Name: Bhuwan Swami

Roll no. – 160202

ECO423A - Assignment 1
Sol. 1

a) Expected Return E(R) = ∑Pi*Ri

Variance = σ2 = ∑Pi*(Ri – E(R))2

Asset 1 Asset 2
Market condition Return Probability Market condition Return Probability
Good 12.00 1/4 Good 3.00 1/4
Average 10.00 1/2 Average 6.00 1/2
Poor 8.00 1/4 Poor 4.00 1/4

Expected Return 10.00 Expected Return 4.75

Standard Deviation 1.41 Standard Deviation 1.30

Asset 3 Asset 4
Market condition Return Probability Rainfall Return Probability
Good 15.00 1/4 Plentiful 12.00 1/3
Average 11.00 1/2 Average 10.00 1/3
Poor 4.00 1/4 Light 5.00 1/3

Expected Return 10.25 Expected Return 9.00

Standard Deviation 3.96 Standard Deviation 2.94

b)

Pairing Covariance Correlation

1 and 2 -0.500 -0.272
1 and 3 5.500 0.982
1 and 4 0 0
2 and 3 -0.438 -0.085
2 and 4 0 0
3 and 4 0 0
c)

Portfolio A B C D E F G H I
Asset 1 1/2 1/2 1/2 0 0 1/3 0 1/3 1/4
Asset 2 1/2 0 0 1/2 0 1/3 1/3 0 1/4
Asset 3 0 1/2 0 1/2 1/2 1/3 1/3 1/3 1/4
Asset 4 0 0 1/2 0 1/2 0 1/3 1/3 1/4

Expected Return 7.375 10.125 9.500 7.500 9.625 8.333 8.000 9.750 12.125
Variance 0.672 7.172 2.667 4.125 6.089 3.167 2.796 4.150 2.323
Standard Devaition 0.820 2.678 1.633 2.031 2.467 1.780 1.672 2.037 1.524
 d)

Expected Return vs Std. Dev. (Assets)

12.00

10.00 Asset 1 Asset 3

Asset 4
8.00
Expected return

6.00

Asset 2
4.00

2.00

0.00
0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50
Standard Deviation

Expected Return vs Std. Dev. (Portfolios)

13.000
I
12.000

11.000
Expected Return

B
H E
10.000 C

9.000
F
G
8.000 A D

7.000

6.000
0.500 1.000 1.500 2.000 2.500 3.000
Standard Deviation
 Sol 2.

Variance of the portfolio with four securities:

σP2 = w12 σ12 + w22 σ22 + w32 σ32 + w42 σ42 + 2*(w1w2 σ12 + w1w3 σ13 + w1w4 σ14 + w2w3 σ23 + w2w4 σ24 +
w3w4σ34),
Where
σij = ρij*σi*σj

Standard deviation on
Securities Weights ρ12 0.2 σ12 6
returns
1 0.3 5 ρ13 0.6 σ13 -36
2 0.2 6 ρ14 0.3 σ14 12
3 0.2 12 ρ23 0.4 σ23 28.8
4 0.3 8 ρ24 0.6 σ24 28.8
ρ34 0.5 σ34 48

σP2 = 0.09*25 + 0.04*36 + 0.04*144 + 0.09*64 + 2*(0.3*0.2*6 + 0.3*0.2*(-36) + 0.3*0.3*12 + 0.2*0.2*28.8

+ 0.2*0.4*28.8 + 0.2*0.3*48) = 26.442

Standard deviation of portfolio σP:

σP = √26.442 = 5.142179

Sol 3.
Portfolio Year 1 Year 2 Year 3 Year 4 Year 5
A 8% 10% -6% -1% 9%
B 10% 6% -9% 4% 11%
C 9% 6% 3% 5% 8%
D 10% 8% 13% 7% 12%

a) Expected return on portfolio of one stock at a time:

Since we have time series data, we give equal weightage to each year for computing expected return

ERA = (8 + 10 – 6 – 1 + 9)/5 = 4 %

A B C D
4.00% 4.40% 6.20% 10.00%

b) Expected return on portfolio of two stocks at a time:

Each portfolio with equal weight ½

ERAB = ERA/2 + ERB/2

Portfolio AB AC AD BC BD CD
Expected return 4.20% 5.10% 7.00% 5.30% 7.20% 8.10%
 c) Expected return on portfolio of three stocks at a time:

Each portfolio with equal weight 1/3

ERABC = ERA/3 + ERB/3 + ERC/3

Portfolio ABC ABD ACD BCD

Expected Return 4.87% 6.13% 6.73% 6.87%

d) Expected return on portfolio of four stocks at a time:

Each portfolio with equal weight ¼

ERABCD = (ERA/4 + ERB/4 + ERC/4 + ERD/4) = (4/4 + 4.4/4 + 6.2/4 + 10/4) = 6.15%

Sol 4.

