Portfolio Management and Performance Evaluation: 4321

University of Minnesota October 24, 2019

Professor Erik Loualiche ([email protected]) Handout 3b

Portfolio Management and Performance Evaluation

This document summarizes the essential concepts and techniques of fina 4321. It is more detailed than the
syllabus but more condensed than the lecture notes. Anything in this document may appear in the final
exam. Some notations of this section may be slightly different from the lecture notes. Please note that this
document is not meant to replace the lecture notes but rather give you some hints on where to put your
emphasis.

TOPIC 0: Review of Basic Concepts

EXERCISE 0.1 (Returns) On January 1, 2005 you buy one share of IBM at the price P0 =$100. Four
months later on May 1 2005, IBM trades at the price of P1 = $106 and provides a dividend of D1 = $5. If
you sold your share on this date (after getting the dividend) what would be the holding period return on
this investment? What is the income yield and what is the capital gain?
Solution: First note that the holding period is 4 months. Now, using the formula for the 4-month period
return = P1 −PP0o+D1 = $106−$100+$5
$100
$11
= $100 = 11% and so the 4-months period return is 11%. The income
yield is = P0 = $100 = 5% and the capital gain is = P1P−P
D1 $5
0
0
= $106−$100
$100 = 6%

EXERCISE 0.2 (Returns) In the previous question, the 4 month period return was 11%. What is the
effective annual rate? What is the effective 6 month rate?
Solution: We’ll use the formula EAR = (1+rate per period)#periods in a year −1. (i) To compute the effective
annual rate, note that there are three 4-month period returns in a year. Thus EAR = (1+0.11)3 −1 = 36.7%.
(ii) To compute the effective 6 month rate, note that there are 1.5, 4-month period returns in 6 months.
Thus the Effective 6−month Return= (1 + 0.11)1.5 − 1 = 16.9%.

EXERCISE 0.3 (Returns) Suppose the CPI is 100 at the beginning of the period and 110 at the end of
the period. Suppose that at the beginning of the period you invested $100 in stocks and you sell these stocks
for $140 at the end of the period. (i) What is the inflation rate for the period? (ii) What is the nominal and
real rate of return of this investment?
Solution: (i) The inflation rate is given by the growth rate in the consumer price index (CPI). Thus,
1 −CP I0
the inflation is i = CP ICP I0 = 110−100
100 = 10%. So the inflation rate is 10% meaning that the prices
have increased by 10%. (ii) To compute the nominal return, we use the standard formula hpr= W1W−W 0
0
=
$140=$100
$100 = 40%, where W0 is the initial amount invested and W1 is the value of the investment at the end of
the period. (iii) To compute the real returns (RR) using the information about the nominal returns (NR) and
inflation i we use the Fisher equation 1 + RR = 1+N R 1+0.4 1.4
1+i . Here, 1 + RR = 1+0.1 and so RR = 1.1 − 1 = 27.27%.
Note that because we have inflation, real returns are smaller than nominal returns.

EXERCISE 0.4 (Returns) On January 1, 2005 you invested $1000 in stocks. 4 months later on May 1,
2005, your stocks paid a total dividend of $100 right before you sold them for $1100. What was the return
on this investment?
$1100−$1000+$100
Solution: Using the hpr formula, the 4-month return is hpr= $1000 = 20%.
2 Handout 3b: Portfolio Management and Performance Evaluation

EXERCISE 0.5 (Computing real returns and standardization) The total nominal return on stock
A over the last 1 year and three months was 20%. The monthly inflation rate over the same period was
constant at 0.4% per month. Answer the following questions.

(a) What was the annualized nominal and real rates of return on stock A?
(b) What was the monthly nominal and real rates of return on stock A?

Solution:

(a) To adjust annual returns we need the annual inflation. To get the annual inflation rate (ia ) from the
monthly inflation (im ), we use the formula shown in class (i.e. we compound the monthly inflation
rate)
number of periods in one year
1 + ia = (1 + rate per period) −1

and since there are 12, 1 months periods in one year, we have

1 + ia = (1 + im )12 = 1.00412 = 1.04907

ia = 4.9%

Now, let N Ra denote the annual nominal returns on the stock. Again, this value is found from:
number of periods in one year
1 + N Ra = (1 + rate per period) −1
12
and since there are 15 = 0.8, 15 months periods in one year, we have

1 + N Ra = (1 + 0.2)0.8 − 1
N Ra = 0.15703 = 15.7%

The annual real return (RRa ) is found by adjusting nominal return for inflation using the Fisher
equation:
1 + N Ra 1.157
1 + RRa = =
1 + ia 1.049
RRa = 0.103 = 10.3%

