Ec1723, Spring 2025: Problem Set 3

This assignment is due at the beginning of class on Tuesday, 2/25. The assignment will not
be accepted after 1:30pm on Tuesday, 2/25.

Problem 1
The riskless interest rate is 1.5%. You hold a portfolio consisting ofvshort-term safe assets
and the market portfolio of risky assets, which has a mean return of 15% and a standard
deviation of 30%. You are considering an individual stock that you believe to have a beta
of 1.2 with the market portfolio, and a standard deviation of return of 60%.
(a) What is the standard deviation of the idiosyncratic component of the individual
stock’s return (the residual in the market model regression)? What is the correlation of the
individual stock’s return with the market return?
(b) If the CAPM holds, what must be the mean excess return of the stock over the riskfree
rate? What must be the stock’s alpha? What must be its Sharpe ratio? Is the Sharpe ratio
on the stock higher or lower than the Sharpe ratio on the market? Explain.
(c) Suppose that the stock has a higher alpha than the CAPM implies. Explain how to
change its weight in your portfolio in such a way as to increase the mean return on your
portfolio without increasing its variance. (Do this in words, or write down a relevant equation
if you can.)
(d) Now suppose the stock has a lower alpha than the CAPM implies. How does your
answer to part (c) change?
(e) Some people argue that deviations from the CAPM are caused by the irrational
behavior of some investors, together with the inability or reluctance of other investors to
short stocks. According to this view, are you more likely to find stocks with large positive
alphas or large negative alphas? Explain.

Problem 2
(Based on 2011 midterm exam 1.) Consider an economy with three assets. A risk-free asset
has a return of 5%. Asset A has an expected return of 15% with a standard deviation of
20%. Asset B has an expected return of 10% with a standard deviation of 20%. Returns to
A and B are uncorrelated. Market participants can take unlimited long or short positions in
all assets.
(a) What are the Sharpe Ratios of assets A and B?
(b) The market portfolio of risky assets has weights of 75% on asset A and 25% on asset
B. What is the market portfolio’s Sharpe ratio? Based only on the three Sharpe ratios you

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have calculated, can you reject the CAPM?
(c) Now calculate betas and alphas for assets A and B with respect to the 75:25 market
portfolio. Based on these results can you reject the CAPM?
(d) The true tangency portfolio of risky assets has one of the following weights on asset
A: {-25%, 0%, 50%, 66.7%, 75%, 100%, 125%}. Which is it? Defend your answer without
doing any calculations beyond the Sharpe ratios, betas, and alphas you have already com-
puted.[Hint: Show how you can rule out all of the other options. You may find it useful to
consider the global minimum variance portfolio.]
(e) Now, use additional calculations to show that the portfolio you selected is in fact the
tangency portfolio.
(f) Consider introducing an additional asset C with standard deviation of 20% that is
uncorrelated with both asset A and asset B. Will asset C necessarily have a zero alpha with
respect to the tangency portfolio we just calculated?

Problem 3
The returns of assets A and B satisfy the equations:

RA − RF = .05 + .60 × (Rm − Rf ) + A (∗)

In the equations Rm is the return on the market portfolio, Rf is the risk-free rate,
σm = .15, σA = .05, σB = .075. As is usual, A and B have expected value 0, are
uncorrelated with each other, and both are uncorrelated with the return on the market
portfolio. In addition, E(Rm ) = .07, and Rf = .02.
(a) What are the values of αA , αB , βA and βB in the above equations.

(b) Solve for Cov(RA , Rm ) and Cov(RB , Rm ).

(c) Solve for E(RA ) and E(RB ).

(d) Create a portfolio consisting of assets A and B that has a beta of 4 with the market
portfolio. What are the weights in assets A and B? Solve for the variance of the portfolio.

(e) Market neutral hedge funds attempt to create portfolios that have positive alpha, but
no exposure to the market (the position has a market beta = 0). Create a market neutral
portfolio that has positive alpha by combining asset A and the market portfolio. What
are the portfolio weights in asset A and the market? What is the alpha and the standard
deviation of the resulting portfolio ?

(f) There are other ways to create market neutral positions. Create a market-neutral position
that generates no cashflows today, but has expected cashflows αp next year and has standard

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deviation of cashflows σA . Describe your investment strategy in terms of how much you buy
and sell of each asset, how much you borrow risk-free, and any short-positions that you take.1

Problem 4
Let’s re-familiarize ourselves with IRR (Internal Rate of Return). See slide 15 of Lecture 4 if you
need a quick review.

(a) You start a business which requires an initial investment of $1500 at t = 0 and additional
expenses of $600 at t = 1. You get cash flows of $0 at t = 2, $1600 at t = 3 and $3200 at t = 4.

(i) Write the equation solved by the IRR.

(ii) Find the IRR of your project. Note: you can solve this with your favorite numerical
program (e.g. Wolfram, Matlab, etc.)

(iii) Suppose investors are willing to invest in a business with the level of risk of your
business if the expected annual rate of return they can earn is .10 ? Based on this
information, will you able to attract outside investors ?

(b) Suppose that an asset costs $100 to buy and yields the following dividends: $5 at
t = 1, 2, 3, 4 and $105 at t = 5. In the problem t is measured in years.

(i) Write the equation solved by the IRR.

(ii) What is the IRR of your investment ?

(iii) (optional question, more mathematical) Can you see a general pattern in this example,
and could you prove how it generalizes?

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Hint: Think about equation (∗)