Contents

I. Introduction ............................................................................................................................................... 1 II. Available Assets, Investment Constraints and Goals ................................................................................ 1 (1) (2) (3) Available Assets......................................................................................................................... 1 Investment Constraints ............................................................................................................. 2 Investment Goals ...................................................................................................................... 2

III Finding the Efficient Frontier .................................................................................................................... 2 IV. Selecting the Optimal Portfolio ............................................................................................................... 4 (1) (2) Find the three portfolios that each best meet one of the investment objectives. .................. 4 Finding the best portfolio ......................................................................................................... 8

V. Robustness Assessment .......................................................................................................................... 10 1. Standard Errors and Confidence Interval............................................................................................ 10 2. Impacts of Estimated Errors ................................................................................................................ 10 (1)Impacts on Portfolio Returns.......................................................................................................... 10 (2)Impacts on Investment Goals: ........................................................................................................ 11 VI. Value at Risk Analysis............................................................................................................................. 12 VII. Stress Testing ........................................................................................................................................ 12 1. Shift of Bond Yield ............................................................................................................................... 13 2. Shift of International Index Yield ........................................................................................................ 14 3. Shift of Common Stock Yield ............................................................................................................... 16 4. Shifts of Correlation ............................................................................................................................ 17 5. Scenarios of Interaction Shifts ............................................................................................................ 18 6. Summary of stress testing................................................................................................................... 21 VIII. Summary .............................................................................................................................................. 21 Appendix ..................................................................................................................................................... 22

I. Introduction
We first the optimal portfolio given three constraints: minimizing the probability of a return less than 6.3%, minimizing the probability of a loss greater than 10%, and maximizing the probability of a return greater than 8%. In our analysis, we determined that the optimal portfolio was the portfolio in which we minimized the probability of a return less than 6.3% by calculating the covariance matrix, plotting the efficient frontier, and comparing three portfolios that each best represent an investment goal with the 100 portfolios that made up the efficient frontier. We then performed a robustness assessment of the optimal portfolio by calculating the standard errors and confidence intervals and assessing the impacts of the estimated errors. We then performed Value at Risk analysis, followed by various methods of stress testing. Our stress testing included finding how our portfolio responded to changes in yield from the bonds, yield from the international index, yield from the common stocks, correlation parameters, and a combination of the above scenarios. Our results demonstrated that we will need to pay a close attention to market condition after the portfolio is created.

II. Available Assets, Investment Constraints and Goals

(1) Available Assets There are five assets can be used to construct the portfolio: Bonds, S&Ps 500 Stocks, Common Stocks, Golden Gate International Index and Options. The correlation matrix is presented below:
Table 2.1 Correlation Matrix Between 5 Assets Assets Bonds S&P's 500 Stocks Common Stocks Golden Gate International Index Options(at the money) Bonds 1 0.51 0.49 0.27 0.47 S&P's 500 Stocks 0.51 1 0.98 0.50 0.94 Common Stocks 0.49 0.98 1 0.48 0.90 Golden Gate International Index 0.27 0.94 0.50 1 0.46 Options(at the money) 0.47 0.27 0.49 0.51 1

The risk (annual standard deviation) and the return (expected annual yield) data for these five assets is summarized below:

Table 2.2 Expected Return and Standard Deviation for Each Asset Risk&Return Expected Annual Yield Annual Standard Deviation Assets Bonds 0.085 0.091 S&P's 500 Stocks 0.13 0.206 Common Stocks 0.135 0.212 Golden Gate International Index 0.13 0.19 Options(at the money) 0.11 0.12

So we calculated the covariance matrix by multiplying standard deviation with correlation matrix. Table 2.3 is covariance matrix.
Table 2.3 Covariance Matrix for 5 Assets Assets Bonds Bonds S&P's 500 Stocks Common Stocks Golden Gate International Index Options(at the money) 0.00828 0.00956 0.00945 0.00467 0.00513 S&P's 500 Stocks 0.00956 0.04244 0.0428 0.01957 0.02324 Common Stocks 0.00945 0.0428 0.04494 0.01933 0.0229 Golden Gate International Index 0.00467 0.01957 0.01933 0.0361 0.01040 Options(at the money) 0.00513 0.02324 0.0229 0.01049 0.0144

(2) Investment Constraints We have constraints on the minimum and maximum weights that each of the asset class can have in the final portfolio:

Table 2.4 Weights Constraints for Each Asset Weights Constraints Assets Bonds 1 0 S&P's 500 Stocks 0.5 0.2 Common Stocks 0.8 0 Golden Gate International Index 0.4 0 Options(at the money) 0.2 0

Maximum Weight for Each Asset Minimum Weight for Each Asset

(3) Investment Goals We want to achieve three goals by creating this portfolio: (1) Minimize the probability of not achieving the 6.3% return level. (2) Have a low probability that loss exceeds 10%. (3) Have a high probability that return exceeds an 8%.

