FINA 6216

ASSIGNMENT 1: Asset Allocation (25 points)

DUE DATE: Week 5

Instructions:
o Please present your analysis in a short, self-contained, professional report
(Word format), being sure to address each issue or question identified
below.
o Grading will be based on the written analysis, and each member of the
team will receive the same grade.
o The write-up should not exceed five double-spaced pages of text (not
including figures and exhibits).
o All figures and exhibits, including analysis performed using Excel, should be
carefully labeled and included in the Word document.
o Discussions need to be clearly articulated so that the reader can follow the
analysis without undue burden.
o Please e-mail the report and the excel spreadsheet by 11.59pm am on
13th February.
o An excel spreadsheet containing the case data is posted on the webpage.
General Information:
The last two decades of the prior century have exhibited many interesting
patterns the high inflation of 1980s and the equity market bull-run of
1990s. Begin by choosing either the 80s or 90s decade. The Excel sheet
provides historical monthly return data for an entire decade for the
following indexes:
1. S&P 500
domestic large equity
2. Russell 2000
domestic small equity
3. LB Long Term Gvt./Corp. bonds fixed income
4. MSCI EAFE
foreign equity
5. T-bills
risk free
Required Background Reading:
BKM, Chapter 13: Section 13.5.
Questions:
1. Calculating inputs (2 points)
Using the monthly time series of data, calculate the following for each asset
class:
a) Monthly and annual average return
1980
Mean
Annual

U.S. 30 Day TBill TR

0.7%
8.6%

Russell 2000 TR
1.3%
15.8%

S&P 500 TR
1.5%
17.6%

LB LT Gvt/Credit TR
1.1%
13.3%

MSCI EAFE TR
1.9%
22.2%

1990
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FINA 6216
ASSIGNMENT 1: Asset Allocation (25 points)
DUE DATE: Week 5
Mean
Annual

U.S. 30 Day TBill TR

0.4%
4.8%

Russell 2000 TR
1.2%
14.1%

S&P 500 TR
1.5%
17.7%

LB LT Gvt/Credit TR
0.7%
8.6%

MSCI EAFE TR
0.7%
8.6%

LB LT Gvt/Credit TR
2.1%
7.4%

MSCI EAFE TR
5.0%
17.1%

b) Month and annual standard deviation of return

1990
Std. Dev
Annual

U.S. 30 Day TBill TR

0.1%
0.4%

Russell 2000 TR
5.0%
17.3%

S&P 500 TR
3.9%
13.4%

c) Correlation between indexes of risky asset classes

Russell
S&P 500
LT Bond
EAFE

Russell
1.000
0.780
0.191
0.441

S&P
500
0.780
1.000
0.413
0.539

LT Bond
0.191
0.413
1.000
0.174

EAFE
0.441
0.539
0.174
1.000

Use the above as Input List for the asset allocation problem below. You may
assume that the T-bill has zero standard deviation and zero correlation with
other asset classes.

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FINA 6216
ASSIGNMENT 1: Asset Allocation (25 points)
DUE DATE: Week 5

Hints:
Which is an unbiased estimate of future return Arithmetic or Geometric
mean?
Annual return parameters can be obtained using two approaches:
1. Calculate the relevant statistic (mean, standard deviation,
correlation) using monthly return (120 observations). Next, obtain
annual statistic.
Annual return = 12 * monthly return
Annual Std. Dev = 12 * monthly Std. Dev
2. First calculate annual return (10 observations). Next, calculate the
relevant statistic.
Do the two approaches yield the same result? If not, which approach is
better? Why?
Note: Please follow approach 1 for the rest of the assignment.
2. Optimal Asset Allocation (8 points)
a) For each portfolio return highlighted in yellow in the spreadsheet Efficient
Frontier, calculate the minimum unconstrained portfolio standard
deviation.
1980

Target Port Mean

14.5
15.3
16.2
17.3
18.3
19.2
20.4
21.6
22.9
24.1

St. Dev
11.3
11.0
10.9
11.1
11.6
12.2
13.4
14.8
16.5
18.3

RUS
0.13
0.05
-0.04
-0.16
-0.26
-0.35
-0.48
-0.60
-0.74
-0.86

S&P
0.06
0.14
0.24
0.36
0.47
0.57
0.71
0.84
0.98
1.11

Weights
LBB
0.75
0.67
0.58
0.48
0.38
0.30
0.18
0.07
-0.05
-0.17

Port Mean
Return
EAFE
0.07
0.14
0.22
0.31
0.40
0.48
0.59
0.70
0.81
0.92

Sum of
Port wgts.

