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    Investments Problem Set

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    The document discusses ABCO increasing its investment in four business lines by borrowing $8 billion at 5% interest. Tripling the current investment results in the same expected returns as the original investment due to constant returns. The new expected return is lower than the original due to the 5% cost of debt. The returns belong to ABCO's equity investors since it is assumed the debt will be paid.

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    Investments Problem Set

    Uploaded by

    zer0fxz8209
    191 views5 pages
    The document discusses ABCO increasing its investment in four business lines by borrowing $8 billion at 5% interest. Tripling the current investment results in the same expected returns as the original investment due to constant returns. The new expected return is lower than the original due to the 5% cost of debt. The returns belong to ABCO's equity investors since it is assumed the debt will be paid.

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    Problem Set 3 of Investments Graduate Course

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    The document discusses ABCO increasing its investment in four business lines by borrowing $8 billion at 5% interest. Tripling the current investment results in the same expected returns as the original investment due to constant returns. The new expected return is lower than the original due to the 5% cost of debt. The returns belong to ABCO's equity investors since it is assumed the debt will be paid.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    191 views5 pages

    Investments Problem Set

    Uploaded by

    zer0fxz8209
    The document discusses ABCO increasing its investment in four business lines by borrowing $8 billion at 5% interest. Tripling the current investment results in the same expected returns as the original investment due to constant returns. The new expected return is lower than the original due to the 5% cost of debt. The returns belong to ABCO's equity investors since it is assumed the debt will be paid.

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    Investments Problem Set

    GT 4.11) Assume in exercise 4.9 that ABCO decides to borrow $8 billion at 5 percent interest to
    triple its current investment in each of its four lines of businesses. Assume this new investment
    has the same per dollar return outcomes as the old investment.

    a. Answer parts a and b of exercise 4.9 given the new investment.

    Scenarios
    Investment Poor Average Good Same probability Good 2x others
    ENT $1,200 20% -5% -8% 2.33% -0.25%
    CON $800 15% 10% -20% 1.67% -3.75%
    PHA $1,400 -10% -5% 27% 4.00% 9.75%
    INS $600 -10% 10% 10% 3.33% 5.00%

    Assuming that returns remain constant, the expected returns do not change with the $8B
    investment.

    Scenarios
    Investment Weight Poor Average Good Same probability Good 2x others
    ENT $3,600 90% 20% -5% -8% 2.33% -0.25%
    CON $2,400 60% 15% 10% -20% 1.67% -3.75%
    PHA $4,200 105% -10% -5% 27% 4.00% 9.75%
    INS $1,800 45% -10% 10% 10% 3.33% 5.00%
    Debt -$8,000 -200% 5% 5% 5% 5.00% 5.00%
    $4,000 -1.20% 0.01%
    b. How does this result compare with the results from exercise 4.9? Why?
    Scenarios
    Investment Weight Poor Average Good Same probability Good 2x others Variance STDDEVp1 STDDEVp2
    ENT $3,600 90% 20% -5% -8% 2.33% -0.25% 0.11% 12.55% 12.82%
    CON $2,400 60% 15% 10% -20% 1.67% -3.75% 0.05% 15.46% 16.38%
    PHA $4,200 105% -10% -5% 27% 4.00% 9.75% 0.28% 16.39% 17.37%
    INS $1,800 45% -10% 10% 10% 3.33% 5.00% 0.09% 9.43% 9.57%
    Debt -$8,000 -200% 5% 5% 5% 5.00% 5.00% -0.77% 0.00% 0.00%
    $4,000 2.0% -9.3% 3.7% -1.20% 0.013%

    Covariance ENT CON PHA INS Debt


    ENT 1.58% 1.33% -1.40% -1.18% 0.00%
    CON 2.39% -2.53% -0.89% 0.00%
    PHA 2.69% 0.93% 0.00%
    INS 0.89% 0.00%
    Debt 0.00%

    Varp1 0.33%
    Varp2 0.29%

    Expected return is lower due to the 5% cost of debt


    c. To whom does this return belong? Why?

    As it is assumed that debt is paid as part of the portfolio, the returns belong to the equity
    investors in ABCO.

