FINS2624 Portfolio

Management
Tutorial 4 Week 5

Problem Set 4
*Q1. Consider the following utility functions, where W
is wealth:
*a. U(W) = W2
*b. U(W) = 1/W
c. U(W) = -W
*d. U(W) = W
*e. U(W) = ln(W)
f. U(W) = W1 /(1 ) with = 2
How likely are each of these functions to represent
actual investor preferences? Why?

Problem Set 4
A. Two important characteristics needed to model utility are
insatiation and risk aversion.
Insatiation refers to investors always preferring more to
less. To model this the utility function must be an increasing
function.
Risk aversion refers to investors preferring certain
outcomes to stochastic ones. To take on more risk investors
need to be compensated for doing so with this
compensation being a risk premium. Risk aversion is
modeled in the utility function by ensuring that the function
is concave.

Problem Set 4
Continued A.

U w ln w
U
w 1 0
w
2U
2

w
0
2
w
U w w1
U
w2 0
w
2U
3

2
w
0
2
w

Problem Set 4
*Q2. Suppose investors have preferences described by
the following utility function with A > 0: U = E(r)
0.5A2. Each investor has to choose between three
portfolios with the following characteristics:
E(rA) = 20%
E(rB) = 12%
E(rC) = 15%

A = 20%
B = 22%
C = 28%

Problem Set 4
*Q2a. Which portfolio would every investor pick and
why?
A. Investors prefer portfolios with lower risk for a given level of
return or higher returns for a given level of risk. That is,
they prefer portfolios that dominate other portfolios.
Given that portfolio A has a higher return and a lower
variance compared to portfolio B and C, it is the desired
portfolio amongst 25all investors, regardless of risk aversion.
20

20

15
Return 10

15
12

5
0
19 20 21 22 23 24 25 26 27 28 29
Standard Deviation

Problem Set 4
*Q2b. What utility would an investor with a risk
aversion parameter, A, of 1 get from the three
portfolios.
A.

U E r 0.5 A 2

U A 0.2 0.5 1 0.2 0.18

2

U B 0.12 0.5 1 0.22 0.0958

2

U C 0.15 0.5 1 0.28 0.1108

2

Problem Set 4
*Q2c. What must be the risk aversion of an investor
that is indifferent between picking portfolio B and
portfolio C?
A.

U B UC

E rB 0.5 A B2 E rC 0.5 A C2

0.12 0.5 A 0.22 0.15 0.5 A 0.28

A2
2

Problem Set 4
*Q3. Consider an investment universe consisting of
three assets with the following characteristics:
E(r1) = 12%
E(r2) = 17%
E(r3) = 7%

1 = 25%
2 = 30%
3 = 20%

1,2 = 0.5
2,3 = 0.35
1,3 = 0.25

Problem Set 4
*Q3a. What is the expected return and standard
deviation of an equally weighted portfolio investing
in all three assets?
A.

rP w1r1 w2 r2 wn rn
PP w12 12 w22 22 wn2 n2 2 w1w2 1,2 1 2 2wn 1wn n,n 1 n 1 n
1
1
1
rP 0.12 0.17 0.07 0.12
3
3
3
2

1
1
1
0.252 0.32 0.2 2
3
3
3
1 1
1 1
2 0.5 0.25 0.3 2 0.35 0.3 0.2
3 3
3 3
1 1
2 0.25 0.25 0.2 0.0372
3 3
P 0.1928
2
P

Problem Set 4
*Q3b. What would the diversification benefit be for an
investor that shifted her investment to the equally
weighted portfolio from an investment consisting
only of asset 1?
A. r1 = 12% 1=25%
rP = 12% P= 19.28%
The diversification benefit by moving to the equally
weighted portfolio is a reduction in standard deviation of
5.72%.

Problem Set 4
*Q3c. If choosing between investing all her capital in
asset 2 or in the equally weighted portfolio, what
would an investor with a risk aversion parameter, A,
of 3 choose?
A.