III Finding the Efficient Frontier

To get the efficient frontier, we find the portfolios that have the minimum level of risks(here we define risk as standard deviation) for given level of returns. The range of returns we are interested in is between the return of the minimum risk portfolio and the maximum return the of five assets potfolio. Given the weight constraints for each asset, the minimum risk (standard deviation) of the five asset portfolio is calculated to be 0.1002, and the maximum annual return that the five asset portfolio could get is calculated to be 0.1340. The portfolios with the minimum risk and maximum return are shown in the table below: 2

Table 3.1 Minimum Risk Portfolio for 5-Asset-Portfolio Minimum Risk Portfolio Asset Weight Portfolio Risk(Standard Deviation) Portfolio Return Bonds 77.68% S&P's 500 Stocks 20% Common Stocks 0 0.1002 0.095 Golden Gate International Index 2.32% Options(at the money) 0

Table 3.2 Maximum Return Portfolio for 5-Asset-Portfolio Maximum Return Portfolio Asset Weight Portfolio Risk(Standard Deviation) Portfolio Return Bonds 0 S&P's 500 Stocks 20% Common Stocks 80% 0.2101 0.134 Golden Gate International Index 0 Options(at the money) 0

We selected 100 return levels between 0.095(return of the minimum risk portfolio) and 0.134(maximum achievable return), minimized the risk for each of the return level to find the optimal portfolio, and then constructed the efficient frontier using these 100 portfolios(See the figure below). The blue arrow at the bottom is the minimum risk =0.1002 for the 5-asset-portfolio, and the blue arrow at the top is the maximum return for the 5-asset-portfolio return=0.134. The programming code used to create this efficient frontier is in the Appendix. The blue curve in the figure is the efficient frontier for the five assets portfolio, while the red line is the efficient frontier for the original three assets portfolio. From this figure we can see that for a given level of return, the five assets portfolio can always has a lower level of risk, which means adding the two additional assets into the portfolio is a great choice for investor because it can reduce risk while retaining the same level of return.

Figure 1 Efficient Frontier of 5 Assets and 3 Assets 0.14 0.135 0.13 0.125 0.12 Return 0.115 0.11 0.105 0.1 0.095 0.09 0.08 0.1 0.12 0.14 Risk 0.16 0.18 0.2 minimum risk 5 Assets 3 Assets 0.22 maximum return

IV. Selecting the Optimal Portfolio

We will follow the steps below to make the selection: first, find the three portfolios that each best meet one of the investment objectives, and second, compare these three portfolios with each other and with all the other portfolios to find the optimal portfolio. (1) Find the three portfolios that each best meet one of the investment objectives. As stated earlier in the report, we want to achieve three goals by selecting the optimal portfolio: Minimize the probability of not achieving the 6.3% return level. Have a low probability that loss exceeds 10%. Have a high probability that return exceeds an 8%. (1) To compare how well the 100 portfolios meet the first investment objective, we calculated the probability of not achieving the 6.3% return level for each of the portfolios and plotted the results in the figure below(we are assuming all the returns have normal distribution here and throughout the report).

Figure 2 Probability of 5-Asset-Portfolio Not Achieving 6.3% Return 0.375

probability of not achieving 6.3% return

0.37 0.365 0.36 0.355 0.35 0.345 0.34 0.335

0.1

0.12

0.14

0.16 risk

0.18

0.2

0.22

The minimum probability of not achieving the 6.3% return level that we can get from these portfolios is 0.3391. The detailed information about the portfolio that minimizes this probability is shown below:
Table 4.1 The Portfolio with the Minimum Probability for Not Achieving Return 6.3% Portfolio that minimize the probability of not achieving the 6.3% return level Asset Weight Probability of not achieving 6.3% return level Portfolio Risk(Standard Deviation) Portfolio Return Bonds 22.45% S&P's 500 Stocks 20% Common Stocks 0 0.3391 0.1275 0.1159 Golden Gate International Index 37.55% Options(at the money) 20%

(2) To compare how well the 100 portfolios meet the second investment objective, we calculated the probability of loss exceeding 10% for each of the portfolios and plotted the results in the figure below:

Figure 3 Probability of 3-Seet-Portfolio Loss Exceeding 10% 0.14

probability of loss exceeding 10%

0.12

0.1

0.08

0.06

0.04

0.02

0.1

0.12

0.14

0.16 risk

0.18

0.2

0.22

The minimum probability of loss exceeding 10% that we can get from these portfolios is 0.024742. The detailed information about the portfolio that minimizes this probability is shown in the table below:
Table 4.2 The Portfolio with the Minimum Probability for Loss Exceeding 10% Portfolio that minimize the probability of loss exceeding 10% Asset Weight Probability of loss exceeding 10% Portfolio Risk(Standard Deviation) Portfolio Return Bonds 68.60% S&P's 500 Stocks 20% Common Stocks 0 0.024743 0.1011 0.0986 Golden Gate International Index 8.68% Options(at the money) 2.71%

(3) To compare how well the 100 portfolios meet the third investment objective, we calculated the probability of return exceeding 8% for each of the portfolios and plotted the results in the figure below:

Figure 4 Probability for Return Exceeding 8% 0.63

probability for return exceeding 8%

0.62 0.61 0.6 0.59 0.58 0.57 0.56 0.55 probability for return exceeding 8% 0.1 0.12 0.14 0.16 Risk 0.18 0.2 0.22

