Problem 4 (50 marks)

Using the Yahoo! Finance website, search the Bank of Nova Scotia (BNS.TO) by finding its stock symbol.
If you are unable to locate the prices for BNS.TO, use prices for BNS (the Bank of Nova Scotia observed
in US dollars at the New York Stock Exchange). For the purpose of this question, assume that the
Canadian dollar and the US dollar had been exchanged one for one. Find historical prices for the stock
(on the left-hand menu) and complete the following:

1. Download historical data for the stock prices (adj. close) from January 1, 2004 through January
1, 2012, on a monthly basis. You will also need to download corresponding monthly prices for
the S&P/TSX Comp index (also available on the Yahoo! Finance site) as well as 3-month T-Bill
rates (download this attachment: T-Bill Rates.xlsx).

2. Calculate returns for both series of prices downloaded from Yahoo site (BNS and S&P /TSX Comp
Index). Prior to that, make sure the data is sorted in ascending order (i.e., first row has the
oldest data). The final spreadsheet should have the two series of returns you downloaded and
calculated from Yahoo! Finance. Make sure all data is expressed in same units.

3. Using the Tools menu in EXCEL, (Tool Pack has to be installed if EXCEL does not show it) perform
regression analyses using the Market Model for BNS.

4. Clearly provide the regression results in a table with an explanation for the coefficients
obtained, and clear interpretation. Specifically, for each regression provide:
 Dependent Variable
 Independent Variable
 Intercept
 Beta Value
 Firm Specific Risk

i. How well does the S&P/TSX Comp Index movement explain the variability of the return
on BNS stock?

ii. What is the alpha of the BNS stock?

iii. Calculate the standard deviation of the stock return (using the equation for R2
=β2σM2/σ2, and the individual regression results).

iv. Calculate systematic risk and firm specific risk for the stock.

Solution:

The regression results:

The dependent variable is the return on BNS.TO

The independent variable is the return on GSPTSE

Looking at the regression P-values, we see that the return on GSPTSE is a significant predictor of the
return on BNS.TO, since the P-value<0.000

The P-value for the constant term is 0.178>0.05, suggesting that the constant term (alpha) is not a
significant predictor of the returns in BNS.TO

The intercept in the alpha = 0.00552. This represents an excess return above the normal or average
return that will be expected from an unskilled investor. Another way of looking at this is that when the
return on GSPTSE is zero, the return on BNS.TO will be 0.00552=0.552%.
Beta Value

𝑟𝑖 = 𝛼𝑖 + 𝛽𝑖 ∗ 𝑟𝑀 + 𝑒𝑖

BNS.TO=0.7109*GSPTSE+0.00552

Comparing the above two equations, we see that:

𝛽 = 0.7109

One interpretation of beta is that when the return on GSPTSE increases by 1 unit (percent), we can
expect the return on BNS.TO to increase by 0.7109 units. Beta is a measure of volatility. Stock with a
beta=1 has the same volatility as the market, while stocks with beta>1 are more volatile than the
market.

Beta reflects the sensitivity of an asset’s price to changes in the value of the market portfolio.
Systematic risks arise through market-wide events, such as unexpected changes in real economic activity
or investor sentiment regarding asset values. In the CAPM, as asset’s beta measured against the market
portfolio is the only measure of systematic risk.

Firm Specific Risk

The residuals from the regression represent the firm specific risk. The expected value of the residuals
from the regression is zero. The residual ei captures all variation in ri that is unrelated to the market
portfolio; that is, that portion of individual security risk that can be diversified away by holding the
security in a portfolio with many securities. The residual return ei then measures risk-adjusted
performance over the period. Because E[ei]=0, abnormal investment performance is measured by the
difference of ei from zero.

i. The R-squared value of 37.9% suggests the about 37.9% of the variation in BNS stock returns is
explained by the variation in S&P/TSX returns. This is not a very high value, so the movement in S&P/TSX
Comp Index is not a very strong predictor of BNS stock returns.

The correlation coefficient between BNS.TO and GSPTSE is below. The correlation coefficient of
0.615, while positive, is not very strong (close to 1). The R-squared is the square of the correlation
coefficient, and it is only 37.9%. Therefore the models prediction capability is not very strong.

ii. 𝑟𝑖 = 𝛼𝑖 + 𝛽𝑖 ∗ 𝑟𝑀 + 𝑒𝑖

BNS.TO=0.7109*GSPTSE+0.00552

Comparing the above two equations, we see that:

𝛼 = 0.00552 = 0.552%
 R2 ∗σ2BNS.TO
iii. 𝛽2 =
σ2GSPTSE

0.37854∗σ2BNS.TO
0.710922 = 0.0433272
=0.050062

𝜎𝐵𝑁𝑆.𝑇𝑂 = 5.01%

iv. Total Variance = Explained Variance + Unexplained Variance

Total Risk = Systematic Risk + Unsystematic Risk

𝜎 2 (𝑟𝑗 ) = 𝛽𝑗2 𝜎 2 (𝑟𝑀 ) + 𝜎 2 (𝜀𝑗 )

Systematic Risk = 𝛽𝑗2 𝜎𝑀

2

Systematic Risk = 0.710922*0.0433272=0.0949%

𝑇𝑜𝑡𝑎𝑙 𝑅𝑖𝑠𝑘 = 𝜎 2 (𝑟𝑗 ) = 𝛽𝑗2 𝜎 2 (𝑟𝑀 ) + 𝜎 2 (𝜀𝑗 )

2
𝑇𝑜𝑡𝑎𝑙 𝑅𝑖𝑠𝑘 = 𝜎𝐵𝑁𝑆.𝑇𝑂 =0.0050622=0.002506

Firm Specific Risk = Total – Systematic Risk = 0.002506-0.000949=0.001558

Comments, according to which the task should be revised:

Problem 4 Part 1: you need to supply the data

Problem 4 Part 4:

Systematic risk for the stock

Systematic risk: Variance = β2σM2

Firm Specific Risk: standard error from regression output and covert it to an annual value.

What is the alpha of the BNS stock: R(BNS) mean – [T-bill mean return converted to decimal

/12 + Beta (Mean Return (S&P/TSX)- T-bill mean return converted to decimal /12))