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FORMULA SHEET For Midterm Exam

1. The document discusses various models for calculating expected returns and risk of portfolios including the single-index model, multifactor model, and Fama-French three-factor model. 2. Key inputs needed for portfolio optimization include expected returns, variances, and covariances of the assets. The single-index model reduces the number of inputs needed by relating asset returns to market returns. 3. The capital asset pricing model and arbitrage pricing theory pricing equation describe the expected return of a portfolio or asset based on systematic risk factors. The Fama-French three-factor model uses size, value, and market factors.

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akshitak.2021
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28 views4 pages

FORMULA SHEET For Midterm Exam

1. The document discusses various models for calculating expected returns and risk of portfolios including the single-index model, multifactor model, and Fama-French three-factor model. 2. Key inputs needed for portfolio optimization include expected returns, variances, and covariances of the assets. The single-index model reduces the number of inputs needed by relating asset returns to market returns. 3. The capital asset pricing model and arbitrage pricing theory pricing equation describe the expected return of a portfolio or asset based on systematic risk factors. The Fama-French three-factor model uses size, value, and market factors.

Uploaded by

akshitak.2021
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Week 1

1. Bank discount method for calculating T-bill price:


Price = 10,000*[1 - (r * n) / 360]
• n = number of days to maturity
• r = prevailing yield
• Assuming par value = $10,000

Week 2
1. Utility function

U = E ( r ) − 1 A 2
2
⚫ E(r) = Expected return on the portfolio
⚫ σ2 = Variance of portfolio return
⚫ A = Coefficient of risk aversion
2. Consider a risky portfolio P (return 𝑟𝑃 , standard deviation 𝜎𝑃 ) and the risk-free asset (e.g., T-bills,
return 𝑟𝑓 ). Consider a complete portfolio C that invest fraction y in the risky portfolio P and fraction
(1-y) in the risk-free asset.
The expected return on the complete portfolio C is:

E[rC ] = y E[rP ] + (1-y) rf = rf + y (E[rP ] - rf )

The standard deviation of the complete portfolio C is: 𝜎𝐶 = y𝜎𝑃


σ
The capital allocation line is: E[rC ] = rf + σC (E[rP ] - rf )
P
3. Optimal allocation to risky portfolio P (y*) is determined by:

E ( rP ) − rf
y* =
A P2
𝐸 [𝑟𝑃 ]−𝑟𝑓
4. The Sharpe ratio of the risky portfolio P is: 𝑆𝑃 =
𝜎𝑃
5. Consider a portfolio made up of Equity and Bond, the expected return on the portfolio is a weighted
average expected return on the Equity and Bond

𝐸 [𝑟𝑃 ] = 𝑤𝐸 𝐸 [𝑟𝐸 ] + 𝑤𝐷 𝐸 [𝑟𝐷 ]

⚫ 𝐸[𝑟𝐸 ] = Expected return on the equity


⚫ 𝐸[𝑟𝐷 ] = Expected return on the bond
⚫ 𝑤𝐸 = portfolio weight in equity
⚫ 𝑤𝐷 = portfolio weight in bond

The variance of portfolio return is 𝜎P2 = 𝑤𝐷2 𝜎𝐷2 + 𝑤𝐸2 𝜎𝐸2 + 2𝑤𝐸 𝑤𝐷 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )
⚫ σ2D = variance of bond return
⚫ σ2E = variance of equity return
⚫ Cov(rD , rE ) = Covariance of returns on bond and equity

The covariance of returns on bond and equity is:

𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 ) = 𝜌𝐷,𝐸 𝜎𝐷 𝜎𝐸
𝜌𝐷,𝐸 = correlation of returns on bond and equity, ranging between -1 and 1

6. When 𝜌𝐷,𝐸 = -1, we can construct a risk-free portfolio by setting portfolio standard deviation to be
zero. The weight in Equity that make the portfolio risk-free is:
𝜎𝐷
𝑤𝐸 = = 1 − 𝑤𝐷
𝜎𝐷 + 𝜎𝐸

Week 3

1. Number of estimated inputs needed for portfolio optimization with N assets:


Expected returns (#=N) + Variances (#=N) + Covariances (#=N*(N-1)/2)

2. Single-index model
𝑹𝒊 = 𝜶𝒊 + 𝜷𝒊 𝑹𝑴 + 𝒆𝒊
⚫ 𝜶𝒊 is security’s expected excess return when the market excess return is 0
⚫ 𝑹𝑴 is the excess return of the market index
⚫ 𝜷𝒊 is the sensitivity of stock excess return to the market excess return
⚫ 𝒆𝒊 is the firm-specific return (E[ei ] = 0)

