Mr.

Mohamed Aljamri Tel: 39636632

Chapter 6: An Introduction to Portfolio Management

Part One: Multiple Choice Questions

1. When individuals evaluate their portfolios, they should evaluate
a. All the U.S. and non-U.S. stocks.
b. All marketable securities.
c. All marketable securities and other liquid assets.
d. All assets and liabilities.

2. The probability of an adverse outcome is a definition of

a. Statistics.
b. Variance.
c. Random.
d. Risk.

3. The Markowitz model is based on several assumptions regarding investor behavior. Which of the
following is not such any assumption?
a. Investors consider each investment alternative as being represented by a probability distribution of
expected returns over some holding period.
b. Investors maximize one-period expected utility.
c. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.
d. Investors base decisions solely on expected return and risk.
e. None of the above (that is, all are assumptions of the Markowitz model)

4. Markowitz believes that any asset or portfolio of assets can be described by ____ parameter(s).
a. One
b. Two
c. Three
d. Four

5. Semivariance, when applied to portfolio theory, is concerned with

a. The square root of deviations from the mean.
b. All deviations below the mean.
c. All deviations above the mean.
d. All deviations

6. The purpose of calculating the covariance between two stocks is to provide a(n) ____ measure of
their movement together.
a. Absolute
b. Relative
c. Indexed
d. Loglinear

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7. In a two stock portfolio, if the correlation coefficient between two stocks were to decrease over time,
everything else remaining constant, the portfolio's risk would
a. Decrease.
b. Remain constant.
c. Increase.
d. Fluctuate positively and negatively

8. Which of the following statements about the correlation coefficient is false?

a. The values range between -1 to +1.
b. A value of +1 implies that the returns for the two stocks move together in a completely linear
manner.
c. A value of -1 implies that the returns move in a completely opposite direction.
d. A value of zero means that the returns are independent.
e. None of the above (that is, all statements are true)

9. You are given a two asset portfolio with a fixed correlation coefficient. If the weights of the two assets
are varied the expected portfolio return would be ____ and the expected portfolio standard deviation
would be ____.
a. Nonlinear, elliptical
b. Nonlinear, circular
c. Linear, elliptical
d. Linear, circular

10. Given a portfolio of stocks, the envelope curve containing the set of best possible combinations is
known as the
a. Efficient portfolio.
b. Utility curve.
c. Efficient frontier.
d. Last frontier

11. If equal risk is added moving along the envelope curve containing the best possible combinations the
return will
a. Decrease at an increasing rate.
b. Decrease at a decreasing rate.
c. Increase at an increasing rate.
d. Increase at a decreasing rate.

12. A portfolio is considered to be efficient if:

a. No other portfolio offers higher expected returns with the same risk.
b. No other portfolio offers lower risk with the same expected return.
c. There is no portfolio with a higher return.
d. Choices a and b

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13. The optimal portfolio is identified at the point of tangency between the efficient frontier and the
a. highest possible utility curve.
b. lowest possible utility curve.
c. middle range utility curve.
d. steepest utility curve.

14. An individual investor's utility curves specify the tradeoffs he or she is willing to make between
a. high risk and low risk assets.
b. high return and low return assets.
c. covariance and correlation.
d. return and risk.

15. As the correlation coefficient between two assets decreases, the shape of the efficient frontier
a. approaches a horizontal straight line.
b. bends out.
c. bends in.
d. approaches a vertical straight line.

16. A portfolio manager is considering adding another security to his portfolio. The correlations of the 5
alternatives available are listed below. Which security would enable the highest level of risk
diversification?
a. 0.0
b. 0.25
c. -0.25
d. -0.75

17. A positive covariance between two variables indicates that

a. the two variables move in different directions.
b. the two variables move in the same direction.
c. the two variables are low risk.
d. the two variables are high risk.

18. A positive relationship between expected return and expected risk is consistent with
a. investors being risk seekers.
b. investors being risk avoiders.
c. investors being risk averse.
d. all of the above.

19. The slope of the efficient frontier is calculated as follows

a. E(Rportfolio)/E(σportfolio)
b. E(σportfolio)/ E(Rportfolio)
c. ΔE(Rportfolio)/Δ E(σportfolio)
d. ΔE(σportfolio)/ΔE(Rportfolio)

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20. The slope of the utility curves for a strongly risk-averse investor, relative to the slope of the utility
curves for a less risk-averse investor, will
a. Be steeper.
b. Be flatter.
c. Be vertical.
d. Be horizontal.

