1

Solution Set 1

1. (4 points)
a i). Indifference curve of a risk averse investor is upward sloping because for a
investment that has a higher risk ( higher variance ), the investor have to be
compensated by a higher expected return to remain equally confident/happy

ii) For a risk neutral investor, risk does not matter, a two investments with
different risk but with the same expected return are equally attractive to him.

iii) For this risk loving guy, the more risk the better. He is willing to accept lower
expected return for a higher risk (this guy is difficult to find, as we saw the
experiment in class)
2. (5 points)
a) (1 point) In order to determine which portfolio the investor with risk aversion of
A=4 will prefer, we have to calculate the utility that the investor receives from
each portfolio.
Utility from Portfolio A =U(Portfolio A) =E(r
A
) -.005Ao
A
2

=6%-.005(4)(7%)
2
=5.02 utils
Utility from Portfolio B =U(Portfolio B) =E(r
B
) -.005Ao
B
2

=10%-.005*(4)(17%)
2
=4.22 utils

Note: utility is measured in utils. An investor will prefer the portfolio that gives him
or her the highest level of utility.
Since, U(Porfolio A) > U(Portfolio B) Investor prefers Portfolio A

b) (1 point) We repeat this exercise for the investor with a risk aversion level of
A=2.
Utility from Portfolio A =U(Portfolio A) =E(r
A
) -.005Ao
A
2

=6%-.005(2)(7%)
2
=5.51 utils
Utility from Portfolio B =U(Portfolio B) =E(r
B
) -.005Ao
B
2

=10%-.005*(2)(17%)
2
= 7.11utils
Again, since, U(Porfolio B) > U(Portfolio A) Investor prefers Portfolio B

c) (2 points) The certainty equivalent rate is the risk free rate that makes the
investor indifferent between the risky portfolio and the risk-free security.
Basically we are trying to answer the following question: what rate can a risk free
portfolio offer to make it equally as attractive as the risky portfolio?

If an investor is indifferent between two securities or two portfolios it MUST be
the case that these securities give the investor the same level of utility. The
certainty equivalent rate for portfolio A is the risk free rate which gives the
investor the same level of utility as he or she receives from portfolio A.
U(risk-free security) =U(Portfolio A)


2

Case of Investor with risk aversion of A=4
Portfolio A: We know from part a) that for this investor U(Portfolio A) =5.02
U(risk-free security) =5.02
We have a formula for the utility from the risk-free security. Lets plug this in
r
f
-.005Ao
rf
2
=5.02
However, since the security is risk-free, by definition the standard deviation
equals zero (o
rf
2
=0). So the second term in our utility equation disappears.
r
f
=5.02 certainty equivalent rate on Portfolio A

r
f
is our certainty equivalent rate. The investor is indifferent between risky
portfolio A and a risk-free portfolio that offers 5.02% with certainty (no risk).

Portfolio B:
U(risk-free security) =4.22
r
f
-.005Ao
f
2
=4.22
r
f
=4.22 certainty equivalent rate on Portfolio B

Case of Investor with risk aversion of A=2
Portfolio A:
We repeat the above exercise for the less risk averse investor
U(risk-free security) =5.51
r
f
-.005Ao
f
2
=5.51
r
f
=5.51 certainty equivalent rate on Portfolio A

Portfolio B:
U(risk-free security) =7.11
r
f
-.005Ao
f
2
=7.11
r
f
= 7.11 certainty equivalent rate on Portfolio B

Note, that the certainty equivalent rates for both risky portfolios are HIGHER for
the A=2 investor than for the A=4 investor. This is because the A=2 investor is
LESS risk averse than the A=4 investor (higher values of A mean higher levels of
risk aversion). The A=2 investor is more willing to take a gamble than the A=4
investor and therefore requires a higher certain rate to dissuade him/her from
taking the gamble of the risky portfolio.

d) (1 point) Now that we have the certainty equivalent rates it is simple to calculate
the risk premia of both portfolios. The risk premium is the additional return
above the certainty equivalent rate that investors demand to compensate them for
risk.
Risk premium =Expected Return Certainty Equivalent Rate





3
A=4
RiskpremiumonPortfolioA=6%5.02%=0.98%
Risk premium on Portfolio B = 10%-4.22% = 5.78%

A=2
RiskpremiumonPortfolioA=6%5.51%=0.49%
Risk premium on Portfolio B = 10%-7.11% = 2.89%

The risk premia on both portfolios are lower for the less risk averse investor (A=2), which is what we
expect. The less risk averse investor demands lower compensation for risk.


3. (4 points)
a. (2 points) To calculate the covariance we first need to calculate the expected
returns and variances for Airline stock and Oil Co. stock.
Airline
E(R
A
) =.4*(25%) +.4*(5%) +.2*(-20%) =8%
Var
A
=.4*[25%-8%]
2
+.4*[5%-8%]
2
+.2*[-20%-8%]
2
=276%
o
A
=16.6%

Oil Co
E(R
OC
) =.4*(8%) +.4*(-3%) +.2*(24%) =6.8%
Var
OC
=.4*[8%-6.8%]
2
+.4*[-3%-6.8%]
2
+.2*[24%-6.8%]
2
=98.16%
o
OC
=9.91%

Now, use these to calculate the covariance between the two stocks.

