Topic 2 In-Class Example
Modern Portfolio Theory
Investment Theory and Portfolio Management
Example 1: Suppose you are interested in two different investments: one is considered a risky investment and one is
considered a risk-free investment. The only information you have regarding the two investments are related to the
two investments’ risk and return profile. The risky investment has a return of 12% and a risk of 5%, while the risk-
free investment has a return of 3% and a negligible level of risk.
You are interested in putting together a portfolio that contains both investments. You are also interested in knowing
how the composition of the portfolio affects its risk and return. Determine the risk and return of the portfolio if you
decide to invest the following percentage of the funds in the risky investment: (a) 0%, (b) 20%, (c) 70%, and (d)
100%.
Based on your calculations, plot the capital allocation line (CAL) for the portfolio.
Example 2: You are currently monitoring the performances of 4 different portfolios and you are interested in
finding out more about how the portfolios are doing. The following are information related to the portfolios:
Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4
Return 12% 6% 8% 10%
Risk 9% 4% 5% 6%
If you know the current risk-free rate is 2%, can determine the Sharpe ratio for each of the above 4 portfolios.
Can you identify which of the 4 portfolios has the “best” performance? Why?
Investment Theory -1- Topic 2 In-class Example
Example 3: Using information from Example 1, plot the CAL if you can lend at the risk-free rate of 3% but you
have to borrow at 5%.
Example 4: You recently received the annual reports of 3 of your favorite firms: Fizzle Brewery (FB), New Age
Publishing (NAP), and Mommy and Me, Inc (MM). The following are the quarterly stock returns of the three firms
from 1999 to 2002:
Period FB (%) NAP (%) MM (%)
1999 Quarter 1 10 8 12
Quarter 2 12 7 14
Quarter 3 11 3 16
Quarter 4 9 5 15
2000 Quarter 1 4 2 17
Quarter 2 -2 4 18
Quarter 3 -4 5 16
Quarter 4 1 6 14
2001 Quarter 1 5 3 12
Quarter 2 9 4 13
Quarter 3 12 6 11
Quarter 4 14 8 12
2002 Quarter 1 15 7 13
Quarter 2 16 4 14
Quarter 3 16 2 13
Quarter 4 15 5 12
Compute the correlation coefficients for the three different pairs of investments. If you are going to invest in only 2
of the 3 stocks and your goal is to minimize the risk of the portfolio, which 2 stocks will you pick?
Investment Theory -2- Topic 2 In-class Example
Example 5: You are interested in putting together a portfolio that contains 2 risky investments: Turtle Computer and
Fantasy Palace. You know that there is practically no relationship between the two investments (i.e. r is 0). The
following table offers other information related to the two investments:
Turtle Computer Fantasy Palace
Expected return, E(r) 15% 10%
Standard deviation, 40% 30%
Determine the expected return and standard deviation of the portfolio with the following compositions:
w1 w2 E(rp) p
0.0
0.2
0.4
0.5
0.6
0.8
1.0
Perform the above calculation using your calculator.
Plot the efficient frontier using the information calculated.
Example 6: The efficient frontier determined in Example 5 is a very jagged curve. To make the curve smoother, you
decide to determine the return and risk of the portfolio by changing the compositions (i.e. weights) of the portfolio
by 0.5% (i.e. 0.005). Calculate the return and risk of the portfolio for all the possible combinations (based on the
specified conditions) and plot the efficient frontier using the calculated information. [Hint: Use Excel]
Investment Theory -3- Topic 2 In-class Example
Example 7: Based on the information you have calculated in Example 6, you can approximate the compositions of
the two risky investments that will help generate a portfolio with the lowest possible level of risk. However, it is
only an approximation. Determine (using your calculator) the exact compositions (up to 4 decimal places) that will
generate the minimum variance portfolio.
In addition, determine (using your calculator) the expected return and risk of the minimum variance portfolio.
Example 8: Using the information from Example 6, determine how the shape of the efficient frontier changes when
the correlation coefficient between Turtle Computer and Fantasy Palace becomes: +1, +0.8, +0.2, –03, –05, and –1.
[Hint: Use Excel]
Investment Theory -4- Topic 2 In-class Example