Question 1:

Suppose that one investment has a mean return of 8% and a standard deviation of return of 14%.
Another investment has a mean return of 12% and a standard deviation of return of 20%.
The correlation between the returns is 0.3. Illustrate in a graph the risk-return trade-off.
Please be sure to label the efficient frontier, as well.
Answer
1 = 8%
2 = 12%
= 0.3

1 = 14%
2 = 20%

w1
0.0
0.3
0.6
0.9
1.0

w2
1.0
0.7
0.4
0.1
0.0

1
8%
8%
8%
8%
8%

2
12%
12%
12%
12%
12%

1
14%
14%
14%
14%
14%

Expected
Standard Deviation
Expected Return
20.00%
12.00%
14.00%
15.01%
10.80%
12.00%
12.17%
9.60% efficient frontier
10.00%
12.95%
8.40%
8.00%
14.00%
8.00%
Expected Return (%)

Return

6.00%
4.00%
2.00%
0.00%
10.00% 12.00% 14.00% 16.00% 18.00%

Standard Deviation of Return (%)

iation of return of 14%.

return of 20%.
urn trade-off.

2
20%
20%
20%
20%
20%

= w11+w22= sqrt(w1^1^+w2^2+2w1w212
12.00%
20.00%
10.80%
15.01%
9.60%
12.17%
8.40%
12.95%
8.00%
14.00%

d Return

0% 14.00% 16.00% 18.00% 20.00% 22.00%

tandard Deviation of Return (%)

Question 2:
The expected return on the market is 12%, and the risk-free rate is 7%.
The standard deviation of the return on the market is 15%. One investor creates a portfolio on the
efficient frontier with an expected return of 10%. Another creates a portfolio on the efficient frontier
with an expected return of 20%. What is the standard deviation of the returns of the two portfolios?
Answer:
Expected return on market
Risk-free rate
standard deviation

12%
7%
15%

First Investor - 10 %:

Second investor - 20 %:

E(R1) = (1-1) Rf + 1E(Rm)

E(R2) = (1-1) Rf + 1E(Rm)

0.1 = (1-1) x 0.07 + 1 x 0.12

0.1 = 0.07 - 0.071 + 0.121
0.1= 0.07 + 0.051
0.03 = 0.051
1 = 0.6

0.2 = (1-1) x 0.07 + 1 x 0.12

0.2 = 0.07 - 0.071 + 0.121
0.2= 0.07 + 0.051
0.13 = 0.051
1 = 2.6

Standard Deviation of R1
1M
0.6 x 0.15
9%

Standard Deviation of R2
1M
2.6 x 0.15
39%

tes a portfolio on the

on the efficient frontier
s of the two portfolios?

12-7 = 5
15/5 = 3
10-7 = 3
3*3 = 9

12-7 = 5
15/5 = 3
20-7=13
3*13 = 39

Question 3:

A bank estimates that its profit next year is normally distributed with a mean of 0.8% of assets
and the standard deviation of 2% of assets. How much equity (as a percentage of assets) does the co
need to be (a) 99% sure that it will have a positive equity at the end of the year and (b) 99.9% sure th
have positive equity at the end of the year? Ignore taxes.
Answer:
a)

99% z score = 2.33

Z= (E+)/
2.33 = (E+0.008)/0.02
0.0466 = E+0.008
E= 3.86 %

b)

100% z score = 3.08

Z= (E+)/
3.08 = (E+0.008)/0.02
0.0616 = E+0.008
E= 5.36 %

f assets) does the company

nd (b) 99.9% sure that it will

score = 3.08

.008)/0.02

Question 4:
A portfolio manager has maintained an actively managed portfolio with a beta of 0.2.
During the last year, the risk-free rate was 5%, and major equity indexes performed very badly,
providing returns of about 30%. The portfolio manager produced a return of 10% and claims
that in the circumstances it was good. Discuss this claim.
Answer:
= 0.2
Rf = 0.05
Rm = -0.30
Rp = -0.10
E(Rp) = Rf + (Rm-Rf)
"-0.10 = 0.05 + 0.2 (-0.30-0.05)
"-0.10 = -0.02
-0.08

The portfolio manager produced a return of - 10 % which is worst than expected in the market and sh
ways to produce positive alpha.

formed very badly,

f 10% and claims

ed in the market and should look for

Question 5:

Regulators calculate that DLC bank (see Section 2.2 in the textbook) will report a profit that is normally
distributed with a mean of $0.6 million and a standard deviation of $2 million. How much equity capit
to that in Table2.2 should regulators require for there to be a 99.9% chance of the capital not being w
Answer:

99.9 % z score = 3.08

Z= (E+)/
3.08 = (E+0.6)/2
6.16=(E+0.6)
E = 5.56
Current equity capital is $5 million, and regulators will require additional 560,000 in equity.

ofit that is normally

n. How much equity capital in addition
of the capital not being wiped out by losses?

000 in equity.

Question 6:
The bidders in a Dutch auction are as follows:

Bidder
A
B
C
D
E
F
G
H

Number of
Price
Shares
60,000
20,000
30,000
40,000
40,000
40,000
50,000
50,000

$50
$80
$55
$38
$42
$42
$35
$60

The number of shares being auctioned is 210,000. What is the price paid by investors? How many sha
Answer:

Bidder
B
H
C
A
E
F
D
G

Number of
Price
Shares
20,000
50,000
30,000
60,000
40,000
40,000
40,000
50,000

$80
$60
$55
$50
$42
$42
$38
$35

Available
Shares
190,000
140,000
110,000
50,000
10,000
0
0
0

The price paid by all the investors to whom shares are allocated is the price bid by E and F, or $42.00.

nvestors? How many shares does each investor receive?

F, or $42.00.

Question 7:

An investment bank has been asked to underwrite an issue of 10 million shares by a company.
It is trying to decide between a firm commitment where it buys the shares for $10 per share and a be
efforts where it charges a fee of 20 cents for each share sold. Explain the pros and cons of the two alte
Answer:
Alternative 1 - Firm Commitment where it buys the shares for $10.00 per share
Pros:

The investment bank can make profit as it tries to sell shares at higher price in the market

Cons:

The investment bank could incur loss if shares are sold for lower price in the market

Alternative 2 - Best efforts where it charges a fee of 20 cents for each share sold
Pros:

Less risky as bank will earn money based on the number of shares sold

Cons:

Lower expected return due to lower risk and limited to 20 cents per share.
Payment received when shares are sold.

r $10 per share and a best

s and cons of the two alternatives.

gher price in the market

rice in the market