INTRODUCTION TO ACTUARIAL SCIENCE 2013-14/S1: Tutorial 6 Portfolio & Capital Market Theory

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SOLUTION TUTORIAL 6 PORTFOLIO AND CAPITAL MARKET THEORY
Q1 BKM7Q4-10

(i). The parameters of the opportunity set are:
E(r
S
) = 20%, E(r
B
) = 12%,
S
= 30%,
B
= 15%, = 0.10
From the standard deviations and the correlation coefficient we generate the covariance
matrix [note that ( , )
S B S B
Cov r r o o = ]:
Bonds Stocks
Bonds


225 45
Stocks

45

900

The minimum-variance portfolio is computed as follows:
w
Min
(S) = 1739 . 0
) 45 2 ( 225 900
45 225
) r , r ( Cov 2
) r , r ( Cov
B S
2
B
2
S
B S
2
B
=
+

=
o + o
o

w
Min
(B) = 1 0.1739 = 0.8261

The minimum variance portfolio mean and standard deviation are:
E(r
Min
) = (0.1739 .20) + (0.8261 .12) = .1339 = 13.39%

Min
=
2 / 1
B S B S
2
B
2
B
2
S
2
S
)] r , r ( Cov w w 2 w w [ + o + o

= [(0.1739
2
900) + (0.8261
2
225) + (2 0.1739 0.8261 45)]
1/2

= 13.92%

(ii).
Proportion
in stock fund
Proportion
in bond fund
Expected
return
Standard
Deviation

0.00% 100.00% 12.00% 15.00%
17.39% 82.61% 13.39% 13.92% minimum variance
20.00% 80.00% 13.60% 13.94%
40.00% 60.00% 15.20% 15.70%
45.16% 54.84% 15.61% 16.54% tangency portfolio
60.00% 40.00% 16.80% 19.53%
80.00% 20.00% 18.40% 24.48%
100.00% 0.00% 20.00% 30.00%

0.00
5.00
10.00
15.00
20.00
25.00
0.00 5.00 10.00 15.00 20.00 25.00 30.00
Tangency
Portfolio
Minimum
Variance
Portfolio
Efficient frontier
of risky assets
CML
INVESTMENT OPPORTUNITY SET
r
f
= 8.00

INTRODUCTION TO ACTUARIAL SCIENCE 2013-14/S1: Tutorial 6 Portfolio & Capital Market Theory
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(iii). The above graph indicates that the optimal portfolio is the tangency portfolio with
expected return approximately 15.6% and standard deviation approximately 16.5%.

(iv). The proportion of the optimal risky portfolio invested in the stock fund is given by:
2
2 2
[ ( ) ] [ ( ) ] ( , )
[ ( ) ] [ ( ) ] [ ( ) ( ) ] ( , )
S f B B f S B
S
S f B B f S S f B f S B
E r r E r r Cov r r
w
E r r E r r E r r E r r Cov r r
o
o o

=
+ +


[(.20 .08) 225] [(.12 .08) 45]
0.4516
[(.20 .08) 225] [(.12 .08) 900] [(.20 .08 .12 .08) 45]

= =
+ +

1 0.4516 0.5484
B
w = =
The mean and standard deviation of the optimal risky portfolio are:
E(r
P
) = (0.4516 .20) + (0.5484 .12) = .1561
= 15.61%

p
= [(0.4516
2
900) + (0.5484
2
225) + (2 0.4516 0.5484 45)]
1/2

= 16.54%


(v). The reward-to-volatility ratio of the optimal CAL is:
( )
.1561 .08
0.4601
.1654
p f
p
E r r
o


= =


(vi). a. If you require that your portfolio yield an expected return of 14%, then you can
find the corresponding standard deviation from the optimal CAL. The equation
for this CAL is:
( )
( ) .08 0.4601
p f
C f C C
P
E r r
E r r o o
o

= + = +
If E(r
C
) is equal to 14%, then the standard deviation of the portfolio is 13.04%.