Given, RM = 16%, βA = 1.6, RA = 22%, g = 12% and PO = Rs. 260.

PO = D1/(RA – g)

⇒ D1 = PO * (RA – g) = 260*(0.22 – 0.12) = Rs. 26

DO = D1/(1+g)

⇒ DO = 26/(1+0.12) = Rs. 23.214

We know,

RA = Rf+ βA * (RM – Rf)

⇒ 0.22 = Rf + 1.6 (0.16 – Rf)

⇒Rf = 0.06, that is, 6%

i. Inflation premium increases by 5%, therefore, Rf = 6+5 = 11%

ii. The decrease in the degree of risk-aversion reduces the differential between the return on market portfolio
and the risk-free return by one half, therefore, RM – Rf = 5%
iii. The expected growth rate of dividend on stock A decrease to 10 %, therefore, g = 10%
iv. The beta of stock A falls to 1.1, that is, βA = 1.1

⇒ RA = Rf+ βA * (RM – Rf)

⇒RA = 0.11 + 1.1 * (0.05) = 0.165, that is, 16.5%

Price per share of stock

PO = DO * (1+g)/(RA – g) = 23.214*1.1/(0.165 – 0.1)

⇒ PO = Rs. 392.85
Sol. 5

a) Given that 60% stocks are of TATA and 40% of Flipkart, that is w1 = 0.6, and w2 = 0.4

Given that σ1 = 0.363 and σ2 = 0.34 and ρ12 = 0.34

Variance of the portfolio, σP2 = w12 σ12 + w22 σ22 + 2 *(w1w2σ12)

⇒ σP2 = 0.36*(0.363)2 + 0.16*(0.34)2 + 2*0.6*0.4*0.34*0.363*0.34

⇒ σP2 = 0.086075

Standard deviation of the portfolio, σP = 0.0860750.5 = 0.293385

b) Contribution of TATA in the variance = (0.6)2(0.363)2 + (0.6)(0.4)(0.34*0.363*0.34) = 0.05747

Contribution of Flipkart in the variance = (0.4)2(0.34)2 + (0.6)(0.4)(0.34*0.363*0.34) = 0.02857

Relative contribution of TATA = 0.05747/0.086 = 0.668

Relative contribution of Flipkart = 0.02857/0.086 = 0.332

c) Beta of each stock relative to this two-stock portfolio:

β = (relative contribution)/(weight)

βTATA = 0.668/0.6 = 1.113

βFlipkart = 0.332/0.4 = 0.835
Sol. 6

Given, E(RM) = 5%, Rf = 2% and β = 1.2

Expected return E(R),

E(R) = Rf+ β * (E(RM) – Rf)

⇒ E(R) = 0.02 + 1.2 * (0.05) = 0.02 + 0.06

⇒ E(R) = 0.08(8%)

This means that a person must have required return of 8% in order to invest in a risky portfolio than a risk free
environment.

Sol. 7

βGodrej = 0.75, E(R) = 13%, Rf = 4% and we need to find market risk premium.

We know market risk premium is the difference between the expected return on a market portfolio and the
risk-free rate, thus using the CAPM formula,

E(R) = Rf + βGodrej(E(RM) – Rf)

⇒ 13 = 4 + 0.75* (E(RM) – Rf)

⇒ E(RM) – Rf = 9/0.75 = 12%.

