Sample Questions.

Portfolio Optimisation.

Question 1. Suppose that two assets have the characteristics as reported in Table 1.1.

Table 1.1.
Asset 1 Asset 2
Amount Invested R 40,000 R 60,000
Expected Return 11% 25%
Standard Deviation 15% 20%
Correlation 0.30

i. Calculate the expected return and standard deviation of the two asset portfolio.
ii. Sketch the portfolio risk-return combinations of the portfolio as the asset weights
change in increments of 20%.
iii. Explain why the efficient frontier has the bow shape as illustrated in part ii of this
question.
Suppose that there is a third asset (Asset 3). The characteristics of all three assets are reported
in Table 1.2.

Table 1.2.
Asset 1 Asset 2 Asset 3
Amount Invested R 40,000 R 25,000 R 35,000
Expected Return 11% 25% 30%
Standard 15% 20% 25%

Correlations
Assets 1 and 2 0.30
Assets 2 and 3 0.10
Assets 1 and 3 0.50

iv. Without carrying out any calculations, explain why the inclusion of a third asset
cannot increase the risk of the portfolio.
v. Calculate the expected return and standard deviation of the three asset portfolio.

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Question 2. Suppose that there are two assets with the following characteristics

Expected Return Standard Deviation

Asset 1 0.20 0.30
Asset 2 0.10 0.15

i. In the same figure sketch the efficient frontier for (i)   1, (ii)   0 and (iii)
  1 . Explain the effects of correlation on the benefits of diversification.
ii. Consider two equally weighted portfolios A and B in which the average asset
variance equals 0.15 and the average covariance equals 0.09. Portfolio A comprises
three assets and portfolio B comprises 100 assets. Calculate the variance of each
portfolio.
iii. Explain what happens to systematic risk as the number of assets in a portfolio
become large.

Question 3. Suppose that there is a risky portfolio and a risk-free asset. The expected return
and standard deviation of the risky portfolio are denoted respectively as rP and  P . The return
of the risk-free asset is denoted rf .

Denote as C the portfolio comprised of the portfolio P and the risk-free asset.

i. Suppose that portfolio P is comprised of n risky assets. Explain how the inclusion
of the risk-free asset in the portfolio P (i.e. portfolio C) changes the structure of the
efficient frontier.
ii. With reference to part i of this question, explain the Capital Allocation Line
equation.
iii. Explain how the investor chooses between combinations of the risky portfolio P
and the risk-free asset. Explain the choice of combination under the assumption that
the investor is (a) risk averse (b) risk loving.

Question 4. Suppose that a risky portfolio P has expected return of 12% and standard deviation
of 24%. Assume that the risk-free rate is 6%. Suppose further that an investor has R 1,000,000
to invest in a portfolio comprised of either P or the risk-free rate or combinations of the two
assets.

i. Plot the Capital Allocation Line for differing portfolios with weights of P between
0 and 1.5 in increments of 0.25.

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 ii. Suppose that a portfolio standard deviation of 12% is required. What is the portfolio
expected return? Determine the amount invested in portfolio P and the amount
invested in the risk-free asset.
iii. Explain why maximising the Sharpe ratio yields the Capital Allocation Line.
iv. Discuss the difference between the Capital Allocation Line and the Capital Market
Line.

Question 5. Suppose that asset 1 has the following information

Expected Market Risk Premium 5%

Risk-Free Rate 4%
Asset 1 Beta 1.5%

i. Calculate and interpret the CAPM expected return for asset 1.

ii. Sketch and discuss the Security Market Line for asset 1.
Assume that the correlation of returns between asset A and the market portfolio equals 0.80
and that the standard deviation of asset A is 0.60 and that the standard deviation of the market
portfolio is 0.30.
iii. Calculate the beta for asset A.

Question 6. If markets are semi-strong form efficient then investment analysis is a waste of
time and money. Discuss.

Question 7. What is the evidence for the efficient markets hypothesis?

Question 8. Consider the following portfolio.

Share Proportion of Portfolio Return Beta

A 0.2 15% 0.8
B 0.5 16.2% 1.1
C 0.3 18.9% 1.3

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 i. Calculate the beta of the portfolio.
ii. Calculate the alpha values (excess returns) of the individual shares and for the
portfolio assuming that the riskless rate of interest is 9% and that the market return
is 16%.
iii. Calculate the returns on the individual shares and on the portfolio that would be
expected next year if the riskless rate of interest were 10% and the market return
were expected to be 18%.
iv. How might portfolio performance be improved next year if
a. A bull market is expected?
b. A bear market is expected?

