Assignment 1

Short answer questions

Q1. d. With higher Sharpe ratios.
An investor that is risk averse wants compensation for taking on risk. An investor with a
high degree of risk aversion wants a higher risk premium for each unit of standard
deviation taken on compared to an investor with a lower degree of risk aversion.
Q2. a. Its variance must be lower than those of all other securities or portfolios.
The minimum variance portfolio includes securities which through diversification
results in the minimum possible variation possible.
Q3.

a) To incorporate the effect of liquidity into the CCAPM, one would have to add a
component in the formula that increases the required return in line with the
investors exposure to liquidity risk. This should result in firm with higher
liquidity risk have higher average returns.
b) In incorporating non-traded assets into the CCAPM, the two most important ones
would be (1) human capital and (2) privately held business.
In regards to human capital, investors seeking to diversify their portfolio would
not buy shares from their employers stock, and possible also limit investments in
the same industry. This would reduce demand for labor-intensive firms, which in
turn would have to offer higher expected returns than predicted by the CAPM.
This would require adjustments to the CCAPM to account for the effect of human
capital. Such adjustments have been proposed by David Meyers.
In regards to privately held business, that has a somewhat smaller effect than
human capital. Owners of private firms can incorporate them or sell them at will.
They can also borrow against their value, which further diminishes the material
difference between ownership of private and public companies. Assuming that
privately held business have similar risk characteristics to those of traded assets,
owners can offset the diversification problem posed by their non-tradable
entrepreneurial assets by reducing their portfolio demand for similar, traded
assets. Thus the CCAPM return-beta equation is not severely disrupted by the
presence of entrepreneurial income.

Analytical questions
1.
20%
18%
16%
14%
12%
E(r) 10%

CML

8%

CAL

6%
4%
2%
0%
0%

5%

10%

15%
SD

20%

25%

30%

a) The slope of the CML is:

(

b) The advantage of my fund over the passive fund is a higher Sharpe ratio, which
can be seen graphically in the figure above. This implies that the expected return
for a given volatility/risk is higher in my portfolio than the passive portfolio.
2.

a) The disadvantage of switching from my fund to the passive portfolio is that my

client would get a lower Sharpe ratio, i.e. would get a lower expected return per
unit volatility in the passive portfolio.
Placing 70 % of his money in the passive fund (and the rest in risk free
investments/T-bills) would give an expected return and volatility of:
( )

[ (

Would he remain in my fund he would get the following expected return and
volatility:
( )

[ ( )

We see that the investor would lower both his expected return and volatility by
switching from my portfolio to the passive portfolio. However, the investor

would be better of in my fund, since he can achieve an expected return of 11.5 %

with a lower volatility in my fund. This can be computed in the following way:
( )

[ (

b) The fee will lower the slope of the CAL by reducing the expected return net of the
fee. By setting the slope of the CAL equal to the slope of the CML we can calculate
the fee that would make the investor indifferent between the two portfolios. This
could be calculated in the following manner:
(

( )

This means that the maximum fee I could charge that would leave my investor at
least as well off in my fund as in the passive fund is 4.4 % per year.
3.

a) The amount invested in the passive portfolio can be calculated as:

( )

b) The fee I can charge the investor is the same as calculated before, 4.4 %. This is
independent of the capital allocation between the risky and the risk-free asset, i.e.
where along the CAL the investor decides to place his investments. What counts
is the reward to volatility ratio of my fund. This affects how large a fee I can
charge. The higher the fee, the lower this ratio gets, but as long as this ratio is
greater than the passive portfolio, i.e. up to a fee of 4.4 %, the investor is better of
choosing my portfolio no matter his degree of risk aversion.