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Master CFA Concepts Using MS Excel

Portfolio Management
Reading 64
Portfolio Concepts

Learn the following in this sheet:

SML
Beta Coefficient
Beta Adjustment
Sharpe Ratio

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Case

Margaret Walker, CFA and Nancy Green, MBA are portfolio managers for Thomas Anderson Invest
Margaret has been managing the investment portfolio for affluent clients in London. Nancy recen
Investment Management firm. She has been asked by Margaret Walker to analyzing an investmen
Garment Company for her clients.

Readymade Garment is Britains med-sized manufacturer of air-jet loom woven heavy denim and
It has operations in several countries and listed in London Stock Exchange, FTSE. It has shown hig
changes in govt. policies in this sector.

Using the historical prices of Readymade Garments Co. & FTSE index, Nancy determines that the
Readymade Garments Co stock and FTSE is 0.8. The FTSE index over the same period had a stan
standard deviation in Readymade Garment stock price was 45%. Also, Margaret tells Nancy to us
Sharpe ratio for their diversified portfolio as 0.125. Using the concepts of CAL and SML, she deter
Readymade Garment Co.'s stock.

Just before reporting her results to Margaret, Nancy was told about the beta instability problem in
She reads the article describing a method to adjust beta given by Blume where adjusted= (1/3) + (
adjustments and shows the calculations to Margaret. In the meet, Nancy tells Margaret that they
because the return expected of 10% is more than required return calculated by her. In response,
statistical inputs derived by Nancy from historical sample estimates often change over period, lea

Perplexed upon encountering instability in her model, Nancy decides to apply Multifactor Models
that Multifactor Models can further be classified into macroeconomic factor models, fundamental
factor model. However, she observes that these models differ in number of factors and their inte

To understand these models, Nancy turns to Arbitrage Pricing Model first. She gathers the followin
investment funds at Thomas Anderson.

Based on her study, she concludes that factor portfolio is a portfolio with specific set of factor s
determined benchmark.
Assuming the benchmark to be portfolio Passive (A), Nancy calculates the tracking error of portfo
portfolio Active (C) as 0.5 % and 1% respectively. As a final step, she uses information ratio to com
these portfolios.

Question 1
Using CAPM, determine the expected return for Readymade Garment Co. shares
Options
Expected Return
A
11.5%

B
C

8.5%
7.8%

Question 2
Regarding the statements made by Nancy & Margaret on instabilities,
Options
Suggestion
A
Both are correct
B
Both are wrong
C
Only one is correct

Question 3
Compared to fundamental factor models, which of the following is correct with respect to Macroeco
Options
No of Factors
Interpretation of factor
A
more
regressed rate of return
B
less
regressed rate of return
C
less
Surprises
Question 4
Calculate the arbitrage opportunity from the Portfolios provided
Options
Arbitrage return
A
0.1%
B
0.1%
C
No Arbitrage Possible
Question 5
Nancy's conclusion on factor portfolio is
Options
Assuption
A
Correct
B
Incorrect because it is not matched to a pre-determined benchmark
C
Incorrect because does not have specific set of factors
Question 6
Which portfolio must have outperformed according to Nancy
Options
Methods
A
Portfolio Semi-Passive
B
Portfolio Active
C
None

mas Anderson Investment Management firm.

ondon. Nancy recently joined Thomas Anderson
alyzing an investment opportunity in Readymade

en heavy denim and shirting fabrics from cotton.

TSE. It has shown high grow in recent years due to

determines that the correlation between

e period had a standard deviation of 30%. The
ret tells Nancy to use the risk-free rate as 4% and
and SML, she determined the expected return on

nstability problem in using historical estimates.

re adjusted= (1/3) + (2/3)*historical. She does the
Margaret that they should invest in this stock
by her. In response, Margaret explains that the
ange over period, leading to time instability also.

Multifactor Models to her analysis. She discovers

models, fundamental factor models and statistical
actors and their interpretations.
gathers the following information of the

pecific set of factor sensitivities to match a pre-

cking error of portfolio Semi-Passive (B) and

ormation ratio to comment on performance of

respect to Macroeconomic models?

mined benchmark
et of factors

Asssumptions
Data for Market
Sharpe Ratio
Standard Deviation
Risk-free Rate

0.125
30%
4%

Data for Readymade Garment Company

Standard Deviation
Correlation Coefficient between market & stock
Estimated expected return from the stock
Expected Return

45%
0.80
15%
10%

Portfolios

Expected Return of Passive ( A )

Expected Return of Semi-Passive ( B )
Expected Return of Active ( C )
Beta of Passive ( A )
Beta of Semi-Passive ( B )
Beta of Active ( C )
Tracking error of Portfolio B
Tracking error of Portfolio C

7.75%
8.00%
8.50%
1.00
1.20
1.50
0.50%
1.00%

Question 1
SML formula for calc required return

Option B

Step1:
Step1:

