Dr Zoe Tsesmelidakis

Problem Set 1
Financial Risk Management

Homework Exercises

Note: Remember to label all important elements in your graphs, particularly the axes,
unambiguously.

I. Efficient Portfolios

Solution: Based on: BMA 10th ed., 8.5

(a) Plot:

(b) The inefficient ones are the ones with a lower return for a given risk or a higher risk
for a given return: A, D, G.

(c) She would pick the efficient portfolio C, so here expected return would be 15%.

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(d) Without the risk-free asset, investors might hold any of the efficient risky portfolios
(or any combination thereof) depending on their risk preference. With the borrowing
and lending opportunity, they hold some combination of the risk-free asset and the
risky asset with the steepest slope (i.e., with the highest Sharpe ratio). The efficient
investment opportunity set is reflected by the straight spanned between the two
assets. The proportions of the two assets in this mix vary in accordance with their
preferences.
rf
(e) F has the highest Sharpe ratio:
=0.1875.

(f) The capital allocation line has the following equation:

T rf
= rf + (the T stands for tangency portfolio)

| {zT }
Sharpe ratio

= 0.12 + 0.1875 0.25 = 16.6875%

Investors proportion of total investment in risky portfolio F:

= wrP + (1 w)rf
= rf + (rP rf )w
0.166875 = 0.12 + 0.06w
w = 25/32 = 0.78125

II. Portfolio Frontier, Minimum-Variance and Tangency Portfolios

Solution: Based on BKM 9th ed., 7.4-7.9

(a) Set the first derivative equal to zero to obtain the weights:

P2 = w2 S2 + (1 w)2 B2 + 2w(1 w)S B SB

P2
= 2wS2 + (1)(2)(1 w)B2 + 2(1 2w)S B SB = 0
w
2 S B SB
w= 2 B2
S + B 2S B SB
w = 17.39% (proportion in the stock fund)

Expected return and standard deviation:

E[rmin ] = 0.1739 0.2 + 0.8261 0.12 = 13.39%

q
min = w2 S2 + (1 w)2 B2 + 2w(1 w)S B SB = 13.92%

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(b) Numbers are obtained by plugging w values into the expected return and standard
deviation formulas:

wStock wBond
0 100% 12.00% 15.00%
20% 80% 13.60% 13.94%
40% 60% 15.20% 15.70%
60% 40% 16.80% 19.53%
80% 20% 18.40% 24.48%
100% 0 20.00% 30.00%

(c) The above graph indicates that the optimal portfolio is the tangency portfolio with
expected return of approximately 15.6% and standard deviation of approximately
16.5%. Results vary with the accuracy of the drawing.
Note that in the above graph, the region of the frontier-of-risky-assets curve below
the minimum variance portfolio is inefficient.

(d)

wS = 0.4516, wB = 0.5484
E[rT ] = 0.4516 0.2 + 0.5484 0.12 = 0.1561

T = 0.45162 0.32 + 0.5484 0.152 + 2 0.4516 0.5484 0.3 0.15 0.1
= 0.1654

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(e) (i) Best personal portfolio yielding E[rP ] = 14% with risky assets only:

E[rP ] = wS E[rS ] + (1 wS )E[rB ]

0.14 = wS 0.2 + (1 wS )0.12
wS = 0.25
P = 14.13%

(ii) Best personal portfolio if there is a risk-free asset:

E[rT ] rf
E[rP ] = rf + P
T
0.1561 0.08
0.14 = 0.08 + P
0.1654
P = 13.04%

Thanks to the risk-free asset, any investor can reach a higher utility since for a
given expected return the risk is smaller. All investors hold a mix between the
tangency portfolio and the risk-free asset, whose proportions in this particular
case are:

= wrT + (1 w)rf
= rf + (rT rf )w
0.14 = 0.08 + (0.1561 0.08)w
w = 78.84% (proportion of the risky asset)
1 w = 21.16% (proportion invested in risk-free asset)

On the fund level, the portfolio consists of:

Risk-free fund: 21.16%

Stock fund: 0.7884 0.4516 = 35.60%
Bond fund: 0.7884 0.5484 = 43.24%%

III. Two-Fund Separation and CAPM

Solution:

(a) Sketch:

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(b) This line is called the Capital Market Line (CML). It is the one capital allocation
line (CAL) that is based on the efficient frontier of all existing risky assets in the
market, i.e, you cannot do any better in terms of efficiency.

