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Tutorial 4

PROBLEM SET 1
Which of the following choices best completes the following statement? An investor with a
higher degree of risk aversion, compared to one with a lower degree, will prefer investment
portfolios
a. with higher risk premiums.
b. that are riskier (with higher standard deviations).
c. with lower Sharpe ratios.
d. with higher Sharpe ratios.
e. None of the above is true.

PROBLEM SET 2
Which of the following statements are true? Explain.
a. A lower allocation to the risky portfolio reduces the Sharpe (reward-to-volatility) ratio.
b. The higher the borrowing rate, the lower the Sharpe ratios of levered portfolios.
c. With a fixed risk-free rate, doubling the expected return and standard deviation of the
risky portfolio will double the Sharpe ratio.
d. Holding constant the risk premium of the risky portfolio, a higher risk-free rate will
increase the Sharpe ratio of investments with a positive allocation to the risky asset.

PROBLEM SET 3
Use the following graph to answer the following questions.

a. Which indifference curve represents the greatest level of utility that can be achieved by
the investor?
Indifference curve 2
b. Which point designates the optimal portfolio of risky assets?
Point F

Tutorial 4
Tutorial 4

PROBLEM SET 4
Use the following data in answering CFA Problems 1–3:

a. Based on the utility formula above, which investment would you select if you were risk
averse with A = 4?
Utility for each investment = E(r) – 1/2 × 4 × σ2
We choose the investment with the highest utility value, Investment 3.
Expected Standard
Investmen Utility
return deviation
t U
E(r) 
1 0.12 0.30 -0.0600
2 0.15 0.50 -0.3500
3 0.21 0.16 0.1588
4 0.24 0.21 0.1518

b. Based on the utility formula above, which investment would you select if you were risk
neutral?
When investors are risk neutral, then A = 0; the investment with the highest utility is
Investment 4 because it has the highest expected return.

PROBLEM SET 5
Consider a risky portfolio that offers an expected rate of return of 12% and a standard
deviation of 18%. T-bills offer a risk-free 7% rate of return. What is the maximum level of
risk aversion for which the risky portfolio is still preferred to bills?
UP = 0.12 – 1/2 × A × 0.182
= 0.12 – 0.0162A
In order for the risky portfolio to be preferred to bills, the following must hold:
0.12 – 0.0162A > 0.07
A < 0.05/0.0162
A < 3.09

Tutorial 4
Tutorial 4

PROBLEM SET 6
The average annual rate of return on the S&P 500 portfolio over the past 80 years has
averaged roughly 8% more than the Treasury bill return and that the S&P 500 standard
deviation has been about 20% per year. Assume these values are representative of investors’
expectations for future performance and that the current T-bill rate is 5%.
a. Calculate the expected return and standard deviation of portfolios invested in T-bills and
the S&P 500 index with weights as follows:

The portfolio expected return and variance are computed as follows:


(1) (2) (3) (4) rPortfolio Portfolio 2
WBills rBills WIndex rIndex (1)×(2)+(3)×(4) (3) × 20% Portfolio
0.0 5% 1.0 13.0% 13.0% = 0.130 20% = 0.20 0.0400
0.2. 5% 0.8 13.0% 11.4% = 0.114 16% = 0.16 0.0256
0.4 5% 0.6 13.0% 9.8% = 0.098 12% = 0.12 0.0144
0.6 5% 0.4 13.0% 8.2% = 0.082 8% = 0.08 0.0064
0.8 5% 0.2 13.0% 6.6% = 0.066 4% = 0.04 0.0016
1.0 5% 0.0 13.0% 5.0% = 0.050 0% = 0.00 0.0000

b. Calculate the utility levels of each portfolio of Problem 10 for an investor with A =2
and A = 3. What do you conclude?
Computing utility from U = E(r) – 1/2Aσ2 = E(r) – σ2, we arrive at the values in the
column labeled U(A = 2) in the following table:
WBills WIndex Portfolio 2Portfolio U(A = 2)
rPortfolio U(A = 3)
0.0 1.0 0.1 0.2 0.0 0.0900 .0700
0.2 0.8 0.1
30 0.1
0 0.0 0.0884
400 .0756
0.4 0.6 0.0
14 0.1
6 0.0
256 0.0836 .0764
0.6 0.4 0.0
98 0.0
2 0.0 0.0756
144 .0724
0.8 0.2 0.0
82 0.0
8 0.0 0.0644
064 .0636
1.0 0.0 0.0
66 0.0
4 0.0 0.0500
016 .0500
The column labeled U(A50
= 2) implies0 that investors
000 with A = 2 prefer a portfolio that is
invested 100% in the market index to any of the other portfolios in the table.

The column labeled U(A = 3) in the table above is computed from:


U = E(r) – 0.5Aσ2 = E(r) – 1.5σ2
The more risk averse investors prefer the portfolio that is invested 40% in the market,
rather than the 100% market weight preferred by investors with A = 2.

