FM213 MT2022 Problem Set Solutions

Class 5
aisle
13. Total usu = idiosyncratic Wsu + rauleet

a. Variance measures the total risk of a security and is a measure of stand-alone risk. Total risk
has both unique risk and market risk. In a well-diversified portfolio, unique risks tend to
cancel each other out and only the market risk remains. Beta is a measure of market risk and
is useful in the context of a well-diversified portfolio. Beta measures the sensitivity of the
security returns to changes in market returns. The Market portfolio has a beta of one.
b. If we hold long positions in both stocks: the correlation coefficient that gives the maximum
reduction in risk for a two-stock portfolio is -1. (If one stock is sold short while on has a long
position in a second stock, then a correlation of +1 is actually best to minimize portfolio risk.)
c. First, the mean returns are; Ñs
-8%+10%+224--8
=
-1
.

Ñm
[Link]/8t.gt24I-
=
161
Mean A = 8%, Mean M=16%,
= .

Then the covariance and variance are;

6m =

(6t-l6%)2t(18E-1g6¥6
= 0.01 t 0.0004 t 0.00Gt = 0.0084

Cov(Ra, Rm)=0.0138, Var(Rm)=0.0084, Gumm .rs/ = 1-8%-8-1 )( 6%-1-6%1

.
+ (lot -8%148-16%1
. + ( 22-1 -8%7124%-16%1
.

3- I

so that, finally, the beta is ; = 0.0138

Beta=0.0138/0.0084=1.643.

d. First work out the covariance between the stock and the market from the correlation;

Cov(Rb,Rm)= (0.8)(0.20)(0.35) = 0.056,

Then use covariance and the variance of the market to give;

Beta = 0.056/0.04 = 1.4.

w
Vanlrml ( Gm ) ? "
14. First we have;
-_

Expected portfolio return = xA E[RA ] + xB E[R B ] = 12% = 0.12

Let xB = (1 – xA ). This gives;

xA (0.10) + (1 – xA) (0.15) = 0.12 ⇒ xA = 0.60 and xB = 1 – xA = 0.40

Given the weights, we can now compute the variance;

Portfolio variance = xA2 σA2 + xB2 σB2 +2 (xA xB ρAB σA σB)

Plugging in the data, we have;

Portfolio variance = (0.60 2 ) (0.20 2 ) + (0.40 2 ) (0.40 2 ) + 2(0.60)(0.40)(0.50)(0.20)(0.40)
✗
A
✗
B
lab 6s GB
= 0.0592

So the standard deviation = σ = 0.0592 = 24.33%

(b) p= wifi + wifi + Zwiwz Girl

= v76? + wifi + Zwiwz 6,62 - 2W ,wzQ6z + 24026162 l
=
( wish + wz 6212 + 2W , wzGi6z( f- 1) .
It we > 0, we >0
,
rimshot
with 1=-1 . It win, wzeoc

minimised with 2=1 .

FM213 MT2018 Problem Set Solutions

Gn 0,15
4×1=0.5
=

15.
a. In general:
✗2=0.5 lip -0.59

Portfolio variance = σP2 = x12σ12 + x22σ22 + 2x1x2ρ12σ1σ2

Thus:
σP2 = (0.52)(0.29322)+(0.52)(0.29272)+2(0.5)(0.5)(0.59)(0.2932)(0.2927)
Evaluating this equation gives σP2 = 0.0682 and standard deviation = σP = 26.12%
b. One of these securities, T-bills, has zero risk and, hence, zero standard deviation and zero
covariance with any other security. Thus:
Other teams
→
σP2 = (1/3)2(0.29322) +(1/3)2(0.29272)+2(1/3)(1/3)(0.59)(0.2932)(0.2927) are Zeno

This delivers σP2 = 0.0303 and thus the standard deviation = σP = 17.41%
Another way to think of this portfolio is that it is comprised of one-third T-Bills and two-
thirds a portfolio which is half Dell and half Home Depot. Because the risk of T-bills is zero,
the portfolio standard deviation is two-thirds of the standard deviation computed in Part (a)
above:
Standard deviation = (2/3)(26.12%) = 17.41%

c. Let us call portfolio A the portfolio composed of half Dell and half Home Depot. The investor
would like to invest in A by financing half of the investment with risk free borrowing. For
each 2 dollars he invests in portfolio A he borrows 1 dollar and invests 1 dollar of his own
wealth. Therefore, the portfolio weights will be: w(A)= 2, w(risk free)= -1. Note that these
weights sum to one. Ask then WA : Ii wt = -0.5
= What's
.

?
Given that the standard deviation of risk free asset is zero, the standard deviation of this wrong
portfolio is: ton (A)
Standard deviation = 2 × 26.12% = 52.24%

Gp2 = Ws? 65 + [Link]

in
+ [Link]
=o 75
= (2.26.12-b12

Gp = 2×26.121 = 52.24% .