(b) To compute the monthly real and nominal returns we follow the same reasoning. The nominal monthly
return is computed from the annual nominal return as follows. Let N Rm denote the monthly nominal
returns on the stock.
number of periods in one month
1 + N Rm = (1 + N Ra ) −1
1
and since there are 12 years in one month, we have
1
1 + N Rm = (1 + 0.15703) 12 − 1
N Rm = 0.0122 = 1.22%

Using the same reasoning, you can find the monthly real return from the annual monthly return as
follows:
number of periods in one month
1 + RRm = (1 + RRa ) −1
1
and since there are 12 years in one month, we have
1
1 + RRm = (1 + 0.103) 12 − 1
RRm = 0.0082 = 0.82%
Handout 3b: Portfolio Management and Performance Evaluation 3

Alternatively, you could use the Fisher equation and use the monthly nominal return and the monthly
inflation rate to find the monthly real return as follows
1 + N Rm 1.0122
1 + RRm = = = 1.0082
1 + im 1.004
RRm = 0.82%
Of course, both approaches give the same answer.

EXERCISE 0.6 (Simple Linear Regression) Suppose you have several observations over time indexed
by t (e.g. t = 1950, 1951, ..., 2007) for two variables (Yt and Xt ) and you want to find the linear relationship
between these two variables. For that, you run the following regression:
Yt = α + β × Xt + et
In class, we saw that in this simple linear regression (i.e one explanatory variable), the β of the regression
and the coefficient of determination R2 are given by
σy,x β 2 σx2
β= 2
and R2 =
σx σy2
where σy,x is the covariance between variables Y and X, and σy is the standard deviation of variable Y
(similarly for variable X).
Finally, in order to answer these questions, always remember that the correlation between two variables
(here Y and X) and the covariance between the same variables is related by the following equation (always
remember this formula)
σy,x
ρy,x =
σy × σx
where ρy,x is the correlation coefficient between variables Y and X.
Answer TRUE or FALSE to the following five questions and provide explanations:

(a) If the correlation between Yt and Xt is equal to 1, then the coefficient β in the above regression must
be 1
(b) If the correlation between Yt and Xt is equal to 0, then the coefficient β in the above regression must
be 0
(c) If the coefficient of determination R2 in the above regression is equal to 1 then the coefficient β in the
above regression must also be 1
(d) If the coefficient of determination R2 in the above regression is equal to 0 then the coefficient β in this
above regression must also be 0
(e) If the coefficient of determination R2 in the above regression is equal to 1 then the correlation between
Yt and Xt must also be 1

Solution:

σ
(a) FALSE. By definition, in a linear regression Yt = α+ β × Xt , we have β = σy,x 2 (where σy,x is
x
the covariance between Y and X) . By definition of correlation between y and x (ρy,x ) we have
σy,x
ρy,x = σy ×σ x
which implies σy,x = ρy,x × σy × σx . Substitute this in the definition of beta we have
ρ ×σ ×σ ρy,x ×σy σy
β = y,x σ2y x = σx . Thus if ρy,x = 1, we have β = σx which in general is not 1 because in
x
general σx 6= σy .
4 Handout 3b: Portfolio Management and Performance Evaluation

ρ ×σ ×σ
(b) TRUE Doing the same algebra steps as in the previous question, we have β = y,x σ2y x . Thus if
x
ρy,x = 0, we have β = 0. Zero correlation means that knowing what happened to X tells nothing about
Y , and thus the regression will not have any predictive power as well.

(c) FALSE. Recall the definition of R2 (a measure of the predictive power of x)

β 2 σx2
R2 =
σy2

and clearly, if R2 = 1, then it does not have to be the case that β = 1 (only if σx2 = σy2 which in general
is not the case)

(d) TRUE. Now, using the previous definition of R2 , because σx2 > 0, we must have that if R2 = 0 then
β = 0. Intuition is that the regression with no predictive power should have β = 0, since knowing X
does not give any information about Y .

(e) FALSE. If R2 = 1, the regression explains all the variance in Y . This means that X is perfectly
predicting Y . However, their correlation does not have to be equal to one for that: if the correlation is
−1, the prediction is also perfect, but the two random variables move exactly in opposite directions.
In fact, you can show that R2 = ρ2y,x using the definition of the R2 and the expression for β obtained
in part (a),
2 2
β 2 σx2

σy σx
R2 = = ρ y,x × = ρ2x,y
σy2 σx σy2

TOPIC 1: Buying and Selling Securities

EXERCISE 1.1 (On types of order) You purchased Jazztell for $80 per share and suppose the current
price of Jazztell is $92. If the price goes to $94 you want to take the gain. What type of order would you
place with your broker?
Solution: A limit sell order (i.e. sell if the price is above $94) is an offensive strategy that may be used
here in order to take advantage of rising stock prices.