The maximum probability that we can get from these portfolios of return exceeding 8% is 0.617136. The detailed information about the portfolio that maximizes this probability is shown in the table below:
Table 4.3 The Portfolio with the Maximum Probability for Return Exceeding 8% Portfolio that maximize the probability of return exceeding 8% Asset Weight Probability of exceeding 10% return level Portfolio Risk(Standard Deviation) Portfolio Return Bonds 0.17% S&P's 500 Stocks 20% Common Stocks 19.83% 0.617136 0.1574 0.1269 Golden Gate International Index 40% Options(at the money) 20%

(4) To be more conclusive, we compared the probability results between the five-asset portfolio and three-asset portfolio. Our results concluded that the five-asset portfolio will always has a better result than the three-asset portfolio.(See Figure 5 below)

Figure 5 Comparisons between 3-Asset-Portfolio and 5-Asset-Portfolio

(a)Efficient Frontier Comparison 0.14 0.38 0.37 0.12 0.36 0.35 0.34 0.08 0.1 0.15 0.2 0.25 (c)Probability(loss>10%) Comparison 0.2 0.15 0.1 0.05 0 0.1 0.33 0.1 0.15 0.2 0.25 (d)Probability(return>8%) Comparison 0.62 0.6 0.58 0.56 0.54 0.1 (b)Probability(return<6.3%) Comparison

0.1

0.15

0.2

0.25

0.15 5-Asset-Portfolio

0.2

0.25 3-Asset-Portfolio

(2) Finding the best portfolio We find the best portfolio by first making the comparison within the three portfolios selected above and then comparing the winner with the 100 portfolios. (1) Comparison within the three portfolios. To find the best portfolio among the three, we first calculated all the three probabilities for each of the portfolios. The results are shown below:
Table 4.4
Portfolios Comparison

Portfolio that minimize the probability of not achieving the 6.3% return level 0.3391 0.0452 0.6108

Portfolio that minimize the probability of loss exceeding 10% 0.3625 0.0248 0.5729

Portfolio that maximize the probability of return exceeding 8% 0.3424 0.0747 0.6171

Probability of not achieving the 6.3% return level Portfolio that minimize the probability of loss exceeding 10% Portfolio that maximize the probability of return exceeding 8%

Portfolio that minimizes the probability of not achieving the 6.3% return level VS Portfolio that minimizes the probability of loss exceeding 10% 8

We can see that although the second portfolio has a lower probability of loss exceeding 10%, which is better, its two other probabilities are worse than those of the first portfolio: the probability of not achieving 6.3% level of return is higher while the probability of return exceeding 8% is lower. With the above being said, since of the three probabilities, the first portfolio has two probabilities that are better than the second one, we should conclude that the first portfolio is better. Portfolio that minimizes the probability of not achieving the 6.3% return level VS Portfolio that maximizes the probability of return exceeding 8% Again, the latter portfolio has one probability that is better than the former portfolio, which is that the probability of return exceeding 8% is higher, but its other two probabilities, the probability of return lower than 6.3% and loss exceeding 10%, are all higher, which is worse. Given above information, we can draw the conclusion that the portfolio that minimizes the probability of not achieving the 6.3% return level is a better portfolio because it has two probabilities that are better than the other one.

In summary, the portfolio that minimizes the probability of not achieving the 6.3% return level is the best portfolio among the three, since it is better than each of the other two. (2) Comparing with the 100 portfolios We plotted the probabilities for all the 100 portfolios and compared them with the corresponding probabilities of the best portfolio we selected above. The results are shown in the following figure. The blue lines show the probabilities for different portfolios and the red lines show the probabilities for the optimal portfolio. We can see from the figure that for all the portfolios with a return lower than 0.1159 (which is the return for the best portfolio we selected above), they have a lower probabilities of return exceeding 8% and a higher probabilities of return lower than 6.3% comparing with the best portfolio we selected above, which means they are worse than the best portfolio. For all the portfolios with a return higher than 0.1159, they have a higher probabilities of loss exceeding 10% and a higher probability of return lower than 6.3% comparing with the best portfolio, which means they are also worse than the best portfolio.

In conclusion, the optimal portfolio we selected above, that is the portfolio that minimizes the probability of not achieving the 6.3% return level, is the best portfolio we can get and is our optimal portfolio given the constraints and goals we have.

V. Robustness Assessment
To assess the robustness of the optimal portfolio, we considered the estimated error for the expected returns of different assets. (Because in our optimal portfolio we will not invest in Common Stock, so here we wont include Common Stocks return in our discussion)

1. Standard Errors and Confidence Interval

Given the standard deviations we got from the historical data, and given the ten-year data we are using to estimate the mean and standard deviation, we can calculate the standard errors for the estimated expected returns(standard error=standard deviation/square root of sample size), which are shown in the table below(because our estimates are based on a ten-year historical data, the sample size is 10):
Table 2.1 Calculation of Standard Errors S&P's 500 Bonds Stocks Standard Deviation 9.1 20.6 Standard Error 2.88 6.51

Golden Gate International Index 19 6.00

Options(at the money) 12 3.79

With the standard errors, we can calculate the confidence interval for each of the estimated expected return. Note: We calculated the interval here based on 90% confidence level. The lower side of the interval= Expected Return - z(probability)*Standard Error, and the upper side of the interval= Expected Return + z(probability)*Standard Error. Table 2.2 Confidence Interval for Expected Returns under 10% confidence level 90% Confidence Golden Gate Level Bonds S&P's 500 Stocks Common Stocks International Index 3.77 2.28 2.47 3.12 Upper End 13.23 23.72 24.53 22.88 Lower End

