Suggested Practice Question (with Answers)

Chapter 6: 11, 14, 20-22

Chapter 8: 2, 4, 12, 13

Solutions

7.The portfolio expected return can be computed as follows:

Wbills × Return + Wmarket × Exp. return = Portfolio expected Portfolio standard

on on market return deviation
bills (= wmarket × 17.12)

.0 5% 1.0 9.24% 9.24% 17.42%

.2 5 .8 9.24 8.39 13.94

.4 5 .6 9.24 7.54 10.45

.6 5 .4 9.24 6.70 6.97

.8 5 .2 9.24 5.85 3.48

1.0 5 .0 9.24 5.00 0

8. Computing the utility from U = E(r) – .005 × A2 = E(r) – .0152 (because A =
3), we arrive at the following table.

Wbills Wmarket E(r)  2 U(A = 3) U(A = 5)

.0 1.0 9.24% 17.42 303.46 4.69 1.65
.2 .8 8.39 13.94 194.32 5.48 3.53
.4 .6 7.54 10.45 109.20 5.90 4.81
.6 .4 6.70 6.97 48.58 5.97 5.49
.8 .2 5.85 3.48 12.11 5.69 5.55
1.0 5.0 5.0 0 0 5.0 5.0

The utility column implies that investors with A = 3 will prefer a position of 40
percent in the market and 60 percent in bills over any of the other positions in the
table; those with A = 5 will prefer 20 percent in the market and 80 percent in bills.
9. The column labelled U(A = 5) in the table above is computed from U = E(r) –
.005 A2 = E(r) – .0252 (since A = 5). It shows that the more risk-averse
investors will prefer the position with 20 percent in the market index portfolio,
rather than the 40 percent market weight preferred by investors with A = 3.
10. Expected return = .3  8% + .7  18% = 15% per year
Standard deviation = .7  28% = 19.6%
11. Investment proportions:
30.0% in T-bills
.7  27% = 18.9% in stock A
.7  33% = 23.1% in stock B
.7  40% = 28.0% in stock C
18 – 8
12. Your reward-to-variability ratio = 28 = .3571

15 – 8
Client’s reward-to-variability ratio = 19.6 = .3571
13.

30

25
CA L (Slope = .3571)
20

E( r) P
15
% Client
10

0
0 10 20 30 40



14. a. E(rC) = rf + [E(rP) – rf] y = 8 + 10y

If the expected return of the portfolio is equal to 16 percent, then solving for y
we get
16 – 8
16 = 8 + 10y, and y= 10 = .8
Therefore, to get an expected return of 16 percent the client must invest 80
percent of total funds in the risky portfolio and 20 percent in T-bills.
b. Investment proportions of the client’s funds:
20% in T-bills
.8  27% = 21.6% in stock A
.8  33% = 26.4% in stock B
.8  40% = 32.0% in stock C
c. C = .8  P = .8  28% = 22.4% per year

15. a. C = y  28%. If your client wants a standard deviation of 18 percent at most,

then
y = 18/28 = .6429 = 64.29% in the risky portfolio.
b. E(rC) = 8 + 10y = 8 + .6429  10 = 8 + 6.429 = 14.429%
16. a.
E(rP) – rf 18 – 8 10
y* = = = 27.44 = .3644
.01 
2
AsP .01  3.5  28 2

So the client’s optimal proportions are 36.44 percent in the risky portfolio and
63.56 percent in T-bills.
b. E(rC) = 8 + 10y* = 8 + .3644  10 = 11.644%
C = .3644  28 = 10.20%
13 – 8
17. a. Slope of the CML = 25 = .20

The diagram is below.

b. My fund allows an investor to achieve a higher mean for any given standard
deviation than would a passive strategy, that is, a higher expected return for
any given level of risk.

