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Chapter 08 - Portfolio Theory and the Capital Asset Pricing Model

CHAPTER 8
Portfolio Theory and the Capital Asset Pricing Model
Answers to Problem Sets
1.

a.

7%

b.

27% with perfect positive correlation; 1% with perfect negative correlation;
19.1% with no correlation

c.

See Figure 1 below

d.

No, measure risk by beta, not by standard deviation.

a.

Portfolio A (higher expected return, same risk)

b.

Cannot say (depends on investor’s attitude -toward risk)

c.

Portfolio F (lower risk, same -expected return).


2.


3.

4.

Sharpe ratio = 7.1/20.2 = .351

a.

b.

Figure 8.13b: Diversification reduces risk (e.g., a mixture of portfolios A
and B would have less risk than the average of A and B).
Those along line AB in Figure 9.13a.

8-1

you would achieve as high an expected return as you’d like. of course. Put 25/32 of your money in F and lend 7/32 at 12%: Expected return = 7/32 X 12 + 25/32 X 18 = 16. If you could borrow without limit.   8-2 . See Figure 3 below b. See Figure 2 below a. D.Chapter 08 . A.   5. 15% in C e.7%. standard deviation = 7/32 X 0 + (25/32) X 32 = 25%. G c. F d.Portfolio Theory and the Capital Asset Pricing Model c. with correspondingly high risk.

158 r2 = 0. 4 + (1. a.67 d.031 1 = 0.55 X 4) 5 8.0% c.   8. If interest rate is 4%.3%.095 2 = 0. Lower. Higher.30 X 6) = 5. If interest rate is 4%. r = 4 + (1. False a.237 8-3 . if rate = 6%. False – a security with a beta of zero will offer the risk-free rate of return. r = 6 + (. 7 + 1(5) + 1(-1) + 1(2) = 13% c.Portfolio Theory and the Capital Asset Pricing Model 6.5)(-1) + 1(2) = 15. False – the beta will be: (1/3  0) + (2/3  1) = 0. 9.75 X 6) = 14.41 X 6) = 12. False (it offers twice the market risk premium) c.5%. if rate = 6%. security one is Campbell Soup and security two is Boeing. False – investors demand higher expected rates of return on stocks with more nondiversifiable risk. True b.2% a.75 X 4) = 13.5% b. Then: r1 = 0.0% e. True e.55 X 6) = 7. Campbell Soup: 4 + (. Amazon: 4 + (2.16 X 6) = 17.Chapter 08 .8% d. 7 + 0(5) + 2(-1) + 0(2) = 5% d. a. True   7.5%. 7 + 1(5) + (-1. r = 6 + (1. b. 7% b. c. In the following solution. 10. r = 4 + (.

01822 0.03320 0.1 0.06 .01729 0. we know that for a two-security portfolio: rp = x1r1 + x2r2 p2 = x1212 + 2x1x21212 + x2222 Therefore.74% 4.30% 6.5 0.02422 0.5 0.8 0.4 0.01797 0.03 0.02 0.04 8-4 0.22% 8.86% 9.8 0.05 0.Chapter 08 . we have the following results: x1 1 0.3 0.02422 0.5 0.02078 0.1 0 x2 0 0.3 0.6 0.2 0.03695 0.04575 0.02% 5.06 0.66% 6.38% 5.10% 3.04 0.02515 0.6 0.05 0.08 0.9 1 rp 3.4 0.50%   when  = 0 when  = 0.04 0.94% 7.1 0.06 0.7 0.04294 0.02496 0.02696 0.04912 0.05617 0.03 0.02496 0.02977 0.05617 Return when corr = 0 0.02 0 0.02415 0.58% 8.2 0.7 0.02 0.03763 0.Portfolio Theory and the Capital Asset Pricing Model Further.9 0.02964 0.02028 0.

08 0.1 0.04 0.0 11.15 Expected Return  0.05 0.Chapter 08 .1% 4.03 0.04 0. The best opportunities lie along the straight line. 0. Portfolio 1 2 3  5.0% 9.06 Standard Deviation 8-5 0.06 0.02 0.0 b. The set of portfolios is represented by the curved line.5 0. See the figure below.06 0.06 a. the optimal portfolio of risky assets is portfolio 1.05 0. and so Mr.02 11. From the diagram. c.04 0.4 r 10.04 0. See the figure below. 0.6 6.02 0 0.08 0. The five points are the three portfolios from Part (a) plus the following two portfolios: one consists of 100% invested in X and the other consists of 100% invested in Y.03 0.Portfolio Theory and the Capital Asset Pricing Model Return when corr = .1 .1     0.05 0 0 0. Harrywitz should invest 50 percent in X and 50 percent in Y.

