Assignment Solutions on Foundations of Finance

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Assignment 2

In this assignment, you are to use a factor model as benchmark to evaluate if a stock (or stocks) of your choice is fairly priced.  Optionally, you canbuild an investment strategy to take advantage any mispricing against your benchmark.

Step 1: Determine which factor model to use.  You can choose single-factor market model (CAPM), Fama-French three-factor model (Fama and French have developed other multi-factor models, for more details on the factors and data sets of the factors, you can find them at Ken French’s website: https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html ).

Step 2: Collecting data.  Choose 1 to 5 risky assets (like US equities) that you can get historical price data for the past 5years or more.  Download the Monthly closing price (use adjusted closing price if there are any corporate actions).  Download your choice of market portfolio (index) monthly closing price for the same sample period.  Download the 1-month Treasury Bill rate (need to divide the raw data by 1200) for the same sample period (available monthly from https://fred.stlouisfed.org/series/TB4WK).  (see demo file)

Step 3: calculate monthly return for each of the risky securities and market index.  Then calculate excess returns = return – risk-free rate.  (see demo file)

Step 4:  Security Characteristics Line regressions for each stock using 5 years of in-sample period data to estimate the beta (and alpha) of the stock.  Show the regression results and SCL graph.  Discuss whether alpha(s) are statistically different from 0.  Calculate the Sharpe ratio for each stock. (see demo file)

Step 5 (OPTIONAL).  Using the in-sample alpha estimates from the SCL, determine the direction (long/short) of the risky assets that you want to trade. Form a positive alpha portfolio with the risky assets, market index, and the risk-free asset.  Be creative.  Calculate your portfolio’s Sharpe ratio.

Assignment 3

In this assignment, you will choose a company of interest and evaluate its stock’s fundamental value.  You will practice how to 1) Use the beta of the stock, market return, and risk-free rate to calculate the required rate of return, 2) evaluate the stock using constant growth dividend discount model.  Assignments should be submitted in the format of excel files, or other formats if you use other programming languages.

Data: 1) the company’s dividend history from finance.yahoo.com or the company’s own website.  2) the company’s market risk exposure measured by “Beta (5Y Monthly)” from the company’s summary page on finance.yahoo.com   3) choose an estimation period for the required return R, at least going back a 5-year period.  4) risk-free rates (annual rates)for the estimation period; the rates are available monthly athttps://fred.stlouisfed.org/series/TB3MS5) monthly market index (use S&P 500) “Adj Close” prices for the estimation period https://finance.yahoo.com/quote/%5EGSPC/history?p=%5EGSPC

Part I.calculate required return R

• Calculate risk-free rate using average of the annual 3-Month Treasury Bill interest rates over the estimation period.
• Calculate the monthly market return = (Adj close at the end of month – Adj close at the end of pervious month)/Adj close at the end of previous month
• Calculate annualized market return = average monthly return * 12
• Use the formula to calculate required return R = risk-free rate + beta*(annualized market return – risk-free rate).

Part II.

• Estimate the growth rate of dividends from dividend history data. There is no specific formula for estimating g using historical data.  You can use the most recent growth rate, the average growth rate for the past 5-years, or your own model.
• Use the Constant Growth Model in the (a case of the Dividend Discount Models): Intrinsic Value = D0(1+g)/(R-g)

where D0 is the current annual dividend, and R is the required return we estimated in part I.

Compare your calculation of intrinsic value to the market price, what are your observations and conclusions?