= )] ( )][ ( [ * ) Pr( ) , ( var

S
state
S BC
state
BC OC A
R E R R E R state R R iance Co
%] 8 . 6 % 24 %][ 8 % 20 [ * 2 .
%] 8 . 6 % 3 %][ 8 % 5 [ * 4 . %] 8 . 6 % 8 %][ 8 % 25 [ * 4 . ) , (
+
+ =
OC A
R R Cov

Cov(R
A
,R
OC
) =-76.4%

To find the correlation coefficient we scale the covariance by the standard deviations
of both stocks:
) 91 . 9 ( * ) 6 . 16 (
4 . 76 ) , (
) , (

= =
OC A
OC A
OC A
R R Cov
R R Corr
o o
= -.46
The two stocks are negatively correlated.

b. (2 points)


4
The Expected Return on the portfolio that is comprised of 50% Airline stock and
50% Oil Co. stock is:
) ( * ) ( * ) (
OC OC A A Portfolio
R E w R E w R E + =
E(R
Portfolio
) =.5* E(R
A
) +.5* E(R
OC
) =7.4%

The Variance of the portfolio is:
) , ( 2
2 2 2 2
OC A OC A OC OC A A Portfolio
R R Cov w w w w VAR + + = o o
) 4 . 76 ( * 5 . 0 * 5 . 0 * 2 16 . 98 * 5 . 0 276 * 5 . 0
2 2
+ + =
Portfolio
VAR =55.34%
Portfolio
o =7.44%

4. (4 points) The expected return on the risky portfolio is 19% and the standard deviation is
25%. The T-bill rate is 5.3%.
a. (2 points) In this problem, y, the amount of the total portfolio in the risky
portfolio, equals 55%. To calculate the expected return on this portfolio we use
the following rule:

f k p
r y R E y R E * ) 1 ( ) ( * ) ( + =
where E(R
k
) is the expected return on the risky portfolio and r
f
is the risk free
rate.
% 3 . 5 * 45 . % 19 * 55 . ) ( + =
p
R E = 12.84%
To find the standard deviation of this portfolio, we use the following rule:
k p
y o o * = , where
k
o is the standard deviation on the risky portfolio
% 25 * 55 . =
k
= 13.75%

b. (1 point) Now construct a Capital Allocation line for a portfolio of these two
securities (T-bills and the risky portfolio).



p
o
E(r
p
)
CAL
% 3 . 5 =
f
r
% 19 ) ( =
K
r E
% 25 =
K

c. (1 point)


5
The slope of the CAL =
io skyPortfol StdDevOfRi
o kyPortfoli emiumOnRis Risk
r R E
k
f k
Pr
) (
=

o

Slope =
25
7 . 13
% 25
% 3 . 5 % 19
=

= 0.548
This is our reward to risk ratio. It says that on the CAL, for a 10% increase in
standard deviation, the risk premium on the portfolio, or the compensation for
risk, increases by 5.48%.

5. (5 points)
a. (2 points) In class we plugged ) (
p
R E and
p
o into the utility function for a risk-
averse investor,
2
005 . ) ( ) (
p p
A R E Portfolio Utility o = , and found the y that
maximized this investors utility by taking a first derivative of utility with respect
to y and setting it equal to zero. By doing this we found the following equation
for y*, the optimal weight in the risky portfolio:
olio RiskyPortf VarianceOf A
o kyPortfoli emiumOnRis Risk
A
r R E
y
k
f k
* * 01 .
Pr
01 .
) (
*
2
=

=
o

2
25 * 3 * 01 .
3 . 5 19
*

= y = 73.07%

This combination represents the point in the CAL diagram where the investors
utility function is tangent to the CAL.

) (
p
r E
p
o
I C (investor) CAL
% 3 . 5 =
f
r
% 19
% 25 =
K

18.3%
15.3%

b. (2 points)
3 . 5 * ) 7307 . 1 ( 19 * 7307 . ) ( + =
p
R E =15.3%
25 * 7307 . =
p
= 18.3%
c. (1 point)
2
25 * 6 * 01 .
3 . 5 19
*

= y = 36.53%



6
This y* is lower than in part a) because this investor is more risk-averse than the
investor in part a). As a result, this investors optimal portfolio contains a lower
ratio in the risky portfolio than the less risk-averse investor.