21. All of the following are assumptions of the Markowitz model except
a. Risk is measured based on the variability of returns.
b. Investors maximize one-period expected utility.
c. Investors' utility curves demonstrate properties of diminishing marginal utility of wealth.
d. Investors base decisions solely on expected return and time.

22. The most important criteria when adding new investments to a portfolio is the
a. Expected return of the new investment.
b. Standard deviation of the new investment.
c. Correlation of the new investment with the portfolio.
d. Both a and b

23. A portfolio of two securities that are perfectly positively correlated has
a. A standard deviation that is the weighted average of the individual securities standard deviations.
b. An expected return that is the weighted average of the individual securities expected returns.
c. No diversification benefit over holding either of the securities independently.
d. Both b and c
e. All of the above

24. All of the following are common risk measurements except

a. Standard deviation
b. Variance
c. Semivariance
d. Covariance
e. Range of returns

25. When assessing the risk impact of adding a new security to a portfolio, it is necessary to consider the
a. New securities variance
b. Variance of every security in the portfolio
c. Weight of every security in the portfolio
d. Average covariance of the new security with every security in the portfolio
e. All of the above

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26. Which of the following is not an assumption of the Capital Market Theory?
a. All investors are Markowitz efficient investors.
b. All investors have homogeneous expectations.
c. There are no taxes or transaction costs in buying or selling assets.
d. All investments are indivisible so it is impossible to buy or sell fractional shares.
e. All investors have the same one period time horizon.

27. The rate of return on a risk free asset should equal the
a. Long run real growth rate of the economy.
b. Long run nominal growth rate of the economy.
c. Short run real growth rate of the economy.
d. Short run nominal growth rate of the economy.

28. Which of the following statements about the risk-free asset is correct?
a. The risk-free asset is defined as an asset for which there is uncertainty regarding the expected rate of
return.
b. The standard deviation of return for the risk-free asset is equal to zero.
c. The standard deviation of return for the risk-free asset cannot be zero, since division by zero is
undefined.
d. Choices a and b.
e. Choices a and c

29. What does WRF = -0.50 mean?

a. The investor can borrow money at the risk-free rate.
b. The investor can lend money at the current market rate.
c. The investor can borrow money at the current market rate.
d. The investor can borrow money at the prime rate of interest.

30. What does WRF = 0.50 mean?

a. The investor is investing the money at the risk-free rate.
b. The investor can lend money at the current market rate.
c. The investor can borrow money at the current market rate.
d. The investor can borrow money at the prime rate of interest.

31. The market portfolio consists of all

a. New York Stock Exchange stocks.
b. High grade stocks and bonds.
c. Stocks and bonds.
d. U.S. and non-U.S. stocks and bonds.
e. Risky assets.

32. The separation theorem divides decisions on ____ from decisions on ____.
a. Lending, borrowing
b. Risk, return
c. Investing, financing
d. Risky assets, risk free assets

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33. The correlation coefficient between the market return and a risk-free asset would
a. be +∞.
b. be - ∞.
c. be +1.
d. be -1.
e. be Zero.

34. As the number of securities in a portfolio increases, the amount of systematic risk
a. Remains constant.
b. Decreases.
c. Increases.
d. Changes.

35. As the number of securities in a portfolio increases, the amount of unsystematic risk
a. Remains constant.
b. Decreases.
c. Increases.
d. Changes.

36. Theoretically, the correlation coefficient between a completely diversified portfolio and the market
portfolio should be
a. -1.0.
b. +1.0.
c. 0.0.
d. -0.5.

37. All portfolios on the capital market line are

a. Perfectly positively correlated.
b. Perfectly negatively correlated.
c. Unique from each other.
d. Weakly correlated.

38. The Efficient Frontier refers to a set of portfolios that

a. Have the highest expected return for a given level of risk.
b. Have the lowest risk for a given level of return.
c. Are dominant to all other portfolios.
d. a, b, and c above are correct.

