Week 3 Tutorials

Examples:

Question 1

The optimal proportion of the risky asset in the complete portfolio is given by
the equation y* = [E(rP)-rf] /(.01A*Variance of P). For each of the variables on
the right side of the equation, discuss the impact the variable's effect on y* and
why the nature of the relationship makes sense intuitively. Assume the investor
is risk averse.

Answer:
The optimal proportion in y is the one that maximises the investor's utility.
Utility is positively related to the risk premium [E(rP)-rf]. This makes sense
because the more expected return an investor gets, the happier he is. The
variable “A” represents the degree of risk aversion. As risk aversion increases,
“A” increases. This causes y* to decrease because we are dividing by a higher
number. It makes sense that a more risk-averse investor would hold a smaller
proportion of his complete portfolio in the risky asset and a higher proportion in
the risk-free asset. Finally, the standard deviation of the risky portfolio is
inversely related to y*. As P's risk increases, we are again dividing by a larger
number, making y* smaller. This corresponds with the risk-averse investor's
dislike of risk as measured by standard deviation.

This allows the students to explore the nature of the equation that was derived
by maximising the investor's expected utility. You can illustrate an
understanding of the variables that supersedes the application of the equation in
calculating the optimal proportion in P.

Question 2

Discuss the characteristics of indifference curves, and the theoretical value of

these curves in the portfolio building process

Answer:

Indifference curves represent the trade-off between two variables. In portfolio

building, the choice is between risk and return. The investor is indifferent
between all possible portfolios lying on one indifference curve. However,
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indifference curves are contour maps, with all curves parallel to each other. The
curve plotting in the most northwest position is the curve offering the greatest
utility to the investor. However, this most desirable curve may not be attainable
in the market place. The point of tangency between an indifference curve
(representing what is desirable) and the capital allocation line (representing
what is possible). is the optimum portfolio for that investor.

Problem 1

Suppose you can form portfolios by only two risky assets A and B, with the
following characteristics:

E(ra) = 10%, σ (ra) = 30%, E(rb) = 5%, σ (rb) = 40%, ρ(ra,rb) = 20%

a. Find the standard deviation, expected return, and portfolio weights of the
minimum variance portfolio (MVP).
b. Find the portfolio weights (wa, wb) that gives you a portfolio with an
expected return equal to 20 percent.
c. Find the portfolio weights (wa, wb) that gives you an efficient two stock
portfolio with a variance of 9 percent.

Solution a:

 2 (rp )  ( wa a ) 2  ( wb b ) 2  2( wa a )( wb b )  a ,b

 2 (rp )  ( wa (0.30)) 2  ( wb (0.40)) 2  2( wa wb )(0.30)(0.40)(0.20)
 2 (rp )  (0.09) wa 2  (0.16) wb 2  (0.048)( wa wb )
 2 (rp )  (0.09) wa 2  (0.16)(1  wa ) 2  (0.048)( wa (1  wa ))
 2 (rp )  (0.09) wa 2  (0.16)(1  2wa  wa 2 )  (0.048)( wa  wa 2 )
 2 (rp )  (0.202) wa 2  (0.272) wa  0.16
Now we take the derivative of  2 (rp ) with respect to wa and set
it equal to zero.
 2 (rp )
 (0.404) wa  0.272  0
wa
wa  0.67, wa  1  wa  0.33
E (rp )  wa E (ra )  wb E (rb )
E (rp )  (0.67)(10%)  (0.33)(5%)  8.35%
 2 (rp )  (0.202) wa 2  (0.272) wa  0.16
 2 (rp )  (0.202)(0.67) 2  (0.272)(0.67)  0.16  0.0684
 (rp )  26.16%

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Solution b:

E (rp )  wa E (ra )  wb E (rb )

E (rp )  wa E (ra )  (1  wa ) E (rb )
20%  wa (10%)  (1  wa )(5%)
15%  (5%) wa
wa  3, wb  1  wa  1  3  2

Solution c:

 2 (rp )  (0.202) wa 2  (0.272) wa  0.16

0.09  (0.202) wa 2  (0.272) wa  0.16
(0.202) wa 2  (0.272) wa  0.07  0
We will use the quadratic equation formula here:
(0.272)  (0.272) 2  4(0.202)(0.07)
wa1,2 
2(202)
wa1  1, wa2  0.35
For wa1  1  E (rp )  E (ra )  10%
For wa2  0.35  E (rp )  wa E (ra )  (1  wa ) E (rb )
E (rp )  (0.35)(10%)  (0.65)(5%)  6.75%
So the efficient portfolio is wa1  1

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Tutorial Assignment: Write your answer to each problem in the blank
space.

1. Arbor Systems and Gencore stocks both have a volatility (variance) of 40%.
Compute the volatility of a portfolio with 50% invested in each stock if the
correlation between the stocks is (a) = 1, (b) = 0.50, (c) = 0, (d) = −0.50, and
(e) = −1.0.

a. In which cases is the volatility lower than that of the original stocks?

b. Suppose Tex stock has a volatility of 40%, and Mex stock has a volatility of
20%. If Tex and Mex are uncorrelated, what portfolio of the two stocks has
the same volatility as Mex alone?
c. What portfolio of the two stocks has the smallest possible volatility?

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2. Suppose Intel’s stock has an expected return of 26% and a volatility of 50%,
while Coca-Cola’s has an expected return of 6% and volatility of 25%. If
these two stocks were perfectly negatively correlated (i.e., their correlation
coefficient is −1),
a. Calculate the portfolio weights that remove all risk.
b. If there are no arbitrage opportunities, what is the risk-free rate of interest in
this economy?

3. Consider the portfolio in Problem 2. Suppose the correlation between Intel

and Oracle’s stock increases, but nothing else changes. Would the portfolio
be more or less risky with this change?

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4. A hedge fund has created a portfolio using just two stocks. It has shorted
$35,000,000 worth of Oracle stock and has purchased $85,000,000 of Intel
stock. The correlation between Oracle’s and Intel’s returns is 0.65. The
expected returns and standard deviations of the two stocks are given in the
table below:

a. What is the expected return of the hedge fund’s portfolio?

b. What is the standard deviation of the hedge fund’s portfolio?

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5. Using the data in the following table, estimate (a) the average return and
volatility for each stock, (b) the covariance between the stocks, and (c) the
correlation between these two stocks.

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6. You are evaluating two investment alternatives. One is a passive market
portfolio with an expected return of 10% and a standard deviation of 16%.
The other is a fund that is actively managed by your broker. This fund has
an expected return of 15% and a standard deviation of 20%. The risk-free
rate is currently 7%. Answer the questions below based on this information.

a. What is the slope of the Capital Market Line?

b. What is the slope of the Capital Allocation Line offered by your broker's
fund?
c. Draw the CML and the CAL on one graph.
d. What is the maximum fee your broker could charge and still leave you as
well off as if you had invested in the passive market fund? (Assume that the
fee would be a percentage of the investment in the broker's fund, and would
be deducted at the end of the year.)
e. How would it affect the graph if the broker were to charge the full amount of
the fee?

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7. Your client, Bo Regard, holds a complete portfolio that consists of a
portfolio of risky assets (P) and T-Bills. The information below refers to
these assets.

a. What is the expected return on Bo's complete portfolio?

b. What is the standard deviation of Bo's complete portfolio?
c. What is the equation of Bo's Capital Allocation Line?
d. What are the proportions of Stocks A, B, and C, respectively in Bo's
complete portfolio?