CM L and CAL
18
16 CA L: Slope = .3571
14
Expected Retrun

12
10
CML: Slope = .20
8
6
4
2
0
0 10 20 30
Standard Deviation

18. a. With 70 percent of his money in my fund’s portfolio the client gets a mean
return of 15 percent per year and a standard deviation of 19.6 percent per year.
If he shifts that money to the passive portfolio (which has an expected return
of 13 percent and standard deviation of 25 percent), his overall expected
return and standard deviation become
E(rC) = rf + .7[E(rM)  rf]
In this case, rf = 8% and E(rM) = 13%. Therefore,
 E(rC) = 8 + .7  (13 – 8) = 11.5%
The standard deviation of the complete portfolio using the passive portfolio
would be
C = .7  M = .7  25% = 17.5%
Therefore, the shift entails a decline in the mean from 14 percent to 11.5
percent and a decline in the standard deviation from 19.6 percent to 17.5
percent. Since both mean return and standard deviation fall, it is not yet clear
whether the move is beneficial or harmful. The disadvantage of the shift is
that if my client is willing to accept a mean return on his total portfolio of
11.5 percent, he can achieve it with a lower standard deviation using my fund
portfolio, rather than the passive portfolio. To achieve a target mean of 11.5
percent, we first write the mean of the complete portfolio as a function of the
proportions invested in my fund portfolio, y:
E(rC) = 8 + y(18  8) = 8 + 10y
Because our target is: E(rC) = 11.5%, the proportion that must be invested in
my fund is determined as follows:
11.5 – 8
11.5 = 8 + 10y, y= 10 = .35

The standard deviation of the portfolio would be: C = y  28% = .35  28% =
9.8%.
Thus, by using my portfolio, the same 11.5 percent expected return can be
achieved with a standard deviation of only 9.8 percent as opposed to the
standard deviation of 17.5 percent using the passive portfolio.
b. The fee would reduce the reward-to-variability ratio, that is, the slope of the
CAL. Clients will be indifferent between my fund and the passive portfolio if
the slope of the after-fee CAL and the CML are equal. Let f denote the fee.
18 – 8 – f 10 – f
Slope of CAL with fee = =
28 28
13 – 8
Slope of CML (which requires no fee) = 25 = .20. Setting these slopes
equal we get
10 – f
28 = .20
10  f = 28  .20 = 5.6
f = 10  5.6 = 4.4% per year
19. a. The formula for the optimal proportion to invest in the passive portfolio is
E(rM) – rf
y* = 2
.01  AsM
 With E(rM) = 13%; rf = 8%; M = 25%; A = 3.5, we get
13 – 8
y* = = .2286
.01  3.5  252
b. The answer here is the same as in 9(b). The fee that you can charge a client is
the same regardless of the asset allocation mix of your client’s portfolio. You
can charge a fee that will equalize the reward-to-variability ratio of your
portfolio with that of your competition.
24. a. If 1957–2012 is assumed to be representative of future expected performance,
A = 2, E(rM)  rf = 4.24%, and M = 17.42% (we use the standard deviation of
the risk premium from the last row of Table 5.7), then y* is given by
E(rM)  rf
y* = 2 = 4.24/(.01 × 2 × 17.422)= .6986
.01  AM

That is, 69.86 percent should be allocated to equity and 30.14 percent to bills.
b. If 1999–2012 is assumed to be representative of future expected performance,
A = 2, E(rM)  rf = 6.04%; and M = 19.73%, then y* is given by
y* = 6.04/(.01 × 2 × 19.732)= .7758
Therefore, 77.58 percent of the complete portfolio is allocated to equity and
22.42 percent to bills.
c. In (a) the market risk premium is expected to be lower while the market risk is
expected to be at a lower level than in (b). The fact that the reward-to-
volatility ratio is expected to be lower in (a) (4.24/17.42 = .243 versus
6.04/19.73 = .31) explains the much smaller proportion invested in equity.
29. 3. [Utility for each portfolio = E(r) – .005 × 4 × 2. We chose the portfolio with
the highest utility value.]
30. 4. [When investors are risk-neutral, A = 0, and the portfolio with the highest
utility is the one with the highest expected return.]
31. b [Investor’s aversion to risk]
32. Indifference curve 2
33. Point E
34. (.6 × $50,000) + [.4 × ($30,000)]  $5,000 = $13,000
35. (b)
 36.
Expected return for equity fund = T-bill rate + risk premium = 6% + 10% =
16%
Expected rate of return of the client’s portfolio = (.6 × 16%) + (.4 × 6%) =
12%
Expected return of the client’s portfolio = .12 × $100,000 = $12,000 (which
implies expected total wealth at the end of the period = $112,000)
Standard deviation of client’s overall portfolio = .6 × 14% = 8.4%
.10
37. Reward-to-volatility ratio =  0.71
.14

Chapter 6

11. a.

