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1995 $ 10.97
1996 $ 20.66
1997 $ 32.31
1998 $ 69.34

a. Estimate the average annual return you would have made on your investment

b. Estimate the standard deviation and variance in annual returns

c. If you were investing in Microsoft today, would you expect the historical standard
deviations and variances to continue to hold? Why or why not?

2. Unicom is a regulated utility serving Northern Illinois. The following table lists the stock
prices and dividends on Unicom from 1989 to 1998.
Year Price Dividends
1989 $ 36.10 $ 3.00
1990 $ 33.60 $ 3.00
1991 $ 37.80 $ 3.00
1992 $ 30.90 $ 2.30
1993 $ 26.80 $ 1.60
1994 $ 24.80 $ 1.60
1995 $ 31.60 $ 1.60
1996 $ 28.50 $ 1.60
1997 $ 24.25 $ 1.60
1998 $ 35.60 $ 1.60

a. Estimate the average annual return you would have made on your investment

b. Estimate the standard deviation and variance in annual returns

c. If you were investing in Unicom today, would you expect the historical standard
deviations and variances to continue to hold? Why or why not?
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3. The following table summarizes the annual returns you would have made on two companies “
Scientific Atlanta, a satellite and data equipment manufacturer, and AT&T, the telecomm giant,
from 1988 to 1998.
Year Scientific Atltanta AT&T
1989 80.95 % 58.26 %
1990 -47.37 % -33.79 %
1991 31 % 29.88 %
1992 132.44 % 30.35 %
1993 32.02 % 2.94 %
1994 25.37 % -4.29 %
1995 -28.57 % 28.86 %
1996 0.00 % -6.36 %
1997 11.67 % 48.64 %
1998 36.19 % 23.55 %

a. Estimate the average and standard deviation in annual returns in each company

b. Estimate the covariance and correlation in returns between the two companies

c. Estimate the variance of a portfolio composed, in equal parts, of the two investments

4. You are in a world where there are only two assets, gold and stocks. You are interested in
investing your money in one, the other or both assets. Consequently you collect the following
data on the returns on the two assets over the last six years.
Gold Stock Market
Average return 8% 20%
Standard deviation 25% 22%
Correlation -.4
a. If you were constrained to pick just one, which one would you choose?
b. A friend argues that this is wrong. He says that you are ignoring the big payoffs that you
can get on gold. How would you go about alleviating his concern?
c. How would a portfolio composed of equal proportions in gold and stocks do in terms of
mean and variance?
d. You now learn that GPEC (a cartel of gold-producing countries) is going to vary the
amount of gold it produces with stock prices in the US. (GPEC will produce less gold when
stock markets are up and more when it is down.) What effect will this have on your
portfolios? Explain.
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5. You are interested in creating a portfolio of two stocks “ Coca Cola and Texas Utilities. Over
the last decade, an investment in Coca Cola stock would have earned an average annual return of
25%, with a standard deviation in returns of 36%. An investment in Texas Utilities stock would
have earned an average annual return of 12%, with a standard deviation of 22%. The correlation
in returns across the two stocks is 0.28.
a. Assuming that the average and standard deviation, estimated using past returns, will
continue to hold in the future, estimate the average returns and standard deviation of a
portfolio composed 60% of Coca Cola and 40% of Texas Utilities stock.
b. Estimate the minimum variance portfolio.
c. Now assume that Coca Cola™s international diversification will reduce the correlation to
0.20, while increasing Coca Cola™s standard deviation in returns to 45%. Assuming all of
the other numbers remain unchanged, answer (a) and (b).

6. Assume that you have half your money invested in Times Mirror, the media company, and the
other half invested in Unilever, the consumer product giant. The expected returns and standard
deviations on the two investments are summarized below:
Times Mirror Unilever
Expected Return 14% 18%
Standard Deviation 25% 40%
Estimate the variance of the portfolio as a function of the correlation coefficient (Start with “1
and increase the correlation to +1 in 0.2 increments).

7. You have been asked to analyze the standard deviation of a portfolio composed of the
following three assets:
Investment Expected Return Standard Deviation
Sony Corporation 11% 23%
Tesoro Petroleum 9% 27%
Storage Technology 16% 50%
You have also been provided with the correlations across these three investments:
Sony Tesoro Storage Tech
Sony 1.00 -0.15 0.20
Tesoro -0.15 1.00 -0.25
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Storage Tech 0.20 -0.25 1.00
Estimate the variance of a portfolio, equally weighted across all three assets.

8. You have been asked to estimate a Markowitz portfolio across a universe of 1250 assets.
a. How many expected returns and variances would you need to compute?
b. How many covariances would you need to compute to obtain Markowitz portfolios?

9. Assume that the average variance of return for an individual security is 50 and that the average
covariance is 10. What is the expected variance of a portfolio of 5, 10, 20, 50 and 100 securities.
How many securities need to be held before the risk of a portfolio is only 10% more than the
minimum?

10. Assume you have all your wealth (a million dollars) invested in the Vanguard 500 index
fund, and that you expect to earn an annual return of 12%, with a standard deviation in returns
of 25%. Since you have become more risk averse, you decide to shift $ 200,000 from the
Vanguard 500 index fund to treasury bills. The T.bill rate is 5%. Estimate the expected return
and standard deviation of your new portfolio.

