Foundations of Finance

Solutions to Problem set 2

Alexi Savov

Topic 3: Portfolio Management with 2 Risky Assets

1. The expected returns and standard deviation of returns for two securities are as
follows:

Security Z Security Y
Expected Return 15% 35%
Standard Deviation 20% 40%

The correlation between the returns is 0.25.

(a) Calculate the expected return and standard deviations of the following portfo-
lios:
i. 100% in Z
ii. 75% in Z and 25% in Y
iii. 50% in Z and 50% in Y
iv. 25% in Z and 75% in Y
v. 100% in Y
Recall that the general formula for expected return for a two-security portfolio
is:
 
E R p = w1 E [ R 1 ] + w2 E [ R 2 ]

Also, the variance of return for a two-security portfolio is:

σp2 = w12 σ12 + w22 σ22 + 2w1 w2 σ1 σ2 ρ.

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 Substituting the numerical values given in the question into these equations
produces the following results:
Expected Standard
Return Deviation
i. 0.15 0.200
ii. 0.20 0.200
iii. 0.25 0.245
iv. 0.30 0.316
v. 0.35 0.400
(b) Draw the mean-standard deviation frontier.
Do it yourself, please.
(c) Which portfolios might be held by an investor who likes high mean and low
standard deviation?
A risk-averse investor will hold an efficient portfolio. Portfolios (ii)–(v) are
efficient because they maximize the expected return for their respective levels
of risk (standard deviation). Portfolio (i) (with all in Z), however, is not efficient
because portfolio (ii) produces a higher expected return for the same level of
risk. Therefore, a risk-averse investor does not want to hold portfolio (i).

Topic 4: Portfolio Theory with a Riskless Assets

2. Suppose that a fund that tracks the S&P 500 has mean E [ Rm ] = 16% and standard
deviation σM = 10%, and suppose that the T-Bill rate is R f = 8%. Answer the
following questions about efficient portfolios:

(a) What is the expected return and standard deviation of a portfolio that is totally
invested in the risk-free asset?
The return on the risk free asset is given as 8%. The standard deviation of that
return is 0 by definition, since the asset is risk free.
(b) What is the expected return and standard deviation of a portfolio that has 50%
of its wealth in the risk-free asset and 50% in the S&P 500?
Expected return is given by:
   
E R p = wM E [RM ] + w f E R f
= (0.5)(0.16) + (0.5)(0.08) = 0.12.

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 Because the standard deviation of the return on the risk free asset is 0, the
standard deviation of the portfolio is:

σp = w M σM = (0.5)(0.10) = 0.05 = 5%.

(c) What is the expected return and standard deviation of a portfolio that has 125%
of its wealth in the S&P 500, financed by borrowing 25% of its wealth at the
risk-free rate?
The standard deviation of return will be equal to:

σp = w M σM = (1.25)(0.10) = 0.125 = 12.5%

Expected return will be equal to:

E( R p ) = w M E [ R M ] + (1 − w M ) R f = 1.25(0.16) + (−0.25)(0.08) = 0.18

This result can also be obtained using:

E [RM ] − R f 0.16 − 0.08

E( R p ) = R f + σp = 0.08 + 0.125 = 0.18.
σM 0.10

(d) What are the weights for investing in the risk-free asset and the S&P 500 that
produce a standard deviation for the entire portfolio that is twice the standard
deviation of the S&P 500? What is the expected return on that portfolio?
From above we have:
σp = w M σM

for the risk of the portfolio. The question asks for w M and w f that produces
σp = 2σM . Substituting 2σp for σM into the equation gives:

2σM = w M σM

This implies
wM = 2

We also know that

w f = 1 − w M = 1 − 2 = −1

This says the following in words: To produce a portfolio that is twice as risky
as the market, invest double your net worth in M (w M = 2), financed by bor-

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 rowing 100% of your net worth by selling short the risk-free asset (w f = −1).
To check that your total risk is double σM , substitute σM = .10 and w M = 2
into:
σp = w M σM = 2(0.10) = 0.20

The expected return on that portfolio is given by:

 
E Rp = w f R f + wM RM
= −1(0.08) + 2(0.16) = 0.24.

The expected return of 24% makes sense since it is double the return on the
market minus the financing cost of borrowing at the risk-free rate.

3. Consider the following data:

Expected Return Standard Deviation

Russell Fund 16% 12%
Windsor Fund 14% 10%
S&P 500 Fund 12% 8%

The correlation between the returns on the Russell Fund and the S&P 500 Fund is
0.7. The T-Bill rate is 6%. Which of the following portfolios would you prefer to
hold in combination with T-bills and why?

(a) Russell Fund

(b) Windsor Fund
(c) S&P 500 Fund
(d) A portfolio of 60% Russell Fund and 40% S&P 500 Fund.