4  20) = 17% Variance = (0. 200 3 200 4 200 5 200 6 200 7 Avera ge Sauros 39.3 14. 5 1.9 1.9 -8.4)(0.5 -3.4 12.08% b. 2 10.2 421.15 4.42  222) + 2(0.6 12.0 77.62  202) + (0.6)(0.36 2.6 14.4 15.7 2.8 108.7 Sharpe Ratio 0.Portfolio Theory and the Capital Asset Pricing Model 12.Chapter 08 . Correlation coefficient = 0  Standard deviation = 14.5)(20)(22) = 327. 0 637.88% Correlation coefficient = –0.8 24.01 1.1 11. His portfolio is better.5 6.6  15) + (0.9 6.8 . The portfolio has a higher expected return and a lower standard deviation.7): TOTA L Deviation from Average mkt return Deviation from Average Sauros return Squared Deviation from Average market return Product of Deviations from Average returns 17.2 -1.3 296.37 3.8 4.04(1/2) = 18.8 8-6 95. a. We can calculate the Beta of her investment as follows (see Table 7.73 4.09 On these numbers she seems to perform worse than the market b.0 2.04 Standard deviation = 327.5  Standard deviation = 10.0 3.6 12.76% c.0 2. Expected return = (0.5 63. 13. a.8 5.4 SD 15.1 442.77 1.6 S&P500 Risk Free 31.5 3.0 1.4 -8.6 18.

4 8-7 .Portfolio Theory and the Capital Asset Pricing Model Market variance Covariance Beta 88.4 1.6 127.Chapter 08 .

5) 0.1 -0.4 time rf net return 2003 200 4 200 5 200 6 200 7 Avera ge 44.710 17.750 0.9 5 -1. c.100 weighted (14.8 20.70 The Sauros portfolio does not generate sufficient returns to compensate for its risk.5 9.5% Campbell’s Soup and 14.4.4 -0.410 22.5% Amazon.4 times market less 0.550 7.0 43.4 at the risk free rate and invest this in the market portfolio.570 5. The Beta of the first portfolio is 0.5.160 0.800 13.800 3.000 3. Expected Return Beta Amazon Dell 2.9% Expected Return Beta Disney Exxon Mobil 0.10 19.2 3 -1.2 6.700 weighted (40. We can devise a superior portfolio with a blend of 85.3 -1.2 17.Portfolio Theory and the Capital Asset Pricing Model To construct a portfolio with a beta of 1.300 22.160 Ford Campbell Soup 1. a.0 22.300 19.960 0.400 weighted (40.Chapter 08 . we will borrow . 85.84 7.60) 0.100 8-8 .714 5.9 20.700 4.858 b.60) 1.1 7. 14.160 1.714 and offers an average return of 5.5 16.900 Amazon Campbells 2.7 -1. This gives us annual returns as follows: 1.

11) 1.591 8-9 17.251 .Portfolio Theory and the Capital Asset Pricing Model weighted (89.Chapter 08 .

04)] = 0. e. c. the investment has a negative NPV.104 = 10.12 – 0.04 = 0. we can find the opportunity cost of capital using the security market line. a.625  x1 = 0.112 = 0. Therefore. a.08 = 8. Again.16)2 x2 = 0.375 8-10 . Market risk premium = rm – rf = 0. the opportunity cost of capital is: r = rf + (rm – rf) r = 0.Portfolio Theory and the Capital Asset Pricing Model 15. 20 15 Expected Return 10 5 0 Beta b.04)   = 0.8%.04)] = 0.12 – 0. In general.8  (0. for a two security portfolio: P2 = x1212 + 2x1x21212 + x2222 (0.0% Use the security market line: r = rf + (rm – rf) r = 0.8.0% d.Chapter 08 .4% and the investment is expected to earn 9.04 + (0. With  = 0. For any investment.10)2 = 0 + 0 + x22(0.4% The opportunity cost of capital is 10.12 – 0.04 + [0. First we find the portfolio weights for a combination of Treasury bills (security 1: standard deviation = 0%) and the index fund (security 2: standard deviation = 16%) such that portfolio standard deviation is 10%. Percival’s current portfolio provides an expected return of 9% with an annual standard deviation of 10%.5  (0.12 – 0.9 16.04 + [1.16 = 16. we use the security market line: r = rf + (rm – rf) 0.

