Problem Set, FIN 201a Investments

Prof. Jens Hilscher, Sep 9, 2014

BRANDEIS INTERNATIONAL BUSINESS SCHOOL

FIN 201A: INVESTMENTS
PROBLEM SET 1: RISK AND RETURN
FALL 2014

Due date: Tuesday September 16
th
2014 (beginning of class). You can hand in a hard copy or
submit the PS on LATTE. Please e-mail Trang Tran (trang01@brandeis.edu) with questions.
Instructions: For analytical questions make sure to show your work for full credit. Do not report
only the final answer but show formulas and calculations when appropriate. You may work in
small groups of 2-3 people to discuss the problem set but you must write up answers individually,
and have to list the names of the group members on your problem set. Also, please write your
program of study on the problem set (it makes it much easier to return the problem sets to you).

1. Investing in the stock market (2 points):
Johnson & Johnson (JNJ) is trading at 104.42 (Sep 5
th
2014 close). JNJ is a large health care
conglomerate. It has done extremely well over the last couple of years (and better than the
market). You think that it may continue to do well.
After careful analysis you conclude that in one year the price will be (60, 85, 110, 120, 155) with
associated probabilities of (0.1, 0.2, 0.4, 0.2, 0.1). Looking at the companys past record you
determine that JNJ will pay a dividend of 2.88 (two quarterly dividends of 0.70 and two quarterly
dividends of 0.74). If you invest your funds risk-free in the money market you will receive 1%.
a. What is the expected return of JNJ stock? What is the risk premium of JNJ stock?
b. Calculate the standard deviation of the return of JNJ stock (remember that you are using
probabilities to do this, not historical data).
You become convinced that this investment opportunity is a good one. In the current conditions
JNJ seems like a safe investment. You decide to buy JNJ stock on margin. You purchase 200
shares, financing half with your own investment and borrowing half from your broker.
c. How much do you borrow from your broker? What is your initial margin?
Tomorrow bad news reaches the economy and the price of JNJ stock drops to 85 immediately.
d. What is the new margin on the account? Do you receive a margin call?
e. Calculate the return on your investment. What would the return have been if you had not
borrowed any funds (Hint: what is the return on JNJ stock)?
f. Now assume that, in one year, the stock price is 110 and JNJ has paid a dividend. Your broker
charged you an interest rate of 2.5% on the amount you borrowed. What is the return on your
investment and what would the return have been if you had not borrowed?

2. Present value, future value (1 point):
a. A savings product requires you to invest the following amounts. 50 today, 100 in one year, 200
in two years, 400 in three years, 500 in four years. What is the future value (in five years) of these
payments, assuming an interest rate of 3%?
b. A bank lends funds to a business. (i) The contract states that the business will repay 150,000 in
eight years. The interest rate is 3%. How much did the bank lend the business? (ii) Now assume
that the market interest rate changes to 4%. What is the present value of the loan to the business?
What is the percent change in the value of the loan? (iii) What would your answers have been if
the initial maturity of the loan had been 10 years?

3. Stock market investment and average excess returns (2 points):
Download annual NYSE stock return (holding period return) data from CRSP. The data is
accessible through WRDS. Follow the steps in Access CRSP on WRDS (on LATTE). Choose
Problem Set, FIN 201a Investments
Prof. Jens Hilscher, Sep 9, 2014
the date range 1963 to 2013. Add this data to the data in PS1.xls on LATTE which contains
annual risk-free returns (from FRED).
a. What was the average and standard deviation of NYSE stock returns?
b. What was the average and standard deviation of risk-free returns? What was the average excess
return (the average difference between the stock return and the risk-free return)?
c. Imagine that at the beginning of 1963 you invested 100 each in stocks and the risk-free
security. What are the values of your two investments at the end of 2013?
d. What are the two values when starting with 100 in 2001 and investing until the end of 2008?
e. What are the geometric average rates of return for the two series (for the full period)? For
which series is it more important to keep the geometric average in mind? Why?

4. Collect stock return data and analyze it using Excel (4 points):
You are interested in analyzing historical stock return data for four U.S. companies that are
included in the S&P500: Microsoft, IBM, Exxon Mobil, and Chevron. The ticker symbols for
these companies are (MSFT IBM XOM CVX). You can enter them directly like this (no comma).
Download monthly stock return (holding period return) data from CRSP, which is accessible
through WRDS. Follow the steps in Access CRSP on WRDS (see above). Choose a date range
of Jan 1990 to Dec 2013. Open the file in Excel. Note that the output data uses PERMNO to
identify the firms. These numbers are: MSFT: 10107, IBM: 12490, XOM: 11850, CVX: 14541.
a. For the four series, calculate the monthly sample average return. Multiply by 12 to get the
annual average return. Which company has the highest, which the lowest return? Discuss if these
average rates of return are useful for getting a sense of expected returns over the next 12 months.
b. For the four series, what is the standard deviation of the monthly returns? Multiply by the
square root of 12 (3.464) to get the annual standard deviations. How does the standard deviation
of these stocks compare to the standard deviation of returns on the market (Hint: look at the
lecture notes)?
c. Looking at the numbers, do you think it would be a good idea to invest all of your money in
one of these stocks?
d. Calculate the correlations between all pairs of stock returns (a total of six correlations). Which
correlations are high, which are low? Why could this be the case?
Some useful Excel commands: (if, for example, you have data in cells A1:A10 and B1:B10).
Mean of series A: = AVERAGE(A1:A10)
Variance of series A: =VAR(A1:A10)
Standard deviation of series A: =STDEV(A1:A10)
Covariance between series A and B: =COVAR(A1:A10, B1:B10)
Coefficient of correlation between series A and B: =CORREL(A1:A10, B1:B10)
Square root of a number: SQRT()

5. VaR value at risk (1 point):
Using the data on the four stock return series you downloaded in the previous question, compare
VaR using the normal distribution and VaR from the monthly return data directly.
a. Based on the monthly sample average returns and standard deviations, what are the values at
risk of the monthly stock returns based on the normal distribution? That is, what are the 5
th

percentiles of the return distributions if you assume that returns are normally distributed?
b. For each series rank the monthly observations. (Hint: How many observations are there? What
is 5 percent of the number of observations?) Find the 5
th
percentile of the return distribution
directly using the data you have and not making any assumptions about the distribution of returns.
c. What do you conclude regarding using the normal distribution as an approximation when
calculating the size of a large loss (VaR)?
d. What are the answers to a., b., and c. when considering the 2.5
th
percentile of the return
distribution (1.96 below the mean assuming normality).