Even though gold seems dominated by stocks, it still might be an attractive

asset to hold as part of a portfolio. If the correlation between gold and stocks
is sufficiently low, it will be held as an element in a portfolio—the optimal
tangency portfolio.
b. If gold had a correlation coefficient with stocks of +1, it would not be held.
The optimal CAL would be comprised of bills and stocks only. Since the set
of risk/return combinations of stocks and gold would plot as a straight line
with a negative slope (see the following graph), it would be dominated by the
stock’s portfolio. Of course, this situation could not persist. If no one desired
 gold, its price would fall and its expected rate of return would increase until it
became an attractive enough asset to hold.

14. False. The portfolio standard deviation equals the weighted average of the
component-asset standard deviations only in the special case that all assets are
perfectly positively correlated. Otherwise, as the formula for portfolio standard
deviation shows, the portfolio standard deviation is less than the weighted average
of the component-asset standard deviations. The portfolio variance will be a
weighted sum of the elements in the covariance matrix, with the products of the
portfolio proportions as weights.
20. Rearranging the table (converting rows to columns), and computing serial
correlation results in the following table:
Nominal Rates
Small Large LT Govt. Intermediate
T-Bills Inflation
Company Company Bonds Govt. Bonds
1920s –3.72 18.36 3.98 3.77 3.56 –1.00
1930s 7.28 –1.25 4.60 3.91 0.30 –2.04
1940s 20.63 9.11 3.59 1.70 0.37 5.36
1950s 19.01 19.41 0.25 1.11 1.87 2.22
1960s 13.72 7.84 1.14 3.41 3.89 2.52
1970s 8.75 5.90 6.63 6.11 6.29 7.36
1980s 12.46 17.60 11.50 12.01 9.00 5.10
1990s 13.84 18.20 8.60 7.74 5.02 2.93
Serial
0.46 –0.22 0.60 0.59 0.63 0.23
correlation

For example: to compute serial correlation in decade nominal returns for large-
company stocks, we set up the following two columns and use the “Correlation”
function of the spreadsheet to find that the serial correlation is –.22.

Decade Previous
1930s –1.25% 18.36%
1940s 9.11% –1.25%
1950s 19.41% 9.11%
1960s 7.84% 19.41%
1970s 5.90% 7.84%
1980s 17.60% 5.90%
1990s 18.20% 17.60%

Note that each correlation is based on only seven observations, so we cannot

really arrive at any statistically significant conclusion. Looking at the numbers,
however, it appears that there is persistent serial correlation with the exception of
large-company stocks. This conclusion changes when we turn to real rates in the
next problem.
21. The table for real rates (using the approximation of subtracting a decade’s average
inflation from the decade’s average nominal return) is:

Small Large LT Govt. Intermediate

T-Bills
Company Company Bonds Govt. Bonds
1920s –2.72 19.36 4.98 4.77 4.56
1930s 9.32 0.79 6.64 5.95 2.34
1940s 15.27 3.75 –1.77 –3.66 –4.99
1950s 16.79 17.19 –1.97 –1.11 –0.35
1960s 11.20 5.33 –1.38 0.89 1.37
1970s 1.39 –1.46 –0.73 –1.25 –1.07
1980s 7.36 12.50 6.40 6.91 3.90
1990s 10.91 15.27 5.67 4.81 2.09
Serial correlation 0.29 –0.27 0.38 0.11 0.00