11. Every investor in the capital asset pricing model owns a combination of the market portfolio
and a riskless asset. Assume that the standard deviation of the market portfolio is 30%, and that
the expected return on the portfolio is 15%. What proportion of the following investor™s wealth
would you suggest investing in the market portfolio and what proportion in the riskless asset?
(The riskless asset has an expected return of 5%)
a. an investor who desires a portfolio with no standard deviation
b. an investor who desires a portfolio with a standard deviation of 15%
c. an investor who desires a portfolio with a standard deviation of 30%
d. an investor who desires a portfolio with a standard deviation of 45%
e. an investor who desires a portfolio with an expected return of 12%

12. The following table lists returns on the market portfolio and on Scientific Atltanta, each year
from 1989 to 1998.
Year Scientific Atltanta Market Portfolio
1989 80.95 % 31.49 %
1990 -47.37 % -3.17 %
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1991 31 % 30.57 %
1992 132.44 % 7.58 %
1993 32.02 % 10.36 %
1994 25.37 % 2.55 %
1995 -28.57 % 37.57 %
1996 0.00 % 22.68 %
1997 11.67 % 33.10 %
1998 36.19 % 28.32 %


a. Estimate the covariance in returns between Microsoft and the market portfolio
b. Estimate the variances in returns on both investments
c. Estimate the beta for Microsoft

13. United Airlines has a beta of 1.50. The standard deviation in the market portfolio is 22% and
United Airlines has a standard deviation of 66%
a. Estimate the correlation between United Airlines and the market portfolio.
b. What proportion of United Airlines™ risk is market risk?

14. You are using the arbitrage pricing model to estimate the expected return on Bethlehem
Steel, and have derived the following estimates for the factor betas and risk premia:
Factor Beta Risk Premia
1 1.2 2.5%
2 0.6 1.5%
3 1.5 1.0%
4 2.2 0.8%
5 0.5 1.2%
a. Which risk factor is Bethlehem Steel most exposed to? Is there any way, within the
arbitrage pricing model, to identify the risk factor?
b. If the riskfree rate is 5%, estimate the expected return on Bethlehem Steel
c. Now assume that the beta in the capital asset pricing model for Bethlehem Steel is 1.1,
and that the risk premium for the market portfolio is 5%. Estimate the expected return, using
the CAPM.
d. Why are the expected returns different using the two models?
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15. You are using the multi-factor model to estimate the expected return on Emerson Electric,
and have derived the following estimates for the factor betas and risk premia:
Macro-economic Factor Measure Beta Risk Premia (Rfactor-Rf)
Level of Interest rates T.bond rate 0.5 1.8%
Term Structure T.bond rate “ T.bill rate 1.4 0.6%
Inflation rate CPI 1.2 1.5%
Economic Growth GNP Growth rate 1.8 4.2%
With a riskless rate of 6%, estimate the expected return on Emerson Electric.

16. The following equation is reproduced from the study by Fama and French of returns between
1963 and 1990.
Rt = .0177 - 0.11 ln (MV) + 0.35 ln (BV/MV)

where MV is the market value of equity in hundreds of millions of dollar and BV is the book
value of equity in hundreds of millions of dollars. The return is a monthly return.
a. Estimate the expected annual return on Lucent Technologies. The market value of equity
is $ 240 billion, and the book value of equity is $ 13.5 billion.
b. Lucent Technologies has a beta of 1.55. If the riskless rate is 6%, and the risk premium
for the market portfolio is 5.5%, estimate the expected return.
c. Why are the expected returns different under the two approaches?
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Live Case Study
Stockholder Analysis
Objective: To find out who the average and marginal investors in the company are. This
is relevant because risk and return models in finance assume that the marginal investor is
well diversified.

Key Questions:
Who is the average investor in this stock? (Individual or pension fund, taxable or tax-

exempt, small or large, domestic or foreign)
Who is the marginal investor in this stock?


Framework for Analysis
1. Who holds stock in this company?
How many stockholders does the company have?

What percent of the stock is held by institutional investors?

Does the company have listings in foreign markets? (If you can, estimate the

percent of the stock held by non-domestic investors)
2. Insider Holdings
Who are the insiders in this company? (Besides the managers and directors,

anyone with more than 5% is treated as an insider)
What role do the insiders play in running the company?

What percent of the stock is held by insiders in the company?

What percent of the stock is held by employees overall? (Include the holdings

by employee pension plans)
Have insiders been buying or selling stock in this company in the most recent

year?

Getting Information on Stockholder Composition

Information about insider and institutional ownership of firms is widely available
since both groups have to file with the SEC. These SIC filings are used to develop
rankings of the largest holders of stock in firms. Insider activity (buying and selling) is
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also recorded by the SEC, though the information is not available until a few weeks after
the filing.
Online sources of information:
http://www.stern.nyu.edu/˜adamodar/cfin2E/project/data.htm
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Appendix on Statistics: Means, Variances, Covariances and Regressions
Large amounts of data are often compressed into more easily assimilated
summaries, which provide the user with a sense of the content, without overwhelming
him or her with too many numbers. There a number of ways in which data can be
presented. One approach breaks the numbers down into individual values (or ranges of
values) and provides probabilities for each range. This is called a "distribution". Another
approach is to estimate "summary statistics" for the data. For a data series, X1, X2, X3,
....Xn, where n is the number of observations in the series, the most widely used summary
statistics are as follows “
• the mean (µ), which is the average of all of the observations in the data series

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