Chapter7 Practice Questions
Chapter7 Practice Questions
Chapter7 Practice Questions
A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a
long-term bond fund, and the third is a money market fund that provides a safe return of 8%.
The characteristics of the risky funds are as follows:
Expected Return Standard Deviation
Stock fund (S) 23% 28%
Bond fund (B) 15 17
a-2. What are the expected value and standard deviation of its rate of return? (Do not round
intermediate calculations. Enter your answers as decimals rounded to 4 places.)
Explanation:
The parameters of the opportunity set are:
E(rS) = 23%, E(rB) = 15%, σS = 28%, σB = 17%, ρ = 0.12
From the standard deviations and the correlation coefficient we generate the covariance matrix [note
that Cov(rS, rB) = ρ × σS × σB]:
Bonds Stocks
Bonds 289 57.12
Stocks57.12 784
The minimum-variance portfolio is computed as follows:
σB2 − Cov(rS, rB) 289 – 57.12
wMin (S) = 2 = =0.2419
σS + σB2 − 2Cov(rS, rB) 784 + 289 − (2 × 57.12)
wMin (B) =1 − 0.2419 = 0.7581
A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a
long-term bond fund, and the third is a money market fund that provides a safe return of 7%. The
characteristics of the risky funds are as follows:
Expected Return Standard Deviation
Stock fund (S) 22% 32%
Bond fund (B) 12 19
The correlation between the fund returns is 0.11.
Solve numerically for the proportions of each asset and for the expected return and standard
deviation of the optimal risky portfolio. (Do not round intermediate calculations. Enter your
answers as decimals rounded to 4 places.)
Explanation:
The proportion of the optimal risky portfolio invested in the stock fund is given by:
[E(rS) − rf] × σB2 − [E(rB) − rf] × Cov(rS, rB)
ws =
[E(rS) − rf] × σB2 + [E(rB) − rf] × σS2 − [E(rS) − rf + E(rB) − rf] × Cov(rS, rB)
[(0.22 − 0.07) × 361] − [(0.12 − 0.07) × 66.88]
= =0.5524
[(0.22 − 0.07) × 361] + [(0.12 − 0.07) × 1,024] − [(0.22 − 0.07+ 0.12 − 0.07) × 66.88]
wB =1 − 0.5524 = 0.4476
The mean and standard deviation of the optimal risky portfolio are:
E(rP) = (0.5524 × 0.22) + (0.4476 × 0.12)
= 0.1752
σp =[(0.55242 × 1,024) + (0.44762 × 361) + (2 × 0.5524 × 0.4476 × 66.88)]1/2
=0.2044
Question 3
A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a
long-term bond fund, and the third is a money market fund that provides a safe return of 5%. The
characteristics of the risky funds are as follows:
Expected Return Standard Deviation
Stock fund (S) 17% 30%
Bond fund (B) 11 22
The correlation between the fund returns is 0.10.
What is the Sharpe ratio of the best feasible CAL? (Do not round intermediate calculations. Enter
your answer as a decimal rounded to 4 places.)
Explanation:
The proportion of the optimal risky portfolio invested in the stock fund is given by:
[E(rS) − rf] × σB2 − [E(rB) − rf] × Cov(rS,rB)
ws =
[E(rS) − rf] × σB2 + [E(rB) − rf] × σS2 − [E(rS) − rf + E(rB) − rf] × Cov(rS,rB)
[(0.17 − 0.05) × 484.00] − [(0.11 − 0.05) × 66.00]
= =0.5401
[(0.17 − 0.05) × 484.00] + [(0.11 − 0.05) × 900.00] − [(0.17 − 0.05 + 0.11 − 0.05) × 66.00]
wB =1 − 0.5401 = 0.4599
The mean and standard deviation of the optimal risky portfolio are:
E(rP)=(0.5401 × 0.17) + (0.4599 × 0.11)
=0.1424
σp =[(0.54012 × 900) + (0.45992 × 484) + (2 × 0.5401 × 0.4599 × 66)]1/2
=0.1994
The reward-to-volatility ratio of the optimal CAL is:
E(rp) − rf 0.1424 − 0.05
= =0.4634
σp 0.1994
Question 4
A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a
long-term bond fund, and the third is a money market fund that provides a safe return of 7%. The
characteristics of the risky funds are as follows:
Expected Return Standard Deviation
Stock fund (S) 18% 35%
Bond fund (B) 15 20
The correlation between the fund returns is 0.12.
You require that your portfolio yield an expected return of 13%, and that it be efficient, that is, on the
steepest feasible CAL.
a. What is the standard deviation of your portfolio? (Round your answer to 2 decimal places.)
b. What is the proportion invested in the money market fund and each of the two risky
funds? (Round your answers to 2 decimal places.)
Explanation:
The proportion of the optimal risky portfolio invested in the stock fund is given by:
[E(rS) − rf] × σB2 − [E(rB) − rf] × Cov(rS,rB)
ws =
[E(rS) − rf] × σB2 + [E(rB) − rf] × σS2 − [E(rS) − rf + E(rB) − rf] × Cov(rS,rB)
[(0.18 − 0.07) × 400.00] − [(0.15 − 0.07) × 84.00]
= =0.2958
[(0.18 − 0.07) × 400.00] + [(0.15 − 0.07) × 1,225.00] − [(0.18 − 0.07 + 0.15 − 0.07) × 84.00]
wB =1 − 0.2958 = 0.7042
The mean and standard deviation of the optimal risky portfolio are:
E(rP)=(0.2958 × 0.18) + (0.7042 × 0.15) = 0.1589
=15.89%
σp =[(0.29582 × 1,225) + (0.70422 × 400) + (2 × 0.2958 × 0.7042 × 84)]1/2
=18.45%
a.