39. If an individual owns only one security the most appropriate measure of risk is:
a. Standard deviation
b. Correlation
c. Beta
d. Covariance

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40. The fact that most investors are risk averse means they will
a. only take risks for which they are properly rewarded
b. not take a risk
c. not voluntarily take a risk
d. not take a risk unless they know the outcome in advance

41. Which of the following statements is true?

a. Some people are risk averse and others are not
b. Some people are more risk averse than others
c. Risk averse people will not take a risk
d. Risk averse people are willing to settle for less return than risk neutral people

42. Risk must involve

a. a chance of loss
b. an unknown probability distribution
c. actual dollars
d. negative expected returns

43. Overall variability of returns is called

a. systematic risk
b. unsystematic risk
c. total risk
d. undiversifiable risk

44. Risk is often measured as

a. central tendency of returns
b. dispersion of returns
c. expected value of returns
d. possibility of negative returns

45. Riskier securities have _____ returns.

a. higher expected
b. lower realized
c. higher instantaneous
d. lower long-term

46. The market rewards investors for bearing _____risk.

a. diversifiable
b. undiversifiable
c. unsystematic
d. total

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47. Total risk can be measured by all of the following EXCEPT

a. variance
b. standard deviation
c. semi-variance
d. arithmetic mean

47. Semi-variance only considers

a. extreme variation
b. adverse variation
c. unexpected variation
d. anticipated variation

48. The correlation coefficient is equal to

𝑐𝑜𝑣(𝑎̃,𝑏̃ )
a.
𝜎𝑎 𝜎𝑏
̃, 𝑏̃)𝜎𝑎 𝜎𝑏
b. 𝑐𝑜𝑣( 𝑎
𝑐𝑜𝑣(𝑎̃,𝑏̃ )𝜎𝑎
c.
𝜎𝑏
𝑐𝑜𝑣(𝑎̃,𝑏̃)
d. 1 − [ ]
𝜎𝑎 𝜎𝑏

49. The minimum value of the correlation coefficient is

a. -1
b. 0
c. +1
d. there is no minimum value

50. The minimum value of covariance is

a. -1
b. 0
c. +1
d. there is no minimum value

51. If two securities are negatively correlated, their covariance is

a. positive
b. negative
c. zero
d. cannot be determined

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52. The covariance between a random variable and a constant is

a. negative
b. positive
c. zero
d. non-negative

53. Return is the

a. benefit associated with an investment
b. realized gain from an investment
c. realized and unrealized gain from an investment
d. measurable gain from an investment

54. Assume the risk-free rate is constant over time. The correlation between the return on security x and
the return on the risk-free asset is
a. negative
b. positive
c. zero
d. cannot be determined without further information

55. The work of Harry Markowitz is based on the search for

a. efficient portfolios
b. undervalued securities
c. the highest long-term growth rates
d. minimum risk portfolios

56. The variance of a two-security portfolio decreases as the return correlation of the two securities
a. increases
b. decreases
c. changes in either direction
d. cannot be determined

57. As portfolio size increases, the variance of the error term generally
a. increases
b. decreases
c. approaches 1.0
d. becomes erratic

58. The least risk portfolio is called the

a. optimum portfolio
b. efficient portfolio
c. minimum variance portfolio
d. market portfolio

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59. COV (A,B) is equal to

a. the product of their standard deviations and their correlation
b. the product of their variances and their correlation
c. the product of their standard deviations and their covariances
d. the product of their variances and their covariances

60. Risk averse people only take risks when

a. they believe they will be rewarded for doing so
b. they have to
c. it is necessary to guarantee an additional realized return
d. actual returns are below expected return

61. Using the following correlation matrix, which two stocks would combine to make the lowest-risk
portfolio? (Assume the stocks have equal risk and returns.)

Stock A B C
A +1 -- --
B -0.2 +1 --
C +0.6 -0.1 +1

A. A and B
B. A and C
C. B and C
D. C and A

62. If the standard deviations of Stock A and B are 0.20 and 0.30 respectively and the COV(A,B)
equals 0.012, what is the correlation coefficient?
a. 0.00072
b. 0.20
c. 0.30
d. 2

63. The expected return on A is 12%; the expected return on B is 15%. What is the expected
return of a portfolio that contains one-third A and the remainder B?
a. 12%
b. 14%
c. 15%
d. 13.5%

64. Securities A and B have expected returns of 12% and 15%, respectively. If you put 40% of your money
in Security A and the remainder in B, what is the portfolio expected return?
a. 13.4%
b. 13.8%
c. 14.6%
d. 15.3%

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65. Assets A (with a variance of 0.25) and B (with a variance of 0.40) are perfectly positively correlated. If
an investor creates a portfolio using only these two assets with 40% invested in A, the portfolio standard
deviation is closest to:
A. 0.5795
B. 0.3400
C. 0.3742
D. 0.3232