The answer is (d). The reason is that the 60/40 portfolio combination of the Russell
Fund and the S&P 500 has the highest Sharpe ratio. In other words, this portfolio
gives the best investment opportunity set together with the risk-free Treasury bill.
More specifically, when you calculate the Sharpe ratio, that is, the slope of the capital
allocation line, ( E [ R M ] − R f )/σM , for each of the three mutual funds as well as the
60-40 combination, you find that the 60/40 combination has the highest slope. Here
are the calculations (where M stands for the mutual fund in each case):

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 (a) Russell Fund
E [RM ] − R f 0.16 − 0.06
= = 0.8333
σM 0.12
(b) Windsor Fund
E [RM ] − R f 0.14 − 0.06
= = 0.8
σM 0.1
(c) S&P Fund
E [RM ] − R f 0.12 − 0.06
= = 0.75
σM 0.08
(d) Portfolio of 0.6 in Russell + 0.4 in S&P 500.
We have to calculate E [ R M ] and σM of this 60/40 portfolio. To do this, we use
the formulas for the mean and standard deviation for a two-asset portfolio. Say
that asset 1 is the Russell fund and asset 2 is the S&P 500.
First, we calculate E [ R M ]:

E [ R M ] = 0.6E [ R1 ] + 0.4E [ R2 ] = 0.6(0.16) + 0.4(0.12) = 0.144

And now we calculate σM :

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σM = w12 σ12 + w22 σ22 + 2w1 w2 ρσ1 σ2
= (0.6)2 (0.12)2 + (0.4)2 (0.08)2 + 2(0.6)(0.4)(0.7)(0.12)(0.08) = 0.0094336

so
σM = 0.097127

Therefore, for the 60/40 combination we have:

E [RM ] − R f 0.144 − 0.06

= = 0.8648
σM 0.097127

Since 0.8648 > 0.8333 > 0.8 > 0.5, the slope for the capital allocation line with the
60/40 mutual fund combination is largest.

Topic 4: Portfolio Management with a Riskless Asset

4. Excel Question. Use the portfolio optimizer posted on the class website. Find out
what happens to the share of asset 3 in the optimal risky portfolio in the following
cases. Explain in words why you think this happens.

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 (a) The expected return of asset 3 is increased.
Allocation to asset 3 increases because it has a more attractive return-risk pro-
file.
(b) The standard deviation of asset 3 is increased.
Allocation to asset 3 decreases because it has a less attractive return-risk profile.
(c) The standard deviation of asset 2 is increased.
Allocation to asset 3 increases because it has a more attractive return-risk pro-
file relative to the other assets (asset less 2 less favorable).
(d) The correlation between assets 2 and 5 is increased.
Allocation to asset 3 increases because it has a more attractive return-risk pro-
file relative to the other assets (assets 2 and 5 less favorable).

Topic 5: The Capital Asset Pricing Model

5. Assume the risk free rate equals R f = 4%, and the return on the market portfolio
has expectation E [ R M ] = 12% and standard deviation σM = 15%.

(a) What is the equilibrium risk premium (that is, the excess return on the market
portfolio)?
The equilibrium risk premium is given by

E [ R M ] − R f = 12% − 4% = 8%

(b) If a certain stock has a realized return of 14%, what can we say about the beta
of this stock?
Nothing. To determine the beta we need to know the expected return, which
in general will not be equal to the realized return.
(c) If a certain stock has an expected return of 14%, what can we say about the beta
of this stock?
The expected return is given by


E [ R] = R f + β E [ R M ] − R f ,

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 implying that the beta is given by

E [ R] − R f
β= .
E [RM ] − R f

Using that E [ R] = 14%, R f = 4%, and E [ R M ] = 12%, we get

β = (14% − 4%) / (12% − 4%) = 1.25.

6. You are given the following two equations:

E ( Ri ) = R f + ( E ( R M ) − R f ) β i (1)
!
E( R M ) − R f
E( R p ) = R f + σp (2)
σM

You also have the following information: E( R M ) = .15, R f = .06, σM = .15. Answer
the following questions, assuming that the capital asset pricing model is correct:

(a) Which equation would you use to determine the expected return on an indi-
vidual security with a standard deviation of returns =.5 and a β = 2? Given
the parameters above, what is the expected return for that security?
We know that the standard deviation of returns on an individual security (in
this case equal to .5) is not relevant for determining its expected return accord-
ing to CAPM since only systematic risk adds to total portfolio risk. Thus only
the β (=2) matters, hence we use equation (1) known as the security market
line. With β = 2 and using the given parameters, we have:

E( Ri ) = .06 + (.15 − .06)(2) = .24

(b) Which equation would you use to determine the expected return on a portfolio
knowing that it is an efficient portfolio (consisting of the market portfolio M
combined with the risk-free rate)? If you were told that the standard devia-
tion of returns on that portfolio is equal to σM and you were given the above
parameters, what is the expected return on that portfolio?
We use equation (2), the capital market line, to determine the expected return
on an efficient portfolio consisting of the market portfolio and the risk-free rate.
Equation (2) says the expected return is determined by the σ of the portfolio.

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 Given that σ = σM and given the parameters above, we have

.15 − .06
E( R) = .06 + (.15) = .15
.15

(c) Can you determine the β of the portfolio in (b)?

Since the portfolio in (b) has σ = σM it is the market portfolio. The market
portfolio has a β = 1, by definition. We can also use equation (1) to calculate
the β of the portfolio:

.15 = E( Ri ) = .06 + (.15 − .06) β

so β = 1.
(d) Given your answers above, expand on what type of risky assets equation (1)
can be used for, and what type of risky assets equation (2) can be used for.
Equation (1), the security market line, gives the "proper" expected return for
any risky asset, whether it is an individual security (that is inefficient by itself)
or an efficient risky portfolio. Equation (2), on the other hand, can be used only
for the expected return on an efficient portfolio. This is clear once we recognize
that if we used equation (2) to get the expected return on the individual security
from (a), with a σ = .5, we would have gotten the following:

.15 − .06
E( R) = .06 + (.5) = .36
.15

The expected return from equation (2) is much too high for the individual secu-
rity. As we saw in Part A, with a β = 2 equation (1) says this security requires
an expected return of "only" 24%. Part of its total risk (σ = .5) gets diversified
away and only the systematic, β-related, risk is priced by the equation (1), the
security market line.