Options(at the money) 4.76 17.24

2. Impacts of Estimated Errors

With the confidence intervals for expected returns, we now assess the robustness of the portfolio by looking at how well the optimal portfolio will perform under 90% confidence levels. The detail discussion is below: (1)Impacts on Portfolio Returns (Please note here we only considered the impact from individual asset returns estimated error but not the joint effects, the reason is that the estimated errors for 10

different assets could potentially cancel out the impacts of the others, hence it is difficult and not very meaningful to assess the joint effects.):

Figure 2.1 Impacts of Different Assets' Estimated Error on Portfolio Return(90% Confidence Level)
18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 13.73 12.65 10.53 11.59 9.45 7.88 11.59 11.59 15.30 12.84 11.59

10.34

Bonds Error Upper End of Confidence Interval

S&P Error

International Index Error

Options Error Originally Estimated Level

Lower End of Confidence Interval

In the above figure, 11.59 is the return of the optimal portfolio if all the estimates are accurate. Based on the confidence interval of Bond return, the return of the optimal portfolio could vary from 12.86 to 10.32, which is shown on the left side of the histogram. The other parts of the histogram just show the similar things for S&P 500, International Index, and options. From the results we can see that with a 90% confidence level, the estimated errors of S&P 500 Index return and the International Index return could potentially have a significant impacts on the return of the optimal portfolio: S&P 500 could potentially lower the portfolio return to about 9.5% and the International Index could potentially lower the portfolio return to about 7.9%. (2)Impacts on Investment Goals: Here we are going to assess how the estimated errors for expected returns are going to impact the three investment goals we have (Because now we know from Figure 2.1 that the estimated error from International Index return will have the largest impact on the optimal portfolio, here we only assess how International Index returns error will impact our investment goals, and the other scenarios wont be worse than this):
Table 2.3 Impacts of International Index returns estimated error on Investment Goals(90% Confidence Level) Probabilities and Portfolio Returns Upper:15.3 Lower:7.88 Original Estimated Return: 11.59 24.01% 45.07% Probability of return less than 6.3 33.91% 2.36% 8.04% Probability of return less than -10 4.52% 71.66% 49.62% Probability of return larger than 8 61.09%

From above tables we can see that the worst case is when the actual International Index return is 3.12 and the portfolio return is 7.88(lower end of the confidence interval - 90% confidence level). If this is the 11

actual expected return, then the probability of return less than 6.3 increased from 33.91% to 45.07%, the probability of return less than -10 increased from 4.52% to 8.04%, and the probability of return larger than 8 is lowered from 61.09% to 49.62%. To summarize the robustness assessment, because of the limited sample size (10 years annual return), we are exposed to a potential high level of estimated error given a 90% confidence level, which means we need to pay a close attention to how the market evolves over time after we created the portfolio. But nevertheless, the optimal portfolio we found in the previous section is still the best decision we can make giving the information we have.

VI. Value at Risk Analysis

Because we dont have the access to the actual historical raw data, here we calculate the VarianceCovariance VaR based on the estimated expected return and standard deviation that are given to us. We know from the previous section that our optimal portfolio has the following parameters: Expected Return=11.59% Standard Deviation=12.75% Assuming the portfolio return has a normal distribution, we can calculate the Absolute VaR and VaR as follows (Because we dont know how much we are going to invest in the portfolio, our VaR will be a percentage of returns rather than a specific amount of money):
Table 3.1 VaR Analysis Confidence Level 95% 99% 99.96% Percentile 5% 1% 0.04% Absolute VaR -9.38% -18.07% -31.16% VaR 20.97% 29.66% 42.75%

Our interpretation of the VaR analysis table above is as follows: (i) During a one year period, the probability of a loss exceeds 20.97% if the size of the portfolio is less than 5% (ii) During a one year period, the probability of a loss exceeds 29.66% if the size of the portfolio is less than 1% (iii) During a one year period, the probability of a loss exceeds 42.75% if the size of the portfolio is less than 0.04%

VII. Stress Testing

So far, we used the method of VaR to get a sense of how often a bad scenario will happen. However, VaR analysis assumes the future outcome will fall in the distribution that is constructed using the 12

historical data, which makes VaR analysis ignore the possibilities of outliers. So we will employ stress testing methods to complete our risk analysis. The purpose of stress testing is to determine the size of potential losses related to specific scenarios. In the following scenarios, we shift the yield of bond, international index and stocks up and down and also change each correlation parameter between assets. We then measure the performance of our optimal portfolio should the shocks occur. (In the following discussion we are assuming we will invest 30 million into the optimal portfolio)

1. Shift of Bond Yield

Table 4.1 is the return, profits, risk and weighs of assets for optimal portfolio.
Table 4.1 Optimal Portfolio Assets Weights Return Profits Risk(Standard Deviation)