66. Ali is considering the diversification benefits of a two stock portfolio. The expected return of stock A
is 14 percent with a standard deviation of 18 percent and the expected return of stock B is 18 percent
with a standard deviation of 24 percent. Ali intends to invest 40 percent of his money in stock A, and
60 percent in stock B. The correlation coefficient between the two stocks is 0.6. What is the variance
and standard deviation of the two stock portfolio?
A) Variance = 0.02206; Standard Deviation = 14.85%.
B) Variance = 0.03836; Standard Deviation = 19.59%.
C) Variance = 0.04666; Standard Deviation = 21.60%.
D) Variance = 0.04666; Standard Deviation = 19.59%

67. Stock A has a standard deviation of 0.5 and Stock B has a standard deviation of 0.3. Stock A and Stock
B are perfectly positively correlated. According to Markowitz portfolio theory how much should be
invested in each stock to minimize the portfolio's standard deviation?
A) 100% in Stock B.
B) 30% in Stock A and 70% in Stock B.
C) 50% in Stock A and 50% in Stock B.
D) 100% in Stock A.

68. Stock A has a standard deviation of 4.1% and Stock B has a standard deviation of 5.8%. If the stocks
are perfectly positively correlated, which portfolio weights minimize the portfolio's standard deviation?
A) 100% in Stock A and 0% in Stock B.
B) 63% in Stock A and 37% in Stock B.
C) 50% in Stock A and 50% in Stock B.
A) 0% in Stock A and 100% in Stock B.

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Part Two: Essay Questions

1. Why do most investors hold diversified portfolios?
Answer:
Investors hold diversified portfolios in order to reduce risk, that is, to lower the variance of the
portfolio, which is considered a measure portfolio risk. A diversified portfolio should accomplish
this because the returns for the alternative assets should not be correlated so the variance of the
total portfolio will be reduced.

2. What is covariance, and why is it important in portfolio theory?

Answer:
The covariance is equal to E[(Ri - E(Ri))(Rj - E(Rj))] and shows the absolute amount of
comovement between two series. If they constantly move in the same direction, it will be a large
positive value and vice versa. Covariance is important in portfolio theory because the variance of
a portfolio is a combination of individual variances and the covariances among all assets in the
portfolio. It is also shown that in a portfolio with a large number of securities the variance of the
portfolio becomes the average of all the covariances.

3. Why do most assets of the same type show positive covariances of returns with each other?
Would you expect positive co variances of returns between different types of assets such as
returns on Treasury bills, Apple common stock, and commercial real estate? Why or why not?
Answer:
Similar assets like common stock or stock for companies in the same industry (for example, the
auto industry) will have high positive covariances because the sales and profits for the firms are
affected by common factors, as their customers and suppliers are the same. Because their profits
and risk factors move together, you should expect the stock returns to also move together and have
high covariance. The returns from different assets will not have as much covariance because the
returns will not be as correlated. This is even more so for investments in different countries where
the returns and risk factors are very unique.

4. What is the relationship between covariance and the correlation coefficient?

Answer:
The covariance between the returns of assets i and j is affected by the variability of these two
returns. Therefore, it is difficult to interpret the covariance figures without taking into account the
variability of each return series. In contrast, the correlation coefficient is obtained by standardizing
the covariance for the individual variability of the two-return series, that is: rij = covij/(ij)

Thus, the correlation coefficient can only vary in the range of -1 to +1. A value of +1 would
indicate a perfect linear positive relationship between Ri and Rj.

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5. Explain the shape of the Markowitz (that is, mean-variance) efficient frontier, specifically what causes
it to be curved rather than a straight line.
Answer:
The efficient frontier has a curvilinear shape because if the set of possible portfolios of assets is
not perfectly correlated, then the set of relations will not be a straight line, but is curved depending
on the correlation. The lower the correlation, the more curved.

6. Draw a properly labeled graph of the Markowitz efficient frontier. Describe the efficient frontier in
exact terms. Discuss the concept of dominant portfolios, and show an example of one on your graph.
Answer:

A portfolio dominates another portfolio if:

1) it has a higher expected return than another portfolio with the same level of risk,
2) a lower level of expected risk than another portfolio with equal expected return, or
3) a higher expected return and lower expected risk than another portfolio.

For example, portfolio B dominates D by the first criterion. A dominates D by the second, and C
dominates D by the third.

The Markowitz efficient frontier is simply a set of portfolios that is not dominated by others
portfolio, namely, those lying along the segment E-F.

7. Assume you want to nm a computer program to derive the efficient frontier for your feasible set of
stocks. What information must you input to the program?

Answer:
The necessary information for the program would be:
1) the expected rate of return of each asset
2) the expected variance of return of each asset
3) the expected covariance of return of all pairs of assets under consideration.

