IE 460

A. Ravindran

Fall 2014
Homework 11 (Last HW!)
(Due Wednesday, Dec. 10)

Problem 1
An investor is considering two stocks A and B for his portfolio. Table 1 gives the
means and standard deviations (Risk) of the annual returns for the two stocks. The
correlation between the annual returns of A and B is 0.1.
Stock
A
B

Table 1
Return
10%
18%

STD (Risk)
15%
30%

The investor is considering diversified portfolios with proportion in A and (1-) in

B, with 0 < <1.
(a)Whatwilltheaveragereturnandrisk(STD)ofaportfoliowith = 0.5?
(b) If the objectives were to maximize return, what will be the optimal value of
What will be its return and risk?
(c) Find the optimal value of that will define a portfolio with minimum variance.
Formulate the optimization problem and solve by hand. What is the risk and return
of the minimum variance portfolio?
Hint: Cov(A,B) = (correlation)(STDA)(STDB)

Problem 2
XYZ stock is valued at $100 per share. It loses 20% in year 1, gains 20% in year 2 and
gains 10% in year 3. What is total return over the three year period? What is the average
annual return? What is the annualized (compounded) average return? Show all
calculations.
Problem 3
A family-run inn is considering the use of overbooking, because the frequency of noshows listed below has left many rooms vacant during the past summer season. An empty
room represents an opportunity cost of $69, which is the average room rate. However,

accommodating an overbooked guest is expensive because the nearby resort rooms

average $119 and the inn must pay the difference.
No-shows
Frequency

0
4

1
3

2
2

3
1

Determine the optimal number of over bookings for the inn using the Critical Fractile
Criterion. Show all steps.

Problem 4
A ski resort is planning a year-end promotion by offering a weekend special for $159 per
person based on double occupancy. The high season rate for these rooms, which includes
lift tickets, normally is $299. Management wants to hold some rooms for late arrivals
who are willing to pay the season rate. If the number of skiers who are willing to pay full
rate has a normal distribution with a mean of 50 and a standard deviation of 10, how
many rooms should be set aside for full-paying skiers? Show all steps.