⇒ E(RM) = 12 + 4 = 16%

Therefore, the market risk premium is 12%. And the expected return on the market portfolio is 16%

Sol. 8

No. of stocks of A = NA = 300, worth Rs. 10/stock

No. of stocks of B = NB = 50, worth Rs. 40/stock.
E(RA) = 8% and E(RB) = 13%

a) Value of portfolio = (300 x 10) + (50 x 40) = Rs. 5000

Weights:
wA = (300 x 10)/(5000) = 0.6
wB = (50 x 40)/(5000) = 0.4

Expected return of the portfolio = wA x E(RA) + wB x E(RB)

⇒ E(RP) = 0.6 * 8 + 0.4* 13 = 10%

b) New value of portfolio = 300 x 12 + 50 x 36 = Rs. 5400

Weights:
wA = (300 x 12)/(5400) = 2/3
wB = (50 x 36)/(5400) = 1/3

Return Earned = 100*(5400 – 5000)/5000 = 8%

Sol. 9

Weight on stock A = w
Weight on stock B = 1 – w

a) Portfolio’s mean return = w*(15) + (1 – w) *(7) = 8w + 7

Portfolio’s variance = w2 σ12 + (1 – w)2 σ22 + 2𝜌X,Y w(1 – w) σ1 σ2

⇒ σP2 = 0.16w2 + 0.09(1 – w)2 + 0.24 𝜌X,Y w(1 – w)

Portfolio’s standard deviation = σP = (0.16w2 + 0.09(1 – w)2 + 0.24 𝜌X,Y w(1 – w))1/2

b) Portfolio’s mean return and volatility for w = 0.4 and correlation coefficients 0, +1, - 1 can be calculated using
expressions obtained in part (a):

For 𝜌X,Y = 0
Mean Return = 8(0.4) + 7 = 10.2%
Volatility = (0.16*0.42 + 0.09*(1 – 0.4)2 + 2*0*0.4*0.6*0.16*0.09)1/2 = 0.2408 or 24.83%

For 𝜌X,Y = 1
Mean Return = 8(0.4) + 7 = 10.2%
Volatility = (0.16*0.42 + 0.09*(1 – 0.4)2 + 2*1*0.4*0.6*0.16*0.09)1/2 = 0.2548 or 25.48%

For 𝜌X,Y = - 1
Mean Return = 8(0.4) + 7 = 10.2%
Volatility = (0.16*0.42 + 0.09*(1 – 0.4)2 + 2*(-1)*0.4*0.6*0.16*0.09)1/2 = 0.2260 or 22.60%

c) 𝜌X,Y = - 1
Volatility = σP = (0.16w2 + 0.09(1 – w)2 - 0.24 w(1 – w))1/2 = 0

⇒ σP = 0.49w2 – 0.42w + 0.09 = (7w – 3)2 = 0

⇒ w = 3/7 for zero volatility

Therefore, weight on stock A is 3/7 and that on stock B is 4/7.

Sol. 10

Given: E(RM) – Rf = 8%, Rf = 5%, βhistorical= 1.5

Forecasted β = 0.8 + 0.2 * βhistorical = 0.8 + 0.03 = 1.1

CAPM required rate = 5 + 1.1(8) = 13.8 %

Since the market premium is 8%, thus the stock is overvalued because the forecast is given 10% whereas the
minimum acceptable return rate is 13.8%
Sol 11

Let w be the weight on stock X and 1 – w be the weight on stock Y.

Portfolio’s mean return = w*(15) + (1 – w) *(7) = 8w + 7

Portfolio’s variance = w2 σ12 + (1 – w)2 σ22 + 2𝜌X,Y w(1 – w) σ1 σ2

σP2σP2 = 0.16w2 + 0.09(1 – w)2 + 0.24 𝜌X,Y w(1 – w)

Portfolio’s standard deviation or volatility = σP = (w2 σ12 + (1 – w)2 σ22 + 2𝜌X,Y w(1 – w) σ1 σ2)1/2

⇒ σP = (0.16w2 + 0.09(1 – w)2 + 0.24 𝜌X,Y w(1 – w))1/2

a) 𝜌X,Y = 0

⇒ σP2 = 0.25w2 – 0.18w + 0.09

For minimum variance,

d(σP2)/dw = 0.5w – 0.18 = 0 ⇒ w = 0.36

⇒ σP2 = 0.0576 and σP = 0.24

Portfolio’s mean return = 8w + 7 = 9.88%

Therefore, for minimum variance in this case, weight of stock X should be 0.36 and that of Y should be
0.64 and the corresponding expected return is 9.88% and volatility is 24%.

