Solutions to Assignment 2 Chapter 7 7.

You can do this graphically and see that the E(r) and Std dev are 0.1937 and 0.2457 respectively. Aside: once you see that the expected return is 0.1937, you can use the following equation to solve for the proportions invested in S and B at the point of tangency (portfolio O). (You need to know the proportions in one of the following questions) Exp ret = (ws)(E(rs)0 + (wb)(E(rb)) 0.1937 = (ws)(0.22) + (1-ws)(0.13) solving for ws: ws = 0.7075 and wb = 0.2925 Alternatively, you can solve for the weights attached to stocks and bonds at poit of tangency using the following (look at footnote 3 of the chapter) wb = (E(rb)-rf)2s - (E(rs)-rf)bsbs (E(rb)-rf)2s + (E(rs)-rf)2b - (E(rs)-rf+E(rb)-rf)bsbs

Again the solution is 29.25% invested in bonds and 70.75% invested in stocks. Then can use these weights to solve for the expected return and standard deviation of the portfolio (using the standard formula) 8. 9. Slope of the line = (Exp return risk free rate)/std dev = (0.1937-0.09)/0.2457 = 0.422 Want to combine the risk free asset and the risky portfolio O for form and investment that returns 15%. Need to solve for the weights in each: risk free asset and portfolio O. Do this by using the expected return on a portfolio equation. 0.15 = (x)(risk free rate) + (1-x)(expected return on O) 0.15 = x(0.09) + (1-x)(0.1937) so x = 0.4214 and 1-x = 0.5786 Standard deviation of this investment = (0.5786)(0.2457) = 0.1422 Proportions invested in: Risk free asset = 42.14 % Stock fund = (0.5786)(0.7075) = 0.4094 Bond fund = (0.5786)(0.2925) = 0.1693 10. Suppose we want the 15% rate of return using only the risky assets:

Again, solve for the weights using the standard expected return equation 0.15 = (prop in S)(0.22) + (1-prop in S)(0.13) so proportion invested in S is 0.2222 and proportion invested in B is 0.7778. Standard deviation of this portfolio (22.22% invested in S and 77.78% in B) is 0.2022 (using the standard equation for variance of a 2 asset portfolio) 11. a. No one would hold gold in isolation since you could improve returns and lower risk by holding stocks instead. However, there may be benefits to holding gold in a portfolio as long as correlation is less than +1. Try drawing the efficient frontier and see which combinations give the best reward to risk ratio once the risk-free rate is introduced. b. If the correlation is +1, the combination of the risk-free asset and Stock will dominate all other combinations so no one will hold gold even in a portfolio. 12. Using the formula to solve for the weights in a minimum variance portfolio, the proportion invested in A should be 60% and the proportion invested in B should be 40% to achieve the lowest variance. Expected return with these proportions in A and B is 0.1 = 10%. In equilibrium, this rate should approach the risk-free rate of return since both investments have zero variance. 13. f borrowing and lending rates are equal, everyone will end up with the same optimal risky portfolio. However, if borrowing rates are higher than lending rates, highly risk averse investors (those who are unlikely to borrow to invest in the risky asset) and highly risk tolerant investors will have different optimal risky portfolios since the Rf (the starting point on the vertical axis) will be different for the two sets of investors. 17. Exp return on S = 0.12; beta = 1.2 and expected return on m = 0.1 0.12 = 0+1.2(0.1) i.e. intercept term must be zero. So if the expected return on m is revised to 0.08, Expected return on S = 0+1.2(0.08) = 0.096 18. For a diversified portfolio, the second is riskier since it has a higher market risk (beta) and in a diversified portfolio, the firm specific risk is not important. For an undiversified portfolio, first is riskier since it appears to have a higher overall risk.

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a. Likely to increase risk due to reduction in diversification. b. Depends on the components. Could eliminate related stocks like stocks in similar industry. Difficult to get a diversified portfolio with just 10 stocks.

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