Tutorial Solutions

As part of efforts to provide feedback on your learning progress, I provide an indicative difficulty level
of questions, measured as the passing rate (e.g., easy questions have higher passing rates). This is based
on the students’ performance in the previous years. For example, a level “B” multiple choice question
means about 70% students passed this question; a level “B” problem solving question means on average
students got about 70% of total marks. You can use it to assess your performance.
Keep in mind that questions in the Problem Set are highly selective, so the Problem Set on average is
more difficult than the final exam paper.

Difficulty level Passing rate Indicator

Easy >80% A
Moderate 60 – 80% B
Difficult 40 – 60% C
Very difficult 25 – 40% D
Extremely difficult <25% E

1. The slope of CAL _________.

A. is the Sharpe ratio
B. measures the return of an asset
C. measures the risk of an asset
D. equals the risk premium of an asset
Difficulty level: A

Answer: (A)

2. Your investment has a 20% chance of earning a 30% rate of return, a 50% chance of earning a
10% rate of return and a 30% chance of losing 6%. What is your expected return on this
investment?
A. 12.8%
B. 11.0%
C. 8.9%
D. 9.2%
Difficulty level: A

Answer: (D)

(0.2)(30%) + (0.5)(10%) + (0.3)(-6%) = 9.2%

3. Your investment has a 40% chance of earning a 15% rate of return, a 50% chance of earning a
10% rate of return and a 10% chance of losing 3%. What is the standard deviation of this
investment?
A. 5.14%
B. 7.59%
C. 9.29%
D. 8.43%
Difficulty level: A
Answer: (A)

4. If you are promised a nominal return of 12% on a one-year investment, and you expect the rate
of inflation to be 3%, what real rate do you expect to earn (using the exact Fisher equation)?
A. 5.48%
B. 8.74%
C. 9.00%
D. 12.00%
Difficulty level: B

Answer: (B)

Do not use the approximation here as the rates are quite large.

5. An investor invests 70% of her wealth in a risky asset with an expected rate of return of 15%
and a variance of 5% and she puts 30% in a Treasury bill that pays 5%. What are her portfolio's
expected rate of return and standard deviation respectively?
Difficulty level: B

6. You invest $10,000 in a complete portfolio. The complete portfolio is composed of a risky asset
with an expected rate of return of 15% and a standard deviation of 21% and a treasury bill with a
rate of return of 5%. How much money should be invested in the risky asset to form a portfolio
with an expected return of 11%?
Difficulty level: B

7. You have $1,000 available to invest. The risk-free rate as well as your borrowing rate is 2%.
The expected return on the risky portfolio is 8%. If you wish to earn an expected return of 11%
return, should you lend or borrow the risk-free asset? If so, how much to borrow or lend?

Difficulty level: C
x: investment weight in the risky portfolio
1-x: investment weight in the risk-free asset

Your expected return = 11% = x*8%+(1-x)*2%, so x = 1.5.

Therefore, you need to invest $1,000*1.5 = $1,500 in the risky portfolio and borrow $1,500 –
1000 = $500 in the risk-free asset.

8. You have a risky portfolio P that comprises 60% of stock X and 40% of stock Y. You are
given E(rx)=14%, E(ry)=10% and rf =5%. To form a complete portfolio with an expected rate of
return of 8%, you should invest approximately __________ in the risky portfolio. This will mean
you will also invest approximately __________ and __________ of your complete portfolio in
security X and Y respectively.
Difficulty level: C

9. Consider a treasury bill with a rate of return of 5% and the following risky securities:
Security A: E(r) = .15; variance = .0400
Security B: E(r) = .10; variance = .0225
Security C: E(r) = .12; variance = .1000
Security D: E(r) = .13; variance = .0625
The investor must develop a complete portfolio by combining the risk-free asset with one of the
securities mentioned above. The security the investor should choose as part of his complete
portfolio to achieve the best CAL would be _________.
A. security A
B. security B
C. security C
D. security D
Difficulty level: C

Answer: (A)
A has the steepest slope; found as:

10. A Treasury bill pays a 6% rate of return. The market portfolio pays 15% with a probability of 20%
or 3.875% with a probability of 80%. What percent of wealth would a risk-neutral investor allocate to
the market portfolio? Explain.
 Difficulty level: C
Answer:

Expected return of the market portfolio:

E(r) = 0.2*0.15 + 0.8*0.03875 = 0.061 or 6.1%

The expected return exceeds the risk free rate. A risk-neutral investor only focuses on expected returns,
and is indifferent to risk. They invest 100% in the market portfolio.

11. Suppose there are only two assets available in the market. A well-diversified market portfolio has
an expected return of 8% per year, together with a standard deviation of 16% per year. Another asset is
the risk-free asset. However, the risk-free lending rate and borrowing rate are different. Assume the risk-
free lending rate is 2% per year while the risk-free borrowing rate is 3% per year. Risk averse investors
use these two assets to construct their complete portfolios.