6. (7 points) Consider two risky assets, A and B. Asset A has expected return 9% and
standard deviation 25%. Asset B has expected return 15% and standard deviation 35%.
Assume that the correlation coefficient between the returns of the two assets is 0.30.
This means the covariance between the two is 262.5%.
a) (2 points)
Portfolio 1: w
A
=0, w
B
=1
) ( ) ( ) (
B B A A k
R E w R E w R E + =
% 15 * 1 % 9 * 0 ) ( + =
k
R E =15%
) , cov( 2
2 2 2 2 2
B A B A B B A A k
R R w w w w + + = o o o
5 . 262 * 1 * 0 * 2 35 1 25 0
2 2 2 2 2
+ + =
k
o =1225
k
o =35%
Portfolio 2: w
A
=0.2, w
B
=0.8
% 15 * 8 . 0 % 9 * 2 . 0 ) ( + =
k
R E =13.8%
5 . 262 * 8 . 0 * 2 . 0 * 2 35 8 . 0 25 2 . 0
2 2 2 2 2
+ + =
k
o =893
k
o =29.9%
Portfolio 3: w
A
=0.8, w
B
=0.2
% 15 * 2 . 0 % 9 * 8 . 0 ) ( + =
k
R E =10.2%
5 . 262 * 2 . 0 * 8 . 0 * 2 35 2 . 0 25 8 . 0
2 2 2 2 2
+ + =
k
o =533
k
o =23.1%
b) (1 point)














c) (1 point) In class we found the equation for the weight in one risky asset that yields
the lowest overall variance. You do not have to go through the steps of deriving this
formula- you can simply plug in numbers.
) , cov( 2
) , cov(
2 2
2
*
B A B A
B A B
A
R R
R R
w
+

=
o o
o

Portfolio
Opportunity Set
E(Rk)
o
Rk



7
5 . 262 * 2 35 25
5 . 262 35
2 2
2
*
+

=
A
w = 72.6%

d) (1 point)
5 . 262 * 273 . * 726 . * 2 35 273 . 25 726 .
2 2 2 2 2
+ + =
k
o =526.8
k
o =22.9%
Notice that this standard deviation is lower than that on the individual risky assets,
showing the benefits of diversification.





e) (2 points)
















7. (7 points)
a) (2 points) If you invest 50% of your money in Indigo Engines and 50% in Taupe
Tables, what would be your portfolio's expected rate of return and standard
deviation?
( ) 0.5*7.6% 0.5*8.5%
K
E R = + =8.05%
% 58 . 41 * 5 . 0 * 5 . 0 * 2 % 15 . 109 * 5 . 0 % 84 . 15 * 5 . 0
2 2 2
+ + =
K
o =52.04%
=
K
o 7.21%

b) (2 points) Suppose that the portfolio in part a) is the optimal risky portfolio and that
there is a risk-free asset with a rate of return of 5%. Assume that you are an
investment advisor and that your client has a risk aversion of A=4. What is the
optimal amount that your client should put in the risky portfolio?
2
8.05 5
*
.01*4*7.21
y

= =1.4668

Min, Variance Portfolio
E(Rk)
o
Rk

CAL
+ K*
K* =Optimal Risky
Portfolio. Point where
the CAL is tangent to
the portfolio
opportunity set
22.9%


8
For this investor, 146.68% of the portfolio is invested in the risky portfolio and -
46.68% is invested in the risk-free security. Basically, this investor is best off
shorting the risk free security (borrowing money at the risk-free rate) and using the
proceeds to buy the risky portfolio on margin.

c) (2 points) Illustrate the following in a graph: the CAL for these two assets, the y-
intercept for the CAL, the optimal indifference curve for the investor, the point
associated with the y* portfolio.




8. (1 point) Which of the following portfolios cannot lie on the efficient frontier? Why?
Portfolio E(Return) Standard Deviation
W 15% 36%
X 12% 15%
Y 5% 7%
Z 9% 21%

Portfolio Z clearly cannot lie on the efficient frontier as it is strictly dominated by portfolios
X and W (X and W are better on all fronts). Because of portfolios X and W we know that
for a portfolio with an expected return of 9%, it is possible to achieve a standard deviation
that is lower than 21%.

We cannot make any definitive statements about the other portfolios. Portfolio W is
suspect, given the very large increase in the standard deviation over Portfolio X, however
since we have no evidence that it is possible to achieve a lower level of risk for that level of
expected return, we cant say it is an inefficient portfolio.



P*
5%
7%
7.21% 10.5756%
K*
8.05%
9.4737%


9
9.(1 point) In which of the following situations would you get the largest reduction in risk by
spreading your investment across two stocks.
D) Perfect negative correlation yields the largest reduction in risk. We saw in class
how the benefits of diversification increase as the correlation between the two risky
securities moves away from 1. The maximum benefit in terms of risk reduction is
when the correlation coefficient equals negative 1, which means the risky securities
are perfect hedges for each other. It is possible to reduce the level of portfolio risk
to zero in this instance.

10. (2 points) Why do most investors hold diversified portfolios? What is the advantage of
this type of investment strategy?

Any intelligent answer on the benefits of diversification received full credit. It was
important to express the concept that by adding securities to your portfolio you reduce
expose to the firm specific or idiosyncratic risk of any individual security, thereby
reducing the overall level of risk. The chance that all of the securities in your portfolio
are up or down simultaneously falls as the number of securities in the portfolio rises.
Because of this the securities you add to your portfolio do not have to be hedges for the
original securities in question to achieve a reduction in risk.

11. y*>1, a graph will look like the one in question 5.