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Chapter 7 12.

Your eccentric Aunt Claudia has left you $50,000 in Alcan shares plus
$50,000 cash. Unfortunately her will requires that the Alcan stock not be sold for one
year and the $50,000 cash must be entirely invested in one of the stocks shown in Table
7.8. What is the safest attainable portfolio under these restrictions?
Safest means lowest risk; in a portfolio context, this means lowest variance of
return. Half of the portfolio is invested in Alcan stock, and half of the portfolio must
be invested in one of the other securities listed. Thus, we calculate the portfolio
variance for six different portfolios to see which is the lowest. The safest attainable
portfolio is comprised of Alcan and Nestle.
Stocks
Alcan & BP
Alcan & Deutsche
Alcan & KLM
Alcan & LVMH
Alcan & Nestle
Alcan & Sony

Portfolio Variance
0.051156
0.090733
0.141497
0.105587
0.034893
0.105028

13. There are few, if any, real companies with negative betas. But suppose you found one
with ___.25.
a. How would you expect this stocks rate of return to change if the overall market rose
by an extra 5 percent? What if the market fell by an extra 5 percent?
In general, we expect a stocks price to change by an amount equal to (beta change
in the market). Beta equal to 0.25 implies that, if the market rises by an extra 5
percent, the expected change in the stocks rate of return is 1.25 percent. If the
market declines an extra 5 percent, then the expected change is +1.25 percent.
b. You have $1 million invested in a well-diversified portfolio of stocks. Now you receive
an additional $20,000 bequest. Which of the following actions will yield the safest overall
portfolio return? i. Invest $20,000 in Treasury bills (which have _ _ 0). ii. Invest $20,000
in stocks with _ _ 1. iii. Invest $20,000 in the stock with ___.25. Explain your answer
Safest implies lowest risk. Assuming the well-diversified portfolio is invested in
typical securities, the portfolio beta is approximately one. The largest reduction in
beta is achieved by investing the $20,000 in a stock with a negative beta. Answer (iii)
is correct.

Chapter 8

3a. Mark Harrywitz proposes to invest in two shares, X and Y. He expects a return of 12
percent from X and 8 percent from Y. The standard deviation of returns is 8 percent for X
and 5 percent for Y. The correlation coefficient between the returns is .2.
a.
Portfolio
r

1
10.0%
5.1%
2
9.0
4.6
3
11.0
6.4
b.

See the figure below. The set of portfolios is represented by the


curved line. The five points are the three portfolios from Part (a) plus
the following two portfolios: one consists of 100% invested in X and
the other consists of 100% invested in Y.

c.

See the figure below. The best opportunities lie along the straight line.
From the diagram, the optimal portfolio of risky assets is portfolio 1,
and so Mr. Harrywitz should invest 50 percent in X and 50 percent in
Y.

8. The Treasury bill rate is 4 percent, and the expected return on the market portfolio is 12
percent. Using the capital asset pricing model:

Expected Return

20
15
10
5
0
0

0.5

1.5

Beta

b. What is the risk premium on the market?


Market risk premium = rm rf = 0.12 0.04 = 0.08 = 8.0%

c. What is the required return on an investment with a beta of 1.5?

Using the security market line:


r = rf + (rm rf)
r = 0.04 + [1.5 (0.12 0.04)] = 0.16 = 16.0%

d. If an investment with a beta of .8 offers an expected return of 9.8 percent, does it have
a positive NPV?
For any investment, we can find the opportunity cost of capital using the security
market
line. With = 0.8, the opportunity cost of capital is:
r = rf + (rm rf)
r = 0.04 + [0.8 (0.12 0.04)] = 0.104 = 10.4%
The opportunity cost of capital is 10.4% and the investment is
expected to earn 9.8%. Therefore, the investment has a negative NPV.
e. If the market expects a return of 11.2 percent from stock X, what is its beta?
r = rf + (rm rf)
0.112 = 0.04 + (0.12 0.04) = 0.9
11. Percival Hygiene has $10 million invested in long-term corporate bonds. This bond
portfolios expected annual rate of return is 9 percent, and the annual standard deviation
is 10 percent. Amanda Reckonwith, Percivals financial adviser, recommends that
Percival consider investing in an index fund which closely tracks the Standard and Poors
500 index. The index has an expected return of 14 percent, and its standard deviation is
16 percent.
a. Suppose Percival puts all his money in a combination of the index fund and Treasury
bills. Can he thereby improve his expected rate of return without changing the risk of his
portfolio? The Treasury bill yield is 6 percent.
Percivals current portfolio provides an expected return of 9% with an annual
standard deviation of 10%. First we find the portfolio weights for a combination of
Treasury bills (security 1: standard deviation = 0%) and the index fund (security 2:
standard deviation = 16%) such that portfolio standard deviation is 10%. In
general, for a two security portfolio:

P2 = x12 12 + 2x1x2 1 2 12 + x22 22


(0.10)2 = 0 + 0 + x22(0.16)2
x2 = 0.625 x1 = 0.375
Further:
rp = x1r1 + x2r2
rp = (0.375 0.06) + (0.625 0.14) = 0.11 = 11.0%
Therefore, he can improve his expected rate of return without
changing the risk of his portfolio.
b. Could Percival do even better by investing equal amounts in the corporate bond
portfolio and the index fund? The correlation between the bond portfolio and the index
fund is _.1.
With equal amounts in the corporate bond portfolio (security 1) and the index fund
(security 2), the expected return is:
rp = x1r1 + x2r2
rp = (0.5 0.09) + (0.5 0.14) = 0.115 = 11.5%
P2 = x12 12 + 2x1x2 1 2 12 + x22 22
P2 = (0.5)2(0.10)2 + 2(0.5)(0.5)(0.10)(0.16)(0.10) + (0.5)2(0.16)2
P2 = 0.0097
P = 0.985 = 9.85%
Therefore, he can do even better by investing equal amounts in the
corporate bond portfolio and the index fund. His expected return
increases to 11.5% and the standard deviation of his portfolio decreases
to 9.85%.