Guiding solution, Finance, tutorial 3

Spring 2018

Ch. 7, problem 2

Answers:

Which of the properties of real estate returns affect portfolio risk?

(a) Standard deviation and (c) Correlation.

After real estate is added to the portfolio, there are four asset classes in the portfolio: stocks, bonds, cash, and real estate. Portfolio variance now includes
a variance term for real estate returns and a covariance term for real estate returns with returns for each of the other three asset classes. Therefore,
portfolio risk is affected by the variance (or standard deviation) of real estate returns and the correlation between real estate returns and returns for each
of the other asset classes. (Note that the correlation between real estate returns and returns for cash is most likely zero.)

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 7, problem 4

Answers:

E(r_S) 20%
E(r_B) 12%
σS 30%
σB 15%
ρ 0,1

From the standard deviations and the correlation coefficient we generate the covariance matrix. This is done by using formula (7.6):

Bonds Stock
Bonds 2,250% 0,450%
Stocks 0,450% 9,000%

The minimum-variance portfolio is computed as follows: (This formula is derived by setting the F.O.C.
(Derived on slide 14 during lecture 7) of the portfolio standard deviation equal to
zero and solving for the weight w_S)

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 Guiding solution, Finance, tutorial 3
Spring 2018

wMin_S 17,39%
wMin_B 82,61%

The minimum variance portfolio mean and standard deviation are:

E(r_Min) 13,39%

σ_Min 13,92%

(Formulas on slide 7-8 in slide deck to lecture 7)

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 7, problem 7

Answers:

The proportion of the optimal risky portfolio invested in the stock fund is given by:

(Derived on slide 20 during lecture 7)

This is done by maximizing the
Sharpe Ratio w.r.t. the weights

The mean and standard deviation of the optimal risky portfolio are:

Here, we use information from problem 4.

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 7, problem 8

Answers:

The Sharp (reward-to-volatility) ratio of the optimal CAL is:

Here, we use information from problem 7 (and problem 4).

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 7, problem 9

Answers 9.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:

(The Sharp ratio we have from problem 8)

If E(r_C) is equal to 14%, then the standard deviation of the portfolio is: 13,04% =(0,14-0,08)/0,4601

Answers 9.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:

Setting E(r_C) equal to 14% we find that:

y= 78,84% =(0,14-0,08)/(0,1561-0,08)
1-y= 21,16%

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 (from 7.7):

- Proportion of stocks in complete portfolio: 35,60% =0,7884*0,4516

- Proportion of bonds in complete portfolio: 43,24% =0,7884*0,5484
- Proportion invested in the T-bill fund (1-y) 21,16%
Check: 100,00%

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 7, problem 12

Answers:

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:

The expression for the portfolio standard deviation is given in equation (7.11)
The weights yielding portfolio standard deviation equal to zero are given in equation (7.12)

w= 66,67%
1-w= 33,33%

The expected rate of return for this risk-free portfolio is: 11,67% This is the risk-free rate.

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 7, problem 17

Answers:

The correct choice is c) - Choose more D.

Intuitively, we note that since all stocks have the same expected rate of return and standard deviation, we choose the stock that will result
in lowest risk. This is the stock that has the lowest correlation with Stock A. (This is Corr(A,D)=0.45)

More formally, we note that when all stocks have the same expected rate of return , the optimal portfolio for any risk-averse investor is the global minimum variance
portfolio (G). When the portfolio is restricted to Stock A and one additional stock, the objective is to find G for any pair that includes Stock A, and then select the combination
with the lowest variance. With two stocks, I and J, the formula for the weights in G is:

Since all standard deviations are equal to 20%:

This intuitive result is an implication of a property of any efficient frontier, namely, that the covariances of the global minimum variance portfolio with all other assets on the frontier are
identical and equal to its own variance. (Otherwise, additional diversification would further reduce the variance.) In this case, the standard deviation of G(I, J) reduces to:

This leads to the intuitive result that the desired addition would be the stock with the lowest correlation with Stock A, which is Stock D. The optimal portfolio is equally
invested in Stock A and Stock D, and the standard deviation is 17.03%.

