1.

Probability Return (%) Probability*Return Return^2 Probability*(Return^2)

A B A*B B^2 A(B^2)
0.10 40% 0.0400 0.1600 0.0160
0.20 30% 0.0600 0.0900 0.0180
0.35 15% 0.0525 0.0225 0.0079
0.25 -5% (0.0125) 0.0025 0.0006
0.10 -15% (0.0150) 0.0225 0.0023
Total 0.1250 0.0448

(i) Expected Return = Sum of all {Probability*Return} = Sum of all (A*B) = 0.1250 = 12.50%

(ii) Standard Deviation of Returns = ( ) [()]

Part 1: E(R2) = Sum of all {Probability*(Return2)} = Sum of all {A(B2)} = 0.0448

Part 2: [E(R)] 2 = [Probability*Return] 2 = [A*B] 2 = (0.1250)2 = 0.0156

Part 3: Standard Deviation = 0.0448 0.0156 = 0.1707 = 17.07%

4
1.2

Money divided equally between investments:

Expected Return 12.50%

Standard Deviation 17.07%
Correlation 0.15

(i) Expected Return of Portfolio = = + = (0.50*0.1250) + (0.50*0.1250) = 0.1250 = 12.50%

(ii) Standard Deviation of Return from Portfolio = + +

= (0.50)2 (0.1707)2 + (0.50)2 (0.1707)2 + 2 (0.15 0.50 0.50 0.1707 0.1707)

=0.0073 + 0.0073 + 0.0022

=0.0167

=0.1294

=12.94%

5
1.6

Expected Return on Market Portfolio 12%

Risk Free Rate 6%

(i) When, Beta=0.20

Expected Return on Investment = E(R)= + [( ) ]

E(R) = 0.06 + 0.20[0.12 - 0.06] = 0.06 + 0.20[0.06] = 0.06 + 0.012 = 0.072 = 7.20%

(ii) When, Beta=0.50

Expected Return on Investment = E(R)= + [( ) ]

E(R) = 0.06 + 0.50[0.12 - 0.06] = 0.06 + 0.50[0.06] = 0.06 + 0.03 = 0.09 = 9.00%

(iii) When, Beta=1.40

Expected Return on Investment = E(R)= + [( ) ]

E(R) = 0.06 + 1.40[0.12 - 0.06] = 0.06 + 1.40[0.06] = 0.06 + 0.084 = 0.144 = 14.40%

6
1.15

Expected Return, , and Standard Deviation of Return, , from a Portfolio Consisting of Two Investments:

Investment 1 Investment 2
Mean Return ( ) 8% 12%
Standard Deviation 14% 20%
Correlation 0.30

0.00 1.00 12.00% 20.00%
0.20 0.80 11.20% 17.05%
0.40 0.60 10.40% 14.69%
0.50 0.50 10.00% 13.82%
0.60 0.40 9.60% 13.22%
0.80 0.20 8.80% 12.97%
1.00 0.00 8.00% 14.00%

(i) Expected Return of Portfolio = = + = (0.50*0.08) + (0.50*0.12) = 0.04 + 0.06 = 0.10 =

10.00%
(ii) Standard Deviation of Portfolio = + +

= (0.50)2 (0.14)2 + (0.50)2 (0.20)2 + 2 (0.30 0.50 0.50 0.14 0.20)

=0.0049 + 0.0100 + 0.0042

=0.0191

=0.1382

=13.82%

Alternative Risk Return Combinations from Two

Investments
14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00%

7
1.16

Expected Return on Market [E(Rm)] 12%

Risk Free Rate [RF] 7%
Standard Deviation 15%
Investor 1 Expected Return 10%
Investor 2 Expected Return 20%

(i) First Investor:

Risk Free Asset:

Let WRF = Weight of Risk Free Asset and WMP = Weight of Market Portfolio
E(Rp) = WRF*RF + [{1 WRF*} E(Rm)]
0.10 = WRF*0.07 + [{1 WRF} *0.12]
0.10 = 0.07WRF + 0.12 0.12WRF
0.10 0.12 = 0.07WRF 0.12WRF
0.02 = 0.05WRF
WRF1 = 0.02/ 0.05 = 0.40
WMP1 = 1 WRF = 1 0.40 = 0.60

Since = 0

Standard Deviation of Portfolio 1 = + +

= (0.40)2 (0.00)2 + (0.60)2 (0.15)2 + 2 ( 0.40 0.60 0.00 0.15)

=0.00 + (0.60)2 (0.15)2 + 0.00

=0.0081

=0.0900

=9.00%

(ii) Second Investor:

Risk Free Asset:

Let WRF = Weight of Risk Free Asset and WMP = Weight of Market Portfolio
E(Rp) = WRF*RF + [{1 WRF*} E(Rm)]
0.20 = WRF*0.07 + [{1 WRF} *0.12]
0.20 = 0.07WRF + 0.12 0.12WRF
0.20 0.12 = 0.07WRF 0.12WRF
0.08 = 0.05WRF
WRF2 = 0.08/ 0.05 = (1.60)
WMP2 = 1 WRF = 1 ( 1.60) = 2.60

Since = 0

8
Standard Deviation of Portfolio 2 = + +

= (( 1.60)2 (0.00)2 + (2.60)2 (0.15)2 + 2 ( 1.60 2.60 0.00 0.15)

=0.00 + (2.60)2 (0.15)2 + 0.00

=0.1521

=0.3900

=39.00%

9
1.18

Beta () 0.20
Risk Free Rate 0.05
Expected Return ( ) (0.30)
Market Return of Portfolio (0.10)

Expected Return = E(R) = [( ) ] +

E(R) = 0.20[ 0.30 0.05] + 0.05

= 0.20[ 0.35] + 0.05

= 0.07 + 0.05

= 0.02

= 2%

According to Capital Asset Pricing Model (CAPM) the average portfolio return should have been -2% but the portfolio
manager has a return of -1% which is better in the circumstances but still negative return resulting in losses.

