MFE 230G Section 4 Hari Phatak 4 September, 2008

Agenda Administrative Notes Note on Homework 2 Quiz 3, Problem 2 Sharpe Ratios and Alpha Credibility of Forecasts Hint on Homework 3

Administrative Homework solutions to be posted Quiz solution – in section/office hours

Note on Homework 2 …if the benchmark is cap-weighted would you expect active risk to increase or decrease?

Quiz 3, Problem 2(I) You model quarterly active returns and alphas with the following binary model: Calculate: –Quarterly standard deviation of d and a. –Covariance of d and a. –The IC of a.

Quiz 3, Problem 2(II) Standard deviations

Quiz 3, Problem 2(III) Covariance

Sharpe Ratios and Alpha(I) Show that a portfolio Sharpe ratio above the benchmark Sharpe ratio implies a positive alpha for the portfolio, but that a positive alpha does not necessarily imply a Sharpe ratio above the benchmark Sharpe ratio.

Sharpe Ratios and Alpha(II) Higher Sharpe ratio positive alpha.

Sharpe Ratios and Alpha(III) Positive alpha higher Sharpe ratio.

Forecasting and Credibility One night during dinner, you receive a phone call from a stock broker recommending that you immediately buy shares in Countrywide Financial. The broker describes how the recent turmoil in the subprime mortgage markets have overly punished Countrywide, and then predicts that Countrywide’s stock price will soon increase from its current $20 to $30, which would still be well below its 52-week maximum of $ Knowing that Countrywide’s active return volatility is 50%, estimating that this stock broker’s IC is 0.05, and ignoring any possible overall market move, what can you say about this forecast for Countrywide?

Hint on Homework 3 What is meant by “equally weighted”?