8. Why are investors' utility curves important in portfolio theory?

Answer:
Investors’ utility curves are important because they indicate the desired tradeoff by investors
between risk and return. Given the efficient frontier, utility curves indicate which portfolio is
preferable for the given investor. Notably, because utility curves differ one should expect different
investors to select different portfolios on the efficient frontier.

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9. Explain how a given investor chooses an optimal portfolio. Will this choice always be a diversified
portfolio, or could it be a single asset? Explain your answer.

Answer:
The optimal portfolio for a given investor is the point of tangency between his set of utility curves
and the efficient frontier. This will most likely be a diversified portfolio because almost all the
portfolios on the frontier are diversified except for the two end points: the minimum variance
portfolio and the maximum return portfolio. These two could be significant.

10. Assume that you and a business associate develop an efficient frontier for a set of investments.
Why might the two of you select different portfolios on the frontier?
Answer:
The utility curves for an individual specify the trade-offs she is willing to make between expected
return and risk. These utility curves are used in conjunction with the efficient frontier to determine
which particular efficient portfolio is the best for a particular investor. Two investors will not
choose the same portfolio from the efficient set unless their utility curves are identical.

11. Draw a hypothetical graph of an efficient frontier of U.S. common stocks. On the same graph, draw an
efficient frontier assuming the inclusion of U.S. bonds as well. Finally, on the same graph, draw an
efficient frontier that includes U.S. common stocks, U.S. bonds, and stocks and bonds from around the
world. Discuss the differences in these frontiers.

Answer:

The hypothetical graph of an efficient frontier of U.S. common stocks will have a curved shape.
Adding U.S. bonds to the portfolio will likely generate a new efficient frontier that is shifted up
(or to the left) of the original stock-only frontier.

The reason for the shift is that we expect bonds to be less correlated with stocks, thereby creating
additional diversification potential.

The third frontier (which includes international securities) will likely display another shift upward
or to the left for similar reasons—lower correlation potential resulting in additional diversification
potential.

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12. Stocks K, L, and M each has the same expected return and standard deviation. The correlation
coefficients between each pair of these stocks are:
• K and L correlation coefficient = + 0.8
• K and M correlation coefficient = +0.2
• L and M correlation coefficient = -0.4

Given these correlations, a portfolio constructed of which pair of stocks will have the lowest
standard deviation? Explain.
Answer:
The portfolio constructed containing stocks L and M would have the lowest standard deviation.
As demonstrated in the chapter, combining assets with equal risk and return but with low positive
or negative correlations will reduce the risk level of the portfolio.

13. What changes would you expect in the standard deviation for a portfolio of between four and 10 stocks,
between 10 and 20 stocks, and between 50 and 100 stocks?
Answer:
Standard deviation would be expected to decrease with an increase in stocks in the portfolio
because an increase in number will increase the probability of having lower and inversely
correlated stocks. There will be a major decline from 4 to 10 stocks and a continued decline from
10 to 20 but at a slower rate. Finally, from 50 to 100 stocks, there is a further decline but at a very
slow rate because almost all unsystematic risk is eliminated by about 18 stocks.

14. Draw a graph that shows what happens to the Markowitz efficient frontier when you combine a risk-
free asset with alternative risky asset portfolios on the Markowitz efficient frontier. Explain why the
line from the RFR that is tangent to the efficient frontier defines the dominant set of portfolio
possibilities.

Answer:

The existence of a risk-free asset excludes the E-A segment of the efficient frontier because any
point below A is dominated by the RFR. In fact, the entire efficient frontier below M is dominated
by points on the RFR-M Line (combinations obtained by investing a part of the portfolio in the
risk-free asset and the remainder in M); for example, the point P dominates the previously efficient
B because it has lower risk for the same level of return. As shown, M is at the point where the ray
from RFR is tangent to the efficient frontier. The new efficient frontier thus becomes RFR-M-F.

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15. Explain how the capital market line (CML) allows an investor to achieve an expected return goal that
is greater than that available to a 100 percent allocation to the market portfolio of risky assets, Portfolio
M.
Answer:
The CML leads all investors to invest in the same risky asset Portfolio M. The investment
prescription of the CML is that investors cannot do better, on average, than when they divide their
investment funds between (1) the riskless asset and (2) the market portfolio rather than 100 percent
allocation to Portfolio M.