b) 𝜌X,Y = 0.4

⇒ σP2 = 0.154w2 – 0.084w + 0.09

For minimum variance,

d(σP2)/dw = 0.308w – 0.084 = 0 ⇒ w = 3/11

⇒ σP2 = 0.07854 and σP = 0.2802

Portfolio’s mean return = 8w + 7 = 9.18%

Therefore, for minimum variance in this case, weight of stock X should be 3/11 (or 0.273) and that of Y
should be 4/11 (or 0.727) and the corresponding expected return is 9.18% and volatility is 28.02%.

c) 𝜌X,Y = -0.4

⇒ σP2 = 0.346w2 – 0.276w + 0.09

For minimum variance,

d(σP2)/dw = 2*0.346w – 0.276 = 0 ⇒ w = 69/173 (or 0.3988)

⇒ σP2 = 0.03495 and σP = 0.1869

Portfolio’s mean return = 8w + 7 = 10.19%

Therefore, for minimum variance in this case, weight of stock X should be 69/173 (or 0.3988) and that of
Y should be 104/173 (or 0.6012) and the corresponding expected return is 10.19% and volatility is
18.69%.
d) Tangent portfolios:
R’ = (0.15 – 0.03, 0.07 – 0.03) = (0.12, 0.04)

𝜌=0
X* = (0.628, 0.372)
E(RP) = 0.628*0.15 + 0.372*0.07 = 0.1202
E(RP) – Rf = 0.0902
Var(RP) = 0.0755
Std. Dev. = 27.48%

𝜌 = 0.4
X* = (0.9328, 0.0672)
E(RP) = 0.9328*0.15 + 0.0672*0.07 = 0.1446
E(RP) – Rf = 0.1146
Var(RP) = 0.1456
Std. Dev. = 38.16%

𝜌 = - 0.4
X* = (0.3988, 0.6012)
E(RP) = 0.3988*0.15 + 0.6012*0.07 = 0.1019
E(RP) – Rf = 0.0719
Var(RP) = 0.0035
Std. Dev. = 5.92%
Sol. 15

Given that expected return on tangent portfolio is 10% and volatility is 40% and risk-free rate is 2%

a) CML passes though the points (0.4, 0.1) and (0, 0.02)
Therefore, equation of CML:
y – 0.02 = [(0.1 – 0.02)/(0.4 – 0)]*(x – 0)

⇒ y = 0.2 x + 0.02 or RP = 0.2 σP + 0.02

b) Given RP = 0.08 (8%)
⇒ σP = (0.08 – 0.02)/0.2
⇒ σP = 0.3 (30%)

Next, we need to find weights to achieve this position. Let w be the weight of the risk-free asset and 1 – w be
the weight for the portfolio.
0.08 = w (0.02) + (1 – w) (0.1)
⇒ w = 0.25

Thus, we would allocate Rs. 250 to the risk-free asset and Rs. 750 to the portfolio.

Sol. 16

a) CML passes though the points (0.3, 0.12) and (0, 0.03)
Therefore, equation of CML:
y – 0.03 = [(0.12 – 0.03)/(0.3 – 0)]*(x – 0)

⇒ y = 0.3 x + 0.03 or RP = 0.3 σP + 0.03

b) Given RP = 0.165 (16.5%)
⇒ σP = (0.165 – 0.03)/0.3
⇒ σP = 0.45 (45%)

Next, we need to find weights to achieve this position. Let w be the weight of the risk-free asset and 1 – w be
the weight for the portfolio.
0.165 = w (0.03) + (1 – w) (0.12)
⇒ w = - 0.5

Thus, we would allocate Rs. 4500 to the portfolio and lend Rs. 1500 from the risk-free asset to reach this
position.
Sol. 17

Market premium = 9%

Market volatility = 30%

Rf = 3%

a) SML equation: E(RP) = 0.03 + 0.09β

b) β = 0.6
E(RP) = 0.03 + 0.09*0.6 = 0.084 (8.4%)

c) β = 0.25*0.6/0.3 = 0.5
E(RP) = 0.03 + 0.09*0.5 = 0.075 (7.5%)

d) β = - 0.25*0.8/0.3 = 2/3
E(RP) = 0.03 + 0.09 (-2/3) = -0.03 (- 3%)