(a) Suppose an investor has a risk aversion level of 3, describe her complete portfolio.
(b) Illustrate the capital allocation line.
(c) Suppose another investor has a risk aversion level of 1.5, describe her complete portfolio.

Difficulty level: E

Answer:
. .
(a) She invests 𝑦 =0.78125 in the market portfolio and 0.2175 in the
∗ . ∗ .
risk free asset. Note to use the lending rate of 2% here. (Try and error, if you are not sure
which rate to be used.)
(b)

Expected 
return 
CAL 

0.08 

CALB 

CALL 
0.03 
0.02 

std 
0.16 
 . .
(c) She invests 𝑦 =1.302 in the market portfolio and short sells -0.302
. ∗ . ∗ .
in the risk-free asset. Note to use the borrowing rate of 3% here.

Textbook Question Part 1:

CFA 7   

Difficulty level: B
  E(rX) = [0.2  (–0.20)] + (0.5  0.18) + (0.3  0.50) = 0.20 or 20% 

  E(rY) = [0.2  (–0.15)] + (0.5  0.20) + (0.3  0.10) = 0.10 or 10% 

CFA 8   

Difficulty level: B
 

X2 = [0.2  (–0.20 – 0.20)2] + [0.5  (0.18 – 0.20)2] + [0.3  (0.50 – 0.20)2] = 0.0592 

X = 0.2433 = 24.33% 

Y2 = [0.2  (–0.15 – 0.10)2] + [0.5  (0.20 – 0.10)2] + [0.3  (0.10 – 0.10)2] = 0.0175 

Y = 0.1323 = 13.23% 
CFA 9   

Difficulty level: B
E(r) = (0.9  0.20) + (0.1  0.10) = 0.19 or 19% 

Textbook Question Part 2:

12.   
Difficulty level: C
 
a. Allocating 70% of the capital in the risky portfolio P, and 30% in risk‐free asset, the client 
has an expected return on the complete portfolio calculated by adding up the expected 
 return of the risky proportion (y) and the expected return of the proportion (1 ‐ y) of the 
risk‐free investment: 
  E(rC) = y  E(rP) + (1 – y)  rf 

                                      = (0.7  0.17) + (0.3  0.07) = 0.14 or 14% per year 

The standard deviation of the portfolio equals the standard deviation of the risky fund 
times the fraction of the complete portfolio invested in the risky fund:     

C = y P = 0.7  0.27 = 0.189 or 18.9% per year 

b. The investment proportions of the client’s overall portfolio can be calculated by the 
proportion of risky portfolio in the complete portfolio times the proportion allocated in 
each stock.   
 

  Investment 
Security Proportions 

T‐Bills    30.0% 
Stock A  0.7  27% =  18.9% 

Stock B  0.7  33% =  23.1% 

Stock C  0.7  40% =  28.0% 

c. We calculate the reward‐to‐variability ratio (Sharpe ratio) using Equation 5.14. 

For the risky portfolio: 

Portfolio Risk Premium
S =    
Standard Deviation of Portfolio Excess Return

E(rP) － rf 0.17 － 0.07
=    =  = 0.3704 
P 0.27

For the client’s overall portfolio: 

E(rC) － rf 0.14 － 0.07
S =    =    = 0.3704 
C 0.189
 
 E(r)

% CAL( slope=.3704)
P
17

14
client


18.9 27 %
 

13.   
Difficulty level: C
a.   E(rC) = y  E(rP) + (1 – y)  rf 

                      = y  0.17 + (1 – y)  0.07 = 0.15 or 15% per year 

0.15 － 0.07
  Solving for y, we get y =    = 0.8 
0.10

Therefore, in order to achieve an expected rate of return of 15%, the client must invest 
80% of total funds in the risky portfolio and 20% in T‐bills. 

b. The investment proportions of the client’s overall portfolio can be calculated by the 
proportion of risky asset in the whole portfolio times the proportion allocated in each 
stock.   
 

  Investment 
Security Proportions 

T‐Bills    20.0% 
Stock A  0.8  27% =  21.6% 

Stock B  0.8  33% =  26.4% 

Stock C  0.8  40% =  32.0% 

     

c. The standard deviation of the complete portfolio is the standard deviation of the risky 
portfolio times the fraction of the portfolio invested in the risky asset:   
C = y P = 0.8  0.27 = 0.216 or 21.6% per year 
14. 
Difficulty level: C
 
a. Standard deviation of the complete portfolio = C = y  0.27 
  If the client wants the standard deviation to be equal or less than 20%, then: 

  y = (0.20/0.27) = 0.7407 = 74.07%   
He should invest, at most, 74.07% in the risky fund. 

b. E(rC) = rf + y  [E(rP) – rf] = 0.07 + 0.7407  0.10 = 0.1441 or 14.41%