Bonds 0.2244

S&P Index 0.2

Stocks 0 0.1159

International index 0.3755

options 0.2

$3.477 million 0.1275

In Table 4.2, the shock of bond yield shift does not change the risk of the portfolio but the return of the portfolio. When yield of bond decreases 100 or 200 basis points, return of the portfolio decreases 1.937% or 3.874% compared to the original scenario. Our goal is to minimize the probability of not reaching 6.3%, to minimize the probability of loss exceeding 10% and to maximize the probability of return exceeding 8%. In Figure 4.1, three probability indicators all move to worse directions. We add a scenario of 500 basis points down shifting to see how the portfolio will perform under a more stressed case. The return of the portfolio decreases from 0.1159 to 0.1047, which means that return reduces from $ 3.477 million to $3.14 million. This is the stress testing for 1 year. When considering a 10-year horizon, the shock in one year will have some effects on the terminal value of the portfolio. For example, if yield(bond) shifts down 100 basis points in one year, the portfolio value after 10 years will be ; while the portfolio value after 10 years will be when there is no shock.

Table 4.2 Performance of Optimal Portfolio Given the Shift of Bond Yield return(portfolio) 0.1159 0.113655 0.111410 0.104676 risk(portfolio) 0.1275 0.1275 0.1275 0.1275 probability (return< 6.3%) 0.339107 0.345576 0.352089 0.371882 probability (loss>10%) 0.045196 0.046896 0.048647 0.054213 probability (return>8%) 0.610863 0.604094 0.597296 0.576732

Optimal Portfolio without shock Yield(bond) shift down 100 basis points Yield(bond) shift down 200 basis points Yield(bond) shift down 500 basis points

13

Yield(bond) shift up 100 basis points Yield(bond) shift up 200 basis points

0.118144 0.120389

0.1275 0.1275

0.332689 0.326317

0.043547 0.041946

0.617594 0.624292

We can also see how the bond yield shift will impact our optimal portfolio in the following figure:
Figure 4.1 Portfolio Return after Bond Yield Shifted
(a) Portfolio Return Before shifts and After Shifts 0.125 0.12 0.115 0.11 0.105 0.1 no shift down 100bp down 200bp down 500bp up 100bp up 200bp 0.32 no shift down 100bpdown 200bp down 500bp up 100bp up 200bp 0.36 0.38 (b) Probability(return<6.3%) Before shifts and After Shifts

0.34

(c) Probability(loss>10%) Before shifts and After Shifts 0.055 0.64 0.62 0.05 0.6 0.045 0.58 0.04 no shift

(d)Probability(return>8%) Before shifts and After Shifts

down 100bp down 200bp down 500bp

up 100bp

up 200bp

no shift

down 100bpdown 200bp down 500bp up 100bp

up 200bp

2. Shift of International Index Yield

In Table 4.3, we can see that the shock of the yield in international index has an impact on the portfolio return. When yield of international index shift down 100 or 200 basis points, the return changes to 0.112144 or 0.108389. Again, we want to minimize the probability of not reaching 6.3%, to minimize the probability of loss exceeding 10% and to maximize the probability of return exceeding 8%. We can see in Figure 4.2 that three probability indicators all moves to worse direction. We add two even worse scenarios to the discussion, a down shift of 500 basis points and a down shift of 800 basis points. We can see that an 800 basis points down shift will have a much larger impact than those of a 500 basis down shift. The profit lowers by $0.6847 million with a 500 basis point down shift and by $0.9113 million with an 800 basis point down shift. The reason behind this is that the weight of international index is higher than the weight of bond in our optimal portfolio. Therefore, it will be more sensitive to the change of international index yield. 14

We found that our portfolio will be heavily impacted by a down shift of 800 basis points. The chance of return less than 6.3% is increased by 10%, the probability of loss more than 10% is increased by 27% and probability of return more than 8% is decreased by 10%. Our optimal portfolio is not acting very well when yield of international index decreases significantly, so we should pay a close attention to the performance of international index and be aware of the high sensitivity of the optimal portfolio to international index. Above we talked about the stress testing for 1 year. When considering a 10-year horizon, the shock in one year will have some effects on the terminal value of the portfolio. For example, if yield (international index) shifts down 200 basis points and 500 basis points in 2 consecutive years, the portfolio value after 10 years will be ; while the portfolio value after 10 years will be when there is no shock.

Table 4.3 Performance of Optimal Portfolio Given the Shift in Yield of International Index return(portfolio) Optimal Portfolio without shock Yield(international index) shift down 100 basis points Yield(international index) shift down 200 basis points Yield(international index) shift down 500 basis points Yield(international index) shift down 800 basis points 0.1159 0.112144 0.108389 0.097122 0.085856 risk(portfolio) 0.1275 0.1275 0.1275 0.1275 0.1275 probability (return< 6.3%) 0.339107 0.349955 0.360925 0.394494 0.428865 probability (loss>10%) 0.045196 0.048069 0.051085 0.061045 0.072462 probability (return>8%) 0.610863 0.599522 0.588098 0.553414 0.518317

15

Figure 4.2 Changes in Portfolio When Yield of International Index Shifts

(a)Portfolio Return Before Shifts and After Shifts 0.12 0.115 0.11 0.105 0.38 0.1 0.095 0.09 0.085 no shift down 100bp down 200bp down 500bp down 800bp 0.36 0.34 0.32 no shift 0.44 0.42 0.4 (b)Probability(return<6.3%) Before Shifts and After Shifts

down 100bp

down 200bp

down 500bp

down 800bp

(c)Probability(loss>10%) Before Shifts and After Shifts 0.075 0.07 0.065 0.06 0.055 0.05 0.045 no shift 0.62 0.6 0.58 0.56 0.54 0.52 0.5 no shift

