BEPP SuS8uS, Spiing 2u14

Pioblem Set 1

!"#$%# %'()*+ ,-'. $/%0#.% 1*$ 2$/1$% /- "$+#. +3$/ 45) -/ 6.*7$,8 9:;<=

>'#%+*-/ 9= Consiuei a ianuom vaiiable X with sample space {x
1
, x
2
} anu
piobability uistiibution p(x
1
)=p
1
anu p(x
2
)=p
2
.

a) Wiite uown the foimulas foi E|Xj anu vai(X).

Now consiuei the ianuom vaiiable Y=aX+b, wheie a anu b aie constants. Note that
the new sample space is {y
1
, y
2
} wheie y
1
=ax
1
+b anu y
2
=ax
2
+b, anu the piobability
uistiibution is p(y
1
)=p
1
anu p(y
2
)=p
2
.

b) Show that E|Yj=a E|Xj +b anu vai(Y) = a
2
vai(X). |Note: this iesult will be useful
to you in subsequent pioblemsj


>'#%+*-/ ;= Consiuei an investment oppoitunity that geneiates a piofit (net of all
investment costs) of eithei +! uollai with piobability " oi #! uollai with piobability
$%

a) What aie the mean anu the vaiiance of the piofit fiom the investment.

b) If you invest in & of these piojects, what is the mean anu the vaiiance of the total
piofit. |Bint: 0se the iesults fiom Question 1bj.
c) Suppose that you want to maximize the mean-vaiiance ciiteiion

!!""
#
$
#$%%"&
(in teims of the class sliues, we aie assuming paiameteis a=1, b=V). Wiite uown the
mean-vaiiance ciiteiion as a function of the numbei of piojects &.

u) In how many piojects shoulu you invest if you want to maximize the mean-
vaiiance ciiteiion. |Bint: You may want to use excel to calculate the ciiteiion foi
uiffeient numbeis of piojects N=0,1,2,3,4,5,j.


>'#%+*-/ ?= Let X anu Y be two ianuom vaiiables. Assume that we know the
correlation coefficient between the X and Y is .

a) Wiite uown the foimula foi E|aX+bYj anu vai|aX+bYj, using the expiession of
E[X], E[Y], Var[X], Var[Y] and , where a and b are positive constants.

Now consiuei the compaiison between vai|aX+bYj anu vai|aXj+vai|bYj.

b) If Var[aX+bY] < Var[aX]+Var[bY], what is the range of ?

c) If Var[aX+bY] > Var[aX]+Var[bY], what is the range of ?

u) If vai|aX+bYj = vai|aXj+vai|bYj, what is the iange of ?


>'#%+*-/ <= Consiuei an investment poitfolio that consists of two stocks, ANZN (A)
anu BKS (B). Suppose that the competition foi maiket shaie in the book anu e-
ieauei maiket exceeus the effect of shocks to the book inuustiy as a whole, inuucing
a negative coiielation between the ietuins of these two stocks.

Suppose you have equal amount of capital investeu in ANZN anu BKS (Su% vs Su%)
in youi poitfolio, anu you know that the expecteu ietuins of these two stocks aie:
E|R
A
j=1u%, anu E|R
B
j=8%. You also know that the vaiiance of these two stocks aie:
vai|R
A
j=(1S%)
2
anu vai|R
B
j=(12%)
2
. Last but not least, you know that the
coiielation =-u.2.

a) Wiite uown the expiession foi the ietuin on youi poitfolio.

b) What is the expecteu value foi the ietuin on youi poitfolio.

c) What is the vaiiance of the ietuin of youi poitfolio. |Bint: iefei to the
expiession foi Question S (a)j.

u) Suppose that theie is an exteinal shock to the maiket foi e-ieaueis anu as a
iesult, changes to -u.S. Bow uoes this affect the vaiiance of youi poitfolio.

e) Compaie the poitfolio vaiiance with that vaiiance of each inuiviuual stock in the
poitfolio. Why is the poitfolio vaiiance smallei.