14.5
15.3
16.2
17.3
18.3
19.2
20.4
21.6
22.9
24.1

1.0
1.0
1.0
1.0
1.0
1.0
1.0
1.0
1.0
1.0

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FINA 6216
ASSIGNMENT 1: Asset Allocation (25 points)
DUE DATE: Week 5

Portfolio Efficient Frontier

30.00

25.00

20.00

Efficient
Portfolio
Portfolio
Return
%

15.00 RUS

S&P

LBB

EAFE

10.0

15.0

CAL

10.00

5.00

0.00
0.0

5.0

20.0

Portfolio Risk %

1990
Target Port Mean
5.5
8.2
11.0
13.9
15.2
17.1
19.7
21.3
23.2
24.8

St. Dev
7.6
7.1
7.6
9.2
10.2
11.7
13.9
15.4
17.2
18.7

RUS
0.23
0.12
0.01
-0.11
-0.16
-0.24
-0.35
-0.41
-0.49
-0.56

S&P
-0.48
-0.12
0.26
0.65
0.82
1.08
1.43
1.65
1.90
2.12

Weights
LBB
1.06
0.90
0.73
0.55
0.47
0.35
0.19
0.10
-0.02
-0.12

Port Mean
Return
EAFE
0.19
0.10
0.01
-0.09
-0.13
-0.19
-0.28
-0.33
-0.39
-0.44

Sum of
Port wgts.

5.5
8.2
11.0
13.9
15.2
17.1
19.7
21.3
23.2
24.8

1.0
1.0
1.0
1.0
1.0
1.0
1.0
1.0
1.0
1.0

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FINA 6216
ASSIGNMENT 1: Asset Allocation (25 points)
DUE DATE: Week 5

Portfolio Efficient Frontier

30.00

25.00

20.00

Efficient
Portfolio
Portfolio
Return
%

15.00 RUS

S&P

LBB

EAFE

10.0

15.0

CAL

10.00

5.00

0.00
0.0

5.0

20.0

Portfolio Risk %

b) For the Global Minimum Variance portfolio, report the expected return,
standard deviation, and portfolio weights.
For 1980,
For 1990

c) Report the expected return, standard deviation, and portfolio weights for
the unconstrained tangency (optimal) portfolio. Describe the process to
identify the tangency portfolio.
You can solve using trial and error, I am OK with that method for this basic
class.
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FINA 6216
ASSIGNMENT 1: Asset Allocation (25 points)
DUE DATE: Week 5

Advanced Method: You can use Solver in Excel to solve the Asset Allocation
problem.
To check whether Solver is installed in your machine, click on Tools, then
Solver.
If Solver is not highlighted, click on Tools, then Add-Ins, and check Solver-Addin. (You could include Analysis-ToolPak and Analysis-ToolPak-VBA as well.)
If Solver is still not highlighted, it may be that Solver was not installed in your
machine when Microsoft-Office was initially loaded. You should install Solver
using the Office CD. Or, you could use one of the machines in the BIC.
Once Solver is highlighted, you are ready to solve the following optimization
problem:
For each value of expected return (highlighted in yellow in
column B), calculate the portfolio weights (w 1, w2, w3, w4 in
columns D to G) that will minimize the portfolio variance (in
column C).
That is, you are asked to plot the minimum variance frontier.
To use solver, you need to set up the rows 27 to 36 in the Efficient Frontier
spreadsheet:
Column C must equal the four-asset portfolio standard deviation. Recall that
the N-asset portfolio variance has N individual variance components and
[N*(N-1)] covariance components. The covariance matrix has been created
in rows 19 to 22.

Click Tools, then Solver.

o
Our objective (Target Cell): Minimize portfolio standard deviation
o
Our choice variables (By changing Cells) is Portfolio weights.
o
Under Box Subject to the constraints, Click Add to impose two
constraints:

The portfolio return must equal the target portfolio return (in
column B).

The sum of portfolio weights must equal 1.