(d)Probability(return>8%) Before Shifts and After Shifts

down 100bp

down 200bp

down 500bp

down 800bp

down 100bp

down 200bp

down 500bp

down 800bp

3. Shift of Common Stock Yield

Because we will not invest in common stock in our optimal portfolio, the shifts of common stock yield will have no impact on our optimal portfolio.
Table 4.4 Performance of Optimal Portfolio Given the Shift in Yield of Common Stock return(portfolio) Optimal Portfolio without shock Yield(common stock) shift up 100 basis points Yield(common stock) shift up 200 basis points Yield(common stock) shift down 100 basis points Yield(common stock) shift down 200 basis points 0.1159 0.115899334 0.115899334 0.115899334 0.115899334 risk(portfolio) 0.1275 0.1275 0.1275 0.1275 0.1275 probability (return< 6.3%) 0.339107 0.339109 0.339109 0.339109 0.339109 probability (loss>10%) 0.045196 0.045197 0.045197 0.045197 0.045197 probability (return>8%) 0.610863 0.610861 0.610861 0.610861 0.610861

16

4. Shifts of Correlation
The shock of the changes of correlation does not change the return of the portfolio but change the risk of the portfolio(See Table 4.5). In Figure 4.3 (the numbers on x-axis corresponds to different scenarios, see Table 4.6 for details), when correlation goes down 50%, the risk of the portfolio will be lowered and three probability indicators will move towards better directions, so we will only discuss the scenarios when correlation goes up 50%. As the weight of common stock is 0 in the portfolio, we will not take the correlation between common stock and other assets into discussion. We found out that the increase of correlation between non-bond assets has a much higher impact on our portfolio than an increase of correlation between bond and other assets. So we will be more focused on the correlations between non-bond assets and will need to pay a specific attention to the correlation between S&P Index and International Index.
Table 4.5 Performance of Optimal Portfolio after Correlation changes return Optimal Portfolio without shock Corr(Bond,S&P Index)shift down 50% Corr(Bond,S&P Index)shift up 50% Corr(Bond,International Index)shift down 50% Corr(Bond,International Index)shift up 50% Corr(Bond,Options)shift down 50% Corr(Bond,Optoins)shift up 50% Corr(S&P Index,Option)shift down 50% Corr(S&P Index,Option)shift to 1 Corr(S&P Index,International Index)shift down 50% Corr(S&P Index,International Index)shift up 50% Corr(International Index,Options)shift down 50% Corr(International Index,Options)shift up 50% 0.1159 0.1159 0.1159 0.1159 0.1159 0.1159 0.1159 0.1159 0.1159 0.1159 0.1159 0.1159 0.1159 risk 0.1275 0.1258 0.1292 0.126 0.1291 0.1266 0.1284 0.1238 0.1280 0.1216 0.1332 0.1244 0.1306 probability (return< 6.3%) 0.339107 0.337057 0.341107 0.337301 0.340991 0.338028 0.340172 0.33458 0.3397 0.331769 0.345629 0.33533 0.342719 probability (loss>10%) 0.045196 0.043061 0.047356 0.043311 0.047228 0.044063 0.046336 0.040585 0.045829 0.037908 0.052523 0.041323 0.049151 probability (return>8%) 0.610863 0.612321 0.609442 0.612148 0.609524 0.61163 0.610106 0.614086 0.610441 0.616091 0.606235 0.613551 0.608298

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Figure 4.3 Changes in Portfolio When Correlation Shifts

(a)Portfolio Risk Before and After Shifts 0.14 0.135 0.13 0.34 0.125 0.12 0.335 0.33 0.355 0.35 0.345 (b)Probability(return<6.3%) Before and After Shifts

10

12

10

12

(c)Probability(loss>10%)Before and After Shifts 0.06 0.055 0.05 0.045 0.04 0.605 0.615 0.62

(d)Probability(return>8%)Before and After Shifts

0.61

10

12

10

12

Note:Each numb er from 1:12 on x-axis corresponds to each correlation, see in Tab le 4.6

Table 4.6 Numbers Corresponding X-Axis in Figure 4.3 0 1 3 5 7 9 11 Optimal Portfolio without shock Corr(Bond,S&P Index) increase 50% Corr(Bond,International Index) decrease 50% Corr(Bond,Options) decrease 50% Corr(S&P Index,Option) decrease 50% Corr(S&P Index,International Index) decrease 50% Corr(International Index,Options) decrease 50%

2 4 6 8 10 12

Corr(Bond,S&P Index) increase 50% Corr(Bond,International Index) increase 50% Corr(Bond,Optoins) increase 50% Corr(S&P Index,Option) increase to 1 Corr(S&P Index,International Index) increase 50% Corr(International Index,Options) increase 50%

