FINA 3080 Practice Problems

Portfolio Mathematics and Capital Allocation

1. True or False (Briefly Explain)

(a) The utility indifference curves of two different risk-averse investors cannot intersect. F
The utility is the same when the variance is 0 and the mean is the same .
(b) If you invest y of your wealth in a risky asset (y > 1), and the borrowing rate rb is higher
than the riskfree rate rf, the expected return on your complete portfolio is given by E(rC) = rb
+ y[E(rP) - rb], where rP is the return on the risky asset. T
When buying on Margain replace
of with ry and solve for a new y to find the
,

optimal complete portfolio.

Suppose you have $100 to invest in two assets, A and B. A and B are the only assets
available. A is a risky asset and B is a riskfree asset. The expected return on A is 5%, and B
earns a riskfree rate of 3%. The standard deviations of returns on A and B are 10% and 0%,
respectively. The covariance between the returns on the two assets is 0.
O
(a) If you invest $30 in A and $70 in B, what is the expected return on your portfolio?
EIVc] [13 %) + 30 % (570 3 %)] 0 036
=
- =

(b) What is the standard deviation of return for the portfolio in (a)?
82 = 30 % (10 %) 0 03
= .

(c) If you want to invest $130 in A, how much do you have to short sell B? Assume you can
fully use the proceeds from the short sale, and ignore margin and collateral requirements.
Shortsell $30 of Band usethe proceeds together with your wealth of $100 to , , invest in A
A (d) Calculate the expected return and the standard deviation of return for the portfolio in (c).
130 _3330 EIre] [(340) + (130 %) (540-390)] 0 056 (c (130%0) (1040) 0 13
= = = =
~
.
.

100 (e) If you short sell $x of B and close your position a year later, how much do you pay when
you buy back B? Ignore margin and collateral requirements.
Since Bears the risk free rate after one year the short seller must pay $X(1 + 3 %)to buy
,

it back .

3. Optimal Allocation

There are only two assets: a riskfree asset which earns 7%, and a risky asset which earns an O
O
expected return of 15% and has a standard deviation of 22%. O
(a) What is the optimal allocation, y*, invested in the risky portfolio if the risk aversion
parameter A = 4? * 0
y =7% = .

41322314 :
41323
(b) What are the expected return E(rC) and the standard deviation σC of the complete
portfolio, and the utility UC when holding the complete portfolio? Uc 7% + (5)(15%:-7%) 2(4)() pot
=

EIrc] 7+ (f)(1510 740)

= 10 31 % -

(c (2)(22%) 9 09 %
= .

8 65% = = .

= .

(c) The borrowing rate is 9% (the lending rate is still 7%). Does this affect the investor with
risk aversion A = 4? For another investor whose risk aversion A is 1.1, what is his optimal
allocation y*?
For A = 4, For A = 1-1,
1
y*
y */
= 0 . 41322314 y *
=
1 502629602
.

not affected
71

y** 15 % 9%
126972201)/ affected
-

-
=
1 .

1-1(220)2