b. To find the proportion invested in the T-bill fund, remember that the mean of the
complete portfolio (i.e., 14%) is an average of the T-bill rate and the optimal
combination of stocks and bonds (P). Let y be the proportion invested in the
portfolio P. The mean of any portfolio along the optimal CAL is:
( ) (1 ) ( ) [ ( ) ] .08 (.1561 .08)
C f P f P f
E r y r y E r r y E r r y = + = + = +
Setting E(r
C
) = 14% we find: y = 0.7884 and (1 y) = 0.2116 (the proportion
invested in the T-bill fund).
To find the proportions invested in each of the funds, multiply 0.7884 times the
respective proportions of stocks and bonds in the optimal risky portfolio:
Proportion of stocks in complete portfolio = 0.7884 0.4516 = 0.3560
Proportion of bonds in complete portfolio = 0.7884 0.5484 = 0.4324
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(vii). Using only the stock and bond funds to achieve a portfolio expected return of 14%, we
must find the appropriate proportion in the stock fund (w
S
) and the appropriate
proportion in the bond fund (w
B
= 1 w
S
) as follows:
.14 = .20 w
S
+ .12 (1 w
S
) = .12 + .08 w
S
w
S
= 0.25
So the proportions are 25% invested in the stock fund and 75% in the bond fund. The
standard deviation of this portfolio will be:

P
= [(0.25
2
900) + (0.75
2
225) + (2 0.25 0.75 45)]
1/2
= 14.13%
This is considerably greater than the standard deviation of 13.04% achieved using T-
bills and the optimal portfolio.

Q2 BKM 7 Q12
Since Stock A and Stock B are perfectly negatively correlated, a risk-free portfolio can be
created and the rate of return for this portfolio, in equilibrium, will be the risk-free rate.
To find the proportions of this portfolio [with the proportion w
A
invested in Stock A
and w
B
= (1 w
A
) invested in Stock B], set the standard deviation equal to zero. With
perfect negative correlation, the portfolio standard deviation is:

P
= Absolute value [w
A

A
w
B

B
]
0 = 5 w
A
[10 (1 w
A
)] w
A
= 0.6667
The expected rate of return for this risk-free portfolio is:
E(r) = (0.6667 10) + (0.3333 15) = 11.667%
Therefore, the risk-free rate is: 11.667%

Q3 BKM 7Q15.
The probability distribution is:
Probability Rate of Return
0.7 100%
0.3 50%
Mean = [0.7 100%] + [0.3 (-50%)] = 55%
Variance = [0.7 (100 55)
2
] + [0.3 (-50 55)
2
] = 4725
Standard deviation = 4725
1/2
= 68.74%

Q4 BKM 7 Q16

P
= 30 = y = 40 y y = 0.75
E(r
P
) = 12 + 0.75(30 12) = 25.5%

Q5 BKM 8Q6
a. The standard deviation of each individual stock is given by:
2 / 1
i
2 2
M
2
i i
)] e ( [ o + o | = o
Since
A
= 0.8,
B
= 1.2, (e
A
) = 30%, (e
B
) = 40%, and
M
= 22%, we get:

A
= (0.8
2
22
2
+ 30
2
)
1/2
= 34.78%

B
= (1.2
2
22
2
+ 40
2
)
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:
INTRODUCTION TO ACTUARIAL SCIENCE 2013-14/S1: Tutorial 6 Portfolio & Capital Market Theory
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E(r
P
) = w
A
E(r
A
) + w
B
E(r
B
) + w
f


r
f

E(r
P
) = (0.30 13%) + (0.45 18%) + (0.25 8%) = 14%
The beta of a portfolio is similarly a weighted average of the betas of the
individual securities:

P
= w
A

A
+ w
B

B
+ w
f

f

P
= (0.30 0.8) + (0.45 1.2) + (0.25 0.0) = 0.78
The variance of this portfolio is:
) e (
P
2 2
M
2
P
2
P
o + o | = o
where
2
M
2
P
o | is the systematic component and ) e (
P
2
o is the nonsystematic
component. Since the residuals (e
i
) are uncorrelated, the non-systematic variance
is:
2 2 2 2 2 2 2
( ) ( ) ( ) ( )
P A A B B f f
e w e w e w e o o o o = + +
= (0.30
2
30
2
) + (0.45
2
40
2
) + (0.25
2
0) = 405
where
2
(e
A
) and
2
(e
B
) are the firm-specific (nonsystematic) variances of Stocks
A and B, and
2
(e
f
), the nonsystematic variance of T-bills, is zero. The residual
standard deviation of the portfolio is thus:
(e
P
) = (405)
1/2
= 20.12%
The total variance of the portfolio is then:
47 . 699 405 ) 22 78 . 0 (
2 2 2
P
= + = o
The total standard deviation is 26.45%.

