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Homework 2

Uploaded by

siddev12344321
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© © All Rights Reserved
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Homework 2

Please solve all the questions mentioned for each chapter.

Chapter 5 :

Question 1: You have $5000 to invest for the next year and are considering 03
choices:

a. A money market fund with an average maturity of 30 days offering a current


yield of 3% per year.
b. A 1-year savings deposit at a bank offering an interest rate of 4%.
c. A 20-year U.S treasury bond offering a yield to maturity of 5% per year.

Question 2: You are considering the choice between investing $5000 in a


conventional 1-year bank CD offering an interest rate of 5% and a 1-year
‘’inflation-plus’’ CD offering 1.5% per year plus the rate of inflation.

a. Which is the safer investment?


b. Can you tell which offers the highest expected return?
c. If you expect the rate of inflation to be 3% over the next year, which is
the better investment? Why?
d. If we have a risk-free nominal interest rate of 5% per year and a risk-free
real rate of 1.5% on inflation-indexed bonds, what can we infer about the
market’s expectation of the inflation rate?

Question 3: Derive the probability distribution of the 1-year HPR on a 30-year


U.S treasury bond with an 8% coupon if it is currently selling at par and the
probability distribution of its yield to maturity a year from now is as follows:

State of the economy Probability YTM


Boom 0.2 11.0%
National Growth 0.5 8
Recession 0.3 7

For simplicity, assume the entire 8% coupon is paid at the end of the year rather
than every 6 months.

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Chapter 6:

Question 1: Which of the following choices best completes the following


statement? Explain.

An investor with a higher degree of risk aversion, compared to one with a lower
degree, will demand investment portfolios

a. With higher risk premiums.


b. That are riskier (with higher standard deviations).
c. With lower Sharpe ratio.
d. With lower trading costs.

Question 2: Consider the following information about a risky portfolio that you
manage and a risk-free asset:

E ¿ ¿.

a. Your client wants to invest a proportion of her total investment budget in


your risky fund to provide an expected rate of return on her overall and
complete portfolio equal to 5%. What proportion should she invest in the
risky portfolio, P, and what proportion in the risk-free asset?
b. What will be the standard deviation of the rate of return on her portfolio?
c. Another client wants the highest return possible subject to the constraint that
you limit his standard standard to be no more than 12%, which client is more
risk averse?

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Chapter 7:

Question 1: When adding real estate to an asset allocation program that currently
includes only stocks, bonds, and cash, which of the properties of real estate returns
most affects portfolio risk? Explain.
a. Standard Deviation.
b. Expected return.
c. Covariance with returns of the other asset classes.

Question 2: Suppose that there are many stocks in the security market and that the
characteristics of stocks A and B are given:
Stock Expected Return Standard Deviation
A 10% 5%
B 15 10
Correlation = -1

Suppose that it is possible to borrow at the risk-free rate, R f . What must be the
value of the value of the risk-free rate? (Hint: think about constructing a risk-free
portfolio from stocks A and B).

Chapter 8:

Question 1: Consider 02 (excess return) index model regression results for A and
B:
R A =1 %+1.2 R M

R-squared= .576
Residual Standard deviation = 10.3%
R B=−2 % +.8 R M

R-squared= .436

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Residual Standard deviation = 9.1%
a. Which stack has more for specific risk?

b. Which has greater market risk?

c. For which stock does market movement explain a greater fraction of return
variability?

d. If R f were constant at 6% and the regression had been run using total rather
than excess returns, what would have been the regression intercept for stock
A?

Question 2: A portfolio manager summarises the input from the macro and micro
forecasters in the table below:
Micro Forecasts
Residual Standard Deviation
Asset Expected Return (%) Beta (%)
Stock
A 20 1.3 58
Stock
B 18 1.8 71
Stock
C 17 0.7 60
Stock
D 12 1 55

Macro Forecasts
Asset Expected Return (%) Standard Deviation (%)
T-Bills 8 0
Passive equity portfolio 16 23

a. Calculate expected excess returns, alpha values and residual variances for
these stocks.
b. Construct the optimal risky portfolio.
c. What is the Sharpe ratio for the optimal portfolio?

4
d. By how much did the position in the active portfolio improve the Sharpe
ratio compared to a purely passive index strategy?
e. What should be the exact make-up of the complete portfolio (including the
risk-free asset for an investor with a coefficient of risk aversion of 2.8?

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