E120

Homework 9
Due 12/01/2014

1. Suppose that there are 2 assets with r1 = 0.20, 1 = 0.40, r2 = 0.10, 2 = 0.25, 12 =
0.05, where 12 is the correlation of returns between asset 1 and asset 2.
(a) If r0 = 0.02, what are the market portfolio return and variance? What are the
corresponding weights (i.e. how much to invest in asset 1, asset 2, and the risk-free
asset to get the market portfolio)?
(b) If r0 = 0.05, what are the market portfolio return and variance? What are the
corresponding weights?
2. Suppose the risk-free asset has expected return of 0.05, and the market portfolio has
expected return 0.15 and standard deviation 0.18. What is the minimum standard
deviation you can achieve if you desire an expected return of 10%?
3. Suppose the risk-free asset has expected return of 0.05, and the market portfolio has
expected return 0.15 and standard deviation 0.18. Is it possible for you to achieve an
expected return of 20% and a standard deviation of 20%? Why, or why not?
4. Assume that the expected rate of return on the market portfolio is 23% and the rate
of return on T-bills (the risk-free rate) is 7%. The standard deviation of the market is
32%. Assume that the market portfolio is efficient.
(a) What is the equation of the capital market line?
(b)

i. If an expected return of 39% is desired, what is the standard deviation of the

corresponding portfolio?
ii. If you have $100 to invest, how should you allocate it to achieve the above
portfolio?

(c) If you invest $300 in the risk-free asset and $700 in the market portfolio, how
much money should you expect to have at the end of the year?
5. Suppose that there are only three stocks in the market: Jazz, Inc., Classical, Inc., and
Rock, Inc. Their outstanding shares and prices are shown in the table below. The
risk-free rate is 2%. Assume that the market is efficient.
Security
Jazz Inc.
Classical Inc.
Rock, Inc.

O.S. Price
Cap
Weight
10,000 $6.00 $60,000
3/20
30,000 $4.00 $120,000
3/10
40,000 $5.50 $220,000 11/20

Suppose that the expected returns of Jazz, Classical, and Rock are 10%, 6%, and 12%,
respectively. An investor who has $10, 000 wants to achieve an expected return of 40%.
How much money should she invest in each stock and the risk-free security?
6. Judge whether the following statements are true or false. Give a brief explanation if
true or a counter-example if false.
(a) Suppose the return rates for two stocks A and B have strictly positive variances.
One is going to invest in these two stocks. Then a combination with strictly
positive weights on both stocks can always reduce the total risk, compared with
investing in either one of these stocks.
(b) When considering two risky assets along with a risk free asset, with all other
variables being fixed, a lower absolute value of correlation coefficient between the
risky assets leads to an optimal portfolio with higher return rate at any given
level of risk.