EXERCISE 1.2 (On types of order) A stock has opened at $10, and during the day had a low price of
$7, high price of $13 and closed trading at $11. Which of the following orders that you gave to your broker
were executed during that day? Note 1: In each question, answer EXECUTED or NOT EXECUTED and
then explain why. Note 2: If you think it is necessary, state the assumptions that you made in order to
answer each question:
(i) Limit buy order at $11
(ii) Market order to buy 100 shares.
Solution: (i) EXECUTED. Since the stock was to be purchased for no more than $11 and the stock was
traded that day below $11, as low as $7. (ii) EXECUTED. I assumed that there was enough liquidity in
the market, i.e. there was other investors willing to sell at least 100 shares of the stock in the market at the
current price.
Handout 3b: Portfolio Management and Performance Evaluation 5

EXERCISE 1.3 (Buying on Margin) Suppose an investor purchases on margin 100 shares of Microsoft
at $100 per share. If the initial margin requirement is 50%, what is the minimum amount the investor needs
to put from her/his own funds? What was the loan? How does the “balance sheet” of the investor looks like
3 months later when the price of Microsoft is $90 per share? What is the value of the equity at this date?
Solution: The total investment is 100×$100 = $10, 000. Since the initial margin requirement is 50%, it means
that 50% of the total invested must come from your own funds. Thus, you invested $10, 000 × 0.5 = $5, 000
and borrowed the rest Loan=$10, 000 × (1 − 0.5) = $5, 000. The balance sheet of the investor looks like the
following (let Pm be the current price of Microsoft):

Assets Liabilities and Equity

100×Pm Loan= $5000
Equity=100 × Pm − $5000

Now, since the value of Microsoft 3-month later is Pm = $90, then the current value of equity is” Equity=100×
$90 − $5000 = $4000.

EXERCISE 1.4 (Buying on Margin and Margin call) An investor bought 100 shares of Google on
margin at the price of $135 per share, borrowing $6,750 from the broker. Suppose the price of Google drops
to $110 and suppose the maintenance margin requirement is 40%. Question: Will this investor receive a
margin call?
Solution: To check if this investor will receive a margin call we need to compute the actual margin and
verify if it is smaller or greater than the maintenance margin requirement of 40%. Using the formula for the
actual margin on a margin purchase, we have that Actual Margin= Value of stock-Loan
Value of stock = 100×$110−$6,750
100×$110 =
$11,000−$6,750
$11,000 = 38.64%. Since 38.64% < 40% the account in undermargined and the investor will receive a
margin call. This means that the value of equity dropped too much and thus the value of the collateral in
the account is considered insufficient. Because of the margin call, the investor will have to increase the value
of the equity in the account by putting either cash, some other security in the account (e.g. some Treasury
Bills) or pay off part of the loan.

EXERCISE 1.5 (Buying on Margin and Margin Call) Suppose the maintenance margin requirement
is 25%. Suppose an investor purchases on margin 100 shares of IBM with a loan of $5, 000. How far could
the stock price fall before the investor gets a margin call?
Solution: Let P be the price of the stock. The value of the investor’s 100 shares is then 100P , and the
equity (net worth) in the account is 100P − $5, 000. The price at which the percentage margin equals the
maintenance margin of 25% is found by solving the equation

100P − $5, 000

= 0.25
100P
which gives P = $66.(6).

EXERCISE 1.6 (Short Sale) Assume you sold short 100 shares of IBM at $25 per share. The initial
margin was 50%. What would the maintenance margin be if a margin call is made at a stock price of $30?
Solution: The amount in your account is $25 × 100 × 1.5 = $3, 750 and you owe 100 shares of stock.
Net equity $3,750−100×$30
Therefore your net equity is $3, 750 − 100P.Thus, Margin= Amount you owe or 100×$30 = 25%
6 Handout 3b: Portfolio Management and Performance Evaluation

EXERCISE 1.7 (Short Sale and Margin Call) You tell your broker to sell short 1,000 shares of
IBM, which currently trades at the price of $100 per share. Suppose your broker has a 50% initial margin
requirement on short sales and a maintenance margin requirement of 30% on short sales. How much can the
price of IBM stock rise before you get a margin call?
Solution: Let P be the price of IBM stock. Then the value of the shares you must pay back is 1, 000P ,
and the equity in your account is SSS(1 + IM R)−Current Value of stocks which is $150, 000 − 1000P. The
critical value of the price (P) is such that the actual margin is exactly 0.3. Thus is found by solving:

SSP (1 + IM R) − Current Value of Stocks $150, 000 − 1000P

Actual Margin = = = 0.3
Current Value of Stocks 1000P
which implies that P = $115.38 per share. Thus if IBM stock rises above $115.38 per share, you will get a
margin call, and you will either have to put additional cash/t-bills or cover your short position by buying
shares to replace the ones borrowed.