Q6 BKM 8Q7
a. The two figures depict the stocks security characteristic lines (SCL). Stock A has
higher firm-specific risk because the deviations of the observations from the SCL are
larger for Stock A than for Stock B. Deviations are measured by the vertical distance of
each observation from the SCL.

b. Beta is the slope of the SCL, which is the measure of systematic risk. The SCL for
Stock B is steeper; hence Stock Bs systematic risk is greater.

c. The R
2
(or squared correlation coefficient) of the SCL is the ratio of the explained
variance of the stocks return to total variance, and the total variance is the sum of the
explained variance plus the unexplained variance (the stocks residual variance):
) (e

R
i
2 2
M
2
i
2
M
2
i 2
+
=
Since the explained variance for Stock B is greater than for Stock A (the explained
variance is
2
M
2
B
o | , which is greater since its beta is higher), and its residual variance
2
( )
B
e o is smaller, its R
2
is higher than Stock As.

d. Alpha is the intercept of the SCL with the expected return axis. Stock A has a small
positive alpha whereas Stock B has a negative alpha; hence, Stock As alpha is larger.

e. The correlation coefficient is simply the square root of R
2
, so Stock Bs correlation with
INTRODUCTION TO ACTUARIAL SCIENCE 2013-14/S1: Tutorial 6 Portfolio & Capital Market Theory
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the market is higher.

Q7 BKM 8Q8

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 > 0.8

c. R
2
measures the fraction of total variance of return explained by the market return.
As R
2
is larger than Bs: 0.576 > 0.436

d. Rewriting the SCL equation in terms of total return (r) rather than excess return
(R):
( )
(1 )
A f M f
A f M
r r r r
r r r
o |
o | |
= +
= + +

The intercept is now equal to:
(1 ) 1% (1 1.2)
f f
r r o | + = +
Since r
f
= 6%, the intercept would be: 1% 6%(1 1.2) 1% 1.2% 0.2% + = =

Q8 BKM 8CFA2
The R
2
of the regression is: 0.70
2
= 0.49
Therefore, 51% of total variance is unexplained by the market; this is nonsystematic risk.

Q9 BKM 9Q3
a. False. = 0 implies E(r) = rf , not zero.
b. False. Investors require a risk premium only for bearing systematic (undiversifiable or
market) risk. Total volatility includes diversifiable risk.
c. False. Your portfolio should be invested 75% in the market portfolio and 25% in T-bills.
Then:

Q10 BKM 9Q20
r
1
= 19%; r
2
= 16%;
1
= 1.5;
2
= 1
a. To determine which investor was a better selector of individual stocks we look at
abnormal return, which is the ex-post alpha; that is, the abnormal return is the
difference between the actual return and that predicted by the SML. Without
information about the parameters of this equation (risk-free rate and market rate of
return) we cannot determine which investor was more accurate.

b. If r
f
= 6% and r
M
= 14%, then (using the notation alpha for the abnormal return):

1
= .19 [.06 + 1.5 (.14 .06)] = .19 .18 = 1%

2
= .16 [.06 + 1 (.14 .06)] = .16 .14 = 2%
Here, the second investor has the larger abnormal return and thus appears to be the
superior stock selector. By making better predictions, the second investor appears
INTRODUCTION TO ACTUARIAL SCIENCE 2013-14/S1: Tutorial 6 Portfolio & Capital Market Theory
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to have tilted his portfolio toward underpriced stocks.

c. If r
f
= 3% and r
M
= 15%, then:

1
= .19 [.03 + 1.5 (.15 .03)] = .19 .21 = 2%

2
= .16 [.03+ 1 (.15 .03)] = .16 .15 = 1%
Here, not only does the second investor appear to be the superior stock selector,
but the first investors predictions appear valueless (or worse).

Q11 BKM 9Q21
a. Since the market portfolio, by definition, has a beta of 1, its expected rate of return is
12%.

b. = 0 means no systematic risk. Hence, the stocks expected rate of return in market
equilibrium is the risk-free rate, 5%.

c. Using the SML, the fair expected rate of return for a stock with = 0.5 is:
( ) 0.05 [( 0.5) (0.12 0.05)] 1.5% E r = + =
The actually expected rate of return, using the expected price and dividend for next year
is:
$41 $3
( ) 1 0.10 10%
$40
E r
+
= = =
Because the actually expected return exceeds the fair return, the stock is underpriced.