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Homework 1

This document contains homework problems related to portfolio optimization and asset pricing models. It includes questions about risk premiums, expected returns, standard deviations, and Sharpe ratios for risky and risk-free assets. It also involves calculating portfolio expected returns and standard deviations given different asset allocations and investor risk preferences.

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31 views3 pages

Homework 1

This document contains homework problems related to portfolio optimization and asset pricing models. It includes questions about risk premiums, expected returns, standard deviations, and Sharpe ratios for risky and risk-free assets. It also involves calculating portfolio expected returns and standard deviations given different asset allocations and investor risk preferences.

Uploaded by

wrt.ojt
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Homework 1

Due 4/1

1. You are considering two alternative 2-year investments: You can invest in a risky
asset with a positive risk premium and returns in each of the 2 years that will be
identically distributed and uncorrelated, or you can invest in the risky asset for only 1
year and then invest the proceeds in a risk-free asset. Which of the following statements
about the first investment alternative (compared with the second) are true?
a. Its 2-year risk premium is the same as the second alternative.
b. The standard deviation of its 2-year return is the same.
c. Its annualized standard deviation is lower.
d. Its Sharpe ratio is higher.
e. It is relatively more attractive to investors who have lower degrees of risk aversion.

2. Visit Professor Kenneth French’s data library website:


http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html and
download the monthly returns of “6 portfolios formed on size and book-to-market
(2*3).” Choose the value-weighted series for the period from 1/1928–12/2012 (1,020
months). Split the sample in half and compute the average, SD, skew, and kurtosis for
each of the six portfolios for the two halves. Do the six split-halves statistics suggest to
you that returns come from the same distribution over the entire period?

3. Given $100,000 to invest, what is the expected risk premium in dollars of investing
in equities versus risk-free T-bills (U.S. Treasury bills) based on the following table?
Action Probability Expected return
Invest in equities 0.6 $50,000
0.4 -$20,000
Invest in risk-free T-bill 1 $8000

4. Which of the following statements are true? Explain.


a. A lower allocation to the risky portfolio reduces the Sharpe (reward-to-volatility)
ratio.
b. The higher the borrowing rate, the lower the Sharpe ratios of levered portfolios.
c. With a fixed risk-free rate, doubling the expected return and standard deviation of the
risky portfolio will double the Sharpe ratio.
d. Holding constant the risk premium of the risky portfolio, a higher risk-free rate will
increase the Sharpe ratio of investments with a positive allocation to the risky asset.

5. Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will
be either $50,000 or $100,000 with equal probabilities of 0.5. 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 11%. 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?

6. Consider a portfolio that offers an expected rate of return of 12% and a standard
deviation of 15%. T-bills offer a risk-free 6% rate of return. What is the maximum level
of risk aversion for which the risky portfolio is still preferred to bills?

Use these inputs for Problems 7 through 13: You manage a risky portfolio with
expected rate of return of 15% and standard deviation of 20%. The T-bill rate is 7%
7. 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?

8. Suppose that your risky portfolio includes the following investments in the given
proportions:
Stock A 20%
Stock B 35%
Stock C 45%
What are the investment proportions of your client’s overall portfolio, including the
position in T-bills?

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

10. 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.

11. 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 11%.
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?

12. 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 15%.
a. What is the investment proportion, y ?
b. What is the expected rate of return on the complete portfolio?

13. Your client’s degree of risk aversion is A=2.5.


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?

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