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Exercise 6

The document contains exercises related to investment science, focusing on concepts such as the capital market line, uncorrelated assets, and zero-beta assets. It includes calculations for expected returns, standard deviations, and portfolio allocations based on given market conditions. Additionally, it discusses the relationship between various portfolios and the application of CAPM pricing formulas.

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9 views1 page

Exercise 6

The document contains exercises related to investment science, focusing on concepts such as the capital market line, uncorrelated assets, and zero-beta assets. It includes calculations for expected returns, standard deviations, and portfolio allocations based on given market conditions. Additionally, it discusses the relationship between various portfolios and the application of CAPM pricing formulas.

Uploaded by

oara.ciencias
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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MS-E2114 Investment science

Leevi Olander, Jaakko Wallenius Exercise 5

6.1 (L7.1) (Capital market line) Assume that the expected rate of return on the market portfolio is 23% and
the rate of return on T-bills (the risk-free rate) is 7%. The standard deviation of the market is 32%.
Assume that the market portfolio is efficient.
a) What is the equation of the capital market line?
b) (i) If an expected return of 39% is desired, what is the standard deviation of this position? (ii) If you
have 1 000 e to invest, how should you allocate it to achieve the above position?
c) If you invest 300 e in the risk-free asset and 700 e in the market portfolio, how much money should you
expect to have at the end of the year?

6.2 (L7.5) (Uncorrelated assets) Suppose there are n mutually uncorrelated assets. The return on asset i has
variance σi2 . The expectedP
rates of return are unspecified at this point. The total amount of asset i in the
market is Xi . We let T = ni=1 Xi and then set xi = Xi /T , for i = 1, 2, . . . , n. Hence the market portfolio
in normalized form is x = (x1 , x2 , x3 , . . . , xn ). Assume there is a risk-free asset with rate of return rf . Find
an expression for βi = Cov[ri , rM ]/Var[rM ] in terms of the xi ’s and σi ’s.

6.3 (L7.7) (Zero-beta assets) Let w0 be the portfolio (weights) of risky assets corresponding the minimum-
variance point in the feasible region. Let w1 be any other portfolio on the efficient frontier. Define r0 , r1 ,
σ02 and σ12 to be the corresponding returns and variances of the returns.
a) There is a formula of the form σ01 = Aσ02 . Find A. (Hint: Consider portfolios p = (1−α)w0 +αw1 , and
consider small variations of the variance of such portofolios near α = 0. Note that dVar[rp ]/ dα |α=0 = 0,
because w0 is the minimum variance point.)
b) Corresponding to the portfolio w1 there is a portfolio wz on the minimum-variance set that has zero
beta with respect to w1 ; that is, σ1z = 0. This portfolio can be expressed as wz = (1 − α)w0 + αw1 . Find
the proper value of α.
c) Show the relation of the three portfolios on a diagram that includes the feasible region.
d) If there is no risk-free asset, it can be shown that other assets can be priced according to the formula

r̄i − r̄z = βiM (r̄M − r̄z ),

where the subscript M denotes the market portfolio and r̄z is the expected rate of return of the portfolio
that has zero beta with the market portfolio. Suppose that the expected returns on the market and the
zero-beta portfolio are 15% and 9%, respectively. Suppose that stock i has a correlation with the market
of 0.5. Assume also that the standard deviation of the returns of the market and stock i are 15% and 5%,
respectively. Find the expected return of stock i.

6.4 (L7.9) Show that for a fund with return r = (1 − α)rf + αrM , both CAPM pricing formulas (pricing form of
the CAPM and certainty equivalent pricing formula) give the price of 100 e worth of fund assets as 100 e.

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