Assignment 2
Instructions
Assignment 2 should be submitted after you have completed Unit 3. This assignment is
worth
Assignment 2 contains four problems. The maximum mark for each problem is noted at
the beginning of the problem. This assignment has a total of 100 marks.
Read the requirements for each problem and plan your responses carefully. Although
your responses should be concise, ensure that you answer each of the required
components as completely as possible. If supporting calculations are required, present
them in good form.
has made. This review component is an important step in your learning process. If you
Support Centre.

Problem 1 (15 marks)
Suppose the return on portfolio P has the following probability distribution:
Probability
Return on P

Bear Market
0.2
-20%

Normal market
0.5
18%

Bull market
0.3
50%

Assume that the risk-free rate is 9%, and the expected return and standard deviation on
the market portfolio M is 0.19 and 0.20, respectively. The correlation coefficient between
portfolio P and the market portfolio M is 0.6.
1. Is P efficient?
2. What is the beta of portfolio P?
3. What is the alpha of portfolio P? Is P overpriced or underpriced?

Problem 2 (20 marks)
Consider a two factor economy. Assume the risk-free rate = 3%, and the risk premiums
are
RP1 = 10%, RP2 = 8%. The return on stock ABC is generated according to the following
equation:
rABC=0.08-0.55F1+1.2F2+eABC
Assume that the stock is currently priced at \$50 per share.
1. What is the expected return for stock ABC using the APT?
2. Is stock ABC underpriced or overvalued?
3. If the expected price next year will be \$55, what is the stock price now that will
not allow for arbitrage profits?
4. Assume that the risk free rate increases to 4%, with the other variables remaining
unchanged. Would you recommend to buy or sell stock ABC?

Problem 3 (15 marks)
Suppose that the index model for two Canadian stocks HD and ML is estimated with the
following results:
RHD =0.02+0.80RM+eHD
R-squared =0.6
RML =-0.03+1.50RM+eML
R-squared =0.4
?M =0.20
where M is S&P/TSX Comp Index, RX is the excess return of stock X.
1. What is the standard deviation of each stock?
2. What is the systematic risk of each stock?

2

3. What are the covariance and correlation coefficient between HD and ML?
4. For portfolio P with investment proportion of 0.3 in HD and 0.7 in ML, calculate
the systematic risk, non-systematic risk and total risk of P.

Problem 4 (50 marks)
Using the Yahoo! Finance website, search the Bank of Nova Scotia (BNS.TO) by
finding its stock symbol. If you are unable to locate the prices for BNS.TO, use prices for
BNS (the Bank of Nova Scotia observed in US dollars at the New York Stock Exchange).
For the purpose of this question, assume that the Canadian dollar and the US dollar had
been exchanged one for one. Find historical prices for the stock (on the left-hand menu)
and complete the following:
through January 1, 2012, on a monthly basis. You will also need to download
corresponding monthly prices for the S&P/TSX Comp index (also available on
the Yahoo! Finance site) as well as 3-month T-Bill rates (download this
attachment: T-Bill Rates.xlsx).
2. Calculate returns for both series of prices downloaded from Yahoo site (BNS and
S&P /TSX Comp Index). Prior to that, make sure the data is sorted in ascending
order (i.e., first row has the oldest data). The final spreadsheet should have the
Make sure all data is expressed in same units.
3. Using the Tools menu in EXCEL, (Tool Pack has to be installed if EXCEL does
not show it) perform regression analyses using the Market Model for BNS.
4. Clearly provide the regression results in a table with an explanation for the
coefficients obtained, and clear interpretation. Specifically, for each regression
provide:
?
? Independent Variable
? Intercept
? Dependent Variable

Beta Value

? Firm Specific Risk

i.

ii.

What is the alpha of the BNS stock?

iii.

Calculate the standard deviation of the stock return (using the equation for R2 =?2?M2/?2, and the individual regression results).

iv.

4

How well does the S&P/TSX Comp Index movement explain the variability of the return on BNS stock?

Calculate systematic risk and firm specific risk for the stock.