the expected return is: rp = x1r1 + x2r2 rp = (0.11 = 11.10)2 + 2(0.375  0.625  0.04 + [1.115 = 11.0097 P = 0.5% and the standard deviation of his portfolio decreases to 9. His expected return increases to 11.09) + (0. b.16)2 P2 = 0.85% Therefore.06) + (0.14) = 0.5  0.Chapter 08 .14) = 0.04)] = 0.5)(0.16)(0. he can do even better by investing equal amounts in the corporate bond portfolio and the index fund.5)2(0.5  0.2% 8-11 .985 = 9.5)2(0. he can improve his expected rate of return without changing the risk of his portfolio. 17.0% Therefore. With equal amounts in the corporate bond portfolio (security 1) and the index fund (security 2).10)(0.12 – 0.10) + (0.5% P2 = x1212 + 2x1x21212 + x2222 P2 = (0.Portfolio Theory and the Capital Asset Pricing Model Further: rp = x1r1 + x2r2 rp = (0.5)(0.4  (0. First calculate the required rate of return (assuming the expansion assets bear the same level of risk as historical assets): r = rf + (rm – rf) r = 0.85%.152 = 15.

3] + [(1/3)1.0)  (–0.2] + [(1/3)0.6%)] + (0.5  (–0.654 0. but there is no widely accepted theory as to what these factors should be. NPV = -25. the model itself will be of theoretical interest only.0)] +[(1/3)0] + [(1/3)0.0] + [(1/3)1. To be useful. The APT does not specify the factors.754 0.72% 20.84 4.57 4.42 5. a.2)] + [(1/3)0. b. -25.3  5.2)  5.322 0.5] = –0. False.Chapter 08 .50 b3(Yield spread) = [(1/3)(–0.6%)] + [(–0.20 3.4%) + [0  (–0.29 Year 0 1 2 3 4 5 6 7 8 9 10 Cash Flow Discount factor -100 15 15 15 15 15 15 15 15 15 15 1 0.81 8.0  6.0  5.64 NPV 18. True.37 8-12 .568 0. Different researchers have proposed and empirically investigated different factors. d.428 0.493 0. By definition.280 0. the factors represent macro-economic risks that cannot be eliminated by diversification.58% Stock P2: r = 5% + (1. c.29 a. True. If this is impossible.2  6.00 13. we must be able to estimate the relevant parameters.4%) + [0.3] = 0.83 b2(Interest rate) = [(1/3)(–2.4%) + [(–2.243 PV -100.371 0.3  6. 19.39 6. True.21% Stock P3: r = 5% + (0.02 11.1%) = 14. Stock P: r = 5% + (1.868 0.1%) = 11.0] = 0.Portfolio Theory and the Capital Asset Pricing Model The use this to discount future cash flows.52 7. Factor risk exposures: b1(Market) = [(1/3)1.30 9.6%)] + (1.1%] = 11. for whatever reason.

4%) + [(–0.18.6%) + (–0.6%) + (0.2% + (0.50)(–0.836.2% + (0.54  7%) + (-0.6%) + (0.0)/8.50% rBoeing = 0.269 23. along with 12 = 0.731 Therefore: x2 = 0.88% RDow = 0.158) and Boeing be security two (2 = 0.19  5.66  7%) + (01.77  5. for a two-security portfolio: p2 = x1212 + 2x1x21212 + x2222 and: x1 + x2 = 1 Substituting for x2 in terms of x1 and rearranging: p2 = 12x12 + 21212(x1 – x12) + 22(1 – x1)2 Taking the derivative of p2 with respect to x1. b. In general.6%)] + [0.0)/16.152% RJ&J = 0. The beta for Amazon relative to Portfolio A is identical.2%) = 4.91  7%) + (0. we have: x1 = 0. an investor should hold Portfolio A.0 = 0.0)/50.375.2%) = 2.346% 22. 8-13 .2% + (0.9 = 0. Substituting these numbers.659 Therefore.58  3.1%] = 12.15  3. setting the derivative equal to zero and rearranging: x1(12 – 21212 + 22) + (1212 – 22) = 0 Let Campbell Soup be security one (1 = 0.8 – 10.Chapter 08 .2%) = 11.76  5.8 = -0.19  3. 21.237).251 Portfolio B: (10.05  7%) + (–0.5 – 10.4  5.6%) + (-0.04 × 3.2%) = 5.Portfolio Theory and the Capital Asset Pricing Model b.014% rMsft= 0. rP = 5% + (0.2 – 10. The ratio (expected risk premium/standard deviation) for each of the four portfolios is as follows: Portfolio A: (22.031 Portfolio C: (4. a.2% + (1.

