FINM7008 Applied Investments

Workshop 2 Solutions

Problem 1.

a. In class, we discussed FOUR different types of secondary market: direct search, bro-
kered, dealer, and auction markets. Define each of these markets. (4 Marks)

c. Shares in Atlanta Ltd currently sell for $45 per share. The table below shows the
anticipated stock price and the dividend to be paid one year from now, given various
states of the economy:

State Probability p(s) Year-end Price Annual Dividend

1 0.1 $72 $5
2 0.2 $67 $3
3 0.4 $55 $2
4 0.2 $45 $2
5 0.1 $32 $0

i. Calculate the holding period return (HPR) for each of the possible states, as-
suming a one-year holding period. (2 marks)
ii. Calculate the expected return on Atlanta Ltd stock. (2 marks)
iii. Calculate the standard deviation of the returns. (1 mark)

Solution:

a. Definitions are as follows:

1. Direct search markets: Buyers and sellers have to find each other themselves;
2. Brokered market: Brokers search out buyers and sellers on the behalf of those
parties. They do not hold inventory of the asset being traded, and only act as
an intermediary;
3. Dealer markets: Dealers have inventories of assets from which they buy and
sell; and,
4. Auction markets: Traders converge either physically or electronically to trade
in one place.

1
 State Probability p(si ) Year-end Price Annual Dividend HPR
1 0.1 $72 $5 0.71111
2 0.2 $67 $3 0.55556
3 0.4 $55 $2 0.26667
4 0.2 $45 $2 0.04444
5 0.1 $32 $0 -0.28889

c. i. HPR is calculated as
Year-end Pricei − Current Price + Dividendi
HPRi = .
Current Price
The calculated HPRs are shown in the above table.
ii. Expected return is calculated as

X
5
Expected Return = HPRi × p(si )
i=1

The calculated expected return is 0.268889.

iii. Standard deviation is calculated as
v
u 5
uX
Standard Deviation = t (p(si ) × (HPRi − Expected Return)2 )
i=1

The calculated standard deviation is 0.07718.

Problem 2. Asset A has an expected return of 18%, Asset B has an expected return of
10%, and the rate of return on T-bills is 7%. The covariance matrix for the two risky assets
is as follows:

Asset A B
A 0.16 0.009
B 0.009 0.04

a. Calculate the expected return and standard deviation of a portfolio consisting of 20%
T-bills, 35% Asset A, and 45% Asset B. (5 Marks)

b. A colleague has provided the following table containing the expected returns and
standard deviations at various weightings of a two-asset risky portfolio containing
Assets A and B:

i. Using calculations, identify which of the above six portfolios presents the high-
est risk-adjusted performance. (2 Marks)

2
 Weighting in A % Weighting in B % Expected Return % Standard Deviation %
100 0 18 40
80 20 16.4 32.69
60 40 14.8 26.14
40 60 13.2 21.05
20 80 11.6 18.68
0 100 10 20.00

ii. Draw a portfolio frontier spanning the two assets, and the capital allocation
line. Ensure you appropriately label your axes, and identify the location of the
minimum variance, and optimal risky portfolios. (3 Marks)

Solution: The covariance matrix implies the following

1 1
σA = (0.16) 2 = 0.4, σB = (0.04) 2 = 0.2

And the information in the question implies that the correlation coefficient between the
two assets is 0.1125.
Cov(A, B) 0.09
ρAB = = = 0.1125
σA σB 0.4 × 0.2
a. The expected return is

E(rp) = 0.35 × 0.18 + 0.45 × 0.1 + 0.2 × 0.07 = 0.122

We compute the standard deviation in two steps
• First, we calculate σp given the two risky assets only. The proportions for assets
A and B are
0.35 0.45
ωAr = = 0.4375, ωBr = = 0.5625
0.35 + 0.45 0.35 + 0.45
The standard deviation for portfolio with only A and B is
1
σpAB = ((ωAr )2 σA2 + (ωBr )2 σB2 + 2ωAr ωBr ρAB σA σB ) 2 = 0.2184

• Second, including the risk-free asset, the standard deviation is

σc = (ωA + ωB ) × σpAB = 0.8 × 0.2184 = 0.1747

b. i. This requires calculating Sharpe ratios, and identifying the weighting combina-
tion which is the highest. The Sharpe ratio is calculated as
Excess Return
Sharpe Ratio =
Standard Deviation of Excess Return
From the above table, the portfolio with 60% A and 40% B has the highest
Sharpe ratio.

3
Weighting in A % Weighting in B % Expected Return % Standard Deviation % Sharpe Ratio
100 0 18 40 0.275
80 20 16.4 32.69 0.2875
60 40 14.8 26.14 0.2984
40 60 13.2 21.05 0.2945
20 80 11.6 18.68 0.2463
0 100 10 20.00 0.15

ii.
E(r) 20
CAL
bc
18 (40, 18)
bc
(32.69, 16.4)
16
ORP bc
ut (26.14, 14.8)
14 bc
(21.05, 13.2)
12 bc
(18.68, 11.6)
10
MVP bc
(20, 10)
8
(0, 7)
6

0
0 5 10 15 20 25 30 35 40 σ 45