Sol. 18

βX = 1.2, βY = 0.8, Rf = 2%, 𝑅̅𝑀 = 12%

̅ 𝑴 – Rf)
E(R) = Rf + β(𝑹

a) E(RX) = 2 + 1.2(12 – 2) = 14%

E(RY) = 2 + 0.8(12 – 2) = 10%

b) Expected return on equally weighted portfolio = E(R) = E(RX)/2 + E(RY)/2 = 12%

c) β of equally weighted portfolio of the two stock

⇒ 12 = 2 + β(12-2)

⇒β=1

d) Now we have β = 1 for two equally weighted stocks and we need to find the expected return

E(R) = 2 + 1*(12 – 2) = 12%

Sol. 20

No. of stocks of X = 200, worth Rs. 3 per share and expected return of 16%, volatility = 30%

No. of stocks of Y = 300, worth Rs. 4 per share and expected return of 10%, volatility = 15%

Total value of shares = 200 x 3 + 300 x 4 = Rs. 1800

Weight corresponding to X = (200 x 3)/1800 = 1/3

Weight corresponding to Y = (300 x 4)/1800 = 2/3

a) Expected return of the market portfolio = 16/3 + 10*2/3 = 12%

b) Volatility of market portfolio = (Var (RM))1/2

Var (RM)= w2 σX2 + (1 – w)2 σY2 + 2𝜌X,Y w(1 – w) σX σY

⇒ Var (RM)= (1/3)2 (0.3)2 + (2/3)2 (0.15)2 + 2*0.4*0.3*0.15*(1/3)*(2/3) = 0.028

⇒ Volatility = (0.028)1/2 = 0.1673 (16.73%)

c) CoV (RX, RM) = Cov (RX, RX/3 + 2RY/3)

⇒ CoV (RX, RM) = σX2/3 + 2 σXY/3 = 0.09/3 + 2*0.4*0.3*.15

⇒ CoV (RX, RM) = 0.042

βX = CoV (RX, RM)/Var (RM)

⇒ βX = 0.042/0.028 = 1.5

CoV (RY, RM) = Cov (RY, RX/3 + 2RY/3)

⇒ CoV (RY, RM) = σY2/3 + 2 σXY/3 = 0.0225/3 + 2*0.4*0.3*.15

⇒ CoV (RX, RM) = 0.0195

βY = CoV (RX, RM)/Var (RM)

⇒ βY = 0.0195/0.028 = 0.6964

d) E(RX) = Rf + βX(E(RM) – Rf)

16 = Rf + 1.5*(12 – Rf)

⇒ Rf = (16 – 18)/ (1 – 1.5) = 4%

Sol. 21

a) Given that both the portfolios have equal weight, the expected return of the market portfolio would be
(13+17)/2 = 15%.

Volatility = [(1/4) * (0.12)2 + (1/4) *(0.25)2 + 2*(0.5) *(0.12) *(0.25) *(1/2) *(1/2)]1/2

Volatility = 0.1635 (16.35%)

Thus, the Sharpe Ratio for M is (0.15 – 0.02)/0.163 = 0.8, as this is less than the Sharpe ratio for the value
of portfolio, the market portfolio is not efficient.

b) Reallocation can be done in investments to improve the Sharpe ratio according to CAPM so that higher
return can be expected for the same volatility or otherwise reduce the volatility for the same expected
return.

Sol. 22

The greater a portfolio’s Sharpe ratio, the better is its risk adjusted performance.

Sharpe ratio for P1 = (0.13 – 0.04)/0.20 = 0.45

Sharpe ratio for P2 = (0.18 – 0.04)/0.30 = 0.467

Since fund P2 has a better Sharpe ratio, so it is recommended to invest in P2

Sol. 23

a) Given that E(RMF) = 14%, It’s volatility = 20%, Rf = 3.8%. Also given that fund B is uncorrelated to fund
M. Therefore, βB,MF = 0, thus required rate of return for stock B to overcome its risk to the portfolio is the
risk-free rate of 3.8%. Given that B’s expected return is higher, it’ll add to the fund M positively. Thus,
the wealth manager is right.