16. According to Markowitz, when adding a risky asset to a portfolio of many risky assets, which
property of the assets is more important, its variance or its covariance/correlation with other
assets and why?
Answer:
The covariance with the other assets is more important in the given scenario as diversification is
accomplished via correlation with other assets. Covariance helps determine that number.

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Part Three: Problems

Problem 1:
Consider the following information about two stocks where the probability of an economic boom
is 40%:
Economic State Return A (RA) Return B (RB)
Boom 38% 6%
Recession –4% 12%

A. Calculate the expected return for stock A and stock B.

B. Calculate the standard deviation of stock A and stock B.
C. Calculate the correlation between stock A and stock B.
Answer:

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Problem 2:
Assume the following annual stock returns for Stocks A and B:
Year A B
1 20% 30%
2 -10% 0%
3 40% 50%
4 10% 40%

Calculate the Variance, Standard deviation, Semi-Variance of A and B and the Covariance,
Correlation between A and B. Would these two stocks be good choices for diversification? Why
or why not?

Answer:

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Problem 3:
You are thinking about investing your money in the stock market. You have the following two
stocks in mind: stock A and stock B. You know that the economy can either go in recession or it
will boom. Being an optimistic investor, you believe the likelihood of observing an economic
boom is two times as high as observing an economic depression. You also know the following
about your two stocks:

State of the Economy Probability RA RB

Boom 2 10% –2%
3
Recession 1 6% 40%
3

a) Calculate the expected return for stock A and stock B

b) Calculate the total risk (variance and standard deviation) for stock A and for stock B
c) Calculate the expected return on a portfolio consisting of equal proportions in both stocks.
d) Calculate the expected return on a portfolio consisting of 10% invested in stock A and the
remainder in stock B.
e) Calculate the covariance between stock A and stock B.
f) Calculate the correlation coefficient between stock A and stock B.
g) Calculate the variance of the portfolio with equal proportions in both stocks using the
covariance from answer e.

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Problem 4:
You are considering two assets with the following characteristics:

Compute the mean and standard deviation of two portfolios if r 1,2 = 0.40 and - 0.60, respectively.
Plot the two portfolios on a risk-return graph and briefly explain the results.

Answer:

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Problem 6:
You have decided to invest 40% of your wealth in McDonalds which has an expected return of
15% and a standard deviation of 15%, and 60% of your wealth in GM which has an expected return
of 9% and a standard deviation of 14%.
a. What is the expected return of your portfolio?
b. If the correlation between McDonalds and GM is 0.5, what is the standard deviation of your
portfolio?
c. If you wanted an expected return of 13%, what percentage should you invest in McDonalds?
d. Based on your percentages in part c, what would the standard deviation of this portfolio be?

Answer:

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Problem 7:
What is the expected return of a portfolio made up of
30% short A, E(R)= 14%
50% long B, E(R)= 16%
80% long C, E(R)= 12%

Answer:

Problem 8:
What is the expected return on this portfolio?

Answer:

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Problem 9:
Assume the following statistics for Stock A and Stock B:

Stock A Stock B
Expected return 0.015 0.020
Variance 0.050 0.060
Standard deviation 0.224 0.245
Weight 40% 60%
Correlation coefficient 0.50

A. What is the expected return of the two-security portfolio described above?

B. What is the standard deviation of the two-security portfolio described above?
C. For a two-security minimum variance portfolio, what proportions would be invested is Stocks
A and B?

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 10:
Calculate the expected return and variance of this portfolio, assuming that equal amount is invested
in each of the following three securities:
Covariance matrix
E(r) Apple Sun Micro Red Hat
Apple 0.20 0.090 0.045 0.050
Sun Micro 0.12 0.045 0.070 0.040
Red Hat 0.15 0.050 0.040 0.060
Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 11:
You have a three-stock portfolio. Stock A has an expected return of 12 percent and a standard
deviation of 41 percent, stock B has an expected return of 16 percent and a standard deviation of
58 percent, and stock C has an expected return of 13 percent and a standard deviation of 48 percent.
The correlation between stocks A and B is .30, between stocks A and C is .20, and between stocks
B and C is .05. Your portfolio consists of 45 percent stock A, 25 percent stock B, and 30 percent
stock C. Calculate the expected return and standard deviation of your portfolio.
Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 12:
Use the following information to calculate the expected return and variance of a portfolio made up
of 30% in Stock A, 40% in Stock B and 30% in Stock C.