The positive serial correlation in decade nominal returns has vanished and it
appears that real rates are serially uncorrelated. The decade time series (although
again too short for any definitive conclusion) suggests that real rates of return are
independent from decade to decade.
22. a. Subscript OP refers to the original portfolio, ABC to the new stock, and NP to
the new portfolio.
i. E(rNP) = wOPE(rOP) + wABCE(rABC) = (.9  .67) + (.1  1.25) = .728%
ii. Cov = r  OP  ABC = .40  2.37  2.95 = .00027966  .028
iii. NP = [w2OP2OP+ w2ABC2ABC + 2 wOPwABC(CovOP,ABC)]1/2
= [(.9 2  2.372) + (.12  2.952) + (2  .9  .1  2.8)]1/2
= 2.16%
b. Subscript OP refers to the original portfolio, GS to government securities, and
NP to the new portfolio.
i. E(rNP) = wOPE(rOP) + wGSE(rGS) = (.9  .67) + (.1  0.42) = .645%
ii. Cov = r  OP GS = 0  2.37  0 = 0
iii. NP = [w2OP2OP + w2GS2GS + 2wOPwGS(CovOP,GS)]1/2
= [(.9 2  2.372) + (.12  0) + (2  .9  .1  0)]1/2
= 2.133%  2.13%
c. Adding the risk-free government securities would result in a lower beta for the
new portfolio. The new portfolio beta will be a weighted average of the
individual security betas in the portfolio; the presence of the risk-free
securities would lower that weighted average.
d. The comment is not correct. Although the respective standard deviations and
expected returns for the two securities under consideration are equal, the
covariances between each security and the original portfolio are unknown,
making it impossible to draw the conclusion stated. For instance, if the
covariances are different, selecting one security over the other may result in a
lower standard deviation for the portfolio as a whole. In such a case, that
security would be the preferred investment, assuming all other factors are
equal.
e. i. Grace clearly expressed the sentiment that the risk of loss was more
important to her than the opportunity for return. Using variance (or
standard deviation) as a measure of risk in her case has a serious limitation
because standard deviation does not distinguish between positive and
negative price movements.
 ii. Two alternative risk measures that could be used instead of variance are:
• Range of returns, which considers the highest and lowest expected
returns in the future period, with a larger range being a sign of greater
variability and therefore of greater risk.
• Semivariance which can measure expected deviations of returns below
the mean, or some other benchmark, such as zero.
Either of these measures would potentially be superior to variance for
Grace. Range of returns would help to highlight the full spectrum of risk
she is assuming, especially the downside portion of the range about which
she is so concerned. Semivariance would also be effective, because it
implicitly assumes that the investor wants to minimize the likelihood of
returns falling below some target rate; in Grace’s case, the target rate
would be set at zero (to protect against negative returns).
Chapter 8

2. a. The standard deviation of each individual stock is given by

2 2
i = [i M+ 2(ei) ]1/2

Since A = .8, B = 1.2, (eA) = 30%, (eB) = 40%, and M = 22% we get

A = (.82  222 + 302)1/2 = 34.78%

B = (1.22  222 + 402)1/2 = 47.93%

b. The expected rate of return on a portfolio is the weighted average of the
expected returns of the individual securities:
E(rp) = wAE(rA) + wBE(rB) + wfrf
where wA, wB, and wf are the portfolio weights of stock A, stock B, and T-
bills, respectively.
Substituting in the formula we get
E(rp) = .30  .13 + .45  .18 + .25  .08 = 14%
The beta of a portfolio is similarly a weighted average of the betas of the
individual securities:
P = wAA + wBB + wff

The beta of T-bills (f ) is zero. The beta of the portfolio is therefore

P = .30  .8 + .45  1.2 + 0  .78

The variance of this portfolio is
 2 2 2
P = PM + 2(eP)
2 2
where PM is the systematic component and 2(eP) is the nonsystematic
component. Since the residuals, ei, are uncorrelated, the nonsystematic
variance is
2 2 2
2(eP) = wA 2 (eA) +wB 2(eB) + wf 2(ef)

= .302  .302 + .452  .402 + .252  0 = .0405

where 2(eA) and 2(eB) are the firm-specific (nonsystematic) variances of
stocks A and B, and 2(ef), the nonsystematic variance of T-bills, is zero. The
residual standard deviation of the portfolio is thus
(eP) = (.0405)1/2 = 20.12%
The total variance of the portfolio is then
2
P = .782  222 + .0405 = .069947
and the standard deviation is 26.45%.
4. a. Firm-specific risk is measured by the residual standard deviation. Thus, stock
A has more firm-specific risk: 10.3% > 9.1%.
b. Market risk is measured by beta, the slope coefficient of the regression. A has
a larger beta coefficient: 1.2 > .8.
c. R2 measures the fraction of total variance of return explained by the market
return. A’s R2 is larger than B’s: .576 > .436.
d. The average rate of return in excess of that predicted by the CAPM is
measured by alpha, the intercept of the SCL. A = 1% is larger than B = –2%.
e. Rewriting the SCL equation in terms of total return (r) rather than excess
return (R):
rA – rf =  + (rM – rf)

rA =  + rf(1 – + rM

The intercept is now equal to
 + rf(1 – 1 + rf (l – 1.2)

Since rf = 6%, the intercept would be: 1 –1.2 = –.2%.

12.a. (2/3) × 1.24 + (1/3) × 1 = 1.16
b. βt+1 = .3 + .7 × 1.24 = 1.168
13. For stock A:
 A  rA  [rf   A  (rM  rf )]  .11  [.06  0.8  (.12  .06)]  0.2%
For stock B:
 B  rB  [rf   B  (rM  rf )]  .14  [.06  1.5  (.12  .06)]  1%
Stock A would be a good addition to a well-diversified portfolio. A short position
in stock B may be desirable.