10
6.14:

ABS CDOs

Part I Part II
SENIOR 75 70
MEZZANINE 20 20
EQUITY 5 10

Part I:

ABSs

SUBPRIME SENIOR
MORTGAGES TRANCHES (75%)
ABS CDO

MEZZANINE SENIOR TRANCHE

TRANCHES (20%) (75%)

EQUITY TRANCHES MEZZANINE

(5%) TRANCHE (20%)

EQUITY TRANCHES
(5%)

Losses to Tranches:

Losses to Subprime Losses to Mezzanine Losses to Equity Losses to Losses to Senior Tranche
Portfolios Tranche of ABS Tranche of ABS Mezzanine Tranche of ABS CDO
CDO of ABS CDO
10% 25% 100% 100% 0%
15% 50% 100% 100% 33%
20% 75% 100% 100% 67%
25% 100% 100% 100% 100%

11
Part II:

ABSs

SUBPRIME SENIOR
MORTGAGES TRANCHES (70%)
ABS CDO

MEZZANINE SENIOR TRANCHE

TRANCHES (20%) (70%)

EQUITY TRANCHES MEZZANINE

(10%) TRANCHE (20%)

EQUITY TRANCHES
(10%)

Losses to Tranches:

Losses to Subprime Losses to Mezzanine Losses to Equity Losses to Losses to Senior Tranche
Portfolios Tranche of ABS Tranche of ABS Mezzanine Tranche of ABS CDO
CDO of ABS CDO
10% 0% 0% 0% 0%
15% 25% 100% 75% 0%
20% 50% 100% 100% 29%
25% 75% 100% 100% 64%

12
6.15

Part I
SENIOR 80
MEZZANINE 10
EQUITY 10

ABSs

SUBPRIME SENIOR
MORTGAGES TRANCHES (80%)
ABS CDO

MEZZANINE SENIOR TRANCHE

TRANCHES (10%) (80%)

EQUITY TRANCHES MEZZANINE

(10%) TRANCHE (10%)

EQUITY TRANCHES
(10%)

Losses to Tranches:

Losses to Subprime Losses to Mezzanine Losses to Equity Losses to Losses to Senior Tranche
Portfolios Tranche of ABS Tranche of ABS Mezzanine Tranche of ABS CDO
CDO of ABS CDO
10% 0% 0% 0% 0%
15% 50% 100% 100% 38%
20% 100% 100% 100% 100%
25% 100% 100% 100% 100%

13
2.15

Particulars Amount (in millions)

Interest Income 3.00
Non-Interest Income 0.90
Total Income 3.90

Particulars Amount (in millions)

Equity Capital 5.00
Pre-tax Operating Income 0.60

There is a 99.90% chance that the profit will not be worse than:

=Mean (99.90%* Standard Deviation)

=0.60 (3.09*2) [3.09 is taken from Z table for 99.90%]

= 5.58

Particulars Amount (in millions)

Mean (A) 0.60
Z* (B) (6.18)
Sum (A+B) 5.58
Less: Equity Capital (5.00)
Required Addition to Equity Capital 0.58

Answer: Therefore, there should be an addition of $0.58 million in equity capital for there to be a 99.90% chance that
the equity capital will not be wiped out by the losses.

14
2.17

Bidder No of Shares Price

B 20,000 80
H 50,000 60
C 30,000 55
A 60,000 50
E 40,000 42
F 40,000 42
D 40,000 38
G 50,000 35

B, H, C, A, E and F are the highest bidders. And therefore, they get the shares.

E and F are the lowest bidders with $42. And hence the amount paid by all the bidders will be $42 per share.

B, H, C and A will get 20000, 50000, 30000 and 60000 shares respectively.

E and F will get (210000 - 160000 = 50000) 50000/2 = 25000 shares each.

Answer: The price paid by investors will be $42 per share. Shares received by Investor A would be 60000, B would
be 20000, C would be 30000, D would be none, E would be 25000, F would be 25000, G would be none and H would
be 50000.

15
2.18

Options No. of Shares Price per Share Fees Per Share Total
Best Efforts Commission 10,000,000 0.20 2,000,000
Buys shares 10,000,000 10.00 100,000,000
Total 102,000,000

Price per share for sale: 102,000,000 100,000,000 = $10.20 per share (Sell for more than this in Firm Commitment)

The decision is based on two factors, namely, whether the bank can sell the shares for more than $10.20 per share and
the risk (risk appetite) the bank is ready to take.

If the bank is 90% confident that it can sell the shares for more than $10.20 per share, then it is advisable to go with
the Firms Commitment to buy the shares.

If the bank is 50% or less than 50% certain then it is better to go with the option of Best Efforts Commission.

16