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 13:
Stocks A and B have a correlation coefficient of -0.8. The stocks' expected returns and standard
deviations are in the table below.
Stock Expected Returns Standard Deviation Amount invested (mkt value)
A 20% 25% $50,000
B 15% 19% $50,000

A. What is the expected return of the stock A and B portfolio?

B. What is the standard deviation of the stock A and B portfolio?
C. What percentage of stock A should be invested to obtain the minimum risk portfolio that contains stock
A and B?

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 14:
Use the following information to calculate the expected return and variance of a portfolio made up
of 30% in Apple and 70% in Sun Micro.
Covariance matrix
E(r) Apple Sun Micro Red Hat
Apple 0.20 0.090 0.045 0.050
Sun Micro 0.12 0.045 0.070 0.040
Red Hat 0.15 0.050 0.040 0.060

b. Calculate the proportion of Security Apple and Security Sun Micro that represent the minimum variance
portfolio.

Answer:

Problem 15:
Find the weights of the minimum variance portfolio, using the following information:
Stock A Stock B
Expected Return 20% 16%
Std. deviation 25% 20%
Correlation Coefficient -0.2

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 16:
Expected return and risk for stock A and B are the following:
Stock A Stock B
Expected return 5% 10%
Risk (standard deviation) 10% 20%

Assume also that the correlation between the two stocks is equal to 0.4 and the risk-free rate of
interest is 2%
A. Find the proportion for the two stocks that define a portfolio for A and B having minimum standard
deviation.
B. Calculate the expected return and the standard deviation of the minimum variance portfolio.
C. Calculate the Sharpe ratio of minimum variance portfolio.

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 17:
A portfolio consists of Stock A and T-bills. Use the following information below to calculate the
following:
Market Value Expected Returns Standard Deviation
Stock A $150,000 0.20 0.232
T-bill $25,000 0.05
A. Calculate the portfolio expected return.
B. Calculate the portfolio variance.
C. Calculate the Interaction component (Interactive risk) of portfolio variance.

Answer:

Problem 18:
An investor wishes to construct a portfolio consisting of a 70% allocation to a stock index and a
30% allocation to a risk-free asset. The return on the risk-free asset is 4.5% and the expected return
on the stock index is 12%. The standard deviation of returns on the stock index is 6%. Calculate
the expected return and the expected standard deviation of the portfolio.
Answer:

Problem 19:
An investor wishes to construct a portfolio by borrowing 35% of his original wealth and investing
all the money in a stock index. The return on the risk-free asset is 4.0% and the expected return on
the stock index is 15%. Calculate the expected return on the portfolio.
Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 20:
An investor wishes to construct a portfolio consisting of a 70% allocation to a stock index and a
30% allocation to a risk-free asset. The return on the risk-free asset is 4.5% and the expected return
on the stock index is 12%. Calculate the expected return on the portfolio.
Answer:

Problem 21:
You manage a risky portfolio with an expected rate of return of 17% and a standard deviation of
27%. The Treasury-bill rate is 7%.

Question 1: One of your clients chooses to invest 70% of a portfolio in your fund and 30% in a T-
bill money market fund. What is the expected value and standard deviation of the rate of return on
your client’s portfolio?

Answer:

Question 2: Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall portfolio will have an expected rate of return of 15%.
(a) What is the proportion y?
(b) Further suppose that your risky portfolio includes the following investments in the given
proportions: Stock A (27%), Stock B (33%), and Stock C (40%). What are your client’s investment
proportions in your three stocks and the T-bill fund.
Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Question 3: Now suppose that your client prefers to invest in your fund a proportion y that
maximizes the expected return on the overall portfolio subject to the constraint that the overall
portfolio’s standard deviation will not exceed 20%.
(a) What is the investment proportion, y?
(b) What is the expected rate of return on the overall portfolio?

Answer:

Problem 22:
Consider two security A and B with the following characteristics:
Security A Security B
Expected return 12% 13%
Standard deviation 0.021 0.029
Correlation coefficient between A and B = 0.6

Suppose you split your money 50–50 between the two securities A and B.
1. What is the expected return of the two-security portfolio?
2. What is the portfolio variance?
3. What percentage of your portfolio variance comes from the interaction component of total risk?
4. Suppose the risk-free rate is 8 percent. What is the expected return and variance of a portfolio containing
50 percent of the risk-free rate and 50 percent Security B

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 23:
The following are monthly percentage price changes for four market indexes:
Month A B C D
1 0.03 0.02 0.04 0.04
2 0.07 0.06 0.10 -0.02
3 -0.02 -0.01 -0.04 0.07
4 0.01 0.03 0.03 0.02
5 0.05 0.04 0.11 0.02
6 -0.06 -0.04 -0.08 0.06

Compute the following:

a. Average monthly rate of return for each index
b. Standard deviation for each index
c. Covariance between the rates of return for the following indexes:
• A-B
• B-C
• B-D
• C-D
d. The correlation coefficients for the same four combinations
e. Using the answers from parts (a), (b), and (d), calculate the expected return and standard deviation
of a portfolio consisting of equal parts of (1) B and C (2) B and D. Discuss the two portfolios.