b) Expected return of new portfolio P = 0.4*(0.2) + 0.6*(0.14) = 0.164 or 16.4%

σMB = Cov (RB, 0.4RB + 0.6RMF) = 0.4*Var(B) + 0.6*Cov (B, MF)

⇒ 0.4 σB2 = 0.144 (since correlation between B and M is zero)

Var (RP) = 0.42 x 0.62 + 0.62 x 0.22 = 0.072

βB,P = 0.144/0.072 = 2

E(RB) = 3.8 + 2*(16.4 – 3.8) = 29%

We know that the actual expected return is 20%. This implies that the Sharpe ratio is not optimal.
Therefore, the friend was right as weight of fund B can be reduced to increase its Sharpe ratio.

c) Expected return of new portfolio P = 0.15*(20) + 0.85*(14) = 14.9%

 σBP = Cov(RB, 0.15RB + 0.85RMF)

⇒ σBP = 0.15 * (0.6)2 = 0.054

Var(RP) = 0.152 * 0.62 + 0.852 * 0.22 = 0.037

β = 0.154/0.037 = 1.459

E(RB) = 3.8 + (1.459)*(14.9 – 3.8) = 20%

Actual expected return is 20%, therefore, it is the correct amount to hold stock B

Sol. 24

a) Expected return, E(RP) = 0.5*12 + 0.5*20 = 16%

Cov(RDSP, RSBI) = 0.25*0.80*0.2 = 0.04

βSBI, DSP = 0.04/(0.25 * 0.25) = 0.64

E(RSBI) = 4 + 0.64 * (16 – 4) = 11.68%

Since actual expected return is higher, adding SBI Magnum fund can increase Sharpe ratio, therefore the
wealth manager is right.

b) New Sharpe Ratio with 50% DSP and 50% SBI:

σ = (0.52 * 0.82 + 0.52 * 0.252 + 2*(0.5*0.5*0.04))1/2 = 0.4423

New Sharpe ratio = (0.16 – 0.04)/ 0.4423 = 0.2713 (or 27.13%)

This Sharpe ratio is not optimal.

c) Optimal weight for the Sharpe ratio can be found using:

x = [(0.252)*(0.16) – (0.04)*(0.08)] / [(0.82)*(0.08) – (0.04)*(0.16)] = 0.15179

Portfolio weight on Stock B = x/(1+x)

XB = 0.15179/1.15179 = 0.1318

⇒ XB = 13.18%
Sol. 25

a) Average return of each month calculated using the adjusted closing prices provided on Yahoo Finance,

Return = (P1/P0) – 1

Giving equal weight to all months for the past five years (June 2014 – June 2019), the Expected return
rate of Canon Inc. is found to be 0.2160% and its variance σ1 = 0.1787%

Similarly, for Nikon Corporation, it is found to be 0.0995% and its variance, σ2 = 0.3912%

Covariance for the two, σ12 is found out to be 0.0926%

Portfolio variance = σP2 = (w2 σ12 + (1 – w)2 σ22 + 2 w (1 – w) σ1,2), where w is the weight on Canon Inc.
stocks and 1 – w is the weight on Nikon Corporation stocks.

Putting the values, we get,

⇒ σP2 = 0.003847w2 – 0.005972w + 0.003912

From here, we can obtain w for minimum variance and it found out to be 0.77

Therefore, wCanon = 77% and wNikon = 23%.

Efficient Frontier for a portfolio of Canon and Nikon:

Canon Nikon Expected Variance Std Dev

Portfolio Return
100% 0% 0.216% 0.1787% 4.23%
90% 10% 0.204% 0.1653% 4.07%
80% 20% 0.193% 0.1596% 4.00%
70% 30% 0.181% 0.1617% 4.02%
60% 40% 0.169% 0.1714% 4.14%
50% 50% 0.158% 0.1888% 4.34%
40% 60% 0.146% 0.2139% 4.62%
30% 70% 0.135% 0.2467% 4.97%
20% 80% 0.123% 0.2872% 5.36%
10% 90% 0.111% 0.3353% 5.79%
0% 100% 0.100% 0.3912% 6.25%
 Efficeint Frontier
0.240%

0.220%
Expected Returns 0.200%

0.180%

0.160%

0.140%

0.120%

0.100%

0.080%

0.060%
3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50%
Standard Deviation