Question 9. The statistics for three stocks A. B and C are given by

Stock A B C
Standard Deviation (%) 40 20 40
Correlation of Returns
Stock A B C
A 1.00 0.90 0.50
B 1.00 0.10
C 0.50

Based only on the information in the table and given a choice between a portfolio made up of
equal amounts of stocks A and B or a portfolio made up of stocks B and C, which portfolio
would you recommend? Justify your answer.

Question 10. The following are estimates for two stocks.

Stock Expected Return Beta Firm-Specific Standard Deviation

A 13% 0.8 30%
B 18% 1.2 40%

The market index has a standard deviation of 22% and the risk-free rate is 8%.

i. What are the standard deviations of stocks A and B?

ii. Suppose that a portfolio is constructed with the following proportions.

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 Stock A 0.30
Stock B 0.45
Stock C 0.25

Compute the expected return, standard deviation and non-systematic standard deviation of the
portfolio.

Question 11. Consider the two excess return single index model regression results for stocks A
and B.
RA  1%  1.2 RM

R 2  0.576
Residual Standard Deviation=10.3%
RB  2%  0.8RM

R 2  0.436
Residual Standard Deviation=9.1%
where Ri  ri  rf , i  A, B, M .

i. Which stock has more firm specific risk?

ii. Which stock has greater market risk?
iii. For which stock does market movement explain a greater fraction of return
variability?
iv. If rf were constant at 6% and the regression had been run using total rather than
excess returns what would have been the regression intercept for stock A?

Question 12. Suppose that the single index model for stocks A and B is estimated from excess
returns with the following results.
RA  3%  0.7 RM  eA

RB  2%  1.2 RM  eB

 M  20% , R 2 stock A=0.20, R 2 stock B=0.12.

i. What is the standard deviation of each stock?

ii. Break down the variance of each stock into the systematic and firm-specific
components.
iii. What are the covariance and correlation coefficient between the two stocks?

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 iv. What is the covariance between each stock and the market index?
v. Suppose that there is a portfolio P comprised of 0.60 in stock A and 0.40 in Stock
B. Repeat parts i, ii and iii of this question for the portfolio.
vi. Contrast the results for asset A, B and portfolio P.

Question 13. A portfolio manager summarises the input from macro and micro forecasters as
follows.

Micro Forecasts
Asset Expected Return (%) Beta Residual Standard Deviation
(%)
Stock A 20 1.3 58
Stock B 18 1.8 71
Stock C 17 0.7 60
Stock D 12 1.0 55
Macro Forecasts
Expected Return Standard Deviation (%)
T-Bills 8 0
Passive Equity Portfolio 16 23

i. Calculate the excess returns, alpha values and residual variances for the four stocks.
ii. Construct the optimal risky portfolio.

Question 14. What is the beta of a portfolio with E[rp ]  18% if rf  6% and E[rM ]  14% ?

Question 15. Consider the following table which gives a security analyst’s expected return on
two stocks for two particular market returns.

Market Return Aggressive Stock Defensive Stock

5% -2% 6%
25% 38% 12%

i. What are the betas of the two stocks?

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 ii. What is the expected rate of return on each stock if the market return is equally
likely to be 5% or 25%?
iii. If the T-Bill rate is 6% and the market return is equally likely to be 5% or 25%,
draw the security market line.
iv. Plot the two securities on the SML graph. What are the alphas of each stock?

Question 15. An investor is using the CAPM model in order to make recommendations to her
client. Her research has developed the following information.

Forecast Return (%) Standard Deviation (%) Beta

Stock X 14.0 36.0 0.8
Stock Y 17.0 25.0 1.5
Market Index 14.9 15.0 1.0
Risk-Free Rate 5.0

i. Calculate the expected return and alpha for each stock.

ii. Identify and justify which stock would be more appropriate for an investor who
wants to
a. add this stock to a well-diversified portfolio.
b. hold this stock as a single-stock portfolio.

Question 16. Discuss the terms ‘systematic risk’ and ‘non-systematic’ risk.

Question 17. A risk-free security is a zero beta security but a zero beta security is not
necessarily risk free. Do you agree?

Question 18. The beta of a security estimated from historical data cannot be a good estimate of
the true beta of a security. Discuss.

Question 19. Why is the efficient set linear in the presence of a riskless asset?

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Question 20. Prove that all portfolios along the capital market line are perfectly correlated.

Question 21. Define (i) an aggressive security (ii) a defensive security. When would you hold
each type in your portfolio?

Question 22.
i. Briefly explain the concept of the EMH and each of its three forms – weak, semi-
strong and strong – and briefly discuss the degree to which existing empirical
evidence supports each of the three forms of EMH.
ii. Briefly discuss the implications of the EMH for investment policy as it applies to
a. Technical analysis in the form of charting.
b. Fundamental analysis.
iii. Briefly explain the roles of portfolio managers in an efficient market environment.