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 24:
As chief investment officer of a small endowment fund, you are considering expanding the fund's
strategic asset allocation from just common stock (CS) and fixed-income (FI) to include private
real estate partnerships (PR) as well:

• Current Allocation: 60 percent of Asset CS, 40 percent of Asset FI

• Proposed Allocation: 50 percent of Asset CS, 30 percent of Asset FI, 20 percent of Asset PR

You also consider the following historical data for the three risky asset classes (CS, FI, and PR)
and the risk-free rate (RFR) over a recent investment period:
rij:
Asset Class E(R) σ CS FI PR
CS 8.6% 15.2% 1.0
FI 5.6% 8.6% 0.2 1.0
PR 7.1% 11.7% 0.6 0.1 1.0
RFR 3.1%

You have already determined that the expected return and standard deviation for the Current
Allocation are: E(Rcurrent) = 7.40% and σcurrent = 10.37%
a. Calculate the expected return for the Proposed Allocation.
b. Calculate the standard deviation for the Proposed Allocation.
c. For both the Current and Proposed Allocations, calculate the expected risk premium per unit of risk
(that is, [E(Rp) – RFR]/σ).
d. Using your calculations from part (c), explain which of these two portfolios is the most likely to
fall on the Markowitz efficient frontier.

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 25:
You are evaluating various investment opportunities currently available and you have calculated
expected returns and standard deviations for five different well-diversified portfolios of risky
assets:

Portfolio Expected Return Standard Deviation

A 7.8% 10.5%
B 10.0% 14.0%
C 3.6% 5.0%
D 11.7% 18.5%
E 6.2% 7.5%

1. Calculate the risk premium per unit of risk for the three portfolios above assuming the risk-free rate
is 3.0%.
2. Which of the five portfolios are most likely to be the market portfolio?
3. If you are only willing to make an investment with σ = 7.0%, is it possible for you to earn a return
of 7.0%?
4. What is the minimum level of risk that would be necessary for an investment to earn 7.0 percent?
5. Suppose you are now willing to make an investment with σ = 18.2%. What would be the investment
proportions in the riskless asset and the market portfolio for this portfolio? What is the expected
return for this portfolio?

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 26:
Assume that the risk-free rate of return is 3% and the market portfolio on the Capital Market Line
(CML) has an expected return of 11% and a standard deviation of 14%. How should you invest
$100,000 if you are only willing to accept a total portfolio risk of 8%?
Answer:

Problem 27:
Assume that a portfolio consists of two assets: risky and risk-free assets. What is the weight of the
risky asset in a portfolio with a variance of 0.005625, given that the stock market index has an
expected return of 10% and a standard deviation of 0.134. the T-bill rate is 2% and its standard
deviation is zero.
Answer:

Problem 28:
If you are willing to make an investment with a standard deviation of 0.068, what is your expected
rate of return, given that T-bills rate is 3%, the tangent portfolio has an expected return of 10%,
standard deviation of 15%. A peer portfolio has an expected return of 12% and standard deviation
of 17%.

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 29:

1. What is the minimum variance portfolio composed of Securities C and E?

2. What is the minimum variance portfolio composed of Securities A and D?
Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 30:
Consider a portfolio of 300 shares of firm A worth $10/share and 50 shares of firm B worth
$40/share. You expect a return of 8% for stock A and a return of 13% for stock B.
(a) What is the total value of the portfolio, what are the portfolio weights and what is the expected
return?
(b) Suppose firm A’s share price goes up to $12 and firm B’s share price falls to $36. What is the new
value of the portfolio? What return did it earn? After the price change, what are the new portfolio
weights?

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 31:

(a) What is the covariance between the returns for Alaskan Air and General Mills?
(b) What is the volatility of a portfolio with
i. equal amounts invested in these two stocks?
ii. 20% invested in Alaskan Air and 80% invested in General Mills?
iii. 80% invested in Alaskan Air and 20% invested in General Mills?

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 32:

Answer:

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Mr. Mohamed Aljamri Tel: 39636632

Problem 33:

Answer:

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