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Problem Set 2

This document contains 12 problems related to portfolio risk and return, the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory (APT), and calculating expected returns using factor models. Specifically, it asks the reader to calculate standard deviations and expected returns for various stock portfolios, determine which portfolios are efficient, compute Sharpe ratios, and answer true/false questions about the CAPM and APT. The problems cover key concepts in investments and asset pricing including the efficient frontier, the security market line, factor models, and performance evaluation.

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Omar Srour
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114 views

Problem Set 2

This document contains 12 problems related to portfolio risk and return, the Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory (APT), and calculating expected returns using factor models. Specifically, it asks the reader to calculate standard deviations and expected returns for various stock portfolios, determine which portfolios are efficient, compute Sharpe ratios, and answer true/false questions about the CAPM and APT. The problems cover key concepts in investments and asset pricing including the efficient frontier, the security market line, factor models, and performance evaluation.

Uploaded by

Omar Srour
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Problem set 2

1. Portfolio risk and return. Here are returns and standard deviations for four investments.

Calculate the standard deviations of the following portfolios.

a. 50% in Treasury bills, 50% in stock P.


b. 50% each in Q and R, assuming the shares have
c. perfect positive correlation.
d. perfect negative correlation.
e. no correlation.
f. Plot a figure like Figure 8.3 for Q and R, assuming a correlation coefficient of .5.
g. Stock Q has a lower return than R but a higher standard deviation. Does that mean
that Q's price is too high or that R's price is too low?.

2. Portfolio risk and return. For each of the following pairs of investments, state which would
always be preferred by a rational investor (assuming that these are the only investments
available to the investor):

a. Portfolio A r = 18% σ = 20%


b. Portfolio B r = 14% σ = 20%
c. Portfolio C r = 15% σ = 18%
d. Portfolio D r = 13% σ = 8%
e. Portfolio E r = 14% σ = 16%
f. Portfolio F r = 14% σ = 10%

3. Efficient portfolios. The figure below purports to show the range of attainable
combinations of expected return and standard deviation.

a. Which diagram is incorrectly drawn and why?


b. Which is the efficient set of portfolios?
c. If rf is the rate of interest, mark with an X the optimal stock portfolio.

4. Efficient portfolios.

a. Plot the following risky portfolios on a graph:

b. Five of these portfolios are efficient, and three are not. Which are inefficient ones?
c. Suppose you can also borrow and lend at an interest rate of 12%. Which of the above
portfolios has the highest Sharpe ratio?
d. Suppose you are prepared to tolerate a standard deviation of 25%. What is the
maximum expected return that you can achieve if you cannot borrow or lend?
e. What is your optimal strategy if you can borrow or lend at 12% and are prepared to
tolerate a standard deviation of 25%? What is the maximum expected return that you
can achieve with this risk?

5. CAPM. True or false?

a. The CAPM implies that if you could find an investment with a negative beta, its
expected return would be less than the interest rate.
b. The expected return on an investment with a beta of 2.0 is twice as high as the
expected return on the market.
c. If a stock lies below the security market line, it is undervalued.

6. APT. Consider a three-factor APT model. The factors and associated risk premiums are:

Calculate expected rates of return on the following stocks. The risk-free interest rate is 7%.

a. A stock whose return is uncorrelated with all three factors.


b. A stock with average exposure to each factor (i.e., with b = 1 for each).
c. A pure-play energy stock with high exposure to the energy factor (b = 2) but zero
exposure to the other two factors.
d. An aluminum company stock with average sensitivity to changes in interest rates and
GNP, but negative exposure of b = −1.5 to the energy factor. (The aluminum company is
energy-intensive and suffers when energy prices rise.)
7. True/false. True or false? Explain or qualify as necessary.

a. Investors demand higher expected rates of return on stocks with more variable rates of
return.
b. The CAPM predicts that a security with a beta of 0 will offer a zero expected return.
c. An investor who puts $10,000 in Treasury bills and $20,000 in the market portfolio will
have a beta of 2.0.
d. Investors demand higher expected rates of return from stocks with returns that are highly
exposed to macroeconomic risks.
e. Investors demand higher expected rates of return from stocks with returns that are very
sensitive to fluctuations in the stock market.

8. Portfolio risk and return. Mark Harrywitz proposes to invest in two shares, X and Y. He expects
a return of 12% from X and 8% from Y. The standard deviation of returns is 8% for X and 5% for
Y. The correlation coefficient between the returns is .2.

a. Compute the expected return and standard deviation of the following portfolios:

b. Sketch the set of portfolios composed of X and Y.


c. Suppose that Mr. Harrywitz can also borrow or lend at an interest rate of 5%. Show on
your sketch how this alters his opportunities. Given that he can borrow or lend, what
proportions of the common stock portfolio should be invested in X and Y?

9. Portfolio risk and return. Ebenezer Scrooge has invested 60% of his money in share A and the
remainder in share B. He assesses their prospects as follows:

a. What are the expected return and standard deviation of returns on his portfolio?
b. How would your answer change if the correlation coefficient were 0 or –.5?
c. Is Mr. Scrooge's portfolio better or worse than one invested entirely in share A, or is it not
possible to say?

10. Sharpe ratio. Look back at Problem 2 in Problem Set 1. The risk-free interest rate in each of
these years was as follows:
a. Calculate the average return and standard deviation of returns for Ms. Sauros's portfolio
and for the market. Use these figures to calculate the Sharpe ratio for the portfolio and
the market. On this measure did Ms. Sauros perform better or worse than the market?
b. Now calculate the average return that you could have earned over this period if you had
held a combination of the market and a risk-free loan. Make sure that the combination
has the same beta as Ms. Sauros's portfolio. Would your average return on this portfolio
have been higher or lower?

Explain your results.

11. APT. Some true or false questions about the APT:

a. The APT factors cannot reflect diversifiable risks.


b. The market rate of return cannot be an APT factor.
c. There is no theory that specifically identifies the APT factors.
d. The APT model could be true but not very useful, for example, if the relevant factors
change unpredictably.

12. APT. Consider the following simplified APT model:

Calculate the expected return for the following stocks. Assume rf = 5%.

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