    GT 4.19

    Asset Weight
    Nike 71.4%
    Cisco -14.3%
    GE 42.9%

    GT 5.2

    Compute the tangency portfolio weights assuming a risk-free asset yields 5 percent:

    Asset Weight
    AOL 70%
    MSFT -7%
    INTC 37%

    GT 5.4

    16%
    AOL
    14%

    12% MSFT
    Mean Return

    10% INTC

    8%

    6%

    4%

    2%

    0%
    0.00% 1.00% 2.00% 3.00% 4.00% 5.00%
    Variance

    GT 4.23

    Variance of 3.81%
    GT 5.2

    AOL 50%

    INTC 50%

    Computer Exercise

    Foreign

    Questions

    a) The US has a higher correlation to the rest of the assets than Canada. That is why in the
    MVP portfolio there is a lower weight for the US. In the tangency portfolio, Canada has a
    lower expected return and as such its weight is reduced – the tangency portfolio seeks to
    maximize expected returns.
    b) France has a low correlation to other assets, hence including it in the MVP portfolio helps
    reduce risk.

    Industries
    Covariance Matrix
    Food&Bev. Chemical Oil Manuf. Utilities Retail Financial
    Food&Bev. 0.00207513 0.00177951 0.00107838 0.001829942 0.001203157 0.001996274 0.001671313
    Chemical 0.00177951 0.00218419 0.00127136 0.002105087 0.001073143 0.002050951 0.001695817
    Oil 0.001078378 0.00127136 0.00257772 0.001127848 0.001108776 0.001297223 0.00133272
    Manuf. 0.001829942 0.00210509 0.00112785 0.002968276 0.001012914 0.002450228 0.001776703
    Utilities 0.001203157 0.00107314 0.00110878 0.001012914 0.001518441 0.001215361 0.001274178
    Retail 0.001996274 0.00205095 0.00129722 0.002450228 0.001215361 0.003051619 0.00207412
    Financial 0.001671313 0.00169582 0.00133272 0.001776703 0.001274178 0.00207412 0.002192931

    Inverted Covariance Matrix


    Food&Bev. Chemical Oil Manuf. Utilities Retail Financial MVP Tang.
    Food&Bev. 2274.183897 -1021.7911 188.80566 -11.64758729 -638.604797 -440.0852063 -261.087238 1 0.009891
    Chemical -1021.791146 2526.45317 -308.54908 -865.7623762 130.9757887 -26.0121646 -337.535454 1 0.010069
    Oil 188.8056599 -308.54908 656.426751 72.2420633 -301.603425 -15.73758169 -172.626382 1 0.008336
    Manuf. -11.64758729 -865.76238 72.2420633 1383.807102 112.8211668 -621.3502024 35.45458283 1 0.011922
    Utilities -638.6047975 130.975789 -301.60342 112.8211668 1591.927977 105.2965777 -547.257363 1 0.005112
    Retail -440.0852063 -26.012165 -15.737582 -621.3502024 105.2965777 1534.39496 -643.944241 1 0.013852
    Financial -261.0872376 -337.53545 -172.62638 35.45458283 -547.257363 -643.944241 1919.234078 1 0.01031
    MVP weights Tangent weights
    Food&Bev. 89.77358279 11.96% 1.58785877 32.59%
    Chemical 97.77874056 13.03% -0.731232819 -15.01%
    Oil 118.9580038 15.85% 1.553990493 31.89%
    Manuf. 105.5647494 14.07% 0.602082852 12.36%
    Utilities 453.5559248 60.44% -2.212914543 -45.41%
    Retail -107.4378579 -14.32% 2.999626024 61.56%
    Financial -7.762017383 -1.03% 1.07343667 22.03%
    750.4311261 1 4.872847447 1

    Expected return 0.0119134 Expected return 0.019740124


    Variance 0.00133257 Variance 0.002938759
    Stdev. 0.03650435 Stdev. 0.054210322
    Sharpe ratio 0.17788011 Sharpe ratio 0.264158629

    Recommendation

    Depending on risk aversion, I would suggest to invest in the tangent portfolio so it maximizes
    expected return and sharpe ratio and, depending on the investor risk profile, the tradeoff of
    volatility (variance) is not that much.
    Questions

    Why are the portfolio weights so different under the minimum variance and Tangent
    portfolios?

    Because both portfolios have a different objective, the tangent portfolio tries to maximize
    expected return whereas the MVP portfolio tries to minimize volatility (variance). According to
    portfolio theory there is a positive correlation between risk (variance) and expected return so
    the portfolios are almost inverse one from each other.

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