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Tut5_with memo

# Tut5_with memo

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05/09/2014

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BUS3026W Finance II 2008 - Tutorial 5 Due: Week beginning 14 April
___________________________________________________________________
Question 1

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 T- bill money market fund that yields a rate of 8%. The probability function of the risky fund is as follows:

Risk return characteristics
Expected Return
Standard Deviation
Stock Fund (S)
20%
30%
Bond Fund (B)
12%
15%
The correlation coefficient between the fund returns is 0.1.
a)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?
b) Tabulate and draw the investment opportunity set for the two risky funds. Use
investment proportions for each fund of zero to 100% in increments of 20%

c) Draw a tangent from the risk-free rate to the opportunity set. What does your graph show for the expected return and standard deviation of the optimal portfolio?

d)Solve numerically for the proportions of each asset and the expected return
and standard deviation of the optimal risky portfolio.
e) What is the reward to variability ratio of the best feasible CAL?

f) You require that your portfolio yield an expected return of 14% and that it be efficient on the best feasible CAL. What is the standard deviation of your portfolio? What is the proportion invested in the T-bill fund and each of the two risky funds?

g)If you were to only use the two risky funds, and still require an expected rate

of return of 14%, what must be the investment proportions of your portfolio? Compare its standard deviation to that of the optimized portfolio in question (f). What do you conclude?

Solution:
a) The parameters of the opportunity set are:
E(rS) = 20%, E(rB) = 12%,\u03c3S = 30%,\u03c3B = 15%, \u03c1 = 0.10
From the standard deviations and the correlation coefficient we generate the covariance
matrix [note that Cov(rS, rB) =\u03c1\u03c3S\u03c3B]:
Bonds
Stocks
Bonds
225
45
Stocks
45
900
The minimum-variance portfolio is computed as follows:
wMin(S) =
1739
.
0
)
45
2
(
225
900
45
225
)
r
,
r
(
Cov
2
)
r
,
r
(
Cov
B
S
2B
2
S
B
S
2B
=
\u00d7
\u2212
+
\u2212
=
\u2212
\u03c3
+
\u03c3
\u2212
\u03c3
[2]
wMin(B) = 1\u2212 0.1739 = 0.8261
[1]
The minimum variance portfolio mean and standard deviation are:
E(rMin) = (0.1739\u00d7 20) + (0.8261\u00d7 12)= 13.39%
[1]
\u03c3Min=
2
/
1
B
S
B
S
2B
2B
2
S
2
S
)]
r
,
r
(
Cov
w
w
2
w
w
[
+
\u03c3
+
\u03c3
= [(0.17392\u00d7 900) + (0.82612\u00d7 225) + (2\u00d7 0.1739\u00d7 0.8261\u00d7 45)]1/2
= 13.92%
[2]
b)
Proportion
in stock fund
Proportion
in bond fund
Expected
return
Standard
Deviation
0.00%
100.00%
12.00%
15.00%
17.39%
82.61%
13.39%
13.92%
minimum variance
20.00%
80.00%
13.60%
13.94%
40.00%
60.00%
15.20%
15.70%
45.16%
54.84%
15.61%
16.54%
tangency portfolio
60.00%
40.00%
16.80%
19.53%
80.00%
20.00%
18.40%
24.48%
100.00%
0.00%
20.00%
30.00%
Graph shown overleaf.
[5]
c) The graph indicates that the optimal portfolio is the tangency portfolio with expected
return approximately 15.6% and standard deviation approximately 16.5%.
d)
The proportion of the optimal risky portfolio invested in the stock fund is given by:
)
r
,
r
(
Cov
]
r
)
r
(
E
r
)
r
(
E
[
]
r
)
r
(
E
[
]
r
)
r
(
E
[
)
r
,
r
(
Cov
]
r
)
r
(
E
[
]
r
)
r
(
E
[
w
B
S
f
B
f
S
2
S
f
B
2B
f
S
B
S
f
B
2B
f
S
S
\u2212
+
\u2212
\u2212
\u03c3
\u2212
+
\u03c3
\u2212
\u2212
\u2212
\u03c3
\u2212
=
4516
.
0
]
45
)
8
12
8
20
[(
]
900
)
8
12
[(
]
225
)
8
20
[(
]
45
)
8
12
[(
]
225
)
8
20
[(
=
\u00d7
\u2212
+
\u2212
\u2212
\u00d7
\u2212
+
\u00d7
\u2212
\u00d7
\u2212
\u2212
\u00d7
\u2212
=
[4]
wB= 1\u2212 0.4516 = 0.5484
The mean and standard deviation of the optimal risky portfolio are:
E(rP) = (0.4516\u00d7 20) + (0.5484\u00d7 12) = 15.61%
[1]
\u03c3p = [(0.45162 \u00d7 900) + (0.54842 \u00d7 225) + (2 \u00d70.4516 \u00d70 . 5 4 8 4\u00d7 4 5 )]1/2
= 16.54%
[2]
0.00
5.00
10.00
15.00
20.00
25.00
0.00
5.00
10.00
15.00
20.00
25.00
30.00
Tangency
Portfolio
Minimum
Variance
Portfolio
Efficient frontier
of risky assets
CML
INVESTMENT OPPORTUNITY SET