Risjk-free Rate
Beta
Market Risk Premium
Required Return

Question 2
Required Return using Adjusted Beta

4%
1.20
3.75%

Step2:
Step2: Sharpe
Sharpe R

8.5%

Step3:
Step3: E(R)
E(R) =
=R

Option A

Risjk-free Rate
Standard Deviation of Market
Market Risk Premium

4%
1.13
3.75%

Required Return
Question 3
fundamental vs macroeconomic factor model

=
=

8.3%

Step1:
Step1: adj
=(1/3)+(
adj=(1/3)+(2

Step2:
Step2: Nancy's
Nancy'
Hence,
her
Hence, her sug
sug
Margaret's
Margaret's
models
models

Option C

Macroeconomic
Macroeconomic factors
factors are
are surprises
surprises in
in the
the macroeconomic
macroeconomic variables
variables while
while fundamental
fundamental ff
Since
Since macroeconomic
macroeconomic factors
factors represent
represent only
only systemic
systemic risk,
risk, they
they are
are usually
usually lesser
lesser in
in numb
num
Macroeconomic
Macroeconomic factors
factors models.
models.

Step1:
Step1:

=
= *(
*(stock
/mm))
stock/

Step2:
Step2: Sharpe
Sharpe Ratio
Ratio =
= [E(R
[E(Rmm))- RRf]/
f]/m
m
Step3:
Step3: E(R)
E(R) =
= RRf f +
+ *(R
*(Rmm-R
-Rf)f)

Step1:
Step1: adj
=(1/3)+(2/3)*historical
adj=(1/3)+(2/3)*
historical
Step2:
Step2: Nancy's
Nancy's Statement:
Statement: E(R)
E(R) =
= Rf
Rf +
+ *(Rm-Rf)
*(Rm-Rf) =
= 8.3%,
8.3%, while
while expected
expected return
return 10%.
10%.
Hence,
her
suggest
to
invest
in
Readymade
Garment
Co.
is
correct.
Hence, her suggest to invest in Readymade Garment Co. is correct.
Margaret's
Margaret's Statement:
Statement: Time
Time instability
instability is
is also
also aa concern
concern for
for inputs
inputs to
to mean-variance
mean-variance
models
models

iables while
riables
while fundamental
fundamental factors
factors are
are regressed
regressed rate
rate of
of return
return to
to the
the factors
factors
yy are
are usually
usually lesser
lesser in
in number.
number. However,
However, fundamental
fundamental factors
factors are
are generally
generally large
large in
in number
number compared
compared to
to

eturn 10%.
return
10%.

mean-variance
mean-variance

er compared
ber
compared to
to

Question 4

Option B

Arbitrage opportunity from the Portfolios provided

Weight of A in new portfolio
Weight of B in new portfolio
Expected Return of new Portfolio

60%
40%
8.1%

Difference in return

Question 5
Factor Portfolio

0.05%

Allocat
Allocat
W
WA*A*AA+
+

Return
Return

Arbitra
Arbitra
&
& buyin
buyi
for
for Por
Por

Option B

Conclusion
Conclusion given
given by
by Nancy
Nancy is
is related
related to
to tracking
tracking portfolio
portfolio rather
rather than
than factor
factor portfolio.
portfolio. However,
However,
&
& zero
zero for
for rest.
rest.
Question 6
Information Ratio
IR for portfolio B
IR for portfolio C

Option B
0.50
0.75

Allocate
Allocate wt.
wt. to
to Portfolio
Portfolio AA &
& CC such
such that
that
W

+W

=
Or
W

+(1-W
WA*A*AA+Wc*c*cc=BB Or WA*A*AA+(1-WAA))**cc=
=BB
Return
Return from
from new
new portfolio=
portfolio= W
WA*A*RRAA+W
+Wc*c*RRcc
Arbitrage
Arbitrage return=
return= W
WA*A*RRAA+W
+Wc*c*RRcc-R
-RBB of
of 0.05%
0.05% can
can be
be achieved
achieved by
by shorting
shorting portfolio
portfolio BB
&
& buying
buying 60%
60% in
in portfolio
portfolio AA &
& 40%
40% of
of portfolio
portfolio C.
C. There
There is
is no
no risk
risk since,
since, beta
beta is
is equal
equal
for
Portfolio
B
and
new
Portfolio.
for Portfolio B and new Portfolio.

n factor
an
factor portfolio.
portfolio. However,
However, factor
factor portfolio
portfolio has
has aa specific
specific set
set of
of factors,
factors, which
which is
is 11 for
for aa particular
particular factor
factor

Since
Since IR
IR for
for portfolio
portfolio CC is
is greater
greater than
than portfolio
portfolio B,
B, Active
Active Portfolio
Portfolio must
must have
have
outperformed
according
to
Nancy.
outperformed according to Nancy.

orting
orting portfolio
portfolio BB
ce, beta
nce,
beta is
is equal
equal

articular
articular factor
factor

olio
olio must
must have
have