Chief investment officer of a major charitable foundation

You 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 the
addition of other asset classes to the endowment portfolio would improve the portfolio by reducing risk and enhancing return. You are aware that depressed conditions in
U.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 an
investment 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 from
stocks and bonds. Preliminary discussions revealed that several trustees believe real estate is too risky to include in the portfolio. The board chairman, however, has
scheduled 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, the
following expectation data have been developed:
Asset Class Return
Standard
Deviation
U.S.
Stocks
U.S.
Bonds
CORRELATION MATRIX
U.S.
Real Estate
U.S.
T-Bills
U.S. Stocks 12.0% 21.0% 1.00
U.S. Bonds 8.0 10.5 0.14 1.00
U.S. Real Estate 12.0 9.0 ?0.04 ?0.03 1.00
U.S. Treasury Bills 4.0 0.0 ?0.05 ?0.03 0.25 1.00

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b. 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 portfolio
risk. (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 calculated
expected returns and standard deviations for five different well-diversified portfolios
of risky assets:
Portfolio Expected Return Standard Deviation
Q 7.8% 10.5%
R 10.0 14.0
S 4.6 5.0
T 11.7 18.5
U 6.2 7.5
a. 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 to
be 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 to
earn a return of 7.0 percent?
d. What is the minimum level of risk that would be necessary for an investment to earn
7.0 percent? What is the composition of the portfolio along the CML that will generate
that expected return?
e. Suppose you are now willing to make an investment with ? = 18.2%. What would be
the 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:
Day
DJIA
Day
DJIA
1
13,010
7
13,220
2
13,100
8
13,130
3
13,165
9
13,250
4
13,080
10
13,315
5
13,070
11
13,240
6
13,150
12
13,310
a. 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:
Day
1
2
3
4
5
Issues traded 3,544
3,533
3,540
3,531
3,521
Advances
1,737
1,579
1,759
1,217
1,326
Declines
1,289
1,484
1,240
1,716
1,519
Unchanged
518
470
541
598
596
a. 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 fund
employing a global macro-oriented investment strategy, you often consider how various macroeconomic events might impact your security selection decisions and portfolio
performance. 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 does
support the APT. Which position seems more plausible?
b. Briefly discuss why Shanken contends that the APT is not testable. What is the
contrary view to Shanken’s position?

You have been assigned the task of estimating the expected returns for three different
stocks: QRS, TUV, and WXY. Your preliminary analysis has established the historical risk
premiums 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 variables
capturing general macroeconomic exposures (MACRO1 and MACRO2). These values are:
?MKT = 7.5%, ?MACRO1 = ?0.3%, and ?MACRO2 = 0.6%. You have also estimated the following
factor betas (i.e., loadings) for all three stocks with respect to each of these potential
risk factors:
FACTOR LOADING
Stock MKT MACRO1 MACRO2
QRS 1.24 ?0.42 0.00
TUV 0.91 0.54 0.23
WXY 1.03 ?0.09 0.00
a. Calculate expected returns for the three stocks using just the MKT risk factor. Assume a
risk-free rate of 4.5%.
b. Calculate the expected returns for the three stocks using all three risk factors and the
same 4.5% risk-free rate.
c. Discuss the differences between the expected return estimates from the single-factor
model and those from the multifactor model. Which estimates are most likely to be
more useful in practice?
d. What sort of exposure might MACRO2 represent? Given the estimated factor betas, is it
really 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 that
are consistent with the reported values for the factor betas and the expected returns for
the 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 should
the price of each stock be today to be consistent with the expected return levels listed at
the beginning of the problem?
c. Suppose now that the risk premium for Factor 1 that you calculated in Part a suddenly
increases by 0.25% (i.e., from x% to (x + 0.25)%, where x is the value established in Part
a. 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 your
opinion about what the stock prices will be in one year, what adjustment will be necessary
in the current (i.e., today’s) prices?