Exercises Q1. Statistics for three stocks, A, B, and C, are shown in the following tables.

Standard Deviations of Returns Stocks SD (%) A 40 B 20 C 40 Correlations of Returns Stock A A 1.00 B C B 0.90 1.00 C 0.50 0.10 1.00

Based only on the information provided in the tables, and given a choice between a portfolio made up of equal amounts of stocks A and B or a portfolio made up of equal amounts of stocks B and C, state which portfolio you recommend. Why? Q2. Mr. As current portfolio of Rs 2 lac is invested as follows: Value (Rs) Proportion E (R ) Govt. Bond 20,000 10% 4.6% Large cap stock 60,000 30% 12.4% Small cap stock 1,20,000 60% 16.0% Total portfolio 13.8% 2,00,000 100% SD 1.6% 19.5% 29.9% 23.1%

A is expecting to get an amount of additional Rs2 lac and plans to invest the entire amount in an index fund that best complements the current portfolio. Mr. B is evaluating the four index funds shown in the following table for their ability to produce a portfolio that will meet two criteria relative to the current portfolio: 1. Maintain or enhance expected return and 2. Maintain or reduce volatility. Each fund is invested in an asset class that is not substantially represented in the current portfolio. Index Fund Characteristics Index Fund E(R) SD Correlation of Returns with the current portfolio A 15% 25% 0.80 B 11 22 0.60 C 16 25 0.90 D 14 22 0.65 State which fund Mr. B should recommend to Mr A.

Q.3.In an economy there are only two stocks and the capitalization of stock A is twice that of B. The standard deviation of return on A is 30% and on B is 50%. The correlation coefficient between the returns is 0.7. (i) (ii) (iii) What is the Standard Deviation of the market index portfolio? What is the beta of each stock? If the stock A is expected to earn 11% in excess of the risk-free rate, what must be the risk premium on the market portfolio?

Q4.Mr. Smart is a portfolio manager who has recently met with a prospective client, Mr. Performer. After conducting a SML performance analysis using the Sensex as his market proxy, Mr. Performer claims that his portfolio has experienced superior performance. Mr. Smart uses the CAPM as an investment performance measure and finds that Mr. Performers portfolio plots below the SML. Mr. Smart uses the S&P CNX Nifty as the market portfolio which is now considered as the best proxy for the efficient market portfolio in India. Mr. Smart concludes that Mr. Performers apparent superior performance is a function of an incorrectly specified market proxy, not superior investment. Justify Mr. Smarts conclusion, by addressing the likely effects of an incorrectly specified market proxy on both beta and the slope of the SML (limit your answer within two sentences only). Q5. Consider the following regression results for Stock X E(R) = 2% + 1.2 (percentage change in oil prices) If you live in Louisiana, where the local economy is heavily dependent on oil industry profits, does Stock X represent a useful asset to hedge your overall economic wellbeing? What if you live in Massachusetts, where most individuals and firms are energy consumers? Q. 6. You are a portfolio manager. You meet with two investors A and B. Each investor expresses an interest in changing his or her investment objective. Both investors are currently holding a well-diversified portfolio of risky assets. (i) A want to increase the expected return of his portfolio. What do you suggest to achieve his objective? Justify your response in the context of the CML. (ii) B wants to reduce the risk exposure of her portfolio but does not want to engage in borrowing or lending activities to do so. Advise her and justify response in the context of SML.

Q7. You are a portfolio manager and using CAPM for making recommendations to your clients. Security research department has developed the following information: E(R ) SD Beta Infosys 14% 15% 0.8 SBI 17% 12% 1.5 S&P CNX Nifty 14% 10% 1 T/B 5% 0 0 Identify and justify which stock would be more appropriate for an investor who wants to (i) add this stock to a well-diversified portfolio. (ii) hold this stock as single stock portfolio.