TB Practice

Collette Gallant, CFA, employs the capital asset pricing model to determine the required returns for stocks. Gallant works for Trey-Black Inc. (TBI) which uses the Treynor-Black model for portfolio optimization. Gallant is deciding whether to include stock ABZ in the TBI’s actively managed portfolio. She forecasts that the ABZ stock return will be 15 percent next year. TBI provides Gallant with the following information. Expected return on the S&P500 stock market index 15% 1-year Treasury bill rate 5% ABZ stock beta 1.25 TBI determines that Gallant’s forecast ability has been very poor. TBI also finds that the average alpha across stocks in their actively managed portfolio equals 1 percent. Determine if Trey-Black’s allocation to ABZ in its actively managed portfolio should be an above or below average, long or short position. Magnitude Position A) Below average Long B) Above average Short C) Below average Short D) Above average Long


I agree. Short – managers ability to forecast is poor and therefore should be below average. Should short because the expected return is higher than the forecasted return.

short because Expected return < Required return. Below average size though, because Collette is a bit rubbish

Magnitude below average because the analyst suck “TBI determines that Gallant’s forecast ability has been very poor” Position short, becasue the expected return is less than the required return on the stock (the stock has a beta greater than 1 and only has an expected return = return on the market) => C)

I’ll try B. short because expected return is < required return But the alpha on the security is 2.5 verses an average alpha of 1 for the rest of the portfolio. Even if the alpha has to be adjusted for a bad forecast it is still 2.5 times as large as the average. I haven’t looked at this in a long time though.

You could also argue that if collette is that bad, you ought to use her as a contra-indicator and take a long position…

C is correct! Mwvt9 - I also went for B for the same reasoning. Looking back at it, I can see why C makes more sense… but what would have been the trigger for above average magnitude, 5%? 10%? 15%? Below the explanation: According to the Treynor-Black model, the actively-managed portfolio takes long positions in positive alpha stocks and short positions in negative alpha stocks. The alpha is defined as the difference between the analyst’s forecast return for the stock and its required return. As stated in the question, the required return for stock ABZ is calculated using the capital asset pricing model: E® = RF + â[E(Rm) – RF] = 0.05 + 1.25[0.15 – 0.05] = 0.175 = 17.5%. Gallant’s forecast return (15%) is less than the required return (17.5%): alpha = 0.15 – 0.175 = -0.025 = -2.5%. Therefore, Gallant’s predicted alpha is much higher in absolute magnitude than the average alpha (1%), which would suggest an above-average short position if Gallant’s forecasting ability is reliable. However, TBI has determined that Gallant’s forecast ability is poor. Therefore, her forecast alpha will be adjusted severely toward zero to account for her poor forecast ability. The end result is that only a small short position will be taken in ABZ.

Arg. I will be reviewing this again tomorrow.

chrismaths Wrote: ------------------------------------------------------- > You could also argue that if collette is that bad, > you ought to use her as a contra-indicator and > take a long position… Funny. We have this analyst thats ALWAYS wrong. She’s our best performer!

I think this is a bad question. I reviewed this tonight and I am still not getting why it is C or, at a minimum, there needs to be more information. If she is the only analyst then all of the alphas will have to be adjusted down by the same amount…the R^2 of her predictions. If that is the case then because the stock in question has a larger alpha it would still make up a larger percentage than the other stocks. For example say her R^2 on forecasts is .25: adjusted alpha for ABZ=.25*.025=.00625=0.625% adjusted alpha for avg stock=.25*.01=.0025=.25% These alphas would then be plugged into the equation to determine weights. If she ISN’T the only analyst (and maybe she is the worst) then I can see why it would be C. But we aren’t given that information. In either case I think we have to make an assumption to get to the answer. What am I missing here?

mwvt, I think it’s safe to assume that she is not the only analyst in her firm unless they specifically say otherwise. I can’t say I know the industry inside and out, but I’d imagine firms with only one analyst are pretty rare.

I work for one! Do you think everything else I wrote looks correct? I am trying to make sure I have this concept before I move on.

I don’t think that you need to adjust the 1% alpha. It says that it is the average alpha across their firm. That is actual data, not a forecast that should be adjusted.

I can see that if the assumption is she isn’t the only analyst (which I agree makes more sense). This question smells of schweser to me…

I think you may be thinking too much into the question. I think they are testing the concept that if your predictions are good and you have a high absolute alpha, you should overweight that security. If your prediction power is not great, you adjust that absolute value down, thus overweighting it less.


short position and low confidence (but i might not have picked up on second part without earlier comment in this thread and reading the section last night)… some decent ideas here though on alternative interpretations.

Agree with Lance… and mwvt - you smelled correctly…

I agree with short but don’t necessarily agree that you can differentiate between above and below average given the information provided. You need a precise adjustment factor, the cfai text actually uses a coefficient multiplier to adjust the alpha for the forcast error based on the analyst. If the average is 1% and her prediction gives you 2.5% (working in absolute terms) if she is extremely bad that could mean a 50% downward adjustment to correct which would still give you a 1.25% alpha and result in an above average weighting. However, a 60% downward adjustment or .4 coefficient would result in a 1% alpha which would be average, etc. This is a very subjective call regarding how bad is bad, in my mind if your track record is 60% off that’s pretty much terrible, but it still doesn’t get you below average.