If you require that your portfolio yield an expected return of 13%, then you can find the
corresponding standard deviation from the optimal CAL. The equation for this CAL is:
E(rp) − rf
E(rc) = rf + σC
σP
0.13 = 0.07 0.1589 – 0.07
σC
+ 0.1845
0.13=0.07 + 0.4817 σC
σC =0.1246 = 12.46%
If E(rC) is equal to 13%, then the standard deviation of the portfolio is 12.46%.
b.
To find the proportion invested in the Money market fund, remember that the mean of the complete
portfolio (i.e., 13%) is an average of the Money market rate and the optimal combination of stocks
and bonds (P). Let y be the proportion invested in the portfolio P. The mean of any portfolio along
the optimal CAL is:
E(rc) = (1 − y) × rf + y × E(rP) = rf + y × [E(rp) − rf] = 7.00 + y × (0.1589 −
0.07)
Setting E(rC) = 13% we find: y = 0.6751 and (1 − y) = 0.3249 (the proportion invested in the Money
market fund).
To find the proportions invested in each of the funds, multiply 0.6751 times the respective
proportions of stocks and bonds in the optimal risky portfolio:
Proportion of stocks in complete portfolio = 0.6751 × 0.2958 = 0.1997
Proportion of bonds in complete portfolio = 0.6751 × 0.7042 = 0.4754
Question 5
Suppose that you have $1 million and the following two opportunities from which to construct a
portfolio:
If you construct a portfolio with a standard deviation of 28%, what is its expected rate of return? (Do
not round your intermediate calculations. Round your answer to 1 decimal place.)
Explanation:
σP = 28 = y × σ = 36 × y => y = 0.7778
E(rP) = 13 + 0.7778(30 − 13) = 26.2%
question 6
Greta has risk aversion of A = 4 when applied to return on wealth over a one-year horizon. She is
pondering two portfolios, the S&P 500 and a hedge fund, as well as a number of 1-year strategies.
(All rates are annual and continuously compounded.) The S&P 500 risk premium is estimated at 7%
per year, with a standard deviation of 18%. The hedge fund risk premium is estimated at 12% with a
standard deviation of 33%. The returns on both of these portfolios in any particular year are
uncorrelated with its own returns in other years. They are also uncorrelated with the returns of the
other portfolio in other years. The hedge fund claims the correlation coefficient between the annual
return on the S&P 500 and the hedge fund return in the same year is zero, but Greta is not fully
convinced by this claim.
a-1. Assuming the correlation between the annual returns on the two portfolios is indeed zero, what
would be the optimal asset allocation? (Do not round intermediate calculations. Enter your
answers as decimals rounded to 4 places.)
a-2. What is the expected risk premium on the portfolio? (Do not round intermediate calculations.
Enter your answer as decimals rounded to 4 places.)
Explanation:
The risk premium for the S&P portfolio is: (1 + 0.07)1 − 1 = 0.07
The risk premium for the hedge fund portfolio is (1 + 0.12)1 − 1 = 0.12
The S&P 1-year standard deviation is:
0.18 × 1–√1 = 0.18.
The hedge fund standard deviation is:
0.33 × 1–√1 = 0.33.
S&P Sharpe ratio is 7.00/18 = 0.3889
The hedge fund Sharpe ratio is 12.00/33.00 = 0.3636.
With a ρ = 0, the optimal asset allocation is
7.00 × 33.002 − 12.00 × (0 × 18.00 × 33.00)
WS&P = =0.6622,
7.00 × 33.00 + 12.00 × 18.002 − [7.00 + 12.00] × (0 × 18.00 × 33.00)
2
wHedge =1 − 0.6622 = 0.3378
Question 7
Greta has risk aversion of A = 4 when applied to return on wealth over a one-year horizon. She is
pondering two portfolios, the S&P 500 and a hedge fund, as well as a number of one-year strategies.
(All rates are annual and continuously compounded.) The S&P 500 risk premium is estimated at 6%
per year, with a standard deviation of 18%. The hedge fund risk premium is estimated at 10% with a
standard deviation of 33%. The returns on both of these portfolios in any particular year are
uncorrelated with its own returns in other years. They are also uncorrelated with the returns of the
other portfolio in other years. The hedge fund claims the correlation coefficient between the annual
return on the S&P 500 and the hedge fund return in the same year is zero, but Greta is not fully
convinced by this claim.
What should be Greta’s capital allocation? (Do not round your intermediate calculations. Round
your answers to 2 decimal places.)
rev: 07_16_2020_QC_CS-220006
Explanation:
With a ρ = 0, the optimal asset allocation is
6.0 × 33.02 − 10.0 × (0 × 18.0 × 33.0)
WS&P = =0.6685
6.0 × 33.0 + 10.0 × 18.02 − (6.0 + 10.0) × (0 × 18.0 × 33.0)
2
wHedge =1 − 0.6685 = 0.3315
With these weights,
E(rp) = 0.6685 × 6.0 + 0.3315 × 10.0 = 0.0733 = 7.33%
The resulting Sharpe ratio is 7.3260/16.2623= 0.4505
Greta has a risk aversion of A = 4, Therefore, she will invest
0.0733
y= =0.6925=69.25
4 × 0.16262
of her wealth in this risky portfolio. The resulting investment composition will be S&P 500: 0.6925 ×
0.6685 = 46.30% and Hedge: 0.6925 × 0.3315 = 22.96%. The remaining 30.74% will be invested in
the risk-free asset.