9/13/2013

Problem 1

V(12/31/2004) = V (1/1/1998) x (1 + GAR)7

= $100,000 x (1.05)7 =

$140,710.04

5-1

Problem 2

a. The holding period returns for the three scenarios are:

Boom:
Normal:
Recession:
E(HPR) =
2(HPR)

(50 40 + 2)/40 = 0.30 = 30.00%

(43 40 + 1)/40 = 0.10 = 10.00%
(34 40 + 0.50)/40 = 0.1375 = 13.75%
[(1/3) x 30%] + [(1/3) x 10%] + [(1/3) x (13.75%)] = 8.75%
2(HPR) [(1/3) x (30% 8.75%)2 ] [(1/3) x (10% 8.75%)2 ] [(1/3) x (13.75% 8.75%)2 ] 0.031979

(HPR) 17.88%
5-2

9/13/2013

Problem 2 Cont.

Risky E[rp] = 8.75%

Risky p = 17.88%

b. E(r) =
=

(0.5 x 8.75%) + (0.5 x 4%) = 6.375%

0.5 x 17.88% = 8.94%

5-3

Problems 3 & 4

3. For each portfolio: Utility = E(r) (0.5 4 2 )

Investment

E(r)

0.12

0.30

-0.0600

0.15

0.50

-0.3500

0.21

0.16

0.1588

We choose the portfolio with the highest utility value,

0.24
0.21
0.1518
is Investment43.

which

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9/13/2013

Problems 3 & 4 Cont.

4. When an investor is risk neutral, A = _ so that

0 the portfolio with the highest
highest expected return
utility is the portfolio with the _______________________.
Investment
4
So choose ____________.

5-5

Problem 5

a. TWR
Year
2002-2003

a. TWR

2003-2004
2004-2005

AAR

Return = [(capital gains + dividend) /

price]
(110 100 + 4)/100 = 14.00%

b. DWR
Time

Cash
flow

Explanation

(90 110 + 4)/110 = 14.55%

-300

Purchase of three shares at $100 per

share

(95 90 + 4)/90 = 10.00%

-208

Purchase of two shares at $110,

plus dividend income on three shares
held

110

Dividends on five shares,

plus sale of one share at $90

396

14.00% 14.55% 10.00%

3.15%
3

GAR [1.14x(1 0.1455)x1.10]1/3 1 2.33%

$0

Dividends on four shares,

plus sale of four shares at $95 per share

$300
$208
$110
$396

(1 IRR) 0 (1 IRR) 1 (1 IRR) 2 (1 IRR) 3

-0.1661%
5-6

9/13/2013

Problem 1

E(r) =
E(r) =

(0.5 x 15%) + (0.4 x 10%) + (0.1 x 6%)

12.1%

6-7

Problem 2
Criteria 1:
Eliminate Fund B
Criteria 2:
Choose Fund D
Lowest correlation,
best chance of
improving return
per unit of risk
ratio.
6-8

9/13/2013

Problem 3

a. Subscript OP refers to the original portfolio, ABC to the new stock, and NP to
the new portfolio.
i. E(rNP) = wOP E(rOP ) + wABC E(rABC ) =

(0.9 0.67) + (0.1 1.25) = 0.728%

0.40 .0237 .0295 = .00027966 0.00028

ii Cov = OP ABC =

iii. NP = [wOP OP + wABC ABC + 2 wOP wABC (CovOP , ABC)]1/2

= [(0.92 .02372) + (0.12 .02952) + (2 0.9 0.1 .00028)]1/2
= 2.2673% 2.27%
2

6-9

Problem 3

b.Subscript OP refers to the original portfolio, GS to government securities, and

NP to the new portfolio.
i. E(rNP) = wOP E(rOP ) + wGS E(rGS ) =
ii. Cov = OP GS =
iii. NP = [wOP OP +
2

wGS2

0 .0237 0 = 0

(0.9 0.67%) + (0.1 0.42%) = 0.645%

GS2

+ 2 wOP wGS (CovOP , GS)]1/2

= [(0.92 0.02372) + (0.12 0) + (2 0.9 0.1 0)]1/2

= 0.9 x 0.0237 = 2.133% 2.13%
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9/13/2013

Problem 3

c. GS = 0, so adding the risk-free government

securities would result in a lower beta for the
new portfolio.
n

i i

i1

6-11

Problem 3

d. The comment is not correct. Although the respective standard deviations and
expected returns for the two securities under consideration are equal, the
covariances and correlations between each security and the original portfolio
are unknown, making it impossible to draw the conclusion stated.

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9/13/2013

Problem 3

e.

Returns above expected contribute to risk as measured by the standard

deviation but her statement indicates she is only concerned about returns
sufficiently below expected to generate losses.

However, as long as returns are normally distributed, usage of should be

fine.

6-13

Problem 4

a.

Although it appears that gold is dominated by stocks, gold can still be an attractive diversification asset. If
the correlation between gold and stocks is sufficiently low, gold will be held as a component in the optimal
portfolio.

b. If gold had a perfectly positive correlation with stocks, gold would not be a part of efficient portfolios. The
set of risk/return combinations of stocks and gold would plot as a straight line with a negative slope. (See
the following graph.)
E(r)
Stock

Gold

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9/13/2013

Problem 4

o The graph shows that the

stock-only portfolio
dominates any portfolio
containing gold.

E(r)
Stock

Gold

o This cannot be an
equilibrium; the price of
gold must fall and its
expected return must rise.

6-15

Problem 5
o No, it is not possible to get
such a diagram.
o Even if the correlation
between A and B were 1.0,
the frontier would be a
straight line connecting A
and B.

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9/13/2013

Problem 6

The expected rate of return on the stock will change by beta

times the unanticipated change in the market return:
1.2 (8% 10%) = 2.4%

Therefore, the expected rate of return on the stock should be

revised to:
12% 2.4% = 9.6%

6-17

Problem 7
b. The undiversified investor is
exposed to both firm-specific
and systematic risk. Stock A
has higher firm-specific risk
because the deviations of the
observations from the SCL
are larger for Stock A than for
Stock B.
Stock A may therefore be
riskier to the undiversified
investor.

a.

The risk of the diversified portfolio consists primarily of systematic risk.

Beta measures systematic risk, which is the slope of the security
characteristic line (SCL). The two figures depict the stocks' SCLs. Stock B's
SCL is steeper, and hence Stock B's systematic risk is greater. The slope of
the SCL, and hence the systematic risk, of Stock A is lower. Thus, for this
investor, stock B is the riskiest.
6-18