Question 23. Good News Inc. just announced an increase in its annual earnings, yet its stock
price fell. Is there a rational explanation for this phenomenon?

Question 24. Suppose that you manage a risky portfolio with expected return of 18% and
standard deviation of 28%. The return on a riskless bond is 8%.
i. Your client chooses to invest 70% in your fund and 30% in the risk-free asset. What
is the expected return and the standard deviation of his portfolio?
ii. Suppose that your risky asset includes the following investments in the given
proportions.
Stock A 25%
Stock B 32%
Stock C 43%
What are the investment proportions of your clients overall portfolio including the position in
the risk-free asset?
iii. Suppose that your client decides to invest in your portfolio a proportion y of the
total investment budget so that the overall portfolio has an expected rate of return
of 16%.
a. What is the proportion y?

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 b. What are the client’s investment in the three stocks and the risk-free asset?
c. What is the standard deviation of the return on your client’s portfolio?
iv. Suppose that your client prefers to invest in your fund a proportion y that maximises
the expected return subject to the constraint that the complete portfolio’s standard
deviation does not exceed 18%
a. What is the investment proportion y?
b. What is the expected rate of return on the complete portfolio?

Question 25. A pension fund manager is considering three mutual funds. The first is a stock
fund, the second is a long-term government and corporate bond fund and the third is a sovereign
bond fund that yields a risk-less rate of return of 8%. The probability distributions of the two
funds are

Expected Return Standard Deviation

Stock Fund (S) 20% 30%
Bond Fund (B) 12% 15%

The correlation between the two funds is 0.10.

i. What are the investment proportions in the minimum variance portfolio of the two
risky funds and what is the expected value and standard deviation of its rate of
return?
ii. Solve numerically for the proportions of each asset and the expected return and
standard deviation of the optimal portfolio.
iii. What is the reward-to-volatility ratio of the best feasible CAL?
iv. You require that your portfolio yield an expected return of 14% and that it be on the
best feasible CAL.
a. What is the standard deviation of the portfolio?
b. What is the proportion invested in the sovereign bond fund and each of the two
risky funds?
v. If you were to use only the two risky funds and still require an expected return of
14% what would be the investment proportions of the portfolio?

You may find the following expression helpful

Σ1e
θ  T 1
e Σ e

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Question 26. Abigail Grace has a $900,000 fully diversified portfolio. She subsequently
inherits ABC Company common stock worth $100,000. Her financial advisor provided her
with the following forecast information.

Expected Monthly Returns Standard Monthly Deviation

of Monthly Returns
Original Portfolio 0.67% 2.37%
ABC Company 1.25% 2.95%

The correlation coefficient of ABC with the original portfolio is 0.40.

i. Assuming Grace keeps the ABC stock calculate the

a. Expected return of her new portfolio which includes ABC stock.
b. Covariance of ABC with the original portfolio.
c. Standard deviation of the new portfolio which includes the ABC stock.
ii. If Grace sells the ABC stock she will invest the proceeds at the risk-free rate of
0.42% per month. Assuming that Grace sells the ABC stock and buys Government
securities calculate the
a. Expected return of her new portfolio which includes Government securities.
b. Covariance of Government securities with the original portfolio.
c. Standard deviation of the new portfolio which includes the Government
securities.
iii. Determine whether the systematic risk of her new portfolio which includes
government securities is higher or lower than that of her original portfolio.

Question 27. Why is alpha called a non-market return premium? Why are high alpha stocks
desirable investment for active portfolio managers? What would happen to a portfolio’s Sharpe
ratio if the alpha of its component securities increased?

Question 28. When the annualised monthly percentage rates of return for a stock market index
were regressed against the returns for ABC and XYZ stocks over a 5 year period ending in
2008 using an ordinary least squares regression, the following results were obtained.

Statistic ABC XYZ

Alpha -3.20% 7.3%
Beta 0.60 0.97
R2 0.35 0.17
Residual Standard Deviation 13.02% 21.45%

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Explain what these regression results tell the analyst about risk-return relationships for each
stock over the sample period. Comment on their implications for future risk-return relationships
assuming both stocks are included in a diversified portfolio especially in view of the following
data obtained from two brokerage houses which are based on two years of weekly data ending
in December 2008.

Brokerage House Beta of ABC Beta of XYZ

A 0.62 1.45
B 0.71 1.25

Question 30. Assume that the following assets are correctly priced according to the security
market line.
r1  6% 1  0.5
r2  12%  2  1.5

i. Derive the security market line.

ii. What is the expected return of a security with a Beta of 2?
iii. Assume that there exists an asset with r3  15% and 3  1.2 . Design the arbitrage
opportunity.

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