University of Applied Sciences Kaiserslautern

Master in Financial Services Management

Portfolio Theory
Problems

1. Case: Humanex

Consider the problem of Humanex, a nonprofit organization deriving more of its income from
the return on its endowment. The firm has invested 50 % of the portfolio in Best Candy, and
has free choice as to where to invest the remainder of its portfolio.
The value of Best Candy stock is sensitive to the price of sugar. In years when the caribbean
sugar crop fails, the price of sugar rises significantly and Best Candy suffers considerable
losses. We can describe the fortunes of Best Candy stock using the following scenario analysis:

Normal year for sugar Abnormal year

Bullish Bearish
Stock Market Stock Market Sugar Crisis
Probability 0,50 0,30 0,20
Rate of return 25 % 10 % - 25 %

1.1 Summarize the three possible outcomes of Best Candy using expected return and
variance/standard deviation.

As was already mentioned, Humanex has 50% of its endowment in Best´s stock. To reduce the
risk of the overall portfolio, it could invest the remainder in T-bills, which yield a sure rate of
return of 5 %.

1.2 Calculate expected return and variance/standard deviation of Humanex, investing 50 % in

Best Candy and the remainder in T-bills.

In an effort to improve the contribution of the endowment to the operating budget, Humanex´s
trustees hire Sally, a recent MBA, as a consultant. Investigating the sugar and candy industry,
Sally discovers, not surprisingly, that during years of sugar crisis in the Caribbean basin,
SugarKane, a big Hawaiian sugar company, reaps unusual profits and its stock price soars. A
scenario analysis of SugarKane´s stock looks like this:

Normal year for sugar Abnormal year

Bullish Bearish
Stock Market Stock Market Sugar Crisis
Probability 0,50 0,30 0,20
Rate of return 1% -5% 35%

1.3. Calculate expected return and variance/standard deviation of SugarKane. ¿Is it a good
investment compared isolated with Best Candy? ¿And for Humanex?

Consider Humanex´s portfolio when it splits its investment evenly between Best and
SugarKane. The rate of return for each scenario is the simple average of the rates on Best and
SugarKane.
Normal year for sugar Abnormal year
Bullish Bearish
Stock Market Stock Market Sugar Crisis
Probability 0,50 0,30 0,20
Rate of return 13% 2,5% 5%

1.4.Calculate expected return and variance/standard deviation of Humanex split evenly

between Best and SugarKane.

Sally now summarizes the reward and risk of the three alternatives:

PORTFOLIO EXPECTED RETURN STANDARD DEVIATION

100%
10,50% 18,90%
in Best Candy
50% en Best and
7,75 9,45
50% in T-bills
50% in Best and
8,25 4,83
50% in SugarKane

To quantify the hedging or diversification potential of an asset, we use the concepts of

covariance and correlation. The covariance measures how much the returns on two risky assets
move in tandem.
To measure covariance, we look at the expected value of the product of each stock´s deviation
from expected return in a particular scenario:

Cov (rBest , rKane) = ∑ Pr (s) [rBest(s) – E(rBest)] [rKane (s) - E(rKane)]

An easier statistic to interpret is the correlation coefficient, which scales the covariance to a
value between -1 (perfect negative correlation) and +1 (perfect positive correlation).

ρ (Best,Kane) = Cov[rBest,rSugarKane] / (σBest.σSugarKane)

Normal year for sugar Abnormal year

Bullish Bearish
Stock Market Stock Market Sugar Crisis
Probability 0,50 0,30 0,20
Candy´s rate of return 25% 10% -25%
SugarKane´s rate of 1% -5% 35%
return
1.5.Calculate the covariance and correlation between Best Candy and SugarKane.
1.6.Calculate the variance of the portfolio applying rule 5.

2. Reconsider the Best and Sugarkane stock market hedging case, but assume that the
probability distribution of the rate of return on SugarKane stock is as follows:

Normal year for sugar Abnormal year

Bullish Bearish
Stock Market Stock Market Sugar Crisis
Probability 0,50 0,30 0,20
Rate of return 7% -5% 20%

2.1 What would be its correlation with Best ?

2.2 Calculate the portfolio rate of return in each scenario and the standard deviation of the
portfolio from the scenario returns.
2.3 Calculate the portfolio standard deviation using rule 5 and show that the result is consistent
with your answer to point 2.2

3. Problem 4 (pag. 183)

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be
either $70,000 or $200,000 with equal probabilities of .5. The alternative risk-free
investment in T-bills pays 6% per year.
a. If you require a risk premium of 8%, how much will you be willing to pay for
the portfolio?
b. Suppose that the portfolio can be purchased for the amount you found in (a).
What will be the expected rate of return on the portfolio?
c. Now suppose that you require a risk premium of 12%. What is the price that
you will be willing to pay?
d. Comparing your answers to (a) and (c), what do you conclude about the
relationship between the required risk premium on a portfolio and the price at
which the portfolio will sell?

