a. Variance of portfolio =?

Asset Variance Weight

Stock 1 0.16 0.75
Stock 2 0.09 0.25
Market 0.04

Portfolio Variance = 0.103

b. Betas

beta =cov(1,M) / var(M)

β(1,M) = 1.6
β(2,M) = 0.8
β(P,M) = w1* β(1,M) + w2* β(2,M) = 1.4

c. R2 is fraction of variation in returns that can be explained by the market

R2 = β^2 * Var(mkt)/Var(return)

R2 (return 1) = 0.64
R2 (return 2) = 0.2844
R2 (portfolio P) = 0.760

1. Problem 2

Weight β R2 Return
$
Riskless 20,000.00 20%
$
GM 40,000.00 40% 1.1 0.4 10.6%
$
MS 40,000.00 40% 0.8 0.3 8.8%

Correlation (GM, $
MS) 0.30
Rf 4%
Excess return 6%
a. Portfolio expected return = weighted average of expected returns = 8.5600%

b. Variance = beta^2 * variance(mkt) / R2

Variance
GM 12%
MS 9%

Portfolio variance

Portfolio variance = 4.28%;

Portfolio standard deviation = 0.21

c. For tangency/market portfolio portfolio:

Weight GM 0.523

0.477
Weight MS
0.097
Exp return
0.260
Std dev

Weight of market portfolio in efficient portfolio: w = std dev(efficient portfolio) / std dev(market
portfolio) = 0.21/0.097 = 2.13

Weight of risk-free asset = 1-w = -1.13

Expected Return: w*return(market) + (1-w)*return(risk-free) = 21% - 5% = 16%

Therefore, the efficient portfolio containing a riskfree asset and the market portfolio with the same
resultant standard deviation of Uncle Larson’s portfolio is much higher at 16% compared to his
portfolio’s expected return of 8.56%. Hence, I will strongly recommend the Investments 35000 class to
Uncle Larson.
2.
a. Average return and variance:

Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4

Average monthly 1.18 1.20 1.25 1.55

return

Monthly Return 52.78 32.58 23.50 28.39

Variance

beta 0.757494 0.719418 0.776756 0.928527

R2 0.240455 0.321791 0.491468 0.587993

b.

As can be observed from above; the variance of the portfolio decreases with addition of new
stocks to the portfolio. This is expected as diversification results in lower variance of the overall
portfolio unless the stocks in the portfolio track each other perfectly.

The beta which is the relevant measure of risk, is the covariance between the portfolio return
and the return on the market portfolio. The beta for the 4 portfolios does not show any
particular trend with addition of stocks to the portfolio.

c. As can be observed above, the average monthly return increases with an increase in the
number of stocks in the portfolio. This aligns with the expectations since increase in the
number of stocks leads to diversification of idiosyncratic risk and hence increase in expected
return. The diversification can be observed in the decreasing variance of the portfolios as
well, and thus, as variance decreases the average return increases.

The beta however, which measures the covariance between the portfolio return and the
return on the market portfolio does not show any particular pattern. This could be because
of the presence of an alpha while calculating the regression coefficient.
3. True or False
4.