1. MFE 230G Section 3 Hari Phatak 28 August, 2008

2. Agenda Note on Homework 1 Tip on Homework 2 Shortfall Analysis Forecasting Factor models, APT and the CAPM Aegis questions

3. Homework 1, Question 3 How does the quantity relate to ? Start with one quantity and work towards the other: You might also try the opposite direction.

5. Homework 2, Question 1 Solution sketch: –First, write down the optimization problem. –Figure out what the solution says about the portfolio weights –Once you have portfolio weights, computing portfolio tracking error should be simple The answer to the last part, on cap.- weighting, can be qualitative.

6. Shortfall Analysis Suppose as a portfolio manager you instruct your trader to sell 100 shares of stock A, which closed at $1 per share. Trades take place the next day at the following prices:

7. Shortfall Analysis (II) Compute opportunity costs: Compute execution costs:

8. Forecasting Show that:

10. APT Last week, we analyzed a numerical example of a factor model. The model simplified our estimation of the variance-covariance matrix. The APT, by contrast, will help us develop returns forecasts.

11. APT (II) Suppose you have the following set of factor forecasts: And a stock has the following exposures:

12. APT (III) If the market’s expected excess return is 6%, and the stock’s beta with respect to the market is 1.1 what is the stock’s alpha?