Solutions To Class Problems - Portfolio Theory

INVESTMENTS
PROF. VENKATESH PANCHAPAGESAN
Solutions to Problems in Portfolio Theory

Problems 13-19 (Chapter 6)
INVESTMENTS
SOLUTION to Problems 13-19 (Chapter 6)

13. Expected return = (0.7 x 18%) + (0.3 x 8%) = 15%;
Standard deviation = 0.7
28% = 19.6%.
14.
Investment proportions:
30.0% in T-bills
0.7 25% =
17.5% in Stock A
0.7 32% =
22.4% in Stock B
0.7 43% =
30.1% in Stock C
15. Your reward-to-volatility ratio:
Sharpe Ratio
18 8
0.3571
28
Client's reward-to-volatility ratio: SR
15 8
0.3571
19.6
16.
30
25
CAL (Slope = 0.3571)
20
E(r)
15
%
Client
10
5
0
0
10
20
30
40
17.
(a) E(rC) = rf + y[E(rP) rf] = 8 + y(18 8)
If the expected return for the portfolio is 16%, then:

2
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16 = 8 + 10 y y
16 8
0.8
10
Therefore, in order to have a portfolio with expected rate of return equal to 16%, the
client must invest 80% of total funds in the risky portfolio and 20% in T-bills.
Clients investment proportions:
20.0% in T-bills
0.8 25% =
20.0% in Stock A
0.8 32% =
25.6% in Stock B
0.8 43% =
34.4% in Stock C
(b) C = 0.8 x P = 0.8 x 28% = 22.4%
18.
a. C = y x 28%
If your client prefers a standard deviation of at most 18%, then:
y = 18/28 = 0.6429 = 64.29% invested in the risky portfolio
b. E(rC) = 8 + 10y = 8 + (0.6429 x 10) = 8 + 6.429 = 14.429%
19. For this question, there is an implicit assumption on the utility function. The meanvariance utility function is given by U(.) = E(R) (1/2)*A*sigma^2 where A=risk aversion
parameter for the investor.
U(.) = [y*E(Rp) + (1-y)*Rf] 0.5*A*(y*p)^2 (Risk-free asset has 0 variance and 0
covariance with risky portfolio)
First derivative (dU/dy) = 0 will provide the optimal weight y* which will maximize the
utility.
a.
y*
E(rP ) rf 0.18 0.08

0.10
0.3644
2
2
0.2744
A P
3.5 0.28
Therefore, the clients optimal proportions are: 36.44% invested in the risky portfolio
and 63.56% invested in T-bills.
b. E(rC) = (0.08*0.6356) + (0.18*0.3644) = 11.644%
C = 0.3644 x 0.28 = 10.203%
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Problems 4-10 (Chapter 7)
INVESTMENTS
SOLUTION to Problems 4-10 (Chapter 7)

4. The parameters of the opportunity set are:
E(rS) = 20%, E(rB) = 12%, S = 30%, B = 15%, = 0.10
From the standard deviations and the correlation coefficient we generate the covariance matrix
[note that Cov(rS , rB ) S B ]:
Bonds
225
Bonds
Stocks
45
Stocks
45
900
The minimum-variance portfolio is computed as follows (see note below):
B2 Cov(rS , rB )
225 45
wMin(S) = 2
0.1739
2
S B 2Cov(rS , rB ) 900 225 (2 45)
wMin(B) = 1 0.1739 = 0.8261
Note: Computing solution for the minimum variance portfolio

We need to minimize = 2 2 + 2 2 + 2 ( , )
w.r.t wS, wB., subject to wS+wB =1.
The solution for wS will be what would make the first derivative = 0.
2 2 + 2(1 )(1)2 + 2(1 2 )( , ) = 0
2 + 2 2 + ( , ) 2 ( , ) = 0
( S2 B2 2Cov(rS , rB ) ) = 2 ( , )
=
1
(
2
S
2Cov(rS , rB ) )
2
B
(2 ( , ))
The minimum variance portfolio mean and standard deviation are:

E(rMin) = (0.1739 .20) + (0.8261 .12) = .1339 = 13.39%
Min = [w S2 S2 w 2B 2B 2w S w B Cov(rS , rB )]1 / 2
= [(0.17392 900) + (0.82612 225) + (2 0.1739 0.8261 45)]1/2
= 13.92%
5.
Proportion in
stock fund
0.00%
17.39%
20.00%
Proportion
in bond fund
100.00%
82.61%
80.00%
Expected
return
Standard
Deviation
12.00%
13.39%
13.60%
15.00%
13.92%
13.94%
minimum
variance
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40.00%
45.16%
60.00%
80.00%
100.00%
60.00%
54.84%
40.00%
20.00%
0.00%
15.20%
15.61%
16.80%
18.40%
20.00%
15.70%
16.54%
19.53%
24.48%
30.00%
tangency
portfolio
25.00
INVESTMENT OPPORTUNITY SET

