Asset Allocation Exercise

FINA 6216: Portfolio Theory and Asset Pricing

Max: 25 points
Due Date: Week 5
Important instructions:
Please present your analysis in a short, self-contained, professional report (PDF format), being sure to
address each issue or question identified below. Grading will be based on the written analysis, and each
member of the team will receive the same grade.
The write-up should not exceed five double-spaced pages of text (not including figures and exhibits). All
figures and exhibits, including analysis performed using Excel, should be carefully labeled and included
inside the PDF report. Discussions need to be clearly articulated so that the reader can follow the analysis
without undue burden. Please upload your report and the excel spreadsheet on Canvas by 10 a.m. on the
due date. An excel spreadsheet containing the case data is posted on the webpage.
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
1. Using the monthly time series of data, calculate the following for each asset class:
a) Monthly and annual average return
b) Month and annual standard deviation of return
c) Correlation between indexes of risky asset classes

(2 points)

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.
Hints:
Which is an unbiased estimate of future return Arithmetic or Geometric mean?
Annual return parameters can be obtained using two approaches.
a. 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
b. 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. Plot and attach the efficient frontier graph
with your project submission.

b) For the Global Minimum Variance portfolio, report the expected return, standard deviation, and
portfolio weights.
c) Report the expected return, standard deviation, and portfolio weights for the unconstrained
tangency (optimal) portfolio. Describe the process to identify the tangency portfolio.
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-Add-in. (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
(w1, 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): 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

(4 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.
a) Calculate the dollar investment in each asset class for both investors.
b) 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?
c) Estimate the average risk profile of your group based on a risk tolerance questionnaire (see WSJ
article 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., BAML) use proprietary software to map questionnaire scores to y* scores.)
4. Asset Allocation with Investment Constraints
(2 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 risk-return perspective?
5. You are hired as a consultant by SMU endowment to guide the asset allocation decision. The
investment horizon is one year. Let us consider three broad asset classes T-bills, large U.S. stocks
and U.S. Treasury bonds. Please present a forecast of one-year expected return for the three asset
classes, being sure to defend the rationale underlying your forecast.
(9 points)
Useful sources to form expectations Historical averages BKM, Table 5.3-5.5.
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 (see articles). Please consider ways to build structure around a fascinating problem.