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 8, problem 4

Answers:

The total risk premium equals α + (β × Market risk premium). We call alpha a nonmarket return premium because it is the portion of the return premium
that is independent of market performance. Alpha is also named the expected excess return of security i when excess return on the market is zero.

The Sharpe ratio indicates that a higher alpha makes a security more desirable. Alpha, the numerator of the Sharpe ratio, is a fixed number that is not affected by the
standard deviation of returns, the denominator of the Sharpe ratio. Hence, an increase in alpha increases the Sharpe ratio. Since the portfolio alpha is the portfolio-
weighted average of the securities’ alphas, then, holding all other parameters fixed, an increase in a security’s alpha results in an increase in the portfolio Sharpe ratio.

We can formulate the model in terms of excess returns:

The Single-Index model can be expressed from the following regression equation:

The expected return is:

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 8, problem 6

Answers 6a:

β_A 0,8 E(r_A) 13%

β_B 1,2 E(r_A) 18%
σ(e_A) 0,3 r_f 8%
σ(e_B) 0,4
σ_M 22%

The standard deviation of each individual stock is given by: Equation (8.3)

σ_A 34,78%

σ_B 47,93%

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 Guiding solution, Finance, tutorial 3
Spring 2018

Answers 6b:

Weight A 30%
Weight B 45%
Weight C 25%

The expected rate of return on a portfolio is the weighted average of the expected returns of the individual securities:

E(r_p) = 14%

The beta of a portfolio is similarly a weighted average of the betas of the individual securities:

Beta_p = 0,78 OBS: We have that Beta_f = 0

The variance of this portfolio is:

where the first term is the systematic component and the second term is the nonsystematic component. Since the residuals are uncorrelated, the nonsystematic variance is:

where σ2(e_A) and σ2(e_B) are the firm-specific (nonsystematic) variances of

Stocks A and B, and σ2(e_f), the nonsystematic variance of T-bills, is zero.
Var(e_p) = 0,0405
Std(e_p) = 20,12% Nonsystematic standard deviation

The total variance of the portfolio is then: 0,78^2*0,22^2 = 0,02944656

Var(r_p) = 0,0699 + 0,0405

Std(r_p) = 26,45% The portfolio standard deviation = 0,0699

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 8, problem 7

Answers 7a.

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.
Answers 7b.

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

Answers 7c.

The R2 (or squared correlation coefficient) of the SCL is the ratio of the explained variance of the stock’s return to total variance, and the total variance is the
sum of the explained variance plus the unexplained variance (the stock’s residual variance):

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Spring 2018

Answers 7d.

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 A’s alpha is larger.

Answers 7e.

The correlation coefficient is simply the square root of R2, so Stock B’s correlation with the market is higher.

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 Guiding solution, Finance, tutorial 3
Spring 2018

Ch. 8, problem 9

Answers:

The standard deviation of each stock can be derived from the following equation for R2. Here, it is given for stock A:

Hence we have:

Var(R_A) = 0,098 =(0,7^2*0,2^2)/0,2

Std(R_A) = 31,30%
Var(R_B) = 0,48 =(1,2^2*0,2^2)/0,12
Std(R_B) = 69,28%

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 Ch. 8, problem 10

Answers:

The systematic risk for A is: 0,0196 =0,7^2*0,2^2

A’s firm-specific risk (residual variance) is: 0,07840 =((0,7^2*0,2^2)/0,2)-0,0196 The firm-specific risk of A/B (the residual variance) is the difference
between A’s/B's total risk and its systematic risk.

The systematic risk for B is: 0,0576 =1,2^2*0,2^2

B’s firm-specific risk (residual variance) is: 0,4224 =(1,2^2*0,2^2)/0,12-0,0576

Information for this problem can be found in problem 9