4. Problem 5 (pag. 184)

Consider a portfolio that offers an expected rate of return of 12% and a standard deviation of
18%. T-bills offer a risk-free 7% rate of return. What is the maximum level of risk aversion for
which the risky portfolio is still preferred to bills?

5. Problems 13 to 19 (pag. 184 and 185)

Use these inputs for Problems 13 through 19 : You manage a risky portfolio with expected
rate of return of 18% and standard deviation of 28%. The T-bill rate is 8%.
13. Your client chooses to invest 70% of a portfolio in your fund and 30% in a T-bill money
market fund. What is the expected value and standard deviation of the rate of return on
his portfolio?

14. Suppose that your risky portfolio includes the following investments in the given
proportions:

What are the investment proportions of your client's overall portfolio, including the
position in T-bills?

15. What is the reward-to-volatility ratio (S) of your risky portfolio? Your client's?.

16.
Draw the CAL of your portfolio on an expected return–standard deviation diagram.
What is the slope of the CAL? Show the position of your client on your fund's CAL.

17. Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall portfolio will have an expected rate of return of
16%.
a. What is the proportion y?

b. What are your client's investment proportions in your three stocks and the T-bill
fund?

c. What is the standard deviation of the rate of return on your client's portfolio?

18. Suppose that your client prefers to invest in your fund a proportion y that maximizes the
expected return on the complete portfolio subject to the constraint that the complete
portfolio's standard deviation will not exceed 18%.
a. What is the investment proportion, y?

b. What is the expected rate of return on the complete portfolio?

19. Your client's degree of risk aversion is A = 3.5.

a. What proportion, y, of the total investment should be invested in your fund?
b. What is the expected value and standard deviation of the rate of return on your
client's optimized portfolio?

6. Problem 20 (page 185)

Look at the data in Table 6.7 on the average risk premium of the S&P 500 over T-bills, and
the standard deviation of that risk premium. Suppose that the S&P 500 is your risky portfolio.
a. If your risk-aversion coefficient is A = 4 and you believe that the entire 1926–2009 period
is representative of future expected performance, what fraction of your portfolio should
be allocated to T-bills and what fraction to equity?
b. What if you believe that the 1968–1988 period is representative?

c. What do you conclude upon comparing your answers to (a) and (b)?

7. Problem 21 (pag. 185)

Consider the following information about a risky portfolio that you manage, and a risk-free
asset: E(rP) = 11%, σP = 15%, rf = 5%.
a. Your client wants to invest a proportion of her total investment budget in your risky fund
to provide an expected rate of return on her overall or complete portfolio equal to 8%.
What proportion should she invest in the risky portfolio, P, and what proportion in the
risk-free asset?
b. What will be the standard deviation of the rate of return on her portfolio?

c. Another client wants the highest return possible subject to the constraint that you limit his
standard deviation to be no more than 12%. Which client is more risk averse?

8. Problems 4 to 10 (pag. 225 and 226)

The following data apply to Problems 4 through 10: 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 T-bill money market fund that yields a rate of 8%. The
probability distribution of the risky funds is as follows:

The correlation between the fund returns is .10.

4. What are the investment proportions in the minimum-variance portfolio of the two risky
funds, and what is the expected value and standard deviation of its rate of return?
5. Tabulate and draw the investment opportunity set of the two risky funds. Use investment
proportions for the stock fund of zero to 100% in increments of 20%.
6. 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 portfolio?
7. Solve numerically for the proportions of each asset and for the expected return and
standard deviation of the optimal risky portfolio.
8. What is the reward-to-volatility ratio of the best feasible CAL?
9. You require that your portfolio yield an expected return of 14%, and that it be efficient, on
the best feasible CAL.
a. What is the standard deviation of your portfolio?
b. What is the proportion invested in the T-bill fund and each of the two risky funds?
10. If you were to use only the two risky funds, and still require an expected return of 14%,
what would be the investment proportions of your portfolio? Compare its standard
deviation to that of the optimized portfolio in Problem 9. What do you conclude?

