Problem Set 1

Problem Set 1 (Chapter 2 and Chapter 3):
1.What are the components of an Investment Return.
2. When adding real estate to an asset allocation program that currently includes only stocks, bonds, and
cash, which of the properties of real estate returns most affects portfolio risk? Explain.
a. Standard deviation.
b. Expected return.
c. Covariance with returns of the other asset classes.
3. Which of the following statements about the minimum-variance portfolio of all risky securities is valid?
(Assume short sales are allowed.) Explain.
a. Its variance must be lower than those of all other securities or portfolios.
b. Its expected return can be lower than the risk-free rate.
c. It may be the optimal risky portfolio.
d. It must include all individual securities.
The following data apply to Problems 4 through 10: A pension fund manager is considering three mutual
funds. The first is a stock fund, the second is a long-term bond fund, and the third is a money market
fund that provides a safe return of 8%.
The characteristics of the risky funds are as follows:
Return Standard deviation
Stock Fund 20% 30%
Bond Fund 12% 15%
Correlation between Funds is 0,1.
4. What are the investment proportions in the minimum-variance portfolio of the two risky funds, and
what are the expected value and standard deviation of its rate of return?
5. Tabulate and draw the investment opportunity set of the two risky funds. Use investment proportions
for the stock fund of 0% to 100% in increments of 20%.
6. Draw a tangent from the risk-free rate to the opportunity set. What does your graph show for the
expected return and standard deviation of the optimal portfolio?
7. Solve numerically for the proportions of each asset and for the expected return and standard
deviation of the optimal risky portfolio.
8. What is the Sharpe ratio of the best feasible CAL?

9. You require that your portfolio yield an expected return of 14%, and that it be efficient, that is, on the
steepest feasible CAL.
a. What is the standard deviation of your portfolio?
b. What is the proportion invested in the money market fund and each of the two risky funds?
10. If you were to use only the two risky funds and still require an expected return of 14%, what would be
the investment proportions of your portfolio? Compare its standard deviation to that of the optimized
portfolio in Problem 9. What do you conclude?
11. Stocks offer an expected rate of return of 18% with a standard deviation of 22%. Gold offers an
expected return of 10% with a standard deviation of 30%.
a. In light of the apparent inferiority of gold with respect to both mean return and volatility,
would anyone hold gold? If so, demonstrate graphically why one would do so.
b. Given the data above, reanswer ( a ) with the additional assumption that the correlation
coefficient between gold and stocks equals 1. Draw a graph illustrating why one would or would
not hold gold in one’s portfolio.
c. Could the set of assumptions in part ( b ) for expected returns, standard deviations, and
correlation represent an equilibrium for the security market?
12. Suppose that there are many stocks in the security market and that the characteristics of stocks A
and B are given as follows:
Stock Return Standard deviation
A 10% 5%
B 15% 10%
Correlation=-1
Suppose that it is possible to borrow at the risk-free rate, rf. What must be the value of the risk-free rate?
( Hint: Think about constructing a risk-free portfolio from stocks A and B. )
13. True or false: Assume that expected returns and standard deviations for all securities (including the
risk-free rate for borrowing and lending) are known. In this case, all investors will have the same optimal
risky portfolio.
14. True or false: The standard deviation of the portfolio is always equal to the weighted average of the
standard deviations of the assets in the portfolio.
15. Suppose you have a project that has a .7 chance of doubling your investment in a year and a .3
chance of halving your investment in a year. What is the standard deviation of the rate of return on this
investment?
16. Suppose that you have $1 million and the following two opportunities from which to construct a
portfolio: a. Risk-free asset earning 12% per year. b. Risky asset with expected return of 30% per year and
standard deviation of 40%. If you construct a portfolio with a standard deviation of 30%, what is its
expected rate of return?
The following data are for Problems 17 through 19: The correlation coefficients between several pairs of
stocks are as follows: Corr( A, B ) = .85; Corr( A, C ) = .60; Corr( A, D ) = .45. Each stock has an expected
return of 8% and a standard deviation of 20%.
17. If your entire portfolio is now composed of stock A and you can add some of only one stock to your
portfolio, would you choose (explain your choice):
a. B
b. C
c. D
d. Need more data
18. Would the answer to Problem 17 change for more risk-averse or risk-tolerant investors? Explain.
19. Suppose that in addition to investing in one more stock you can invest in T-bills as well. Would you
change your answers to Problems 17 and 18 if the T-bill rate is 8%?

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Problem Set 1 (Chapter 2 and Chapter 3):

1.What are the components of an Investment Return.

c. Covariance with returns of the other asset classes.

b. Its expected return can be lower than the risk-free rate.

c. It may be the optimal risky portfolio.

d. It must include all individual securities.

The characteristics of the risky funds are as follows:

Return Standard deviation

Stock Fund 20% 30%

Bond Fund 12% 15%

Correlation between Funds is 0,1.

8. What is the Sharpe ratio of the best feasible CAL?

a. What is the standard deviation of your portfolio?

Stock Return Standard deviation

d. Need more data

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