FINA 1082 –Principles of Finance
Seminar 7
Part A
In-class Questions
1. Markowitz Portfolio theory is most accurately described as including an assumption that:
a. risk is measured by the range of expected returns
b. investors have the ability to borrow or lend at the risk-free rate of return
c. investor utility curves demonstrate diminishing marginal utility of wealth.
2. An investor currently holds a portfolio that is expected to return 12 percent. The investor is
planning to sell one of the securities included in the current portfolio that has an expected return of
14 percent and use the proceeds to purchase a security that has an expected return of 13 percent.
Compared to the investor’s current portfolio, the expected return for the investor’s revised portfolio
will be:
a. Above 12 percent whether or not any change occurs in the standard deviation of the portfolio.
b. Below 12 percent whether or not any change occurs in the standard deviation of the portfolio.
c. below 12 percent only if the standard deviation of the new security is higher than the standard
deviation of the security that was sold
3. The shares CBC Ltd are currently selling for $25.00 per share. You have developed the following
probability distribution of the price and dividend one year from now.
State of the Market Probability Price
Awful 0.3 $32.50
Normal 0.4 $30.00
Awesome 0.3 $25.00
The variance of the returns for CBC Ltd shares is closest to:
a. 0.0054
b. 0.0141
c. 0.0737
d. 0.1187
4. You are given the following information in three stocks
Stock A offers an expected return of 8.0% p.a. with a standard deviation of 15.0% p.a.
Stock B offers an expected return of 10.0% p.a. with a standard deviation of 20.0% p.a.
Stock C offers an expected return of 10.0% p.a. with a standard deviation of 15.0% p.a.
For each of the following statements indicate whether the statement is true or false and explain
why?
a. A risk neutral investor will be indifferent between stocks B and C.
b. A risk-averse investor would prefer to invest in stock B rather than the stock C
c. A risk-averse investor would prefer to invest in stock C rather than stock A
d. a risk seeking investor would be indifferent between stocks B and C
5. You are considering two assets with the following characteristics:
E ( R1 ) =0.15 , E ( σ 1 )=0.10 , w1=0.5
E ( R2 ) =0. 20 , E ( σ 2 )=0. 2 0 , w2=0.5
Compute the mean and standard deviation of two portfolios if , ρ1 , 2=0.40 and −0.60 respectively.
Briefly explain the results.
Part B
Self-study Questions
6. Given:
E ( R1 ) =0.10 , E ( R 2 )=0.15 , E ( σ 1 )=0.03 , E ( σ 2) =0.05Calculate the expected returns and
expected standard deviations of a two-stock portfolio in which stock 1 has a weight of 60 percent
under the following conditions:
a. ρ1 , 2=1.00
b. ρ1 , 2=0.75
c. ρ1 , 2=0.25
d. ρ1 , 2=0.00
e. ρ1 , 2=−0.25
f. ρ1 , 2=−0.75
g. ρ1 , 2=−1.00
7. An investor has an equal amount invested in each of the following four securities:
Expected
Annual
Security
Rate of
Return
W 0.10
X 0.12
Y 0.16
Z 0.22
The investor plans to sell Security Y and use the proceeds to purchase a new security that has the
same expected return as the current portfolio. The expected return for the investor’s new portfolio,
compared to the current portfolio, will be:
a. lower regardless of changes in the correlation of returns among the securities.
b. The same regardless of changes in the correlation of returns among the securities.
c. lower only if the correlation of the new security with securities W, X and Z is lower than the
correlation of security Y with the other securities.
8. Discuss mean-variance analysis and its assumptions; and calculate the expected return and the
standard deviation of return for a portfolio of two or three assets.
9. Explain the minimum-variance and efficient frontiers; and discuss the steps to solve for the
minimum-variance frontier.
10. Discuss diversification benefits, and explain how the correlation in a two-asset portfolio and
the number of assets in a multi-asset portfolio affect the diversification benefits.
11. The shares DBY Ltd are currently selling for $8.00 per share. You have developed the following
probability distribution of the price and dividend one year from now.
State of the
Probability Price Dividend
Market
Bearish 0.3 $6.80 $0.40
Normal 0.4 $7.60 $0.40
Bullish 0.3 $9.60 $0.80
Assume year end cash flows. The standard deviation of the rate of returns for DBY Ltd shares is
closest to:
a. 2.6%
b. 12.7%
c. 16.3%
d. 25.4%