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Week 4 solutions

Investments and Portfolio Management (University of Sydney)

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Week 4: Solutions to homework problems

BKM chapter 6

5. Consider a portfolio that offers an expected rate of return of 12% and a standard deviation
of 18%. T-bills offer a risk-free 7% rate of return. What is the maximum level of risk
aversion for which the risky portfolio is still preferred to T-bills?

Answer: When we specify utility by U = E(r) – 0.5Aσ2, the utility level for T-bills is: 0.07
The utility level for the risky portfolio is:
U = 0.12 – 0.5 × A × (0.18)2 = 0.12 – 0.0162 × A
In order for the risky portfolio to be preferred to bills, the following must hold:
0.12 – 0.0162A > 0.07 ⇒ A < 0.05/0.0162 = 3.09
A must be less than 3.09 for the risky portfolio to be preferred to bills.

For Problems 10 through 12: Consider historical data showing that the average annual rate
of return on the S&P 500 portfolio over the past 90 years has averaged roughly 8% more than
the Treasury bill return and that the S&P 500 standard deviation has been about 20% per
year. Assume these values are representative of investors’ expectations for future
performance and that the current T-bill rate is 5%.

10. Calculate the expected return and variance of portfolios invested in T-bills and the S&P
500 index with weights as follows:

Answer: The portfolio expected return and variance are computed as follows:

(1) (2) (3) (4) rPortfolio σPortfolio

σ2Portfolio
WBills rBills WIndex rIndex (1)×(2)+(3)×(4) (3) × 20%
0.0 5% 1.0 13.0% 13.0% = 0.130 20% = 0.20 0.0400
0.2 5 0.8 13.0 11.4% = 0.114 16% = 0.16 0.0256
0.4 5 0.6 13.0 9.8% = 0.098 12% = 0.12 0.0144
0.6 5 0.4 13.0 8.2% = 0.082 8% = 0.08 0.0064
0.8 5 0.2 13.0 6.6% = 0.066 4% = 0.04 0.0016
1.0 5 0.0 13.0 5.0% = 0.050 0% = 0.00 0.0000

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11. Calculate the utility levels of each portfolio of Problem 10 for an investor with A = 2.
What do you conclude?

Answer: Computing utility from U = E(r) – 0.5 × Aσ2 = E(r) – σ2, we arrive at the values
in the column labeled U(A = 2) in the following table:

WBills WIndex rPortfolio σPortfolio σ2Portfolio U(A = 2) U(A = 3)

0.0 1.0 0.130 0.20 0.0400 0.0900 0.0700
0.2 0.8 0.114 0.16 0.0256 0.0884 0.0756
0.4 0.6 0.098 0.12 0.0144 0.0836 0.0764
0.6 0.4 0.082 0.08 0.0064 0.0756 0.0724
0.8 0.2 0.066 0.04 0.0016 0.0644 0.0636
1.0 0.0 0.050 0.00 0.0000 0.0500 0.0500

The column labelled U(A = 2) implies that investors with A = 2 prefer a portfolio that is
invested 100% in the market index to any of the other portfolios in the table.

12. Repeat Problem 11 for an investor with A = 3. What do you conclude?

Answer: The column labeled U(A = 3) in the table above is computed from:
U = E(r) – 0.5Aσ2 = E(r) – 1.5σ2
The more risk averse investors prefer the portfolio that is invested 60% in the market,
rather than the 100% market weight preferred by investors with A = 2.

Use these inputs for Problems 13 through 19: You manage a risky portfolio with an
expected rate of return of 18% and a standard deviation of 28%. The T-bill rate is 8%.

13. Your client chooses to invest 70% of a portfolio in your fund and 30% in an essentially
risk-free money market fund. What are the expected return and standard deviation of the
rate of return on his portfolio?

Answer:
Expected return = (0.7 × 18%) + (0.3 × 8%) = 15%
Standard deviation = 0.7 × 28% = 19.6%

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14. Suppose that your risky portfolio includes the following investments in the given
proportions:

What are the investment proportions of your client’s overall portfolio, including the
position in T-bills?

Answer: Investment proportions:

30.0% in T-bills
0.7 × 25% = 17.5% in Stock A
0.7 × 32% = 22.4% in Stock B
0.7 × 43% = 30.1% in Stock C

15. What is the reward-to-volatility (Sharpe) ratio (S) of your risky portfolio? Your client’s?

Answer:
0.18 − 0.08
Your reward-to-volatility (Sharpe)
= ratio: S = 0.3571
0.28
0.15 − 0.08
Client’s reward-to-volatility (Sharpe)
= ratio: S = 0.3571
0.196

16. Draw the CAL of your portfolio on an expected return-standard deviation diagram. What
is the slope of the CAL? Show the position of your client on your fund’s CAL.

Answer:
30
CAL (Slope = 0.3571)
25

20

E(r)% P
15
Client
10

0
0 10 20 30 40

σ (%)

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17. Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall portfolio will have an expected rate of return of
16%.

a. What is the proportion y?

Answer: E(rC) = rf + y × [E(rP) – rf] = 0.08 + y × (0.18 − 0.08)

If the expected return for the portfolio is 16%, then:
0.16 − 0.08
16% = 8% + 10%
= ×y⇒y = 0.8
0.10
Therefore, in order to have a portfolio with expected rate of return equal to 16%, the
client must invest 80% of total funds in the risky portfolio and 20% in T-bills.

b. What are your client’s investment proportions in your three stocks and the T-bill
fund?

Answer: Client’s investment proportions:

20.0% in T-bills
0.8 × 25% = 20.0% in Stock A
0.8 × 32% = 25.6% in Stock B
0.8 × 43% = 34.4% in Stock C

c. What is the standard deviation of the rate of return on your client’s portfolio?

Answer: σC = 0.8 × σP = 0.8 × 28% = 22.4%

18. Suppose that your client prefers to invest in your fund a proportion y that maximizes the
expected return on the complete portfolio subject to the constraint that the complete
portfolio’s standard deviation will not exceed 18%.

a. What is the investment proportion, y?

Answer: σC = y × 28%
If your client prefers a standard deviation of at most 18%, then:
y = 18/28 = 0.6429 = 64.29% invested in the risky portfolio.

b. What is the expected rate of return on the complete portfolio?

Answer: E (rC ) = 0.08 + 0.1× y = .08 + (0.6429 × 0.1) = 14.429%

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19. Your client’s degree of risk aversion is A = 3.5.

a. What proportion, y, of the total investment should be invested in your fund?

E(rP ) − r f 0.18 − 0.08 0.10

Answer: y* = = = = 0.3644
Aσ 2
P 3.5 × 0.28 2
0.2744
Therefore, the client’s optimal proportions are: 36.44% invested in the risky portfolio
and 63.56% invested in T-bills.

b. What are the expected value and standard deviation of the rate of return on your
client’s optimized portfolio?

Answer: E(rC) = 0.08 + 0.10 × y* = 0.08 + (0.3644 × 0.1) = 0.1164 or 11.644%

σC = 0.3644 × 28% = 10.203%

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