⚫ Key assumption 1: 𝐶𝑜𝑣(𝑅𝑀 , 𝑒𝑖 ) = 0

⚫ Key assumption 2: 𝐶𝑜𝑣(𝑒𝑖 , 𝑒𝑗 ) = 0 for 𝑖 ≠ 𝑗

3. Expected Return, Risk, and Covariance in the Single-Index Model


⚫ E (𝑅𝑖 ) = 𝛼𝑖 + 𝛽𝑖 𝐸(𝑅𝑀 )
⚫ Total risk = Systematic risk + Firm-specific risk:
𝜎 2 (𝑅𝑖 ) = 𝛽𝑖2 𝜎 2 (𝑅𝑀 ) + 𝜎 2 (𝑒𝑖 )
⚫ Covariance = Product of betas × Market variance:
𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑗 ) = 𝛽𝑖 𝛽𝑗 𝜎 2 (𝑅𝑀 )
⚫ Correlation: Product of correlations with the market index:
𝐶𝑜𝑟𝑟(𝑅𝑖 , 𝑅𝑗 )= = 𝐶𝑜𝑟𝑟(𝑅𝑖 , 𝑅𝑀 )*𝐶𝑜𝑟𝑟(𝑅𝑗 , 𝑅𝑀 )

4. Number of inputs to be estimated with N assets under single-index model:


Firm-specific alphas 𝛼𝑖 (# = N)
+ Firm-specific variances 𝜎 2 (𝑒𝑖 ) (# = N)
+ Betas 𝛽𝑖 (# = N)
+ Market risk premium 𝐸(𝑅𝑀 ) and variance 𝜎 2 (𝑅𝑀 ) (# = 2)
= 3N+2 estimates
5. The expected return and variance of the portfolio P is:

E (𝑅𝑃 ) = 𝛼𝑃 + 𝛽𝑃 E (𝑅𝑀 )
𝜎 2 (𝑅𝑃 ) = 𝛽𝑃2 𝜎 2 (𝑅𝑀 ) + 𝜎 2 (𝑒𝑃 )

For a well-diversified portfolio, 𝜎 2 (𝑒𝑝 ) will be close to 0 and hence portfolio variance
𝜎 2 (𝑅𝑃 ) = 𝛽𝑃2 𝜎 2 (𝑅𝑀 ) (approximately!)

6. Adjusted beta formula:


𝛽 =𝑤𝑝 𝛽𝑝 +(1-𝑤𝑝 ) 𝛽𝑑
• 𝛽𝑝 = your personal view of beta
• 𝑤𝑝 = the weight you place on your personal view
• 𝛽𝑑 = beta estimated using historical data

7. Capital Asset Pricing Model (CAPM):

𝐶𝑜𝑣(𝑟𝑖 ,𝑟𝑚 )
𝐸(𝑟𝑖 ) − 𝑟𝑓 = 𝛽𝑖 [𝐸 (𝑟𝑚 ) − 𝑟𝑓 ], where 𝛽𝑖 = 2
𝜎𝑚

Week 4
1. APT Pricing Equation for Single-Index Model:

𝐸[𝑟𝑃 ] − 𝑟𝑓 = 𝛽𝑃 [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
2. Multifactor model:

𝑅𝑖 = 𝐸(𝑅𝑖 ) + ∑ 𝛽𝑖,𝑘 𝐹𝑘 + 𝑒𝑖
𝑘

• 𝐸[𝑒𝑖 ] = 0, 𝐸[𝐹𝑘 ] = 0
• 𝐶𝑜𝑣(𝐹𝑘 , 𝑒𝑖 )=0 for any 𝑘 and 𝑖
• 𝐹𝑘 measures deviation of the factor K from its expected value
• 𝛽𝑖,𝑘 measures stock i’s sensitivity to the systematic factor 𝐹𝑘
3. Multifactor model with tracking portfolios as factors:

𝑅𝑖 = 𝛼𝑖 + ∑ 𝛽𝑖,𝑘 𝑅𝑘 + 𝑒𝑖
𝑘
• 𝑅𝑘 is excess return on a tracking portfolio for macro factor K
• 𝐸[𝑒𝑖 ] = 0, 𝐶𝑜𝑣(𝑒𝑖 , 𝑒𝑗 ) = 0 for 𝑖 ≠ 𝑗
• 𝐶𝑜𝑣(𝑅𝑘 , 𝑒𝑖 ) = 0 for any k and i

4. APT Pricing Equation for Multifactor model:


𝐸(𝑅𝑃 ) = ∑𝑘 𝛽𝑃,𝑘 𝐸(𝑅𝑘 )

5. Fama-French Three-Factor Model:


𝐸(𝑟𝑖 ) − 𝑟𝑓 = 𝛽𝑀 𝐸(𝑟𝑀 − 𝑟𝑓 ) + 𝛽𝑆𝑀𝐵 𝐸(𝑅𝑆𝑀𝐵 ) + 𝛽𝐻𝑀𝐿 𝐸(𝑅𝐻𝑀𝐿 )

𝑅𝑆𝑀𝐵 = Return on a portfolio of Small firms Minus Return on a portfolio of Big firms
𝑅𝐻𝑀𝐿 = Return on a portfolio of High B/M firms Minus Return on a portfolio of Low B/M firms
𝛽𝑀 : beta on the market factor
𝛽𝑆𝑀𝐵 : beta on the Small-Minus-Big factor
𝛽𝐻𝑀𝐿 : beta on the High-Minus-Low factor

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