4 - Problem - Set FRM - PS PDF
4 - Problem - Set FRM - PS PDF
Problem Set 1
Dr Frederic Schweikhard Hilary Term 2015
Dr Zoe Tsesmelidakis
Problem Set 4
Financial Management Financial Analysis
Homework Exercises
Note: Remember to label all important elements in your graphs, particularly the axes,
unambiguously.
I. Efficient Portfolios
Consider the following perfectly positively correlated portfolios and assume there is no
possibility to lend or borrow money.
Portfolio A B C D E F G H
Expected return (%) 10 12.5 15 16 17 18 18 20
Standard deviation (%) 23 21 25 29 29 32 35 45
(b) Some of these portfolios are efficient. Identify the inefficient ones.
Assume investors can now borrow and lend money at a unique rate of 12%.
(d) How does the existence of such a risk-free asset aect the portfolio choice of investors?
(e) Which of the above portfolios has the highest Sharpe ratio?
(f) What is the maximum expected return that the investor in (c) can now achieve?
What proportion of her investment is in risky assets?
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II. Portfolio Frontier, Minimum-Variance and Tangency Portfolios
A pension fund manager is considering three mutual funds. The first is a stock fund, the
second is a long-term government and corporate bond fund, and the third is a Treasury-
bill money market fund that yields a rate of 8%. The probability distribution of the risky
funds is as follows:
Expected return Standard deviation
Stock fund (S) 20% 30%
Bond fund (B) 12% 15%
The correlation between the risky fund returns is 0.1.
(a) What are the investment proportions in the global minimum-variance portfolio of the
two risky funds? Find the minimum by setting the first derivative of the variance
with respect to the weight of one asset equal to zero. Whats the expected value and
standard deviation of the rate of return?
(b) Tabulate and draw the investment opportunity set of the two risky funds. Use in-
vestment proportions for the stock of zero to 100% in increments of 20%.
(c) Draw a tangent from the risk-free rate to the opportunity set. What does your graph
show for the expected return and standard deviation of the optimal risky portfolio?
(d) What are the exact and of the tangency portfolio? Note that the weight for the
first of the two assets is given by (cf. BKM, ch. 7, pg. 236)
[E(rS ) rf ] B2 [E(rB ) rf ] SB
wS = .
[E(rS ) rf ] B2 + [E(rB ) rf ] S2 [E(rS ) + E(rB ) 2rf ] BS
If you want, you can show that this equation holds. To do so, start with the formula
for the Sharpe ratio, plug in all available information including the components of
the portfolio variance and return, and then set the first derivative of the Sharpe ratio
with respect to the weight of one asset equal to zero.
(e) You require that your personal portfolio yield an expected return of 14% and that it
be efficient.
(i) What would be the investment proportions of your portfolio if you could only
invest in the risky funds?
(ii) What would be the investment proportions of your portfolio if you could invest
in all three funds? What do you conclude?
Consider a CAPM-style economy, in which investors form portfolios out of a set of n risky
securities as well as riskless investment F yielding 5%. Suppose one investor chooses the
efficient portfolio P that consists of 40% of F and 60% of the tangency portfolio T . P
has an expected return of 8% and a standard deviation of 10%.
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(a) Illustrate these facts in a - graph.
(b) How do you call the straight line spanned by the points F and P ?
(d) Under which conditions does the tangency portfolio correspond to the so-called mar-
ket portfolio assumed in the CAPM?
(e) Determine the expected return and standard deviation of the market portfolio.
(f) Give the CAPM equilibrium condition prevailing in this market that relates the
market return to individual stock returns. Explain its meaning and make a new
sketch to illustrate this relationship.
(g) Determine the beta of P and the expected return according to the CAPM. What
type(s) of risk is an investor in P exposed to?
Self-Study Exercises
(a) Investors prefer diversified companies because they are less risky.
(b) If stocks were perfectly positively correlated, diversification would not reduce risk.
(d) A stock with less standard deviation always contributes less to portfolio risk than a
stock with a higher standard deviation.
(e) Two perfectly negatively correlated assets allow to replicate the risk-free asset.
(f) The standard deviation of the portfolio is always equal to the weighted average of
the standard deviations of the assets in the portfolio.
(g) Assume that expected returns and standard deviations for all securities (including
the risk-free rate for borrowing and lending) are known. In this case all investors will
have the same optimal risky portfolio.