(c) (i) Set of feasible portfolios: A large area bounded from above by the CML and
from below by another Capital Allocation Line connecting the risk-free asset and
the worst risky asset available (i.e., the one with the lowest Sharpe ratio).
(ii) Efficient frontier: The portfolios on the CML.
(iii) Global minimum-variance portfolio: 100% investment into the risk-free asset
(of course assuming we only consider efficient portfolios initially, this wasnt
mentioned in the question explicitly and has been revised).
(iv) Tangency portfolio: The one on the CML that touches the efficient frontier of
risky assets.

(d) Tangency portfolio corresponds to market portfolio if investors have homogeneous

beliefs (about distributions of future outcomes), since only then they all hold the
same tangency portfolio. In pure portfolio theory, individuals can have different
expectations about future returns and hence the efficient frontier of risky assets and
the tangency portfolio differ across investors. Yet, the CAPM only holds if all in-
vestors hold the same market portfolio, which is why homogeneous beliefs are also
part of its set of assumptions.

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(e) We have to infer the coordinates of T in - space. The share of T is 0.6, therefore:

P = wrT + (1 w)rf
P = rf + w(T rf )
8% = 5% + 0.6(T 5%)
T = 10%
Obtain T :
T rf
P = rf + P

| {zT }
Sharpe ratio
T rf
T = P
P rf
0.05
T = 0.1 = 16.67% = 1/6
0.03

(f) The CAPM equilibrium condition (and pricing formula) is:

i = 5% + i 5%

This is also the equation for the Security Market Line. It relates the expected return
of a stock to its systematic risk. The CAPM does not just hold for efficient portfolios
(contrary to the CML) but also (and particularly) for individual stocks, as well as
inefficient portfolios.
Intuition: Investors do only need to take beta (systematic risk) into account when
pricing stocks as all idiosyncratic risk is diversified away by holding the market portfo-
lio. In the CAPM world, everybody holds the market portfolio and is thus diversified
in the best possible way!

(g) There are two approaches to calculating the beta of P:

1. Determine beta using the computation rules for covariances (covered in the lec-

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 ture):

cov(rP , rM ) cov(0.6rM + 0.4 0.05, rM ) 0.6cov(rM , rM )

P = = = = 0.6
var(rM ) var(rM ) var(rM )

2. The beta of a portfolio of assets is just the weighted average of the betas of the
individual components. Here this means:

P = wF F + wM M
| {z } | {z }
risk-free asset market portfolio

P = 0.4 0 + 0.6 1 = 0.6

Given beta, the expected return results in straightforward manner as:

P = 5% + P 5% = 8%

An investor who holds P only bears systematic risk since all idiosyncratic risk has
been diversified away (like in the case of all investors in the CAPM world). We know
that he holds the market portfolio since P consists of it.
On the other hand, if he an investor only held one stock and nothing more, he would
bear the total risk (systematic plus idiosyncratic risk) as he would not benefit from
any diversification effect at all.

Self-Study Exercises

IV. True or False

Solution:
(a) False, they can diversify themselves attain their personal optimum more effectively.
(b) True.
(c) False, there usually is a non-diversifiable part.
(d) False, correlation matters too, e.g., a stock which is negatively correlated with the
stocks in the portfolio but a higher std. dev. than another stock with a higher
correlation would be more effective at reducing portfolio risk.
(e) True.
(f) False, this only holds if the portfolio assets have perfect positive correlation among
one another.
(g) True, provided that all assumptions underlying the Tobin Separation Theorem are
satisfied.