U E r 0.5 A 2
U 2 0.17 0.5 3 0.32 0.035
U P 0.12 0.5 3 0.19282 0.0642

Problem Set 4
Q3d. What about an investor with a risk aversion
parameter of 1?
A.

U E r 0.5 A 2
U 2 0.17 0.5 1 0.32 0.125
U P 0.12 0.5 1 0.19282 0.1014

Problem Set 4
*Q3e. What is the covariance between the return on
the equally weighted portfolio investing in all three
assets and the return of an equally weighted
portfolio investing only in assets 1 and 3?

1
1
1
A. E rP1 E r1 E r2 E r3
3
3
3
1
1
E rP 2 E r1 E r3
2
2
1
1
1
1
1

Cov rP1 , rP 2 Cov E r1 E r2 E r3 , E r1 E r3

3
3
2
2
3

Problem Set 4
Continued A.
1/3 r1

1/3 r2

1/3 r3

1/2 r1 Cov(1/3 r1, 1/2

r1)
= 1/6Cov(r1,r1)
=1/612

Cov(1/3 r2, 1/2

r1)
= 1/6 Cov(r2,r1)

Cov(1/3 r3, 1/2

r1 )
= 1/6 Cov(r3,r1)

1/2 r3 Cov(1/3 r1, 1/2

r3)
= 1/6 Cov(r1,r3)

Cov(1/3 r2, 1/2

r3)
= 1/6Cov(r2,r3)

Cov(1/3 r3, 1/2

r3 )
= 1/6Cov(r3,r1)
= 1/6 32

1 2
1 32 2Cov r1,r3 Cov r2 ,r1 Cov r2 ,r3
6
1
Cov rP1,rP 2 252 20 2 2 0.25 25 20 0.5 25 30 0.35 30 20 310
6
Cov rP1,rP 2

Problem Set 4
*Q4. Consider investors with preferences represented by the
utility function U = E(r) 0.5A 2.
*a. Draw the indifference curve representing a utility level
of 10% for an investor with a risk aversion parameter of 3
in expected return-standard deviation space.
*b. In the same graph, draw the indifference curve
representing a utility level of 15% for an investor with a
risk aversion parameter of 3.
c. In the same graph, draw the indifference curve
representing a utility level of 10% for an investor with a
risk aversion parameter of 5.

Problem Set 4
A.
Indifference Curves
0.5
0.45
0.4
0.35

Expected Return

0.3

0.25

B
C

0.2
0.15
0.1
0.05
0
0

0.05

0.1

0.15

0.2

0.25

Standard Deviation

0.3

0.35

0.4

Problem Set 4
Q5. Consider the following assets:

The assets are combined into the following

portfolios:
Portfolio P: An equally weighted portfolio consisting
of assets A and B.
Portfolio Q: An equally weighted portfolio consisting
of assets X, Y and Z.

Problem Set 4
Q5a. What are the expected returns of the two
portfolios P and Q?
A.

1
1
E rP 14.71 16.12 15.415%
2
2
1
1
1
E rQ 18.99 24.01 21.17 21.39%
3
3
3

Problem Set 4
Q5b. What is the covariance of the two portfolios P and
Q?
A.
1/2 rA

1/2 rB

1/3 rX

1/3 rY

1/3 rZ

1/6
Cov(rX,rA)
= 1/6
300

1/6
Cov(rY,rA)
= 1/6
300

1/6
Cov(rZ,rA)
= 1/6
175

1/6
1/6
1/6
Cov(rX,rB)
Cov(rY,rB)
Cov(rZ,rB)
1 1
1
1
1
Cov rP ,rQ Cov
rX 1/6
rY rZ = 1/6
= 1/6
rA rB , =
2
2
3
3 280

360
600 3
1
Cov rP ,rQ 300 300 175 360 600 280 335.8333
6