5. Scenarios of Interaction Shifts

The first hypothetical scenario is an international financial crisis, for example Asia and Europe have financial crisis at the same time. In this scenario, foreign stocks will go down, investors will become more risk averse and will pull their money back from international investment and invest more in US Treasury bond is presumed to be the safest investment, and this will drive the bond price up and in turn 18

lower the bond yield. We are assuming here the yield of bond will shift down 200 basis points, the yield of international index will shift down 500 basis points, and correlation between bond and international index would increase 50%. In Table 4.6, we compare the performance of the optimal portfolio before and after the shock. In Figure 4.4 (a), we can see that after the international financial crisis the return decreases 20% and risk increases 1.25%. In Figure 4.4 (b), probability of not achieving the 6.3% increased to 41%; probability of loss exceeding 10% increased to 68%; probability of return exceeding 8% decreased to 54%.
Table 4.7 Performance of Optimal Portfolio Given the Multiple Shifts in Hypothesized International Financial Crisis (yield of bond shifts down 200 basis points; the yield of international index shifts down 500 basis points; correlation [bond, international]index increases 50%) return Optimal Portfolio no Shift Optimal Portfolio after Shift 0.1159 0.09263 risk 0.1275 0.1291 Probability (return< 6.3%) 0.339107 0.409226 Probability (loss>10%) 0.045196 0.067833 Probability (return>8%) 0.610863 0.538976

Figure 4.4 Interaction Scenario of International Financial Crisis

(a)Risk-return Before Shifts and After Shifts 0.15 0.14 0.13 0.5 0.12
probability Return

(b) Probability Indicators Before Shifts and After Shifts 0.7 0.6

0.11 0.1 0.09

0.4 0.3 0.2

0.08 0.07 0.06 0.1 0.12 0.14 0.16 Risk 0.18 0.2 0.22 0.1 0

no shift

international financial crisis(hypothesized)

Probability(return<6.5%) Probability(loss>10%) Probability(return>8%)

Efficient Frontier Risk-return Before Shifts Risk-return After Shifts

The second hypothetical scenario is financial crisis arises from US, for example the Financial Crisis in 2008, which brings shifts in yields and correlation. The yield of S&P 500 will shift down 500 basis points, 19

the yield of international index will shift down 500 basis points, and correlation between S&P 500 Index and international index would increase 50%. In Table 4.8, we compare the optimal portfolio before shifts and after shifts. In Figure 4.5 (a), we can see that after US financial crisis the return decreases 39.65% and risk increases 4.47%. In Figure 4.5 (b), probability of not achieving the 6.3% return level increased to 48%; probability of loss exceeding 10% increased to 10%; probability of return exceeding 8% decreased to 47%.
Table 4.8 Performance of Optimal Portfolio Given the Multiple Shifts in Hypothesized US Financial Crisis (yield of S&P 500 Index shifts down 500 basis points; the yield of international index shifts down 500 basis points; correlation [S&P 500 Index, international index] increases 50%) Probability Probability Probability return risk (return< 6.3%) (loss>10%) (return>8%) Optimal Portfolio before Shift 0.1159 0.1275 0.339107 0.045196 0.610863 Optimal Portfolio after Shift 0.069951 0.1332 0.47919 0.100994 0.469932

Figure 4.5 Interaction Scenario of US Financial Crisis

(a)Risk-return Before Shifts and After Shifts 0.14 0.13 0.12 0.11
Return

(b)Probability Indicators Before Shifts and After Shifts 0.7 0.6 0.5
Probability

0.4 0.3 0.2

0.1 0.09 0.08

0.1 0.07 0.1 0.12 0.14 0.16 Risk 0.18 0.2 0.22 0 no shift US financial crisis(hypothesized)
Probability(return<6.3%) Probability(loss>10%) Probability(return>10%)

Efficient Frontier Risk-return Before Shifts Risk-return After Shifts

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6. Summary of stress testing

To summarize, we found out in our above discussion that International Index will potentially have the largest individual impacts on the performance of our portfolio, which makes sense since it has the largest proportion in our optimal portfolio and also has a very high standard deviation. Besides that, should a serious financial or economic crisis happen in US or other major economies, our portfolio will be affected heavily with a lower return and lower probabilities of meeting our investment goals. With the above being said, after the portfolio is created, we should closely monitor the financial and economic conditions around the world, and will probably need to rebalance the portfolio when it is necessary.

VIII. Summary
After determining our optimal portfolio in our first report, we analyzed the robustness, value at risk, and stress testing of our portfolio. We performed the robustness analysis using calculations of standard errors and confidence intervals, then assessed the impact of those estimated errors on those portfolios. Since he lacked the historical data of our portfolio, we calculated the value at risk based on the expected return and standard deviation. Finally, we reported the performance of our optimal portfolio when i.) ii.) iii.) iv.) Yield from the Bonds shifts up or down by several basis points, 100 basis points, or 200 basis points (e.g. Interest Rate Risk). Yield from the Golden Gate Bank International Index Fund suffers a downward shift by several basis points, 100 basis points, or 200 basis points (e.g. Foreign Exchange Risk). Common stocks yield trails the historic 10-year average annual yield by several basis points, 100 basis points, or 200 basis points (e.g. Stock Price Risk). Some key correlation parameters change.