EXERCISE 1.8 (Short Sale and Margin Call) Assume an investor short sells 100 shares of M at the
price of $135 per share. The short sale has an initial margin requirement of 50%. Suppose the maintenance
margin requirement is 40% and that shortly afterwards M closes at $165. (i) Will this investor receive a
margin call at the end of the day? (ii) If yes, how much the investor will have to put in the account to
increase the value of the equity? (assume that after a margin call, the actual margin will have to back to
the initial margin requirement)
Solution: To check if the investor will receive a margin call, first we need to compute the actual margin
and compare it with the maintenance margin requirement. The actual margin is given by

SSP (1 + IM R) − Current Value of Stock

Actual Margin=
Current Value of Stock
Now, the Short Sale Proceeds (SSP) were SSP=100×$135 = $13, 500, the Current Value of the Stock is
=100×$165 = $16, 500 and the Initial Margin Requirement is IM R = 50%.Substitute these values in the
previous formula we have

$13, 500(1 + 0.5) − $16, 500 $20, 250 − $16, 500

Actual Margin= = = 22.7%
$16, 500 $16, 500

Since Actual Margin= 22.7% < 40%, the investor will receive a margin call and thus will have to do something
to increase the value of the equity in the account. Typically, the investor will put cash or Treasury Bills in
the brokers account.
To figure out how much the investor needs to put in the account (denote this amount by $X), use the fact
that the actual margin will have to go back to the initial margin requirement of 50%, i.e.

SSP (1 + IM R) + $X-Value of Short Securities

Initial Margin = 0.5 =
Value of Short Securities
$20, 250 + $X − 100 × $165
0.5 =
100 × $165
⇒ $X = $4, 500

Important: note the difference between margin call on buying on margin and margin calls on short sales.
When buying on margin, a margin call happens when price depreciates, while on a short sale, you a margin
call happens when the price appreciates.
Handout 3b: Portfolio Management and Performance Evaluation 7

EXERCISE 1.9 (Effect of margin purchase on returns) Suppose you buy 10 shares on the margin
and suppose the current price is $100 per share. The initial margin requirements is 50% which means that
you borrow 50% of the required amount and invest 50% from your own money. The total purchase requires
$1,000, of which $500 is borrowed and $500 is from your own cash. In one year, you have 100 shares on your
account. Compare the return on this investment with the return on the same investment financed only with
your own funds under two different scenarios: Scenario #1: The stock price goes up by 20%. and Scenario
#2: The stock price goes down by 20%. What do you conclude?
Solution: Let’s look at the two scenarios:
Scenario #1: The stock price goes up by 20%. In this case you gain $2 per share. What is the return from
the investment in this scenario?
Gain (or loss) 200
Return1 = = = +40%
Your Investment 500
Scenario #2: The stock price goes down by 20%. In this case you loose $2 per share. What is the return
from the investment in this scenario?
−200
Return2 = = −40%
500
How does these returns compare to the case where there was no borrowing (i.e. no financial leverage)? Well,
in this case, you would have to invest the $1000 from your own funds. Under Scenario 1 you would gain
200
$2 per share and thus your return would be Return1 = 1000 = +20% which is smaller than 40%. Under
scenario 2 you would loose $2 per share and thus your return would be Return2 = −2001000 = −20% which is
higher than 50%. So you can gain more but ALSO loose more with a margin purchase. Thus, with financial
leverage the returns are amplified and thus the investment becomes more risky.

EXERCISE 1.10 (Effect of short sales purchase on returns) Suppose you short sale 10 shares at
the current price is $100 per share. Suppose the initial margin requirement is 50% which means that you
need to post 50% of the sale proceeds onto the account to serve as collateral (e.g. cash). Compare the return
on this investment with the return on the same investment financed only with your own funds under two
different scenarios: Scenario #1: The stock price goes up by 20%. and Scenario #2: The stock price goes
down by 20%. What do you conclude?
Solution: Consider two scenarios in one year:
Scenario #1: The stock price goes up by 20% (new price is $120). What is the return from the investment
in this scenario?
Gain (or loss) 10 × ($100 − $120) −200
Return1 = = = = −40%
Your Investment 500 500
Scenario #2: The stock price goes down by 20% (new price is $80). What is the return from the investment
in this scenario is
10 × ($100 − $80) 200
Return2 = = = +40%
500 500
Again, comparing to the no short selling case (i.e. the investor finances the whole investment) that is reported
in the previous example, the returns are amplified: can gain more but also loose more.