9. Problem 12 (pag. 226)

Suppose that there are many stocks in the security market and that the characteristics of stocks
A and B are given as follows:

Suppose that it is possible to borrow at the risk-free rate, rf. What must be the value of the risk-
free rate? (Hint: Think about constructing a risk-free portfolio from stocks A and B.)

10. Concept check 2 (pag. 285)

Data from the last eight decades (see Table 5.3) for the S&P 500 index yield the following
statistics: average excess return, 7.9%; standard deviation, 23.2%.
a. To the extent that these averages approximated investor expectations for the period, what
must have been the average coefficient of risk aversion?
b. If the coefficient of risk aversion were actually 3.5, what risk premium would have been
consistent with the market's historical standard deviation?

11. Concept check 3 (pag. 289)

Suppose that the risk premium on the market portfolio is estimated at 8% with a standard
deviation of 22%. What is the risk premium on a portfolio invested 25% in Toyota and 75% in
Ford, if they have betas of 1.10 and 1.25, respectively?

12. Concept check 4 and 5 (pag. 293)

Stock XYZ has an expected return of 12% and risk of β = 1. Stock ABC has expected return
of 13% and β = 1.5. The market's expected return is 11%, and rf = 5%.
a. According to the CAPM, which stock is a better buy?
b. What is the alpha of each stock? Plot the SML and each stock's risk–return point on one
graph. Show the alphas graphically.
The risk-free rate is 8% and the expected return on the market portfolio is 16%. A firm
considers a project that is expected to have a beta of 1.3.
a. What is the required rate of return on the project?
b. If the expected IRR of the project is 19%, should it be accepted?

13. Problem 1 (page 311)

What must be the beta of a portfolio with E(rP) = 18%, if rf = 6% and E(rM) = 14%?

14. Problem 2 (page 311)

The market price of a security is $50. Its expected rate of return is 14%. The risk-free rate is
6% and the market risk premium is 8.5%. What will be the market price of the security if its
correlation coefficient with the market portfolio doubles (and all other variables remain
unchanged)? Assume that the stock is expected to pay a constant dividend in perpetuity.

15. Problem 3 (page 311)

Are the following true or false? Explain.

a. Stocks with a beta of zero offer an expected rate of return of zero.
b. The CAPM implies that investors require a higher return to hold highly volatile securities.
c. You can construct a portfolio with beta of .75 by investing .75 of the investment budget in
T-bills and the remainder in the market portfolio.

16. Problem 8 (pag. 312)

You are a consultant to a large manufacturing corporation that is considering a project with the
following net after-tax cash flows (in millions of dollars):

The project's beta is 1.8. Assuming that rf = 8% and E(rM) = 16%, what is the net present value of
the project? What is the highest possible beta estimate for the project before its NPV becomes
negative?
17. Problem 9 (pag. 312)

Consider the following table, which gives a security analyst's expected return on two stocks for
two particular market returns:

a. What are the betas of the two stocks?

b. What is the expected rate of return on each stock if the market return is equally likely to
be 5% or 25%?

c. If the T-bill rate is 6% and the market return is equally likely to be 5% or 25%, draw the
SML for this economy.

d. Plot the two securities on the SML graph. What are the alphas of each?

e. What hurdle rate should be used by the management of the aggressive firm for a project
with the risk characteristics of the defensive firm's stock?

18. Problem 18 (pag. 313)

I am buying a firm with an expected perpetual cash flow of $1,000 but am unsure of its risk.
If I think the beta of the firm is .5, when in fact the beta is really 1, how much more will I
offer for the firm than it is truly worth?

19. Problem 6 (pag. 275)

The following are estimates for two stocks.

The market index has a standard deviations of 22% and the risk-free rate is 8%.
a. What are the standard deviations of stocks A and B?
b. Suppose that we were to construct a portfolio with proportions:
Compute the expected return, standard deviation, beta, and nonsystematic standard deviation
of the portfolio.

20. Problem 7 (pag. 276)

Consider the following two regression lines for stocks A and B in the following figure.

a. Which stock has higher firm-specific risk?

b. Which stock has greater systematic (market) risk?
c. Which stock has higher R2?
d. Which stock has higher alpha?
e. Which stock has higher correlation with the market?