Using the above four situations, we constructed our own interaction scenarios for more stress testing. Our stress testing determined that our portfolio was exceptionally sensitive to changes in yield from the Golden Gate Bank International Index fund, since that holds the most weight, and came to the conclusion that we would need to closely monitor the financial and economic conditions around the world and rebalance our portfolio from time to time in response to those conditions. The calculations from our first report and financial analysis from our second report should be enough to convince the board that our optimal portfolio is the best way to invest in and manage the Golden Gate Bank Retirement Fund.

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Appendix
Code for Figures in Report
clc % clear memory: clear all; % close figures: close all; % cxhange directory: cd 'C:\Users\LYL\Documents\Risk Management\projects'; addpath 'C:\Users\LYL\Documents\Risk Management\projects'; %% %shift change in yield(bond) return_bond=[0.1159 0.113655 0.111410 0.104676 0.118144 0.120389]; p1_1=[0.339107 0.345576 0.352089 0.371882 0.332689 0.326317]; p1_2=[0.045196 0.046896 0.048647 0.054213 0.043547 0.041946]; p1_3=[0.610863 0.604094 0.597296 0.576732 0.617594 0.624292]; subplot(2,2,1);plot(return_bond,'r'); set(gca,'XTick',1:1:6) set(gca,'XTickLabel',{'no shift','down 100bp','up 200bp'}) subplot(2,2,2);plot(p1_1,'b'); set(gca,'XTick',1:1:6) set(gca,'XTickLabel',{'no shift','down 100bp','up 200bp'}) subplot(2,2,3);plot(p1_2,'g'); set(gca,'XTick',1:1:6) set(gca,'XTickLabel',{'no shift','down 100bp','up 200bp'}) subplot(2,2,4);plot(p1_3,'y'); set(gca,'XTick',1:1:6) set(gca,'XTickLabel',{'no shift','down 100bp','up 200bp'})

100bp','down 200bp','down 500bp','up

100bp','down 200bp','down 500bp','up

100bp','down 200bp','down 500bp','up

100bp','down 200bp','down 500bp','up

%% %shift change in yield(international index) return_iix=[0.1159 0.112144 0.108389 0.097122 0.085856]; p2_1=[0.339107 0.349955 0.360925 0.394494 0.428865]; p2_2=[0.045196 0.048069 0.051085 0.061045

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0.072462]; p2_3=[0.610863 0.599522 0.588098 0.553414 0.518317]; subplot(2,2,1);plot(return_iix,'r'); set(gca,'XTick',1:1:5) set(gca,'XTickLabel',{'no shift','down 800bp'}) subplot(2,2,2);plot(p2_1,'b'); set(gca,'XTick',1:1:5) set(gca,'XTickLabel',{'no shift','down 800bp'}) subplot(2,2,3);plot(p2_2,'g'); set(gca,'XTick',1:1:5) set(gca,'XTickLabel',{'no shift','down 800bp'}) subplot(2,2,4);plot(p2_3,'y'); set(gca,'XTick',1:1:5) set(gca,'XTickLabel',{'no shift','down 800bp'}) %% %correlation shifts risk_corr=[0.1275 0.1258 0.1292 0.126 0.1291 0.1266 0.1284 0.1238 0.1311 0.1216 0.1332 0.1244 0.1306]; p3_1=[0.339107 0.337057 0.341107 0.337301 0.340991 0.338028 0.340172 0.33458 0.343287 0.331769 0.345629 0.33533 0.342719]; p3_2=[0.045196 0.043061 0.047356 0.043311

100bp','down 200bp','down 500bp','down

100bp','down 200bp','down 500bp','down

100bp','down 200bp','down 500bp','down

100bp','down 200bp','down 500bp','down

23

0.047228 0.044063 0.046336 0.040585 0.049796 0.037908 0.052523 0.041323 0.049151]; p3_3=[0.610863 0.612321 0.609442 0.612148 0.609524 0.61163 0.610106 0.614086 0.607895 0.616091 0.606235 0.613551 0.608298]; x=0:1:12; subplot(2,2,1);plot(x,risk_corr,'r'); subplot(2,2,2);plot(x,p3_1,'b'); subplot(2,2,3);plot(x,p3_2,'g'); subplot(2,2,4);plot(x,p3_3,'y'); %% %2 interaction scenarios-international crisis clear; x1=[0.1275]; y1=[0.1159]; x3=[0.1291]; y3=[0.069951]; subplot(1,2,1);plot(sigma,r_port,'b',x1,y1,'*',x3,y3,'o') y2=[0.339107,0.045196,0.610863; 0.47919,0.100994,0.469932]; x2=[0;1]; subplot(1,2,2);plot(x2,y2,'r'); set(gca,'XTick',0:1:1) set(gca,'XTickLabel',{'no shift','international financial crisis(hypothesized)'}) %% %2 interaction scenarios-US crisis clear; x1=[0.1275]; y1=[0.1159]; x3=[0.1332]; y3=[0.085899]; subplot(1,2,1);plot(sigma,r_port,'b',x1,y1,'*',x3,y3,'o') y2=[0.339107,0.045196,0.610863; 0.431751,0.081411,0.517663]; x2=[0;1]; subplot(1,2,2);plot(x2,y2,'r'); set(gca,'XTick',0:1:1) set(gca,'XTickLabel',{'no shift','US financial crisis(hypothesized)'})

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