CML
20.00
Tangency
Portfolio
Efficient frontier
of risky assets
15.00
Minimum
Variance
Portfolio
10.00
rf = 8.00
5.00
0.00
0.00
5.00
10.00
15.00
20.00
25.00
30.00
6. The above graph indicates that the optimal portfolio is the tangency portfolio with expected
return approximately 15.6% and standard deviation approximately 16.5%.
7. The proportion of the optimal risky portfolio invested in the stock fund is given by:
wS
[ E (rS ) rf ] B2 [ E (rB ) rf ] Cov(rS , rB )

[ E (rS ) rf ] B2 [ E (rB ) rf ] S2 [ E (rS ) rf E (rB ) rf ] Cov(rS , rB )
[(.20 .08) 225] [(.12 .08) 45]

0.4516
[(.20 .08) 225] [(.12 .08) 900] [(.20 .08 .12 .08) 45]
wB 1 0.4516 0.5484
The mean and standard deviation of the optimal risky portfolio are:
E(rP) = (0.4516 .20) + (0.5484 .12) = .1561
= 15.61%
p = [(0.45162 900) + (0.54842 225) + (2 0.4516 0.5484 45)]1/2
= 16.54%
8. The reward-to-volatility ratio of the optimal CAL is:
E (rp ) rf
.1561 .08
0.4601 =0.4601 should be .4603 (rounding)
.1654
9.
a. If you require that your portfolio yield an expected return of 14%, then you can find the
INVESTMENTS
corresponding standard deviation from the optimal CAL. The equation for this CAL is:
E (rC ) rf
E (rp ) rf
C .08 0.4601 C .4601 should be .4603 (rounding)
If E(rC) is equal to 14%, then the standard deviation of the portfolio is 13.03%.
b. To find the proportion invested in the T-bill fund, remember that the mean of the
complete portfolio (i.e., 14%) is an average of the T-bill rate and the optimal
combination of stocks and bonds (P). Let y be the proportion invested in the portfolio
P. The mean of any portfolio along the optimal CAL is:
E (rC ) (1 y) rf y E (rP ) rf y [ E(rP ) rf ] .08 y (.1561 .08)

Setting E(rC) = 14% we find: y = 0.7881 and (1 y) = 0.2119 (the proportion invested in
the T-bill fund).
To find the proportions invested in each of the funds, multiply 0.7884 times the
respective proportions of stocks and bonds in the optimal risky portfolio:
Proportion of stocks in complete portfolio = 0.7881 0.4516 = 0.3559
Proportion of bonds in complete portfolio = 0.7881 0.5484 = 0.4322
10. Using only the stock and bond funds to achieve a portfolio expected return of 14%, we must
find the appropriate proportion in the stock fund (wS) and the appropriate proportion in the
bond fund (wB = 1 wS) as follows:
.14 = .20 wS + .12 (1 wS) = .12 + .08 wS wS = 0.25
So the proportions are 25% invested in the stock fund and 75% in the bond fund. The standard
deviation of this portfolio will be:
P = [(0.252 900) + (0.752 225) + (2 0.25 0.75 45)]1/2 = 14.13%
This is considerably greater than the standard deviation of 13.04% achieved using T-bills and
the optimal portfolio.

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INVESTMENTS

PROF. VENKATESH PANCHAPAGESAN

Solutions to Problems in Portfolio Theory

SOLUTION to Problems 13-19 (Chapter 6)

15. Your reward-to-volatility ratio:

Client's reward-to-volatility ratio: SR

CAL (Slope = 0.3571)

If the expected return for the portfolio is 16%, then:

(b) C = 0.8 x P = 0.8 x 28% = 22.4%

E(rP ) rf 0.18 0.08

Problems 4-10 (Chapter 7)

SOLUTION to Problems 4-10 (Chapter 7)

The minimum-variance portfolio is computed as follows (see note below):

Note: Computing solution for the minimum variance portfolio

The minimum variance portfolio mean and standard deviation are:

INVESTMENT OPPORTUNITY SET

[ E (rS ) rf ] B2 [ E (rB ) rf ] Cov(rS , rB )

[(.20 .08) 225] [(.12 .08) 45]

C .08 0.4601 C .4601 should be .4603 (rounding)

E (rC ) (1 y) rf y E (rP ) rf y [ E(rP ) rf ] .08 y (.1561 .08)

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