Financial Economics Practice problems set # 4 Portfolio Theory CAPM Fall 2013 Problem 1 Consider an economy with two

two risky assets, A and B. The characteristics of these assets are provided below: Asset E(r) ! "A,B A 20% 10% B 25% 20% +1 a) Represent graphically the set of efficient portfolios obtained by combining the two assets. What is the composition of the minimum variance portfolio (MV1)? What are the expected return and standard deviation of return of the minimum variance portfolio? b) Suppose now that short-sales are no longer allowed. In a new graph, represent the set of efficient portfolios. What is the composition of the minimum variance portfolio (MV2) in this case? c) Assume there exists a risk-free asset F with rF = 5%. Short-sales are still not allowed. On the graph of part b) above, represent the new set of efficient portfolios. d) In a new graph, depict how your answer to part c) would change if short-sales are allowed but only up to 30% (that is, you cannot short-sell more than 30% of any asset). What is the composition of the minimum variance portfolio (MV3) in this case? Problem 2 We consider a financial market composed of only 2 risky assets (which are imperfectly correlated) and 1 risk-free asset. Risky asset 1 has a Beta equal to !1=1.2 and an expected return equal to E(r1)=12.2%. Risky asset 2 has a Beta equal to ! 2=0.6 and an expected return equal to E(r2)=8.6%. You will assume in what follows that all the assumptions of the CAPM are satisfied. a) Find the level of the risk-free rate. b) Find the expected return of the market portfolio. c) What are the respective weights of assets 1 and 2 in the tangency portfolio? Problem 3 Assume that the CAPM accurately represents security returns. Your portfolio consists of 50% invested in the risk-free asset and the remaining 50% allocated as follows among four risky securities: Security (i) E(ri) !i xi 1 0.076 0.2 10% 2 0.124 0.8 10% 3 0.156 1.2 10% 4 0.188 1.6 20% a) What is your current portfolios expected return and beta? b) If you wished to earn a 12% expected return on your portfolio, one possibility would be to sell some of your holdings in the risk-free asset and invest the proceeds from that sale in the market portfolio (M). If you decide to rebalance your portfolio this way, what would be your new portfolio weights and your portfolios overall beta? c) Alternatively, you could invest your portfolio only in the market portfolio and the risk-free asset. What would be your portfolio weights to obtain a 12% expected return? d) Which portfolio rebalancing strategy do you prefer?

Problem 4 Consider a market with many risky assets and a risk-free security. Asset returns are not perfectly correlated. All the CAPM assumptions hold and the market is in equilibrium. The risk-free rate is 5%, the expected return on the market is 15%. Mr. T and Mrs. R are two investors with meanvariance utility functions and different risk-aversion coefficients. They both invest into efficient portfolios of market portfolio and risk-free security. a) Mr. Ts portfolio has an expected return of 11%. What are the weights of his efficient portfolio? What is the beta of his portfolio? b) Mrs. Rs portfolio has a beta of 2.0. What are the weights of her efficient portfolio? c) Plot the Security Market Line and place portfolios of Mr. T and Mrs. R on the same graph together with the market portfolio. d) If the market portfolios standard deviation is 30%, represent graphically the Efficient Frontier. Plot the locations of Mr. Ts and Mrs. Rs portfolios on the efficient frontier. e) Find the coefficients of risk aversion for Mr. T. and Mrs. R. Are your results in line with part (c)? f) A particular stock Xs expected return is 25%. What is its beta? If the stock X returns standard deviation is 70%, what is the coefficient of correlation between stock X and the market portfolio?

Financial Economics Practice problems set # 4 Portfolio Theory CAPM Fall 2013 Problem 1
a)

E(r) 25% A B

20%

15%

0%
MV 1 A

10%

20%

"

2 #B ! $ A, B# A# B 0.2 2 ! 1 " 0.1 " 0.2 0.02 = 2 = = = +2 = 200% 2 2 2 # A + # B ! 2 $ A, B# A# B 0.1 + 0.2 ! 2 " 1 " 0.1 " 0.2 0.01

MV 1 min .! var . xB = 1 ! xA = !1 = !100%

E (rMV 1 ) = 2 " E (rA ) ! 1 " E (rB ) = 2 " 0.20 ! 0.25 = 0.15 = 15%

# MV 1 = 0

b)

E(r) 25% MV2=A B

20%

rf = 5%

0%

10%

20%

"

The set of efficient portfolios is simply the line in between A and B. Other risk return combinations require to short-sale either A or B. Hence, they are not feasible when short-sales are forbidden. Obviously A is the minimum variance portfolio in this case. Hence:
MV 2 xA = 1 = 100%

and

MV 2 MV 2 xB = 1 ! xA =0

c) The efficient set is the dotted line + the portion of line in between points A and B (see graphic).

d) The dotted line is the new set of efficient portfolios. The minimum variance portfolio MV3 (which is also the tangency portfolio) is the combination of A and B such that wA = -30% and wB = 130%

E(r)

B 25% 20% A

rf = 5%

10% Problem 2

20%

"

a)-b) The following relations (SML) link the beta of the two stocks, their expected returns, the risk-free return and the expected return on the market portfolio:

The solution of this system yields: RF =5% and E[RM] = 11%. c) The expected return of the market is 11 % = x 12.2 % + (1-x) 8.6 %. Thus the weights of assets 1 and 2 in the market portfolio are x = 2/3 and (1-x) = 1/3 respectively. In the CAPM the market portfolio coincides with the tangency portfolio.