21. Problem 8 (pag. 276)

Consider the two (excess return) index model regression results for A and B:
RA = 1% + 1.2RM
R-square = .576
Residual standard deviation = 10.3%
RB = − 2% + .8RM
R-square = .436
Residual standard deviation = 9.1%
a. Which stock has more firm-specific risk?
b. Which has greater market risk?
c. For which stock does market movement explain a greater fraction of return variability?
 d. If rf were constant at 6% and the regression had been run using total rather than excess
returns, what would have been the regression intercept for stock A?

Derivatives

22.Problem 5 (pag 700)

23.Problem 7 (pag 700 y 701)

24.Problem 8 (pag 701)

25.Problem 9 (pag 701)

26.Problem 10 (pag 701)

27.Problem 13 (pag 702)

28.Problem 14 (pag 702)

29.Problem 15 (pag 702)

30.Problem 16 (pag 702)

31.Problem 20

32.Problem 21
33.problem 22 (page 703)

34.problem 24

35.problem 27

36.problem 1 (page 704)

37.Concept check 3 (page 720)

38.Concept check 4 (page 722)

39.problem 6 (pag 746)

40.problem 9 (pag 747)

41.Problem 10 (pag 747)

42.Problem 11 (pag 747. Use excel spreadsheet)

43.Concept check 3 (pag. 768)

44.Concept check 5 (pag. 772)

45.Problem 7 (pag 779)

46.Problem 8 (pag 780)

47.Problem 13 (pag 780)

48.Concept check 1 (pag 788)

49.Concept check 2 (pag 790)

50.Concept check 3 (pag 791)

51.Problem 5 (pag 812)

52.Problem 7 (pag 812)

53.Problem 8 (pag 812)

54.Problem 10 (pag 812)

55.Problem 18 (pag 813)

56.It is march 1. A U.S. company expects to receive 50 million Japanese yen at

the end of july. Yen futures contracts on the CME have delivery months of
April, July, October and December. One contract is for the delivery of 12,5
million yen. The company therefore shorts four July yen futures contracts on
March 1. When the yen are received at the end of july, the company closes out
its position. Suppose that the futures price on March 1 in cents per yen is 0,78
and that the spot price when the contract is closed out is 0,72. ¿What is the
total inflow received by the company with this strategy?.

57.It is June 8 and a company knows that it will need to purchase 20.000 barrels
of crude oil at some time in October or November. Oil futures contracts are
currently traded for delivery in june, September and December on NYMEX,
and the contract size is 1.000 barrels. The company therefore decides to use
the December contract for hedging and takes a long position in 20 december
contracts. The futures price on june 8 is $ 18 per barrel. The company finds
that it is ready to purchase the crude oil on November 10. It therefore closes
out its futures contract on that date. The spot price and futures price on
November 10 are $ 20 per barrel and $ 19,10 per barrel. ¿What is the total
outflow paid by the company with this strategy?

58.Next year a stock will reduce its value to $ 50, starting from a price of $ 100,
or will increase to $ 200. The rf rate is 10% a year.

a) ¿What is the hedge ratio of a 1 year call option with an exercise price of $
100?
b) Use the ratio calculated in a) to value the call

59.Company A’s Stock is selling at $ 90. A 26-weeks call on that stock sells at
$ 8. The exercise price is $ 100. The rf rate is 10% a year.

a) Suppose that puts on stock A don´t trade, but you would like to take a
position like that. ¿How would you do that?
b) Suppose that you could buy a put. ¿What should be the value of a 26-
weeks put with an exercise Price of $ 100?
60.Option´s traders generally refer to "straddles" and "butterflies" strategies. Here
there is an example of each one:
 Straddle: Buy of a call with exercise Price of $ 100 and simultaneously
buy of a put with an exercise Price of $ 100.
 Butterfly: Simultaneously purchase of a call with an exercise prise of $
100, sell of two calls with an exercise Price of $ 110, and buy of a call
with an exercise Price of $ 120

a) Draw the payoff´´s diagram at expiration for both strategies.

b) Each strategy is a bet on variability. Explain the nature of that bet.

61. Suposse a stock with a market price today of $ 80, and at the end of a 6-
months period its price can increase to $ 100 (+25%) or fall to $ 64 (-20%).
Suposse a call option and a put option with exercise price of $ 80, expiring in 6
months. The risk free rate is 2.5 % for six months. Value both options.