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Suppose, you have just begun working for an investment firm called Covili and Wyatt. Paul Covili, one of the firm's founders, has been talking to

Suppose, you have just begun working for an investment firm called Covili and Wyatt. Paul Covili, one of the firm's founders, has been talking to you about the firm's investment portfolio. As with any investment, Paul is concerned about the risk of the investment as well as the potential return. The company wants you to build a diversified portfolio which contains three stocks. Covili and Wyatt currently uses a commercial data vendor for information about its positions. Because of this, Paul is unsure exactly how the numbers provided are calculated. The data provider considers its methods proprietary, and it will not disclose how stock betas and other information are calculated. Paul is uncomfortable with not knowing exactly how these numbers are being computed and also believes that it could be less expensive to calculate the necessary statistics in-house. To explore this question, Paul has asked you to do the following assignments.

Questions:

1. Using monthly data for the last 5 years calculate the average monthly returns and standard deviations for the three stocks in your portfolio, Three-month Treasury Bill, and S&P 500.

2. What is the correlation of the returns between the stocks in your portfolio and the market?

3. Use the market model to estimate the beta for each of the three stocks using the last 5 years risk premiums. Then, estimate the annual required return for each stock based on CAPM using the estimated betas, the average market risk premium and the average risk-free rate.

4. What is the beta shown in Yahoo Finance for each stock? How different it is from your estimated beta?

5. What is your portfolio beta and expected portfolio return? (You can assign the weight for each stock as you like.)

Instructions for Task :

1. You may download data from the following sources:

a. Go to www.finance.yahoo.com and download the ending monthly stock prices for the last 5 years. Use the adjusted closing price, which adjusts for dividend payments and stock splits.

b. Go to www.finance.yahoo.com and download the ending value of the S&P 500 index (^GSPC) for the last 5 years.

c. Go to the St. Louis Federal Reserve website (www.stlouisfed.org) and download the three-month Treasury bill secondary market rate (TB3MS) or go to www.finance.yahoo.com and download 13 Week Treasury Bill (^IRX) for the last 5 years.

2. Beta is often estimated by linear regression. A model commonly used is called the market model, which is: Rt Rft = i + i [RMt Rft] +

Where, Rt = Return on the stock Rft = Risk-free rate RMt = Return on a stock market index such as the S&P 500 index i = Intercept of the regression i = Slope of the regression (or the stock's estimated beta

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