Click Solve. When the Box appears, Click keep solver solution.
3. Optimal Capital Allocation (5 points)
Consider two investors with significantly different risk profiles. Let us assume
that both investors have total wealth of $1 million. The optimal weight (y*) in
the tangency portfolio is 0.50 for the conservative investor (Roberto). For the
moderate-risk investor (Cathy), the optimal weight (y*) in the tangency
portfolio is 0.90.
Calculate the dollar investment in each asset class for both investors.
For 1990s
Risk free asset allocation is 50% and rest 50% is divided into other classes of
assets for Roberto for tangent portfolio.
For Roberto

Risk free

RUS

S&P

LBB

EAFE
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FINA 6216
ASSIGNMENT 1: Asset Allocation (25 points)
DUE DATE: Week 5
Dollar Investment

$
500,000.00

$
(206,557.04)

$
822,644.40

$
48,337.10

$
(164,424.46)

Risk free asset allocation is 10% and rest 90% is divided into other classes of
assets for Cathy for tangent portfolio.
For Cathy
Dollar Investment

Risk free
$
100,000.00

RUS
$
(371,802.68)

S&P
$
1,480,759.92

LBB
$
87,006.79

EAFE
$
(295,964.03)

Is the composition of the risky portfolio the same for both investors? If
so, explain why, and discuss the role of risk aversion in the allocation
decision?

No this is not same for both the investors. Because each investors risk aversion
is different and hence the weightage of risk for each investor in the risky portfolio
is different.

o
o

Estimate the average risk profile of your group based on a risk tolerance
questionnaire (see WSJ article from Week 1 or one of websites below).
What should be the optimal allocation for your team? (Notes: Theory
suggests that the investor with moderate risk tolerance has a y* close to
1. Financial firms (e.g., Merrill Lynch) use proprietary software programs
to map questionnaire scores to y* scores.)
http://www.investored.ca/Quizzes/RiskComfort/quiz_risk.htm
http://www.kiplinger.com/tools/riskfind.html

4. Asset Allocation with Investment Constraints (3 points)

Note that you are only required to describe the process.
a) Your client is a mutual fund, who is restricted from short selling
securities as per fund charter. Describe the changes in Solver to solve
the asset allocation problem.
b) Your client is a social investor, who mandates that you consider both
financial objectives and the investments impact on society. Suppose
Index S&P-PUFF tracks tobacco stocks and is part of your input list.
Describe the changes in Solver to solve the asset allocation problem
with the new constraint.
Examples of industries that social investors avoid include alcohol,
tobacco, gambling, defense, environment pollutants, and animal
testing.
c) Will investment constraints improve portfolio performance from a riskreturn perspective?
5. SMU Asset Allocation (7 points)
You are hired as a consultant by the SMU endowment in Sep 2012 to assist in
the asset allocation exercise. The investment horizon is one year. Let us
consider three broad asset classes T-bills, large stocks and long-term bonds.
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FINA 6216
ASSIGNMENT 1: Asset Allocation (25 points)
DUE DATE: Week 5

Please report your estimate of expected return for the three asset classes,
being sure to defend the rational behind your expectations.
Useful sources to form expectations Historical averages BKM, Table 5.3.
Recent rates on Treasury Bonds and Bills Federal Reserve Bank of St. Louis
FRED system interest rates.
Equity market premium BKM, Chapter 13.5.
(Note that the last exercise is challenging and even experts have great difficulty
in predicting market performance. Please view this exercise as an attempt at
building structure around a fascinating problem).
The 3 months T bill rate is .02% and since our investment horizon is for 1 year, we want to calculate the annual rate of the
T bill and so we will take 4 t bills of 3 month T-bills for a one year horizon. And we calculate using (1+r)^n -1 and convert
it to annual rate which is .08%.
And then we use this expected return of .08% as the risk free rate to calculate the return on the large stocks. Since market
beta is 1 and we are calculating return for large stocks we reduce our beta to 0.9. And since return of S&P 500 ETF for
large stocks over the past 10 years, it has achieved a 16.99% return per year through an average of monthly returns.
We converted it to average annual returns by (1+r/12)^12-1.Which we calculated to be 18.38. Then, using CAPM, the
expected return for large stocks was calculated as 16.61%.
For large bonds, we have taken data from FLBAX. Over the past 5 years, the return has on this large bond is 11.22%
annually using month end returns. And then we annualized by using (1+r/12)^12-1. Which we calculated as 11.81%.

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