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Department of Finance

FNCE30001 Investments
Semester 2, 2015
Assignment 1: Risk Aversion and Capital Allocation
Note: Solutions will be provided on the LMS for questions with a * next to them. The remaining
questions will be discussed during tutorials, to the extent possible.

PART A
Problem 1*
Chapter 5: questions 5 & 10 on pages 89-90 of Bodie, et al Principles of Investments
P1.1 [Question 5 on page 89 of Bodie, et al Principles of Investments]
Suppose your expectations regarding the share market are as follows:
State of the economy

Probability

HPR

Boom

0.3

44%

Normal growth

0.4

14

Recession

0.3

-16

Use Equation 5.6 to 5.8 to compute the mean and standard deviation of the HPR on shares.
P1.2 [Question 10 on page 90 of Bodie, et al Principles of Investments]
Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be
either $50 000 or $150 000, with equal probabilities of 0.5. The alternative riskless
investment in T-notes pays 5%.
a. If you require a risk premium of 10%, how much will you be willing to pay for the
portfolio?
b. Suppose the portfolio can be purchased for the amount you found in (a). What will the
expected rate of return on the portfolio be?
c. Now suppose you require a risk premium of 15%. What is the price you will be willing to
pay now?
d. Comparing your answer to (a) and (c), what do you conclude about the relationship
between the required risk premium on a portfolio and the price at which the portfolio will
sell?
Problem 2
Chapter 5: questions 11-14, on page 90 of Bodie, et al Principles of Investments

For questions 11-14, assume that you manage a risky portfolio with an expected rate
of return of 17% and a standard deviation of 27%. The T-note rate is 7%.
P2.1 [Question 11 on page 90 of Bodie, et al Principles of Investments ]
a. Your client chooses to invest 70% of a portfolio in your fund and 30% in a T-note cash
fund. What is the expected return and standard deviation of your clients portfolio?
b. Suppose your risky portfolio includes the following investments in the given proportions:
Share A

27%

Share B

33%

Share C

40%

What are the investment proportions of your clients overall portfolio, including the position
in T-notes?
c. What is the reward-to-volatility ratio (S) of your risky portfolio and your clients overall
portfolio?
d. Draw the CAL of your portfolio on an expected return/standard deviation diagram. What
is the slope of the CAL? Show the position of your client on your funds CAL.
P2.2 [Question 12 on page 90 of Bodie, et al Principles of Investments]
Suppose the client in question 11 decides to invest in your risky portfolio a proportion (y) of
his total investment budget so that his overall portfolio will have an expected rate of return
of 15%.
a. What is the proportion y?
b. What are your clients investment proportions in your three shares and the T-note fund?
c. What is the standard deviation of the rate of return on your clients portfolio?
P2.3 [Question 13 on page 90 of Bodie, et al Principles of Investments]
Suppose the client in questions 11 and 12 prefers to invest in your portfolio a proportion (y)
that maximizes the expected return on the overall portfolio subject to the constraint that the
overall portfolios standard deviation will not exceed 20%.
a. What is the investment proportion, y?
b. What is the expected rate of return on the overall portfolio?
P2.4 [Question 14 on page 90 of Bodie, et al Principles of Investments]
You estimate that a passive portfolio invested to mimic the S&P/ASX 200 share index yields
an expected rate of return of 13% with standard deviation of 25%. Draw the CML and your
funds CAL on an expected return/standard deviation diagram.
a. What is the slope of the CML?
b. Characterize in one short paragraph the advantage of your fund over the passive fund.

Problem 3*
Chapter 5: CFA questions 4, 5 & 6 on page 91 of Bodie, et al Principles of Investments
Use the following data in answering CFA problems 4-6.
Utility formula data
Investment

Expected return, E(r)

Standard deviation,

0.12

0.30

0.15

0.50

0.21

0.16

0.24

0.21

Required risk premium=1/2 A 2 where A=4


P3.1 [Question 4 on page 91 of Bodie, et al Principles of Investments]
Based on the formula for required risk premium above, which investment would you select
if you were risk averse with A=4?
P3.2 [Question 5 on page 91 of Bodie, et al Principles of Investments]
Based on the formula above, which investment would you select if you were risk neutral?
P3.3 [Question 6 on page 91 of Bodie, et al Principles of Investments]
The variable (A) in the utility formula represents which of the following?
a. investors return requirement
b. investors aversion to risk
c. certainty equivalent rate of the portfolio
d. preference for one unite of return per four units of risk

Problem 4*
An investment in Acme, Inc. has an expected return of 12.9% and a standard deviation of
18.6%.
a) Calculate the utility level of this investment for three different investors: one with a
risk aversion coefficient of A 1 = 1.5, a second with A 2 = 3.5, and a third with A 3 =
6.0. Use the utility function U = E(r) (0.5)(A)( 2).
b) At what risk-free rate would each investor in part a) be indifferent between investing
either in the risk-free asset or in this (risky) investment?
P

PART B (Due on the week of 3 August)


Problem 5
Chapter 5: Question 6 on page 89 of Bodie, et al Principles of Investments
The shares of Business Adventures sell for $40 a share. The likely dividend payout and endof-year price dependent on the state of the economy by the end of the year as follows:
Dividend

Share Price

$2.00

$50

Normal economy

1.00

43

Recession

0.50

34

Boom

a. Calculate the expected HPR and standard deviation of the HPR if all three scenarios
are equally likely.
b. Calculate the expected return and standard deviation of a portfolio invested half in
Business Adventures and half in Treasury notes. The return on notes is 4%.