8 xy = 60/(80 + 60 – 40) = 0. This portfolio has the following portfolio weights: xx = 200/(200 + 50 – 150) = 2.2 – 5.000.00) – (1.08) = 0.04) + (0.344 Portfolio C: (4.52.6(–1.8 – 5.0% b. 24.62.000.00) = 0 Factor 2: (0. as indicated by the following calculations: Portfolio A: (22.00) – (0.00)] – (0.000.00) = 0 Factor 2: (2.75) + [0.04) + (1. let xx be the portfolio weight of X (and similarly for Investments Y and Z.81.00)] – (1.5 – 5.5(–1.51.091 The results do not change. If the interest rate is 5%.25) + (0.750.6 xz = –40/(80 + 60 – 40) = –0.0% ry = [(–1.75) + [0.0% rz = (2.08) = 0.Portfolio Theory and the Capital Asset Pricing Model c.25) + (0.52.5 xz = –150/(200 + 50 – 150) = –1. respectively).04] + (2.35 Portfolio B: (10. then Portfolio C becomes the optimal portfolio. rx = (1.8 = -0.4 The sensitivities of this portfolio to the factors are: Factor 1: (0. This portfolio has the following portfolio weights: xx = 80/(80 + 60 – 40) = 0.Chapter 08 .00)0.09 = 9.41.5 The portfolio’s sensitivities to the factors are: Factor 1: (2.16 = 16.42.00.9 = 0. a.0)/50.0 xy = 50/(200 + 50 – 150) = 0.00) = 1.00) = 0 Because the sensitivities are both zero. the expected risk premium is zero.80.0)/8. or 8 percent.08) = 0.0 = 0.0 The expected risk premium for this portfolio is equal to the expected risk premium for the second factor.01. 8-14 .12 = 12. Let rx be the risk premium on investment X. c.0)/16.250.

75  0.04) + (0.75) + (xy)(–1.04) + (2.00) = 0.0 xy = 0.08)] + (0.104 = 10.75  0. or 4 percent.00  0. they differ in their sensitivities to factor 2.82.25) + (0.5 The risk premium for this portfolio is: (2. one portfolio with zero sensitivity to each factor is given by: xx = 2.0 Factor 2: (1.08)] + (0.5)[(–1.8 The sensitivities of this portfolio to the factors are: Factor 1: (1.08)] +(5/11)[(–1.5)[(2.0% r2 = (6/11)[(1.14 = 14.00) – (0. The sensitivity requirement can be expressed as: Factor 1: (xx)(1. xx = 0 xy = 0. while each fund has a sensitivity of 0.00  0.2 xz = –80/(160 + 20 – 80) = –0. Two of these are: 1.04) + (2.00  0. This portfolio has the following portfolio weights: xx = 160/(160 + 20 – 80) = 1.04) + (1.2(–1.08)] = 0.Chapter 08 .22.4% These risk premiums differ because.60.04) + (0. e.75) + [0.00) + (xz)(2.5 In addition.16) = –0.00) = 1. Because the sensitivities to the two factors are the same as in Part (b).14) – (1.25  0.5 xz = 0.08)] = 0.08)] +0  [(2.04) + (1. xx = 6/11 xy = 5/11 xz = 0 The risk premiums for these two funds are: r1 = 0[(1.00) = 0 The expected risk premium for this portfolio is equal to the expected risk premium for the first factor.5 to factor 1.50.00  0.6 xy = 20/(160 + 20 – 80 ) = 0.61.00  0.5 2.50. f.00  0.01 8-15 .81. we know that: xx + xy + xz = 1 With two linear equations in three variables.00  0.00)] – (0.25  0.08) + (0. there is an infinite number of solutions.Portfolio Theory and the Capital Asset Pricing Model d.00.5 xz = –1.00  0.

A portfolio with a positive risk premium is: xx = –2. it is clear that the Arbitrage Pricing Theory does not hold in this case.Chapter 08 .5 8-16 xz = 1.5 .0 xy = –0.Portfolio Theory and the Capital Asset Pricing Model Because this is an example of a portfolio with zero sensitivity to each factor and a nonzero risk premium.