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Week 7 Tutorial Solution

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Week 7 Tutorial Solution

Uploaded by

Saiful Amri
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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BEAM047

Week 7 Tutorial
Portfolio Theory
Question 1
An economy has three states (booming, normal, recession) and three assets
(A, B, and C). The payoffs of these assets in different states of the economy
are summarized in the table below:
State of the Return Return Return
economy on A on B on C Prob.
Recession 1.00% -3.00% -1.00% p1
Normal 1.00% 5.00% 3.00% 1 – p1 – p2
Booming 1.00% 12.00% 9.00% p2

a. What is the risk-free rate in this economy?


b. Return on Asset C has an expected value of 3% and variance of 0.0012.
Calculate the probability that each state occurs.
c. Your portfolio consists of assets A and B only. The standard deviation of
your portfolio return is 0.02. What is the expected return of your
portfolio?
Question 1 Solution
a. Asset A is the risk-free asset because its return is the same in all
states. Thus, the risk-free rate is 1%.

b. Following the definitions, we have

After simplifications, we get

Solve the system of equations, we get p1 = 0.3, p2 = 0.2.


Thus, the probability for recession, normal, and booming is 30%, 50%,
and 20% respectively.
Question 1 Solution (Cont’d)
c.
Asset B’s expected return = 0.3×(-0.03) + 0.5×0.05 + 0.2× 0.12 = 4%
Asset B’s return variance
= 0.3 × (-0.03 – 0.04)2 + 0.50 × (0.05 – 0.04)2 + 0.2 × (0.12 – 0.04)2
= 0.0028
sB = 0.0028^0.5 = 0.0529

Let w be the weight for B and (1–w) be the weight for A


Since A is risk-free, the S.D. of my portfolio is sp = wsB (from lecture notes)
Given sp = 0.02 and sB =0.0529, we obtain w = 0.3781
Thus, the expected return of my portfolio is
E(rP) = 0.3781×0.04 + (1–0.3781)×0.01= 2.13%
Question 2
Stock A has an expected return of 10% and a standard deviation
of 0.05. Stock B has an expected return of 15% and a standard
deviation of 0.1. The correlation coefficient between the returns
of these two stocks is -1. There are many other securities in this
market, including a risk-free asset that investor can buy or short
sell. What must be the value of the risk-free rate in this market?
Question 2 Solution
Since A and B have a correlation coefficient of -1, we can invest in both of
them to replicate the risk-free asset.
Let w be the weight for stock A. We want to create a portfolio with zero risk.
sp2 = 0.052 × w2 + 0.12 × (1 – w)2 + 2 × w × 0.05 × 0.1 × (1 – w) × (-1) = 0
After some simplification, we get ( 15w – 10 )2 = 0
Thus, w = 2/3
The expected return of this portfolio is
E( rp ) = (2/3) × 10% + (1/3) × 15% = 11.67%
Question 3
Consider a market with only two assets A and B. Both A and B
have the same expected return of 10%, and the standard
deviation of return on both assets is 0.2. The correlation
coefficient of returns on A and B is 0.3.
a. Characterize the minimum variance portfolio (MVP). That is,
calculate its expected return and standard deviation of
return.
b. Plot the portfolio frontier when short sales are allowed. Label
as many relevant numbers as you can in the graph.
c. Plot the portfolio frontier when short sales are not allowed.
Question 3 Solution
(a) Let w be the weight for A and (1 – w) be the weight for B.
E(rp) = w × E(rA) + (1 – w) × E(rB) = w × 10% + (1 – w) × 10% = 10%
That is, w does not affect the expected portfolio return.
The portfolio frontier is a horizontal line at 10%.

sp2 = 0.22 × w2 + 0.22 × (1 – w)2 + 2 × 0.2 × 0.2 × w × (1 – w) × 0.3


= 0.056w2 – 0.056w + 0.04
= 0.056(w – 0.5) 2 + 0.026
Thus, the minimum variance portfolio can be constructed using w=0.5 and
has a standard deviation of . Its expected return is 10%.
(Alternatively, you can use calculus to find the minimum or use the formula
given in the lecture notes.)
Question 3 Solution (Cont’d)
(b) E(r)

0≤𝑤≤1 or

MVP A, B
10% Portfolio frontier

w = 0.5 w = 0 or 1

s
0.1612 0.2
Question 3 Solution (Cont’d)
(c) E(r)

MVP A, B
10% Portfolio frontier (range limited
due to short sale restriction)

s
0.1612 0.2

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