#0.122 = RF + (E[ RM ] % RF ) $ 1,2 " !0.086 = RF + (E[ RM ] % R f )$ 0,6

Problem 3 a) Solve for any two CAPM relationships among securities 1,2,3, and 4 to find E(rM ) and rF :

&" 0.124 = "rF " 0.8( E (rM ) " rF ) & E (r2 ) = rF + ( 2 ( E (rM ) " rF ) &0.124 = rF + 0.8( E (rM ) " rF ) # + 0.188 = + r + 1.6( E (r ) " r ) F M F '% '% % $ E (r4 ) = rF + ( 4 ( E (rM ) " rF ) $ 0.188 = rF + 1.6( E (rM ) " rF ) #0.064 = 0.8( E (r ) " r ) M F $ E (rM ) " rF = 0.08 rF = 0.188 " 1.6( E (rM ) " rF ) = 0.188 " 1.6 ! 0.08 = 0.06 = 6% E (rM ) = 0.08 + 0.06 = 0.14 = 14% E (rP ) = x F rF + x1 E (r1 ) + x 2 E (r2 ) + x3 E (r3 ) + x 4 E (r4 ) E (rP ) = 0.5 ! 0.06 + 0.1 ! 0.076 + 0.1 ! 0.124 + 0.1 ! 0.156 + 0.2 ! 0.188 = 0.1032 = 10.32%

( P = x F ( F + x1 (1 + x 2 ( 2 + x3 ( 3 + x 4 ( 4 ( P = 0.5 ! 0 + 0.1 ! 0.2 + 0.1 ! 0.8 + 0.1 ! 1.2 + 0.2 ! 1.6 = 0.54
b) E (rP ) = x M E (rM ) + (0.5 " x M )rF + x1 E (r1 ) + x 2 E (r2 ) + x3 E (r3 ) + x 4 E (r4 )

12% = x M 14% + (0.5 " x M ) ! 6% + .01 ! 7.6% + 0.1 ! 12.4% + 0.1 ! 15.6% + 0.2 ! 18.8% x M = 0.21 sell 21% out of your 50% T - bills and buy the market portfolio : your expected return would be 12%.

# P = x M # M + (0.5 " x M # F ) + x1 #1 + x 2 # 2 + x3 # 3 + x 4 # 4 # P = 0.21 ! 1.0 + 0.29 ! 0 + 0.1 ! 0.2 + 0.1 ! 0.8 + 0.1 ! 1.2 + 0.2 ! 1.6 = 0.75
c) E (rP ) = xM E (rM ) + (1 " xM )rF xM [ E (rM ) " rF ] = E (rP ) " rF E (rP ) " rF 0.12 " 0.06 xM = = = 0.75 E (rM ) " rF 0.14 " 0.06 .xF = 1 " xM = 0.25 # P = xM # M + (1 " xM # F ) # P = 0.75 !1.0 + 0.25 = 0.75 d) I would prefer strategy (c) as it involves an efficient portfolio. Strategy b) combines the original portfolio with the market portfolio, however nothing guarantees that the initial portfolio is efficient implying that strategy (b) might not lead to an efficient portfolio.

Problem 4 a) E (rT ) = xM E (rM ) + xF rF = xM E (rM ) + (1 ! xM )rF

E (rT ) ! rF = xM ( E (rM ) ! rF ) xM = E (rP ) ! rF 0.11 ! 0.05 = = 0.6 = 60% " xF = 1 ! xM = 0.4 = 40% E (rM ) ! rF 0.15 ! 0.05 E (rP ) ! rF = 0.6 E (rM ) ! rF

E (rP ) = rF + #T ( E (rM ) ! rF ) " #T =

b) E (rR ) = rF + # R ( E (rM ) ! rF ) = 0.05 + 2.0(0.15 ! 0.05) = 0.25 = 25%

xM =

E (rR ) ! rF 0.25 ! 0.05 = = 2.0 = 200% " xF = 1 ! xM = !1.0 = !100% E (rM ) ! rF 0.15 ! 0.05

Mrs. R short - sells 100% of the risk - free security (that is, borrows at the risk - free rate) and invests all the proceeds in the market portfolio.
c) E(r) SML E(rR)=25% E(rM)=15% E(rT)=11% rF=5% 0 !T=0.6 !M=1.0 !R=2.0 !

d)

E(rM)=25%

E(rM)=15% E(rM)=11% rF=5%

"T=18%

"M=30%

"R=60%

"

2 2 2 2 2 2 2 2 2 #T = xT 0.0324 = 0.18 , M # M + xT , F # F + 2 xT , M xT , F # M # F $ MF = xT , M # M = 0.6 " 0.30 = 0.0324 ! # T = 2 2 2 2 2 2 2 2 2 #R = xR 0.3600 = 0.60 , M # M + xR , F # F + 2 xR , M xR , F # M # F $ MF = xR , M # M = 2.0 " 0.30 = 0.3600 ! # R =

e)

xT , M = xR , M =

E (rM ) " rF E (rM ) " rF 0.15 " 0.05 # AT = = = 1.85 2 2 AT $ T xT , M $ M 0.6 ! 0.32 E (rM ) " rF E (rM ) " rF 0.15 " 0.05 # AR = = = 0.55 2 2 A$ R xR , M $ M 2.0 ! 0.32

AR < AM and this makes sense as T is more risk - averse than R. f) E (rX ) # rF 0.25 # 0.05 E (rX ) = rF + % X ( E (rM ) # rF ) " % X = = = 2.0 E (rM ) # rF 0.15 # 0.05

%X =
.

cov X , M

2 M

& X ,M$ X$ M & X ,M$ X % $ 2.0 ! 0.30 = " & X ,M = X M = = +0.86 2 $M $M $X 0.70