Tutorial 4
Tutorial 4

PROBLEM SET 7
You manage a risky portfolio with expected rate of return of 18% and standard deviation of
28%. The T-bill rate is 8%.
a. Your client chooses to invest 70% of a portfolio in your fund and 30% in a T-bill money
market fund. What is the expected value and standard deviation of the rate of return on
his portfolio?
E(rC ) = 70% × 18% + 30% × 8% = 𝟏𝟓%
σC = 70% × 28% = 𝟏𝟗. 𝟔%

b. Suppose that your risky portfolio includes the following investments in the given
proportions:
Stock A 25%, Stock B 32%, Stock C 43%

What are the investment proportions of your client’s overall portfolio, including the
position in T-bills?
Investment proportions: T-bill money market Fund= 30%
Stock A 70% × 25% = 𝟏𝟕. 𝟓%
Stock B 70% × 32% = 𝟐𝟐. 𝟒%
Stock C 70% × 43% = 𝟑𝟎. 𝟏%

c. What is the reward-to-volatility ratio (S) of your risky portfolio? Your client’s?
18% − 8%
SP = = 𝟑𝟓. 𝟕𝟏%
28%
15% − 8%
SC = = 𝟑𝟓. 𝟕𝟏%
19.6%

d. Draw the CAL of your portfolio on an expected return–standard deviation diagram.


What is the slope of the CAL? Show the position of your client on your fund’s CAL.

30
CAL (Slope = 0.3571)
25

20

E(r) P
15
% Client
10

0
0 10 20 30 40



Tutorial 4
Tutorial 4

e. Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall portfolio will have an expected rate of return of
16%.
i. What is the proportion y?
E(rC ) = rf + y[E(rp ) − rf ]
E(rC ) = 8% + y[18% − 8%]
y = 𝟖𝟎%

ii. What are your client’s investment proportions in your three stocks and the T-bill
fund?
Investment proportions: T-bill money market Fund= 20%
Stock A 80% × 25% = 𝟐𝟎%
Stock B 80% × 32% = 𝟐𝟓. 𝟔%
Stock C 80% × 43% = 𝟑𝟒. 𝟒%

iii. What is the standard deviation of the rate of return on your client’s portfolio?
σC = 80% × 28% = 𝟐𝟐. 𝟒%

f. Suppose that your client prefers to invest in your fund a proportion y that maximizes the
expected return on the complete portfolio subject to the constraint that the complete
portfolio’s standard deviation will not exceed 18%.
i. What is the investment proportion, y?
18% = y 28%
y = 64.29%

ii. What is the expected rate of return on the complete portfolio?


E(rC ) = 8% + 64.29%[18% − 8%]
E(rC ) = 𝟏𝟒. 𝟒𝟑%

g. Your client’s degree of risk aversion is A = 3.5.


i. What proportion, y, of the total investment should be invested in your fund?
E(rp ) − rf
y∗ =
Aσp 2
18% − 8%
y∗ =
3.5 × 28%2

y = 𝟑𝟔. 𝟒𝟒%

ii. What is the expected value and standard deviation of the rate of return on your
client’s optimized portfolio?
E(rC ) = 8% + 36.44% × 10% = 𝟏𝟏. 𝟔𝟓%
σC = 36.44% × 28% = 𝟏𝟎. 𝟐𝟎%

Tutorial 4
Tutorial 4

PROBLEM SET 8
IMI uses the capital market line to make asset allocation recommendations. IMI derives the
following forecasts:
 Expected return on the market portfolio: 12%
 SD on the market portfolio: 20%
 Risk-free rate: 5%

A client seeks IMI’s advice for a portfolio asset allocation and informs IMI that he wants
the SD of the portfolio of the portfolio to equal half of the SD for the market portfolio.
Using the capital market line, what expected return can IMI provide subject to client’s risk
constraint?
σC = 20% × 50% = 10%
E(rM ) − rf E(rC ) − rf
S= =
σM σC
12% − 5% E(rC ) − 5%
=
20% 10%
)
E(rC = 𝟖. 𝟓%

Tutorial 4
Tutorial 4

PROBLEM SET 9
You estimate that a market portfolio mimics the S&P 500 stock index, yields an expected
return of 13% with a standard deviation of 25%. You manage a risky portfolio with
expected return 18% and standard deviation 28%. The risk-free rate is 8%.
a. What is the slope of the CML and CAL?

E(rM ) − rf
SCML =
σM
13% − 8%
=
25%
= 𝟐𝟎%
E(rP ) − rf
SCAL =
σP
18% − 8%
=
28%
= 𝟑𝟓. 𝟕𝟏%

b. Your client ponders whether to switch the 70% that is invested in risky portfolio to the
market portfolio. Show him the maximum fee you could charge (as a percentage of the
investment in your fund, deducted at the end of the year) that would leave him at least as
well off investing in risky portfolio as in the market portfolio. (Hint: The fee will lower
the slope of his CAL by reducing the expected return net of the fee.)
(E(rP ) − f) − rf
SCAL with a fee =
σP
18% − f − 8%
=
28%

E(rM ) − rf
SCML =
σM
13% − 8%
=
25%
= 𝟐𝟎%

SCAL with a fee = SCML


18% − f − 8%
= 𝟐𝟎%
28%
f = 𝟒. 𝟒%

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Tutorial 4

c. Consider the client with A = 3.5.


If he chose to invest in the market portfolio, what proportion, y, would he select?
E(rM ) − rf
y∗ =
AσM 2
13% − 8%
=
3.5(25%)2
= 𝟐𝟐. 𝟖𝟔%

Tutorial 4