 1 %−1.6× 1.5 %+1.6 × 1 %=10.6 %

iii. Assume that the risk premiums on factors 1-3 are 0, so expected returns are driven by a
one factor model as E[R]= α+ rf + β4 (E[R4]). If α is zero, E[rA]=5%+1*1%=6% and
E[rB]=5%+0.7*1%=5.7%. However, assume that A has an expected return of 4% (α=-
2%), and B has an expected return of 7% (α=+1.3%). Design a hedge portfolio that
exploits this arbitrage opportunity. Assume that A and B are well-diversified and do
not carry any idiosyncratic risk. Calculate the cash flow of this portfolio.

Recall the two conditions of an arbitrage: No capital invested, and no risk exposure.
Clearly, we want to buy the under-valued asset B, and sell short the over-valued asset A.
We need to figure out how to do this, so that the two conditions above hold.
For no capital invested, we need the sum of our investments in the short and the long side
to sum to zero. This means that whatever we collect from the short sale, we invest it in
assets. The size of our long position has to equal the size of our short position.
 Suppose that in this trade we start by short selling £1M pounds of asset A. We need to
figure out how much money we need to put on B so that the weighted betas are equal to 0.
A has a beta of 1 and B has a beta of 0.7.
The equation we need to solve is: X A × β A + X B × β B=0
−$ 1 M ×1+ X B ×0.7=0, which gives X B=1.42 M
This means that we have to invest 1.42 million on B for our weighted beta exposure to be
zero. This makes sense since beta of B is lower than A, so the weight on it has to be larger
to make the sum equal to 0.
So where is the additional 0.42M going to come from? The risk-free rate. This means we
borrow 0.42 M at the risk-free rate and put the money in B. So, let’s see what the arbitrage
conditions look like:
Our short position is: -1M in A and -0.42M in r f. [borrowing is like shorting the risk-free
asset]
Our long position is 1.42M in B.
So, no capital invested.
The weighted betas are −$ 1 M ×1+1.42 ×0.7−0.42 ×0=0 [recall that the beta of the
risk-free asset is 0]
The arbitrage conditions are satisfied!

The cash flow from this trade is:

£ 1.42 M × [5 %+1.3 % +0.7 × R 4 ] −£ 1 M × [ 5 %−2 %+1 × R 4 ]−£ 0.42 M × 5 %

Notice that the only risky variable in the above is R4 . However, our arbitrage trade
completely eliminates this risky exposure, as it cancels out.
The cash flow from this trade is £38,460.
There are many other trades that satisfy arbitrage conditions. The larger the trade, the
higher the cash flow.

iv. Assume now that these portfolios do not fully eliminate idiosyncratic risk, so that
E[r]= α+rf + β4 (E[r4]) + e(u). u is a zero mean idiosyncratic return element that is
uncorrelated across stocks. How will the cash flow of the trade change in this case?

£ 1.42 M × [5 %+1.3 % +0.7 × R 4 +uB ] −£ 1 M × [ 5 %−2 % +1× R4 +u A ]−£ 0.42 M ×5 %

Notice that now we have more variables in the equation, the idiosyncratic risks, which are
not hedged. Thus, we cannot be certain what the cash flow will be. It may be higher or
lower, depending on the realizations of the u’s for A and B. In expectation the strategy
 will yield the same cash flow (Since e[u]=0), however there will be some variance, which
will be proportional to the Var[u].

6. You are working for a hedge fund and you have been researching a AAA (ie very low risk
of default) 10-year corporate bond which you believe is trading cheaply. You expect the
bond to have a return of 7.5% p.a., while the comparable 10-year Treasury bond has an
expected return of 6%. The annual volatility of the corporate bond is 6.5% and that of the
Treasury bond is 6%; the correlation between them is 0.95. You think of buying the
corporate bond and short selling the Treasury to hedge yourself, but the spread of only
1.5% between the expected returns on the two bonds makes this not a very exciting
proposition.
Your thoughts turn to leveraging your position. You can borrow or lend short term at the
Treasury bill rate of 5.4%. Your initial capital is £1M.
(a)Supposing that you want to construct a portfolio consisting of the corporate bond, the
treasury bond, and borrowing or lending, design the portfolio that has an expected return
of 40% and minimum risk.
This is a more advanced exercise.
If you invest a fraction c of your portfolio in the corporate bond, and a fraction t in the
Treasury bond the expected return on the portfolio is:

E [ r p ] =7.5 % ×c +6 % ×t+ 5.4 % × ( 1−t−c )=5.4 %+ 2.1%c+0.6 %t

Note that weights on some security of larger than 1, and a weight on another security less
than 0 implies leverage (i.e., borrowing from some security and investing the proceeds in
another). In this case, do get an expected return of 40%, we will need to have leverage.
Using the standard formula for the variance of a portfolio, and noting that the risk of T-bills is
zero, the variance of the portfolio is:
Var[rp] = (6.5%)2c2 + 2 x 0.95 x 6.5% x 6% x ct + (6%)2t2
= (42.25c2 + 74.1ct + 36t2)%%
To get a return of 40%, need:
E[rp] = 40% so 5.4 + 2.1c + 0.6t = 40, and
t = (40 – 5.4 – 2.1c)/0.6 = 57.667 – 3.5c.
Substituting for t in the variance gives a variance (times 10000) of:
Var[rp] = 42.25c2 + 74.1c(57.667 – 3.5c) + 36(57.667 – 3.5c)2
= 223.9c2 – 10259c +119720
Differentiating, this is minimised when c = 10259/(2x223.9) = 22.91.
So t = 57.667 – 3.5c = -22.52.
This means that the weight on the risk-free T-bill is 1-22.91+22.52=0.6.
So, we short the treasury getting £22.5mn. Our total wealth is now initial capital plus the
money from the short sale, so 23.5 million. This means we put £22.9mn in the corporate
bond, and 0.6million in the T-bill.
Thus our E[r] is 5.4% x 0.6 + 7.5% x 22.91 +6%x(-22.52)=40%
(b) What is the volatility of the portfolio?
Substituting back, this gives
Var[rp] =223.9(22.91)2 – 10259(22.91) +119720%%
so the standard deviation - the square root of the variance – is 47%. That means that the
standard deviation of annual gains or losses relative to the mean is £0.47m on every £1m of
capital invested.
(c) You set up the strategy. The correlation turns out to be 0.8 rather than the 0.95 you had
assumed. What would you expect the volatility of the portfolio to be?
Substituting into the formula for volatility gives a portfolio volatility of 90.8%. Of course the
lower the correlation the higher the variance, because our hedge becomes less effective.