CH 6 Numerical

Chapter-6
Efficient Diversification and CAPM

a) E(rC) = y × E(rP) + (1 – y) × rf
= (0.7 × 0.17) + (0.3 × 0.07)
= 0.14 or 14% per year
σC = y × σP
= 0.7 × 0.27
= 0.189 or 18.9% per year
b) T-bills 30%
Stock A 0.7 × 27% = 18.9%
Stock B 0.7 × 33% = 23.1%
Stock C 0.7 × 40% = 28.0%
c) Calculation of the reward-to-variability ratio (Sharpe ratio)
For the risky portfolio:
For the client’s overall portfolio:

e) E(rC) = y × E(rP) + (1 – y) × rf
i.e. 15 = y × 17 + (1 – y) × 7
Or, 15 – 7 = 10 y
So, y = = 0.8
Therefore, in order to achieve an expected rate of return of 15%,
the client must invest 80% of total funds in the risky portfolio and
20% in T-bills.
Clint’s Investment proportion will be:
T-bills 20%
Stock A 0.8 × 27% = 21.6%
Stock B 0.8 × 33% = 26.4%
Stock C 0.8 × 40% = 28.0%
The standard deviation of the complete portfolio will be:
σC = y × σP
= 0.8 × 0.27
= 0.216 or 21.6% per year
(27,17)
(25,13)
• Calculation of opportunity set
E(rp)=
Proportion of X Proportion of M Wx.E(rX)+WM.E(rM)

(Wx) (WM) SD
0 1 10 20.00
0.2 0.8 11 17.09
0.4 0.6 12 21.17
0.6 0.4 13 29.46
0.8 0.2 14 39.40
1 0 15 50.00
16
14
12
10
E(r)
6 Series1
0
15.00 20.00 25.00 30.00 35.00 40.00 45.00 50.00 55.00

Calculation of weight of the optimal risky
portfolio:
• Weight of stock fund:
Expected return and standard deviation of
optimal risky portfolio:
E(rP) = wX E(rX) + wM E(rM)
= 0.2564 x 15% + 0.7436 x 10% = 11.282%
P =
= (0.2564) 2
× (50)2 + (0.7436)2 × (20)2 + 2 × 0.2564 × 0.7436 × (-200)
= 164.3524 + 221.1764 - 76.2636
= 309.2652
= 17.5859%
Calculation of minimum variance portfolio:
Investment proportion of X fund:
Investment proportion of equity fund:

wM = 1 – wX = 1 – 0.1818 = 0.8182
Expected return on minimum variance portfolio:
E(rmin) = wX E(rX) + wM E(rM)
= 0.1818 x 15 + 0.8182 x 10
= 10.909%
Standard deviation of returns on minimum variance portfolio:
P =
=
= 82.6281 + 267.7805 - 59.4995
= 290.9091
= 17.0561%
Slope of CAL =
Portfolio Mean E(rc)= y × E(rP) + (1 – y) × rf
= 0.2222 × 11.28 + 0.7778 × 5%
= 6.395%
Portfolio Standard deviation (c) = y ×  P
= 0.2222 × 17.58%
= 3.91%
Sharpe ratio =
According to the question,
Discount rate = Expected rate of return
E(rj) = rf + [E(rm) -rf]xj
= 9% + (19% - 9%) × 1.7 = 26%
Calculation of NPV
Discount
Year Cash flows factor @26% PV
0 -20 1 -20
1-9 10 3.3657 33.657
10 20 0.0992 1.984
NPV 15.641
We know that the discount rate below which the
NPV is negative is IRR of the project because
NPV of any project at IRR is 0. so for the possible
beta estimate we have to find IRR first.
Calculation of IRR
Fake PBP =
Discount Discount factor

Year Cash flows PV@ 50% PV@48
factor @50% @48% %
0 -20 1 -20 1 -20
1-9 10 1.9480 19.480 2.02218 20.222
10 20 0.0173 0.347 0.01983 0.397
NPV -0.173 0.618
By Interpolation:
E(rj) = rf + [E(rm) -rf]xj

49.5625 = 9% + (19% - 9%) × j
= j
j = 4.056
Q-31
a. Beta of the aggressive stock (A) = ?
Beta of the defensive stock (D) = ?
A =
D =
b. E(rA) = 0.5 × 2% + 0.5 × 32% = 17%
E(rD) = 0.5 × 3.5% + 0.5 × 14% = 8.75%
c. Expected return is the T-bill rate = 8% i.e.
risk free rate = 8%
Expected market when beta = 1 is
E(rM) = 0.5 × 5% + 0.5 × 20% = 12.5%
Thus, SML graph will be as following:
The aggressive stock has a fair expected rate of return of:
E(rA) = 8% + (12.5% – 8%) 2.0 = 17%
The security analyst’s estimate of the expected rate of return
is also 17%. Thus the alpha for the aggressive stock is zero.
Similarly, the required return for the defensive stock is:
E(rD) = 8% + (12.5% – 8%) 0.7 = 11.15%
The security analyst’s estimate of the expected return for D is
only 8.75%, and hence:
αD = actual expected return – required return
= 8.75% – 11.15% = –2.4%
e. Management of aggressive firm should use
the hurdle rate for a project with the risk
characteristics of the defensive firm’s stock
having project beta 0.7 (i.e. defensive firm’s
beta).
Therefore the correct discount rate is 11.15%, the
fair rate of return on stock D.
6.34 Solution
Given:
Investment in fully diversified portfolio = Rs 900,000
Investment in ABC company = Rs 100,000
Ratio of investment = 0.9:0.1
E(rP) = 0.67%
E(rABC) = 1.25%
P = 2.37%
ABC = 2.95%
Correlation between original portfolio and ABC
company, (P, ABC) = 0.40
a. i. Expected return on new portfolio, E(rNP) = ?
E(rNP) = wP E(rP) + wABC E(rABC)
= (0.9 × 0.67) + (0.1 × 1.25)
= 0.7280%
ii. Covariance between original portfolio and ABC company,
Cov(P,ABC) = P,ABC × P × ABC
= 0.40 × 2.37 × 2.95
= 2.7966
iii. Standard deviation of new portfolio (NP ) = ?
NP=
=
= 2.2672 %
6.35 Solution
Yield on T-bill money market fund (rf) = 5.5%
Expected return on stock fund, E(rs) = 15%
Expected return on bond fund, E(rB) = 9%
Standard deviation on stock fund, (s) = 32%
Standard deviation on bond fund, (B) = 23%
Correlation of stock and bond fund, (SB) = 0.15
Cov(SB) = SB × s × B = 0.15 × 32% × 23% = 110.4
a. Investment proportion of stock fund (w S)=?
wS = = 0.3142
Investment proportion of bond fund (w B) = 1 - wS = 1 – 0.3142 = 0.6858

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Chapter-6

Efficient Diversification and CAPM

For the client’s overall portfolio:

Proportion of X Proportion of M Wx.E(rX)+WM.E(rM)

Investment proportion of equity fund:

Discount Discount factor

E(rj) = rf + [E(rm) -rf]xj

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