CHAPTER 7: CAPITAL ALLOCATION BETWEEN THE RISKY ASSET AND THE RISK-FREE ASSET

1.

Expected return = (0.7 18%) + (0.3 8%) = 15% Standard deviation = 0.7 28% = 19.6%

2. Investment proportions: 0.7 25% = 0.7 32% = 0.7 43% = 30.0% in T-bills 17.5% in Stock A 22.4% in Stock B 30.1% in Stock C

4.

30 25 20 E(r) 15 % 10 5 0 0 10 20 30 40

CAL (Slope = 0.3571) P

Client

( % )

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5.

a.

E(rC) = rf + y[E(rP) rf] = 8 + y(18 8) If the expected return for the portfolio is 16%, then: 16 = 8 + 10 y y = 16 8 = 0.8 10

Therefore, in order to have a portfolio with expected rate of return equal to 16%, the client must invest 80% of total funds in the risky portfolio and 20% in T-bills. b. Clients investment proportions: 0.8 25% = 0.8 32% = 0.8 43% = c.
C

20.0% in T-bills 20.0% in Stock A 25.6% in Stock B 34.4% in Stock C

= 0.8 P = 0.8 28% = 22.4%

6.

a.

C = y 28% If your client prefers a standard deviation of at most 18%, then: y = 18/28 = 0.6429 = 64.29% invested in the risky portfolio

b.

E(rC) = 8 + 10y = 8 + (0.6429 10) = 8 + 6.429 = 14.429% E (rP ) rf 18 8 10 = = = 0.3644 2 2 27.44 0.01A P 0.01 3.5 28

7.

a.

y* =

Therefore, the clients optimal proportions are: 36.44% invested in the risky portfolio and 63.56% invested in T-bills. b. E(rC) = 8 + 10y* = 8 + (0.3644 10) = 11.644% C = 0.3644 28 = 10.203%

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8.

a.

Slope of the CML =

13 8 = 0.20 25

The diagram follows. b. My fund allows an investor to achieve a higher mean for any given standard deviation than would a passive strategy, i.e., a higher expected return for any given level of risk.

CML and CAL

18 16 14 12 10 8 6 4 2 0 0 10 Standard Deviation 20 30 Expected Retrun

CAL: Slope = 0.3571

CML: Slope = 0.20

11.

a.

If the period 1926 - 2002 is assumed to be representative of future expected performance, then we use the following data to compute the fraction allocated to equity: A = 4, E(rM) rf = 8.22%, M = 20.81% (we use the standard deviation of the risk premium from Table 7.4). Then y* is given by:

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y* =

E (rM ) rf 8.22 = = 0.4745 2 0.01A M 0.01 4 20.812

That is, 47.45% of the portfolio should be allocated to equity and 52.55% should be allocated to T-bills. b. If the period 1983 - 2002 is assumed to be representative of future expected performance, then we use the following data to compute the fraction allocated to equity: A = 4, E(rM) rf = 8.38%, M = 16.26% and y* is given by: y* = E (rM ) rf 8.38 = = 0.7924 2 0.01A M 0.01 4 16.26 2

Therefore, 79.24% of the complete portfolio should be allocated to equity and 20.76% should be allocated to T-bills. c. In part (b), the market risk premium is expected to be higher than in part (a) and market risk is lower. Therefore, the reward-to-variability ratio is expected to be higher in part (b), which explains the greater proportion invested in equity.

13.

a. b. c.

E(rC) = 8% = 5% + y(11% 5%) y = C = yP = 0.50 15% = 7.5%

85 = 0.5 11 5

The first client is more risk averse, allowing a smaller standard deviation.

20.

a (0.6 $50,000) + [0.4 ( $30,000)] $5,000 = $13,000

21.

22.

c Expected return for equity fund = T-bill rate + risk premium = 6% + 10% = 16% Expected return of clients overall portfolio = (0.6 16%) + (0.4 6%) = 12% Standard deviation of clients overall portfolio = 0.6 14% = 8.4% 7-4

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